Securitization Colloquium

Copyright © Mayer, Brown, Rowe & Maw. All rights Reserved.

Securitization Colloquium

Spring, 2003


What’s asset securitization?


• What is securitization?

• What is the history of securitization?

• Why do entities securitize?

• What is the profile of an ordinary securitization?

• Why are law and accounting so important for securitization?


• Process: The pooling of assets and the issuance of securities

to finance those assets

• Substance: The use of superior data on a pool of assets in

order to finance the assets, or distribute risk, more efficiently, usually by means of the use of “structure”

What is Securitization?


What goes into predicting whether GM will repay its unsecured debt:

• Automobile industry in general

• North American, European, Asian, and Latin American automobile industries

• GM v. domestic & international competitors

Example: General Motors


• Politics and international trends

• Management

• Unions

• Balance sheet and income statement

• Luck!



How about GMAC, where financial assets reside?

• Fewer variables

• More dependent on interest rates, quality of receivables as opposed to quality of autos

• Multiple businesses + residential and commercial mortgage businesses



How about the senior debt of GMAC?

• Focus on specific financial assets

• Law prevents exclusive focus on those assets



Securitization involves:• Isolation of pool of assets from financial fortunes of originator

• Focus on historical data with similarly situated assets

• Predicting the future behavior of the pool at hand

Securitization

PurchaserIssuer

Special PurposeEntity

Originator

transfer ofpool transfer of

pool or interest in pool

issuance ofsecurities


Securitization

• Efficiency #1: Isolation in order to enable investor to predict

behavior

• Efficiency #2: Unbundling and allocation of risks/rewards to

different populations


Credit Risk

• Securities precisely targeted to credit risk profile desired by investors

SpecialPurposeEntity

PurchaserIssuer

Retained

Unrated

AAA

BBB

B

Investor


Credit Risk; Tenor

• Securities precisely targeted to tenor profile desired by investors

PurchaserIssuer

6 mo.

1 year

5 years

3 mo.bullet

bullet

bullet

amortizable, etc.


Further Allocation of Credit Risk

PurchaserIssuer

CreditEnhancer


Originator

transfer ofassets

transfer ofassets

securitiesinvestors

1) 1st loss originator

2) 2nd loss credit enhancer

3) 3rd loss investors by category

Allocation

of

Risk


Servicing Risk

PurchaserIssuer


Originator

transfer ofassets

transfer ofassets

securities

• Retention of servicing risk by originator

100% ownershipinterest

servicer of assets


Allocation of Interest Rate Risk

PurchaserIssuer


Originator

transfer offixed rate assets

transfer ofassets

issuance ofsecurities

floating rate

Swap Provider

fixedrate

floatingrate

potentialback-to-back swap


What is the History of Securitization?

MBS:• 1970s securitization of residential mortgages

Government sponsored entities (“GSEs”)• Federal Home Loan Mortgage Corporation (FHLMC/“Freddie

Mac”)• Federal National Mortgage Association (FNMA/“Fannie Mae”)

• Allocation of credit risk to GSEs

• Retention of interest rate risk by originators


What is the History of Securitization?

ABCP:

• Early 1980s securitization by “Multi-Seller Commercial Paper Vehicles”

• Capital arbitrage• Allocation of risk as in paradigm

ABCP VehicleOriginator transfer ofinterest in assets

issuance ofCP

SponsoringBank

liquidity andcredit

enhancementfacilities


What is the History of Securitization?• Middle 1980s securitization of non-mortgage related assets, or ABS

• Late 1980s securitization of commercial mortgage related assets, or CMBS

• Allocation of risk/rewards as in above paradigm

• Trade receivables, autos, credit cards, home equity loans, manufactured housing, leases, commercial loans, cross-border


0

100000

200000

300000

400000

500000

600000

700000

800000

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

U.S. Public Mortgage Backed Activity, 1980-2002(Proceeds in millions)

Source: Thompson Financial


0

50000

100000

150000

200000

250000

300000

350000

400000

1985 1987 1989 1991 1993 1995 1997 1999 2001

U.S. Public Asset Backed Activity, 1985-2002(Proceeds in millions)



U.S. Public Asset Backed Activity 1996by Type of Assets Securitized

Credit Card Rec.Home EquityAuto LoansEquip. LeasesMfgd. HousingStudent LoansAll Others

31%

24%20%

6%

5.5%5.5%

8%



U.S. Public Asset Backed Activity 2002by Type of Assets Securitized

Home EquityCredit Card Rec.Auto LoansMfgd. HousingStudent LoansEquip. LeasesAll Other

39.4%

17.9%

22.9%

1%

6%1.5%

11.3%



U.S. Public Mortgage Backed Assets 1996by Type of Assets Securitized

FHLMCFNMAResidentialFixed RateComm.GNMAMortgage LoanAll Other

27%

25%12%

9%

8%

6.5%

6.5%6%



U.S. Public Mortgage Backed Assets 2002by Type of Assets Securitized

FHLMCFNMAResidentialComm.GNMAMultifamily

39.7%

20.5%

27.1%

4.6%8.6%


0.6%


Why do Entities Securitize?

• Securitization satisfies current macro economic trends

• What are those trends? 3 produced a need for securitization ... Over-regulation of financial institutions

Search for cheaper sources of capital

Convergence of capital markets into one

1 made it possible

Improving computer-based technology



• Largest trend of all:



What are the precise, originator-driven motivations?

• Balance sheet relief

• Cheaper cost of financing

• Increased liquidity

• Matching assets and liabilities

• Sources of funds in times of economic stress

• Gain on sale


Balance Sheet Relief

• FAS 140: Isolation of financial assets

• Why does an issuer want balance sheet relief? Removal of assets and related debt improves

ratios and need for more expensive capital Note rating agency discount


Securitization of 50 assets & 37.5 of related debt

so reduced capital to 12.5

Assets Liabilities/Capital

50 37.5 Debt

12.5 Capital

50 50

Liabilities/Capital

100 75 Debt

25 Capital

100 100

Assets


Less expensive capital necessary, or same capital, butcapital/assets ratio improved

Assets Liabilities/Capital

37.5 Debt

25 Capital

62.5*

62.5 62.5

*retained interest of 12.5 in asset pool of 50


Capital/Assets Ratio

Before: .25

After: .40

Other ratios may improve similarly


Cheaper Cost of Financing

• GMAC A

• GMAC Securitization Up to 94% of debt rated AAA because of

isolation of assets from bankruptcy risk of parent

• Transactions Cost

• Asset-backed premium AAA = AA+


Increased Liquidity

• Investors who prefer mix of credit risk and tenor that is different than senior debt

• Originator’s name can be divorced from securities altogether ABCP Credit enhancers


Sources of Funds in Time of Economic Stress

• Rated v. unrated

• Bankruptcy remote structures


Matching Assets and Liabilities

Issuer

3 mo.

6 mo.

1 year

3 year revolver

& 5 year bullet, etc.


Gain on Sale

• FAS 140: Net gain equals proceeds minus basis Allocation of basis based on fair market value sold and

retained portions Valuation of retained portion based on variety of

assumptions• Defaults

• Payment speed

• Interest rates

Ability to “create” regular flow of net income appears to create need for less “other capital”


Three Steps to Creating our own Securitization

1) Pool and package individual loans or debt instruments

2) Convert the package into securities

3) Enhance the credit of the securities to facilitate their sales to investors


• A group of significant economic scale and geographic diversity, with

• An unfulfilled or underfulfilled need for funds, and

• A body of historical data about their ability to repay debt

Borrowers


Borrowers• Securitize loans

collateralized by the future flow of expected earnings

• Discretionary use of funds above and beyond tuition payment

• Defer payment of principal and interest for 1-3 years

• Will not compete with government-sponsored tuition lending programs

GraduateStudents


• Using technology to streamline the loan application, qualification and approval process

• Use historical information to mitigate risk by isolating the low-risk students -- Best & Brightest

• Package the pool of loans to meet the risk appetites of institutional investors

Originator

Seeks to lower the cost of moving funds from investors to borrowers

B&B.com

Borrowers


• Verified student I.D.

• Access to records (privacy)

• Variety of means for delivery of funds

• School branding

Offers credit cards over the Internet @ 11% interest to students at qualified graduate schools


• Law, business, medicine

• Graduation rate

• Placement statistics

• Average starting salaries

• Alumni contribution statistics

• Tuition loan repayment record

• Overall reputation

Acceptance and credit limit depends upon:

Type and Quality of School


• Degree pursued

• GPA

• Class rank

• Internships

• Anticipated graduation date

• Credit check

Acceptance and credit limit depends upon:

Type and Quality ofStudent


SPV

• Purchase the debt

• Issue securities

• Administer the collection of cash flows and servicing of debt

• Pass interest and payments on to investors

• Avoid taxation

Originator

Special Purpose Vehicle is created to:

Sub ofB&B, LLC

Borrowers


Underwriter

SPV

• Knows how to package securities for market

• Sets prices and tranches

• Understands legal requirements of institutional investors

• Works with the rating agency

Originator

Underwriter or issuer prices and markets securities to investors

InvestmentBank A

Borrowers


Underwriter

SPV

• Sets a defined credit standard

• Protects investors against unknown assumption of risk

• Increases marketability of securities

• Reduces yield that must be paid to investors

OriginatorRating Agency

Poor &Moody

Borrowers

RatingAgency


Underwriter

SPV

• Historic record of loan defaults

• Rate of bankruptcy

• Size of default losses

• Debt seasoning -- what % of borrowers are now making payments

• Geographic diversification

• Quality of borrowers

Originator

Rating Agency Evaluates

Poor &Moody

Borrowers

RatingAgency


Underwriter

SPV

Originator To give $100 million pool of securities a AAA rating, Poor & Moody demands a credit enhancement to cover

Poor &Moody

Borrowers

RatingAgency

$15 million in losses


Underwriter

SPV

• A series of tranches $85 million of senior

securities

$15 million of first-loss subordinated securities

• Insurance protection from a AAA rated surety company

• Spread account

• Letter of credit

• Cash collateral loan

Originator

Options for Credit EnhancementBorrowers

RatingAgency

CreditEnhancer


Underwriter

SPV

Arrange for Bank B to service the loans -- process payments,

compute interest, issue statements, etc. -- and

SPV provides a $15 million capital

contribution as buffer against investor loss

Originator

Which Option Do We Choose?Borrowers

RatingAgency

CreditEnhancer


What’s in it for Bank B?

• Preemptive access to high-end financial product consumers

Brokerage services Insurance products Auto loans Jumbo mortgages Business loans


Underwriter

SPV

• AAA-rated securities

• Fixed-rate or floating rate interest payments

• Short- or long-term debt

• Lower-rated, higher-yield securities

Originator

Investors can buyBorrowers

RatingAgency

CreditEnhancer

Investors


Loan origination

Fund transfer

Access to historical information

Sale of securities

Superior data on asset pool


What’s asset securitization?

Securitization Colloquium

Documents

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