Securitizations and Structured Finance Flashcards
What is Securitization?
- Raising capital by using an Underlying Portfolio (UP) of assets to issue debt securities using a Special Purpose Vehicle (SPV);
- In a way that insulates the End Investor from all risks unrelated to the UP’s performance.
P. 747; Lecture Notes.
Henceforth, the Borrower shall be referred to as the ‘Originator’.
Who are the Parties involved in a Securitization?
- SPV.
- Originator.
- Liquidity Provider.
- Credit Enhancement Provider.
- Guaranteed Investment Contract Provider.
- Bond Trustee.
- Share Trustee.
- Underwriter.
Lecture Notes.
Not all of these parties are necessarily involved in every securitization, such as the Share Trustee or the GIC Provider.
Which Documents comprise a typical Securitization?
- Sale Agreement.
- Trust Deed.
- Servicing (Administration) Agreement.
- Liquidity Support (Facility) Agreement.
- Credit Enhancement (Agreements and Provisions).
- Management (of the SPV) Agreement.
- Security Documentation.
- Bond Documentation.
- Underwriting Agreement.
- Prospectus (Offering Circular).
- Derivatives Agreement(s).
Lecture Notes.
Again, not all of these documents are necessary in every securitization.
Which methods can the SPV use to Purchase the Underlying Portfolio?
- Public issuance of debt.
- Private placement of debt.
- Term loan, whether bilateral or syndicated.
Henceforth, consider it elects to issue bonds.
Lecture Notes.
Flexibility within the financing structure can reduce funding costs, e.g. short-term assets can be used to fund medium-term debts and vice versa.
What measure is used to gauge the Value of the Underlying Portfolio?
Cashflow, as it indicates the SPV’s ability to repay the bonds it issues.
P. 749.
Additional considerations like market valuation, insolvency remoteness, and the like are also relevant.
How does Securitization generate Value for both the Originator and Bondholder?
Separating the Originator’s lowest-risk assets from its balance sheet, and raising finance thereagainst decreases:
* Its cost of borrowing; and
* Investment risk for the Bondholder.
Lecture Notes.
Tranching may also be used to further optimize the cost of finance.
How does Tranching optimize the Cost of Borrowing?
The blended interest rate, i.e. the median interest rate across all tranches, is calibrated to be lower than what the interest rate would be for any single tranche.
Lecture Notes.
As discussed elsewhere, tranching does not offend the Pari Passu principle.
For the Originator, what are the Advantages of Securitization relative to the alternatives?
- Lower cost of funding.
- Capital adequacy relief.
- Improved liquidity (especially for revolving structures).
- Maintenance of exclusivity with Debtors.
- Faciliation of access to international capital markets for Originators who could not have otherwise accessed them.
Lecture Notes.
For the Bondholder, what are the Advantages of Securitization relative to the alternatives?
- Lower risk-weighted investment.
- Increased Debtor (SPV) creditworthiness.
- Incorporates independent credit analysis by including Credit Rating Agencies.
- Higher liquidity, due to the securities being rated and Bonds.
- If self-purchasing and a bank, capital adequacy relief through the transformation of banking book assets into trading book assets.
Lecture Notes.
For the Originator, what are the Disdvantages of Securitization relative to the alternatives?
- High up-front costs, both to set up the SPV and over-collateralize it. The former may be countervailed by economies of scale.
- Opportunity cost of over-collateralization, i.e. inert capital.
- Increased complexity and document-intensity.
- The Crown Jewels Problem and potential unpopularity with existing creditors, especially secured ones whose blessing may be necessary.
Lecture Notes.
For the Bondholder, what are the Disdvantages of Securitization relative to the alternatives?
- Prepayment risk.
- Securities may be less liquid than Vanilla Bonds.
- Familiarity with the asset type is necessary.
Lecture Notes.
To a Prospective Bondholder, what are the Factors it considers before investing?
- UP’s quality.
- SPV’s title in the UP.
- Supporting collateral.
- Credit enhancement.
- SPV’s Insolvency remoteness.
Lecture Notes.
Regarding the last point, full and uncontestable beneficial interest held by the SPV is ideal.
What metrics are used to gauge an Underlying Portfolio’s Quality?
- Asset transferability.
- Recharaterization Risk (RCR).
- Maturity: The longer, the riskier.
- Dilution Risk:° The higher, the riskier.
- Credit Rating: The higher, the better.
- Strength of the Originator’s title.
- Exposure to early termination rights.
- Exposure to default and enforcement rights.
- Frequency and size of payment installments: The greater, the better.
Effectively, any relevant legal and commercial issue.
Lecture Notes.
° Dilution Risk is the risk of quality degradation due to the addition of lesser assets over time.
What is Insolvency Remoteness?
Te SPV’s degree of separation from the Originator’s credit risk.
P. 748; Lecture Notes.
“All emphasis in the structuring of the transaction [should be] on the assets being securitized, and all extraneous factors that could possibly seize the cashflow generated by these assets should be removed from the structure.”
For a Prospective Bondholder, why is Insolvency Remoteness so important?
It significantly influences the transaction’s credit rating, since without it, the Originator’s credit risk would contaminate the SPV.
Lecture Notes.
For Banks, is Securitization effective for minimizing Capital Adequacy Requirements (CARs)?
Yes. By transferring debt off-balance-sheet, it creates space for new issuances.
Lecture Notes.
Why is Credit Rating an important metric for Securitization?
Given investors’ lack of time and resources to fully investigate credit quality, ratings largely determine the minimum return they will accept.
Lecture Notes.
Therefore, to raise funds at as low a cost as possible, it is critical to be assigned as high a credit rating as possible.
In determining Credit Rating, is the Credit Risk of the Credit Enhancement and Liquidity Support providers relevant?
Yes.
P. 764.
How may the SPV’s Legal Title in the Underlying Portfolio be Impeached?
In various assets, it may transpire that:
* Assignment was contractually prohibited.
* Third Parties possessed legitimate claims in the interests therein.
* The UDs possessed set-off rights against the Originator, which now obtain against the SPV.
P. 760-761
How may the SPV Hedge against the Impeachment of its Legal Title in the Underlying Portfolio?
It may oblige the Originator to warrant that:
* No contractual restrictions against Assignment exist.
* It is solely entitled to the interest in the assets and has not created any rights therein in favor of third parties.
* Either no set-off rights exist or that all set-off rights have been disclosed.
What is a True Sale Securitization?
One where the Originator transfers its interest in the UP to the SPV by way of sale, including any security or guarantees.
P. 748.
‘Sale’ denotes a Loan Transfer. Ideally, Novation is used, but due to potential issues with security, notice, or general restrictions, Equitable Assignment is typically resorted to. The other methods may be used, but are relatively suboptimal.
What does the term ‘True Sale’ Denote?
A sale that is sufficient under bankruptcy law to remove the Receivables from the Originator’s bankruptcy estate.
Ideally, this means Novation, but Assignment is also acceptable.
Lecture Notes.
What are the Originator’s Objectives in a True Sale Securitization?
- To fully disconnect itself from the SPV.
- To raise finance at a favorable price relative to the alternatives.
- To optimize its balance sheet from the standpoints of both capital adequacy and risk management.
- To fully insulate itself from the risk of the portfolio’s nonperformance, and any liabilities associated therewith.
Textbook – P. 758.
What must the Sale Agreement address?
- Selection of assets comprising the UP.
- Substitution of assets comprising the UP.
- Method(s) of transfer.
- T&Cs, i.e. CPs, R&Ws, EODs, Covenants, etc.
- Ring-fencing and other insolvency remoteness considerations.
Lecture Notes.
Power of Attorney may well be included.
Which Type of Assignment is preferred in Securitization?
Equitable Assignment (EA), namely because it is non-notified and the Originator may wish to avoid informing the Underlying Debtors (UDs) unless absolutely necessary.
P. 748.
Examples of absolute necessity include breach of contract or default, and even, notice will be contained to a need-to-know basis.
How is using Non-Notified Equitable Assignment problematic for the SPV, and by extension, the Bondholders?
- UDs get a good discharge by paying the Originator, which is problematic if it becomes insolvent or breaches warranties.
- UDs accumulate set-off rights against the Originator.
- Priority disputes and the Rule in Dearle v Hall.
- EA may offend negative pledges and contractual restrictions.
- SPV cannot claim in its own name against the Debtors, although this is mostly a procedural problem.
Textbook – P. 749; Lecture Notes.
In Practice, how are Loans transfered by Equitable Assignment for a Securitization?
By way of offer and acceptance.
* The Originator offers the UP to the SPV, who accepts by way of payment, whereupon equitable title therein is transferred.
* Accordingly, even if notice is given to the UDs, legal title will not be transferred until a written assignment is executed.
Lecture Notes.
In a Mortgage-Backed Securitization, how are the Underlying Mortgages transferred from the Originator to the SPV?
Incompletely:
* Firstly, equitable title is transferred to the SPV, with legal title remaining with the Originator on trust for the SPV; then,
* Arrangements are made for a complete transfer contingent on a trigger, e.g. default.
Lecture Notes.
This is done to avoid the very expensive and time-consuming Land Registry fees.
What are the Risks associated with an Incomplete Transfer of Mortgages for the SPV in a Mortgage-Backed Securitization?
-
Vulnerability to disposition of the assets by the Originator to a Good Faith Purchaser who is unaware of the SPV’s rights.
- Remediable by keeping custody of the Charge Certificates with the SPV or its Agent.
-
No Power of Sale prior to the execution of the Deed of Transfer.
- Remediable by using Power of Attorney to exercise the Originator’s Power of Sale.
Lecture Notes.
How may Cashflow Difficulties be mitigated by the SPV?
- Credit enhancement.
- Liquidity support.
What is Credit Enhancement?
A type of facility aimed at compensating shortfalls in bond repayments due to underperformance in the UP.
Effectively, it mitigates credit risk by increasing solvency.
Lecture Notes.
What is Liquidity Support?
A type of facility aimed at compensating shortfalls in bond repayments due to liquidity mismatches in the UP.
Effectively, it mitigates liquidity risk by abetting timely repayment.
Lecture Notes.