Transcript Insert Pitchbook Title - American Securitization Forum

Securitization 201:
Analytics for Cash Securitization
American Securitization Forum – Education Institute Seminar
January 2006
CONFIDENTIAL
Table of Contents
 Executive Summary
 Issuer Considerations
 Traditional Structure and Enhancements
 Investor Considerations
 Spread Methodology and Valuation Analysis
 Model Input Assumptions and Results
 Appendix
 Rating Agency Consideration
2
Executive Summary
Executive Summary
The objective of this sessions is to present the framework and pricing analysis for most types of cash
structure securities
The presentation will cover the following items:

Rating agency considerations and collateral level risk measurements as inputs

Issuer considerations and benefits of issuing asset backed securities

Investor considerations for purchasing asset backed securities

Valuation of structured securities for amortizing and non-amortizing asset types
4
Asset Backed Securities – Amortizing Loans
 Credit Sensitive structured products – must deal with credit and prepayment risk
Amortizing Loans (Mortgages, Auto)
 Borrowers make periodic monthly payments over the life of the loan that includes scheduled and
unscheduled principal and interest
 Set Repayment schedule – Amortization Schedule
 Projection of cash flow requires projection of non contractual prepayments (excess principal payments)
and defaults
 Recovery of defaults will lead to prepayments (“involuntary prepayment”) of the principal balance
 Defaults can lead to decrease of cash flow due to non payment though only after recovery has been received
5
Asset Backed Securities – Revolving Loans
Revolving Loans (Credit Cards, Trade Receivables)
 Do not have a schedule for the periodic payment
 Instead borrower makes a minimum periodic payment
 If payment less than the interest than the outstanding balance will increase
 If payment is greater than the interest or additional borrowings than the outstanding balance will decrease
 The concept of prepayment does not apply (e.g. Credit Cards)
6
Issuer Considerations
Benefits of issuing an asset backed security
 The creation of a bankruptcy remote Special Purpose Vehicle (“SPV”) allows for higher credit rating
based on the credit quality of the isolated asset in a stand alone entity compared to the corporate
issuer leading to a lower cost of funds
 SPV requirements
 Bankruptcy remote/non consolidation opinion– based on legal opinions
 True Sale of Asset to separate legal entity – validates sale of asset
 Based on credit enhancement will be rated by the rating agency for collateral and enhancement levels
and not corporate issuer
 A sub-investment grade originator may issue at AAA if they have the appropriate enhancement level and legal structure
 Ratings Factors
 Credit quality of the collateral based on the historical default and recovery rates
 Longer external and/or internal credit enhancements
 The quality of the Seller/Servicer
 Cash flow and stress payment structure – model to assess cash flow deviation from the payment schedule (may be as
simple as historical pattern or as extensive as a macroeconomic model)
 Legal Structure
 Facilitates the liquidity and growth of certain consumer finance products (Credit Card, Mortgages)
8
Corporate Bond vs. Asset Backed Securities Credit Analysis
 Only requirement is evaluation of cash flows under certain stressed scenarios to determine the timing
and magnitude o f shortfalls on schedule cash receipts
 Delinquencies
 Defaults/Recoveries
 Prepayments
In a true securitization repayment is not dependent on the ability of the Servicer to
replenish the pool with new collateral or to perform more than routine administrative
functions (1)
(1) Standard and Poors, “Rating Hybrid Securitizations” Structured Finance (October 1999)
9
Traditional Structure and Enhancements
Traditional Structure
Internal Credit
Enhancement
Originator(1)(2)
$
True Sale Assets
Trustee Fee
Services
Bankruptcy Remote
Special Purpose
Vehicle (“SPV”)
Servicer(1)
Service Fee
Trustee
Services
Principal
and
Interest
$
Investors
External Credit
Enhancement
(1) Originator and Servicer often are the same entity
(2) Sometimes Servicer/Originator may take a subordinate position in the pool providing
some of the structural credit enhancement
11
Revolving Structures
 Structured securities from revolving, not amortizing pools of collateral, tend to fall into one of four
categories
 Credit Card Series
 Collateralized Debt Obligation
 Single Seller Conduits
 Asset Backed Commercial Multi-Seller Conduits
12
Credit Enhancement Mechanics
External – 3rd party guarantee
 Parental guarantee (this jeopardizes the possibility to issue debt rated above the parent rating)
 Letter of Credit (provided by Banks, tied to the Banks Rating)
 Bond Insurance (Monoline)
 Disadvantage to external credit enhancement is the subjectability to the credit risk of the 3rd party (“weak link” test)
Internal
 Reserve Fund
 Cash reserve fund (cash deposit invested in eligible investments)
 Excess Servicing Spread Account (allocation of the excess spread into a reserve account)
 Overcollateralization – Seller Interest taken by the Originator
 Amount of collateral in excess of the amount of the liability
 Senior/Sub Structures
 Most popular form
 Level of protections changes over time due to prepayments
 Shifting interest mechanisms may offset prepayment but need to assess contraction vs. credit risk
13
Cash flow and Payment Structure
 Passthrough
 Senior Tranche and the CF distributed pro rata to the bond holders (e.g. participation certificates)
 Paythrough
 Senior tranches divided into additional tranches that follow different payment priorities from the cash flow of the collateral
 Cash flow needs to pay the following:
 Principal
 Interest
 Fees (Servicer Fee, Credit Enhancement, Trustee Fee etc.)
 Agency will analyze if the Cash flows match the obligations and stress the cash flow by shocking the
following:
 Losses (seasoned loss curves): Delinquencies, Gross Losses and Net Losses
 Interest rates
 Prepayments (CPR, MPR, SMM)
14
Rating Agency Risk Measurement Framework
 Two parallel risk measurement systems have evolved within the rating agency world for securitization,
one focused on defaults, the other focused on loss or yield. And so there are at least three types of
scores at use in today’s market:
 Defaults: the cash runs out and the investor is not paid in full;
 Expected Losses: the shortfall by which the initial bond price exceeds the present value of cash flows to the investor,
discounted at the promised level of yield; or
 Structuring a transaction means selecting the metric by which to rate the deal, obtain cash flow results
from different scenarios, and use the score as an internal feedback to develop a final transaction
structure.
 Two traditions of scenario analysis have developed alongside the two philosophies of risk scoring.
 In one tradition, stresses are developed based upon a consensus determination of what severity means in historical
terms, and they are used to make the structure bullet-proof.
 In the other tradition, a microstructure of risk is ascribed to the collateral, and a simulation of the impact of the asset risk
microstructure on liability cash flows is examined in a simulation framework.
15
Investor Considerations
Investor Considerations
Upside
 Relative Value return for Investor

Ratings needs, Insurance companies need the NAIC bands

Payback/paydown needs

Appetite for prepayment and interest rate risk - need compensation for negative convexity effect on HELOC and MBS related products
 Better security through direct claim to assets
 Rating resilience
 Higher rating stability than comparably rated corporates
 Key Reason for subordinated investors is the possibility of upside
 Existence of a legally binding payment waterfall in a structured transaction
 Trustee controlling money
 High standard of ongoing data disclosure
 Orderly transition of certainty in bond performance with the passage of time from less certain to more retain
Downside
 Uncertainty of cash flows
 Modeling – specialized knowledge required in some sectors
17
Extension and Contraction Risk for Amortizing Asset
Contraction Risk
Extension Risk
Decrease Interest
Rate Environment
Increase Interest
Rate Environment
 Increased prepayment risk –
refinancing
 Increased reinvestment risk
at lower rate
tn
Collateral
Cash
Flow
 Reduced prepayments –
competitive rates
 Inability to reinvest to
generate higher return
t0
tn
18
Methodology and Valuation Techniques
Valuation Methodology
 Yield to Maturity (“YTM”) = interest rate that makes the Present Value of the expected Cash flow =
Market Price
 The benchmark for an amortizing asset is based on the weighted average life and not the maturity
 Bond Equivalent Yield allows comparison of Yield to Treasury
 For Bonds 2X Semi-annual which is not true for ABS/MBS due to monthly cash flow and ability reinvest
 Bond Equivalent Yield = 2 [(1+im)6 – 1] where
 Im= Yield
 Assume monthly yield 0.6%
 BEY = 2 x [1 + 0.06%]6 -1] = 0.0731 = 7.31%
20
Limitations to Cash flow yield curve
 For YTM (“IRR”) as a measure the investor must assume
 Reinvest the coupon payments at a rate equal to the Yield to Maturity
 Requirement to hold the bond until maturity
 YTM for long term bonds say little since reinvestment is a big (potentially over 60%) of the potential $ value
 Reinvestment Risk
 Risk may exist to reinvest at a lower rate then computed yield
 Interest Rate Risk
 Risk associated with having to sell a security before its maturity date at a price less than purchase price
 Uncertainty of Cash flow
 May shift due to changes in the actual cash flows due to:

Prepayment

Default

Recovery
21
Limitations to Cash flow yield curve
 Given YTM and zero coupon rate

Longer maturity the more the bonds total $ return is dependent on reinvestment income to realize the YTM at time of purchase
and therefore has a greater reinvestment risk. (Z-spread)
 Given YTM and maturity for a coupon bond

Higher coupon will lead to more risk of the reinvestment of the coupon payment at the coupon in order to produce the YTM

A bond selling at premium will be more dependent on reinvestment income than a bond selling at par because reinvestment has
to make up the capital loss when holding the bond to maturity. In contrast, bond selling at par because of capital gains to be
realized at maturity.
22
Types of Spreads – Nominal, Z-Spread, Option Adjusted
Nominal Spread
 Difference between the cash flow yield and the benchmark Treasure yield based on the weighted
average life of the bond
Zero Volatility Spread - Z-Spread
 Measure of spread the investor would realize over the entire Spot Rate Curve if the Bond was held to
maturity. It is not the spread at one point of the yield curve as the nominal spread
Option Adjusted Spread – OAS
 The constant spread added to all 1 year rates on the binomial tree that creates the arbitrage free value
equal to the market price
23
Nominal Spread
Nominal Spread
 This spread masks the fact that a portion of the nominal spread is compensation for the prepayment
risk. A support tranche may have a high nominal spread that may not be collected if repayments occur.
 Nominal Spread includes
 Credit Risk
 Liquidity Risk
 Option Risk
24
Zero Volatility Spread – Z-Spread
Z-Spread
 Measure of spread the investor would realize over the entire Spot Rate Curve if the Bond was held to
maturity. It is not the spread at one point of the yield curve as the nominal spread
 Calculated as the spread that will make the PV of the CF from the non-treasure bond when discounted
at the treasure spot curve rate plus the spread, = the market price of the bond
Determination of the Z-Spread for an 8%, 10-year Non-Treasury Isue Selling at $104.19 to yield 7.4%
Period
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Years
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
8.00
8.50
9.00
9.50
10.00
Cash flow ($) Spot Rate (%)
$4.00
3.0000
$4.00
3.3000
$4.00
3.5053
$4.00
3.9164
$4.00
4.4376
$4.00
4.7520
$4.00
4.9622
$4.00
5.0650
$4.00
5.1701
$4.00
5.2772
$4.00
5.3864
$4.00
5.4976
$4.00
5.6108
$4.00
5.6643
$4.00
5.7193
$4.00
5.7755
$4.00
5.8331
$4.00
5.9584
$4.00
6.0863
$4.00
6.2169
Total
Present Value assuming Spread of
100 bp
125 bp
146 bp
3.9216
3.9168
3.9127
3.8834
3.8240
3.8162
3.7414
3.7277
3.7163
3.6297
3.6121
3.5973
3.4979
3.4767
3.459
3.3742
3.3497
3.3293
3.2565
3.2290
3.2061
3.1497
3.1193
3.094
3.043
3.0100
2.9826
2.9366
2.9013
2.8719
2.8307
2.7933
2.7622
2.7255
2.6862
2.6537
2.621
2.5801
2.5463
2.5279
2.4855
2.4504
2.4367
2.3929
2.3568
2.3472
2.3023
2.2652
2.2593
2.2137
2.1758
2.1612
2.1148
2.0766
2.0642
2.0174
1.979
51.1833
49.9638
48.963
107.5910
105.7166
104.2144
25
Zero Volatility Spread – Z-Spread
 Represents risk for

Credit

Liquidity

Option
 Z-Spread can be set to any benchmark
 Libor
 Treasury
 Issuer
26
What does the Z-Spread mean
When benchmark is the Treasury Spot Curve
 Z-Spread incorporates
 Credit Risk
 Liquidity Risk
 Option Risk
When benchmark is the spot rate of the issuer
 Z-spread incorporates
 Liquidity risk of the issuer
 Option risk
 For the issuer rate as a benchmark the credit risk is not incorporated in the spread
27
Divergence Z-Spread and Nominal Spread
 Typically for standard non coupon paying bonds with a bullet maturity the z-spread and nominal spread
will not differ significantly
Divergence function of
 Term structure of interest rate
 Short term issue has small divergence due to shape of the yield curve
 Steeper spot curve leads to divergence in spread
 Basically flat yield curve uses the same discount rate as the YTM
 Characteristics of security
 Coupon rate
 Time to maturity

Z-spread greater at steep yield curve environment due to reinvestment of the payments
 Type of principal repayment provision (amort or non-amort)

Increased divergence for principal payment over time instead of as a bullet at maturity
28
Option Adjusted Spread - OAS
Option Adjusted Spread
 Developed as a measure of the yield spread to allow conversion of price differences to yield spread to
determine relative value. Gives you a basis for comparing bonds after eliminating the cost of the
prepayment option the structure has
 If on the run Treasury is used as a benchmark the OAS measures

Credit Risk

Liquidity Risk
 OAS can be set to any benchmark when you bootstrap the curve to maturity
 To compare need to review OAS assumptions since very dependent on valuation model
 Volatility assumptions
 Benchmark curve assumptions (Treasury Spot Curve, Libor, Issuer)
 i-rate volatility big driver

Higher interest rate volatility leads to a lower OAS, option to structure is worth more
29
Option Cost
 Option Cost = Z-Spread – OAS
 At no volatility (static) interest rate environment no option cost exists
 For most MBS/ABS the option cost is positive because borrowers ability to alter the cash flow will result
in an OAS less than the z-spread.
 Option Cost
 Positive

Investor sold option to Borrower/Issuer
 Negative

Investor has purchased an option form the borrower or issuer
30
Pitfall of the nominal spread
 Z-spread = OAS + Option Cost
 Z-spread = nominal cost @ short term flat yield therefore
 Nominal Spread = OAS + option cost
 High amount of nominal spread could include significant amount of option cost – spread investor has
given the issuer/borrower
31
Valuation of ABS and Spread Utilization
Two approaches to value ABS transactions
 Zero Volatility Spread - Z-Spread
 Option Adjusted Spread – OAS
ABS has one of the following three characteristics
 The ABS does not have a prepayment option (e.g. Credit Card, Trade Receivable)
Z-Spread – since no prepayment there is no option cost and the OAS and Z-spread are equal
 The ABS has a prepayment option but borrowers do not exhibit a tendency to prepay when refinancing
rates fall below the loan rate (e.g. Auto Loans)
Z-Spread – since no prepayment there is no option cost and the OAS and Z-spread are equal
 The ABS has a prepayment option and borrowers do exhibit a tendency to prepay when refinancing
rates fall below the loan rate (e.g. Mortgages)
OAS – Prepayment and therefore interest path dependent - option cost needs to be assessed
32
Model Input Assumptions and Results
Model Cash Flow
Cash flow is generated by incorporating
 A monthly interest rate to discount the cash flow
 Incorporate a refinance/prepayment rate
 Loss/recover assumptions (cumulative loss curve)
34
Cumulative Loss Curve
 Construct for analyzing the credit deterioration is the cumulative loss curve
 Losses reduce the return principal and interest for investors
 The cumulative loss curve plots the cumulative losses/charge offs to the initial outstanding loan
balance of the pool
 Relation between prepayment and expected loss
 As obligors prepay , even though the charge off rate rises, the cumulative loss rate slows down
 In such cases, it is important to examine the hazard rate, the rate of charge off relative to the then outstanding loan
balance
 To normalize spikes a 6-month time horizon is recommended
 For a typical portfolio, the hazard rate ascends as the portfolio seasons; however, the cumulative loss
rate tends to flatten as the impact of the ascending rate is reduced by the reduction in the pool size
 Since corporate bonds do not amortize the loss curve or a similar performance matrix does not exist
35
Model Assumptions - Payment Rate
Credit Cards
 MPR = Monthly Payment Rate
MPR = Collections / Beginning Debt Balance for the month
Auto Loan
 ABS = prepayment as % of original collateral amount
 SMM = prepayment based on prior months balance (i.e. monthly CPR) (includes impact of seasoning)
ABS = SMM / [1 + [SMM x (M -1)]]
Mortgages
 CPR = Conditional Prepayment Rate
 Determined based on prepayment and default model
 % per annum (physical calculation does not factor in seasoning)
36
Prepayment impact
 Prepays principal and reduces total interest (excess spread)
 Reduces the weighted average maturity of the pool (duration)
 May impact the quality of the pool
 Introduces callability risk
 May increase Reinvestment rate or lead to extension risk
37
Duration - Measuring Interest Rate Risk
 Duration and convexity is used to estimate the interest rate exposure to parallel shifts in the yield curve
 Duration measures the price sensitivity to changes in the interest rate
 Duration = (V- + V+) / 2 x V0 (y)
Where
 y = change in rate used to calculate new values (i.e. change in interest rate)
 V+ = estimated value if the yield is increased by y
 V- = estimated value if the yield is decreased by y
 V0 = initial price (per $100 of par value)
38
Model Outputs
Rating Agencies
 Analyze credit quality of the collateral
 Assess required credit enhancement for rating levels through
 selecting the metric by which to rate the deal
 obtain cash flow results from different scenarios
 use the score as an internal feedback
Issuer
 Determine credit enhancement to analyze transaction cost
Investor
 Verify credit
 Verify yield assumptions - price yield curve
 Estimate duration
39
Appendix
Rating Agency Considerations
Credit Quality of the Collateral
 Analyzed by asset type
 Evaluation of borrowers’ ability to pay its obligation
 Review of originators collection and underwriting experience in the asset class to assess default
probabilities and loan characteristics (i.e. standard or customized)
 Review Pool diversification for concentration risk
 Greater concentration may lead to more default risk and increase credit risk
 Limit concentration based on credit risk based concentration limits

Can be geographic, industry, individual obligor, collateral type, maturity, interest. Agencies have requirements by asset type
42
Quality of Seller/Servicer
 Agencies require all loans to be serviced
 Servicing involves
 Collection and application of monies to SPV
 Delinquency notification
 Recovery and Liquidation of collateral
 Administration of the loan portfolio including

Distribution of proceeds according to the payment waterfall

Reporting
 In many transactions the Servicer is the Originator
 A backup or specialty Servicer may be required if Originator is of low credit quality
 The role of the Servicer is critical in an Asset Backed Transaction since the issuer is not a corporation with employees but
simply loans and receivables
 Rating Agencies will review the following to determine if Servicer is acceptable or not
 Backup Servicer may be requested if not
 Servicing History and experience in the asset class
 Underwriting Standards
 Servicing capabilities and scalability – available human resources
 Financial condition
 Growth and competitive business environment
43
Corporate Bond vs. Asset Backed Securities Credit Analysis
 Significant difference due to required cash flow analysis
 Management of the corporation must undertake necessary activities to generate and collect revenues and incur costs for
creating new products and services
 Corporate Bond Analysis needs to include:
 Issuers Character

Quality of Management and track record

Strategic position

Financial philosophy

Control Systems
 Analysis of the Capacity to pay

Industry trends

Regulatory environment

Operating and competitive position

Financial position and sources of liquidity based in financial ratios
–
Profitability Ratios (ROE, profit margin, asset turnover)
–
Debt coverage analysis (short term solvency (current ratio,) leverage ratios (Debt to Cap), coverage ratios (Ebit to interest)

Company structure (parent company support, priority of claim)

Special event risk
 Cash flow

Inability to pay increases reliability on external financing further enhancing obligations and inability to pay - CFO
44
Payment Structure
Passthrough
$100MM
10,000 Certificates
Each certificate 1/10,000 of the Cash flow
Paythrough
$100MM
A-1 @ 30MM
Ability to bifurcate senior note to further redistribute credit and repayment risk
A-2 @ 50MM
B @20MM
Subordinate 1st loss position
45
Legal Structure
 In general a corporation will utilized structured financing to seek a higher credit rating through the
utilization of certain assets as collateral instead of the general credit of the issuer
 Agencies want to make sure that corporate creditors do not have access to the collateral in the event
of a bankruptcy
 SPV is established to create bankruptcy remote legal entity
 Legal opinion required
 The SPV is set up as a wholly owned sub but treated as a separate legal entity
 Via a true sale the assets are transferred to the SPV and held for the benefit of the investors
46