KEY FEATURES OF SECURITISATION

Securitisation structures vary according to the objectives of the originator, the assets involved, and the requirements of the targeted investors, but in general they tend to share a number of common features as described below.

Assets: The asset in a securitisation is the right to receive payment of interest and principal in terms of

a loan agreement or payment of amounts due as a result of a trade. The SPV can purchase the assets at a premium above face value, at face value, or at a discount against face value. In the latter instance the face value of the assets will be greater than the face value of securities issued to fund the purchase, thereby effecting what is called overcollateralisation. Assets that can be securitised should have the following attributes (Kothari, 2003: 75):

− Stable Cash Flows: The assets in question should give rise to steady and easily identifiable cash flows over time. Periodically paying assets are more conducive to securitisation due to their smooth cash flows.

− Quality of the Receivables: The assets should generally be of a high quality, evidenced by regular past payment history. Lower quality assets can also be securitised, but require a higher degree of credit enhancement.

− Diversification of the Portfolio: The degree of diversification of a portfolio is an important rating factor. The greater the diversification, the less likely it is that the default of a few assets will affect the portfolio. No individual asset should have a significant value relative to the total portfolio.

− Homogeneity of the Assets: The advantage of homogeneous assets is that the pooling, and the analysis of the pool, will be easier since historical data can be applied to projecting the future risks in the portfolio.

− No Executory Clauses: Executory contracts refer to contracts where the originator has certain obligations, e.g. to maintain an asset subject to a rental agreement. In a securitisation, the

underlying contracts must not be influenced by the insolvency of the originator. To be securitisable, the underlying contract should therefore not contain an obligation by the originator.

− Capacity to Assign: Securitisation involves the transfer of a right to receive, that is, the transfer of a right against a third party to the assignee. The law of the land or the contract between the parties should not prohibit the right to assign the right to receive.

− Independence from the Originator: The on-going performance of the assets should be independent from the existence of the originator, and should not depend on the originator being a going concern. However, certain securitisation transactions e.g. future flow securitisations, depend on the continuing existence of the originator.

The suitability of assets for securitisation lies not so much in what they are, but in whether the assets are amenable to rigorous credit and statistical analysis (Giddy, 2000:3). Normally, at least three years of data are required on the composition of the assets, ageing, defaults, losses and dilution. It is also important that the assets show stable and consistent trends.

Securities: The asset-backed financial securities or notes are issued in the form of bonds by the SPV to

fund the acquisition of assets. A bond is defined as a debt issuance that pays a specific amount on redemption and, usually, an amount at regular periods through its life (Place, 2000:51). The most common types of bonds, reflecting different investor requirements, are described below.

− Conventional or Fixed-Rate Bonds: A conventional bond is one that has a series of fixed coupons and a redemption payment at maturity. Coupons can be paid annually, semi-annually, or quarterly. Since the coupons are fixed, the price of a fixed-rate bond changes in a direction opposite to that of interest rates. As rates rise, the price of a bond will fall, and vice versa.

− Floating-Rate Bonds or Floating-Rate Notes (FRNs): A floating-rate bond has a variable coupon linked to some short-term reference rate, e.g. LIBOR.10 _{It is usually issued at a margin (or spread) above} this reference rate. For these bonds, coupon rates are reset periodically according to changes in the reference rate. Coupons are normally paid quarterly or semi-annually. Since the coupons are variable, the price of an FRN does not change as interest rates change; however, the price will change if the credit spread changes.

− Zero-Coupon Bonds: A zero-coupon bond has only one redemption payment and is sold at a discount to its principal or face value. In pricing the bond it will be discounted at the spot rate, i.e. the discount rate specific to that maturity. The yield is the difference between the issue price and the principal redemption amount.

− Strips: A strip is a zero-coupon bond derived from separating a standard coupon-bearing bond into its constituent interest and principal payments that can be separately held or traded as zero-coupon bonds. Stripping refers to the act of separating a coupon-bearing bond into its individual cash flows. A strip is one of these separate cash flows. A five-year bond with an annual coupon could, for example, be separated into six zero-coupon bonds, five representing the cash flows arising from the coupons and one relating to the principal repayment. When strips were first introduced in the United States, STRIP was an acronym for Separately Traded Registered Interest and Principal, but the term “strip” is now used (Place, 2000:32).

Stripped mortgage-backed securities are created by paying the entire principal to one bond class and all the interest to another bond class. A zero-coupon mortgage-backed security is referred to as a principal-only (PO). These securities are created by stripping the interest from a securitised pool of mortgage loans to create the PO and its associated interest-only (IO) security (Carron, 1995:567, cited in Fabozzi et al., 1995). The PO only represents the principal in the pool of mortgages. They are sold at a large discount to face value and pay no periodic interest coupon. Principal is returned in the form of scheduled amortisation and prepayments until the entire face amount of the PO is repaid to the investor. The IO security only represents the interest from the asset pool and the investor receives only periodic interest coupons during its life with no principal redemption at maturity. An IO has no par or face value and is sold at a discount to its notional11 value.

PO and IO securities are especially sensitive to prepayments. With a PO, higher prepayments lead to a more rapid return of principal and a higher yield, which in turn leads to an increase in the value of the PO. PO securities thus increase in value when prepayments increase, and vice versa. In contrast to a PO investor, an IO investor will prefer slow prepayments. Prepayments cause the outstanding principal to decline, and the notional amount on which interest is calculated to reduce correspondingly. In fact, if prepayments are made too rapidly, the IO investor may not recover the amount paid for the IO (Fabozzi, 1996:284). IO securities thus decline in value when prepayments increase, and vice versa.

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− Medium-Term Notes: A medium-term note (MTN) is a debt instrument with the unique characteristic of being offered continuously to investors by the issuer (Fabozzi, 1996:153). An MTN12 _{programme is a programme under which an issuer can issue many bonds without having} to issue the same documentation in each instance again. This has the advantage of reducing the time to issuance. The notes can be issued as fixed-coupon notes, zero-coupon notes or floating- rate notes.

− Commercial Paper: Commercial paper (CP) refers to short-term unsecured promissory notes issued in the open market as an obligation of the issuing entity (Fabozzi, 1995:186, cited in Fabozzi et al., 1995). In the securitisation market Asset-Backed Commercial Paper (ABCP) conduits are large issuers of CP.

SPV: Central to the securitisation process is the creation of an SPV, which may be established under

either trust or company law. The originator sells assets to the SPV, transferring ownership of the relevant pool of loans and receivables and any collateral rights. The SPV pays for the assets by issuing securities backed by the asset pool. The SPV is a shell company, also called an orphan company, which holds the assets for the benefit of the investors (De Paauw and Ross, 2000:13). Cash flow from the underlying assets is used to meet the SPV’s debt servicing obligations, other on- going costs such as trustee, management and custodian costs, and to repay principal, as the securities mature or are retired. In this way the SPV serves as the mechanism by which risk is transferred from the originator to investors. Investors must absorb any bad debts that emanate from the asset pool as well as any other events that may reduce the adequacy of the underlying cash flows to service the issued securities (to the extent that losses exceed the credit enhancement in the structure). The SPV thus operates as a barrier; it acts to separate investors from the credit risk of the originator and the originator from any subsequent deterioration of the performance of the transferred assets (Eastwood and Liaw, 2000:5).

Bankruptcy-Remoteness13 _{- A securitisation SPV is structured to ensure that its assets are isolated from}

the bankruptcy risk of the originator. Typical requirements that have to be met to achieve bankruptcy remoteness are set out below (Telpner, 2003:5).

12 _{Also called a DMTN or Domestic Medium Term Note; the term MTN is misleading in that it describes the continuing}

issuance of notes and not the maturity of the notes.

− The SPV must neither be owned nor controlled by the originator. An independent third party such as a charitable institution or trust should be the owner of the SPV.

− The SPV must have its own board with independent directors.

− The organisational documents of the SPV must restrict its ability to declare itself bankrupt without approval by a requisite number of independent directors.

− The business activities of the SPV must be strictly limited to those necessary to carry out the securitisation.

− The SPV must maintain assets, bank accounts and record keeping separate from the originator.

− The SPV must pay its own expenses out of its own funds.

− The originator must disclose to its creditors that the assets of the SPV are separate and not available to satisfy their claims.

− All dealings between the originator and the SPV should be at an arm’s length basis.

True Sale: One of the main goals of securitisation is the separation of the credit risk of the asset pool

that is being securitised from the credit risk of the originator (Moody’s, 2003a:5). Simply structuring the SPV to be bankruptcy-remote does not ensure that its assets will be separated from those of the originator in the event that the originator becomes subject to a bankruptcy proceeding. The transfer of the underlying assets must be an absolute assignment, or “true sale”, of those assets (Telpner, 2003:5). Through a true sale or absolute transfer of an asset pool to an SPV, the assets are legally separated from those of the originator. A true sale refers to the concept that once the sale and transfer of the assets to the SPV have been effected, these cannot be challenged, voided or otherwise reversed in the bankruptcy of the originator or otherwise (International Finance Corporation, 2004:2). This means that, if the originator were to file for bankruptcy protection, the unsecured creditors of the originator would not have any claim against the asset pool and its related cash flows. Conversely, investors in the securitisation transaction would not have any claim against the originator’s estate in the event of the originator’s bankruptcy. The investor can depend only on the cash flows generated

from the asset pool and credit support built into the transaction for repayment of the securities – legally the investor has no recourse to the originator.

An originator could be presumed not to have executed a true sale if there is, inter alia, (BIS, 1992:8):

− any obligation to repurchase or exchange any of the assets sold;

− any kind of legal recourse through which any risk of loss from the assets sold could be retained or returned to the originator; or

− any obligation to any party for the payment of interest and principal with regard to the assets sold (other than those arising from services provided).

Commingling Risk: After the sale of the assets to the SPV, the SPV is the new beneficiary of the

obligors’ interest and principal payments. However, other parties to the transaction, such as servicers or account banks, which collect and hold the funds for the SPV, may go into default, causing a commingling of funds belonging to the SPV with the defaulted parties’ bankrupt estates (Bund, Mezzanotte et al, 2004:2).

Credit Enhancement: Credit enhancement is a key feature of securitisation structures. Its purpose is to

protect investors by absorbing credit losses, thereby improving the credit rating and thus marketability of the securities issued by the SPV. An asset-backed security is said to be credit enhanced if there is some feature present in the transaction that makes it more likely that the holder of the security will receive payments when these are due. Credit enhancement accomplishes two goals (Telpner, 2003:5).

− It provides a source of funds to supplement payments on the underlying assets in the event that the collections on the assets are insufficient to pay scheduled interest and principal.

− It allows different tranches of securities to achieve desired ratings, even where the assets themselves cannot support such a rating.

The credit enhancement is sized, normally by the rating agency, to reflect an expected loss level determined in relation to a series of adverse scenarios that could affect the asset pool during the pool’s life (De Paauw and Ross, 2000:16). Usually, this results in an enhancement that covers, by a

multiple of several times, the historical default rates of the underlying assets. The appropriate degree of credit enhancement can either be built in structurally or obtained externally (Eastwood and Liaw, 2000:5).

In the earlier stages of the development of the securitisation market, external credit enhancement prevailed (De Paauw and Ross, 2000:17). External credit enhancement typically involves letters of credit, insurance, or guarantees provided by a third party. The credit enhancement is called upon if an asset in the pool defaults, with the credit enhancer purchasing the asset at face value, or otherwise restoring value to the SPV. In evaluating a given securitisation transaction, the rating agency assumes that the credit quality of the structure cannot be higher than the weakest link in the credit enhancement provided. Thus, with external credit enhancement, the rating of the most senior securities issued by the SPV is capped at the rating level of the third-party guarantor, irrespective of the quality of the asset pool. Downgrades in the credit ratings of external credit enhancers have thus led many securitisation sponsors to opt for internal forms of credit enhancement (Lumpkin, 1999:38).

Structural, or internal, credit enhancement does not rely on an injection of outside resources to replace losses. Instead, it reallocates losses among the participants in the structure. Internal credit enhancement can take many different forms (Moody’s, 2003:5) and these are discussed below.

− Subordination: Typically a securitisation transaction carves up the cash flows generated from the asset pool into various classes or tranches of differing seniority. A senior tranche has the first claim on the cash flows, while a subordinated or junior tranche has a lower claim. As long as losses do not exceed the face value of the subordinated tranches, the senior tranches will be paid in full. The subordinated tranches thus provide credit enhancement by absorbing losses on the asset pool before more senior tranches have to. Credit risk is therefore concentrated in the junior or lower-rated tranches. The most junior (usually unrated) tranche, also called the equity piece or first-loss piece, carries a disproportionately large share of the credit risk and is normally retained by the originator.

− Excess Spread: Excess spread is the difference between the return on the underlying asset pool and the debt service and other expenses of the SPV. Excess spread is typically the first line of defence for absorbing losses and is tapped into before any other form of credit enhancement is used. If excess spread is unused, it is returned to the originator as profit extraction, or trapped in a reserve account.

− Cash Reserve Account: The originator may pre-fund a certain amount of cash in a reserve account of the SPV to absorb potential losses. Alternatively, the structure may be such that the SPV captures excess spread until a cash reserve account is built up to a specified level. If losses occur and the reserve account is depleted, any excess spread would normally first be used to replenish the reserve account to a certain level before it is released to the originator. The structure may also have performance-related triggers, which require additional cash flows to be trapped if the quality of the underlying assets deteriorates.

− Overcollateralisation: This is the term used when the value of the assets sold to the SPV exceeds the value of the securities issued, i.e. the assets are sold at a discount to their face value. The cash flow generated by the additional collateral is thus available to absorb potential losses.

− Trigger Events: Trigger events are occurrences of specified events such as the insolvency of the originator, a deterioration in pool credit quality as expressed in the delinquency or loss levels, a decrease in excess spread, or a decrease in the minimum required debt service coverage ratio (DSCR). The minimum DSCR is the requirement that the cash flows generated by the assets must exceed the debt service by a predetermined factor, thus allowing for monitoring the performance of the underlying asset pool. A breach of the trigger events will prompt certain actions e.g. trapping excess spread in the reserve account, or an early repayment of the securities in the securitisation transaction.

− Early Repayment: This is also called early amortisation. Early repayment clauses are common to revolving securitisations. They are designed to force a wind-down of the transaction and rapid repayment of principal to investors if specified triggers are breached. In an early repayment event no more revolving is permitted and all obligor repayments are used to pay down the securities.

The aggregate amount of credit enhancement appears to support only a fraction of the total value of the securities in issue. In reality, however, it reflects highly condensed credit risk (Bank for International Settlements, 1992:4).

Prepayment Risk: Prepayments are payments made in excess of the scheduled principal payments

(Giddy, 2000:7). Prepayments are more common and applicable in longer term, prepayable and high volume assets such as mortgage loans (Pulido, 2004:5). A common feature of mortgage loans is that they allow the borrower to prepay some or the entire principal loan, without penalty, at any time before the stated maturity of the loan. Because of the right granted to the homeowner to prepay, an