Securitization

The securitization is a financial technique which transforms not very liquid credits into easily negotiable transferable securities as of the obligation S. It can take multiple forms and be used to satisfy various needs.

In its most current form, it consists, for a company holder of not very liquid credits, to sell those at an intermediate company created for the occasion which finances this purchase by borrowing in the market by the emission of negotiable evidences of indebtedness guaranteed by the credits. In addition to the guarantee, the financial flows generated by the credits are used to pay the interests due on the titles emitted as well as the return of capital: it is said that the titles are “ leant ” in the active. On the financial markets, these titles leant with credits are called in a generic way of the Asset Backed Securities (ABS), the intermediate company created for the occasion being called a Special Purpose Vehicle (SPV) or Special Purpose Company (SPC). Securitization will be able for example to thus apply to wallets of credits or goods real, as with any distributing credit of the regular Cash-flow S.

This way of financing was developed with the the United States at the end of the Années 1980 and was mainly used then by the finance companies. It then developed to strongly since become at the same time an instrument of management of the assessment, risk management and creation (or extraction) of value. In 2006 the global amount of the emissions of securitization in Europe was of 452 billion € against 78 billion in 2000. The American emissions represented approximately the double.

Simplified presentation

At the base, the concept is relatively simple: a financial, industrial or commercial company, raises capital by emitting obligations on the basis of financial flow which will be generated in the future by Actif S or rights, possibly by preserving daily management of the aforesaid credits or rights.

In order to facilitate the analysis of the risk related to the wallet, i.e. to envisage financial flows, the yielded credits or rights will be preferably of comparable nature, such as for example.

Discretion and maintenance of the relation with the customer

Especially in Europe, a bank which yields a wallet of credit prefers that the transaction remains discrete. What she wants especially it is that its customer (the borrower) does not know anything of it.

That this wish is reasonable or not, one can undoubtedly bind it to the fact that for many European banks, the credit is regarded as the starting point of a total relation that the bank hopes profitable.

In a certain way, this vision of the credit is undoubtedly shared per many customers of the banks, which consider that the relation of credit that they have with their banker is of confidential nature. It is especially the case of the companies.

The operations of securitization are of course made in the observance of the regulation on the protection of the private life. For example, the investors or the analysts will not know anything the identity of the customer. They will have a sequence number at most, while the list of the customers, possibly on ROMANIAN CD, will be preserved under seal by an intermediary of confidence (notary for example) and will be used only if the bank goes bankrupt.

In order to satisfy this need for discretion:

  1. in a general way, the customers (borrowers) are not informed a transfer of their credit
  2. the bank will continue to be the interlocutor of the customers, with this distinction that henceforth, it will perceive the funds on behalf of the SPC as a manager (and an either owner) of the credits; in the jargon of securitization, one will say that the bank became the servicer credits.

This is largely facilitated by the use of securitization.

Extraction of value

An operation of securitization necessarily does not meet other needs only the desire for extracting from the value for credits.

Knowing that any productive credit of financial flows can be titrized, securitization can be used as instrument of arbitration, in a strict sense of the term.

Exemple:

  • Purchase of a diversified wallet of obligations emitted by companies.

  • Transfer of the obligations with a SPC which finances the purchase by a titrized bond emission.
  • If the wallet brings back on average EURIBOR +0,30% and that the cost of financing of securitization is EURIBOR + 0,20%, the operator which put the operation places empoche from there an immediate profit coming from this differential.

This type of transaction of securitization, where the credits are unspecified credits on companies, is called “ Collateralised Debt Obligations ” ( CDO ). In the CDO, one distinguishes also sometimes the “ Collateralised Bond Obligations ” ( CBO , where the titrized credits are jumps , or obligations) and the “ Collateralised Loan Obligations ” ( CLO , where the titrized credits are appropriations).

After the RMBS (Residential Mortgage Backed Securities) and the CMBS (Commercial Mortgage Backed Securities), securitizations of residential and commercial mortgage credits, the CDO are the most important segment of the market of securitization. One finds there also CDO of obligations titrized (where the titrized credits are themselves of the obligations emitted within the framework of an operation of securitization, for example of the RMBS), with also about CDOs of CDO (where the titrized credits are themselves of CDOs, one speaks about public garden CDO or CDOs to the square ( CDO ² ), certain operations “with the cube” - CDOs of public garden CDO- starting to appear).

Structuring of the obligations

Generally, several classes of obligations will be emitted, with higher classes (or “English senior”) and subordinate classes .

To give a very simple example, one will emit 3 classes of obligation (has, B and C), given that if the wallet undergoes a loss, it is the class “C” which will undergo this one initially. When class “C” is exhausted (i.e. the investor in this class very lost), the class “B” will start to lose money, and so on.

One will say in this case there that the class “C” is subordinated to the classes “has” and “B”, and that the class “B” is subordinated to the class “has”, the latter being the higher class (senior).

He goes without saying that the investors will be remunerated differently according to the risk of loss which they incur: for the investor of the class “C”, interest rate will have to remunerate the relatively high risk which it runs.

The reason for which these classes are created is very simple: by creating subordinated classes, one improves quality of credit of the class “has” until reducing the probability of loss on this class to an extremely low level (see Notation), which will reduce the cost of financing of this class (a weak risk means, obviously, a weak remuneration of risk).

All the easy way amounts creating sufficiently heterogeneous classes of risk so as to minimize the overall costs of financing.

The creation of subordinate classes is known as the cutting (“ tranching ” in English). The way in which the cutting will be made will depend on the analysis carried out by the credit rating agencies.

Notation of the products

See also: financial Notation

The market of securitization is a market which completely depends on the capacity of the credit rating agencies to give a financial note to the operation, and of capacity of the financial actors to make confidence with the conclusions of these agencies.

The credit rating agencies are companies independent specialized in the financial Notation of the companies or the operations.

They thus bring information essential with the potential investors who have neither time to be invested in the examination of a wallet of credits (sometimes constituted of ten thousands of credits), nor instruments which their make it possible to make simulations of performances of wallet.

Consequently, whatever the operation considered, the credit rating agencies are obliged actors. They will examine this one and evaluate the chances of loss for the investors.

In the case of a wallet of mortgage credits for example, they will examine the quality of the wallet (standard of customer, incomes, geographical location, ready ratio/borrowed amount, etc) and will allot to each loan a “chance of loss”.

Then, according to the way in which the operation is structured, they will allot to the wallet a notation which will go for example from “AAA” (best quality) to “BBB” (the lowest quality of the “reasonable investment”, also called “investment rank”: starting from “BB” one is in the “speculative one”).

The following example (extremely diagrammatic) will illustrate the process.

Let us consider a wallet of appropriations of 1.000.

It is probable that the agencies conclude that the wallet does not have, in oneself, a sufficient quality to reach quality “BBB”.

On the other hand, if one indicates to the credit rating agency that one will constitute in the SPV a “plug”, a “reserve” intended to absorb the first losses, the agencies will take account of this protection measure to evaluate the possible losses of the investors.

One has just started with “ to structure ” the operation.

In fact, one has just introduced a factor (the reserve) which raises the quality of the operation from the point of view of the credit risk supported by the investor.

One will speak about a technique of “Rehaussement of credit” (“ credit enhancement ”).

The reserve which will absorb the losses could be made up of various ways:

  • it can act of a money reserve at disposal of the SPC. This reserve will be made up for example of a subordinate loan granted by yielding: it is about one of the means among others of making so that the first risk of the operation is taken by yielding.
  • more simply, it can act of a class of obligations subordinate to all the other obligations.

Let us imagine since the agency has the following criteria:

  • Quality BBB: this quality will be reached if a reserve of 0,75% of the amount of the wallet absorbs the first losses;
  • Qualité a: if the reserve is of 3%
  • Qualité AA: if the reserve is of 5%
  • Qualité AAA: if the reserve is of 8%

These various possibilities are opposite illustrated.

As one sees it in the illustration, this amounts considering each time the financing of the wallet by two classes, the higher and a subordinate clause, the subordinate clause being used as reserve.

With this information, we can start with truly structuring the operation.


This reserve perhaps financed by a higher value of the wallet compared to the amount of debt raised, or by the difference between the output of the wallet and remuneration of the investors (profit of arbitration).

Decision of cutting

Taking into account information of which we lay out, here the way of which we could structure the operation and the classes that we could emit, with each time the notation which will be given by the credit rating agency. The illustration shows two possibilities of structuring.

The cutting is operated in the following way, by taking account of the analysis of the credit rating agencies:

To determine the quality of credit of each class of obligations, one looks at the amount which is “below” this class, that it is in the form of reserve or of subordinate classes. One can thus “slice” the operation as it is wished, to create as many classes as it is wanted, insofar as various levels of reserves are created.

When the credit rating agency carries out the analysis of the operated cutting, only one element will be important when she considers the quality of risk of a section: the raising of total credit whose this class profits, including the sections which are subordinated to him, and which determines its notation.

Then, one is indeed free to structure the operation as it is wished. At the time of the choice between the two possibilities shown in the illustration for example, the essential criterion will be the cost of respective financing of each branch of the alternative according to the market rates at this time there.

The choice between the various possibilities of cutting will thus depend primarily on and the differential market situation of interest rate to be paid with various the classes.

Specificities of the investment

Damping of the wallet

The only source of financial flows available being flows of the wallet of credit, the operations of securitization have certain important characteristics for the investors.

To illustrate this point, let us take a wallet of mortgage credits: generally, each month, each borrower will pay an amount which will be representative

  • of the interest in charge to the borrower
  • of a refunding with part of the capital.

I.e. the wallet will diminish with time.

This damping of the wallet will be more or less accelerated according to two other factors:

  • the number of defects (at the time of a defect, the loan becomes exigible and will be refunded anticipativement by the sale of the financed house (realization of the Gage)
  • the number of advance payments (when a borrower decides to refund by anticipation: for example, when it found a financing cheaper near a competitor).

Whereas the interests paid by the borrowers are used to pay the payable interest with the investors, it is obvious that each return of capital will have to be used to refund the capital of the obligations.

The payments on titrized obligations generally being done at quarterly intervals, the investors will touch each quarter of the interests and a return of capital whose amount is dubious.

Consequently, the horizon of placement, the duration and the Duration of the obligations are dubious, which can be very awkward to estimate the value of the investment.

Seniority

In general, the returns of capital will be used initially to refund the higher class (senior). When this one is refunded, the lower classes will be refunded.

Consequently, the horizon of placement, dubious, also varies according to the class in which one invests.

Advance payment

In general, this type of operation will finish when the wallet of credits reaches an amount equal to 10% of its initial amount.

The reasons of this rule are simple: an operation of securitization requires the intervention of a certain number of parts, which implies standing fixed overheads which weigh increasingly heavy on the cost of financing as the obligations are refunded.

Consequently, the legal structure allows yielding to repurchase the wallet when this one reached the predetermined level (10%). The SPC will use the price of repurchase to refund the remainder of the obligations and the operation will be liquidated (and the dissolved SPC).

Rate

The titrized obligations, in any case in Europe, generally pay a floating rate, i.e. every three months, the investors receive a coupon calculated according to the main thing of the obligation, and a rate which will be a Reference rate (such as EURIBOR) more one margin (which will be all the more high as the risk is important).

This will not surprise the financial ones: since the horizon of investment is dubious (rate/rhythm of refunding of the principal unknown), an obligation withrate fixes would be extremely difficult to manage for the investor: he also must generally ensure a correct management credit-liability of its assessment.

Example

The example below is drawn from a real operation.

As it is seen, the payments in the main thing are affected in priority with the refunding of class A.

Consequently, the class has is said to refunding “pass-through” (financial flows pass through the SPC to land directly in the investors) and carries a floating rate.

On the other hand, for the classes B and C, the elements according to entered in account:

  • the structure of the operation implied that the operation would be refunded completely anticipativement before the classes B and C begin their damping (in light, the classes B and C represented less than 10% of the total, limiting under which the operation could finish anticipativement)
  • the modeling of the operation (and the low and very stable rate of defect and advance payments) allowed to envisage with a good certainty the moment when this advance payment would intervene.

The classes B and C thus were of the obligations withfixed rate, and their refunding is known as “software bullet”. An obligation “software bullet” is a redeemable bond in fine (refundable in once at the limit, “bullet” in English) but whose date of refunding is not completely certain: in certain exceptional circumstances (such as an unforeseen accelerated damping of the wallet), this date can vary.

Classes of credits usable

There does not seem to be of limit in the active which one can titriser.

In addition to the traditional appropriations, one will be able titriser of the commercial credits, rents of movable or real credits, royalties, future flows, in short about any credit or right which one can reasonably envisage future financial flows.

As examples of “exotic” securitizations more, the Italian government titrisé the future products of Lotto and of the sale of a wallet of real estate, David Bowie titrisé the future incomes of its catalog of titles in 2002, and a British bank titrisé the future incomes of a chain of bars.

Principal types of operations

The operations can be classified according to the subjacent credits.

  • ABS: Asset Backed Securities : the generic term
  • RMBS: Residential Mortgage Backed Securities : operation leant with appropriations habitat mortage holders
  • CMBS: Commercial Mortgage Backed Securities: leant with commercial mortgage credits
  • CDO: Collateralised Debt Obligation: leant with debts various (group CBO and CLO)
  • CBO: Collateralised Jump Obligation: leant with obligations
  • CLO: Collateralised Loan Obligation: leant with appropriations with companies
  • WBS: Whole Securitisation Business: leant with flows of marketing activity or industrial

At the end of 2004, the US market was mainly made up of the loans related to the bank cards (21%), of the real loans (25%), the loans for the purchase of cars (15%) and of the CDO (15%). One also found, with shares much weaker, the student loans or the Leasing of planes.

In February 1970 the American department with housing and the urban development carries out first true securitization, on real loans.

The market developed by the additions of successive improvements like the use of Special Purpose Vehicle or a third. That allowed in 1985 securitization for the first time of a credit other than a wallet of real estate credits, appropriations for the purchase of cars in fact. This type of credits remain one of the titrisés products. In 1986 the first securitization of a wallet of appropriations of bank cards took place, for an amount of 50 million $.

The current market is mainly American and European. The United Kingdom represented in 2006 52% of the emissions except CDO. It was followed from Spain, Germany and the Netherlands. With 7.7 millards € of emissions on an European market of 370.9 billion €, France was 5th.

With of this episode, more general doubts settled against vehicles of placement which can present two gaps if they are badly controlled:

  • their products put back on cash the flows awaited solvent debtors being able to be little
  • their value of credit rests on goods brought in guarantee being likely to be overestimated compared to the amount of the credits to recover in the event of nonrefunding, or at the very least to have a value of very fluctuating resale.

The second part of the year 2007 thus involved the return to simpler products and a certain fall of securitization.

Random links:Kiriko Nananan | Morterone | 150 meters (athletics) | World challenge of the endurance | The Specialists (group) | Clayton,_l'Illinois