6.6 Fixed-Income Securitization

Question 1

Securitization

Answer 1

the process of creating streams of cash flows from an underlying pool of assets

Ownership of these assets is transferred to a special legal entity that issues asset-backed securities (ABS)

By purchasing these securities, investors receive a direct claim on these cash flows. Although the underlying assets are usually relatively simple, ABS can be very complex structures.

Question 2

Covered bonds

Answer 2

issued by financial institutions and backed by a segregated pool of specifically identifiable assets, such as mortgage loans

Investors who purchase these bonds have dual recourse

Question 3

dual recourse

Answer 3

meaning that they have claims against both the issuer and the assets in the segregated pool

Question 4

while backed by assets, covered bonds are different from securitizations in two important ways:

Answer 4

1. The assets in the segregated pool remain on the issuer’s balance sheet.
2. Cash flows go directly from the issuer to investors without passing through an intermediary.

Question 5

pass-through securities

Answer 5

backed by an underlying pool of assets

these are true securitizations because the assets are transferred from their owner to a legally distinct entity that the cash flow from these assets “pass through” before they are received by investors

The special purpose entity can be structured into tranches that redistribute cash flows on different schedules.

–> This tranching, or subordination, creates securities with different risk-return profiles

–> This structural enhancement allocates credit risk, allowing investors to choose their desired level of exposure. Other structural enhancements redistribute exposure to prepayment risk by scheduling the timing of cash flows to various tranches.

Question 6

For example, a special purpose entity can issue three classes of securities:

Answer 6

A senior class paying a market reference rate (MRR) plus 25 basis points. Because it has the first priority claim on the cash flows from the underlying pool of assets, this tranche has a credit rating similar to a sovereign issuer.

A mezzanine class paying MRR + 200bps and carrying a credit rating similar to an investment grade corporate issuer.

An equity class with a speculative grade credit rating that has a claim on any residual cash flow that remains after obligations to the higher classes have been met.

Question 7

The best-known examples of the pass-through structure

Answer 7

mortgage-backed securities (MBS)

–> have mortgage loans as their underlying assets

–> these may be residential mortgage-backed securities (RMBS) based on home mortgage loans or commercial MBS (CMBS) backed by loans on various types of commercial properties

Question 8

The risks of securitization

Answer 8

the possibility that the underlying cash flows may be received sooner or later than expected (contraction risk and extension risk, respectively).

Additionally, there is the possibility of defaults on the underlying loans (credit risk).

Question 9

The steps in this securitization process are:

Answer 9

1. The manufacturer sells automobiles to its customers on credit
2. The manufacturer establishes a legally distinct special purpose entity (SPE)
3. The SPE purchases loans from the manufacturer, which now has €1,000 million in cash
4. The SPE creates securities backed by the loans acquired from the manufacturer
5. Investors purchase securities from the SPE
6. Loan payments from customers are received by the SPE
7. The SPE distributes cash flows to investors

Question 10

there are three key parties to a securitization:

Answer 10

1. The seller (or depositor) originates the assets that are used as collateral
2. The issuer is the legally distinct SPE, also known as a special purpose entity (SPV), that is established to create the asset-backed securities
3. The servicer collects payments on the underlying loans

Question 11

The Role of the Special Purpose Entity

Answer 11

As a legally distinct entity, an SPE is bankruptcy remote from the depositor.

Once assets have been transferred to an SPE, they are no longer owned by the depositor and cannot be claimed by its creditors in the event of a bankruptcy.

For example, if a bank securitizes a pool of loans, investors who purchase the securities are only exposed to the risk that the borrowers will be unable to repay their loans, not the risk that the originating bank will fail

Question 12

In the securitization process, which of the following is most likely a third party to the transaction? The:

a) seller of the collateral.

b) special purpose entity.

c) financial guarantor.

Answer 12

c) financial guarantor.

Question 13

A BBB rated corporation wishes to issue debt to finance its operations at the lowest cost possible. If it decides to sell a pool of receivables into a special purpose entity (SPE), its primary motivation is most likely to:

a) allow the corporation to retain a first lien on the assets of the SPE.

b) segregate the assets into a bankruptcy-remote entity for bondholders.

c) receive a guaranty from the SPE to improve the corporation’s credit rating.

Answer 13

b) segregate the assets into a bankruptcy-remote entity for bondholders.

because in a securitization, the courts in most jurisdictions have no discretion to change seniority because the bankruptcy of the originating company does not affect the SPE.

Hence removing assets from the balance sheet into an SPE is an important decoupling of the credit risk of the entity needing funds from the SPE and the bond classes issued by it. \

This explains why the SPE is structured as a bankruptcy-remote entity.