Lecture 3: Securitisation ( Culp. P.304-8) and Sathye et al (2003), Credit Analysis and Lending Management, Wiley, pp.252-55

– Securitisation is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security

– Process by which an asset (or asset pool) is divested via the sale of securities which are collateralized by the cash flow on the original asset (pool)

Securi’n: The process

Sec’n in Australia

> Assets commonly securitised include– Loans (mortgages, home equity, motor vehicles

etc)– Receivables (credit card receivables, computer

leases, aircraft/watercraft/equipment leases, etc)• Mortgage-backed securities(MBS) and Asset-backed

Securities (ABS)• This is done for capital management, liquidity

management and interest rate risk management• Characteristics of assets that can be securitised

-

MBS issuers

Types of assets to sec’ed

The assets must have high quality cash flows ( that is, low probability of default) E.g. Home loans

- The must have same risk ( e.g. home loan)- They must have insurance• Following types of assets can be securitised• Asset having high-quality cash flows and low probability

of debt•

Types

• Two types of securitisation structures: pass through structures and pay through structures

• These depends on the purpose of securitising lending assets

A. Pass Through Structures : 1. Stable Pool:• There is owner of the lending assets • There is special-purpose vehicle (SPV)

through which assets are sold completely• A trustee/manager that manages the assets

and their cash flows

Contd

• The manager receives cash inflows from the lending assets

• Example: principal and interest payments would be received via the lending institution and be passed them onto the investor

• The trustee/manager invests surplus cash flow to maintain value of the assets

Contd

• 2. Dynamic pools- They have assets with maturities shorter than the actual

securitisation structure- As cash flows come from the lending assets, the

trustee/manager invests them to maintain the value of the pool.

B. Pay Through Structure- Not much different from pass through structure except

asset ownership.- Lending institutions do not sell the assets- They package the cash-flows into SPV such as credit

card receivables

Securitisation and credit risk management

• It is important that there is no legal recourse ( claim back) to the lending institution if the securitised loan default. If such provision is not included, the lending institution is in risk

• If assets are sold at deep discounts then there is risk of liquidity. That is, lending institution may suffer from liquidity problem.

• To manage such credit risk, fair value for the credit should be received

Contd

• If the borrowers are informed that their loans are sold to SPV, it may affect the relationship between the lender and the clients ( specially corporate one)

• This problem is overcome by assigning the assets to SPV which means that title remains with the lending institution.

• Credit derivatives can serve as an alternative

Other risks

• Liquidity risk– shortfalls or timing differences in cash flow from

assets in pool may prevent security payments from being serviced on schedule

• Interest rate risk– Risk of losses arising from mismatched assets

(pool) and liabilities (securities• Sponsor/structuring agent

– Initiator of securitisation• Originators

– Companies selling assets to SPV

Collaterised Debt Obligations (CDOs)

• It is ABS• Initially, all the cash flows from a CDO's

collection of assets are pooled together. This pool of payments is separated into rated tranches. Each tranche also has a perceived (or stated) debt rating to it.

• The highest end of the credit spectrum is usually the 'AAA' rated senior tranche. The middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings and the lowest junk or unrated tranches are called the equity tranches. Each specific rating determines how much principal and interest each tranche receives

Various Tranches( Slices)

Structure of Tranches

• The 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments. As such, it has the most predictable cash flow and is usually deemed to carry the lowest risk. On the other hand, the lowest rated tranches usually only receive principal and interest payments after all other tranches are paid. Furthermore they are also first in line to absorb defaults and late payments.

Contd

• This is the most basic model of how CDOs are structured. CDOs can literally be structured in almost any manner, so CDO investors can't presume a steady cookie-cutter breakdown. Most CDOs will involve mortgages, although there are many other cash flows from corporate debt or auto receivables that can be included in a CDO structure.

Who Buy CDOs ? Why ?

• Insurance companies, banks, pension funds, investment managers, investment banks and hedge funds are the typical buyers. These institutions look to outperform Treasury yields, and will take what they hope is appropriate risk to outperform Treasury returns. Higher returns when the payment environment is normal and when the economy is normal or strong. When things slow or when defaults rise, the flip side is obvious and greater losses occur.

CDOs- Why?

• The existence of these debt obligations is to make the aggregate loaning process cheaper to the economy. The other reason is that there is a willing market of investors who are willing to buy tranches or cash flows in what they believe will yield a higher return to their fixed income and credit portfolios than Treasury bills and notes with the same implied maturity schedule.

Risks of CDOs

• Unfortunately, there can be a huge discrepancy between perceived risks and actual risks in investing. Many buyers of this product are complacent after purchasing the structures enough times to believe they will always hold up and everything will perform as expected. But when the credit blow-ups happen, there is very little recourse. If credit losses choke off borrowing, credit crunch begins

Importance of CDOs

• If loans cannot be carved up into tranches the end result will be tighter credit markets with higher borrowing rates.This boils down to the notion that firms are able to sell different cash flow streams to different types of investors. So, if a cash flow stream cannot be customized to numerous types of investors, then the pool of end product buyers will naturally be far smaller. In effect, this will shrink the traditional group of buyers down to insurance companies and pension funds that have much longer-term outlooks than banks and other financial institutions that can only invest with a three- to five-year horizon.

Credit derivatives (CD)

• Credit derivatives (CD)CD is a credit risk management techniqueThere are 2 parties : protection buyer (bank) who transfer risks and protection seller (Insurance companies) who assumes riskThree CDs: credit default swap , total return swaps and credit optionsCredit default swap acts like an insurance policy. Against a periodic fee, protection seller pays an agreed amount in case a credit event such as bankruptcy, credit rating change, loan default borrower and changes in credit spreads

Contd

– The protection seller (PS) pays residual value (difference between face value and market value of the assets)

– Total return credit swap (TRCS) deals with entire economic interests in particular credit or portfolios of loans. Under TRCS, PS pays the bank or protection buyer any loss in market value of the reference loan. If market value increases more than agreed value, PS will receive the residual.

– There is fee equivalent to LIBOR or BBSW (average bank bill rate)

– Credit option acts like normal options

CAT Bond

• Insurance companies would like to enter into capital market with new products such as catastrophe (CAT) Bond.

• Some investment banks such as Munich Re ( reinsurance ) are setting up reinsurers to develop alternative risk financing deals such as CAT Bond

• Cat bonds pay a higher interest or coupon rates than straight bond

Contd

• The principal ( face value) owed at maturity may be reduced or lost if specific catastrophe such as flood occurs. If there is no catastrophe, face value will be returned.

• CAT Bond can be structured in a number of ways. There can be zero CAT Bond which is sold at a discount and no coupon is paid

• CAT Bond may attach specific loss rate and if losses exceed a certain threshold, bondholder may not get anything.

• Investment banks can underwrite or trade CAT Bonds in the capital market, but classical risk (insurance) products cannot be sold in the capital market

Tutorial Questions

• 1. Explain the concept of securitisation• 2. Distinguish pass through structures and pay

through structures• 3. Discuss the characteristics of securitised

assets• How does securitisation help credit risk

management• Discuss the importance of securitisation of

insurance risk through CAT Bond

Contd

• What is CDOs? Why is it required ?• What is the difference between CDOs

and Securitisation ?• How are CDOs used for risk

management ?• How is credit crunch related to narrower

secondary mortgage markets ?