An analysis of the Product and Market functions of Asset-Backed Securitization

Bachelorarbeit von Nadine Senanayake

Introduction:

In the past the basic concept of banking was when depositors were aspired to pay into banks or financial institutions which successively transferred these funds at a margin to individuals, businesses and credit worthy borrowers using methods of lending. The proportionate credit risk was the main apprehension of financial institutions that utilized existing functions and developed techniques to estimate the probability of these investors defaulting. In the 1980's significant technological advances assisted in the Securitization process, which enabled banks to hedge their credit-risk exposure by means of Securitization. Securitization was ranked amongst the big developments in the past years, like De-regulation, Globalization, Internationalization and the increasing permeation of technology.

‘Securitization can be defined as a process of packaging individual loans and other debt instruments, concerting the package into a security, and enhancing their credit status or rating.’ ‘Whereas the eighties were the age of securitization, one could describe the nineties as the age of asset securitization.[...] The worldwide issuance of assetbacked securities is expected to grow enormously in the future.’ In the 1990's we have seen a notable shift from the traditional ‘loan financing’ to Securitization of bank assets within financial markets. The ABS has and remains to be an important form of balance sheet financing for financial institutions. Securitization is a widely used mechanism by financial institutions which add value to investors/shareholders and stakeholders if implemented in it's eligible framework. Since the proposed Financial Services Modernization Act of 1999 came into effect, the Glass-Steagall Act of 1933 which previously imposed restrictions on the integration process of banks, insurance and stock trading was eradicated; consequently:

‘Boundaries between governments and markets were redrawn.’ This enabled consenting bankers the liberty to utilize mechanisms, which imparted in trail-blazing structures being introduced into the market. Moreover, dexterous bankers who have the capability to understand the complicated nature or intricacy of these structures did use them for their benefit by exploiting lacunas or setbacks in both the product and market sphere of the system.

Hence, the focus of the paper will be to analyze the product functions namely, how the product was first initiated and the main incitement behind the core elements of ABS. Moreover, I will proceed to discourse the market functions, which is when the core elements have been transfigured into an ultimate product, and inaugurated in the secondary market. Conclusively, I will elucidate on the risks related to the product and market functions and further compile thoughts on proposed solutions for these risks.

In the first chapter the author will define the core element of Asset-Backed Securitization and continue to expatiate on the main structure of the ABS process. Thereafter, I will describe the history and development of the Asset backed securities market. Subsequently, I will analyze the role played by the rating agencies, credit enhancers, investors, SPV and the trustee that assist with implementing the ABS structure.

In the second chapter the author will introduce ABS and define the different types of ABS by giving a short description of each type, namely, ABS, MBS, and CDO including the relevance of credit derivatives in the ABS market.

In the third chapter, the author will define the risks in the micro aspect and not in it's macro sense as I would like to remain within the framework of the product and market functions.

Finally, the author proposes and suggests techniques in which one could increase transparency and continue to benefit from trading these securities which will continue to add value to financial institutions and medium sized enterprises. At last the author will conclude by highlighting the future prospects of Asset-Backed Securitization, after taking into considerations the risks and proposed solutions.

Table of Contents:

Text Sample:

Chapter 1.7.2, The relationship of SPV- Investors:

The institutional investor’s purchases securities from the SPV in the form of Passthrough certificates or Pay-through certificates. Due to the well established measures used to structure these notes, they obtain a low risk ratio. These Pass-through certificates are obligated to deposit low equity capital due to the low risk structure of this particular asset class. This is due to a combination of the attractive rating and credit enhancement techniques. The equity capital that needs to be deposited with a mortgage–backed security for example, averages at: 0% for GNMA (US Government national mortgage association) Pass-Through, 20% for FNMA (Fannie Mae - Federal National Mortgage Association) and FHLMC (Freddie Mac - Federal Home Loan Mortgage Corp) Pass-Through and 50% for the rest of the Mortgage-Backed Securities.

Due to the earning power on these securities, they anticipate higher yields. In the ABS market ‘Investors have access to triple-A rated securities at very high spreads’, which in turn make these securities eminently attractive to investors?

Due to the complexity of these financing structures and credit volumes, the majority of the investors of these structures from medium- and long-term investments tend to be institutional investors.

1.7.3 The relationship between SPV-Trustee:

The trustee is a pivotal link between the SPV and the investor. As the factual sub-agent bondholder he takes and administers his responsibilities directly on behalf of the investors. In the trustee agreement, besides the concrete assignment of duties competencies and responsibilities, the trustee also controls the transfer of the credit portfolio together with the physical securities (collateral) from the SPV to the trustee.

‘There exists a perfected security interest in the underlying collateral pledged by the issuer to the trustee for the benefit of the note holders and the enforceability of the underlying agreements.’ In the case that the relinquishment is not possible based on legal grounds, any discrepancies in the documents in order to satisfy claims of the SPV will be pledged to the trustee on a regular basis. In the instance of an assignment (by way of security), the securities will not just be pledged, but also assigned complete authorization. The trustee will be the fiduciary owner of the ceded securities. In practice the trustee is often referred to as ‘company collateral agent’. Due to these special concessions, the legal status of the investors with regards to the assigned securities is secured.

1.7.4 The relationship between of SPV-Credit Enhancer:

The SPV relies on the methods of credit enhancement to improve the rating of the underlined portfolio of assets being transferred in the form of securities to institutional investors. In order to receive a higher than expected rating on the ABS, internal and external forms of credit enhancement are utilized.

1.7.4.1 Internal Credit enhancement:

The interest rate received from the obligor most often exceeds the rates paid to the investor. The deviation between the two rates is paid into a yield spread account in the case of any defaults or liquidity problems. Furthermore, a portfolio is overcollateralized when the value of the underlying asset is valued greater than the total value of the securities issued to investors. Hence, the incoming proceeds exceed the outgoing proceeds, leaving excess collateral which is further utilized as a shield against potential losses.

1.7.4.2 External Credit enhancement:

Derivative financial instruments provided by ‘swap counterparties’ or ‘cap providers’ don the mantle of external credit enhancers, in order to mitigate risk by hedging against currency risks or transforming fixed interest rates to floating rates. This is performed by agreeing upon a swap contract at rates contractually decided upon previously. Moreover, a letter of credit is an assurance for a limited sum, providing a letter of assurance, which is generally provided by a financial institution. This guarantees protection of the underlying asset portfolio, up to a limited sum in the occurrence of an unexpected credit event.

1.7.5 The relationship between SPV- Rating Agencies:

The rating agency provides the asset portfolio with a rating based on the worthiness of the borrower, quality of assets and not conceiving the creditworthiness of the originator, due to the legal transfer of assets from the originator to the SPV. The rating agency plays an important role in the securitization game; paving the way for security price estimates to be based on ratings.