Securitization

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Securitization</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#servicing agent">servicing agent</a><p class="word_list"> <a href="#servicing fee">servicing fee</a><p class="word_list"> <a href="#servicing rights">servicing rights</a><p class="word_list"> <a href="#Securitization">securitization</a><p class="word_list"> <a href="#tranches">tranch</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <p class="body">A <b><a name="Securitization">securitization</a></b> is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a financing company that has issued a large number of auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing loans, but there isn't a <a href="../articles/liquidity.htm">liquid</a> secondary market for individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the pool to investors. For the financing company, this raises capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a <a href="../articles/hedging_and_diversification.htm">diversified</a> pool of auto loans, which may be an attractive alternative to a <a href="../articles/corporate_bond.htm">corporate bond</a> or other fixed income investment. The ultimate debtors—the car owners—need not be aware of the transaction. They continue making payments on their loans, but now those payments flow to the new investors as opposed to the financing company.</p> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table><p class="body">All sorts of assets are securitized:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">auto loans</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">student loans</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">mortgages</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">credit card receivables</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">lease payments</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">accounts receivable</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">corporate or sovereign debt, etc.</p> <p class="bullet"> </p> <p class="bullet">Assets are often called <a href="../articles/collateral.htm"> collateral</a>.</p> <p class="body">In a typical arrangement, the owner—or "originator"—of assets sells those assets to a <a href="../articles/off_balance_sheet_finance.htm">special purpose vehicle</a> (SPV). This may be a <a href="../articles/corporation.htm">corporation</a>, US-style trust, or some form of partnership. It is established specifically to facilitate the securitization. It may hold the assets—collateral—on its balance sheet or place them in a separate trust. In either case, it sells <a href="../articles/coupon_bond.htm">bonds</a> to investors. It uses the proceeds from those bond sales to pay the originator for the assets.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table6"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">Most collateral requires the performance of ongoing servicing activities. With credit card receivables, monthly bills must be sent out to credit card holders; payments must be deposited, and account balances must be updated. Similar servicing must be performed with auto loans, mortgages, accounts receivable, etc. Usually, the originator is already performing servicing at the time of a securitization, and it continues to do so after the assets have been securitized. It receives a small, ongoing <b> <a name="servicing fee">servicing fee</a></b> for doing so. Because of that fee income, <b><a name="servicing rights">servicing rights</a></b> are valuable. The originator may sell servicing rights to a third party. Whoever actually performs servicing is called the <b><a name="servicing agent">servicing agent</a></b>.</p> <p class="body">Cash flows from the assets—minus the servicing fees—flow through the SPV to bond holders. In some cases, there are different classes of bonds, which participate differently in the asset cash flows. In this case, the bonds are often called <b><a name="tranches">tranches</a></b>. If the securitization is structured as a <a href="../articles/off_balance_sheet_finance.htm"> pass-through</a>, there is only one class of bonds, and all investors participate proportionately in the net cash flows from the assets.</p> <p class="body">When assets are transferred from the originator to the SPV, it is critical that this be done as a legal sale. If the originator retained some claim on those assets, there would be a risk that creditors of the originator might try to seize the assets in a bankruptcy proceeding. If a securitization is correctly implemented, investors face no <a href="../articles/credit_risk.htm">credit risk</a> from the originator. They also face no credit risk from the SPV, which serves merely as a conduit for cash flows. Whatever cash flows the SPV receives from the collateral are passed along to investors and whatever party is providing servicing. </p> <p class="body">Depending on the nature of the collateral, it may or may not pose credit risk. For example, people may fail to make their credit card payments, so credit card receivables entail credit risk. On the other hand, many <a href="../articles/mortgage_backed_security.htm">mortgage-backed securities</a> in the United states have little or no credit risk. <a href="../articles/mortgage_backed_security.htm">Ginnie Mae</a> guarantees timely payment of <a href="../articles/par_value.htm">principal</a> and interest on its <a href="../articles/mortgage_backed_security.htm">mortgage pass-throughs</a>. Ginnie Mae is backed by the full faith and credit of the US government, so the pass-throughs are free of credit risk. </p> <p class="body">If collateral entails credit risk, a securitization will often be structured with some sort of <a href="../articles/credit_enhancement.htm">credit enhancement</a>. This may include over-collateralization, a third party guarantee, or other enhancements. Also, by their nature, securitizations diversify the default risk of the underlying assets.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table7"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><a href="../articles/credit_risk.htm">Credit ratings</a> are often obtained for those securitizations that entail credit risk, and most ratings are <a href="../articles/junk_bond.htm"> investment grade</a>. If a securitization has different classes of bonds, each may receive a different credit rating. Credit ratings can be misleading for novices. The fact that a securitization has a AAA rating doesn't mean it is risk free. It only means that the chance of a bond holder incurring a loss attributable to default on the underlying assets is remote. Other risks, which can affect the timing of payments, may be considerable. Also, because valuing the underlying assets is often difficult, there is a risk that an investor will overpay for a securitization the investor is ill-equipped to value on its own. </p> <p class="body">Standard categories of securitizations are</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/mortgage_backed_security.htm">mortgage-backed securities</a> (MBS), which are backed by mortgages;</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/asset_backed_security.htm">asset-backed securities</a> (ABS), which are mostly backed by consumer debt;</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/collateralized_debt_obligation.htm">collateralized debt obligations</a> (CDO), which are mostly backed by corporate bonds or other corporate debt.</p> <p class="body">Each segment of the market offers unique opportunities and risks, reflecting the nature of the underlying assets and market conventions that have evolved over time. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table8"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/asset_backed_security.htm">asset-backed security</a> A securitized interest in non-mortgage assets.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/coupon_bond.htm">bond</a> Securitized debt.</p> <p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/collateralized_debt_obligation.htm">collateralized debt obligation</a> A securitized interest in debt.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/collateralized_mortgage_obligation.htm">collateralized mortgage obligation</a> A type of MBS with cash flows segregated into bonds offering different maturity and risk characteristics.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_enhancement.htm">credit enhancement</a> Any methodology that reduces the credit risk of a transaction with a counterparty.<p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/credit_risk.htm">credit risk</a> Risk</strong> due to uncertainty in a counterparty's ability to meet its obligations.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/hybrid.htm">hybrid instrument</a> A financial instrument that blend characteristics of debt and equity markets.</p> <cop yrigh t( c)c ont i ngen cy anal y sis, 2 00 5> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/medium_term_note.htm">medium-term note</a> A debt security issued through shelf-registration under US law.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/mortgage_backed_security.htm">mortgage-backed security</a> Securitized interest in a pool of mortgages. 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Goodman and Fabozzi (<a target="_blank" href="http://www.riskbook.com/link/goodman_and_fabozzi_2002.htm">2002</a>) and Deacon (<a target="_blank" href="http://www.riskbook.com/link/deacon_john_2004.htm">2004</a>) are excellent books on CDOs.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap430"> <area target="_blank" href="http://www.riskbook.com/link/fabozzi_f_(2001).htm" shape="rect" coords="0, 0, 84, 124"> </map> <img border="0" src="../images/book_fabozzi_MBS_125.gif" usemap="#FPMap430" width="85" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/fabozzi_f_(2001).htm"> Handbook of Mortgage-Backed Securities</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Frank Fabozzi (ed.)</b></td> </tr> <tr> <td width="10%"> <map name="FPMap431"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"></map> <img border="0" src="../images/star_6.gif" usemap="#FPMap431" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap432"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap432" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2001</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap433"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/fabozzi_f_(2001).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap433" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap435"> <area target="_blank" href="http://www.riskbook.com/link/hayre_l_(2001).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_salomon_125.gif" usemap="#FPMap435" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/hayre_l_(2001).htm"> Mortgage-Backed and Asset-Backed Securities</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Lakhbir Hayre (Ed.)</b></td> </tr> <tr> <td width="10%"> <map name="FPMap434"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"></map> <img border="0" src="../images/star_6.gif" usemap="#FPMap434" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap39"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap39" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2001</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap436"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/hayre_l_(2001).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap436" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap376"> <area target="_blank" href="http://www.riskbook.com/link/goodman_and_fabozzi_2002.htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_fabozzi_and_goodman_2002_125.gif" usemap="#FPMap376" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/goodman_and_fabozzi_2002.htm"> Collateralized Debt Obligations</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>D. Lucas, L. Goodman and F. Fabozzi</b></td> </tr> <tr> <td width="10%"><map name="FPMap21"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap21" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap375"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="3, 0, 89, 15"> </map> <img border="0" src="../images/tech_1.gif" usemap="#FPMap375" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2006</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap437"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/goodman_and_fabozzi_2002.htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap437" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table17"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap381"> <area target="_blank" href="http://www.riskbook.com/link/deacon_john_2004.htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_deacon_john_2004_125.gif" usemap="#FPMap381" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table18"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/deacon_john_2004.htm"> Global Securitisation and CDOs</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>John Deacon</b></td> </tr> <tr> <td width="10%"><map name="FPMap378"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap378" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap382"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap382" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2004</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap380"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/deacon_john_2004.htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap380" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table19"> <tr> <td width="100%" bgcolor="#FFFFFF"> <p align="center"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com"> http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 2004</td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </body>