Credit Risk Transfer Mechanisms - Foundations Chapter 1 Flashcards
4.9 Describe the securitization process.
4.3 THE MECHANICS OF SECURITIZATION Securitization involves the repackaging of loans and other assets into new securities that then can be sold in the securities mar-kets. The collateral for the new securities is the pool of loans and other assets. The performance of the new securities will depend upon the performance of the collateral. 5The U.S. Court of Appeals for the District of Columbia Circuit, 17-5004, February 9, 2018 – Loan Syndication and Trading Association (LSTA) vs. the Securities Exchange Commission and Board of Governors of the Federal Reserve System, 1:16-cv-00652. 6Corporate bonds that offer enough liquidity and market activity to facilitate credit risk analysis generally are from large corporations. Securitization provides a funding vehicle for financial institutions and non-financial corporations. This is important because today banks throughout the world do not have sufficient capital by themselves to satisfy the needs of businesses, consumers, and governments. Moreover, securitization offers financial institutions and non-financial corporations a tool for risk management. Banks, for example, have used securitization to remove mort-gage loans, corporate bank loans, credit card receivables, and automobile loans from their balance sheets. The securitization of these assets resulted in the creation of mortgage-backed securities, collateralized loan obligations, credit card-backed securities, and automobile-backed securities, respectively. The latter two securitized products are referred to as asset-backed securities (ABS). Prior to securitization, entities that originated loans simply held them in their portfolio as an investment. This is referred to as the traditional “buy-and-hold” strategy. Because an entity would originate a loan and then hold it in its portfolio, the traditional buy-and-hold strategy is also referred to as the “originate-and-hold” strategy. The key risks that the originating entity faced by following this strategy were credit risk, price risk, and liquidity risk. Securitization, instead, involves the originating entity assembling a pool of similar loans and using that pool as the collateral for the new securities. This strategy is referred to as “originate-to-distribute” strategy. It reduces the originating entity’s risks compared to the originate-to-hold strategy. First, the originating entity does not own the collateral, so it does not face credit risk. Second, there is no price risk faced by the originating entity because it does not own the individual assets included in the pool. Finally, by using illiquid loans or receiv-ables as collateral for a securitization, the originating entity no longer holds an illiquid asset and therefore does not face liquidity risk. The key element in a securitization is a legal entity that is established by the originating entity called a special purpose vehicle (SPV). The SPV purchases the pool of loans from the originating entity (the “sponsor”) and takes ownership of those loans. The SPV obtains the funds to purchase the pool of loans from the originating entity by selling the new securities. The holders of these new securities receive inter-est and principal payments based on rules for the distribution of interest and principal and how defaults will be treated. Typically, the SPV issues senior bonds, junior bonds, and equity. These are referred to as “classes” or “tranches.” The senior bond class has the highest level of protection against credit risk and typically has a credit rating of AAA. There can be more than one class of junior bonds with varying credit ratings below AAA. The equity class, also referred to as the residual class, only receives proceeds after all of the debt classes receive payments and therefore is exposed to the greatest credit risk. It is important to emphasize that it is not just banks that have used securitization. Manufacturing companies, for example, have used securitization as a risk management tool and a mechanism for raising funds. Here are four examples of non-bank sponsors of securitizations: * General Motors has created GM Financial (a captive finance company) to provide automobile loans (as well as leases) to its customers. GM Financial and its affiliates have created SPVs to buy the loans (and leases) originated by GM Financial and its affiliates. The SPVs include AmeriCredit Automobile Receivables Trust (AMCAR), GM Financial Automobile Leas-ing Trust (GMALT), and GM Financial Consumer Automobile Receivables Trust (GMCAR). * Harley-Davidson created Harley-Davidson Financial Services (a captive finance company) to provide loans to its customers who want to purchase the company’s motorcycles. Its SPV issued its first securitization in 2016, a USD 301.9 million deal, and in 2019 came to market with a USD 552.16 million deal. * SoFi, a personal finance company, uses securitization exten-sively. In April 2018, SoFi (through its SPV) issued two stu-dent loan-backed securitizations (USD 960 million in SOFI-A Notes and USD 869 million in SOFI-B notes) and a consumer loan securitization (USD 774 million in SCLP 2018-1 Notes), for a total of USD 2.6 billion in securitizations. 7 * Sprint Corporation has a wide range of wireless and wireline communications services for consumers, businesses, and gov-ernments. It has used securitizations for its wireless accounts receivable. The trend toward securitization began in 1968 with the birth of the Government National Mortgage Association (GNMA, also known as Ginnie Mae). 8Consumer ABSs in the United States and residential mortgage-backed securities (RMBS) in the U.K. emerged in the 1980s. The 1990s saw the develop-ment of commercial mortgage-backed securities (CMBS) in the United States. Between 2000 and 2007, there was a surge in the issuance of very complex, risky, and opaque CDOs in the U.S. private label securitization market. Figure 4.1
4.10 How do the SEC’s risk retention provisions force banks to have “skin in the game”?
4.10 The rules require securitizers to retain, without recourse to risk transfer or mitigation, at least 5% of the credit risk.
