Copyright 1999 Ian H. Giddy Managing Credit Risks 3 SELL ASSETS (MAY ADD MORE) Copyright 1999 Ian H. Giddy Managing Credit Risks 5

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1 Managing the Credit Risks/1 Asset-Backed Securities Managing the Credit Risks Managing the Risks Identifying the risks The role of rating agencies Managing the credit risks Managing the sovereign risks Prof. Ian Giddy Stern School of Business New York University Copyright 1999 Ian H. Giddy Managing Credit Risks 3 Identifying the Risks Managing the Risks Credit risks Liquidity risk Servicer performance risk Swap counterparty risk Guarantor risk Legal risks Sovereign risk Interest rate and currency risks Prepayment risks ORIGINATOR SELL ASSETS (MAY ADD MORE) ASSETS SERVICER SUB- ORDINATED INVESTORS OVER- COLLATERAL LIQUIDITY FUND POOL PERFORMANCE GUARANTOR OWNER Special Special Purpose Purpose Company Company (or (or Trust) Trust) RESERVE FUND FIRST LOSS PROVIDER CAP OR COLLAR PROVIDER SPECIAL INSURER (HAZARD, ETC.) 3 SWAP COUNTER- PARTY 2 1 PERMITTED INVESTMENTS INTEREST & PRINCIPAL GUARANTOR SENIOR INVESTORS Copyright 1999 Ian H. Giddy Managing Credit Risks 4 Copyright 1999 Ian H. Giddy Managing Credit Risks 5 Form of credit enhancement Pre-securitization risk reduction Credit risk reduction of the asset Credit risk reduction at the trust level Screening of assets to be included in the portfolio Diversification of the portfolio Issuer-provided enhancement Third party credit guaranty Pooler credit guaranty Senior/subordinated ABS Replacement of sub-standard assets Direct recourse Overcollateralization Third party partial enhancement Third party full enhancement Rating Agencies Why a rating? compare alternatives across different ratings categories; obtain a relative as well as an absolute measure of credit risk be reasonably sure of a market to sell the security. Repackaging of cash flows Legal structure based credit risk reduction Legal insulation from originator default Legal insulation from servicer default Copyright 1999 Ian H. Giddy Managing Credit Risks 9

2 Managing the Credit Risks/2 Managing the Risks: Role of the Rating Agencies Asset portfolio analysis Legal structure of the transaction Credit quality of the originator The trustee The cash flow structure The counterparties Copyright 1999 Ian H. Giddy Managing Credit Risks 10 Key Factors Agencies Examine the quality of the pool of assets, evaluated as a portfolio the credit quality of all the parties to the deal. operational support for servicing, transfer, recording, follow-up, etc; credit enhancement legal structure sovereign risks market price risks payment timing risks Copyright 1999 Ian H. Giddy Managing Credit Risks 11 Aspects of the Business Reviewed by Rating Agencies and the Credit Enhancer Organization and management structure Financial performance Business strategy and planning processes Controls and procedures Asset origination and credit assessment procedures Quality of its loan documentation Credit administation and debt recovery procedures Role of Originator's Review Systems Produce historical information on the assets to be securitized Identify and segregate the securitizable assets and track their cash flows Report on the performance of the securitized assets Copyright 1999 Ian H. Giddy Managing Credit Risks 12 Copyright 1999 Ian H. Giddy Managing Credit Risks 13 Rating Agency Requirements - 1 Legal Structure Information on parties involved in the ABS issuance, namely, the originator(s), servicer, merchant bank, lawyers, accountants, trustees, credit enhancer, liquidity banks. Proposed legal structure and documentation e.g., type of assets to be securitised, senior/subordination features; passthroughs/pay-throughs, any recourse provisions, corporation/trust, over-collateralisations, other risks and claims structure, etc. Legal and accounting opinions (and subsequently regulator's opinion) on the characterization of the transferred assets i.e., a "true sale" or "pledge". The legal opinion should also extend to opinions on the possible impact of the issuer's bankruptcy on the securitised assets, liability to stamp duty and sales tax. Tax opinions on how to SPV would be taxed and whether investors' investment in the ABS represent debt or equity to the SPV. Copyright 1999 Ian H. Giddy Managing Credit Risks 14 Rating Agency Requirements - 2 Credit Risk 10-year industry statistics/analysis on the assets to be securitised e.g., yield statistics of assets, non-performing loans, ageing/delinquencies, customer demographics and repossession rate. Summarized 10-year historical records/statistics on the originator's HP portfolio, focusing on portfolio performance and characteristics including the following: growth yield underwriting standards and loan terms/maturity recourse provisions to motor-vehicle dealers ageing/delinquencies rate collection and recovery procedures (including repossession rate) customer profile/demographics new versus used equipment prepayment history Copyright 1999 Ian H. Giddy Managing Credit Risks 15

3 Managing the Credit Risks/3 Rating Agency Requirements - 3 Credit Risk (continued) Information on the intended pool selection process including the following: maturity period seasoning loan to value of assets whether insured, types of policy, insure amount delinquency factor any previous extension and rewrites interest rate Cash Flow Structure Cash flow mechanics/control Timing of receipts and payments Liquidity support Copyright 1999 Ian H. Giddy Managing Credit Risks 16 Managing the Credit Risks The assets are chosen and the legal structure designed to get an investment grade rating. Internal credit improvement, eg. the SPV's debt is "overcollateralized", or the parent agrees to replenish the asset pool if its value falls, or the SPV has a subordinated debt tranche External credit improvement, eg. a guarantee or letter of credit is purchased from a third party Copyright 1999 Ian H. Giddy Managing Credit Risks 17 Managing the Risks LOCs and and puts puts Overcollaterization Senior/ subordinate structure Cash collateral First-Loss Protection Recourse to to originator Second- Loss Protection Copyright 1999 Ian H. Giddy Managing Credit Risks 18 Over-Collateralization/ Subordinated Tranche COLLATERAL POOL OVER-COLLATERAL SPECIAL-PURPOSE VEHICLE SENIOR ASSET-BACKED SECURITIES SUBORDINATED ABS (may be owned by seller) Copyright 1999 Ian H. Giddy Managing Credit Risks 19 Senior/Subordinated Structure with Cash Reserve Account Use of a Cash Reserve Account Cash Collateral Account Proceeds Seller/Servicer Proceeds Borrower 1 Originating Bank Subordinated Investor Interest Receivables Principal and Interest Subordinated Certificates Grantor Trust Residual Interest Principal and Interest Senior Certificates Senior Investor Interest Letter of Credit Bank 6 Reserve Account Trustee 3 Investors LOC Credit Enhancement 8 Copyright 1999 Ian H. Giddy Managing Credit Risks 20 Copyright 1999 Ian H. Giddy Managing Credit Risks 21

4 Managing the Credit Risks/4 Use of a Cash Reserve Account Borrower Letter of Credit 6 Reserve Account Copyright 1999 Ian H. Giddy Managing Credit Risks 22 Bank 2 4 Trustee 3 Investors 1 The payments are made to the bank, as before the sale 2 The bank passes the payments on to the trustee 3 The trustee pays investors their interest 4 The trustee pays the bank a fee for servicing the loan 5 The difference between the porfolio yield, the investor interest and the servicing fee is paid to the reserve account 6 The reserve account is used to reimburse the letter of credit bank for 7 draws occasioned by defaults by borrowers on the loans 8 When the reserve account reaches its cap, excess funds flow back to the selling bank. Rating Analysis Pre-securitization risk reduction Legal structure based credit risk reduction Credit quality of deal participants Integrity of cash flow structure Credit enhancement Rating Originator s credit underwriting standards Screening of assets to be included in the portfolio Legal insulation from originator default Legal insulation from servicer default Internal credit enhancement Third party credit enhancement Diversification of the portfolio Originator/Seller/Servicer Trustee, swap counterparties Guarantors Cash flow sufficiency and mismatches Safeguards and agreements such as swaps or caps Direct recourse Senior/subordination or overcollateralization Reserve or spread accounts Cash collateralized accounts Financial guarantees Copyright 1999 Ian H. Giddy Managing Credit Risks 23 Managing the Sovereign Risks Secure sovereign guarantees Employ offshore jurisdictions Securitize foreign-source assets or cash flows Obtain a guarantee from a foreign financial institution Managing the Sovereign Risks Secure sovereign guarantees Employ offshore jurisdictions Securitize foreign-source assets or cash flows Obtain a guarantee from a foreign financial institution Copyright 1999 Ian H. Giddy Managing Credit Risks 24 Copyright 1999 Ian H. Giddy Managing Credit Risks 25 Managing the Risks: Offshore Purchase Agreement Asset-Backed Securities YPF (Latin American oil producer) Oil (under sales agreement) Oil Trading Co. (Cayman Is. SPV) US$ Oil (under purchase agreement) Highly rated U.S. oil buyer Notes US$ US$ Noteholders Trust Fixed debt payments Role of Financial Guarantees Prof. Ian Giddy Stern School of Business New York University Copyright 1999 Ian H. Giddy Managing Credit Risks 26

5 Managing the Credit Risks/5 Role of Financial Guarantees The Financial Guarantors Why use guarantees? The guarantors: banks, pool insurers, financial guarantors What do they guarantee? Who guarantees the guarantors? Getting a guarantee Cost of a guarantee Ongoing monitoring by the guarantee companies Copyright 1999 Ian H. Giddy Managing Credit Risks 28 Banks General property/casualty companies providing "pool" insurance Specialized financial guaranty companies Copyright 1999 Ian H. Giddy Managing Credit Risks 29 What do they Guarantee? Who Guarantees the Guarantors? Full principal and interest guarantee Partial guarantees Regulatory controls Rating the guarantors Role of reinsurance Copyright 1999 Ian H. Giddy Managing Credit Risks 30 Copyright 1999 Ian H. Giddy Managing Credit Risks 31 Practical Aspects of Financial Guarantees Getting a guarantee Cost of a guarantee Ongoing monitoring by the guarantee companies Case Study: Atherton Franchisee Loan Funding What are the credit risks of the underlying franchise loans? What other risks should a rating agency consider? What is Fitch s method for rating franchise loans? How are investors protected? Group work Copyright 1999 Ian H. Giddy Managing Credit Risks 32 Copyright 1999 Ian H. Giddy Managing Credit Risks 33

6 Managing the Credit Risks/6 Ian H. Giddy Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel ; Fax Copyright 1999 Ian H. Giddy Managing Credit Risks 43