Necessary Ingredients and Benefits of Asset Securitization

The Eight Necessary Ingredients Benefits of Asset Securitization

The Eight Necessary Ingredients

In view of the experience in the development of the U.S. asset securitization 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 the growth of others. But the important thing is that they all have to develop simultaneously.

Asset Securitization: Theory and Practice Dr. Joseph Hu

Legal Framework
For each asset securitization transaction, an airtight legal arrangement has to set up to guard the investor interest in the underlying assets. Most important, the law has to protect the investor against any other claim on the cash flow of the securitys underlying assets when the originator/seller is in bankruptcy. 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 funds for the origination of the underlying loans.

Asset Securitization: Theory and Practice Dr. Joseph Hu

Legal Framework
As mentioned earlier, an SPE, being a bankruptcy-remote entity, has no other assets other than the loans acquired from the lender, and has no other liabilities other than those associated with the issued security. Additionally, there has to be legal arrangement to define the duties and responsibilities of the issuer, the trustee, the custodian of the pool of assets, and the servicer of the security.

Asset Securitization: Theory and Practice Dr. Joseph Hu

Cash Flow Analysis

From a financing point of view, securitization is in essence enabling the lender to obtain the cash that is equivalent to the present 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 conduct the cash flow analysis to ensure that the obligation of the SPE can be paid in a full and timely manner. In analyzing and pricing the future cash flow, many assumptions are being made. In addition to the assumed discount rate for the present value calculation, the analysis requires the assumptions on the behavior of the cash flow, such as economic scenarios during the life of the underlying assets, borrowers propensity to repay the loans, and incidence of default.

Asset Securitization: Theory and Practice Dr. Joseph Hu

Cash Flow Analysis

Actually, the discount rate may not be randomly assumed. As will be mentioned later in the discussion of an active secondary market, the yield of similarly securities currently traded in the secondary market is usually selected to approximate the discount rate. Only on the basis of in-depth analysis of the historical cash flows of a vast amount of underlying assets can all the cash flow assumptions be made realistically.

Asset Securitization: Theory and Practice Dr. Joseph Hu

Accounting Treatment
Three accounting issues are critical in asset securitization. The first is the tax treatment of the interest income of the security. Since the security is issued by the SPE and it has interest income from the underlying loans, it supposedly will be taxed. But taxation at the SPE level would render the securitization uneconomical because the interest income to the investor of the security 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 exempted from federal taxation. (For tax purposes, the issuing entity can also adopt the owners trust status.)

Asset Securitization: Theory and Practice Dr. Joseph Hu

Accounting Treatment
The second issue is the protection for the investor in terms of a clear accounting of interest and principal of the periodic cash flow from the underlying loans. Typically, for each transaction, there is a cash-flow waterfall. The waterfall clearly spells out how the monthly interest and principal cash flow is allocated among all the participants of a transaction. Based on this waterfall, the servicer of the security needs to inform the investor about the components of the monthly cash flow and the part of the cash flow that is taxable versus nontaxable. There also has to be clear accounting of the sequence of various expenses of securitization and payments to the trustee, the custodian, and the servicer.

Asset Securitization: Theory and Practice Dr. Joseph Hu

Accounting Treatment
Third, all cash flows have to be tied out by the accountant for the transaction. All interest and principal of the underlying assets under various scenarios as calculated by the issuer (or the investment banker on behalf of the issuer) have to be tied as they are specified in the offering memorandum and the prospectus of the transaction.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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 the security would naturally be concerned with the credit risk of the underlying assets as well as the security. For example, for most of RMBS, the credit is guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac. To the extent that the credit of RMBS or CMBS and ABS are not guaranteed by either one of them, the credit of a security needs to be enhanced through various mechanisms. In general, as discussed last week, credit enhancement can be structured in terms of a senior/subordinate (or overcollateralization) cash flow structure, corporate-parent guarantee, surety bonds, and letter of credit. Depending on how each or a combination of the above four mechanisms is structured, the credit of the security often needs to be rated by one or tow or all three credit rating agencies.
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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 intermediary connecting the issuer and the investor. However, during the entire process of securitization, the investment banker performs many critical functions. It entails coordinating and helping with the issuer to deal with the legal, the accounting, the taxation, and the analytical cash-flow aspects of the security. After all that work, the investment banker acts as a dealer by setting the price of the security, purchasing the entire issuance of the security, and distributing it to the investor. After this dealer function, the investment banker also provides liquidity for the security by making the market through actively interaction in buying and selling the security in the secondary market.
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Government Debt Market

In order to have a healthy securitization market, it is necessary to have a sound government debt market. Since government securities are free of credit risk, the trading of government debt securities establishes the market level of risk-free yields of various maturities. This credit-risk free relationship between maturities and yields is call Treasury yield curve. This yield curve therefore provides the appropriate benchmarks for the pricing of initial offers and the subsequent secondary-market trading of all other fixed-income securities of various maturities that entail various degrees of credit risk. All non-government fixed-income securities trade at some yield spreads over the Treasury yield curve.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Active Secondary Market

A successful primary market for the issuance of securities requires the support of an active secondary market. The secondary market provides information on how a to-be-issued similar security should be priced. For asset-backed securities, there is a quick way of distinguishing the primary versus the secondary market. A primary market is where new securities are issued. It is where issuers deal with investors. A secondary market is where investors deal with investors. In both markets, the middlemen are investment bankers.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Active Secondary Market

Once the security is issued, the investor needs an active secondary market to provide liquidity so that the security can be bought and sold without much price volatility caused by factors not related to interest rates. But here it is important to mention that 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 the security in the secondary market, it needs the cooperation of the investor. If the investor simply hoard the security after the primary issuance and not willing to ever trade the security, it would be very difficult for the investment banker alone to maintain an active secondary market.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Active Secondary Market

Since asset securitization involves many aspects of lenders originating consumer or commercial loans and in turn selling these loans in the form of asset-backed securities to investors, it is critical at the outset to distinguish the definition and the function 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 the market where lenders interact with borrowers. Consumer loans are originated in a primary market by lenders to finance a great variety of consumptions. They include, but not limited to, automobile loans (auto loans), credit cards, manufactured housing loans, student loans, and home equity loans. Lenders have various ways to obtain the funds to originate the loans.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Active Secondary Market

Once these loans have been originated, lenders have the option of keeping them in their portfolios or selling them to other lenders or investors. The trading (sale and purchase) of loans is conducted in a secondary market where lenders interact with other lenders or investors. Functions. From their definitions, the primary market is to originate loans and to the extent that the loans need to be selffunded not by loan originators, the secondary market is to provide the funding of the loans. The primary and the secondary markets 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 lenders or investors. The trading (sale and purchase) of loans is conducted in a secondary market where lenders interact with other lenders or investors.
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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, ranging from short-term money market investors, to commercial bank portfolio managers, to long-term pension fund managers. Additionally, foreign investors are increasingly important, as the capital markets have turned increasingly global. Actually, the remarkable development of the market can be attributed to the innovative design of the asset-backed securities themselves.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Variety of Investors
Through maturity tranching and credit tranching, asset-backed securities were able to meet the demands of a great variety of investors. The higher-yielding feature of asset-backed securities attracted yield-oriented investors. The maturity tranching allowed asset-backed securities to attract maturity-oriented investor who otherwise could not purchase these 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.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Benefits of Asset Securitization

To summarize the discussion of the previous weeks in terms of the economics of asset securitization, two distinct benefits can be 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 borrowing cost of loans.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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Lowering the Borrowing Cost of Loans

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

15.00 14.00 13.00 12.00 Mortgage Rate (%) 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

360

Spread Mt Tsy

330 300 270 240 210 180 150 120 90 60 30 0 Spread (basis point)

Source Federal Reserve System

Asset Securitization: Theory and Practice Dr. Joseph Hu

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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 and thrifts, securitization allows them to originate loans without having to fund the loans through expanded long-term liabilities. They can behave just like mortgage bankers. The bottom line of securitization for lenders is that long-term, or even short-term, loans can be originated with even shorter term funding. This avoids any potential balance-sheet maturity mismatching by selling the newly originated loans through securitization. It significantly reduces the funding costs of originating loans and the benefit of lowered funding costs is passed on to borrowers.
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Effective Balance Sheet Management

From the viewpoint of balance-sheet management, securitization is an asset sale. It allows lenders to originate loans and earn origination fees without expanding their balance sheets. Not having to portfolio the newly originated loans, lenders do not have to expand liabilities to fund the loans. Carrying the concept a step further, securitization enables portfolio lenders to efficiently manage balance sheets by selling new and existing (seasoned) loans. As the asset side of the balance sheet is reduced through securitization, lenders can correspondingly reduce their liabilities. This enhances the efficiency of lenders use of capital.

Asset Securitization: Theory and Practice Dr. Joseph Hu

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