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PRIMER

SECURITIZATION

by

2000JUNE

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Thisbookletisacollectionoffoursecurizationarticlespublishedin theCanadianTreasurerMagazine between August 1999andFebruary2000. Itisintendedasatutorialto familiarize corporate issuers(sellers) andinvestorsonthemechanicsand

fundamentalsofsecuritizationinCanada.

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bySCI. SCI is regulatedbySFAfor conduct ofinvestmentbusiness intheUK.U.S.Residents:ScotiaCapital(USA)Inc.,a wholly owned subsidiaryofSCI,acceptsresponsibility forthe contentsherein,subjecttotheterms andlimitationsse toutabove.AnyU.S.person wishingfurtherinformationortoeffecttransactions in

anysecuritydiscussed herein should contact ScotiaCapital(USA)Inc.at212-225-6500.

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In Canada, the top five Schedule 1banks have been in the forefront of se-curitizing their assets in the capitalmarkets. Most readers probably havecredit cards, mortgages or loans fromone or more of the big banks. If you do,theres a real possibility that one of

your loan balances has been sold to a

third party. As the end obligor, youwould never know this, since the bankthat lent you the money would still ad-minister your loan.

Through their investment-dealersubsidiaries, each bank has also estab-lished multi-seller securitization con-duits to assist corporate clients in raisingmoney through the sale of assets.

What is securitization? While thereis no definition in the dictionary, secu-ritization can be described as themonetization of financial a ssets.Such assets can be short-term, such as

trade receivables, or long term, such asresidential mortgages. The sale ofthese assets is considered a true salefor legal purposes, but there are stringsattached, which make the transactionfeel more debt-like.

An alte rna ti ve , mo re tec hn ica ldefinition of securitization is an off-

balance-sheet, fully secured, limited-recourse financing. Although there isan official sale of the assets to a spe-cial-purpose entity, usually a securi-tized trust, the seller usually is givenand maintains a residual interest in theentity. The trust is primarily financedfrom the issuance of notes, which havea senior claim on all assets and thecashflow from the assets. The sellersinterest is subordinated to the seniornotes claim and to all other claimsagainst the trust (i.e. trust expenses,swap costs, etc.).

As a simplified example, lets as-sume that the seller sells $1 MM worthof loans (say, for simplicity, mortgages

with an aggregate principal balance of$1 MM) into the trust, which then is-sues $1 MM of notes into the CP orbond market. The trust turns aroundand pays the seller $950, 000 of thenote proceeds plus a residual note witha $50,000 face value. The amount of

upfront proceeds from the sale de-pends directly on the quality of the as-sets. The rest of the cash remains in thetrust for credit enhancement. Theresidual note also entitles the seller toreceive all excess interest cashflowsfrom the loans and its $50,000 facevalue after all principal has been re-deemed from the other, more seniornotes. This effectively means that theresidual noteholder will be the first tobe affected by losses on the assets andthe last to be paid back its interest andprincipal. (Figure 2 illustrates the

structure.)On a month-to-month basis, the

trust receives all interest and principalpayments from the loans and usesthem to pay down the notes, principalfor principal (that is, the equivalentamount of principal repaid on themortgages is paid down on the noteprincipal). The interest from the assets,being at a higher yield than the coupon(or yield if discounted) on the notes,should be more than sufficient to paydown the notes; the excess interestspread flows back to the seller. The ex-

T C ,

commercial paper and bonds, has grown from just $2 billion

in issued notes at the beginning of the 1990s to over $48 bil-

lion as of February, 1999. This remarkable growth reflects the in-

creasing sophistication of financiers and investors alike in meeting

their objectives. Securitizing assets has enabled corporations to tap

into new, cheap funding sources that do not have the negative im-

pact of leverage on their balance sheets. On the flip side, institu-tional investors have been able to add high-yielding and

high-grade securities to their portfolios in their quest to beat their

performance benchmarks.

FEATURE/SECURITIZATION

A securitization

primer: Part oneIn the first of a four-part series on the fundamentals of securitization,

the author discusses the basic principles of the procedure in theCanadian market.

By Andrew Lin

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CANADIANTreasurer AUGUST/SEPTEMBER 1999 23

cess spread also covers trust expensesand any cashflow shortfall caused by adefaulting mortgagor. If a default oc-curs, it reduces the amount of excessspread cashflow going to the seller orresidual noteholder.

Aside from ancillary expenses, thetrust pays down its funding cost of thenotes over the life of the assets and re-turns the upside to the seller. The mag-

nitude of that upside depends on theassets generating the promised cash-flow. In other words, we hope that theobligors dont default. The extent of thedownside for the seller is its residual in-terest returning nothing. The key hereis that the seller is not obligated tocover losses in the trust above what ithas invested in its residual note.

In effect, its as if the seller is fundinghimself with a loan, at a rate equal tothe trusts funding rate plus some otherexpenses. If the trust is structuredproperly and fairly, the losses on the

loans should affect the residual interestbut not the primary noteholders.Therefore, losses should affect the sell-er in the same way, whether it ownedthe assets or securitized the assets andheld onto a residual note. Since the sell-er is also usually the administrator ofthe assets, its almost as if the seller stillowned the assets and is getting a cheapsource of funding.

What is no t Se cu ri ti za ti on ? Al -though weve established what securiti-zation is, it also makes sense to define

what it is not. In particular, factoring

and secured financing two methodsof raising funds using a companys as-sets may be considered the prede-cessors to securitization.

Factoring is a common term amongmanagerial accountants in troubledcompanies trying to boost cashflow. Itis an outright sale of short-term assets,such as accounts receivable, at a dis-counted price to a third party like a col-lection agency. It is similar tosecuritization, since there is a sale of fi-nancial assets, but it is less efficient.The company retains no interest in the

receivables and no longer controls thecollection of the cashflow, and the dis-count may be significant if the compa-ny is cash-strapped or in distress.

Secured financing is similar to secu-ritization in that a company leveragesits financial assets in raising low-costfunds. Also, the company receives allthe upside of the as sets cashflows.However, the company does not sell theassets; they remain on the borrowersbalance sheet. Unlike securitization,this procedure attracts capital tax andincreases debt and leverage ratios. The

assets are used as collateral only, and, ifthe borrower defaults, secured credi-tors can sue for amounts owing aboveand beyond the value of the collateral.

Securitization evolved from thesetwo forms of raising funds, enablingfirms to accomplish the same goals

without the associated consequences.As with factoring, the company sells as-sets; but it also maximizes sale pro-

ceeds. Like secured financing,securitization is a form of low-cost bor-rowing, but without the negative tax

and debt-leverage effects.Securitizable Assets: Table 1 lists

the most common securitized assets.The main qualities that a portfolio ofassets should have before it can be se-curitized are :

1. Stability of Cashflows: Investorsare essentially buying a set of cash-flows, and therefore, understandably,they want to know with some certainty

when theyll receive those cashflows. Inthe case of securitized bonds, any pos-sibility of variance from the schedule

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will throw off the pricing of the bonds.Prepayment on a loan portfolio is a pri-mary culprit in causing deviations froma set principal amortization schedule.

2. Certainty of Cashflows: Evenmore important to investors than thetiming of the cashflows is whether ornot the cashflows will be realized at all.Therefore, a portfolio of assets beingsecuritized must have an acceptable

level of predicted loan losses that arefully neutralized by the credit enhance-ment mechanisms of the trust.

3. Historical Default and Prepay-ment Data:An abundance of statisticaldata is usually needed as proof that theassets have the two cashflow qualitiesnoted above. Usually, the extremepoints reached in a full business cycleof default and prepayment statistics areused to stress test the securitized truststructure.

4. Large Diversified Portfolio: Usu-ally, the portfolio of assets to be securi-

tized must exceed a certain size interms of number of loans and loanamounts. A widely diversified portfo-lios future default and prepaymentrates will be better correlated to the his-torical experience (all other economicand business variables being the same)than a non-diversified portfolio withasset concentrations of one character-istic or another.

These qualities are not prerequisitesfor securitization, but they make the se-curitization easier to execute and moreefficient for the seller. If the asset does

not have these qualities, then the struc-ture needs more credit enhancement,

which comes at the expense of the sell-er (i.e. the seller might have to fund ahigher reserve and therefore receiveless up-front sale proceeds). If the assetis too risky and the timing of the pay-ment too volatile, then the credit en-

hancement becomes so great that thetransaction is uneconomical.

Assets that generate future cashflowstreams can be placed on a spectrum of

securitizability. Conservative assets

such as mortgages and auto loanswould be at one end (most securitiz-able) and more risky and volatile assets

such as junior oil income trust unitswould appear at the other end (least se-curitizable).

The waterfall: The waterfall defines

the order of cash distributions to thevarious stakeholders of the trust. It setsthe priority of each stakeholder in re-ceiving funds generated by the assets atany time and under any circumstance.Just like a real waterfall that flows downa series of steps, with a little waterbeing trapped at each step, the assetcashflows get distributed in order ofpriority to fulfill various claims. This isdone at the end of each interest-pay-ment period (usually every month)throughout the life of the asset.

Typically, trust expenses such as ad-

ministration fees and trustee fees arepaid first. Next, stand-by fees for liquid-ity lines and/or letters of credit are paiddown. Then swap expenses along withrepayment of principal and interest onvarious classes of notes are paid down,followed by top-up amounts needed tofund any cash reserves in the trust. Theexcess, if any, would then flow back tothe seller. (Alternatively, the trust maybe structured so that excess cashflowflows to the most junior noteholder,

which is often the seller/administrator).There should be sufficient cash

flowing down the waterfall to pay downall expenses to keep the trust runningand all notes that represent the trustscost of funds. Each class of noteholderscan look to the next lower class of note-holders, the excess spread and the re-serve, if any, as credit support.

Andrew Lin, P. Eng., MBA, CFA, is a secu-ritization structuring specialist in theStructured Finance & SecuritizationGroup of ScotiaMcLeod Inc. in Toronto.Part two of this series will appear in thenext issue of Canadian Treasurer.

Figure 2 Typical Securitization Schematic

Seller retains subordinatedInterest ($0.5 MM)

Liquidity agreementand/or Letter of Credit

Swap Agreement withnotional reset option

$1 MM NoteProceeds

TRUST$0.95 MM

proceeds ofnote issuance

$0.5 MM Proceedsof note issuance

R-1 (high) CP Notes($1 MM)Mortgage

Receivables

FinancialInstitution

SwapCounterpartySeller

Money MarketInvestors

Cash ReserveAccount

Figure 1The Securitization Process

Non-investmentGrade

Investment Grade

Seller assets

Loan to value

Spread accounts

Lock-up events

Letter

Liquidity line

Swap

Loans

Conduit

Creditenhanced

MoneyMarket/Bond

Desks

Commercial Paper/Bonds

Table 1: Conventional FinancialAssets Being Securitized in Canada

Auto LoansCredit Card ReceivablesCommercial MortgagesEquipment LeasesMutual Fund Deferred Sales

CommissionsPersonal Lines of Credit BalancesDepartment Store Card BalancesResidential Mortgages

Reverse MortgagesSecured Commercial LoansAuto Leases

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For issuance, there must be suffi-cient liquidity in the market so that the

notes can be rolled over on maturitydates that is, payment can be madeon maturing notes by the successful is-suance of new notes. In addition, thetrust should not be able to expose itselfto market risk. The following threecomponents of credit enhancement,liquidity lines and swaps are three im-portant elements that help to bullet-proof the trust (and therefore, itsnotes) against risk.

Credit Enhancements: The commontheme of all forms of credit enhance-

ments is the increase of the collateralagainst which the notes are secured.This can be done through (1) subordi-nated note tranching, (2) using a de-ferred seller payment to fund a reserve,(3) using the excess interest spread tocover losses and fund a reserve, (4) in-corporating a letter of credit, or (5) im-plementing a lock-up mechanism.

1. Subordinated Note Tranching: Thenotes issued by the securitized trust tofund the purchase of the assets are typ-ically arranged in a hierarchy of classes

with the senior class being by far thelargest. The senior note is rated(or

equivalent by different rating agencies)if in the form of a bond, orR-1 (high) (or equivalent) if in the formof. They are typically supported byone or more subordinated classes; themost junior, the residual note, may bekept by the seller. Each successive classusually has a lower rating than the onepreceding it, and the residual note, atthe bottom, is usually unrated. Themost senior notes have the entiretrusts assets as security for the amountlent, providing them with significantovercollateralization. Similarly, the

next most senior notes have a de-creased amount of overcollateraliza-tion. The residual note has little or noovercollateralization.

2. Deferred Seller Payment for Re-serve: One of the most common meth-ods of providing credit enhancement isby holding back some of the asset saleproceeds. The seller typically receives90% to 99% of the sale price, while therest is held in a reserve account of thetrust. Instead of receiving the rest ofthe cash, the seller receives a subordi-

nated interest in the trust assets, whichentitles it to the contents of the reserveafter all more senior claims on the trusthave been satisfied. This interest issubordinated to all other notes inter-ests and other claims and takes theform of a note, certificate, retained co-ownership interest or even an . Oc-casionally, a seller may wish to sell itssubordinated interest in the form of a

note, so that no component of the se-curitization remains on its balancesheet. However, the market for the sub-ordinated interest is very small inCanada. The residual note is usually arisky asset, being the first note to be af-fected by losses and the last to be paidback its principal.

3. Excess Spread for Losses and Re-serve: Excess interest spread is definedas the difference between the interestrate generated on the securitized as-sets over the cost of funds of the trust -

that is, the weighted average yield onthe notes issued. Alternatively, it canbe seen as the dollar value of the inter-est income over the interest expense.Out of the excess spread are paid theexpenses of the trust. The net excessspread after trust expenses is then usu-ally used to further fund the reserve (ifinitially funded by the deferred sellerpayment), with the rest going to theresidual noteholder.

4. Letter of Credit: A letter of credit isusually used in place of subordinated

S

asset-backed notes. However, timeliness of investment return

is also a critical factor. A securitization structure must not

only guarantee the safety of investors money, but it must also en-

sure that the notes can be paid when due.

FEATURE/RISK MANAGEMENT

A securitization primer:

Part twoHaving explored the basic principles, the second of a four-part series

on the fundamentals of securitization discusses the structural components anddecisions involved in a securitization program

By Andrew Lin

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notes or, if the quality of the assets islow, in conjunction with subordinatednotes, providing collateral to the note-holders, since it would serve as a guar-anteed source of funds from a financialinstitution. It can be drawn upon by thetrust if a shortfall in cashflow from theassets is larger than the excess spreadand the reserve can sustain.

5. Lock-up Mechanism: This mecha-nism works in combination with theexcess spread. When defaults reach acertain level, the trust becomes lockedup so that the residual noteholder nolonger receives any cash, and all cashfrom the excess spread is used to paydown the principal of the noteholdersas quickly as possible. In a lock-up, thefunds in the reserve account are alsoused to pay down note principal. Instructures with several tranches ofnotes outstanding (besides the resid-ual note), most lock-up mechanisms

change the priority between the vari-ous note tranches. All cash is used topay down all interest; then principal onthe most senior note, before any inter-est, is paid on the next most seniornote (which must accrue the interest).Through this payment acceleration,the note liability of the trust decreasesfaster than the assets, creating addi-tional overcollateralization. This is alsoknown as turbo-ing the principal.

Liquidity Lines: CP, not bond issuance,provides liquidity of the notes issued by

the trust. The -based trust rolls over every few weeks or months, eachtime redeeming a small portion of thenotes in proportion to the asset princi-pal being amortized down.

To receive the R-1 (high) rating, itsnot enough that the assets backing thenotes are of the highest quality. In-vestors must also be able to realizetheir return upon the agreed upon ma-turity.

The trust faces a small amount ofuncertainty each time it refinances, asit must find new buyers to purchase the

notes and use the proceeds to pay thematuring notes. A liquidity line is apromise from a financial institutionthat, in the event of a market-wide dis-ruption where the issuance of isntpossible, the financial institution willpurchase the notes so the trust can payits maturing notes.

Interest Rate Swaps: Interest-rateswaps must be applied to the trust ifthe interest income and the interestexpense (cost of funds) of the trust arenot both fixed or both floating. In the

case of the -based securitization,the funding of the trust will always befloating. If the assets are fixed-rate,like mortgages, then it is necessary toincorporate a fixed-to-floating swapfor the principal amount. Similarly, ifthe securitized trust is issuing fixed-rate bonds but has floating-rate inter-est revenue from its asset, then it isnecessary to incorporate a floating-to-

fixed swap for the principal amount ofthe loans.

Interest-rate swaps are generallydone using bankers acceptances (s)as the floating benchmark. This meansthat, even if the trust is overlaid with aswap to fully hedge the fix/floating risk,there still exists the basis risk between and s.The spread has gener-ally been quite stable over the past few

years. It will continue to reflect the dif-

ference in risk between the financialhealth of banking institutions versusCanadian blue-chip corporations.Swap desks at several financial institu-tions and investment dealers have thecapability of overlaying a basis swap tocover the -to-risk, but the cost is

fairly high.

The bottom line on structure: All thecomponents discussed above help tomake the structure robust and givegreater assurance to investors to buythe securities. However, there are coststo each of them. Swap lines may becostly, especially if theyre non-stan-dard (i.e. based on CP instead of BA).Liquidity lines and letters of credit havestand-by fees. Lock-up mechanismsaccelerate the repayment of low-inter-est notes, thereby leaving the trust

funded by the higher-interest notes. Allthese cut into the excess spread goingback to the seller (or residual notehold-er), lowering its return. Investors likethese mechanisms but sellers knowtheyre costly. The bottom-line is that itaffects the bottom line.

9. Other Seller DecisionsThe structural components discussedin the previous section form theessence of a securitization transaction.They determine the quality and the rat-ing of the securities that will be issued

from the trust. However, there are otheraspects of the trust itself that the sellerhas to decide upon. These issues dontaffect the quality of the security that theinvestors hold, but theyre important inthe management of the trust itself.

Term vs. cp: Most trusts will issuepredominantly either or term debt.Some that have multiple tranches mayissue a combination of the two, but

each tranche would likely issue onlyterm or (i.e. senior notes support-ed with subordinated term notes - but

wed consider these trusts, since thesubordinated notes make up a veryminor part of the debt). Some trustshave been structured so oneclass/grade of notes can issue both and term notes, but the managementof these trusts tends to get complicat-ed, especially in a lock-up situation.

In general, its a good idea to struc-ture a -based trust if the assets beingsecuritized are short-term or floating-rate. Conversely, a term-based trust

works better for assets with a longer lifeand low prepayment volatility.

Single-Seller vs. Multi-Seller

Trusts: A single-seller trust is a securi-tized trust designed for one seller andusually for one specific asset of thatseller. A multi-seller trust, usually runby an investment dealer that also dis-tributes the securities, contains poolsof different assets that have been soldby different sellers. Each has its own de-gree of credit enhancement dependingon the quality of the pool. The identi-ties of the sellers are not publicly dis-closed, although the type of assets inthe trust is. This anonymity is impor-tant to the sellers, who view their secu-

ritization activities as a competitiveadvantage in their industry. Whereasthe single-seller trust is customized to aclient of a certain size, the multi-sellertrust is a standardized conduit forclients large or small. Table 1 outlinesthe main differences.

Andrew Lin, P.Eng., MBA, CFA, is a secu-ritization structuring specialist in theStructured Finance & SecuritizationGroup of ScotiaMcLeod Inc. in Toronto.Part three of this series will appear inthe next issue of Canadian Treasurer.

Multi Seller Single Seller

Lower up-front costs Flexibility, but more costlyAnonymity / Confidentiality Public ProfileCP-based only Ability to issue term debt as well as CPInvestors buys the Program, not Greater administration requirementsindividual deals for the Seller

Table 1 : Trust Types

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FEATURE/RISK MANAGEMENT

DECEMBER 1999 / JANUARY 2000

Depending on the size and com-plexity of the transaction, investment

bankers, the main facilitators andmanagers of the transaction, may askfor a structuring fee above and be-

yond the distribution fee that theirdealer networks would charge to dis-tribute the asset-backed paper intothe capital markets.Lawyers fees can add be-tween $50,000 and severalhundred thousand dollars,depending on the com-plexity of the structure andthe uniqueness of the fi-nancial asset, since every

detail must be reflected inthe legal documentation.Other third-party fees candouble this amount.

Lastly, since the seller usually con-tinues to be the administrator of thesecuritized assets, ongoing adminis-trative activities must be performedfor the life of the securitization. Thesold assets must be tracked and man-aged separately from the rest of thecompanys assets, with regular report-ing to the trustee and other third par-ties. This may demand modifications

to corporate information systems,which may place a burden on systems

resources.

SO WHY SECURITIZE?

Each potential seller makes a quantita-tive and/or qualitative assessment of

the benefits derived from asecuritization and weighsthem against the transac-tion and on-going costs. Ifthe benefits outweigh thecosts, then it makes sensefor the securitization to pro-ceed. The benefits are var-

ied, but usually involve thefollowing:

M ax i mi z at i on o f P ro ce e ds :Sometimes companies just need to sellassets to raise money. Perhaps thecompany is in distress; perhaps itsprofitable but faces a tempoXrary cashcrunch because its growing too fast. Orperhaps the company just thinks it canrealize a better return in some other in-vestment with cash raised from theasset. In many cases, securitization isthe most efficient way of monetizing a

financial asset such as a loan or mort-gage. A lender may consider such anasset to be somewhat illiquid, since itcant simply call its loan or liquidatethe collateral to which its secured. Ithas the rights only to a future cashflowstream unless the borrower breachesthe loan agreement. The market for thefinancial asset may also be illiquid ifthe assets potential buyers are alsocompetitors who arent inclined to ac-commodate the seller. Securitization

addresses these hurdles by giving acompany access to buyers in thebroader capital markets.

Although most sellers are healthy,on-going concerns, one can see how areceiver/liquidator of a bankruptcy

would be especially attracted to secu-ritization instead of selling at dis-tressed prices. Credit-rating agenciesfactor heavily on the performance ofthe assets instead o f the company.During the early 1990s, the ResolutionTrust Corporation () in the U.S. wasgiven the mandate to sell the commer-

cial mortgage assets of hundreds ofdefunct savings & loans companies. Byamassing pools of good mortgagesand securitizing them, the pio-neered the commercial mortgage-backed security () market.Instead of selling the mortgages atbargain-basement prices in the

whole-lo an market, the tappedinto the debt capital markets by sellingcertificates backed by large pools ofcommercial mortgages. It could createthe market because it had a criti-cal mass of securitizable assets. Such

P ,

structurally challenging. A working group of professionals

from within the seller organization, along with the invest-

ment bankers/dealers, lawyers, internal and external accountants

and auditors, rating agencies, trustees, consultants and other third

parties can make for expensive meetings if theyre being paid by

the hour.

A securitization primer:

Part threeAfter reviewing the basic principles of securitization and the structural components of asecuritization program in two previous articles, this installment explains why sellers undertake

the exercise in the first place and why buyers are attracted to securitized assets.

by Andrew Lin

In many cases,securitization isthe most effi-cient way of

monetizing a fi-nancial asset

such as a loan ormortgage

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critical mass provided sufficient assetdiversification to back the securitiesand enough pools ofs to create aliquid secondary trading market bothelements being critical factors in an in-stitutional investors decision to buythe security. B al an ce S h ee t a nd I nc om eStatement Impact: Just as important asmaximizing sale proceeds are the ef-

fects of the securitization onthe financial statements ofthe seller. You will recall thatsecuritization results in atrue sale for accounting andtax purposes, even thoughthe seller continues to ad-minister the assets. If theseller uses the proceeds topay down outstanding debt,both assets and liabilities de-crease by the same amount,resulting in de-leveraging.This improves the debt/eq-

uity ratio of the seller.Securitization can also affect the

bottom line, so that the income state-ment shows a reduction in capital taxand a gain on the sale of the asset. TheLarge Corporations Tax is a federal taxon Canadian companies based on apercentage of their total capitalization.By reducing the debt or equity out-standing with the securitization pro-ceeds, the capital base of the companydecreases and, therefore, capital taxalso decreases. Note that, for financialinstitutions, the law is slightly different.

In the case of financial institutions,capital tax is generally based on itsshare capital.

In addition to , Canadian compa-nies are also taxed on their capital atthe provincial level, with the rate vary-ing depending on the jurisdiction.Together, and provincial capital taxcan add 50 to 90 basis points (pre-tax)to the cost of funding with on-balance-sheet debt.

Note that Schedule I and II banks arethe exception to the rule here as well.Banks face a more onerous hurdle than

other financial institutions. A bank canrecognize the gain only if it holds no re-tained interest in the transaction.Otherwise, it can recognize that gainonly when the retained interest cash-flow is realized.

Capital Relief for Banks: Given theextra hurdles imposed on banks to gainthe benefits of securitization, the con-cept shouldnt seem attractive. YetCanadas largest banks have recentlybeen the leading securitizers in thecountry. The reason becomes apparent

when we analyze what securitizationdoes for the capital adequacy ratios ofthe banks that is, their risk-weightedratios or Tier 1 and Tier 2 ratios. TheOffice of the Superintendent ofFinancial Institutions (), the regu-latory agency for banks and other fi-nancial institutions, has provided thatall deposit-taking banks must set asidea certain amount of equity capital as a

percentage of the assets(mostly loans) that bankshold. Therefore, if a bank

wants to make more loans,it has to issue more stock orotherwise let its capital ade-quacy ratios decline. Sincesecuritization officially re-moves assets from the bal-ance sheet and shifts riskfrom the banks depositorsto the securitization vehi-cles investors, it increasesthe banks capital adequacy

ratios, thereby creating capital relief forthe bank.

Reduced Cost of Funding: For manysmall to mid-sized companies, securiti-zation can offer the least expensivesource of funding. A small car-leasingcompany facing a line of credit from abank at the prime rate plus somespread could turn to securitizing itsauto leases and face an effective fund-ing rate of the going commercial paper() rate plus some spread for the pro-gram fee of a multi-seller conduit.

Alternative Source of Funding: Forbanks and large companies with invest-ment-grade credit ratings, the cost ofraising funds in the or bond marketscompared to securitization depends ona combination of short-term rates,long-term rates, credit spreads, swapspreads and set-up costs. However,even at times when on-balance-sheetborrowings are more attractive, somefirms may choose to securitize to diver-sify their funding sources. Throughsuch a strategy, a company avoids a

cash crunch if one market or anotherfaces a liquidity crisis, as in August1998, when credit spreads increaseddramatically in the bond markets.

C on du it St ra te g y: Lastly, somecompanies securitize not to raise fundsby selling financial assets but to enablethem to put more of the same assets ontheir books. A financing company, forexample, faced with limited sources offunds, can continually originate loansand subsequently securitize them intoa trust serving as a conduit. The com-

pany can make profits on the differen-tial in the interest income from theloans versus the cost of funds of the se-curitization. It can also earn feesthrough the management and adminis-tration of the loans, while keeping itsorigination and administration staffemployed.

WHY INVESTORS BUY

Weve discussed the many and complexreasons that sellers securitize assets. Incontrast, the reasons that investors buysecuritized assets are much simpler.Portfolio managers tend to look for newnames to put into their portfolios be-cause of concentration limits imposedon them by their mandates. Securitiesissued by a trust backed by assets soldby a bank would be considered to be adifferent borrowers debt in a portfoliothan the direct debt of the same bank,since the trust is an arms-length third

party to the bank. This helps the in-vestor achieve the goal of portfolio di-versification. In the money market,asset-backed programs usually havegreater flexibility in maturity dates in

which investors may want to buy tobalance their portfolio or take an inter-est-rate view.

By far the greatest reason for buyingis the extra yield that the notes offer. Inthe competitive bond market, whereeven the passive index outperforms amajority of active portfolios, investorsare keen to invest in high-grade instru-

ments paying a premium over conven-tional securities of the same rating. Inthe money market world, money man-agers not only have to beat their perfor-mance benchmark, but at the sametime, execute cash-management dutiesof the corporate treasury. As a result,the manager faces two conflicting ob-

jectives: providing liquidity for day-to-day cash needs while still trying torealize a decent return on the funds.

R-1 (high) asset-backed commercialpaper issued by multi-seller conduitshave recently been issued at 8-10 bps

over BAs, which are rated only R-1(mid). Recently AAA-rated credit-card-backed five-year bonds have been trad-ing at about the same spread over

AA-rated senior bank paper of the sameterm.

Investors continue to be offered se-curitized notes of a higher rating at thesame or higher spreads than the under-lying banks own paper of a lower rat-ing. Why does this inconsistencypersist? In the past, the illiquidity asso-ciated with the private-placement na-ture of the securities and a large supply

Securitizationofficially re-

moves assetsfrom the

balance sheetand shifts risk

from the banksdepositors tothe securitiza-tion vehicles

investors

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18 CANADIANTreasurer

from banks and other financial institu-tions contributed to the situation. Bothfactors have diminished in importance.Most issues are now public securities,and issuances have moderated.

However, the most significant rea-son for the reluctance of investors to

wholeheartedly embrace securitizationis the structural complexity of thenotes. After all, the concepts are not

easy to understand. The life of the trustis usually limited to the life of the as-sets. It winds down instead of being areal going concern that is, a corpora-tion with products, management strat-egy and growth prospects. Creditsupport in the structure isdetermined by historicaldata, with a large dose ofcomplex statistical analysis.Some portfolio managershave stated that theydrather put their money in areal corporation, with all the

risk involved, than intowhat they perceive to be ablack box.

As wi th all new ass etclasses, time and experi-ence are the best educators.Sellers and structurers are respondingto investor concerns of transparency todemystify the black box for investors.Over time and with greater acceptanceand understanding, we can expectspreads on securitized paper to narrow.In the meantime, portfolio managers

who dare to educate themselves on the

structures of securitizations havefound a way of enhancing return andbeating their benchmarks.

FUTURE ASSETS TO BESECURITIZED

As if the present set of securitization of-ferings on the market werent enough tosatisfy investor demand, several struc-tured bonds have recently been done,and there are others on the horizon thatuse the cutting edge of securitizationtechniques. These include:

Bonds backed by Single-ObligorPayment Streams: The assignment ofsingle-obligor payment streams to backa structured bond is not, strictly speak-ing, a securitization, but it uses securi-tization techniques to achieve similargoals. In this scenario, a company or or-ganization with an investment-gradecredit rating that doesnt want an assetand the associated debt (which wouldbe incurred to buy the asset) on its bal-ance sheet would set up a trust to ac-quire the asset instead of buying the

asset itself. Then the company wouldlease the asset from the trust. At thesame time, the trust would issue bondsin the capital markets to raise the nec-essary funds to acquire the asset. Thesebonds would be backed by an assign-ment of the lease cashflows comingfrom the lessee. Since the lease obliga-tion would rank parri passu with anyother general obligation or debt of the

lessee, the lease-backed bond shouldhave the same credit rating as thelessee.

The concept of single-obligor leasesecuritization, or Credit Lease bond, isnot a new one and has been used by

commercial landlords foryears to raise money by issu-ing private-placement notesbacked by the long-termleases of major, high-creditcorporate tenants or bypledging the rental streamas security for bank loans.

Now this concept has beenextended to governmentsand corporations for the ac-quisition of all kinds of long-term, infrastructure-typeassets, and they are execut-

ed in the public capital markets.Milit-Air, the Toronto Hospital and

Borealis Infrastructure Trust have all is-sued bonds secured by federal orprovincial governmental payments. InMay 1998, Milit-Air was formed to pro-vide aircraft, flight simulators and otherequipment and facilities to train fighter

pilots for the Canadian Air Force andthe military of other allied countries aspart of the Flying Training inCanada () program. It issuedbonds backed by 20-year pilot tuitionpayments by the Canadian governmentfor the use of the facilities. In November1998, the Toronto Hospital issuedbonds secured by payments from theProvince of Ontarios Ministry of Healthto fund a major redevelopment andrenovation project, although there wasno lease obligation by the Province inthis case. Very recently, in June 1999,

Borealis issued bonds backed by theProvince of Nova Scotias lease pay-ments for the use of a group of newschools. The proceeds were used tofund the development of those schoolsfor use by the government. Lastly, sev-eral railway companies in North

America (including and ) have en-tered into long-term leasing agree-ments to use rail cars and locomotives,financed by asset-backed bonds (in avariation called a synthetic lease).

In the cases involving leasingarrangements, the lessee does not pro-

vide a guarantee on the bonds.However, the structure imposed onthem through the terms of the lease,and the assignment of the rights of thelessor with regard to the lease to thebondholders, make the obligation ofthe bond effectively that of the lessee,

without having to state it on the lesseesbalance sheet.

In the single-obligor lease structure,

the conventional securitization con-cept of diversification as a primary riskmitigant is absent. In its place is thegood underlying credit of the lesseebacking the debt. In conventional secu-ritizations, the vast majority of the debtissued in each case is rated R-1 (high)or AAA, with such notes being credit-enhanced by some small amount oflower-rated subordinated notes orother mechanisms. In the single-oblig-or lease structure, the rating of the

whole debt is usually the same as thatof the underlying lessee. However, the

common theme of both this new struc-ture and the conventional structure isthe fundamental concept of packaginga future cashflow stream into an assetto back a debt security.

Intellectual Property Rights: Backin the conventional world of securitiza-tion, investment bankers and corporatelawyers are searching to find new and

wonderful asset classes to securitize.The emerging class of intellectual prop-erty rights has turned into the newfrontier of modern securitization prac-

tice. Intellectual property rights, from afinancial point of view, can be consid-ered to be any creation or discoverythat can be legally copyrighted orpatented and can generate a futurecashflow stream. This group includesmusic royalties, publication rights andpatent rights.

In addition to nerdy number-crunchers, even David Bowie has got-ten into the securitization act. Thepopular singer securitized the futureroyalty stream from his catalogue ofpast recordings in a securitized bond

DECEMBER 1999 / JANUARY 2000

In addition tonerdy number-crunchers, evenDavid Bowie has

gotten into thesecuritizationact.

In Los Angeles, they talk the

language of the 21st century. In

Cologne or Strasburg, the

argument revolves around the

35-hour week, retirement at 50,

and who gets what subsidy.

Paul Johnson, The Spectator

Did you know?

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CANADIANTreasurer DECEMBER 1999 / JANUARY 2000 19

offering in 1996. These Bowie Bondswere rated A and had a principal size ofUS$55 million. In comparison, a rela-tively small collection of non-financialcorporations in Canada are rated A orabove.

The extent of Bowies work and thefuture royalty stream associated with iteasily justified the size of the issue. Youmay also recall from one of the previous

issues that one of the important char-acteristics of a securitizable asset is asteady, predictable cashflow stream.The track record of Bowies record salesis unparalleled in this area. His IggyStardust album has generated a steadystream of sales, year in and year out, forthe past two decades. Its this kind ofstrong statistical payment pattern in

which investors take comfort. In a nut-shell: Bowie has staying power one ofthe unique and necessary ingredientsin the securitization of music royaltystreams.

If that isnt enough to reaffirm thecoolness of securitization, JamesBrown, the godfather of soul, recentlyannounced that he, too, will securitizehis music royalty stream. (Asked whathe felt about securitizing his music, heis suspected to have replied Ah FEELGOOD!).

Related to music royalty streams, butnot as glamorous, are royalty streamsfrom books and novels by authors suchas Tom Clancy and publishers such asSimon & Schuster. Securitizing publica-tion royalties may be easier than music

royalties, because publishers usuallyhave large catalogues of books to whichthey own the rights. (Many authors sellownership of their books to the publish-ing companies because of cash con-straints). Therefore, publishers mayhave the widely diversified portfolio ofassets needed for securitization. Notethat although Bowie and Brown mayhave large portfolios of songs that

would fit a securitization, not many en-tertainers do. Similarly, very few indi-vidual authors can claim to have a largeenough portfolio of work to be consid-

ered diversified but most major pub-lishers do.

Lastly, patent rights, especially asthey pertain to drugs, may become thenext big securitizable asset class. Smallbiotechnology companies spend mostof their money on . By the time acompany brings its drug through thetesting stage to regulatory approval, itmay have little money left to marketand mass-produce it. A biotech firmmust often work in partnership with alarge pharmaceutical company to prof-it from its discovery. Securitization

would allow the firm to tap into a newsource of funding and gain a greatermeasure of independence.

Securitizing drug patents does havesome drawbacks. For one thing, it

wouldnt fit the usual criteria of a secu-ritization. The asset would have nocashflow track record, and the poten-tial cashflow stream could be quitevolatile. There would also be very little

diversification, as the biotech firmwo uld not likely have many mar-ketable drugs in its portfolio at any

particular time to be securitized.Despite these drawbacks, you can beassured that there will be great securi-tization potential for a blockbusterdrug, such as an vaccine, theminute that its announced.

Andrew Lin, P.Eng., MBA, CFA, is a secu-ritization structuring specialist in theStructured Finance & Securitization

Group of ScotiaMcLeod Inc. in Toronto.Part Four of this series will appear in thenext issue of Canadian Treasurer.

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CANADIANTreasurer FEBRUARY/MARCH 2000 11

Transparency and Reporting: Investorsneed to understand what theyre buy-ing. In the past, they have voiced strongconcerns that the securitization struc-tures that back the notes are big blackboxes. Although they understand thegeneral structure of the trusts that holdthe assets and protects their interests,the governing legal documentationsuch as the trust indentures or the mas-ter co-ownership agreements, together

with the financial models, are often theproprietary property of the sellers.

Information on the on-going perfor-mance of the trusts is also difficult toobtain. Monthly servicer reports revealscant information or are not widely dis-tributed to the public.

Although most investors simply lookto the credit rating agencies to monitorand assess the health of on-going secu-ritizations, more tenacious investors dotheir own homework. They prefer notto rely on third parties such as ratingagencies that have no legal liability toinvestors in their published ratingopinions. They look for variances be-

tween expected and actual prepay-ments and losses, levels of cash re-serves for credit enhancement and thedegree that swap positions taken by thetrust are in or out of the money to as-sess counterparty risk. These investors,as portfolio managers, answer to theirclients and investment committees

who may be wary about investmentssuch as securitizations that are not in-tuitive. They need this type of informa-tion to perform the analysis to defendtheir investment decisions.

Sellers have been reluctant to dis-close all details about the assets thatthey have sold into securitizations andthat they are still administrating. This isespecially true for private companiesthat have low levels of reporting and dis-closure responsibilities. Such informa-tion could be considered competitiveinformation. Delinquency and loss dataon loan assets could reflect upon thesellers underwriting competency.Recognition of gains on sales may leadto criticisms of aggressive accounting bycompetitors. Instead, sellers have tradi-

tionally used rating agencies to monitortheir securitizations and to give theirstamp of approval to investors.

However, sellers are increasingly ac-knowledging the need of investors formore disclosure. They are preparingmore detailed information on theirmonthly servicer reports and addinginvestors to monthly mailing lists attheir request. With the sellers permis-sion, several investment dealers arepublishing monthly reports summa-

rizing the performance of the securi-tized trusts and increasing the level ofdisclosure. In multi-seller conduits,

where anonymity is one of the mainadvantages for the sellers, the monthlyreports will not likely reveal their iden-tity. But the reports usually give moreinformation on the make-up of theasset classes in the conduits and theperformance of each class.

With increasing transparen cy, in-vestors will gain greater comfort inbuying securitizations. This should re-sult in greater demand for asset-

backed products and tighter spreads incapital markets.

Non-Investment Grade/Non-Sequen-tial Bond Tranches: In the money mar-kets, securitizations have generallybeen well accepted because of the highlevel of safety inherent in short-term,high-quality commercial paper.Interest-rate risk (i.e.the hedging offixed-rate assets funded by floating-rate CP) and prepayment risk on the se-curitized assets are generally placed

with other parties such as swap coun-

A

both participate. Buyers must be convinced that the under-

lying asset backing the security is a good one, that the

trusts credit-enhancement structure is sufficient to protect their

interests, and that the incremental return on the security is worth

their while. Securitizers (sellers) must also believe that the transac-

tion is worth their time, that they will receive an attractive price for

the assets sold into the trust, and that they will receive the neces-

sary accounting and tax treatments as a result of the transaction.

A securitization primer:

Part four Issues facing theindustrySeveral issues of concern to buyers and sellers of securitized assets have to be

resolved before the market will live up to its full potential.

By Andrew Lin

FEATURE/CAPITAL MARKETS

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12 CANADIANTreasurer FEBRUARY/MARCH 2000

terparties, liquidity lenders or the selleritself. By contrast, a securitization in thebond market usually passes on theserisks onto the bond investor, making therisk/return analysis more complex.

Where as a CP securi tization mayraise the bulk of its financing (i.e. 90% ormore) in R-1 (high) notes, a complexbond securitization, say a CMBS (com-mercial mortgage-backed security),

may raise a lower amount (i.e. 75%) intriple-A bonds (usually because of thegreater credit risk of the underlyingasset). The rest of the bond financing

would be in subordinated sequentialtranches spanning the range of ratingsfrom AA to B (or lower). Each tranche

would typically pay down its principalsequentially (in order of seniority), andeach would enhance the credit of thetranches more senior to it. However, un-like the U.S. market, which has moredepth and breadth, the Canadian mar-ket for non-investment grade (i.e. below

BBB) bonds in Canada is very small.Sellers often must sell the non-invest-ment grade tranches at a huge discountor keep the notes themselves, an optionthat jeopardizes the argument that thesecuritization is a true sale.

To add to the complication, theremay be non-sequential tranches, suchas an interest-only tranche, to deal withthe excess spread from the assets. In theU.S., where multiple bond tranching ofsecuritization is more advanced, thereare even innovative tranches, such as aJump-Z tranche or companion tranch-

es, both of which are designed to dealwith un ex pe ct ed prepay me nt s th atwould otherwise adversely affect thereturn of the sequential tranches.These more exotic instruments are rarein Canada because of the mark etsmuch smaller size and the more con-servative nature of Canadian investors.

Nevertheless, this lack of investor in-terest in non-investment grade andnon-sequential bond tranches will notprevent the Canadian securitizationmarket from maturing. Other innova-tions will likely materialize to accom-

modate the distinct nature of Canadiancapital markets, perhaps through de-rivatives or increased credit enhance-ments, which will mitigate the risksthat Canadian investors try to avoid.

Risk Transference and Capital Relief:The previous two sections dealt withinvestor-oriented issues, but sellersalso have on-going concerns about se-curitization. One of the tasks that a sell-er must face is convincing its auditorthat the sale of its assets is a true sale foraccounting purposes. The seller usually

retains a residual interest in the securi-tization for credit enhancement of thestructure. The greater the interest, thegreater the support to the structure andthe easier it becomes to sell the rest ofthe securitization to investors.

The problem is that the greater thesupport given by the seller, the greaterthe risk that the auditor will not regardthe transaction as a sale. The auditor

could conclude that there has been notransfer of risk to the buyer (the trust)and, therefore, there is no actual sale.From a Canadian GAAP perspective,the prime test of a true sale is a transferof the beneficial interest in the asset,

with the seller retaining the lesser of:(1.) a 10% interest, or (2.) whatever isconsidered reasonable to show truetransference of the risk and rewards ofownership. The seller could meet thiscriterion by showing that the size of itsresidual interest would be completelyoffset by predicted losses on the asset

The investors concern with this ar-gument is that it doesnt allow muchroom for a margin of error before theirinvestments are affected. If the sellerprovides only a minimal credit en-hancement to satisfy the auditors, in-vestors will have less interest in thenotes of the securitization. The key instructuring a securitization is findingthe enhancement level that balancesthe interests of the seller, the auditorand the investors.

Banks have an additional risk-trans-ference problem when it comes to rat-

ing agencies. The banks, asdeposit-taking institutions, mustachieve acceptable capital adequacylevels. OSFI, the regulatory agency forfinancial institutions, acknowledges abanks sale of assets under a securitiza-tion, accepting the resulting increase inthe banks capital ratios, thereby pro-viding the bank with capital relief.However, rating agencies generally donot view securitization so positively.

Although the bank may show a true saleand risk transference from an account-ing point of view, rating agencies, in

most cases, will not agree that signifi-cant risk has really been transferred.The rating agencies feel that, in mostsecuritizations, the seller is transferringonly catastrophic risk and this is notsufficient risk to warrant off-balancesheet treatment. In such cases, ratingagencies mitigate the effects of securiti-zation, adding back all or most of theassets to its balance sheet before calcu-lating capital ratios. Thus, the banktends not to receive capital relief for itsefforts in its credit rating.

Rating agencies would recognize the

securitization as a true sale of assetsonly if the bank sold off its residual inter-est in the securitization and relin-quished its role of servicer (which wouldlikely go to the new owner of the residualinterest), thereby disassociating itself to-tally from the securitized assets. This

would be difficult for the bank, sincebuyers of residual interests are rare andit would not likely want to extricate itself

from the administration of the assets,since no one else would be able to ad-minister the assets as efficiently).

Legal Rights and BankruptcyRemoteness: The last topic in this arti-cle is the independence of the trust andits assets from the seller. Officially, thetrust is an independent third party fromthe seller. Officially, the trust owns theassets, although the seller is often hiredby the trust as the servicer of the assets.This means that, if the trust is dis-pleased with the servicing of the assets

or if the seller/servicer goes into bank-ruptcy, the trust has the right and au-thority to transfer the assets to anotherservicer. If this were to happen, allobligors of the loans (the assets) wouldbe notified and instructed to send theirpayments to the new administrator.

This presents a concern. If the sellerin bankruptcy administers the assets ofthe trust, the assets may be deemed tobelong to the seller and may be consoli-dated with the sellers remaining assets,leaving the noteholders of the trust asgeneral creditors of the seller. This con-

cern was allayed in the initial bankrupt-cy hearing, in 1997, of Eatons. Eatonshad securitized its credit-card receiv-ables in a trust. The trust continued touse Eatons as the servicer, becauseEatons was inextricably linked with thecredit-card operations. But the trust ob-tained a court ruling that the credit-card receivables belonged to the trustand therefore were not to be consolidat-ed with the assets of Eatons, thus pro-tecting them from the stores creditors.

This ruling upheld the robustness ofthe trust and the validity of the securiti-

zation structure. However, the courts todate have issued only this single prece-dent, and each ruling must look to thelegal documentation of the trust to de-termine the validity of its third-partynature. Only time and more bankrupt-cies will tell if securitization is as robustas we think it is.

Andrew Lin, P.Eng., MBA, CFA, is a secu-ritization structuring specialist in theSpecialized Finance Group of ScotiaCapital Inc. in Toronto. This is the finalinstallment of a four-part series.

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TrademarkofTheBankofNovaScotia. ScotiaCap italIn c.authori zeduserof themark. TheScotia Capita ltradema rkrepresentsthecorporateandinvestmentbankingbusinessesofTheBankofNovaScotia,ScotiaCapitalInc.andScotiaCapital(USA)Inc.-allmembersoftheScotiabankGroup.

Innovative,customizedfinancingsolutions for Canadiancorporationsand government-relatedinstitutions.

The Securitization Team

Structuring:

TransactionFinance:

Research:

Canadian MoneyMarkets:

DavidSantangeli (416)862-3118 david_santangeli@scotiacapital.com

JohnKidd (416)863-7982 john_kidd@scotiacapital.com

KelsonYang (416)862-3119 kelson_yang@scotiacapital.com

GregSmith (416)862-3207 greg_smith@scotiacapital.com

Mike Smith (416)863-7018 mike_smith@scotiacapital.com

LarrySmall (416)862-3185 larry_small@scotiacapital.com

DavidAdamo (416)863-7600 david_adamo@scotiacapital.com

Roger Quick (416)863-7236 roger_quick@scotiacapital.com

DarcyDoherty (416)863-7259 darcy_doherty@scotiacapital.com

GuyLancaster (416)945-4145 guy_lancaster@scotiacapital.com

GregLawrence (416)862-3032 greg_lawrence@scotiacapital.com

Andrew Lin (416)863-7815 andrew_lin@scotiacapital.com

ThomasKurfurst (416)862-3177 thomas_kurfurst@scotiacapital.com

Doug Noe (416)945-4060 doug_noe@scotiacapital.com

Robert Bose (416)862-4537 robert_bose@scotiacapital.com

PaulaCruickshank (416)945-4490 paula_cruickshank@scotiacapital.com

IrisYeung (416)945-4579 iris_yeung@scotiacapital.com

Robert Chu (416)945-4634 robert_chu@scotiacapital.com

PamFord (416)863-7081 pam_ford@scotiacapital.com

Robert Follis (416)945-4865 robert_follis@scotiacapital.com