Special types of securitization

Master trust

A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has

the flexibility to handle different securities at different times. In a typical master trust

transaction, an originator of credit card receivables transfers a pool of those receivables to the trust

and then the trust issues securities backed by these receivables. Often there will be many tranched

securities issued by the trust all based on one set of receivables. After this transaction, typically

the originator would continue to service the receivables, in this case the credit cards.

There are various risks involved with master trusts specifically. One risk is that timing of cash flows

promised to investors might be different from timing of payments on the receivables. For example, credit

card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually

pay off much more quickly. To solve this issue these securities typically have a revolving period, an

accumulation period, and an amortization period. All three of these periods are based on historical

experience of the receivables. During the revolving period, principal payments received on the credit

card balances are used to purchase additional receivables. During the accumulation period, these

payments are accumulated in a separate account. During the amortization period, new payments are passed

through to the investors.

A second risk is that the total investor interests and the seller's interest are limited to receivables

generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with

how the seller controls the terms and conditions of the accounts. Typically to solve this, there is

language written into the securitization to protect the investors.

A third risk is that payments on the receivables can shrink the pool balance and under-collateralize

total investor interest. To prevent this, often there is a required minimum seller's interest, and if

there was a decrease then an early amortization event would occur.[6]

Issuance trust

In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance

trust, which does not have limitations, that master trusts sometimes do, that requires each issued

series of securities to have both a senior and subordinate tranche. There are other benefits to a

issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase

demand because pension funds are eligible to invest in investment-grade securities issued by them, and

they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts

are now the dominant structure used by major issuers of credit card-backed securities.[6]

Grantor trust

Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage

Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of

securitization. An originator pools together loans and sells them to a grantor trust, which issues

classes of securities backed by these loans. Principal and interest received on the loans, after

expenses are taken into account, are passed through to the holders of the securities on a pro-rata

basis.

Owner trust

In an owner trust, there is more flexibility in allocating principal and interest received to different

classes of issued securities. In an owner trust, both interest and principal due to subordinate

securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and

return profiles of issued securities to investor needs. Usually, any income remaining after expenses is

kept in a reserve account up to a specified level and then after that, all income is returned to the

seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess

reserves and excess finance income to prepay securities before principal, which leaves more collateral

for the other classes.

Motives for securitization

Advantages to issuer

Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be

able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can

have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple

hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002,

but a senior automobile backed securities issued by Ford Motor Credit in January 2002 and April 2002

continue to be rated AAA, because of the strength of the underlying collateral, and other credit

enhancements.[6]

Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect

matched funding by eliminating funding exposure in terms of both duration and pricing basis."[2]

Essentially, in most banks and finance companies, the liability book or the funding is from borrowings.

This often comes at a high cost. Securitization allows such banks and finance companies to create a

self-funded asset book.

Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or

range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a

sale for accounting purposes, these firms will be able to lessen the equity on their balance sheets

while maintaining the "earning power" of the asset.

Locking in profits: For a given block of business, the total profits have not yet emerged and thus

remain uncertain. Once the block has been securitized, the level of profits has now been locked in for

that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed

on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes

it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good

example of this are Catastrophe Bonds and Entertainment Securitizations. Similarly, by securitizing a

block of business (thereby locking in a degree of profits), the company has effectively freed up its

balance to go out and write more profitable business.

Off balance sheet: Derivatives of many types have in the past been referred to as "off balance sheet."

This term implies that the use of derivatives has no balance sheet impact. While there are differences

among the various accounting standards internationally, there is a general trend towards the requirement

to record derivatives at fair value on the balance sheet. There is also a generally accepted principle

that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting

adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the

income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives

products, particularly Credit Default Swaps, now have more or less universally accepted market standard

documentation. In the case of Credit Default Swaps, this documentation has been formulated by the

International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation

on how to treat such derivatives on balance sheets.

Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the

firm. When a securitization takes place, there often is a "true sale" that takes place between the

Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying

assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance

sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any

respect, this does distort the true earnings of the parent company.

Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance

companies, for example, may not always get full credit for future surpluses in their regulatory balance

sheet), and a securitization effectively turns an admissible future surplus flow into an admissible

immediate cash asset.

Liquidity: Future cashflows may simply be balance sheet items which currently are not available for

spending, whereas once the book has been securitized, the cash would be available for immediate spending

or investment. This also creates a reinvestment book which may well be at better rates.

Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave

a materially worse quality of residual risk.

Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees,

rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in

securitizations, especially if it is an atypical securitization.

Size limitations: Securitizations often require large scale structuring, and thus may not be cost-

efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par structures as well as credit

enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss,

especially for structures where there are some retained strips.

Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality credit-enhanced assets: Due to the stringent

requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated

entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or

A rated bonds, and risk averse institutional investors, or investors that are required to invest in only

highly rated assets, have access to a larger pool of .

Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional

investors tend to like investing in bonds created through Securitizations because they may be

uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at

least in theory) from the assets of the originating entity, under securitization it may be possible for

the securitization to receive a higher credit rating than the "parent," because the underlying risks are

different. For example, a small bank may be considered more risky than the mortgage loans it makes to

its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying

higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and

hence less profitable).