Securitization is the process whereby relatively illiquid financial assets such as mortgages are packaged together and sold off to individual investors. Securitization turns relatively illiquid instruments into quite liquid investments called asset-backed securities. A market maker agrees to create a secondary market by buying and selling the securities. Securitization originated in the mortgage market in the early 1980s, when mortgage loans began to be packaged together and sold off as securities in the secondary market often with government insurance guaranteeing that the principal and interest would be repaid. Securitization became popular because it provides a way of protecting against interest rate risk in an environment of increased interest rate volatility. Securitization offers reduced credit risk because of the pooling of assets.
The securitization process involves a number of participants. The role of major participants in securitization process are given below.
The party behind a securitization is the originator. This entity generates (originates) or owns the defined or identifiable cash flow (that is, an income stream from receivables). An example of an originator with assets that can be securitized is a retail bank. Following assets are typically securitized: mortgages, automobile loans, credit card receivables, trade receivables, educational loans, etc. Securitized assets often have some or all of the following features: (i) large pool that permits diversification; (ii) low default rate; (iii) insensitivity to interest rate change; (iv) limited prepayment risk; (v) short maturity; and (vi) relatively homogeneous pools.
Originator usually appoints an arranger, which is typically a financial institution (e.g. investment bank), to design and set up the securitization structure. An arranger: (i) determines the structure of the risk profile of the receivables to create different tranches of security; (ii) sets up a SPV; and (iii) designs credit enhancement and liquidity support
3. Special Purpose Vehicle (SPV)
Setting up the SPV
The legal status of the SPV depends on the jurisdiction where it is established. In many jurisdictions it is a thinly capitalized corporate entity (that is, a company that has a very low equity capital compared to the amount of debt it owes) and someone other than the originator holds SPV’s shares, typically a trust. In other jurisdictions, such as those where the trust concept is not recognized, there may be legislation governing securitization and the SPV may be set up according to its provisions. Such legislation may provide, for example, that the SPV can be established as a fund, without legal personality, mutually owned by investors, or as a corporate entity with limited liability (e.g. limited liability company).
If a jurisdiction is unable to accommodate a required legal form for an SPV, or there are certain advantages to establishing it elsewhere, then it will be established outside the jurisdiction of the originator (offshore). Tax considerations are particularly important in choosing where to establish the SPV and they are often established in low-tax or no-tax jurisdictions, such as Ireland, Luxembourg, the Netherlands and the Cayman Islands.
The reasons the SPV is established in such ways are so that it: (i) s not treated as a subsidiary of the originator; (ii) is not affected by the insolvency of the originator; and (iii) does not need to have its balance sheet consolidated with the originator’s balance sheet (although this may depend on the accountancy practices and various other rules in the jurisdiction).
Ensuring that SPV is bankruptcy remote
It is important that the SPV is, as far as legally possible, bankruptcy remote from the originator (that is, the SPV is set up and operates so that it is highly unlikely that it will become subject to bankruptcy proceedings initiated over the originator). Common steps to achieve bankruptcy remoteness include: (i) placing restrictions in the SPV’s charter and transaction documents that prevent it from incurring liabilities outside those contemplated by the securitization (ii) appointing directors (or a director) independent of the originator; (iii) including limited recourse wording in all significant transaction documents that restricts a counterparty taking enforcement action against the SPV’s assets.
The newly incorporated SPV (also called the issuer) issues securities to investors to fund the purchase of the isolated receivables from the originator. The securities are usually bonds or notes or, occasionally, equity securities, and may be issued in several structured tranches (that is, different classes of securities with different payment priorities and characteristics, such as different credit ratings or interest rates.
The securities may be privately or publicly issued, depending on the individual circumstances of a transaction. However, if publicly listed, various listing requirements must usually be complied with when issuing the securities. A party separate from the investors usually holds on behalf of all investors the benefit of the covenants and rights contained in the securities. Where the trust concept is recognized, this rights holder is typically a trustee (e.g. in US) and the securities are usually constituted under an indenture (public issuance) or bond purchase agreement (private placement) that set out the terms and conditions of the issue and also the rights in the securities held by the trustee.
Tranching the securities
To optimize the risk profile of the securities and therefore maximize the range of investors to whom they can be sold, the securities are divided into different classes. These typically consist of several sequential tranches with differing priorities as to payment of principal and interest, and carrying differing rates of interest. The more senior tranches have the right to priority of payment over more junior tranches, but the more junior tranches carry a higher rate of interest. Each tranche (or at least the most senior tranches) is generally given a credit rating by a credit rating agency. Securitization transactions usually involve such multiple-tranche structures. As the sophistication of structured products and the combination of derivative and securitization structures increases (e.g. synthetic securitizations), it has become possible for investors to specify credit, yield, maturity and currency characteristics for arrangers to structure, rather than wait for issuers with the desired credit quality and borrowing needs to issue appropriate securities.
Types of SPV’s
The methods employed to transfer and take assets off-balance sheet involve direct sales using SPVs or other conduits. There are three types of conduits: single-seller SPV, multi-seller conduits, and securities arbitrage vehicles. The single-seller SPV purchases assets from a single originator. Banks originating large uniform assets (mortgage debts) usually use these instruments. Multi-seller conduits are legal entities administered and serviced by the banks to provide funds either through direct loans or asset purchase agreements under which the SPV purchases trade receivables. The originating bank normally provides direct credit enhancements and provision of liquidity facility to the conduit. Securities arbitrage vehicles are organized to buy rated securities that are funded through the structure of the program, rather than by the underlying assets. That is, the conduit must be structured so as to ensure a steady inflow of new assets or obligations. The assets (current or future receivables) are transferred from an originating (sponsor) balance sheet to the balance sheet of an SPV
Typically, financial institutions, insurance companies, pension funds, hedge funds, companies, high net worth individuals. Investors purchase the securities issued by the SPV according to their risk/return preferences. Tranching offers investors the opportunity to diversify their investment portfolio by purchasing securities with different seniority and yield. Market liquidity of securities is also very important to investors, so that they do not have to hold the security to maturity but can instead sell it on a public market.
SPV appoints the servicer to administer and collect the underlying receivables in the capacity of SPV’s agent for a servicing fee stipuated under the servicing agreement. The originator or a company within the originator’s group is often appointed as servicer (so that the profit from securitization can be exctracted from the SPV to the originator trough service agreement). However, sometimes a third party servicer is appointed.
6. Rating Agencies
The SPV engages the rating agencies to rate the creditworthiness of the securities. Rating agencies rate the securities to indicate whether the SPV has a strong or weak capacity to pay interest and principal. The rating is provided after detailed statistical analysis on the probability of default and the effects of such default on the ability of the SPV to comply with its payment obligations in respect of the securities.
Rating agencies play a pivotal role in the securitization process as the ultimate appraiser of the underlying pool of collateral. In their process of appraising and evaluating the likelihood of default by subjecting the cash flows of the pool of underlying assets to stress tests under severe market conditions, various risks are priced to determine the fair market value of the new securities. Investors’ acceptance of the ratings as a well-defined standard, as well as the appropriateness of the amount of credit enhancement, are paramount for a successful securitization process for ABS, as they need not perform individual appraisals for the new instruments that could be prohibitively costly. Assuming credit risk analysis is undertaken for a rated security, the decision to invest turns into consideration of market or interest rate risk, and analysis of duration and convexity of the underlying instrument.
There are three main credit rating agencies: (i) Standard & Poor’s; (ii) Moody’s Investor Services; and (iii) Fitch Ratings.
7. Enhancement Providers
Investors usually demand very high investment grades for asset-backed securities (ABS). The assets themselves do not earn these grades without enhancements that reduce risks of credit, liquidity, currency and prepayment.
Credit enhancement reduces the risk of default of the debtors on the underlying assets. Credit enhancement is used to improve the liquidity, marketability, appeal, and safety of the underlying cash flows (interest and principal) of a new instrument in the capital market. It is a form of dressing up an illiquid asset by beefing up its pay-off, while reducing the variability of cash flows so that wider classes of investors find the rate of return commensurate with risk. The amount and type of credit enhancement depends on the extent to which one wishes to make the new instrument in par to a highly-rated security. This enhancement is provided internally by (i) underwriters or dealers that agree to buy the entire subordinated tranche or (ii) banks or insurers that provide unconditional guarantees which the SPV can draw if debtors default.
Liquidity enhancement reduces the risk of failure of the servicer to timely transfer debtors’ payment to the SPV, which might ultimately prevent ABS investors from being paid. Liquidity enhancement can also address the risks of set-off, prepayment, discounts and other reductions of payment, as well as invalid assignments of underlying assets. This enhancement is provided in the same manner as the credit enhancement.
Financial institutions specializing in swap transactions enter into swap contracts with the SPV to take on risks of interest rates changes, currency movements or defaults and other non-payment events with respect to underlying assets (effectively providing insurance to SPV against these risks).
Many jurisdictions have now legislated to make securitization possible or to promote their securitization market. Regulatory issues that may arise (whether as part of securitization legislation or otherwise) include: (i) issues affecting the originator, such as accountancy practices and capital adequacy requirements; (ii) the structuring of the SPV; (iii) whether any of the parties must be licensed or are subject to supervision by a regulatory body; (iv) the rules on offering and trading securities; (v) laws governing the underlying receivables (e.g. consumer lending obligations); (vi) data protection restrictions impacting on the proposed transfer of customer information accompanying the transfer of receivables.