Securitization and its process

Prepared For
Md. Nafeez-Al-Tarik
Guest Faculty
Modern Financial Engineering

Prepared by
Md. Khairul Islam
Student Id: 182
MBA program (Batch:01)

November 28, 2014

Savar, Dhaka 1342

Department of Finance & Banking

Jahangirnagar University

What is Securitization?
Securitization is a process in which entity securitizing its assets is not borrowing but selling a
stream of cash flows that was otherwise to accrue to it. It is a process through which an issuer
creates a financial product by combining other financial assets and then marketing different
tiers of the repackaged instruments to investors for issuers funding. The repayment of
securities is exclusively dependent on the performance of the assets.
Securitization is a complex series of financial transactions designed to maximize cash flow
and reduce risk for debt originators. This is achieved when assets, receivables or financial
Instruments are acquired, classified into pools, and offered as collateral for third-party
Investment. Then, financial instruments are sold which are backed by the cash flow or value
of the underlying assets.

Why securitization?
Lower cost inherent cost and weighted average cost. The best example of
economics of securitization is an arbitrage CDO.
Alternative investor base institutional and retail.
Matching of assets and liabilities.
Issuer rating irrelevant.
Multiplies asset creation ability.
Non-conventional source; may allow higher funding.
Off-balance sheet financing removal of accounts.
Frees up regulatory capital.
Improves capital structure.
Higher trading on equity with no increased risk.

What is the Process of securitization?

The process of securitization is relatively easy. First, an entity desiring financing identifies an
asset that is suitable to use. Loans or receivables are common examples of payment streams
that are securitized. Second, a special legal entity or Special Purpose Vehicles ("SPV") is
created and the originator sells the assets to that SPV. This effectively separates the risk
related to the original entities operations from the risk associated with collection. When done
properly the loans owned by the SPV are beyond the reach of creditors in the case of
bankruptcy or other financial crisis, the SPV is bankruptcy remote. Next, to raise funds to
purchase these assets the SPV issues asset-backed securities to investors in the capital
markets in a private placement or pursuant to a public offering. These securities are
structured to provide maximum protection from anticipated losses using credit enhancements
like letters of credit, internal credit support or reserve accounts. The securities are also
reviewed by credit rating agencies that conduct extensive analyses of bad-debts experiences,
cash flow certainties, and rates of default. The agencies then rate the securities and they are
ready for sale usually in the form of mid-term notes with a term of three to ten years. Finally,
because the underlying assets are streams of future income, a Pooling and Servicing
Agreement establishes a servicing agent on behalf of the security holders. The services
generally include: mailing monthly statements, collecting payments and remitting them to the
investors, investor reporting, accounting, and collecting on delinquent accounts, and
conducting repossession and foreclosure proceedings.

Figure: securitization process

The originator either has or creates the underlying assets, transaction receivables to be
securitized.
Selection of receivables to be assigned
Formation of Special purpose vehicle (SPV)
Special purpose vehicle (SPV) acquires the receivables under a discounted value
The servicer for the transaction is appointed (normally originator)
Servicer collects the receivables (usually escrow mechanism) and pays off the
collection to Special purpose vehicle (SPV)
The Special purpose vehicles (SPV) either pass the collection to the investor (or
reinvest the same to pay off)
In case of default the servicer takes action against debtors as Special purpose vehicle
(SPV)s agent
When only small amount of o/s receivables are left to be collected, the originator
usually cleans up the transaction by buying back the o/s receivables
At the end of the transaction, the originator profit, if retained and subject to any losses
to the extent agreed by the originator in the transaction is paid off.

Features of Securitization:
The investors looks at the cash flows of the entity and not the entity itself
hence its also called as assets backed financing.
It is also called structured funding because risk is structured in accordance
with investors needs.
Originators liability is in the form of credit enhancement.

Requirement of Securitization:

Legal environment
Accounting environment
Regulatory environment
Tax environment
Back office systems/Information
System
Strong investor demand

Players in the Securitization Process:

There are numbers of parties in a securitization process

Originator
Aggregator
Depositor
Issuer
Investors
Trustee
Underwriter
Servicer

The primary players in the securitization of any particular pool of assets can vary. The flow
Chart illustrates the roles of and the relationships between the various primary parties in a
typical issue. Each party is addressed below
Originator: The parties, such as mortgage lenders and banks, that initially creates the assets
to be securitized.
Aggregator: Purchases assets of a similar type from one or more Originators to form the
pool of assets to be securitized.
Depositor: creates the SPV/SPE for the securitized transaction. The Depositor acquires the
pooled assets from the Aggregator and in turn deposits them into the SPV/SPE.

Issuer: acquires the pooled assets and issues the certificates to eventually be sold to the
Investors. However, the Issuer does not directly offer the certificates for sale to the investors.
Instead, the Issuer conveys the certificate to the Depositor in exchange for the pooled assets.
In simplified forms of securitization, the Issuer is the SPV which finally holds the pooled
assets and acts as a conduit for the cash flows of the pooled assets.
Underwriter: usually an investment bank, purchases all of the SPVs certificates from the
Depositor with the responsibility of offering to them for sale to the ultimate investors. The
money paid by the Underwriter to the Depositor is then transferred from the Depositor to the
Aggregator to the Originator as the purchase price for the pooled assets.
Investors: purchase the SPVs issued certificates. Each Investor is entitled to receive
monthly payments of principal and interest from the SPV. The order of priority of payment to
each investor, the interest rate to be paid to each investor and other payment rights accorded
to each investor, including the speed of principal repayment, depending on which class or
tranche of certificates were purchased. The SPV makes distributions to the Investors from the
cash flows of the pooled assets.
Trustee: the party appointed to oversee the issuing SPV and protect the Investors interests by
calculating the cash flows from the pooled assets and by remitting the SPVs net revenues to
the Investors as returns.
Servicer: The party that collects the money due from the borrowers under each individual
loan in the asset pool. The Servicer remits the collected funds to the Trustee for distribution
to the Investors. Servicers are entitled to collect fees for servicing the pooled loans.
Consequently, some Originators desire to retain the pools servicing rights to both realize the
full payment on their securitized assets when sold and to have a residual income on those
same loans through the entitlement to ongoing servicing fees. Some Originators will contract
with other organizations to perform the servicing function, or sell the valuable servicing
rights.

Benefits of Securitization:
There are good reasons why securitization has taken off. The existence of a liquid secondary
market for home mortgages and other financial debt instruments increases the availability of
capital to make new loans. This increases the availability of credit. Securitization also helps
to decrease the cost of credit by lowering originators financing costs by offering lenders a
way to raise funds in the capital market with lower interest rates. Finally, securitization
reallocates risk by shifting the credit risk associated with securitized assets to investors, rather
than leaving all the risk with the financial institutions.

Typically cheaper financing than traditional funding

Diversification of funding
Non-recourse to the originator/seller of the receivables
Early monetization of assets
Control of obligor exposure

Mechanics of securitization:
Securitization involves a true sale of the underlying assets from the balance sheet of the
Originator. This is why a separate legal entity, the SPV, is created to act as the issuer of the
notes. The assets being securitized are sold onto the balance sheet of the SPV. The process
Involves:
Undertaking due diligence on the quality and future prospects of the assets.
Setting up the SPV and then affecting the transfer of assets to it.
Underwriting of loans for credit quality and servicing.
Determining the structure of the notes, including how many tranches are to be issued,
in accordance to originator and investor requirements;
the notes being rated by one or more credit rating agencies;
Placing of notes in the capital markets.
The sale of assets to the SPV needs to be undertaken so that it is recognized as a true legal
transfer. The originator will need to hire legal counsel to advise it in such matters. The credit
rating process will consider the character and quality of the assets, and also whether any
enhancements have been made to the assets that will raise their credit quality. This can
include overcollateralization, which is when the principal value of notes issued is lower than
the principal value of assets, and a liquidity facility provided by a bank. A key consideration
for the originator is the choice of the underwriting bank, which structures the deal and places
the notes. The originator will award the mandate for its deal to the bank on the basis of fee
levels, marketing ability and track record with its type of assets.

Example:
To illustrate the process of securitization, we consider a hypothetical airline ticket
receivables transaction. The purpose of this section is to show the issues that will be
Considered by the investment bank that is structuring the deal.
Originator: United Finance Ltd.
Transaction: Ticket receivables airline future flow securitization bonds 500m threetranche floating rate notes, legal maturity 2018, and average life 4.1 years
Issuer: Dhaka bank Ltd.
Arranger: IDLC Finance Ltd
Due diligence
IDLC Securities will undertake due diligence on the assets to be securitized. For this case, it
will examine the airline performance figures over the last five years, as well as model future
projected figures, including:
Total passenger sale
Total ticket sales
Total credit card receivables
Geographical split of ticket sales
It is the future flow of receivables, in this case credit card purchase of airline tickets that is
being securitized. This is a higher-risk asset class than say, residential mortgages, because the
airline industry has a tradition of greater volatility of earnings than say, mortgage banks.