1. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall.1 CHAPTER 27 Market For Asset-Backed Securities

2. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 Learning Objectives How asset-backed securities are created The basic structure of a securitization The parties to a securitization The primary motivation for a corporate to raise funds via a securitization The role of the special purpose vehicle The different types of structures: self-liquidating and revolving 2

3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 Learning Objectives (continued) The various forms of credit enhancement The cash flow characteristics of the major types of asset-backed securities not backed by residential mortgage loans The credit risks associated with asset-backed securities The role of securitization in financial markets 3

4. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4 CREATION OF AN ABS An asset-backed security (ABS) is a security created by pooling loans other than residential prime mortgage loans Assets subject to securitization come in two types: existing assets and receivables to arise in the future There are two types of securitizations, existing asset securitization and future flow securitization 4

5. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5 CREATION OF AN ABS (continued) The originator originates the loans or receivable that is later securitized The loan or receivable is subject to the underwriting standards of the originator To securitize the assets, the originator creates a legal entity called a special purpose vehicle (SPV), which receives the assets in an arms-length transaction between the originator and the SPV 5

6. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6 CREATION OF AN ABS (continued) The Parties to a Securitization A securitization may involve a conduit that buys the loans and securitizes them There is also a trustee for the securities issued with responsibility of representing the interests of the bond classes 6

7. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7 CREATION OF AN ABS (continued) Transaction Structure There may be various tranches of securities Nonagency MBS are credit enhanced All ABSs are credit enhanced Enhancement levels are determined relative to a specific rating desired 7

8. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 CREATION OF AN ABS (continued) Role of the SPV There are four principal reasons why a corporation may elect to raise funds via a securitization rather than a corporate bond –Potential for reducing funding costs –Diversify funding sources –Accelerate earnings for financial reporting purposes –Potential relief from capital requirements 8

9. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 CREATION OF AN ABS (continued) Credit Enhancement Mechanisms The most common form of credit enhancement is bond insurance, referred to as a surety bond or a wrap Most securitizations that employ internal credit enhancements follow a predetermined schedule that prioritizes the manner in which principal and interest generated by the underlying collateral must be used 9

10. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 CREATION OF AN ABS (continued) Credit Enhancement Mechanisms This schedule is known as the cash flow waterfall, or simply the waterfall. The cash flow that remains after all of the scheduled periodic payment obligations are met is the excess spread 10

11. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 COLLATERAL TYPE AND SECURITIZATION STRUCTURE Amortizing versus Nonamortizing Assets The collateral for an ABS can be classified as either amortizing or non-amortizing Amortizing assets are loans in which the borrower’s periodic payment consists of a scheduled principal and interest payment over the life of loan (an amortization schedule) 11

12. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 COLLATERAL TYPE AND SECURITIZATION STRUCTURE (CONTINUED) Amortizing versus Nonamortizing Assets The standard residential mortgage loan falls into this category. Auto loans and certain types of home equity loans are amortizing assets Non-amortizing assets do not have a schedule for the periodic payment that the individual borrower must make 12

13. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13 COLLATERAL TYPE AND SECURITIZATION STRUCTURE (continued) Amortizing versus Nonamortizing Assets A non-amortizing asset is one in which the borrower must make a minimum periodic payment, such as credit card receivables and home equity loans When amortizing assets are securitized, the collateral is fixed over the life of the structure 13

14. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14 COLLATERAL TYPE AND SECURITIZATION STRUCTURE (continued) Amortizing versus Nonamortizing Assets This is called self-liquidating structure For nonamortizing assets, for a period of time referred to as the lockout period or revolving period, all principal received is used to purchase new collateral Hence, new assets are being added to the collateral, and this structure is referred to as a revolving structure 14

15. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15 COLLATERAL TYPE AND SECURITIZATION STRUCTURE (continued) Amortizing versus Nonamortizing Assets After the lockout period, called the amortization period, principal received is distributed to the bond classes 15

16. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16 COLLATERAL TYPE AND SECURITIZATION STRUCTURE (continued) Fixed Rate Versus Floating Rate There are fixed-rate and floating-rate asset- backed securities Floating-rate asset-backed securities are typically created where the underlying pool of loans or receivables pay a floating rate 16

17. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17 COLLATERAL TYPE AND SECURITIZATION STRUCTURE (continued) Fixed Rate Versus Floating Rate The most common are securities backed by credit card receivables, home equity line of credit receivables, closed-end home equity loan with an adjustable rate, student loans, Small Business Administration loans, and trade receivables 17

18. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18 MAJOR ASSET CLASSES SECURITIES Credit Card Receivable-Backed Securities For credit card receivable asset-backed securities, interest is paid monthly and the principal is not amortized Instead, the principal payments made by credit card borrowers are retained for a period of time known as the lockout period or the revolving period 18

19. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19 MAJOR ASSET CLASSES SECURITIES (continued) Credit Card Receivable-Backed Securities After the lockout period, the principal is paid back to investors during the principal- amortization period. If the credit quality of an issue deteriorates, there are provisions for earlier amortization of the principal These provisions are known as early amortization or rapid amortization 19

20. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20 MAJOR ASSET CLASSES SECURITIES (continued) Automobile Loans-Backed Securities For asset-backed securities backed by automobile loans, borrowers pay regularly scheduled monthly loan payments (interest and scheduled principal repayments), and may make prepayments 20

21. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21 MAJOR ASSET CLASSES SECURITIES (continued) Automobile Loans-Backed Securities For securities backed by automobile loans, prepayments result from –Sales and trade-ins requiring full payoff –Repossession and subsequent sale –Loss or destruction of the vehicle –Payoff of the loan with cash to save interest –Refinancing of the loan at lower interest 21

22. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22 MAJOR ASSET CLASSES SECURITIES (continued) Automobile Loans-Backed Securities Prepayments for auto loan-backed securities are measured in terms of the absolute prepayment speed (APS) The ABS is the monthly prepayment expressed as a percentage of the original collateral amount 22

23. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23 MAJOR ASSET CLASSES SECURITIES (continued) Automobile Loans-Backed Securities The SMM (Monthly CPR) expresses payments based on the prior month’s balance The cash flow of securities backed by automobile loans do not have a great deal of uncertainty 23

24. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24 MAJOR ASSET CLASSES SECURITIES (continued) Rate Reduction Bonds Rate reduction bonds are backed by a special charge included in the utility bills of utility customers If the assets that back up the bonds are “stranded assets,” then the bonds are known as stranded cost bonds or stranded asset bonds 24

25. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 25 MAJOR ASSET CLASSES SECURITIES (continued) Student Loan Backed Securities Student loans are made to cover college costs and tuition for a wide range of vocational and trade schools Securities backed by student loans, popularly referred to as SLABS, have similar structural features as other asset- backed securities 25

26. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26 MAJOR ASSET CLASSES SECURITIES (continued) Student Loan Backed Securities Congress created the Student Loan marketing Association (“Sallie Mae”) as a government sponsored enterprise to purchase student loans in the secondary market and to securitize pools of student loans 26

27. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 27 MAJOR ASSET CLASSES SECURITIES (continued) Small Business Administration Loan-Backed Securities The Small Business Administration (SBA) is an agency of the U.S. government empowered to guarantee loans made by approved SBA lenders to qualified borrowers The loans are backed by the full faith and credit of the government Most of SBA loans are variable-rate loans where the reference rate is the prime rate 27

28. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 28 CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS Asset Risks If there are a few borrowers in the asset pool that are significant in size relative to the entire pool balance, the diversification benefit can be lost, resulting in a higher level of credit risk referred to as concentration risk 28

29. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 29 CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS (continued) Structural Risks The rating agencies analyze the structure to test whether the collateral’s cash flows match the payments that must be made to satisfy the issuer’s obligations. This risk is referred to as structural risk 29

30. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 30 CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS (continued) Third-Party Providers Several third parties are involved These include third-party credit guarantors, the servicer, a trustee, issuer’s counsel, a guaranteed investment contract provider, and accountants The rating agency will investigate all third- party providers 30

31. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 31 CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS (continued) Potential Legal Challenges The longstanding view is that investors in ABS are protected from the creditors of the seller of the collateral That is, when the seller of the collateral transfers it to the trust, the transfer represents a “true sale” and therefore in the case of the seller’s bankruptcy, the bankruptcy court cannot penetrate the trust to recover the collateral or cash flow from the collateral 31

32. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 32 CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS (continued) Potential Legal Challenges However, this issue has never been fully tested The closest challenge was the bankruptcy of LTV Steel Company 32

33. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 33 SECURITIZATION AND THE IMPACT ON FINANCIAL MARKETS The key benefit of securitization to financial markets is that it allows for the creation of tradable securities with better liquidity for financial claims that would otherwise have remained in the portfolio of financial intermediaries and therefore highly illiquid 33

34. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 34 Summary Asset-backed securities are creating by pooling loans and receivables through a process known as securitization The motivation for issuing asset-backed securities rather than issuing a corporate bond is the potential reduction in funding cost ABS are credit enhanced to provide greater protection to bond classes against defaults 34

35. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 35 Summary (CONTINUED) In analyzing credit risk, the rating agencies will examine asset risks, structural risks, and third parties to the structure Securitization has resulted in financial disintermediation While there are benefits of securitization, there are also concerns about its impact 35