Chapter One The Expanding Frontiers of Asset Securitization Dr. Cary Lin

Introduction  『 Securitization 』  What is asset securitization  Primary goal of asset securitization  Advantages of securitization for issuers  Investment attributes of asset-backed securities  Concerns raised by securitization

What is Asset Securitization? Asset securitization: the pooling and transformation of homogeneous cash flow producing, illiquid assets, loans and receivables, and issuing credit-enhanced marketable securities (claims) backed by assets --- Asset Backed Security or ABS. In this definition a security is a financing in which the originator is not the investor and a loan is a financing in which the originator is the investor. Securitization separates the originator from the ultimate investor Asset securitization is structured financing: it combines features of traditional lending system and securities system.

Asset-Backed Securities Asset-Backed Securities (ABS) are debt or equity instruments which:  Represent interest in a pool of assets sold by originator into SPV  Typically secured by homogeneous assets with relatively predictable cash flows  Assets are legally separated from the seller/originator, limiting investor exposure to the seller/originator bankruptcy  Credit enhancements leading to high credit ratings  Structured Finance

Sample of Securitized Assets  Residential Mortgage (Mortgage-Backed Securities)  Commercial mortgages (CMBS)  Non-Mortgages Credit card receivables Auto loans Student loans Trade receivables Heath Care receivables

Special Purpose Vehicles  SPV is the operating mechanism of asset securitization – must provide organizational framework for securitization – must isolate the assets from originators – must achieve “ true sale ” of assets – must not engage in business activities that would make it subject of bankruptcy proceeding – to sum up, SPV must be a bankruptcy-remote and bankruptcy proof entity – so, SPV is essentially the linchpin in asset securitization

Goals of Asset Securitization  Primary goal: To obtain credit rating for an issuance backed primarily on the quality of the securitized assets and any credit enhancements backing the obligation without regard to originator ’ s own creditworthiness  to remove assets from balance sheet (off balance sheet) and then further to boost return on assets and return on equity  to channel alternative sources of funding  to improve leverage ratio

Originators: Commercial banks Finance companies Special Purpose Vehicle (Special Purpose Trust Special Purpose Company) Credit Enhancer: (Insurance company, Banks, Internal guarantee, Government entity Obligors Investors: loan transfer Credit enhancement securitization Servicer: Commercial banks Finance companies Corporations

Advantages of Securitization for Issuers  New and cheaper cost of funding  Management of regulatory capital  Book fee income up-front in lieu of spread income  Management of Interest rate volatility

Advantages of Securitization for other Players  Credit Enhancer receives fee for credit enhancement pays only when normal losses are exceed  Servicer  servicing fee income  float income  servicing rights can be sold

Advantages of Securitization for other Players (Cont.)  Trustee fee income to administer the trust Increased capital market recognition  Investor  high quality liquid investment  ABS provides qualifying investments for institutional investors  high credit quality rating stability

Troublesome Problems  Window Dressing  Moral Hazard  (Adverse Selection)