Securitization

The Ministry of Education and Science of the Russian Federation

Plekhanov Russian University of Economics

Chair of Foreign Languages

PROJECT

                                              “Securitization”

Performed by

Galanov V.I.

Finance Faculty

group 2402

Supervised by

Trostina K.V.

Project defended on:

30th of March 2012

Evaluation:

________________

Tutor`s signature:

________________

Moscow 2012

Contents

Introduction

Chapter 1. Securitization

1.1 Nature of securitization

1.2 The process of securitization

1.3 Types of securitization

Chapter 2. Securitization: Practices and Implications

2.1 David Bowie Bonds

2.2 Motives for securitization

2.3 Securitization in Russia

Conclusion

References

Glossary

2

Introduction

2

Chapter 1. Securitization

1.1     Nature of securitization

In February 1970, the U.S. Department of Housing and Urban Development created the first transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).

The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.

Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.

The first public Securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods.

At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.

Securitization only reached Europe in the late 1980s, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 1990s or early 2000s, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards), Insurance-backed transaction or even more esoteric asset classes (for example securitization of lottery receivables for the Greek government, executed by Philippe Tapernoux).

As the result of the credit crunch precipitated by the subprime mortgage crisis the market for bonds backed by securitised loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. As a result interest rates are rising for loans that were previously securitised such as home mortgages, student loans, auto loans and commercial mortgages.

1.2 The process of securitization

Participants of securitization process are divided into three groups:

1.      Asset Originator, it’s can be:

      Banks

      Real estate funds

      Leasing companies

      Developers

      Any other company that  has some illiquidity assets which generate stable cash flows

2.      Issuing agent or Special Purpose Vehicle (SPV) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives. SPVs created for the transaction and act as the borrower, acquire certain property rights or obligations.

3.      Capital market Investors. Companies which buy securities issued by the SPV.

The scheme of securitization process

In its most basic form, the process involves two steps (see chart).

In step one, a company with loans or other income-producing assets — the originator — identifies the assets it wants to remove from its balance sheet and pools them into what is called the reference portfolio. It then sells this asset pool to an issuer, such as a special purpose vehicle (SPV) — an entity set up, usually by a financial institution, specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes.

In step two, the issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on — less a servicing fee — directly to the SPV or the trustee. In essence, securitization represents an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risk) from issuers to investors.

In a more recent refinement, the reference portfolio is divided into several slices, called tranches, each of which has a different level of risk associated with it and is sold separately. Both investment return (principal and interest repayment) and losses are allocated among the various tranches according to their seniority. The least risky tranche, for example, has first call on the income generated by the

underlying assets, while the riskiest has last claim on that income.

The conventional securitization structure assumes a three-tier security design — junior, mezzanine, and senior tranches.

1.3 Types of securitization

Type of securitization depends on the type of assets which have Originator and type of securities which SPV issued on market.

              Most common types of securitization:

      MBS  (Mortgage-Backed Securities). Securities collateralized by a pool of mortgage loans.

      CDO (Collateralized Debt Obligations). CDO are securities backed by pools of various types of debt instruments, which may include corporate bonds issued by financial institutions, loans or tranches of securities issued in the securitization.

      CMO  (Collateralized Mortgage Obligation). Obligation secured by the mortgage - the security provided by a pool of securities backed by mortgages. The structure of the pool requires the presence of several types of securities with different maturities.

      CMBS (Commercial Mortgage-Backed Securities). Mortgage-backed securities issued by real estate collateral. Together with other types of MBS have provided growth in property prices seen in recent years.

      RMBS (Residential Mortgage-Backed Securities). Mortgage-backed securities collateralized by residential premises

Securitization was initially used to finance simple, self – liquidating assets such as mortgages. But any type of asset with a stable cash flow can in principle be structured into a reference portfolio that supports securitized debt.

Securities can be backed not only by mortgages but by corporate and sovereign loans, consumer credit, project finance, lease/trade receivables, and individualized lending agreements.

The generic name for such instruments is asset-backed securities (ABS), although securitization transactions backed by mortgage loans (residential or commercial) are called mortgage-backed securities.  A variant is the collateralized debt obligation, which uses the same structuring technology as an ABS but includes a wider and more diverse range of assets.

2

Chapter 2. Securitization: Practices and Implications

2.1. David Bowie Bonds

Bowie Bonds are asset-backed securities of current and future revenues of the 25 albums (287 songs) that David Bowie recorded before 1990.

Asset Originator: Dawid Bowie - famous rock musician. His asset is 25 albums (287 songs).

SPV: Fahnestock and Co. (Investment Bank)

Investor: Prudential Financial Inc. (American Insurance Company)

Issued in 1997, the bonds were bought for US$55 million by the Prudential Financial, Inc. The bonds paid an interest rate of 7.9% and had an average life of ten years, a higher rate of return than a 10-year Treasury note (at the time, 6.37%). Royalties from the 25 albums generated the cash flow that secured the bonds' interest payments. Prudential also received guarantees from Bowie's label, EMI Records, which had recently signed a $30m deal with Bowie.

By forfeiting ten years worth of royalties, David Bowie was able to receive a payment of US$55 million up front. Bowie used this income to buy songs owned by his former manager.[2] Bowie's combined catalog of albums covered by this agreement sold more than 1 million copies annually at the time of the agreement.

The Bowie Bond issuance was perhaps the first instance of intellectual property rights securitization. The securitization of the collections of other artists, such as James Brown, Ashford & Simpson and the Isley Brothers, later followed. These Bonds are named Pullman Bonds after David Pullman, the banker who pushed the original Bowie deal.

2.2. Motives for securitization

2.3. Securitization in Russia

2

Conclusion

2

References

1)           Michael Simkovic: «Competition and Crisis in Mortgage Securitization»

2)           Michael Simkovic: «Secret Liens and the Financial Crisis of 2008», American Bankruptcy Law Journal, Vol. 83, p. 253, 2009

3)           Raynes, Sylvain and Ann Rutledge, «The Analysis of Structured Securities», Oxford U Press, 2003, p. 103.

4)           «ESF Securitization Data Report Q2»:business

5)           Andreas Jobst, Back to Basics, «What is Securitization?»

6)           Claire A. Hill, Whole Business Securitization in Emerging Markets, Duke Journal of Comparative and International Law 12:2 (2002)

7)           «Asset Securitization Comptroller's Handbook», Comptroller of the Currency Administrator of National Banks, 1997.

8)           «Hearing before the U.S. House subcommittee on Policy Research and Insurance in «Asset Securitization and Secondary Markets»» (July 31, 1991), page 13

9)           «Common Structures of Asset-Backed Securities and Their Risks», Tarun Sabarwal, December 29, 2005

10)      T Sabarwal «Common Structures of Asset Backed Securities and Their Risks», December 29, 2005

11)      Financial Accounting Standards Board (FASB) Statement No. 140 «Accounting for transfers and servicing of financial assets and extinguishments of liabilities—a replacement of FASB Statement No. 125», September 2000

12)      Reis-Roy, Calvin (2003). An Analysis of the Law and Practice of Securitization

13)      «The Handbook of Asset-Backed Securities», Jess Lederman, 1990

2

Glossary

1)           Amortization - The deduction of capital expenses over a specific period of time (usually over the asset's life).

2)           Asset originator – company that has some illiquidity assets which generate stable cash flows.

3)           Asset-Backed Security (ABS) - is a security whose value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets

4)           Average life - An estimate of the number of terms to maturity, taking the possibility of early payments into account. Average life is calculated using the weighted average time to the receipt of all future cash flows.

5)           Balance Sheet – is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time.

6)           Bond - a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing (облигация);

7)           Cash Flow - is the movement of money into or out of a business, project, or financial product.

8)           Collateral - properties or assets that are offered to secure a loan or other credit. Collateral becomes subject to seizure on default (залог, обеспечение по кредиту);

9)           Collateralized Debt Obligation (CDO) - An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. 

10)      Collateralized Mortgage Obligation (CMO) - A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches.

11)      Commercial Mortgage-Backed Securities (CMBS) - A type of mortgage-backed security that is secured by the loan on a commercial property.

12)      Costs -  the value of money that has been used up to produce something, and hence is not available for use anymore.

13)      Credit - A contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some date in the future, generally with interest. 

14)      Currency - generally accepted medium of exchange (валюта);

15)      Debt - An amount of money borrowed by one party from another.

16)      Derivative - a financial instruments that derive their price from the value of another security or rate, called the underlying asset (дериватив, производный финансовый инструмент);

17)      Diversification – a technique that reduces risk by allocating investments among various financial instruments, industries and other categories (диверсификация);

18)      Earnings - The amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year.

19)      Fee - is the price one pays as remuneration for services.

20)      Fixed Interest Rate - A loan or mortgage with an interest rate that will remain at a predetermined rate for the entire term of the loan.

21)      Floating Interest Rate - An interest rate that is allowed to move up and down with the rest of the market or along with an index.