State what securitization is, outline its process and account for what each participant does.
The idea
Securitization pools financial assets such as mortgages, auto loans or card receivables. It sells them to a separate legal entity, and funds that purchase by issuing securities backed by the pool's cash flows. The originator creates the assets and sells them, ideally in a true sale so the pool sits outside its bankruptcy estate. The special purpose vehicle or trust holds the pool and issues the notes. The arranger, usually an investment bank, designs the tranches and places them. Rating agencies assess the structure and assign ratings. The servicer collects payments from borrowers and manages delinquencies. The trustee protects noteholders and checks that cash is paid out under the documented waterfall. Investors buy the tranches. The usual slip is mixing up servicer and trustee. The servicer faces the borrowers, and the trustee faces the investors. The sequence is pool, sell, structure and rate, issue, then collect and distribute.
A practice question
Which of the following best describes securitization?
- Selling a pool of assets to a separate entity that issues tranched securities backed by the pool's cash flows - correct
- Issuing a single corporate bond that is backed by the general credit of the originator, secured on no particular pool of assets and with no separate entity involvedWhy not: This is ordinary corporate debt: no assets are transferred to a separate entity and nothing is tranched.
- Selling the credit risk of one loan to a counterparty through a derivative while the loan stays on the lender's booksWhy not: This describes a credit derivative, in which no pool is sold and no notes are issued against it.
- Sharing a large loan among several banks, each of which holds its portion on its own balance sheetWhy not: This describes loan syndication: no special entity is created and no securities are issued against a pool.
Securitization transfers a pool of assets to a separate entity that issues securities, usually in tranches, repaid from the pool's cash flows. Corporate bonds, credit derivatives and syndications do not involve that combination.
A harder one
A bank sells a pool of auto loans to an SPV in a transaction that is legally a true sale. The main purpose of the true sale is to:
- Make the originator liable to investors for any shortfall in principal, which raises the notes' ratingWhy not: A true sale removes recourse to the originator; making it liable would defeat the transfer.
- Remove the need for credit enhancement, because the pool is then free of default riskWhy not: Selling the loans does not change their credit quality; losses still occur and enhancement is still needed.
- Keep the pool out of the originator's bankruptcy estate, so investors rely on the pool and not the originator - correct
- Allow the originator to keep legal title to the loans and receive the interest, with the SPV holding only a contractual claim on those cash flowsWhy not: That describes a secured borrowing, in which title stays with the originator; in a true sale title passes to the SPV.
A true sale places the assets beyond the reach of the originator's creditors, which is what makes the SPV bankruptcy remote. Credit enhancement is still needed, and the originator has no continuing liability for losses.
The hardest tier
Which sequence correctly orders the main steps of a standard securitization?
- Loans are pooled; the SPV issues notes; ratings are assigned after the notes have been sold; the SPV then buys the loans from the originator with the proceedsWhy not: Reverses the order: ratings are needed before marketing, and the SPV pays for the loans from note proceeds.
- Loans are pooled and sold to the SPV; the structure is rated; the SPV issues notes and pays the originator; the servicer collects and the waterfall distributes cash - correct
- The originator issues notes against its own balance sheet; the loans stay with the originator; the servicer then pays investors from the originator's general funds, with no SPVWhy not: Describes secured funding, not securitization: there is no sale to an SPV, so the pool is not isolated.
- Loans are pooled and sold to the SPV; the structure is rated; the trustee collects from borrowers and the servicer distributes cash to noteholders under the waterfallWhy not: Swaps servicer and trustee roles: the servicer collects from borrowers and the trustee oversees distribution to investors.
The pool is assembled, transferred to the SPV, structured and rated, funded by note issuance and then administered: servicer collects, trustee ensures payment by the waterfall.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in An Introduction to Securitisation
- Explain cash waterfall, equity piece, first-loss piece and over-collateralization as they apply within securitization.
- Analyse how issuing securitized products through a trust works differently from using a special purpose vehicle (SPV), and tell apart the three chief SPV structures: amortizing, revolving and master trust.
- Account for why securitization is undertaken and what it offers.
- Outline the different kinds of credit enhancement and weigh them up.
- Account for the tools used to analyse the performance of securitized structures and name the asset classes each suits best.
- Define and calculate, for relevant securitized structures, the weighted average life (WAL), weighted average maturity (WAM), weighted average coupon (WAC), debt service coverage ratio (DSCR), monthly payment rate (MPR), default ratio and delinquency ratio.
- Cover the techniques for forecasting prepayments, and compute the PSA (Public Securities Association) rate along with the CPR (constant prepayment rate).