Key Players in the Process of Securitization

There are six key participants in the process of securitization (see Figure 2.2). The loan originator can be a bank or a thrift which makes loans to borrowers. Generally, the originator also services loans after they have been sold off from the balance sheet, collecting payments and ensuring that the borrower meets his obligations to repay and collecting payments on the securitized loans. Only a few commercial banks have the ability to securitize loans and most banks sell pool of loans to arrangers or issuers. Loans may be sold several times before entering into a securitization pool.

The SPV is created by an issuer or arranger though transferring assets. It is usually thinly capitalized and has no independent management or employees. There are no other decisions to be made in the SPV and a trustee performs an administrative role by the receipt and distribution of cash. In the process of securitization, an SPV is a legal form of a trust which is structured to be bankruptcy-remote and tax neutral (Gorton and Souleles, 2006). It is set up solely to purchase loans from the originator and issue securities to investors. Before transferring loans to the SPV, loans with similar features have been pooled together and are collateral guaranteeing payments on securities against underlying assets. Since cash flows from loans are sold to SPVs with the proceeds, the pool of

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purchased assets can be financed by arrangers issuing securities in the capital market. Since an SPV is a trust with independent bankruptcy, selling loans to the trusts allows both originators and arrangers to protect themselves from losses on mortgage loans. In order to obtain off-balance sheet treatment for the SPV, the asset transfer needs to be treated as a “true sale” (Gorton and Souleles, 2006).3

Since there is an adverse selection problem between arrangers and investors due to information advantages about loan quality, the arranger has an incentive to sell bad loans and retain good ones. In order to mitigate the problem that a shortfall of cash flow in the SPV is below the amount which is obligated to pay investors, credit enhancements and liquidity enhancements are provided by a credit enhancer to guarantee payments to investors and reduce the credit risk of payment receivables. The credit enhancer provides the SPV with explicit or implicit resources as credit enhancements. The most common way of providing an explicit recourse is to retain partial interests in the transferred assets by tranching securities to make a subordination structure according to probabilities of default of underlying borrowers. The most senior tranches and junior or mezzanine tranches, which are called A notes and B notes respectively,

3 _{Financial Accounting Standard No. 140 (FAS 140) sets two general}

requirements for a true sale. One is that the SPV must be a “qualifying” SPV (QSPV). The other one is that sponsor must surrender control of the financial assets.

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tend to be sold in the capital market, whereas the most junior securities, named C notes, are typically privately placed and may be retained in the SPV. Some other forms of credit enhancement include over- collateralization, excess spread (cash flow from underlying assets), and collateral interest. In addition, third parties provide credit enhancements, such as letters of credit, surety bonds and other instruments.4 Meanwhile, the liquidity enhancer provides backup cash to make sure that investors will receive principal and interest on time. The guarantees of highly rated credit enhancers are added to the bundle of rights purchased by investors to protect them from losses.

Credit rating agencies (CRAs) are responsible for giving credit ratings based on their own criteria (Ashcraft and Schuermann, 2008). Investors do not have time to analyze these securities and make investment decisions mainly based on the ratings which are given by CRAs. In general, the lower the probability of default, the higher rating securities have. Thus, the most senior tranches usually have a higher rating than other tranches. In order to get higher rating, different forms of internal credit enhancements from the originating bank and external credit enhancement are given by third parties, as noted earlier.

4 _{Ashcraft and Schuermann (2008) provide a detailed discussion about several}

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Servicers are sometimes employed by arrangers to offer service related to originated loans, such as the collection of loan payments, in return for a service fee paid by the SPVs. As noted, originators usually service loans to make sure borrowers meet their obligations but sometimes originator and servicer are not the same institution. When an arranger wants to issue securities, the underwriter or an investment bank gets involved to help issue securities and is responsible for pricing and marketing the securities to investors. Finally, investors play a vital role in the success of securitized markets. They will receive loan interest and principal payments though servicing firms. In general, institutional investors are more likely to purchase these securities, such as insurance companies, pension funds, mutual funds and sometimes individuals.

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Figure 2.2 Key players in the process of securitization

Originator Borrower Credit Rating Agencies Investors Issuer/Arranger or SPV Underwriter _Servicer Credit Enhancer

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