Tuesday, November 6, 2007

Issuance

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the

purchase. Investors purchase the securities, either through a private offering (targeting institutional

investors) or on the open market. The performance of the securities is then directly linked to the

performance of the assets. Credit rating agencies rate the securities which are issued in order to

provide an external perspective on the liabilities being created and help the investor make a more

informed decision.

In transactions with static assets, a depositor will assemble the underlying collateral, help structure

the securities and work with the financial markets in order to sell the securities to investors. The

depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the

beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the

parent which initiates the transaction. In transactions with managed (traded) assets, asset managers

assemble the underlying collateral, help structure the securities and work with the financial markets in

order to sell the securities to investors.

Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the

assets, the principal and the interest payments, for a fee.

The securities can be issued with either a fixed interest rate or a floating rate. Fixed rate ABS set

the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds. Floating rate

securities may be backed by both amortizing and nonamortizing assets. In contrast to fixed rate

securities, the rates on “floaters” will periodically adjust up or down according to a designated index

such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The

floating rate usually reflects the movement in the index plus an additional fixed margin to cover the

added risk[7]

Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal

are "credit enhanced," meaning their credit quality is increased above that of the originator's

unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive

cash flows to which they are entitled, and thus causes the securities to have a higher credit rating

than the originator. Some securitizations use external credit enhancement provided by third parties,

such as surety bonds and parental guarantees (although this may introduce a conflict of interest).

Individual securities are often split into tranches, or categorized into varying degrees of

subordination. Each tranche has a different level of credit protection or risk exposure than another:

there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,”

etc.) classes that function as protective layers for the “A” class. The senior classes have first claim

on the cash that the SPV receives, and the more junior classes only start receiving repayment after the

more senior classes have repaid. Because of the cascading effect between classes, this arrangement is

often referred to as a cash flow waterfall. In the event that the underlying asset pool becomes

insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan

claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain

unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities

are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes

receive a lower credit rating, signifying a higher risk. [7]

The most junior class (often called the equity class) is the most exposed to payment risk. In some

cases, this is a special type of instrument which is retained by the originator as a potential profit

flow. In some cases the equity class receives no coupon (either fixed or floating), but only the

residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets. This is often

the case where the underlying assets are mortgages which, in essence, are repaid every time the property

is sold. Since any early repayment is passed on to this class, it means the other investors have a more

predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the

principal and interest receipts can be easily allocated and matched. But if the assets are income-based

transactions such as rental deals it is not possible to differentiate so easily between how much of the

revenue is income and how much principal repayment. In this case all the income is used to pay the cash

flows due on the bonds as those cash flows become due.

Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a

security. Additional protection can help a security achieve a higher rating, lower protection can help

create new securities with differently desired risks, and these differential protections can help place

a security on more attractive terms.

In addition to subordination, credit may be enhanced through:[6]

* A reserve or spread account, in which funds remaining after expenses such as principal and

interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when

SPE expenses are greater than its income.
* Third-party insurance, or guarantees of principal and interest payments on the securities.
* Over-collateralization, usually by using finance income to pay off principal on some securities

before principal on the corresponding share of collateral is collected.
* Cash funding or a cash collateral account, generally consisting of short-term, highly rated

investments purchased either from the seller's own funds, or from funds borrowed from third parties that

can be used to make up shortfalls in promised cash flows.
* A third-party letter of credit or corporate guarantee.
* A back-up servicer for the loans.
* Discounted receivables for the pool.

Servicing

A servicer collects payments and monitors the assets that are the crux of the structured financial deal.

The servicer can often be the originator, because the servicer needs very similar expertise as the

originator.

The servicer can significantly affect the cash flows to the investors because it controls the collection

policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any

income remaining after payments and expenses is usually accumulated to some extent in a reserve or

spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings

of asset-backed securities based on the performance of the collateral pool, the credit enhancements and

the probability of default.[6]

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of

the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is

typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and

those who own the assets, typically the investors.

Repayment structures

Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed

is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity

of the loan. Fully amortizing securitizations are generally collateralized by fully amortizing assets

such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern

with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying

asset pool, so many prepayment models have been developed in an attempt to define common prepayment

activity. The PSA prepayment model is a well-known example. [8][7]

A controlled amortization structure is a method of providing investors with a more predictable repayment

schedule, even though the underlying assets may be nonamortizing. After a predetermined “revolving”

period, during which only interest payments are made, these securitizations attempt to return principal

to investors in a series of defi ned periodic payments, usually within a year. An early amortization

event is the risk of the debt being retired early.[7]

On the other hand, bullet or slug structures return the principal to investors in a single payment. The

most common bullet structure is called the soft bullet, meaning that the final bullet payment is not

guaranteed on the expected maturity date; however, the majority of these securitizations are paid on

time. The second type of bullet structure is the hard bullet, which guarantees that the principal will

be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors

are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard

bullet securities in exchange for a guarantee.[7]

Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on

maturity. This means that the first tranche, which may have a one-year average life, will receive all

principal payments until it is retired; then the second tranche begins to receive principal, and so

forth.[7] Pro rata bond structures pay each tranche a proportionate share of principal throughout the

life of the security.[7]

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