The party that initiates a securitization transaction, referred to as the “sponsor,” may be the originator of the receivables (or an affiliate of the originator) or may aggregate the
receivables to be securitized by purchasing them from the originators or in the secondary market. Prior to securitization, receivables in a sponsor’s portfolio are commonly financed through short-term lending arrangements in the form of repurchase agreements or secured loans.
Securitization structures vary widely on the basis of asset type and other factors.13 At the most basic level, however, a securitization of consumer loans or other receivables generally involves the sale of a pool of receivables to a special purpose, bankruptcy-remote entity known as the “depositor,” which in turn transfers the receivables to a trust or other issuing entity. The issuing entity14 then issues securities, in the form of debt or equity, whose cash flows depend primarily on the receipt of payments on the pool of receivables. Most MBS and ABS are backed by a fixed pool of receivables that amortize over time. Short-term receivables or revolving assets such as the receivables arising in credit card accounts are frequently securitized in a “master trust” structure, in which the issuing entity acquires additional receivables in designated accounts and issues additional securities from time to time.
For tax reasons, as discussed below, ABS are generally issued in the form of debt; one or more classes of equity interests are also issued and may be retained by the sponsor of the Agency Mortgage Market securitization (or an affiliate) or sold to investors. MBS are most commonly issued in the form of pass-through certificates.
A principal goal of any securitization structure is the separation of the securitized receivables from the risks associated with possible future insolvency of the sponsor. It is expected that investors in mortgage-backed or asset-backed securities, unlike buyers of
corporate debt, should assume the risks associated with a pool of receivables but not the credit risk of the sponsor. Securitizations are structured to minimize insolvency risk through, among other things, a “true sale” of the receivables to an entity that itself presents no material risk of becoming subject to bankruptcy proceedings because its powers are strictly limited and its creditors are only those associated with the securitization transaction. A sale is referred to as a
13 See Securitization of Financial Assets, Ch. 4, (Jason H.P. Kravitt ed. 2008).
14 An issuing entity may be a foreign or domestic corporation, a partnership or a limited liability company, but a trust is most commonly used.
“true sale” when it is expected that the transfer of the receivables would be respected as a sale by a bankruptcy court or a conservator or receiver in a non-bankruptcy insolvency proceeding, and would not be characterized as a loan collateralized by the receivables.15
Another important goal in structuring a securitization is to avoid creating adverse tax consequences for investors. Securitizations are generally structured to avoid or to minimize the effect of imposition of an additional layer of taxation in the form of an entity-level corporate tax on the issuing entity; otherwise, securitization would not be economically practicable.16
Most securitization structures employ one or more forms of internal or external
enhancement in order to reduce security holders’ exposure to credit risk or interest rate risk. In the 1980s external enhancement in the form of pool insurance, letters of credit, and corporate guarantees from third-party guarantors or insurers were popular forms of credit enhancement.
However, the inconsistent availability of these forms of third-party enhancement, as observed in their unexpected withdrawal during disruptions in the real estate markets, and the desire to de-link the credit ratings of the securities from the ratings of any particular enhancer, led to greater use of internal enhancement that embeds risk hedging into the structure of the
securitization.17 Common methods of internal credit enhancement include use of excess spread, subordination, and overcollateralization.18 Interest rate risk may be hedged through the use of interest rate swap or cap agreements.19 Enhancement levels are generally determined by the rating agencies selected to provide credit ratings to the various classes of offered securities.
15 Certain entities, such as banks, insurance companies and other financial institutions, are not covered by the bankruptcy code and are subject to alternative insolvency regimes. See generally Tamar Frankel, Securitization, Ch. 10 (2005).
16 Tax considerations, including tax structures created by Congress in order to facilitate securitization, are discussed below.
17 Eric Bruskin and Anthony Sanders, “The Non-agency Mortgage Market: Background and Overview,” Working Paper (March 1999), p. 4.
18 Excess spread is the difference between the weighted average net interest rate on the receivables and the weighted average rate at which interest accrues on the securities; interest collections in excess of the amount needed to pay accrued interest on the securities may be used to cover losses or to build overcollateralization.
Subordination is the structuring of classes of securities such that losses are borne first by the class lowest in seniority and then by more senior classes. Overcollateralization is the amount by which the total principal balance of the receivables exceeds the total principal balance of the securities; this amount is available to absorb losses. Frank J. Fabozzi and Vinod Kothari, “Securitization: The Tool of Financial Transformation,” Yale ICF Working paper No. 07-07 (2007), p. 7, available at <http://ssrn.com/abstract=997079>.
19 These derivative instruments sometimes also serve as a source of credit enhancement, although their primary purpose is generally hedging of interest rate risk.
The process of collecting payments on the pooled receivables and other administrative matters with respect to the receivables are generally managed by one or more servicers, who may be supervised by a master servicer. Trust-level administrative functions such as
calculation of amounts payable to security holders, distribution of payments and preparation of reports to investors are generally performed by the trustee or by a master servicer or
administrator.
One or more broker-dealers are generally retained by the sponsor to market the securities to prospective purchasers. Although MBS and many types of ABS are generally offered for sale to the public,20 investors in these securities are for the most part institutional investors such as thrifts, insurance companies, pension funds, commercial banks, and Fannie Mae and Freddie Mac. The shift over time in the proportion of mortgage loans and MBS held by various types of institutions illustrates the effect of securitization in broadening the investor base. In 1970, more than half of all holders of mortgage loans and interests in mortgage loans were savings and loan associations. By the end of 2008, only 6% of the holders of mortgage-related investments were thrifts, while the share of holdings by other types of institutional investors had increased. See Figure II.1 below.
20 Either in offerings registered with the SEC or, in the case of MBS issued or guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae or another federal government agency or instrumentality, in offerings exempt from
registration.
Figure II.1
Holders of Home Mortgages and Securities
1970 2008
Sources: Federal Flow of Funds.