1 Diane Delelis Securitization Finance (Basics) Luděk Benada
2 Index Introduction... 3 I. Detailed presentation...3 II. Vocabulary of securitization...4 III. An example...5 IV. Advantages Access to a new funding source Risks transfer Balance Sheet Management Discretion and maintaining customer relationships...7 V. Securitization as a strategic instrument...8 VI. Risks associated with securitization: the case of subprimes in Conclusion : What future for the securitization of credit risks?...10
3 Introduction Securitization is conventionally a financial technique which consist in a transfer of financial assets such as debts (e.g. unpaid invoices or outstanding loans) to investors by transforming these debts through an ad hoc society in financial securities issued on the capital market. Such a securitization is made by combining a portfolio (that is to say a lot) of a similar debts (mortgages, consumer loans, mono-thematic bills, etc.) which is then yield to an ad hoc structure (company, fund or trust) which finances the purchase price by placing share with investors. Each securities (bonds, treasury notes, etc.) represent a fraction of the securitized porfolio and give investors the right to receive payments of debts (e.g. When the bills are paid, or when the mortgages pay monthly) as interest and principal repayment. Securitization can also aim not to transfer to investors that the financial risk to the assets involved, in which case the assets are not sold, but the risk or part of the risk transferred by a synthetic securitization. Created in the USA in the 1960s, securitization has also expanded significantly in Europe since 2000, while the products and structures became more complex. In France, securitization was introduced by the Act of December 23, Under the leadership of Pierre Beregovoy, the idea was to facilitate the development of mortgage lending by allowing banks to take out the loans from their balance sheets and improve their "Cooke" ratio. The subprimes crisis which occurred in 2007 caused a slowdown in the market, while market authorities consider whether securitization should be better managed. I. Detailed presentation Securitization can be applied to debt portfolios or real estate, but also to any asset distributing future payments, whether or not debt. In its most common form, it is for a company holding illiquid assets, sell them to an intermediate entity created for the occasion, which finances the purchase by borrowing on the market by issuing securities negotiable debt secured by the assets. The securities are purchased by investors who participate in the transaction exclusively on the basis of the guarantee on assets whose future cash flows will be used to pay interest on the securities and their repayment. Each investor acquires, in a sense a fraction of the portfolio of securitized assets: securities purchased by investors are "backed" to the portfolio of assets. In financial markets, these are generically called assetbacked securities (ABS), the intermediary company created for the occasion being called a Special Purpose Vehicle (SPV), Special Purpose Company (SPC), Structured Investment Vehicle (SIV) or conduit. For investors, the special feature of securitization is that they are paid by the portfolio sold and therefore take risks, risks that are sometimes partially covered or structured, and generally assessed by rating agencies that publish a qualitative rating of risk on securities issued.
4 To facilitate the analysis of portfolio risk, that is to say, to predict the flow of funds, assets or rights transferred are preferably of the same nature, such as: A portfolio of residential mortgage loans; A portfolio of commercial mortgage loans; A set of rights related to leasing operations on machines; The future lease of one or more residential or commercial buildings. In addition, to resell quality securities, the portfolio is subject to a risk of nonpayment assessment by the financial institution that structures the transaction, and generally also by at least two rating agencies. An amount equivalent to the first risk (which is most likely to occur) is formed in secondary debt subordination (finance) to the main titles and that will suffer the first losses of the portfolio. They are then usually sold to the transferor company, which keeps the first risk of non payment of its debts, the quality of the main bonds found them all increased. In most cases, the main bonds are themselves divided into various classes dependent on themselves, each class of securities with a distinct risk profile, more or less high, sanctioned by a quality rating given by rating agencies and which allows investors to assess their risk. II. Vocabulary of securitization Originator : company that sell the debts (or others assets) through securitization. Eligibility criteria : list of requirements for a debt owed by the originator to be securitized. Debtor : company or person required to pay a debt securitized. Custodian: company responsible for the preservation of evidence of securitized assets (identity of debts, specifications, sales notes,...). Setting manager (or servicer): company responsible for managing the payment of securitized assets. In general it is the seller himself. Sometimes a company (known as Backup Servicer) promises to recover debts in case of failure of the setting manager. Reserve of liquidity : amount retained by the SPV to pay various operating expenses of the securitization transaction or cover a temporary shortage of funds in the structure (such as an irregularity in the flow, but not the defects). Originator: company that was responsible for the creation of debts or assets (the original lender in the case of debts). Is often as the seller. Priority bond (or Senior): bond (share or obligation) for which payment has priority over other payments (subordinated debt, management fees, commissions) made by the SPV. By their nature, the seniors have the lowest risk of default. Subordination bond (finance): bond (share or obligation) for which payment is subject to the payment of securities of the upper class. So those are the subordinated debts that will suffer first non-payment of debts. Often the most subordinated securities are redeemed by
5 the seller itself so that it takes to bear the first risk of non payment of his debts. Management Company: A company that manages the securitization transaction and its accounting to its completion. It is especially used in legal systems that use the form of mutual fund securitization. SPC or SPV: Special Purpose Vehicle or Special Purpose Company (the issuer), generic name of financing vehicles created to acquire the debts of the seller and usually also to issue securities on the market. This intermediate entity between the seller and the investors is also a performance guarantee of the securitization transaction in case of failure of the seller. Vehicle Rollover : means that we sometimes place between the SPV and investors. It promises to repurchase the securities for resale it in another form (eg commercial paper) to change the periodicity of payment of securities and their nature. This makes the new bonds more accessible to investors. Credit enhancement: improving the degree of security of securities issued. To quantify this notion, the securitization transaction calculates a Rate of Credit Enhancement (RCE) to achieve. For example, if we want to achieve a 20% RCE on 100 euros of eligible debt, we will issue 80 euros in the form of priority securities sold to investors, and 20 euros in the form of subordinated debt sold to the seller. The priority bonds are thus made more secure. III. An example Let's take one example. A bank, the seller, wishes to raise funding based on a portfolio of mortgages. The bank sells to the Special Purpose Company, created for the occasion, the loan portfolio and all rights (including rights relating to life insurance) The Special Purpose Company issues bonds whose interests and capital repayments will be provided exclusively by the financial flows of the loan portfolio; With the result of the bond issue, the Special Purpose Company shall pay to the bank the selling price of the portfolio. Economically, everything goes for the bank as if it had obtained financing "directly" and has provided funding based on the quality of credit portfolio. Legally, there is no relationship between the investor and the bank, because the SPC is interposed between the two: bankruptcy or failure of the seller will have no effect on either the transaction or on investors.
6 IV. Advantages 1. Access to a new funding source On the face of it, selling assets to finance is not a complex financial technique. But here we consider the sale of assets sometimes difficult to sell, and big portfolios ( 500 million is a usual amount in the market). In addition to the amount of the transaction, there is the question of the ability of the purchaser to analyze the risk of the portfolio, with the consequent opportunity for the seller to obtain a fair price. As stated in the definition, securitization can then transform the illiquid portfolio of liquid securities, which allows to "sell" the portfolio rather than an investor, but to a multiplicity of investors, that is to say to the capital market, a market of a large number of investors present all around the world. In order to meet the seller and the investors, securitization obeys certain rules of setting up and structuring which aims to provide all actors in the transaction a transparent risk assessment, and thus establishing a "fair" price. Moreover, as investors will take their investment decisions not based on the quality of the company, but based on the quality of assets sold, even a company that would not be in a very good financial situation may raise capital on reasonable terms to the extent that it can identify quality assets on its balance sheet. 2. Risks transfer Second advantage, the risk of loss on the portfolio has increased among investors, which means that if the portfolio is finally revealed of poor quality and whether cash flows are insufficient, it is the investor who will suffer, if necessary, a financial loss. However, it is rare that the entire risk is passed on to investors. In general, some mechanisms are introduced so that the seller retains what we call the "first risk" on the portfolio. However, the mechanism allows the seller in any case to limit its risk (to limit it to a certain level, or to "capper" it to use a common term on financial markets) to a certain amount, the excess risk is bear by the investors. For banks, subject to control risk by their controller, securitization, used as a tool to transfer risk, is therefore particularly important.
7 3. Balance Sheet Management Securitization allows in principle to manage the balance sheet by controlling the swelling of it if it is considered excessive. Indeed, by refinancing the loan portfolio, a seller releases funds and may increase its business or generate new assets while maintaining its balance sheet at a controlled level, as the assets are removed from its balance sheet. Moreover, banks have heavily used securitization as a management tool of regulatory capital required by the Cooke ratio under the Basel recommendations of the Basel Committee. In the 1990s, the appearance of balance sheet management has driven the most important development of securitization, enabling companies and banks to make real regulatory arbitrage, while a real trend of disposal of assets caused slippage. Also, in the 2000s, as well as financial accounting authorities have established new rules, IFRS for all companies and Basel II for financial institutions, which have greatly reduced the opportunities for arbitration. Since then, aspects of balance sheet management, in an accounting sense, have fallen sharply, while the management aspects of regulatory assessment (or prudential) in banks have been maintained but cleaned. 4. Discretion and maintaining customer relationships Especially in Europe, a bank that sells a credit portfolio, prefer that the transaction is discrete. What she mostly wants is that his client (the borrower)'doesn't know about it. Either this wish is reasonable or not, you could probably link it to the fact that for many European banks, the credit is considered the starting point for an overall relationship that the bank expects profitable. In a way, this vision of the credit is probably shared by many bank customers, who consider the credit relationship they have with their banker is confidential. This is especially true for companies. Securitization transactions are of course made iregarding regulations on the protection of privacy. For example, investors and analysts do not know the identity of the client. They will have at most a serial number while the customer list, possibly on CD ROM, will be kept under seal by a trusted intermediary (eg lawyer) and will only be used if the bank fails.$ To meet this need for discretion: 1. In general, clients (borrowers) are not aware of the sale of their credit 2. the bank will continue to be the contact for customers, with the distinction that now, it will receive funds on behalf of the SPC as a manager (not owner anymore) of assets, in the securitization's language, we say that the bank became the servicer of the assets. This is largely facilitated by the use of securitization.
8 V. Securitization as a strategic instrument In the United States, many financial companies require the securitization to fund their activity. It is not uncommon in this country that companies are financed almost exclusively by the securitization : finance companies for example, which produce credits related to credit cards and securitize the portfolio as soon as it reaches a certain amount. We can analyze this trend as a consequence of the specialization of firms. We know that the current trend is outsourcing or contracting out, and it is not an accident: in order to maximize its profits, each firm determines its core business and will tend to rid of additional activities. To give a rough example, a bank does not intend to run a restaurant. She then subcontract the work of the restaurant business to a specialized company. To some extent, securitization is also indicative of this trend. These american finance companies have decided that their core business was the credit risk assessment and management of credit risks. We say that the function of this company is the "origin" of credits. From this perspective, an important additional activity will be the collection of funds required to grant loans. For this activity, we can consider the following models: 1 st model : Fundraising on the capital market or by the deposit of clients, which means that the company becomes a bank, with the following: Balance sheet of the company expands gradually as new loans are made; Cash and balance sheet management should take account of rate differentials and maturity between funding sources and assets (asset and liability management = ALM); Financial management, which depends on access to finance, will become an important component of the activity. To ensure its activities, the company will have to hire employees, buy expert systems and thus move away from its core business as it has been determined. This is not a bad thing, as we have described here the creation of a bank, but the fact remains that the core activity will begin to be abandoned, and the company will have to redefine its core business. 2 nd model: systematic Securitization of assets when they reach a certain level: The size of the balance sheet remains under control because as soon as a certain amount is reached, the assets are sold; Cash Management and ALM is simplified by framework agreements with major financial groups that cover interest rate risks during the portfolio construction. The company is focused on its core business, and it maximizes the profitability of its business risk-taking credit retaining the first loss on securitized portfolios (while covering
9 itself up for exceptional losses). Between these two extreme models, there are endless possibilities, but we see that the success of securitization is somehow a consequence of the increasingly strong specialization of companies. The above example shows how securitization is actually outsourcing the finance function of the company. We could also have taken the example of the function of assets portfolio management: a company whose core function is the origination of loans does not necessarily has the function to check the regular payment of funds or provide their recovery in case of default by the borrower. However this feature also requires the acquisition of systems and staff that will not be used for the core activity of the company. Therefore, this activity may again be outsourced. In fact, we can actually see that in the United States and the United Kingdom, it is quite common for a bank to entrust a third company with the daily management of its loan portfolio whose servicing is the core activity. In Europe, the movement is later and the few specialist companies are struggling to gain acceptance. VI. Risks associated with securitization: the case of subprimes in 2007 The subprime crisis of August 2007 has highlighted some excesses in the use of real estate securitization in the U.S. The subprime market in particular has ballooned to unprecedented levels due to the use of securitization because the more credit organizations securitized loans already granted, the more they finance to grant new loans. In addition, subprime securitized were mixed with other products and re-securitized several times in successively in the world scale, so it became very difficult to know who owns subprime-related products and how much. The quality of securitized credit amalgamated in portfolios, the liquidity of the securities market and the work of rating agencies have been implicated in the subprime crisis. Indeed, the risk assessment of these products more structured is more complex, which has raised concerns about the capacity of agencies to assess those risks. The representatives of the G7 called for more transparency in the work of rating agencies (Standard & Poor's, Moody's, Fitch Ratings). Beyond that episode, more general doubts settled against investment vehicles that may have two shortcomings if they are not properly controlled: Products are based on the expected payments of debtors which could be not solvent Their asset value is based on property as collateral that are likely to be overvalued relatively to the amount of debts to recover in case of default, or at least to have a resale value very fluid. The second part of 2007 has resulted in a return to simpler products and a certain decline in securitization: $ 350 billion in the third quarter of 2007, the ABS market has fallen to 100 billion in the fourth quarter of 2007.
10 Conclusion : What future for the securitization of credit risks? The financial crisis has highlighted the flaws in the securitization of credit risks and especially the lack of knowledge in general players in this market. Today, we can legitimately wonder about the future of these products in the post-crisis finance, however, these techniques of financing are still useful for businesses. Since the last quarter of 2009, we can note that the European securitization market is recovering gradually in volume but still weak but investors return to this market segment for simple operations and which nature of the underlying assets is of high quality (granularity, economy of origin, etc....). For example, part of the EDF credit (payment flows of electricity bills considered as stable and low risk) is regularly securitized, allowing EDF to immediately recover a large fraction of the current value of turnover of existing contracts and so to finance its large investments without increasing capital requirements nor debt.