asset securitization by hu

7/30/2019 Asset Securitization by Hu

1/22

Necessary Ingredients and Benefits ofNecessary Ingredients and Benefits ofAsset SecuritizationAsset Securitization

The Eight Necessary Ingredients

Benefits of Asset Securitization


2/22

Asset Securitization: Theory and PracticeDr. Joseph Hu

2

The Eight Necessary Ingredients

In view of the experience in the development of the U.S. assetsecuritization market, eight factors contributed to the success of

the market. They are: legal framework cash flow analysis accounting treatment credit risk evaluation investment banking government debt market

active secondary market variety of investors

These factors oftentimes have been complementary to one

another. The development of one factor contributed to thegrowth of others. But the important thing is that they all have todevelop simultaneously.


3/22


3

Legal Framework

For each asset securitization transaction, an airtight legalarrangement has to set up to guard the investor interest inthe underlying assets. Most important, the law has to protectthe investor against any other claim on the cash flow of thesecuritys underlying assets when the originator/seller is inbankruptcy.

Thus, for each securitization transaction, a bankruptcy-remote

special-purpose entity is established.

The economic purpose of the SPE is on the one hand to

purchase all the loans that are originated and sold by the lender;and on the other, issue security to the investor to raise fundsfor the origination of the underlying loans.


4/22


4

Legal Framework

As mentioned earlier, an SPE, being a bankruptcy-remote entity,has no other assets other than the loans acquired from thelender, and has no other liabilities other than those associatedwith the issued security.

Additionally, there has to be legal arrangement to define theduties and responsibilities of the issuer, the trustee, thecustodian of the pool of assets, and the servicer of the security.


5/22


5

Cash Flow Analysis

From a financing point of view, securitization is in essenceenabling the lender to obtain the cash that is equivalent to thepresent value of the future cash flow of the underlying assets,after netting out necessary costs of securitization.

At the outset of securitization, it is critical for the issuer to conductthe cash flow analysis to ensure that the obligation of the SPEcan be paid in a full and timely manner.

In analyzing and pricing the future cash flow, many assumptionsare being made. In addition to the assumed discount rate for thepresent value calculation, the analysis requires the assumptions

on the behavior of the cash flow, such as economic scenariosduring the life of the underlying assets, borrowerspropensity to repay the loans, and incidence of default.


6/22


6

Cash Flow Analysis

Actually, the discount rate may not be randomly assumed. Aswill be mentioned later in the discussion of an active secondarymarket, the yield of similarly securities currently traded in thesecondary market is usually selected to approximate the discountrate.

Only on the basis of in-depth analysis of the historical cashflows of a vast amount of underlying assets can all the cash flow

assumptions be made realistically.


7/22


7

Accounting Treatment

Three accounting issues are critical in asset securitization. Thefirst is the tax treatment of the interest income of the security.Since the security is issued by the SPE and it has interest incomefrom the underlying loans, it supposedly will be taxed.

But taxation at the SPE level would render the securitizationuneconomical because the interest income to the investor of thesecurity will also be taxed. To avoid the double taxation, if the

SPE can satisfy all the requirements of being a grantor trust,then it will granted a grantor-trust status that it is legally exemptedfrom federal taxation. (For tax purposes, the issuing entity canalso adopt the owners trust status.)


8/22


8


The second issue is the protection for the investor in terms of

a clear accounting of interest and principal of the periodic cashflow from the underlying loans.

Typically, for each transaction, there is a cash-flow waterfall.The waterfall clearly spells out how the monthly interest andprincipal cash flow is allocated among all the participants of atransaction. Based on this waterfall, the servicer of the security

needs to inform the investor about the components of the monthlycash flow and the part of the cash flow that is taxable versus non-taxable.

There also has to be clear accounting of the sequence ofvarious expenses of securitization and payments to the trustee,the custodian, and the servicer.


9/22


9


Third, all cash flows have to be tied out by the accountant for

the transaction. All interest and principal of the underlyingassets under various scenarios as calculated by the issuer (or theinvestment banker on behalf of the issuer) have to be tied as theyare specified in the offering memorandum and the prospectus ofthe transaction.


10/22


10

Credit Risk Evaluation

Since the lender is issuing a security that is backed by a pool of

consumer or commercial loans it origins, the investor of thesecurity would naturally be concerned with the credit risk of theunderlying assets as well as the security. For example, formost of RMBS, the credit is guaranteed by Ginnie Mae, FannieMae, or Freddie Mac. To the extent that the credit of RMBS orCMBS and ABS are not guaranteed by either one of them, thecredit of a security needs to be enhanced through variousmechanisms.

In general, as discussed last week, credit enhancement can bestructured in terms of a senior/subordinate (or over-

collateralization) cash flow structure, corporate-parentguarantee, surety bonds, and letter of credit. Depending onhow each or a combination of the above four mechanisms isstructured, the credit of the security often needs to be rated by

one or tow or all three credit rating agencies.


11/22


11

Investment Banking

The underwriting and the distribution of a newly issued

security are the responsibilities of the investment banker.The investment banker can be viewed as an intermediaryconnecting the issuer and the investor. However, during theentire process of securitization, the investment banker performsmany critical functions. It entails coordinating and helping withthe issuer to deal with the legal, the accounting, the taxation, andthe analytical cash-flow aspects of the security.

After all that work, the investment banker acts as a dealer bysetting the price of the security, purchasing the entireissuance of the security, and distributing it to the investor.

After this dealer function, the investment banker also providesliquidity for the security by making the market through activelyinteraction in buying and selling the security in the secondarymarket.


12/22


12

Government Debt Market

In order to have a healthy securitization market, it is necessary to

have a sound government debt market. Since governmentsecurities are free of credit risk, the trading of government debtsecurities establishes the market level of risk-free yields ofvarious maturities.

This credit-risk free relationship between maturities and yields iscall Treasury yield curve. This yield curve therefore provides

the appropriate benchmarks for the pricing of initial offers and thesubsequent secondary-market trading of all other fixed-incomesecurities of various maturities that entail various degrees ofcredit risk. All non-government fixed-income securities trade

at some yield spreads over the Treasury yield curve.


13/22


13

Active Secondary Market

A successful primary market for the issuance of securities

requires the support of an active secondary market. Thesecondary market provides information on how a to-be-issuedsimilar security should be priced.

For asset-backed securities, there is a quick way of distinguishingthe primary versus the secondary market. A primary market iswhere new securities are issued. It is where issuers deal

with investors. A secondary market is where investors dealwith investors. In both markets, the middlemen are investmentbankers.


14/22


14


Once the security is issued, the investor needs an active

secondary market to provide liquidity so that the security canbe bought and sold without much price volatility caused by factorsnot related to interest rates. But here it is important to mentionthat to a great extent the investor has the ability to create an

active secondary market.

As mentioned early, while the investment banker has the moral

responsibility to make markets by actively buying and selling thesecurity in the secondary market, it needs the cooperation ofthe investor. If the investor simply hoard the security after theprimary issuance and not willing to ever trade the security, it

would be very difficult for the investment banker alone to maintainan active secondary market.


15/22


15


Since asset securitization involves many aspects of lenders

originating consumer or commercial loans and in turn sellingthese loans in the form of asset-backed securities to investors, itis critical at the outset to distinguish the definition and thefunction of the primary market versus the secondary market

of these loans.

Definitions. In the context of consumer or commercial loans, a

primary market is where these loans are originated. It is themarket where lenders interact with borrowers. Consumer loansare originated in a primary market by lenders to finance a greatvariety of consumptions. They include, but not limited to,

automobile loans (auto loans), credit cards, manufacturedhousing loans, student loans, and home equity loans. Lendershave various ways to obtain the funds to originate the loans.


16/22


16


Once these loans have been originated, lenders have the option

of keeping them in their portfolios or selling them to other lendersor investors. The trading (sale and purchase) of loans isconducted in a secondary market where lenders interact withother lenders or investors.

Functions. From their definitions, the primary market is tooriginate loans and to the extent that the loans need to be self-

funded not by loan originators, the secondary market is to providethe funding of the loans. The primary and the secondarymarkets therefore rely heavily on each other to function well.Once these loans have been originated, lenders have the option

of keeping them in their portfolios or selling them to other lendersor investors. The trading (sale and purchase) of loans isconducted in a secondary market where lenders interact withother lenders or investors.


17/22


17

Variety of Investors

One ultimate factor required for a successful development an

asset securitization market is the growth of an investor base.This base needs to cover a large variety of investors, rangingfrom short-term money market investors, to commercial bankportfolio managers, to long-term pension fund managers.

Additionally, foreign investors are increasingly important, as thecapital markets have turned increasingly global.

Actually, the remarkable development of the market can beattributed to the innovative design of the asset-backedsecurities themselves.


18/22


18

Variety of Investors

Through maturity tranching and credit tranching, asset-backed

securities were able to meet the demands of a great variety ofinvestors. The higher-yielding feature of asset-backed securitiesattracted yield-oriented investors.

The maturity tranching allowed asset-backed securities to attractmaturity-oriented investor who otherwise could not purchasethese securities due to maturity-mismatch of their investment

requirement.

The credit tranching made asset-backed securities appealing to

credit-oriented investors who by law can only invest securities

with investment-grade credit.


19/22


19

Benefits of Asset Securitization

To summarize the discussion of the previous weeks in terms of

the economics of asset securitization, two distinct benefits canbe cited:

effective balance-sheet management for the issuer

broadening of the mix of investment for the investor.

For consumers, the ultimate benefit is the lowering the borrowingcost of loans.


20/22


20

Lowering the Borrowing Cost of Loans

Monthly Spread of 30-Year Mortgage Rates to 10-Year Treasuries,1983 to 2008

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

15.00

Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

SourceFederal Reserve System

Mortgage

Rate(%)

0

30

60

90

120

150180

210

240

270

300

330

360

Spread(basispoint)

Spread

Mt

Tsy


21/22


21

Effective Balance Sheet Management

Through most of the past twenty years, securitization has greatly

benefited not only lenders but also borrowers and investors.These benefits actually reinforce one another.

From the viewpoint of depository lenders such as banks andthrifts, securitization allows them to originate loans without havingto fund the loans through expanded long-term liabilities. Theycan behave just like mortgage bankers.

The bottom line of securitization for lenders is that long-term, oreven short-term, loans can be originated with even shorter termfunding. This avoids any potential balance-sheet maturity

mismatching by selling the newly originated loans throughsecuritization. It significantly reduces the funding costs oforiginating loans and the benefit of lowered funding costs ispassed on to borrowers.

Eff i B l Sh M


22/22


22

Effective Balance Sheet Management

From the viewpoint of balance-sheet management, securitization

is an asset sale. It allows lenders to originate loans and earnorigination fees without expanding their balance sheets. Nothaving to portfolio the newly originated loans, lenders do not haveto expand liabilities to fund the loans.

Carrying the concept a step further, securitization enablesportfolio lenders to efficiently manage balance sheets by selling

new and existing (seasoned) loans. As the asset side of thebalance sheet is reduced through securitization, lenders cancorrespondingly reduce their liabilities. This enhances theefficiency of lenders use of capital.

asset securitization by hu

Documents