1. 1 Securitization, Risk Management and Bank Capital Ashish Dev Executive Vice President Group Head, Enterprise Risk Management KeyCorp ashish_dev@keybank.com

2. 2 Introduction What is Securitization? –An entity pools together identifiable cash flows over time and packages the pool of collaterals into notes, with explicit priority of payments and sells them to investors. –Thus securitization is, first and foremost, a financing mechanism for the issuer of the collaterals. –The tranche structure makes securitization interesting, in terms of risk.

3. 3 Introduction Size and Growth of the Market –The total Securitization market in the world stands at about US $ 3.0 trillion. –The US market is by far the largest in volume. –High growth in European and Asian markets in recent years. –As capital markets develop in countries around the world, securitization market is likely to take off in the near future.

4. 4 Types of Securitizations Securitization types are defined based on the type of the underlying pool of assets – mortgage loans ==> MBS – consumer loans ==> ABS – corporate loans ==> CLO – corporate bonds ==> CBO Mortgage backed securities (MBS) were the first ones and are still the most predominant type of securitization.

5. 5 Securitization Tranches Securitization (of a pool of loans) allocates interest income and principal repayments from the underlying pool to a prioritized collection of securities notes called tranches. Cash-flow waterfall: senior notes are paid before mezzanine, and mezzanine notes before first-loss (equity) position. Waterfall defines loss on a given tranche from the loss in the underlying pool.

6. 6 Illustration of Tranches

7. 7 Prepayment Risk in Securitizations Prepayment risk: potential loss due to full or partial prepayment of the outstanding balance by borrowers –Important for Mortgage backed securities. –Prepayments happen when interest rates are low. –MBS issued by government agencies, credit risk is negligible and prepayment risk is the predominant risk. –In case of Credit cards, issuer replaces prepaid balances by new set of credit card receivables.

8. 8 Credit Risk in Securitizations Credit risk: potential loss due to defaults by borrowers in the pool –Credit risk is driven mostly by probabilities of default by individual borrowers recoveries in the event of borrowers’ default correlations in default behavior between different borrowers Extent of over-collateralization

9. 9 Loans/Bonds vs. Securitizations Similarities –Similar principal and interest cash flows in the event of no loss –Both are rated by agencies Differences Generally, credit risk models designed for loan/bond portfolios are not applicable to securitization tranches

10. 10 Models of Credit Risk for Securitizations Economic capital for securitizations should be determined from a dedicated model that –treats tranche as part of the investor’s portfolio –derives tranche loss from the loss distribution of the underlying pool Recent credit risk models for securitizations –Pykhtin & Dev (RISK, May 2002): granular pools –Pykhtin & Dev (RISK, January 2003): non-granular pools –Gordy & Jones (RISK, March 2003): granular and non- granular pools

11. 11 Basel II and Securitizations Capital charge is determined by Standardized or IRB approach IRB approaches include –Ratings-based approach (RBA) calibrated to Pykhtin-Dev model applied whenever external rating available –Supervisory Formula approach (SFA) based on Gordy-Jones model applied when external rating is not available –Internal assessment approach (IAA) applied to Asset Backed Commercial Paper conduits only

12. 12 Supervisory Formula Approach Capital charge: area under the curve between tranche bounds

13. 13 Ratings and Required Capital Agency ratings are based on either expected loss (Moody’s) or probability of default (S&P) Generally, economic capital for a tranche cannot be determined from the credit rating alone. Other determinants of economic capital or regulatory minimum capital –Tranche thickness and seniority –Granularity of underlying pool (i.e., effective number of assets)

14. 14 Ratings Based Approach Basel Committee has made an attempt to incorporate the effects of thickness, seniority and granularity into the RBA

15. 15 Comparison of Models SFA and RBA are calibrated to different models –but the models can be calibrated to yield similar capital charges

16. 16 Conclusions As capital markets develop in countries around the world, Securitization is likely to be one of the fast growing financial instruments. For purposes of Credit Capital, Securitization Tranches should not be treated similar to loans and bonds -- they require a model based on the loss distribution of the underlying pool. Economic or Regulatory Capital cannot be determined from rating alone. Development of recent models and their adoption in Basel II have significantly enhanced understanding of risk in Securitizations.