Asset-Backed Securities: It's as easy as this! A Practical Factbook Helge Münkel Telephone: helge.muenkel@hvb.

Transcription

1 Asset-Backed Securities: It's as easy as this! A Practical Factbook Helge Münkel Telephone: helge.muenkel@hvb.de February 2006 page 1

2 Contents 1 Index 2 Introduction to ABS 3 Description of main asset classes Overview Glossary of main terms and definitions What to look for? 4 Description of main structures Overview Glossary of main terms and definitions What to look for? 5 Rating agencies' approach to rating ABS General thoughts Selected methodologies What to look for? 6 Basel II General Introduction The Standardized Approach The Ratings Based Approach 7 Bloomberg Functions 8 Contacts February 2006 page 2

3 Contents 1 Index 2 Introduction to ABS 3 Description of main asset classes Overview Glossary of main terms and definitions What to look for? 4 Description of main structures Overview Glossary of main terms and definitions What to look for? 5 Rating agencies' approach to rating ABS General thoughts Selected methodologies What to look for? 6 Basel II General Introduction The Standardized Approach The Ratings Based Approach 7 Bloomberg Functions 8 Contacts February 2006 page 3

4 Index Term Page(s) ABS 9,10 A/B structure 40 Advanced internal ratings based approach 112,114,116 AFC (available funds cap) 63 Amortization 53 Arranger 13,14 Asset Manager 13,14 Attachment point 52 Basel II 112 BO (Bankruptcy Order) 28 Buy-to-let 29 Call 55 Capitalist Master Trust 61 CCJ (County Court Judgment) 28 CDO 10,25 CDO of ABS 10,25 CDO squared 10,25 Clean-up call 55 Term Page(s) CLO 10,25 Collateral 49 Collateral risk 67 Collateral asset manager rating 80,92 CMBS 10,23 Combined waterfall 53 Combo note 57 Commingling risk 57 Conduit model 105 Conforming RMBS 22 Controlled amortization 63 Correlation 70,86 Credit enhancement 52 Credit event 68 Credit tenant lease 23 CSO 10,25 DAC (detachable coupon) 56 Debt-to-income ratio 28 February 2006 page 4

5 Index Term Page(s) Default distribution over time 89 Default matrix 83 De-linked Master Trust 62 Discounted loans 39 DSCR (Debt Service Coverage Ratio) 32 Eligibility criteria 37 Enforcement event 53 European Union Directive CAD III 112 Excess spread 52 Excess spread compression 38 Expected loss 72 Expected loss approach 72 First lien 31 Foundation internal ratings based approach 112,114,116 ICR (Interest Coverage Ratio) 32 IC test (interest coverage test) 34,41 Initial lock-out period 63 IRB (Internal ratings based approach) 112,114,116 Term Page(s) Interest deferral 63 Internal assessment approach (IAA) 116,117 I/O strip (interest-only strip) 56 Issuer call 55 IVA (Individual Voluntary Arrangement) 28 Jumbo loans 29 Large loan model 105 Less liquid properties 29 Level of management 54 Liquidity facility 54 Loss definition 57 Loss distribution 70 Loss severity 39 LTV (Loan-to-value ratio) 30 Master trust 59 MERC (mortgage early redemption certificates) 56 Monoline wrap 63 Monte Carlo-simulation 80 February 2006 page 5

6 Index Term Page(s) Moody's diversity score 96 Moody's idealized expected loss table 95 Non-call period 55 Non-conforming RMBS 22 OC test (Overcollateralization test) 34,41 OC thickness 43 Originator 13,14 Overcollateralization 52 Par-value test 34 Pass-through certificates 56 Pay-through certificates 56 Performance triggers 54 Portfolio correlation level 88 Portfolio quality tests 34,37 Post-enforcement waterfall 53 Prime RMBS 22 Principal deficiency ledger 58 Pre-enforcement waterfall 53 Term Page(s) Prepayments 38 Probability of default approach 72 Property Score 32 Pro-rata 53 Rating agencies 13,14 Rating default rate 88 Rating loss rate 89 Rating recovery rate 89 Ratings based approach (RBA) 116 Regulatory call 55 Reserve fund 52 Revolving period 65 Revolving pool 54 Right-to-buy 29 RMBS 10,22 S&P correlation measure 33 S&P default measure 33 S&P variability measure 33 February 2006 page 6

7 Index Term Page(s) Seasoning 27 Second lien 31 Segregated waterfall 54 Self-certification 28 Seller 13,14 Sequential 53 Servicer 13,14 Set-off risk 57 Socialist Master Trust 60 Solvabilitätsrichtlinie V 112 Special Purpose Vehicle 13,14 SROC (Synthetic rated overcollateralization) 41 Standardized approach 112,114,116 Static pool 54 Step-up call 55 Subordination 52 Subprime RMBS 22 Supervisory formula 117 Term Page(s) Swap counterparty 13,14 Synthetic 45,48,49 Tax call 55 Time call 55 Trading bucket 54 True Sale 45,46,47 Trustee 13,14 Turbo notes 52 VECTOR 80 Waterfall 50 Weighted average rating factor 83 Weighted average remaining term 27 February 2006 page 7

8 Contents 1 Index 2 Introduction to ABS 3 Description of main asset classes Overview Glossary of main terms and definitions What to look for? 4 Description of main structures Overview Glossary of main terms and definitions What to look for? 5 Rating agencies' approach to rating ABS General thoughts Selected methodologies What to look for? 6 Basel II General Introduction The Standardized Approach The Ratings Based Approach 7 Bloomberg Functions 8 Contacts February 2006 page 8

9 Introduction to ABS BASIC IDEA Asset backed securities ("ABS") * are securities backed by a pool of receivables. Investors generally only bear the risk arising from these receivables and are generally independent from the credit risk of the respective (former) owner of such assets (the originator/seller). This is the core of securitization! The receivables of the underlying portfolio that is securitized generate interest and principal payments. These payments as well as potential losses that may occur in case the underlying obligors of the securitized assets do not serve their obligations, are distributed to investors according to certain rules (also called "the structure"). Hence, investors in ABS have to focus on both the underlying risk of the securitized portfolio and the rules that determine which consequences investors have to face in case a certain event occurs. Typically, the securitized assets are referenced by various notes with different risk profiles, and hence, ratings. The fact that different notes have different risk profiles, though they all reference the same underlying portfolio is based on the respective aforementioned transaction structure. This enables investors to satisfy their individual risk appetite and needs. ABS allows for a broad band of flexibility in terms of asset classes being securitized and structures being applied. * This presentation will focus on the European ABS market, and hence, will not cover the US or other markets. Moreover, this presentation will not cover Asset Backed Commercial Paper ("ABCP"), which are short- term revolving asset-backed securities that are mostly privately placed and differently structured. February 2006 page 9

10 Introduction to ABS MAIN ASSET CLASSES IN SECURITIZATION * Asset-Backed Securities ("ABS") (in a broad sense**) Mortgage-backed securitities ("MBS") Collateralized Debt Obligations ("CDO")** Asset-Backed Securities ("ABS") (as a specific asset class)** Residential mortgage loans ("RMBS") Commercial mortgage loans ("CMBS") Loans to SMEs ("CLOs") Loans to multinationals ("CDOs")** Bonds ("CBOs") Consumer/auto loans, credit cards etc. ("Consumer-related ABS") Project finance, whole-business, government-related etc. ("Non-consumer-related ABS") Specials like "CDO of ABS", "CDO^2", "CSO" etc. * Please refer to section 2 for more detailed explanations ** The terms ABS and CDO are typically both used twice ABS: as a general term comprising all asset classes and as a specific asset class; CDO: as a specific asset class and as a subcategory within this asset class February 2006 page 10

11 Introduction to ABS BASIC SECURITIZATION STRUCTURE* AAA Originating Bank Assets Transfer of risks/ remuneration Compensation in case of predefined events Special Purpose Vehicle ("SPV") Transfer of risks/ remuneration Compensation in case of predefined events AA A BBB Transfer of risks/ remuneration Compensation in case of predefined events Investors Equity Piece * Please refer to section 3 for more detailed explanations February 2006 page 11

12 Introduction to ABS MAIN REASONS FOR CONDUCTING ABS Originator/Seller-perspective: Balance Sheet Management: generation of liquidity (potential balance sheet contraction in a second step by redeeming debt), reduction of risk-weighted assets/increase of equity ratio, increase of profitiability by investing newly generated liquidity in higher yielding assets, asset-liability management Portfolio/-Risk Management: transfer/sale of risk (without recourse), optimization of the overall balance sheet's risk structure in case of new investments using the newly generated liquidity Fund/-Profit Management: cheaper funding as the ABS tranches' ratings are mostly higher than those of the originator/ seller, diversification of funding sources, switch from interest to commission income as originator/seller normally fulfills certain functions within the ABS transaction like servicer etc. Arbitrage: purchase, repackage and sale of risk, e.g. for the sake of leveraging credit risk to serve investors' specific needs in terms of risk profiles etc. (mainly CDOs) Other: transforming formerly illiquid assets such as mortgage loans into liquid instruments (ABS bonds), leading to price information/market valuation of a specific (part of the) loan portfolio, positive rating implication by, for instance, improving certain key ratios, e.g. non-performing loans as a portion of total assets etc. Investor-perspective: Benefiting from investments in new asset classes Benefiting from the flexibility of ABS structures in that the investors' specific needs in terms of risk profiles, term structures or liquidity issues can be met Beneftting from the fact that the performance of ABS bonds is generally independent from the originator's/seller's credit risk Historically, ABS bonds offered higher coupons/spreads compared to corporate bonds (for a given rating class and term) as well as a relatively high rating stability February 2006 page 12

13 Introduction to ABS KEY TRANSACTION PARTIES Arranger Swap Counterparty Servicer AAA Seller/Originator Asset Manager Assets Special Purpose Vehicle ("SPV") AA A BBB Investors Equity Piece Rating Agencies Trustee Provider of external credit enhancement/liquidity February 2006 page 13

14 Introduction to ABS KEY TRANSACTION PARTIES Seller/Originator: the previous owner of the assets Special purpose vehicle ("SPV"): specifically created for the purpose of the ABS transaction, i.e. it purchases assets/sells protection from/to the originator and issues credit linked notes/buys protection on the capital market; SPV is typically bancruptcy-remote and located off-shore for tax reasons Arranger: determines the underlying pool of assets and sets up the transaction's structure (on behalf of the originator) Servicer: collection and distributution of the cash flows that arise from the assets (interest and/or principal payments), arrears management, collateral management (e.g. regarding mortgage loans in case of a RMBS transaction); in Europe, the role of the servicer is mostly fulfilled by the originator Provider of external credit enhancement/liquidity: provides subordinated loans, guarantees, insurances (as protection for investors against credit risk) as well as liquidity facilities (as a means to bridge timing mismatches that may occur between the time when cashflows are collected from the underlying pool and cashflows are scheduled to be distributed among the various notes (sometimes also referred to as a "sponsor") Rating agencies: assess both the credit (and potentially market) risk of the underlying pool of assets and the structural features of the transaction, and consequently determine the size of the required credit enhancement to achieve a certain rating level Trustee: "agent" of the investors in that controls and checks cashflows, loss allocations, adherence to provisions etc. Swap counterparty: provision of interest-rate swap, as the SPV must not bear any interest rate risk due to the bancruptcyremoteness requirement, and as the securitized assets very often generate fixed-rate interest income, while the notes are mostly floaters (typically, notes offer 3-month Libor/Euribor plus a spread); moreover, provison of currency swap in case of the underlying assets and issued notes being denominated in different currencies Asset Manager: in case of managed, i.e. non-static pools (please refer to page 54) the asset manager is allowed to buy and sell assets during a certain time period subject to rules February 2006 page 14

15 Introduction to ABS MAIN PARTICIPANTS ON THE ABS MARKET Originators/Sellers: Banks are by far the most important group securitizing all kinds of assets mentioned above Governments securitize assets such as residential and commercial mortgage loans as well as delinquent tax receivables/ social security contributions etc. Corporates mainly securitize trade receivables, however, very often not via ABS, but via Asset-Backed Commercial Paper ("ABCP"), which are not addressed in this guide book Insurance companies securitize risks arising from (re-) insurance contracts Investors: Banks Pensions, mutual, money market funds Insurance companies Corporates Supranationals Structured Investment Vehicles ("SIV"), which generally fund a diversified portfolio of highly rated assets by issuing commercial paper or medium term notes. Their aim is to generate a spread between the yield on the portfolio and the vehicle s cost of funding. February 2006 page 15

16 Introduction to ABS PUBLIC EUROPEAN ABS ISSUANCE VOLUME PER PRODUCT CATEGORY in bn EUR RMBS CMBS CLO CDO ABS The European ABS issuance volumes increased signifcantly during recent years, with RMBS always being the dominant asset class. The aggregated outstanding volume of ABS exceeded that of corporates. February 2006 page 16

17 Introduction to ABS PUBLIC EUROPEAN ABS ISSUANCE VOLUME PER DOMICILE OF ASSETS in bn EUR Other United Kingdom Spain Portugal Netherlands Italy Germany France The UK has always clearly dominated the European ABS market in terms of issuance volumes, with Italy, the Netherlands, Spain and Germany following. February 2006 page 17

18 Introduction to ABS COMPARISON WITH COVERED BONDS ABS Covered Bonds Issuer The issuer is a special purpose vehicle ("SPV"). In most countries, the issuer is the originator of the assets and an operating entity. Claim Investors have a claim on the collateral and its cashflows. Investors always have a claim for recourse to the issuer. The claim of the investors against the issuer is independent from the performance of the collateral. Hence, the investor has a dual claim against the issuer and against the cover pool. Eligible assets Balance sheet treatment Structural risk Homogeneity Cover pool Regulation Bond structure Insolvency case In most countries, there is no specific legal framework that defines ABS. The structures are constructed based on the specific needs of the originator and the investor. There are generally no restrictions on the type of underlying assets. Assets and the associated risks are transferred from the originator's balance sheet to a SPV (in case of true sale deals only). As the structure is not set in a specific legal framework, structural risks are higher than for covered bonds, however, certain market standards like UK Master Trust structures developed, leading to standardization. ABS are generally non-standard (notwithstanding certain repeat issuer's platforms, e.g. certain Master Trusts). There are certain techniques which have proven effective in practice, but individual transactions can vary. The originator defines the assets. Once done, the pool can be static or revolving. Hence, non-performing loans remain in the pool, leading to potential losses for investors (this might be different for certain deals like managed CDOs). Degree of regulation is different from country to country. For example, there is no specific law in the UK, however there are securitization laws in France and Italy. Controlled amortization and pass through repayments are very common in ABS, leading to soft-bullet structures. Investors have a claim on the cash flows and the collateral assets in the SPV. Performance triggers and other structural protection mechanisms may lead to an acceleration of payments, an increase of reserve accounts etc. for the sake of investors. In most countries, a specific law sets the rules for the issuance of covered bonds and defines the eligible assets for the cover pool. The assets are generally limited to public sector loans and mortgage loans. Cover assets remain on the balance sheet of the issuer, maintained either in distinct cover pools, cover pool register or kept in subsidiaries. Structural risk is generally limited due to the specific legal frameworks and the dual claim against the issuer and the cover pool. The characteristics of a covered bond are standardized within the relevant legal framework. The individual covered bonds are different if they are contractually enhanced (structured covered bonds). The cover pool is dynamic. The issuer actively manages the cover pool of covered bonds. Hence, cover assets are replaced if they no longer meet the criteria defined by law (depending on the legal framework). Issuers of covered bonds are specifically regulated and supervised. In most countries, they are restricted in their business activities (notwithstanding exceptions like in Spain or Germany). Covered bonds are bullet in most cases. Pass-through repayment is not possible. Hence, there is no prepayment risk. If the cover pool no longer meets the eligibility criteria and is insufficient to back the liabilities of outstanding covered bonds, the pool accelerates. In this case, covered bond holders rank pari passu among themselves. If the collateral were insufficient to repay all covered bond claims, covered bond investors would rank pari passu with senior unsecured debt in their claim against the issuer. February 2006 page 18

19 Introduction to ABS LATEST DEVELOPMENTS ON THE ABS MARKET Credit default swaps on ABS tranches The first CDS on ABS were traded in Q Standardization of CDS on ABS contracts by an ISDA-agreement (published in June 2005) that defined credit events as well as settlement processes Development of the ABx (CDS on ABS index) in the US, which has already promoted CDS on ABS trading by serving as a benchmark tool Development of the ABS50 (ABS index based on the 50 largest/most liquid cash bonds) in Europe as well as a future contract that will reference this index February 2006 page 19

20 Contents 1 Index 2 Introduction to ABS 3 Description of main asset classes Overview Glossary of main terms and definitions What to look for? 4 Description of main structures Overview Glossary of main terms and definitions What to look for? 5 Rating agencies' approach to rating ABS General thoughts Selected methodologies What to look for? 6 Basel II General Introduction The Standardized Approach The Ratings Based Approach 7 Bloomberg Functions 8 Contacts February 2006 page 20

21 Description of main asset classes Overview GENERAL DIFFERENTIATION All assets that will be described and categorized in this section can generally be subdivided into Performing versus non-performing assets, i.e. either the respective obligors still serve their obligations by paying interest and principal when due as of closing of the ABS transaction (the huge majority of ABS deals) or interest and/or principal payments are overdue, at least to some extent Existing versus future flow assets, i.e. either the respective assets already exist as of closing of the ABS transaction, i.e. the lender and borrower already agreed upon a contract and typically the borrower already got the money (the huge majority of ABS deals) or the assets will be generated in the future, e.g. ABS bonds may be backed by credit card transactions that will occur in the future, i.e. when the respective originating bank receives money based on a specified credit card business, such cashflows will always be used to pay interest and principal on the notes February 2006 page 21

22 Description of main asset classes Overview RMBS Prime RMBS*: residential mortgage loans to borrowers with no adverse credit history, past defaults or mortgage/rental arrears Subprime RMBS*: residential mortgage loans to borrowers with adverse credit history, past defaults or mortgage/rental arrears Distinction based on the borrowers' credit quality Conforming RMBS*: mainly first-ranking mortgage loans to prime borrowers belonging to certain types of mortgage loans, e.g. owner-occupied mortgage loans, mortgage loans for the purpose of purchases or re-mortgages etc. Non-conforming RMBS*: residential mortgage loans to subprime borrowers or borrowers that self-certified their income, second-ranking mortgage loans, non-owner-occupied mortgage loans ("buy-to-let", "right-to-buy"), equity release loans etc. Distinction based on the borrowers' credit quality and the mortgage type (hence, it is more comprehensive than the above mentioned distinction) * Mixtures of the above mentioned classification exist, e.g. rating agencies may deem a certain mortgage loan "near-prime" in case it adheres to most crucial determinents, however, not to all of them.hence, the differenciation will remain qualitative to some extent. February 2006 page 22

23 Description of main asset classes Overview CMBS Mainly classified according to the type of real estate that secures the respective commercial real estate loan(s) Office buildings Retail (exemplary sub-category: shops/shopping mall) Residential buildings/multi-family houses Industrial real estate/warehouses Hotels Land Nursing homes Mixed use Credit tenant lease ("CTL") typically comprise properties leased to high quality tenants. Very often, CTLs unconditionally obligate the lessee to pay interest and principal due under the loan as well as all costs associated with occupying and maintaining the property. Hence, when analyzing a credit tenant lease CMBS rating agency's strongly focus on the rating of the lessee as the major driver for the probability of default of a loan, as opposed to property characteristics. February 2006 page 23

24 Description of main asset classes Overview ABS Consumer related ABS: Credit card debt Personal/consumer loans Auto loans/leases Non-consumer related ABS: Project finance (incl. infrastructure projects, aircraft loans and leases) Government sponsored deals securitizing unpaid social security contributions, unpaid taxes etc. Leasing contracts with SMEs Future flow transactions (notes are backed by future cashflows generated, e.g. by certain financial payment rights) Health care receivables (notes are backed by a sub-souvereign's obligation to pay back the debt of the region's health authorities, e.g. vis-a-vis pharmacies) Whole business (including UK pub transactions) February 2006 page 24

25 Description of main asset classes Overview CDO Loans to small- and medium sized companies (relatively great number of loans having a relatively low average nominal value leading to diversified pools "CLOs" (sometimes deemed as an own asset class and not as a sub-category of CDOs, as CLOs substantially differ from all other CDO types; however, sometimes also referred to as "SME CDOs") Loans to multinational corporates (relatively low number of loans having a relatively high average nominal value leading to less diversified pools "CDOs"*) Bonds, e.g. corporate or sovereign bonds (both high grade/high yield "CBOs") Special underlyings such as RMBS-/CMBS-/ABS-/CDO-tranches ( "CDO of ABS" or "CDO squared") Special products, e.g. leveraged loans (either to SMEs or multinationals), PIKs Credit/Equity default swaps (Collateralized Swap Obligations "CSO") A mix of all underlyings mentioned above * Please refer to page 10, which describes that the term "CDO" is used on two levels, namely as a specific asset class and as a sub category) February 2006 page 25

26 Contents 1 Index 2 Introduction to ABS 3 Description of main asset classes Overview Glossary of main terms and definitions What to look for? 4 Description of main structures Overview Glossary of main terms and definitions What to look for? 5 Rating agencies' approach to rating ABS General thoughts Selected methodologies What to look for? 6 Basel II General Introduction The Standardized Approach The Ratings Based Approach 7 Bloomberg Functions 8 Contacts February 2006 page 26

27 Description of main asset classes Glossary of main terms and definitions ALL ASSET CLASSES Number of loans/receivables/obligations: synonyms for the number of assets in the underlying portfolio; as the type of assets differs from transaction to transaction, e.g. mortgage loans in RMBS deals versus SME loans in CLOs versus bonds in CBOs, different terms are actually used Average (loan) balance: aggregated pool amount divided by numer of loans/receivables/obligations Single obligor concentration: the nominal value of the largest credit divided by the aggregated pool amount WA seasoning: weighted average seasoning, i.e. the underlying pool's weighted average time difference between the issuance of the respective credit and today (the higher the better, as it is typically assumed by rating agencies that the likelihood of a borrower's default decreases over time due to the additional money/equity the obligor uses to pay back the obligation; may be different for bullet loans subject to potential alternative products the borrower saves money for and that will be used to redeem the credit at its maturity, e.g. life insurance policy etc.) WART: weighted average remaining term of the underlying pool's asset Eligibility criteria: quality criteria the underlying assets (and/or the portfolio as a whole) have to adhere to as of closing (or throughout the transaction's life), e.g.: "assets have to be current as of closing" versus "assets have never been overdue as of closing" or max. single obligor concentration = 1% of aggregated pool amount February 2006 page 27

28 Description of main asset classes Glossary of main terms and definitions RMBS* DTI-ratio: debt-to-income ratio of a borrower, i.e. his or her monthly debt (interest and principal) payments divided by monthly gross income: this indicates his or her ability to serve interest and principal payments, hence the higher DTI the worse (in case of insufficient data regarding monthly debt payments especially regarding interest payments, and moreover as typical in the UK, so-called "income multiples" are calculated, i.e. total debt divided by yearly gross income) Self-certification loans: borrower is not able/not required to prove/certifiy his or her income, e.g. in case of self-employed people without appropriate tax statements or certain mortgage products lended to borrowers with rather strong credit scores CCJ: County court judgment: this is applied to an individual s credit history by county courts following successful claims by creditors for the non-payment of amounts owed (this specific term is typically used in the UK). IVA: Individual voluntary arrangement between the borrower and his or her creditors, which might already be completed or still pending (this specific term is typically used in the UK).) BO: Bankruptcy orders in case the borrower once filed for bankruptcy (the claims may already be satisfied or may still be pending) * In the following, we will not show any specific terms and definitions for the asset class "ABS", as these are coverered either by the respective terms and definitions for RMBS (consumer related ABS) or CDO (non-consumer related ABS) February 2006 page 28

29 Description of main asset classes Glossary of main terms and definitions RMBS BTL: Buy-to-let mortgage loans, i.e. the borrower does not live in the respective financed house or apartment, but rents it to a third person (<> "owner-occupied") RTB: Right-to-buy mortgage loans, i.e. loans to lower-income individuals to purchase homes formerly owned by their local councils or municipal governments and sold to the occupants under a specific legislation (BTL, RTB and owner-occupied loans should always sum up to 100% for a specific mortgage portfolio's "occupancy distribution") Less liquid properties: very large, small or specific properties that might be more difficult to sell, e.g. in a stress scenario like a forced sale following the bankruptcy of a borrower (the respective size limit for determining a property "less liquid" depends on the respective region etc., e.g. size limits are set more conervatively in Southern Italy when compared to Northern Italy) Jumbo loans: large loans exceeding certain thresholds, e.g. EUR 400,000, however, the threshold depends on the respective region and rating agencies' classifications (overlap with the classification "less liquid properties"). February 2006 page 29

30 Description of main asset classes Glossary of main terms and definitions RMBS and CMBS WA LTV: weighted average loan-to-value ratio (based on the real estates' last valuation) the lower the better as it indicates the level of protection in case of the borrower's default Original WA LTV: based on the above mentioned calculation as of the issuance date of the respective mortgage loans Current WA LTV: based on the above mentioned calculation as of today, hence this value is normally lower than the original WA LTV due to amortization (<> bullet loans) WA indexed LTV: the real estate value is indexed to a certain year, i.e. mostly increased depending on the respective real estate's last valuation date and geographic location WA LTAV: weighted average loan-to-appraised-value, i.e. the real estate value is decreased by a certain haircut, e.g. in Germany such a haircut is determined by 16 PfandBG / Beleihungswertvermittlungsverordnung " (PfandBG: covered bonds law dealing, among others, with real estate valuations) WA LTMV: weighted average loan-to-market-value, i.e. based on the real estate's current market value (which may be different from the real estate's indexed value, since such indexation is calculated based on general aspects (see above: real estate's last valuation date and geographic loacation) rather than being based on the specifics of the respective real estate) WA LTFV: weighted average loan-to-foreclosure-value, i.e. based on the real estate's stress value in case of the borrower's default (typically calculated in the Netherlands and normally rather high, as the real estate's value is assumingly significantly lower in case of a forced sale) WA exit LTV: based on the estimated mortgage loans' amortization until maturity, it is the WA LTV as of the maturity of the respective loans, i.e. in case there is still a bullet payment due from the borrower as of maturity of the mortgage loan, the WA exit LTV indicates the risk in case of borrowers not being able to make their bullet payments February 2006 page 30

31 Description of main asset classes Glossary of main terms and definitions RMBS and CMBS WA LTV WA CLTV: weighted average combined loan-to-market-value; important in case of several mortgage loans referencing to one real estate First lien mortgage loan In case of the borrower's default, this mortgage loan will be credited the proceeds from the real estate sale first it ranks senior Example: Value of real estate: = EUR 200 Mortgage loan outstanding = EUR 80 Prior ranking mortgage loan = EUR 40 Second lien mortgage loan In case of the borrower's default, this mortgage loan will be credited the proceeds from the real estate sale after the first lien mortgage loan is fully redeemed it ranks junior LTV: ( )/200 = 60% LTV of prior lien: 40/200 = 20% The WA CLTV does not take into account ranking, but simply calculates the respective figure based on the sum of all loans divided by the real estate's value CLTV: 60% February 2006 page 31

32 Description of main asset classes Glossary of main terms and definitions CMBS ICR: Interest coverage ratio, i.e. the respective commercial loan's incoming cashflows (typically rental income from the commercial real estates) divided by the interest to be paid on such loan (in case of a CMBS deal with an underlying portfolio consisting of more than one loan, a WA ICR for the whole transaction is typically calculated) DSCR: Debt service coverage ratio, i.e. the respective commercial loan's incoming cashflows (typically rental income from the commercial real estates) divided by the interest AND principal to be paid on such loan (in case of a CMBS deal with an underlying portfolio consisting of more than one loan, a WA DSCR for the whole transaction is typically calculated) Property score: rating agencies (mainly S&P and Moody's) sometimes publish a WA property score for the real estates backing the loans that are securitized via a CMBS transaction. These scores typically range from 1 (best) to 5 (worst) and are based on qualitative categories such as Geographic location of the respective real estate Offer-demand pattern for the respective real estate Quality of the respective real estate (endowment and state) Functionality of the respective real estate Additional aspects such as available parking etc.) February 2006 page 32

33 Description of main asset classes Glossary of main terms and definitions CDO S&P default measure: the annualized expected portfolio default rate (par amount weighted average default probability of the underlying assets based on their ratings, also taking into account the respective remaining terms of the assets) S&P variability measure: the annualized standard deviation of the assets' default rates around the expected portfolio default rate (hence, this measure takes into account the relative credit quality of the respective assets based on their ratings, different sizes and maturities). This measure explicitly takes correlation into account S&P correlation measure: assesses the impact of the above mentioned correlation upon the standard deviation of the portfolio default rate. More precisely, it is the ratio of the standard deviation of the portfolio computed a) with and b) without correlation. For instance, in case of a correlation measure of 1.4, the portfolio default rate's standard deviation is 40% larger due to correlation February 2006 page 33

34 Description of main asset classes Glossary of main terms and definitions CDO WA recovery rate/wa spread: rating agencies typically set thresholds for certain portfolio characteristics, which, if not met, lead to certain events, e.g. re-investments/trading may not be allowed in managed CDOs anymore. Normally, there is a matrix of WA recovery rates versus WA spreads (of the assets for a respective CDO's underlying portfolio), which are the basis for so-called "Portfolio Quality Tests". Hence, in case the combination of such two measures does not reach the required threshold limit (e.g. the spread is too low, given a certain recovery rate), re-investments/trading may be suspended (in certain cases, re-investments/trading may still be allowed, unless the portfolio quality tests are worsened by such reinvestment/trade). If a rating agency mentions a "Minimum WA recovery rate/spread" for the respective portfolio in its pre-sale report, it means that this is the lowest WA value of such a measure in the aforementioned matrix for instance, a min. WA recovery value of 40% means that the matrix does not include any combination of a WA recovery rate and a WA spread with the former being below 40%. OC/IC tests: Overcollateralization/interest coverage tests are also portfolio quality tests (OC tests are also referred to as "Parvalue tests" and are described in more detail on page 41). Moody's Diversity Score*: correlation measure of a CDO's underlying pool of assets; it measures the equivalent number of asssets of such a pool that have a 0% correlation amongst themselves Are identical in all respects (yield, maturity, margin etc.) February 2006 page 34

35 Contents 1 Index 2 Introduction to ABS 3 Description of main asset classes Overview Glossary of main terms and definitions What to look for? 4 Description of main structures Overview Glossary of main terms and definitions What to look for? 5 Rating agencies' approach to rating ABS General thoughts Selected methodologies What to look for? 6 Basel II General Introduction The Standardized Approach The Ratings Based Approach 7 Bloomberg Functions 8 Contacts February 2006 page 35

36 Description of main asset classes What to look for? GENERAL APPROACH Although there is a large variety regarding the underlying portfolios of securitization transactions in Europe, it is important to note that there are some common characteristics which are important when assessing the credit risk arising from consumer related (e.g. RMBS, consumer-related ABS, certain CMBS) or corporate related (e.g. CLOs) ABS deals Main question: what drives the obligors' ability and willingness to serve their obligations, which is a prerequisite to ultimately pay interest and principal on the issued notes? Each Credit Sector is susceptible to specific economic factors Corporate Risk Bankruptcy filings Investment growth Debt leverage ratio/debt structure Upgrade/Downgrade ratio Provisions for bad loans and write-offs in bank loan portfolios in relation to lending growth etc. Consumer Risk Personal bankruptcy filings Unemployment rate Housing market Debt-to-income ratio/debt structure etc. February 2006 page 36

37 Description of main asset classes What to look for? ALL ASSET CLASSES WA levels for certain portfolio characteristics (LTV, seasoning, loan size etc.) versus the distribution of such characteristics (for instance, are any mortgage loans with LTVs > 100% included in an underlying RMBS pool?); investors bearing the first losses that occur in an underlying portfolio (please refer to the section below that explains how losses are distributed among investors in ABS deals) are typically more interested in the tails of a specific portfolio characteristic's distribution, as these tails generally drive the timing and size of losses (e.g. mortgage loans with higher LTVs generally have higher default probabilities and loss severities) Eligibility criteria, i.e. how strict are these on a single loan level as well as on a portfolio level (mitigation of potential concentration risks etc.; eligibility criteria typically refer to certain characteristics as of closing, while "portfolio limits"/"quality tests" typically refer to tests being conducted throughout the deal's life in case of revolving portfolios) Actual portfolio characteristics versus portfolio limits/portfolio quality tests (in case of non-static portfolios, the latter rather than the portfolio characteristics as of closing are important, as per definition the pool changes continuously) Arrears levels of portfolio as of closing (incl. distribution of arrears e.g. bucket of assets < or > 30 days in arrears - and arrears history), which should also be compared to deals that securitized similar/the same assets Geographic distribution of assets, e.g. concentrations on "problematic" areas with high unemployment rates, weak real estate markets etc. should be avoided (southern versus northern Italy, eastern versus western Germany etc.) Borrower type, for instance in consumer related deals (employed versus self-employed versus civil servant) or in corporate related deals (industry bucket) Loan type, for instance amortizing loan versus bullet loan etc. WA margin/coupon of the underlying assets as an indication of the size of casflows that are generated is there possibly a negative carry, i.e. the cashflows generated from the underlying portfolio's assets are lower than the cashflow needed to serve the notes February 2006 page 37

38 Description of main asset classes What to look for? ALL ASSET CLASSES Prepayment assumptions, i.e. how fast is the underlying portfolio expected to amortize (prepayments are defined as unscheduled principal payments by borrowers, including early redemptions). Potential positive effects include: Increased relative credit enhancement* Shorter WALs of the respective notes, leading to a higher yield compared to notes for which such shorter WAL was already expected upon pricing. Potential negative effects include: Excess spread compression (less assets generate cash going forward, which is typically a problem in case of sequential amortization*, as this leads to higher rated, and hence "cheaper" notes being amortized first, leading to an increase of the WA costs on the liability side and/or in case of high yielding assets being prepayed, leading to a decrease of the WA interest income on the asset side; generally: this is different for revolving pools that are replenished by purchasing new assets after redemptions occured) In case of notes trading above par, higher-than-expected prepayments may lead to lower-than-expected total returns for such notes Timing mismatches (e.g., in case of pay-through structures: if cash received by the issuer cannot be passed on to the noteholders immediately, but only on the next payment date) that could decrease excess spread levels Re-investment risks in a low yield environment Assuming that mainly less risky (economically stronger) borrowers prepay as they have the means to do so, the remaining portfolio s average quality deteriorates Notably, prepayment assumptions as of closing are normally not updated in many trading systems, leading to the need to compare actual prepayment rates with originally expected rates in order to quantify a fair price * Please refer to the pages 52 and 53 for a description of the concept of credit enhancement (including excess spread) and sequential amortization. February 2006 page 38

39 Description of main asset classes What to look for? RMBS* Discounted loans, for instance UK non-conforming RMBS transactions often include mortgage products with "discountmargins/teaser rates", i.e. the respective borrower pays a lower interest rate for a certain time period (normally at the beginning); the risks that arise from the temporarily reduced cashflow generation of the underlying portfolio consisting of such loans is sometimes mitigated by a specially dedicated reserve fund more importantly, borrowers may have a higher default probability after their discounted margin is increased to a "stabilized level" (payment shock) RMBS and CMBS The size of prior ranking mortgages is very important for the calculation of a loss severity Generic example: Value of real estate: EUR Example: Size of mortgage loan: EUR 80 and size of prior ranking mortgage loan: EUR Example: Size of mortgage loan: EUR 120 LTV amounts to 60% in both examples, HOWEVER, in case of the borrower's default the loss severity differs signifcantly Assumption: proceeds from the real estate's forced sale of EUR Example: 80 (55 40) = 65/80 = 81.3% 2. Example: = 75 75/120 = 62.5% Loss severity much higher in case of an existing prior ranking mortgage loan, although the LTV was the same for both examples However, it is the overall size of the prior ranking mortgages (i.e. the WA LTV of prior lien; please refer to page 31 for the definition of the LTV of prior lien) that is important, and not the portion of mortgage loans that have a prior lien, e.g. all mortgage loans of a given pool may have a prior lien, however, as long as the respective prior liens are small, they are not threatening for investors * In the following, we will not show any areas of potential risk factors for the asset class "ABS", as these are coverered either February 2006 page 39 by the respective potential risk factors for RMBS (consumer related ABS) or CDO (non-consumer related ABS)

40 Description of main asset classes What to look for? CMBS Rental income distribution, i.e. who are the main tenants of the commercial real estates backing the loan(s), and hence, the main sources of rental income that is needed to pay interest and principal on such loan(s) and finally on the issued notes (assessment of the tenant diversification and credit quality in terms of ratings etc.) Remaining lease term versus remaining loan term, i.e. it is not only important that the respective loan's ICR/DSCR are large enough, but that the rental income is generated for at least throughout the loan's remaining life (and even if the remaining lease term of the real estates backing a loan is long enough, possible termination rights of tenants have to be taken into account) Hedging for underlying loans: underlying loans in CMBS transactions often have interest rate and/or currency hedges on the borrower level (as opposed to the issuer, i.e. SPV-level), which may lead to increased risk of swap breakage costs being incurred when compared with transactions where a swap is at the issuer level, which means that breakage costs might be deferred by drawing on the transaction's available liquidity. Hence, it is important to analyze the rank of breakage costs in the transaction's waterfall (please refer to the section "Description of main structures") A/B structures refers to a commercial mortgage loan that is split into a senior portion, which is securitized, and a junior portion, which is sold or held outside the securitization structure. The senior portion is often referred to as the "A" loan and the junior portion as the "B" loan. Most importantly, both rely on the same collateral. Poorly drafted or implemented A/B structures may delay the recovery process and/or restrict the work-out options available to a special servicer following a loan event of default (hence, inter-creditor arrangements within such A/B structures should be analyzed closely). February 2006 page 40

41 Description of main asset classes What to look for? CDO SROC ("Synthetic rated overcollateralization"): this test is used as a monitoring tool by S&P throughout the deal's lifetime (the SROC is not part of the transaction's documentation, but an analytical tool used by S&P) and compares the portfolio's respective break even default rate, i.e. the max number of defaults the pool could sustain in a certain rating scenario without failing to pay interest and principal on the note of such rating level and the portfolio's respective scenario default rate, i.e. the expected number of defaults the underlying pool is expected to suffer in a certain rating scenario In case the former is lower than the latter, the respective note on the analyzed rating level is considered for a downgrade. Overcollateralization ("OC") test's (they are part of the overall transaction's documentation based on rating agencies' requirements) generic definition for a given tranche i (at a given point in time) Par Value of Asset + Cash Par Value of Liabilities senior to tranche i + Par Value of tranche i Interest coverage ("IC") test's (they are part of the overall transaction's documentation based on rating agencies' requirements) generic definition for a given tranche i (at a given point in time): Total Amount of interest Total Amount of interest on Liabilities senior to tranche i + Interest on tranche i February 2006 page 41

42 Description of main asset classes What to look for? CDO OC test's rules for asset valuation: Are any haircuts (reduction of assets' par value) required for certain assets, e.g. assets rated CCC/Caa or below? haircuts are bespoke, however a typical rule may be: the OC test looks at the nominal principal balance of the asset, regardless of whether the asset was purchased below or above par. However, a par value haircut is conducted if a rating agency rates a certain amount of assets in the underlying portfolio CCC or below. if this amount exceeds a given limit, the amount of assets that exceed this limit must be subject to either a fixed 30% par value haircut (i.e. these assets are deemed to have a value of 70% of their nominal amount) OR a floating par haircut equal to their nominal amount multiplied by their market value. the purpose of these haircuts is to trigger an earlier de-leveraging of senior notes if the credit quality of the portfolio deteriorates beyond expected levels (this is because upon the breach of an OC test, interest income may be used to redeem -parts of- the senior notes, i.e. the liability side of the CDO is decreased) alternatively, par value haircuts may be conducted in case assets were purchased below a given threshold of par (for example: 85% of par). The definition of rating-based valuation rules is related to how many ratings, e.g. haircuts are already required in case one rating agency rates a certain asset CCC/Caa or only in case two rating agencies rate this asset CCC/Caa (problem of split-ratings)? Are the valuation rules the same for all different notes (or are there differences between OC tests for senior and mezzanine notes)? How are assets valuated that were purchased below par? How are assets valuated that were purchased above par, but currently trade below par? In case of several IC, OC or other portfolio quality tests being incorporated in the deal's documentation: which test is likely to be breached first, leading to which consequences, e.g. is the OC test for a lower rated tranche or the OC test for the most senior tranche breached first? February 2006 page 42

43 Description of main asset classes What to look for? CDO OC test's rules for asset valuation: What are the consequences of the breach of an OC test? Typically, re-investments are suspended upon trigger breach and incoming cash is used to pay down notes sequentially until the respective trigger is not breached any more deleveraging of senior notes Are the trigger levels/oc test levels reasonable when compared to historical asset performance? What is the OC thickness, e.g. after the OC trigger of the note junior to a given tranche i is breached, how many additional defaults have to occur until the OC trigger of the tranche senior to tranche i is breached relative cushion between the two tranches "surrounding" tranche i (relative OC thickness as opposed to absolute OC thickness) Comparison of initial OC/IC levels and the respective OC/IC limits if the difference is initially low, it is rather negative for equity investors, as the respectice OC/IC test is breached earlier. In other words, the likelyhood of interest on junior notes being re-directed to senior notes' amortization is higher (hence, reinvestment diversion tests may be more attractive for equity investors, as upon breach of such tests, excess spread is used to buy additional collateral generating additional cashflows going forward, which can be distributed to equity investors as well) The amount of cash (<>invested assets) a CDO holds (e.g. because the CDO manager cannot find eligible assets to invest in), as it generates less/no spread February 2006 page 43