FI 17 Fixed-Income Securitization

An asset-backed security (ABS) is a security that is backed by, and repaid out of, a pooled set of loans or receivables. Rather than lending directly, an investor buys a claim on the cash that a group of borrowers is scheduled to pay. In a securitization, the payments coming off a designated pool of assets are collected and then redistributed by a special purpose issuer, which applies them to the interest and principal owed to investors, in an order set ahead of time.

Because that order is preset, a securitization lays a brand new ranking, or subordination structure, over the same pool of assets: different investors are paid at different points and absorb losses in a different sequence. The arrangement forms a direct link between the people who borrowed the money and the people who ultimately fund it, across many kinds of loans and receivables. Securitization is a global activity, used across the Americas, Asia, and Europe.

The pool of assets that stands behind the securities goes by several names: the securitized assets, the reference portfolio, or the collateral. At a high level the process runs in a short chain. The original source holds assets such as loans or receivables; similar assets are gathered into a pool; that pool is transferred to a special purpose entity (SPE); the SPE issues asset-backed securities against the pool; and investors buy those securities. In other words, the assets move from the originator into the SPE, and the SPE in turn sells ABS to investors.

This structure produces gains for three broad groups: the issuers who originate and sell the assets, the investors who buy the resulting securities, and economies and financial markets as a whole. The sections that follow take each product type, each benefit, the full transaction flow, the parties involved, and the pivotal role of the SPE in turn.

Securitized products span a range of complexity. Listed from the simplest to the most involved, the main types are the following.

Covered bonds

Covered bonds are the plainest structure. The issuers are mainly European banks, which carve out a specific pool of mortgage loans and keep it segregated from the rest of the bank’s assets. That ring-fenced pool then acts as the cover, or collateral, for bonds the bank issues. If the bank ever defaults on a covered bond, holders can look to the underlying pool for payment. Covered bonds are not counted as full securitizations for two reasons: the loans are never moved into a separate, independent SPE but stay on the bank’s own balance sheet, and holders are paid directly by the bank rather than out of the cash flows generated by that pool.

Pass-through securities

Pass-through securities are true securitizations. Here the chosen pool really does leave the balance sheet and move into a separate, independent legal entity, which then issues securities against it. Investors receive the interest and principal from the loans in the pool as those payments are passed through the entity. The payments are shared out proportionally across the tranches, spreading the payment risk among investors who want different levels of exposure. What each investor actually receives will vary, since it turns directly on the pool’s aggregate credit risk and on the way borrowers actually pay.

Bonds with structural enhancements

Bonds with structural enhancements sharpen the predictability of a pass-through. They channel the pool’s cash flows to named tranches on a schedule fixed in advance, which softens the effect of surprises such as defaults, early prepayments, or stretched-out repayment periods. The tranches are also subordinated: lower tranches shoulder more of the default and timing risk than higher ones. Issuers may go further and attach various credit enhancements to trim the risk that investors carry.

Mortgage-backed securities

Mortgage-backed securities (MBS) are simply ABS whose pool consists of mortgages. In the United States it is common to separate MBS from ABS backed by non-mortgage assets, as the grouping below shows.

Subordination and tranching

Subordination, also called tranching, means splitting the deal into more than one bond class, where the classes differ in how they draw cash from the underlying pool. The classes divide into senior bond classes and subordinated bond classes, an arrangement often called a senior and subordinated structure. The subordinated pieces are sometimes labelled non-senior or junior bond classes. Because every investor is paid from the same shared pool of cash, tranching sets both the order in which investors are paid and the order in which they absorb any losses.

The table below sketches a simple structure with enhancements. A pool of assets worth 100 yields a benchmark market reference rate (MRR) plus 250 basis points. That yield is split so that the safest, most senior claim earns a narrow spread while the residual piece takes whatever is left.

MRR: market reference rate. Spreads shown in basis points.

Securitization gathers income-producing assets, for example loans or receivables, moves their ownership away from the original lender and into a purpose-built legal entity, and has that entity issue securities to investors. The incoming payments then service the interest and principal on those securities. The advantages fall to three groups.

Benefits to issuers

Banks traditionally write loans so that borrowers can finance purchases and investments, and those loans usually sit on the bank’s balance sheet, illiquid, until they are fully repaid. A bank stands between borrowers and investors. If it can split the act of originating a loan from the act of funding it, it can lift its profitability, collecting origination fees while cutting the capital it must hold against loans that are sold on. By moving assets and lending risk off the balance sheet, a bank sells illiquid holdings, operates more efficiently on a risk-adjusted basis, lowers its leverage, and earns fee income. In the end, securitization lets a bank keep originating loans well beyond what its own balance sheet could support.

Benefits to investors

Securitization opens a direct channel between borrowers and investors, so investors can shape their interest rate and credit risk exposure to fit their own needs for risk, return, and maturity; issuers, for their part, can design the risk and return profile of a deal to match an investor’s tolerance. Few institutions or individuals have the specialized machinery needed to originate, monitor, and collect on the underlying loans, yet many can comfortably hold securities backed by those same loans, because a well-built ABS behaves much like a standard bond. A pension fund with a long horizon, for instance, can use securitized debt to reach for higher returns, line up asset maturities with the dates its liabilities come due, and widen the range of assets it holds, all while keeping the freedom to adjust its positions quickly and cheaply.

Benefits to economies and financial markets

Securitization turns illiquid loans sitting on a bank’s books into securities that trade, and secondary-market trading lets investors discover equilibrium prices, which makes financial markets more efficient. It also lifts overall liquidity in the system and lowers liquidity risk. Beyond that, it gives companies a funding route apart from the traditional tools of bonds, preferred equity, and common equity: by pooling assets such as receivables and loans, a company can cut its funding cost and raise its return on capital. A manufacturer can extend credit to its customers through a financing subsidiary, securitize those loans, take in cash from the SPE, and recycle that cash into financing for still more sales. Had it instead kept the customer loans on its own balance sheet, it would have needed to issue more debt, raising its leverage and funding cost and weakening its credit quality. Securitizing the loans lets it tap markets directly and move the loans off its books, capturing cheaper funding without denting its overall credit standing.

Securitization is not risk-free, however. Its risks fall broadly into two families: those tied to the timing of the ABS cash flows, namely contraction and extension risk, and those tied to the credit risk that is built into the underlying loans and receivables. Later modules examine how structures dampen these risks. Some of them are widely blamed for helping to trigger the market turmoil of 2007 to 2009.

A securitization has to satisfy a number of legal and regulatory conditions, and it draws in several parties to carry the transaction out and keep those conditions met. A hypothetical car maker, Bright Wheel Automotive (BRWA), makes the flow concrete.

The underlying loans

BRWA’s financing subsidiary lends to BRWA customers, with the purchased vehicle serving as collateral. These are fixed-rate loans with maturities averaging four years, and they are fully amortizing: the principal is repaid across 48 monthly payments (12 months times four years). Each month the borrower makes an equal total payment made up of an interest portion and a principal portion. Because the loan amortizes, the interest slice shrinks and the principal slice grows as the balance falls, while the total payment stays level. The subsidiary decides whether to grant credit and it also services the loans, meaning it administers them: collecting payments, chasing borrowers who fall behind, and, if a customer defaults, seizing and selling the vehicle to recover the outstanding principal. The servicer need not always be the issuer, but here BRWA plays both parts.

Raising funds through an SPE

Suppose BRWA wants to raise EUR 1,000 million and weighs two routes: a four-year corporate bond, or an ABS backed by the car loans. It aims for the lowest possible rate relative to its benchmark, the gap between them being the credit spread. Car makers are capital-intensive, so tying up capital on the balance sheet to finance customer purchases is a poor use of it; selling the loans frees that capital and books profit that can fund the core business.

BRWA first sets up a separate legal entity, Car Loan Trust (CLT), which is a special purpose entity (also called a special purpose vehicle or special purpose company), and sells it the EUR 1,000 million of car loans. CLT is legally independent and bankruptcy-remote from BRWA, and it becomes the true owner of the loans. That separation is the point: if BRWA were to file for bankruptcy, the loans backing the ABS sit safely inside CLT and BRWA’s creditors have no claim on them. Building the bankruptcy-remote entity and fully transferring the loans can be intricate, and the rules differ across jurisdictions. The summary terms below describe the notes CLT issues.

The full set of steps

Following the money end to end, the transaction runs through seven steps.

1. BRWA sells vehicles that are financed by loans.
2. BRWA sells those loans to CLT.
3. CLT pays BRWA cash for the loans (the EUR 1,000 million).
4. CLT issues and sells ABS backed by the pooled loans.
5. Investors pay cash to CLT for the ABS.
6. BRWA’s customers make their periodic loan payments to CLT.
7. CLT directs the agreed periodic payments through to the ABS investors.

Three parties sit at the centre of any securitization.

• The seller of the collateral, a party also known as the depositor. In the BRWA deal this is BRWA, which aggregated the loans and sold them on.
• The SPE that acquires the loans or receivables and pledges them as collateral behind the ABS it issues. Here that is CLT. The prospectus usually names the SPE as the issuer, since it is the entity that actually issues the securities.
• The servicer of the loans, which in the example is BRWA’s financing subsidiary.

A wider cast is also involved: independent accountants, lawyers, trustees, underwriters, rating agencies, and at times financial guarantors. Standing apart, as they do, from the seller of the collateral, these are termed third parties to the securitization.

The key legal documents

Beyond the usual bond indenture and its covenants, two documents matter especially. The first is the purchase agreement between the seller and the SPE, which sets out the representations and warranties the seller makes about the assets it is selling; these assurances tell investors about asset quality and are central to judging the risk of the ABS. The second is the prospectus, which lays out the structure of the deal, including the priority and size of the payments owed to the servicer, the administrators, and the ABS holders, along with the credit enhancements the deal uses.

The trustee

A trustee, or trustee agent, carries the label disinterested trustee and is normally a financial institution. It safeguards the assets once they have passed to the SPE, keeps custody of the money owed to ABS holders until it is disbursed, and sends periodic cash-flow reports to those holders as the prospectus requires. Those reports are the investors’ only channel for updating their view of the ABS credit standing.

The legal shelter that the SPE builds for both the originator and the investors is what makes a securitization work; without an SPE, the deal could not be done. Raising funds this way can be cheaper than a corporate bond secured by the very same collateral, precisely because the SPE is untouched by a bankruptcy of the seller.

In most jurisdictions the courts have no power to rewrite the payment seniority, because the originator’s bankruptcy does not reach the SPE. Pulling the assets off the balance sheet and into an SPE therefore decouples the credit risk of the company that needs funding from the bond classes the SPE issues. That is the reason the SPE is built to be bankruptcy-remote, and the reason the clean legal split between issuer and SPE matters so much. The only credit risk left for investors is that the borrowers whose loans sit in the SPE default; so long as those borrowers keep paying interest and principal, the SPE can keep paying the security holders.

In many countries the protection rests on recognizing the transfer as a true sale, in which every right of the original lender passes to the SPE irrevocably and in full under local law. The SPE then holds full legal ownership of the assets, which are removed from the seller’s balance sheet. Legal frameworks are not uniform, though: in places where trust law as a concept is less mature, hurdles to issuing ABS have surfaced. Investors should therefore weigh the legal considerations that apply wherever they buy an ABS.