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The Mechanicsof Securitization

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A Practical Guide to Structuringand Closing Asset-Backed

Security Transactions

SULEMAN BAIGMOORAD CHOUDHRY

John Wiley & Sons, Inc.

The Mechanicsof Securitization

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Cover Design: John Wiley & Sons, Inc.Cover Image:# Dynamic Graphics/Jupiter Images

Copyright# 2013 by Suleman Baig and Moorad Choudhry. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copy fee tothe Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400,fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permissionshould be addressed to the Permissions Department, JohnWiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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The views, thoughts and opinions expressed in this book are those of Suleman Baig in his individualcapacity and should not in any way be attributed to Deutsche Bank AG or to Suleman Baig as arepresentative, director, or employee of Deutsche Bank AG.

The views expressed in this book are an expression of Moorad Choudhry’s personal views only anddo not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, itssubsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracyof the data included in this book and accepts no responsibility for any consequence of their use. Thisbook does not constitute an offer or a solicitation of an offer with respect to any particular investment.

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Library of Congress Cataloging-in-Publication Data:Baig, Suleman.The mechanics of securitization: a practical guide to structuring and closing asset-backed security

transactions/Suleman Baig, Moorad Choudhry.p. cm.— (Wiley finance series)

Includes bibliographical references and index.ISBN 978-0-470-60972-9 (cloth); ISBN 978-1-118-22073-3 (ebk);ISBN 978-1-118-25895-8 (ebk); ISBN 978-1-118-23454-9 (ebk)1. Asset-backed financing. I. Baig, Suleman. II. Title.HG4028.A84C46 2013332.1 078—dc23 2012038292

Printed in the United States of America.

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To my parents— Suleman Baig

To a Solid Bond in Your Heart—Moorad Choudhry

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Contents

Foreword xi

Preface xv

PART ONEIntroduction to Securitization 1

CHAPTER 1Introduction to Securitization and Asset-Backed Securities 3

The Concept of Securitization 4The Process of Securitization 7Securitizing Mortgages 14ABS Structures: A Primer on Performance Metrics and Test

Measures 18Securitization: Features of the 2007–2008 Financial Crisis 24Summary and Conclusions 33References 34

CHAPTER 2The Securitization Market Post-2007 35

Market Observation 35Impact on Rating Agencies 40Summary and Conclusions 42

PART TWOGuide to Closing a Securitization Transaction 45

CHAPTER 3Structuring and Execution of a Transaction 47

A Securitization Process 47Summary and Conclusions 69

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CHAPTER 4The Rating Agency Process and Legal Review 71

Select Rating Agencies 71Undertaking Legal Due Diligence 73Begin Drafting Documents 78Set Up the SPV 82Modeling the Transaction 85Determine Capital Structure/Trigger Levels 90Prepare Marketing Materials 96Pricing, Close, and Settlement 98Summary and Conclusions 99

CHAPTER 5Static Synthetic CDO Cash Flow Waterfall Model 101

Summary and Conclusions 107

PART THREETransaction Closing Templates and Checklists 111

CHAPTER 6Transaction Templates and Checklists 113

Red Sea Master Series Limited Structure Diagram 113Underlying Asset Pool 113Draft Term Sheet 120Closing Process 126Structuring Notes 127Rating Agency Preparation and Questionnaire 129Loan-Level Data: Rating Agency Checklist 138Agenda for Rating Agency Site Visit 140Legal Counsel Review 140Form of Transfer Certificate 144Investor and Rating Agency Presentation Template 147In-House Credit Rating Mapping Chart: Lower and Upper

Values 149Rating Agency Presentation: Corporate Bank Origination

Processes 149Loan Transfer Schedule of Tasks 154Loan Transfers, Accounting Movements 158Sign-Off Document: Securitization Project 160

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Securitization Testing: Finance Department 161Accounting Process on Closing 166EUR Junior Tranche Trade Ticket 167Senior Tranche Trade Ticket 168Internal Transfer Booking Process 169Questions from Trustee, Paying Agent, and Services Provider 169Summary and Conclusions 172

About the Authors 173

Index 175

Contents ix

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Foreword

It is regrettable that many of securitization’s contributions to modern financehave been overshadowed by infamy since the financial crisis. While it hasmade for popular journalism to debate securitization in the abstract, there hasbeen surprisingly little attempted commentary to actually explain whatsecuritization is or does. Possibly, this is due to the fact that most punditsseem to underappreciate the regularity with which securitization techniquescan be found in the financial system. The volume of securitized debt alonewarrants more study and transparency in terms of the technology’s innerworkings. Thus, rather than discounting its utility, current thought leaders offinance (and certainly future students) would be best served by having betteraccess to information around securitization’s basic value proposition. Surelya more enlightened understanding would allow the debate to move beyondthe rhetorical and reorient efforts toward identifying and deploying morepractical uses of the technology. With that in mind, a book focused onexplaining the basic mechanics of securitization is long overdue.

In its most basic form, a securitization vehicle acts as a small, single-purpose bank. As such, it plays the role of a financial intermediary betweenend borrowers and end investors. Where it does depart from a traditionalbank, though, is in its balance sheet construct. Although it still finances itselfby issuing debt and equity like a bank, its assets consist of a single, focusedasset strategy. The single-purpose nature of its balance sheet is a distinct valuecreator for the financial system. It affords an investor the practical ability oftaking exposure to a virtual bank that has a clearly defined risk mandate(financing only consumer loans, corporate loans, or real estate loans, forinstance). In this regard, securitization is a uniquely powerful financialtechnology; it redefines the investible universe for investors and increasesthe options they have to diversify their portfolio risk. In the context of anoverall portfolio investment strategy, the ability to take “pure” asset classexposure provides for better risk calibration and more flexibility for investorsto shape their targeted risk-return profiles.

The aforementioned diversification benefit made available to an individ-ual investor can be expanded into a global context. Prior to the availability ofsecuritization, the realistic ability of a lender to diversify globally was limitedby practical access to foreign markets. Though a regionally concentrated

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lender maywant to diversify its loan book, a lack of origination infrastructurein the new market would deem it prohibitive. Given such practical con-straints, the lender would be limited to only indirect methods, which wouldmean either purchasing a stake in a foreign lender or sourcing a loanparticipation. The former approach lacks asset-class risk clarity and bringsrisks perhaps far beyond what the lender had initially desired (as it capturesthe foreign banks’ entire business). The latter is restrictive in that it typicallyonly works for exposures to large corporate loans (i.e., ones that can beparsed and syndicated). The fact that it “practically” allows for regionallysourced risk to be diversified with clearly defined alternative asset exposuremakes securitization a key lever in reducing overall global systemic risk.

For both the individual and global examples, however, one needs to becareful not to confuse risk dispersion with risk transformation: Securitizationin itself does not change the risk of an underlying asset class. This has been thebiggest challenge with how securitization has been falsely characterized andhence tainted in the context of the U.S. subprime mortgage market. It isincorrect to suggest, as some have, that it was the securitization technology initself that caused the losses experienced by global investors. In the end,securitization was only the vehicle by which investors chose to take exposureto the U.S. subprime mortgage asset class. It was the flawed understandingand choice of asset class that caught out the affected participants (originators,investors, rating agencies, and regulators).

The lesson is very clear from this experience: One should not forget thatsecuritization is only a tool. And as with all tools, users need to understand itspurpose so it can be used effectively, and most importantly, appropriately.

For the skeptic, it is also important to recognize how mainstreamsecuritization technology has become. As a start, one only needs to lookat the magnitude with which central banks have utilized the technology. Forinstance, securitized debt (asset-backed securities, covered bonds, and so on)has been the primary source of collateral used to back the liquidity provisionmade to the monetary system. For that matter, the European FinancialStability Facility, established to provide financial assistance to euro areamember states, is built on the back of securitization technology. Specifically,the EFSF borrows from the capital markets on the back of collateral (i.e.,security) provided by a portfolio of guarantee commitments from euro areamembers. Interestingly, the most notable example is the German Pfandbriefmarket; it is believed to be the oldest securitized market and has been inoperation for approximately 200 years. Perhaps ironically, the principalunderlying collateral in this market is personal home mortgages, and it is stillthe largest source of funding for German banks to this day.

More generally though, securitization principles can be found in anycircumstance where there exists a financial obligation and such obligation’s

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creditworthiness is enhanced by the contribution of collateral. The collateralafforded can take many forms, of course (financial assets, property rights,future revenue streams). All these forms can serve as further consideration tohelp strengthen an outstanding general promise to repay debt. The pledgingof collateral to reshape the credit risk profile for a lender is a basic funda-mental principle of securitization, and examples of its use are evidentthroughout the fixed income landscape (municipal revenue bonds, high-yieldbonds, bank loans, repurchase obligations).

One might ask, “Why are the borrowers in these markets willing topledge security against their debt?” In simple terms, it is all about optimizingrisk and return between different borrowers and lenders. By offering collat-eral, the borrower will generally benefit by getting better loan terms. Equally,the borrower will often be able to attract more willing lenders to offer thesame loan (i.e., better pricing and capacity). This example should be familiarto anyone who has purchased a home with a mortgage; the smaller the size ofthe mortgage relative to the value of the home (the collateral in this instance),the better the mortgage terms and overall availability. I have used this simpleexample purposefully; it highlights how germane securitization concepts are,even in our personal lives.

I suspect practitioners of securitization would question my use of a singleloan, or single secured borrowing, as the basis for framing securitizationmechanics. This is not surprising, given that most industry participantsassimilate securitization with the packaging of large numbers of smallindividual loans. If one steps back, however, and truly looks at the basicsof what securitization does, it’s simply a scalable version of the securedlending business. Secured borrowing is an old technology that predates theterm “securitization” and is in itself a simple technology. In fact, it is notsurprising that it is in use today, given that the concept has been usedthroughout history by individuals, corporations, and government borrowersalike. I suppose what is new is the fact that in today’s high-tech world it can bescaled. The advent of computer technology during the tail end of the lastcentury is what has enabled secured borrowing to be industrialized, hencewarranting its own nomenclature. Without computers, it would not be easyfor loan originators to efficiently aggregate and track large numbers of loanssuch that they could be financed or sold in bulk.

In the end, words at times attract a connotation that drifts away fromtheir intended meaning. I would suggest the inappropriate negative connota-tion ascribed to securitization is misplaced in this way. Like many newtechnologies introduced during the industrial revolution, securitization issimply a more efficient version of an old technology. In a world where loansare generally no longer recorded in paper format nor are they decisioned in abank branch, it is not surprising that the way they are financed should evolve

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as well. So, as one proceeds through the text of this worthwhile book,one should take due care to truly understand the specific workings ofsecuritization-based financing. As mentioned previously, many of securitiza-tion’s basic features are quite mainstream and are not as obscure as its namesuggests.

Securitization has a genuine role to play in the global financial system andwill not disappear. One needs only to reflect on experiences of other marketsfor context (e.g., the junk bond market of 1980s, the high-tech bubble of1990s): These markets didn’t disappear, either. And like securitization of the2000s, each of these episodes can make the financial markets stronger,provided we take a lesson from them and act on the message.

Oldrich MasekManaging DirectorJPMorgan ChaseOctober 23, 2012

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Preface

In 2009 The Times newspaper of London carried an interview with PaulVolcker. The former chairman of the Federal Reserve “berated bankers fortheir failure to acknowledge a problemwith personal rewards and questionedtheir claims for financial innovation.” According to The Times, Mr. Volckerrebuked “senior figures in the financial world for failing to grasp themagnitude of the financial crisis and belittled their suggested reforms.” Asbankers demanded that new regulation should not stifle innovation,Mr. Volcker was quoted as saying, “The biggest innovation in the industryover the past 20 years has been the cash machine.”

It’s a pity that this impression is now fairly commonplace in business,media, and political circles. One only has to look at the mobile telephoneindustry, and to be aware that it was financed mainly by recourse tofinancial engineering techniques that included securitization, to understandthat innovation in finance has often been a force for much good in theworld. It is worthy of preservation, and if one was to observe a rickshawpuller on the streets of Dhaka, Bangladesh (average salary $1 per day) usinga cell phone, one would indeed be convinced of this. The technology neededto make the cell phone available to a mass population worldwide requiredhundreds of billions of dollars in investment, and a fair proportion of thesefunds were raised via the securitization markets.

This book is not a general textbook on banking or finance, much less apolemic on the virtues of free markets and capitalism. It is a very focusedguide aimed at practitioners in structured finance who are involved withoriginating, structuring, or arranging securitization transactions. Essen-tially it has been written to act as a checklist of necessary tasks forcommercial banks that are interested in closing a securitization of assetseither off their own balance sheet or on behalf of a third-party bank. Theseassets might be corporate loans, mortgages, credit card loans, or other moreesoteric “future flow” cash receivables, but the essential principles thatmust be followed when securitizing any asset class are virtually identical,and differ only in detail. These essential principles are covered here. Muchsecuritization activity in the immediate post-2008 era was of the “in-house”variety, with an objective of creating tradeable securities that could then be

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used as collateral when obtaining funding from their central bank. Thetemplates in this book are of equal application to someone planning such atransaction.

Ultimately we hope this book is of most value to practitioners looking toclose a securitization deal for the first time, and for whom the checklist formatof this book is intended to act as a project management guide.

ORGAN I ZAT I ON OF TH E BOOK

This book is organized into three parts. Part One is a primer for those wishingan introduction to securitization and asset-backed securities (ABS), andcontains two chapters. Chapter 1 is the primer and Chapter 2 is an assessmentof the impact of the 2008 bank crash. In Part Two we discuss the structuringand execution of an ABS transaction, and the rating agency and legal reviewrequirements. The contents of Part Two are designed to act as a checklist andtemplate, and can be readily applied by commercial banks looking to under-take their own securitization transactions.

Part Three uses templates, checklists, and pro forma documents from anactual corporate loans ABS deal to provide color to the text in Part Two.

The authors welcome comments or review critique, which should be sentto them via John Wiley & Sons Limited.

Suleman BaigMoorad Choudhry

LondonJune 2012

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Acknowledgments

We would like to thank Laurence Rickard and Eric Eastlund for their inputand assistance. Both, along with Nicholas Dibley, are confirmed Jedis ofsecuritization.

Thanks also to Stuart Turner, Mark Burgess, Maira Chatziperou, DanCunningham, Gino Landuyt, Paul Kerlogue, Anne Azencot, Sharad Samy,the legendary Jim Croke, and Khurram Butt for their invaluable help andinput during the work that went into the series of structured financetransactions that were Picaros Funding PLC (Euromoney Structured FinanceDeal of the Year for 2005), Calculus Master Series Limited, Castafiore FundLimited, and Red Sea Master Series Limited.

Fans of George Remi will detect a pattern here . . .

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The Mechanicsof Securitization