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Securitization Colloquium

Securitization Colloquium. Spring, 2003. What’s asset securitization?. What is securitization? What is the history of securitization? Why do entities securitize? What is the profile of an ordinary securitization? Why are law and accounting so important for securitization?.

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Securitization Colloquium

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  1. Securitization Colloquium Spring, 2003

  2. What’s asset securitization?

  3. What is securitization? • What is the history of securitization? • Why do entities securitize? • What is the profile of an ordinary securitization? • Why are law and accounting so important for securitization?

  4. What is Securitization? • Process: • The pooling of assets and the issuance of securities to finance those assets • Substance: • The use of superior data on a pool of assets in order to finance the assets, or distribute risk, more efficiently, usually by means of the use of “structure”

  5. Example: General Motors What goes into predicting whether GM will repay its unsecured debt: • Automobile industry in general • North American, European, Asian, and Latin American automobile industries • GM v. domestic & international competitors

  6. Example: General Motors • Politics and international trends • Management • Unions • Balance sheet and income statement • Luck!

  7. Example: General Motors How about GMAC, where financial assets reside? • Fewer variables • More dependent on interest rates, quality of receivables as opposed to quality of autos • Multiple businesses + residential and commercial mortgage businesses

  8. Example: General Motors How about the senior debt of GMAC? • Focus on specific financial assets • Law prevents exclusive focus on those assets

  9. Securitization Securitization involves: • Isolation of pool of assets from financial fortunes of originator • Focus on historical data with similarly situated assets • Predicting the future behavior of the pool at hand Originator transfer of pool transfer of pool or interest in pool issuance of securities Special Purpose Entity Purchaser Issuer

  10. Securitization • Efficiency #1: • Isolation in order to enable investor to predict behavior • Efficiency #2: • Unbundling and allocation of risks/rewards to different populations

  11. Credit Risk • Securities precisely targeted to credit risk profile desired by investors AAA Special Purpose Entity Purchaser Issuer Investor Retained BBB Unrated B

  12. Credit Risk; Tenor 3 mo. • Securities precisely targeted to tenor profile desired by investors bullet Purchaser Issuer 6 mo. bullet 1 year bullet 5 years amortizable, etc.

  13. Further Allocation of Credit Risk Originator Credit Enhancer 1) 1st loss originator 2) 2nd loss credit enhancer 3) 3rd loss investors by category transfer of assets transfer of assets Special Purpose Entity Purchaser Issuer investors securities Allocation of Risk

  14. Servicing Risk Originator • Retention of servicing risk by originator servicer of assets transfer of assets 100% ownership interest Special Purpose Entity Purchaser Issuer transfer of assets securities

  15. Allocation of Interest Rate Risk Originator transfer of fixed rate assets Special Purpose Entity Purchaser Issuer transfer of assets issuance of securities floating rate floating rate fixed rate potential back-to-back swap Swap Provider

  16. What is the History of Securitization? MBS: • 1970s securitization of residential mortgages • Government sponsored entities (“GSEs”) • Federal Home Loan Mortgage Corporation (FHLMC/“Freddie Mac”) • Federal National Mortgage Association (FNMA/“Fannie Mae”) • Allocation of credit risk to GSEs • Retention of interest rate risk by originators

  17. What is the History of Securitization? ABCP: • Early 1980s securitization by “Multi-Seller Commercial Paper Vehicles” issuance of CP Originator ABCP Vehicle transfer of interest in assets liquidity and credit enhancement facilities Sponsoring Bank • Capital arbitrage • Allocation of risk as in paradigm

  18. What is the History of Securitization? • Middle 1980s securitization of non-mortgage related assets, or ABS • Late 1980s securitization of commercial mortgage related assets, or CMBS • Allocation of risk/rewards as in above paradigm • Trade receivables, autos, credit cards, home equity loans, manufactured housing, leases, commercial loans, cross-border

  19. U.S. Public Mortgage Backed Activity, 1980-2002 (Proceeds in millions) Source: Thompson Financial

  20. U.S. Public Asset Backed Activity, 1985-2002 (Proceeds in millions) Source: Thompson Financial

  21. U.S. Public Asset Backed Activity 1996 by Type of Assets Securitized 8% 31% 5.5% 5.5% 6% 20% 24% Source: Thompson Financial

  22. U.S. Public Asset Backed Activity 2002 by Type of Assets Securitized 11.3% 1.5% 39.4% 6% 1% 22.9% 17.9% Source: Thompson Financial

  23. U.S. Public Mortgage Backed Assets 1996 by Type of Assets Securitized 6.5% 27% 6% 6.5% 8% 9% 25% 12% Source: Thompson Financial

  24. U.S. Public Mortgage Backed Assets 2002 by Type of Assets Securitized 0.6% 8.6% 4.6% 39.7% 27.1% 20.5% Source: Thompson Financial

  25. Why do Entities Securitize? • Securitization satisfies current macro economic trends • What are those trends? 3 produced a need for securitization ... • Over-regulation of financial institutions • Search for cheaper sources of capital • Convergence of capital markets into one 1 made it possible • Improving computer-based technology

  26. Why do Entities Securitize? • Largest trend of all: Using knowledge to create wealth

  27. Why do Entities Securitize? What are the precise, originator-driven motivations? • Balance sheet relief • Cheaper cost of financing • Increased liquidity • Matching assets and liabilities • Sources of funds in times of economic stress • Gain on sale

  28. Balance Sheet Relief • FAS 140: Isolation of financial assets • Why does an issuer want balance sheet relief? • Removal of assets and related debt improves ratios and need for more expensive capital • Note rating agency discount

  29. Assets Liabilities/Capital 100 75 Debt 25 Capital 100 100 Assets Liabilities/Capital 50 37.5 Debt 12.5 Capital 50 50 Securitization of 50 assets & 37.5 of related debt so reduced capital to 12.5

  30. Assets Liabilities/Capital Less expensive capital necessary, or same capital, but capital/assets ratio improved 37.5 Debt 62.5* 25 Capital 62.5 62.5 *retained interest of 12.5 in asset pool of 50

  31. Capital/Assets Ratio Before: .25 After: .40 Other ratios may improve similarly

  32. Cheaper Cost of Financing • GMAC A • GMAC Securitization • Up to 94% of debt rated AAA because of isolation of assets from bankruptcy risk of parent • Transactions Cost • Asset-backed premium AAA = AA+

  33. Increased Liquidity • Investors who prefer mix of credit risk and tenor that is different than senior debt • Originator’s name can be divorced from securities altogether • ABCP • Credit enhancers

  34. Sources of Funds in Time of Economic Stress • Rated v. unrated • Bankruptcy remote structures

  35. Matching Assets and Liabilities Issuer 3 mo. 6 mo. 1 year 3 year revolver & 5 year bullet, etc.

  36. Gain on Sale • FAS 140: • Net gain equals proceeds minus basis • Allocation of basis based on fair market value sold and retained portions • Valuation of retained portion based on variety of assumptions • Defaults • Payment speed • Interest rates • Ability to “create” regular flow of net income appears to create need for less “other capital”

  37. Three Steps to Creating our own Securitization 1) Pool and package individual loans or debt instruments 2) Convert the package into securities 3) Enhance the credit of the securities to facilitate their sales to investors

  38. Borrowers • A group of significant economic scale and geographic diversity, with • An unfulfilled or underfulfilled need for funds, and • A body of historical data about their ability to repay debt

  39. Graduate Students Borrowers • Securitize loans collateralized by the future flow of expected earnings • Discretionary use of funds above and beyond tuition payment • Defer payment of principal and interest for 1-3 years • Will not compete with government-sponsored tuition lending programs

  40. B&B.com Seeks to lower the cost of moving funds from investors to borrowers Borrowers Originator • Using technology to streamline the loan application, qualification and approval process • Use historical information to mitigate risk by isolating the low-risk students -- Best & Brightest • Package the pool of loans to meet the risk appetites of institutional investors

  41. Offers credit cards over the Internet @ 11% interest to students at qualified graduate schools • Verified student I.D. • Access to records (privacy) • Variety of means for delivery of funds • School branding

  42. Approved Acceptance and credit limit depends upon: ü Type and Quality of School • Law, business, medicine • Graduation rate • Placement statistics • Average starting salaries • Alumni contribution statistics • Tuition loan repayment record • Overall reputation

  43. Approved Acceptance and credit limit depends upon: ü Type and Quality of • Degree pursued • GPA • Class rank • Internships • Anticipated graduation date • Credit check Student

  44. Sub of B&B, LLC Borrowers Special Purpose Vehicle is created to: Originator • Purchase the debt • Issue securities • Administer the collection of cash flows and servicing of debt • Pass interest and payments on to investors • Avoid taxation SPV

  45. Investment Bank A Borrowers Underwriter or issuer prices and markets securities to investors Originator • Knows how to package securities for market • Sets prices and tranches • Understands legal requirements of institutional investors • Works with the rating agency SPV Underwriter

  46. Poor & Moody Borrowers Rating Agency Originator • Sets a defined credit standard • Protects investors against unknown assumption of risk • Increases marketability of securities • Reduces yield that must be paid to investors Rating Agency SPV Underwriter

  47. Poor & Moody Borrowers Rating Agency Evaluates Originator • Historic record of loan defaults • Rate of bankruptcy • Size of default losses • Debt seasoning -- what % of borrowers are now making payments • Geographic diversification • Quality of borrowers Rating Agency SPV Underwriter

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