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LO 35.7: Define and calculate the delinquency ratio, default ratio, monthly payment rate (M PR), debt service coverage ratio (D SC R ), the weighted average coupon CWAC), the weighted average m aturity fWAM), and the weighted average life fWAL) for relevant securitized structures.
As described previously, the delinquency ratio, default ratio, and monthly payment rate (MPR) serve as triggers to signal early amortization of the receivables pool for an ABS.
Example: Delinquency ratio, default ratio, monthly payment rate
Suppose an ABS has a total outstanding balance of credit card receivables of $57,800,000. $49,900,000 of the total receivables are current, $5,750,000 of the receivables are over 30 days past due, $1,270,000 of the receivables are over 60 days past due, and $880,000 are over 90 days past due. In addition, $1,100,000 of receivables were written off. Total monthly principal and interest payments per month are $1,560,000. Calculate the delinquency ratio, default ratio, and monthly payment rate for this ABS.
Answer:
The delinquency ratio 1.522%, computed by dividing the value of credit card receivables over 90 days past due by the total credit card receivables pool ($880,000 / $57,800,000).
The default ratio is 1.903%, calculated by dividing the amount of written off credit card receivables by the total credit card receivables pool ($1,100,000 / $57,800,000).
The monthly payment rate (MPR) is 2.699%, calculated as the percentage of monthly principal and interest payments divided by the total credit card receivables pool ($1,560,000 /$57,800,000).
M B S Performance Tools
The debt service coverage ratio (DSCR), weighted average coupon (WAC), weighted average maturity (WAM), and weighted average life (WAL) are performance tools used to analyze MBS. The debt service coverage ratio (DSCR) is calculated by dividing net operating income (NOI) by the total amount of debt payments. Net operating income is the income or cash flows that are left over after all of the operating expenses have been paid. The DSCR is a performance tool that measures the ability of a borrower to repay the outstanding debt associated with commercial mortgages. A DSCR less than one indicates that the underlying asset pool of commercial mortgages do not generate sufficient cash flows to cover the total debt payment. Total debt service refers to all costs related to servicing a companys debt. This often includes interest payments, principal payments, and other obligations. As investors confidence levels in the securitization increase, the required DSCR decreases, and vice versa. For residential mortgages, this ratio is typically between 2.5 and 3.0. However, higher DSCR are needed with more risky receivables where the value of the receivables is highly discounted in the event of a default.
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Example: Debt service coverage ratio
Suppose an MBS has net operating income from commercial mortgaged properties equal to $89,572,500. The total debt payments for notes issued against these mortgages is equal to $87,958,000. Calculate the debt service coverage ratio (DSCR).
Answer:
The DSCR is equal to 1.02, calculated as $89,572,500 / $87,958,000. A DSCR greater than one implies that there is sufficient cash flows generated from the underlying mortgage pool to meet debt payments. However, this is a very low DSCR for mortgages.
The weighted average coupon (WAC) is calculated by multiplying the mortgage rate for each pool of loans by its loan balance and then dividing by the total outstanding loan balance for all pools. Thus, it measures the weighted coupon of the entire mortgage pool. The WAC is compared to the net coupon payable to investors as an indication of the mortgage pools ability to pay over the outstanding life of the MBS.
Example: Weighted average coupon
Suppose an MBS is composed of three different pools of mortgages: $6 million of mortgages that yield 7.8%, $10 million of mortgages that yield 6.0%, and $4 million of mortgages that yield 5%. Calculate the weighted average coupon (WAC).
Answer:
The WAC is calculated as follows:
WAC = [0.078(6 million) + 0.06(10 million) + 0.05(4 million)] / (6 million +10 million
+ 4 million)
= (0.468 million + 0.6 million + 0.2 million) / 20 million = 1.268 million / 20 million = 0.0634 or 6.34%
If notes issued by the SPV are for 5.5%, for example, then an excess spread will be generated if there are no defaults on the original mortgages.
The weighted average maturity (WAM) is the weighted average months remaining to maturity for the pool of mortgages in the MBS. To calculate the WAM, the weight of each MBS pool is multiplied by the time until maturity of each MBS pool, and then all the values are added together. (Note that the weight is determined by taking the total value of the pool for one maturity and dividing that by the total value of all loans.)
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The volatility of an MBS is directly related to the length of maturity of the underlying securities. The WAM is calculated based on stated maturity dates or reset dates. A WAM calculated based on stated maturity dates includes the liquidity risk of all mortgage securities in the portfolio by using the actual maturity date. A WAM calculated based on reset dates captures the effect of prepayments on the maturity of the loans.
Example: Weighted average maturity
Suppose an MBS is composed of three different pools of mortgages: $6 million of mortgages that have a maturity of 180 days, $10 million of mortgages that have a maturity of 360 days, and $4 million of mortgages that have a maturity of 90 days. Calculate the weighted average maturity (WAM).
Answer:
The WAM is calculated as follows:
WAC = [180(6 million) + 360(10 million) + 90(4 million)] / (6 million + 10 million +
4 million)
= (1,080 million + 3,600 million + 360 million) / 20 million = 5,040 million / 20 million = 252 days
The weighted average life (WAL) of the mortgage notes issued is calculated by summing the time to maturity multiplied by a pool factor using the following formula:
WAL =
(a / 365) x PF(t)
Figure 4 illustrates how WAL is calculated for an MBS with an initial outstanding balance for the entire pool of $89,530,000. The pool factor, PF(t), is the outstanding notional value adjusted by the repayment weighting. The actual days, a, until the next payment are stated in column B. This amount in column B is then divided by 365 in column F to calculate the time to maturity. The amount in column F is multiplied by column C to compute each individual notes weighted life and this is recorded in column G. WAL is then determined as the summation of column G.
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Figure 4: Calculation ofWAL
A
Payment
Date
11/21/2008 1/26/2009 4/26/2009 7/26/2009 10/25/2009 1/24/2010 4/25/2010 7/25/2010 10/24/2010 1/24/2011 4/24/2011 7/24/2011 10/24/2011 1/24/2012 4/24/2012 7/24/2012 10/24/2012 1/24/2013 4/24/2013 7/24/2013
B
Actual Davs (a)
66 90 91 91 91 91 91 91 92 90 91 92 92 91 91 92 92 90 91
Prepayment Forecasting
C
PFft) 1.00 0.94 0.89 0.83 0.75 0.73 0.68 0.63 0.58 0.54 0.49 0.45 0.41 0.37 0.33 0.29 0.25 0.22 0.18 0
D Paid
Principal
5,059 4,941 4,824 4,706 4,588 4,471 4,353 4,235 4,118 4,000 3,882 3,765 3,647 3,529 3,412 3,294 3,176 3,058 16,472
E
F
Outstanding Balance (000s)
89,530 84,471 79,530 74,706 70,000 65,412 60,941 56,588 52,353 48,235 44,235 40,353 36,588 32,941 29,412 26,000 22,706 19,530 16,472
0
a / 365 0.1808 0.2466 0.2493 0.2493 0.2493 0.2493 0.2493 0.2493 0.2521 0.2466 0.2493 0.2521 0.2521 0.2493 0.2493 0.2521 0.2521 0.2466 0.2493
0
WAL =
G
(al365) x
p m 0.1808 0.2318 0.2219 0.2069 0.1870 0.1820 0.1695 0.1571 0.1462 0.1332 0.1222 0.1134 0.1033 0.0922 0.0823 0.0731 0.0630 0.0542 0.0449
0
2.565

LO 35.6: Explain the various performance analysis tools for securitized structures and identify the asset classes they are m ost applicable to.
There are a number of performance tools designed to analyze the collateral pool of asset- backed security (ABS) and mortgage-backed security (MBS) products. MBS products were first created to provide cheaper financing for residential homes by issuing pass- through securities. Investors benefited from a new liquid asset class and lenders benefited by removing interest rate risk off the balance sheet. In addition, MBS were backed by a government-sponsored entity with Ginnie Mae issues. Auto loans and credit card ABS products also became more popular with investors during the low interest rate environment of 20022007. Investor demand grew for ABSs because they provided diversification benefits and offered higher returns than the corporate bond market.
The portfolio performance of ABS and MBS products is largely dependent on the ability of individuals to pay off their obligations in the form of consumer debt and mortgages. Performance measures serve as trigger methods to accelerate amortization. ABS structures
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also have reserve accounts to protect against losses resulting from interest shortfalls. A key difference between the collateralized debt obligations (CDOs) and ABS structures is the number of underlying loans. A CDO portfolio typically consists of less than 200 loans, while ABS or MBS structures often have much greater diversity with thousands of obligors.
Auto Loan Performance Tools
There are specific performance measures that are used for different asset class types. Auto loans have features that are very favorable for investors in this ABS product. Auto loans are collateralized with assets that are highly liquid in the event of default. In addition, most loans have a short three to five year horizon. Thus, there is virtually no prepayment risk and losses are relatively low compared to other ABS.
A good measure of performance for auto loan ABS is the loss curve. The loss curve shows the expected cumulative loss for the life of the collateral pool. The expected losses based on the loss curve are compared to actual losses. Originators of prime loans typically have evenly distributed losses. Subprime or non-prime loan originators have higher initial losses resulting in a steeper loss curve. Losses for all types of loans typically decline in later years of the curve.
.Another important performance tool for the auto loan ABS is the absolute prepayment speed (APS), which indicates the expected maturity of the issued ABS. The APS measures prepayment by comparing the actual period payments as a percentage of the total collateral pool balance. The APS is an important measure that is used to determine the value of the implicit call option of the ABS issue at any time.
Credit Card Performance Tools
Another type of ABS product is collateralized by pools of credit card debt. The fact that credit cards have no predetermined term for outstanding balances differentiates this class from other ABS products. Despite having no predetermined term, most credit card debt is repaid within six months. The repayment speed of a credit card ABS is controlled by scheduled amortization or a revolving period under a master trust framework. Recall that the master trust allows multiple issues and principal collections to be used to purchase new receivables.
Three important performance tools for credit card receivables of ABS are the delinquency ratio, default ratio, and monthly payment rate (MPR). These three ratios serve as triggers to signal early amortization of the receivable pool. The delinquency ratio and default ratio measure the credit loss on credit card receivables pools. An early indication of the overall quality of the credit card ABS collateral pool is the delinquency ratio. The delinquency ratio is computed by dividing the value of credit card receivables that are 90 days past due by the total value of the credit card receivables pool. The default ratio is calculated by dividing the amount of written off credit card receivables by the total credit card receivables pool. The monthly payment rate (MPR) is calculated as the percentage of monthly principal and interest payments divided by the total credit card receivables pool. Rating agencies require every non-amortizing ABS (such as credit cards) to set a minimum MPR as a trigger for early amortization.
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LO 35.5: Describe and assess the various types o f credit enhancements.
Credit enhancements play an important role in the securitization process by improving the credit rating for the asset-backed security (ABS) or mortgage-backed security (MBS) tranches. The benefits of improved credit quality are even greater for the lowest- rated assets. The different types of credit enhancements used in securitization include: overcollateralization, pool insurance, subordinating note classes, margin step-up, and excess spread.
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The first two types of credit enhancements are designed to increase the ability of collateral to absorb losses associated with defaults in the underlying asset pool. The lowest class of notes often exhibit overcollateralization where the principal value of the notes issued are valued less than the principal value of the original underlying assets. The additional collateral of the ABS issues absorbs initial losses with no impact to investors. The credit rating can also be enhanced by offering pool insurance. A composite insurance company provides pool insurance on the ABS issues that covers the loss of principal in the collateral pool in the event an SPV defaults.
Other types of credit enhancements are designed to control the cash flows from the collateral pool. Subordinating note classes of a collateral pool into different tranches is another type of credit enhancement. Junior or class B notes are subordinate to more senior class A notes. Therefore, investors in class B do not receive payments of principal until the class A notes are fully redeemed or until rating agency requirements are met. The collateral pool is required to pass certain performance tests over a period of time before making principal payments on subordinate notes.
Two other cash flow related credit enhancements are margin step-up and excess spread. ABS issues sometimes use a margin step-up that increases the coupon structure after a call date. The issuer has the option to redeem the notes after this call date. The margin step-up provides investors with an extra incentive to invest in the issues. However, the issuer may refinance if the increased coupons are greater than market rates.
The excess spread is the difference between the cash inflows from the underlying assets and the cash outflows in the form of interest payments on the ABS issues. The securitization is structured such that the liability side of the SPV (issued notes) has a lower cost than the asset side of the SPV (receivables from mortgages, loans, or credit card debt). After administration expenses are covered, any remaining excess spread is held in a reserve account to protect against future losses. If there are no future losses, the remaining excess spread is returned to the originator.
P e r f o r m a n c e M e a s u r e s f o r S e c u r i t i z e d S t r u c t u r e s

LO 35.4: Explain the reasons for and the benefits o f undertaking securitization.
Benefits to Financial Institutions
The three main reasons for a financial institution to use securitization are for funding assets, balance sheet management, and risk management. Typically a financial institution specializes in financing specific assets such as residential mortgages, automobile loans, commercial loans, or credit card debt. Securitization of these assets provides funding for the financial institution that helps support growth, diversifies the funding mix, and reduces maturity mismatches. The diversification of the funding mix reduces risk and the cost of funding. The originator separates the assets from its balance sheet by going through a third party (i.e., the SPV).
Asset-backed securities (ABS) issued by a SPV often have higher credit ratings than the original notes issued by the originator. If the SPV has a higher credit rating, then the originating institution benefits by lowering the cost of issuing debt when going through the SPV. ABS markets are not as liquid as bond markets, but the lower credit ratings of SPVs typically make them a more cost effective funding option. Thus, the cost savings from securitization creates a cash surplus for the originator. In addition, financial institutions often use short-term liabilities (such as savings and checking account balances) to fund long-term assets (such as residential mortgages). Securitization allows notes to be issued
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by the SPV that match the time horizon of the underlying asset. At the same time, the originator is able to remove the risk of mismatched durations on the balance sheet.
Another reason financial institutions securitize assets is to manage the capital on their balance sheets. The Basel I Accord set capital requirements for banks based on the riskiness of the assets. Basel I capital requirements provided a big incentive for banks to securitize assets in order to gain regulatory capital relief. SPVs are not categorized as banks, so they are not subject to the same capital requirements as banks. For example, regulators may require banks to hold capital of 8% of the banks total asset value. An originating bank is able to reduce capital requirements by selling assets to an SPV. As mentioned earlier, originators often keep a portion of the capital exposure by retaining the first-loss piece. Therefore, the capital requirements from the securitization are significantly reduced, but not completely eliminated. By reducing capital requirements, securitization is a form of raising capital. Banks need to issue less preferred stock and other forms of equity when they securitize assets. The reduction of capital also increases the return on equity (ROE) which is a key ratio for investors.
In addition to providing regulatory relief, securitization provides additional risk management benefits in the form of removing non-performing assets from the balance sheet. Securitization removes the credit risk as well as the negative sentiment associated with non-performing assets. Furthermore, the originator may receive surplus profit from the SPV in the event these non-performing assets start returning cash flows in the future.
Benefits to Investors
Securitization also provides benefits for investors. As a result of securitizations, investors have access to new liquid assets that were previously not available to them. This allows investors to create different risk-reward profiles and diversify into new sectors. Securitized notes often provide higher risk-reward incentives than corporate bonds with the same credit rating. The improved performance results from the originator maintaining the equity tranche. In addition, holding a securitized asset diversifies the risk exposure because the securitized asset is purchased from an SPV with a pool of assets as opposed to a corporate bond from one entity. Securitization broadens the market for buyers and sellers through diversification and customization of new liquid products. The increased liquidity reduces transaction costs, which benefits both borrowers and investors.
C r e d i t E n h a n c e m e n t s

LO 35.3: Analyze the differences in the mechanics o f issuing securitized products using a trust versus a special purpose vehicle (SPV) and distinguish between the three main SPV structures: amortizing, revolving, and m aster trust.
The three main special purpose vehicle (SPV) structures used in the securitization process are amortizing, revolving, and master trust. The master trust is a special type of structure that is used for frequent issuers. The difference in how payments are received over the asset-backed securitys life determines whether the ABS is better suited to the amortizing or revolving structure.
In an amortizing structure, principal and interest payments are made on an amortizing schedule to investors over the life of the product. Because payments are made as coupons are received, this type of structure is referred to as a pass-through structure. Amortizing structures are very common with the securitization of products that have amortization schedules such as residential mortgages, commercial mortgages, and consumer loans. Amortizing structures
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are valued based on the expected maturity and the weighted-average life (WAL) of the asset. The WAL is the time-weighted period that the underlying assets are outstanding. Because borrowers of mortgages and consumer loans often have the option to pay off the loans early, the WAL must include pre-payment assumptions to estimate the rate at which principal is repaid over the life of the loans.
Revolving structures are used with products that are paid back on a revolving basis. Thus, under the revolving structure, principal payments of the assets are paid in large lump sums rather than a pre-specified amortization schedule. Credit card debt and auto loans are examples of products that are securitized using a revolving structure due to their short time horizon and high rate of pre-payments. Under a revolving structure, payments are not simply passed through. Rather, principal payments are often used to purchase new receivables with criteria similar to assets already in the pool. Investors are repaid by principal payments through controlled amortization or in single lump sum payments referred to as soft bullet payments.
Professors Note: The term revolving structure is similar in nature to a revolving loan issued by a commercial bank to a corporation. Under the terms o f a revolving loan, the corporation has a line o f credit and is required to pay down that line o f credit to zero every year. Thus, the loan does not amortize to reduce the balance, rather the balance is reduced in large lump sum payments.
A master trust structure allows an SPV to make frequent issues or multiple securitizations. The originator transfers assets to the master trust SPV who in turn issues new notes from this asset pool. Master trusts are often used in the securitization of mortgages and credit card debt.
Figure 3 illustrates the securitization process for credit card asset-backed securities (ABS) using the SPV master trust structure. The pool of credit card receivables is changing over time. However, the master trust structure enables the SPV to issue multiple ABS through the single trust. Investors from different series receive payments from the entire pool of credit card ABS.
Excess spread is created from the high yield credit card debt less the cost of issuing the ABS. The excess spread is the difference between the cash inflows from the underlying assets and the cash outflows in the form of interest payments on the ABS issues. After administration expenses are covered, any remaining excess spread is held in a reserve account to protect against future losses. If there are no future losses, the remaining excess spread is returned to the originator.
As illustrated by Figure 3, under a trust arrangement two distinct SPVs are created. The additional entity is created to further distance the originator from the issuer and the underlying assets. A common arrangement will involve a master trust, or special purpose vehicle (SPV), and a grantor trust. In contrast to the previous approach (i.e., corporation), the assets do not serve directly as collateral. Under this arrangement, the originator sells the assets to the master trust (SPV 1) for cash, but the master trust in turn deposits the assets in the grantor trust (SPV 2). The master trust receives a beneficial interest in the grantor trust, which represents the same economic position as if only one SPV was employed. Now the claims of the securitized products are backed by the beneficial claim on the master trust rather than on the assets themselves.
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Credit card debt is not collateralized and typically suffers from a low rate of recovery in the event of default. Therefore, a financial guarantor is used as a credit enhancement. If there are payment defaults for a series, the excess spread is shared to cover the losses. The ability of SPV master trust structures to sell multiple issues to investors that share excess spreads over these multiple series makes this structure very different from the amortizing and revolving structures.
Figure 3: Master Trust Structure
S e c u r i t i z a t i o n B e n e f i t s

LO 35.2: Explain the terms over-collateralization, first-loss piece, equity piece, and cash waterfall within the securitization process.
The securitization process issues notes that are structured to meet specific needs of investors by pooling the assets into different classes referred to as tranches. The quality of credit on the lowest rated assets can be enhanced by a method known as overcollateralization. The lowest class of notes is often overcollateralized by issuing notes with a principal value that is less than the principal value of the original underlying assets purchased from the originator. For example, assume a mortgage pool was securitized based on 100 mortgages, but the originator included 101 mortgages in the pool. This issue is overcollateralized by one mortgage. Thus, investors in the mortgage pool can absorb one default before suffering any economic losses.
The first-loss piece is the class of assets with the lowest credit quality. This is the most junior level where losses are first absorbed in the event of a default. The originator often maintains ownership of the first-loss piece. Because the originator still has ownership of this first-loss piece, it is also sometimes referred to as the equity piece (or the equity tranche). The first-loss piece or equity piece is often non-rated and absorbs initial losses.
The cash waterfall process of securitization refers to the order in which payments from the asset pool are paid to investors. Senior tranches are paid prior to making payments to junior tranches. A third party is hired to run tests in order to ensure cash flows are sufficient to pay all outstanding liabilities.
Figure 2 illustrates how cash flows are allocated to the different tranches in the cash waterfall process. If the first coverage test passes, then interest payments are made to
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subordinate tranche levels. However, if a coverage test fails, then the principal of the notes will begin to be paid off starting with the most senior tranche.
S P Y S t r u c t u r e s

LO 35.1: Define securitization, describe the securitization process and explain the role o f participants in the process.
Securitization is the process of transforming the illiquid assets of a financial institution or corporation into a package of asset-backed securities (ABSs) or mortgage-backed securities (MBSs). A third party uses careful packaging, credit enhancements, liquidity enhancements, and structuring to issue securities backed by the pooled cash flows (i.e., principal and interest) of the same underlying assets. Cash is transferred to the selling party, and the obligation is effectively removed from the sellers balance sheet if the sale is made without recourse. Hence, securitization represents an off-balance-sheet transaction.
A wide range of assets can be securitized (e.g., mortgages, credit card receivables, auto loans, etc.). The common feature of all ABS and MBS is that the underlying assets generate cash flows. It is important to note that the third party in the securitization process is not involved in the origination of the assets underlying the securitized product.
The two key participants in the securitization process are the originator and the issuer. The originator is the entity that seeks to convert its credit-sensitive assets into cash. The credit risk is then transferred away from the originator. The issuer is a third party who stands between the originator and the eventual investor that purchases the securities. The issuer buys the assets from the originator. The issuer must be a distinct legal entity from the originator in order for the sale of the assets to be considered a true sale. In a true sale, the assets are transferred off the originators balance sheet and there is no recourse. A special purpose vehicle (SPV) [also sometimes referred to as a special purpose entity (SPE)] is a separate legal trust or company that is set up specifically for the purpose of securitization.
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The SPV separates the underlying asset pool supporting the securitized issues from the other assets of the originator. This is an important step in the process because it ensures that the securitized assets are not affected if the originator becomes insolvent. This process of securitization provides credit enhancement to the newly issued securities as the third party SPV guarantees the credit quality of the issues. Thus, the investors purchasing the securitized issues are not concerned about the financial strength or creditworthiness of the originator. Investors are only concerned about the credit quality of the securitized issues and the SPV guaranteeing them. Thus, in the event that the originating financial institution becomes financially insolvent, it would not impact the SPV (except for any consideration on the first-loss piece which will be discussed later).
As stated previously, the SPV may be designated as a corporation or a trust. For tax purposes, SPVs are often incorporated in offshore locations such as the Cayman Islands, Dublin, or the Netherlands, which are regions that have SPV-friendly legislation. If the SPV is set up as a corporation, the originator sells the assets to the SPV in exchange for cash. The SPV, in turn, issues claims directly against the assets of the SPV. In European countries, accounting regulations allow SPVs to be structured as corporations. However, this method may not distance the originator from the assets enough for accounting purposes in the United States. Therefore, in the United States, the SPV trust is the most common structure.
The most common application for an SPV is to set up cash flow securitization where the originator sells the assets to the SPV who funds the purchase of the assets by issuing notes to investors. However, SPVs are also used to convert the currency of underlying assets through currency swaps, issue credit-linked notes (CLNs), and transfer illiquid assets into liquid assets (e.g., accounts receivables from equipment leases).
The structuring agent is the de facto advisor for the securitization issue. This agent is largely responsible for the security design (e.g., maturity, desired credit rating, credit enhancement, etc.) and forecasting the interest and principal cash flows. The structuring agent may also be the sponsor as the two roles have natural overlap.
In the event of a default, a trustee is charged with the fiduciary responsibility to safeguard the interests of the investors who purchase the securitized products. The trustee will monitor the assets based on pre-specified conditions of the asset pool such as minimum credit quality and delinquency ratios.
An insurance company referred to as the financial guarantor is sometimes used to wrap the deal by providing a guarantee of financial support in the event the SPV defaults. Financial guarantors are more common in a master trust arrangement, which we will cover later in this topic.
The custodian was initially responsible for safeguarding the physical securities. This role has evolved to also include the collection and distribution of the cash flows of assets like equities and bonds.
Credit rating agencies such as Moodys, Standard & Poors, or Fitch also play an important role in the securitization process. The rating agencies provide formal credit ratings for each securitization. The rating agencies quantify the corporate credit quality of the originator. In addition, they provide analysis on competitors, the industry, regulatory issues, the legal
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structure of the SPV, and cash flows. If the credit rating is too low, the securitization deal may be restructured by the structuring agent to offer additional credit enhancements.
Figure 1 illustrates how the SPV purchases assets from an originator. The purchase of these assets is funded by issuing notes and selling them to investors. The structure of the issues is often customized to meet the credit quality needs of the investors via tranches. As mentioned, the process of securitization allows the originator to remove credit risk and assets from their balance sheet.
Figure 1: Securitization Process
Credit T ranches Class A notes
Class B notes
Class C notes
Class D notes
C a s h W a t e r f a l l P r o c e s s

LO 34.7: Assess the rating o f C D O s by rating agencies prior to the 2007 financial crisis.
The average investor has a very difficult time understanding securitized financial products, like collateralized debt obligations (CDOs). As such, they have come to rely on the stamp of approval from a third party that is thought to be independent. Rating agencies, like Moodys Investors Service, Standard & Poors, and Fitch Ratings, have profited from investors need for supposedly independent ratings on complex financial products. From 2000 to 2007, Moodys rated nearly 43,000 mortgage-linked securitized products. Over half of this group of 43,000 received a AAA stamp of approval. By comparison, only six U.S. private sector companies had such a rating during this same time period.
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Professor’s Note: The Financial Crisis Inquiry Commission (FCIC), which was established by Congress, found that 73% o f the pool of securitized products rated AAA by Moody’s had been downgraded to junk bond status by April 2010.
Part of the push for solidly investment-grade ratings is that insurance companies, pensions, and money market funds have regulatory and internal requirements that only allow investments in investment-grade assets. Based on this level of demand and the fact that the rating agencies all had a profit motive, they were very willing to provide high ratings for many securitized products. The process would start with rating any tranche possible with a AAA rating. Then the typical next step was to repackage below-AAA rated tranches into new CDOs whereby another group emerged as AAA-rated because the default risk kept being pushed down further and further to the lowest equity tranches. This process would be repeated a few times until a substantial portion of securitized products received the coveted AAA stamp of approval.
When adjustable rates loans reached their reset periods and default rates rose well above any previously considered margin of safety, downgrades ensued en masse. By their very nature, the downgrades drove down prices, but this cycle was further compounded because once the assets were downgraded below investment-grade, every insurance company, pension fund, money market, and bank with capital constraints had to sell as well. Investors were not so much buying an income stream as they were buying a AAA-rated income stream, and once default rates began rising, the downward spiral of prices began.
In fairness to the rating agencies, it is also important to understand an alternate interpretation beyond merely a profit motive that caused the inaccurate ratings. The Financial Crisis Inquiry Commission (FCIC) found that the rating agencies were influenced by flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight.
The competitive pressure between these rating agencies, two of which are publicly traded, was intense. Flowever, the competition did not translate into substantial salaries for key employees in the rating process. The result was that the best employees would leave the rating agencies and go to work for the financial firms who were actively securitizing products. The benefit to the originators was that the converted employees knew the internal ratings guidelines at the ratings agencies. For example, in order to achieve a AAA rating, a securitized product needs to have an average FICO score of 613 for all borrowers in the pool. Equipped with this knowledge, the originators could then package pools of loans with mostly 330 scores and just enough 680s to bring the average up to 615. This translated into higher default probabilities than should have naturally existed for a 615 rated borrower. There should have been more focus on the dispersion of credit scores and not just the average for the pool.
As the FCIC uncovered more details, they found many flaws in the system. The profit motive was paramount, but it drove creative packaging by the originators. The profit motive was also influenced by the competitive landscape of the industry. The profit motive will always exist in the world of high finance. What investors need to understand is that they need to dive deeply into the risk profile of any asset before adding it to their portfolios.
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K e y C o n c e p t s
LO 34.1
There were three key underlying flaws in the securitization process that led to the 2007 2009 financial crisis. The first is that members of the securitization supply chain were incentivized to find borrowers, sell them a loan, and package that loan for resale without retaining any default risk. This led to lax lending standards. Second, the securitized products themselves were very opaque. Neither investors nor the rating agencies that they relied upon fully understood how to evaluate their potential risks. Third, financial institutions use of off-balance-sheet techniques to hold securitized loans further disguised the risk spectrum from investors.
LO 34.2
The traditional bank credit function can remain robust in a world of concentrated risks by utilizing credit risk transfer techniques, including bond insurance, collateralization, termination, reassignment, netting, marking to market, syndication of loan origination, or the outright sale of a loan portfolio in the secondary market.
LO 34.3
The originate-to-hold model involves originating a loan using a binary approval process and then holding the loan until maturity. In this case, the lender retains all credit risk and the loan origination process will therefore be more stringent. The originate-to-distribute model enables lenders to originate a loan based on risk-reward pricing and then outsource the risk through various channels. This provides better access to capital for less creditworthy borrowers and more diversification options for investors.
LO 34.4
Credit derivative products, such as credit default swaps, first-to-default puts, total return swaps, and asset-backed credit-linked notes are all innovations that separate default risk from the underlying security. They offer the ability to insure and transfer specific risks to both investors and insurance sellers.
LO 34.3
A collateralized debt obligation (CDO) is an asset-backed security that can branch into corporate bonds, emerging market bonds, residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), real estate investment trust (REIT) debts, bank loans, other forms of asset-backed securities backed by auto and credit card loans, and even other CDOs. A collateralized loan obligation (CLO) is a specialized form of CDO that only invests in bank loans.
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LO 34.6
With a synthetic CDO, the originator retains the reference assets on their balance sheet, but they transfer credit risk, in the form of credit default swaps, to an SPV which then creates the tradable synthetic CDO. This derivative product is used to bet on the default of a pool of assets, not on the assets themselves. A single-tranche CDO is a highly customizable offshoot from synthetic CDOs. Investors can customize their maturity, coupon, collateral, subordination level, and target rating.
LO 34.7
Rating agencies were at the core of the selling process of securitized products, such as CDOs. The average investor could not understand the complex products, so they relied on the stamp of approval from the ratings agencies, who were biased by their profit motive and were often unable to fully understand the securitized products themselves.
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C o n c e p t C h e c k e r s
1.
Which of the following statements was not one of the flaws in the securitization process prior to the start of the credit crisis in 2007? A. An active originate-to-distribute model where a strong profit motive took
precedence over ethical lending and underwriting.
B. The securitized products were so opaque that investors could not evaluate the
true risks of the investment.
C. Structured investment vehicles (SIVs) were used to enhance the risk discovery
process for investors and regulators.
D. Banks held securitized assets in off-balance-sheet entities, thus further masking
the true risks in the system.
2.
3.
Which of the following statements is not correct regarding total return swaps (TRS)? A. A TRS is designed to mirror the return on an underlying asset like a loan, stock,
or even a portfolio of assets.
B. The payer pays any depreciation in the underlying asset to the receiver. C. The payer pays any dividends or interest received to the receiver. D. The receiver is creating a synthetic long position in the underlying asset.
XYZ Hedge Fund wants to get exposure to a high-yield pool of commercial loans without actually investing in the loans. It wants a leverage ratio of 7.3. If the hedge fund is willing to invest $33 million in this investment, which credit derivative is best for them and what is their expected return given that the reference asset earns LIBOR plus 285 basis points, the counterparty earns LIBOR plus 150 basis points, and the required collateral earns 3.5%? A. Total return swap with a 13.63% return. B. Asset-backed credit-linked note with an 11.34% return. C. Total return swap with an 11.34% return. D. Asset-backed credit-linked note with a 13.63% return.
4.
Which of the following statements describe part of the risk mitigation process for a collateralized debt obligation (CDO)?
I. Default risk is restructured in such a way that previously lower-rated issues can
be re-formulated into highly rated debt instruments.
II. The equity tranche has no certain return and bears the highest level of default
risk. A. I only. B. II only. C. Both I and II. D. Neither I nor II.
5.
Which of the following was not a cause of the misalignment between investors and rating agencies incentives prior to the credit crisis of 2007-2009? A. Profit motive of the rating agencies. B. Pressure from the originators of securitized products. C. Manipulation of the ratings process by the originators. D. Investors lack of understanding of the products they were purchasing.
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C o n c e p t C h e c k e r An s w e r s
1. C Structured investment vehicles (SIVs) were actually used to create further layers of
opaqueness. These are the off-balance-sheet entities used by banks to hold securitized products in a way that made them very difficult for investors to scrutinize.
2. B A total return swap transfers both credit and market risk. The payer only pays any
appreciation and any dividends or interest connected with the underlying asset. The receiver is responsible to pay the payer any depreciation in the underlying asset.
3. D The best credit derivative for this hedge fund is an asset-backed credit-linked note. With leverage of 7.5 and an investment of $35 million, we know that the notional value of the pool of commercial loans is $262.5 million. The hedge fund will earn 3.5% on their $35 million in collateral. This translates into $1,225 million. They will also earn the 135 basis point spread on the entire $262.5 million. This translates into $3.54375 million. The hedge funds percentage return is 13.63% [($1,225 million + $3.54375 million) / $35 million].
4. C The default risk in a CDO is structured through various tranches in such a way that a pool of assets that were once lower rated could be AAA rated after the securitization process. The equity tranche is the most junior tranche. Therefore, it offers the highest return potential but with no certain return. The equity tranche also bears the highest level of default risk.
5. D According to the findings of the congressionally formed Financial Crisis Inquiry
Commission, the root causes of the misalignment were the flawed computer models at the rating agencies, the profit motive of the rating agencies, pressure from the originators, the drive for market share coming from the rating agencies, the rating agencies lack of provided (not available) resources to conduct the proper due diligence, and the absence of meaningful public oversight. A thorough post-audit of the crisis will also reveal that originators also manufactured the securitized products to specifically arrive at a AAA rating given their acquired knowledge of the rating agencies decision flow charts.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
A n In t r o d u c t i o n t o S e c u r i t i z a t i o n
Topic 35
E x a m F o c u s
Securitization is the process of selling cash-flow producing assets to a third party special purpose entity (SPE), which in turn issues securities backed by the pooled assets. Mortgage- backed securities (MBSs) securitize residential mortgages where the property serves as the collateral. For the exam, be prepared to discuss the securitization process of selling cash-flow producing assets to a special purpose vehicle (SPV) and contrast the differences between amortizing, revolving, and master trust structures. Also, be familiar with the different types of credit enhancements, and be prepared to define and calculate the various performance tools for securitized structures discussed.
S e c u r i t i z a t i o n P r o c e s s

LO 34.6: Describe synthetic C D O s and single-tranche C D O s.
In a traditional CDO, which is also called a cash CD O , the credit assets owned by the SPV are fully funded with cash, and the repayment of the obligation is tied directly to cash flow from the underlying debt instruments. There is an alternative form of CDO called a synthetic CDO, which takes a different approach. With a synthetic CDO, the originator retains the reference assets on their balance sheet, but they transfer credit risk, in the form of credit default swaps, to an SPV which then creates the tradable synthetic CDO. This process is typically used to provide credit protection for 10% of the pool of assets held on the originators balance sheet. The other 90% of the default risk is hedged with a highly- rated counterparty using a senior swap. This complex derivative is a way of betting on the default prospects of a pool of assets rather than on the assets themselves.
There is also a form of CDO that is highly customizable. This is called a single-tranche CDO. With this credit derivative, an investor is trying to earn a better spread than on comparably rated bonds by selecting a specific reference asset with customizable maturity, coupon, collateral, subordination level, and target rating. This customization feature creates open dialogue between the single-tranche CDO buyer and seller, and by default will help prevent the seller from dumping unwanted risks on the buyer without prior knowledge. One key customizable feature is the attachment point, which is the point at which default begins to be the financial responsibility of the single-tranche CDO buyer.
R a t i n g C D O s B e f o r e t h e C r e d i t C r u n c h

LO 34.5: Explain the credit risk securitization process and describe the structure o f typical collateralized loan obligations (CLO s) or collateralized debt obligations (C D O s).
The credit risk securitization process is a technique that uses financial engineering to combine a segregated pool of assets into one tradable security with various inherent risk levels. The company that starts this process is called the originator. The originator will purchase a series of different assets, like corporate bonds, leveraged loans, mortgages, auto loans, or perhaps credit card loans. These assets are held on the originators balance sheet until they have a sufficient quantity of assets to repackage this pool into a security.
The actual repackaging process occurs in an off-balance-sheet entity, like a special purpose vehicle (SPV). Once assets are transferred to the SPV, securities must be issued, based on this reference pool of assets, to fund the purchase of the assets. The securitized asset is structured in such a way that the originator has no recourse for losses sustained after an investor purchases a securitized asset.
Part of the securitization process also involves establishing various risk layers within the new investment product. These layers are called tranches. The senior tranches have the lowest risk of loss. There are several mezzanine tranches as well. The idea is that in the event of default by the underlying assets, the most junior tranches will realize the loss first. In fact, the senior tranches will not experience any loss unless the more junior tranches all experience 100% losses. This cash loss process is sometimes called the waterfall structure of securitized products and it provides an apparent safety margin for the senior tranches.
There is a very broad category of securitized products known as collateralized debt obligations (CDOs). In general, a CDO is an asset-backed security that can branch into corporate bonds, emerging market bonds, residential mortgage-backed securities (RMBS),
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commercial mortgage-backed securities (CMBS), real estate investment trust (REIT) debts, bank loans, other forms of asset-backed securities backed by auto and credit card loans, and even other CDOs.
Figure 3: A CDO With TV Underlying Securities
Senior Tranche
Cash
w W
Return
SPY
Cash
w Return
i
Mezzanine Tranches
Security 1
Security 2
Security N
Junior Tranche
Perhaps the most well-known form of a CDO is called a collateralized loan obligation (CLO). CLOs focus on repackaging high-yield bank loans. With a CLO, below-investment- grade bonds are restructured into tranches, which include investment-grade senior tranches, a junior equity tranche, and possibly intermediate-quality tranches between the senior and junior tranches (i.e., mezzanine tranches). The senior tranches achieve investment-grade ratings by effectively outsourcing the default risk to the equity tranche. This allows the originator of the high-yield loans to sell the senior tranches to insurance companies and pension funds, which are required to own investment-grade debt instruments. It is also important to note that bank loans are amortizing, which means they have a shorter duration than corporate bonds with similar maturities.
Consider an example of the CLO repackaging process. A bank compiles $1 billion in high-yield loans that are below investment-grade. This group of loans will meet certain parameters, such as the number of industries represented in the loan pool, the maximum percentage in any given industry, and the maximum percentage in any given issuer. This data will communicate risk to potential investors. The bank will securitize this CLO into perhaps three tranches. A senior secured tranche class A, a senior secured tranche class B, and a residual or equity tranche that is subordinate. The weighted average life of the loans in the CLO is six years with an average coupon of LIBOR plus 230 basis points. The senior class A notes will have a face value of $830 million, a 12-year maturity, a coupon of LIBOR plus 40 basis points, and a robust investment-grade rating. The senior class B notes will have a face value of $60 million, a 12-year maturity, a coupon of LIBOR plus 150 basis points, and a low-end investment-grade rating. The subordinated equity tranche will have a face value of $90 million, a 12-year maturity, a residual claim on any CLO assets, and a non-investment-grade rating.
During the first six years of this example CLO, loans begin to mature. However, the tranches all have a 12-year maturity. The CLO originator will reinvest the maturing proceeds in additional six-year loans adhering to the initial industry and concentration risk
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stipulations. After this initial rebalancing, the CLO investors will begin to receive principal repayments as the loans mature. The first in line will be the senior class A notes. Since the underlying high-yield loans are paying such a high spread over what the senior tranches will receive, the equity tranche has the potential to earn a very substantial return if defaults do not materialize. Typically, the originating bank will retain the equity tranche to keep a small amount of skin in the game.
S y n t h e t i c C D O s a n d S i n g l e -Tr a n c h e C D O s