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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