Securitization: The Process, Credit Enhancement, and Liquidity Support
Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1
Chapter 16 is a big one. It’s the detailed mechanics chapter for securitization, the most important structured finance technique in the credit markets. This is Part 3’s centerpiece, and it bridges everything we’ve learned so far with the CDO chapters coming next.
What Securitization Really Is
Here’s the setup. A firm owns credit-sensitive assets (like loans or receivables). It sells those assets to a third party. That third party issues new securities backed by the original assets. The original firm gets cash and transfers credit risk. Investors in the new securities get exposure to the asset pool.
Two things happen simultaneously: financing (the firm gets cash) and risk transfer (credit risk moves to new investors).
The buyer of the assets acts as the primary credit insurer for the original firm. Then the buyer reinsures by issuing securities of its own. So securitization is really credit reinsurance done through the capital markets.
All the Players
A securitization involves a lot of parties. Culp lists them all:
Sponsor: The institution that initiates the process. When a bank is securitizing its own loans, it’s usually also the sponsor. When a non-financial company is securitizing receivables, a bank adviser often initiates things.
Originator/Transferor: The original asset owner that wants to convert credit-sensitive assets into cash.
SPE (Special Purpose Entity): A brand-new entity set up specifically to intermediate the securitization. It buys the assets and issues the securities. Can be a corporation or a trust. Sometimes you need two SPEs to satisfy all the legal, tax, and accounting requirements.
Trustee: Looks out for investors. Perfects the security interest in the assets. Monitors asset quality.
Custodian/Servicer: Collects cash flows on the underlying assets and distributes them.
Structuring Agent: The general contractor. Designs how assets are repackaged into securities. Models the cash flow waterfalls. Determines credit and liquidity enhancements needed.
Underwriter: Markets and distributes the securities.
Rating Agencies: S&P, Moody’s, Fitch. Their ratings are critical. Without a good rating, many structured products can’t be sold.
Law Firms: Culp emphasizes this one. Good legal counsel is essential. And he says bluntly: “Do not skimp on your legal counsel.” Especially after Enron, getting the legal structure right is non-negotiable.
The Consolidation Problem
One of the trickiest parts of securitization is making sure the originator doesn’t have to put the sold assets back on its balance sheet. That would defeat the whole purpose.
The old 3% equity test (from EITF guidance) was too easy to game. FAS140 tightened things up with four principles: the SPE must be bankruptcy-remote, its activities must be limited and specified upfront, the originator must surrender effective control, and the SPE must be able to pledge or resell the assets.
Then Enron happened.
Culp walks through the McGarret A transaction. Enron Energy Services sold TNPC warrants to an LLC, which financed the purchase through a trust, which borrowed from banks. Then Enron entered a total return swap with the trust that effectively kept all the economic risk with Enron. The bankruptcy examiner concluded that: (1) the equity at risk wasn’t real equity, (2) the total return swap turned everything into pure Enron credit risk, and (3) Enron retained a substantive economic stake.
FIN46R (the “anti-Enron rule”) followed. It defined variable interest entities (VIEs) and required consolidation by whoever holds the biggest economic exposure. This changed the game for structured finance and created headaches for perfectly legitimate structures too.
Credit Enhancement
The structuring agent has several tools to improve the credit quality of securities issued by the SPE:
Internal Credit Enhancement
Subordination: The most basic form. Junior debt absorbs losses before senior debt does. We covered this extensively in Chapter 13.
Overcollateralization (O/C): The assets exceed the fixed liabilities. How do you create O/C?
- Direct equity issue: Issue $80 in debt against $100 in assets, fund the gap with $20 in equity. Works but hard to find equity investors for SPEs.
- Holdback: Buy the assets at a discount. If assets are worth $100 but the SPE pays $81, you’ve got $19 in O/C. Holdback is usually set as a multiple of historical losses.
- Cash collateral account (CCA): The originator deposits cash into a reserve account. Simple and effective. But be careful: if the CCA depends on actual asset performance, it might create a link that forces consolidation.
Excess spread: The difference between interest earned on the collateral and interest paid on the SPE’s debt, minus senior fees. It’s basically retained earnings for the structure. Can be diverted into a CCA to build up credit protection, or paid out to equity holders.
In Culp’s numerical example: a $100 million loan portfolio securitized into $80 million senior debt and $20 million subordinated debt, with a $5 million CCA and 2.5% excess spread. Total credit enhancement for senior debt: 27.5%.
External Credit Enhancement
Insurance/Wraps/Guaranties: The SPE buys a financial guarantee for the collateral or wraps specific tranches. Senior debt gets the rating of the guarantor.
Letter of Credit: A bank provides an LOC that can be drawn if defaults exceed the subordination level.
Credit Default Swap: The SPE buys portfolio credit protection with a deductible equal to the subordinated layer.
Put Option on Assets: The SPE gets the right to sell the collateral at a fixed price if defaults erode value.
Liquidity Support
This is separate from credit enhancement. Liquidity risk is about timing, not ultimate ability to pay. The assets might eventually pay off, but the cash might arrive too late to service the securities.
This can happen from delinquencies (late payments on the underlying assets) or from structural mismatches (assets pay semiannual fixed coupons but liabilities pay quarterly floating rate).
Rating agencies require specific liquidity tests. Interest coverage (I/C) tests check whether cash on hand can cover upcoming interest payments. O/C tests on a cash flow basis check overall liquidity adequacy.
Internal Liquidity Support
Maturity structuring: Match asset and liability maturities where possible. But you often can’t because investor demand requires specific payment frequencies.
Extendable notes: These have an interim maturity and a final maturity. If the cash flow waterfall is adequate at the interim date, notes get redeemed. If not, maturity automatically extends. This isn’t considered a default. The period between interim and final maturity is the amortization period.
Reserves: Cash accounts funded from the excess spread. Basically rainy day funds for the waterfalls.
External Liquidity Support
Letters of credit with recourse: The traditional tool. If cash runs short, draw on the LOC. The bank then has a loan obligation from the originator to repay. But Basel II and FIN46R have made these less popular.
Asset swaps: The SPE pays interest on the collateral as received and gets back a floating payment stream matching its liabilities. This solves both timing and basis mismatches. Important: defaulted collateral is subtracted from the notional so the swap dealer doesn’t become a credit support provider. It’s pure liquidity, not credit protection.
Securitization as Credit Reinsurance
Culp ties it all together with a simple example. An originator sells $100 million in assets to an SPE. The originator retains $1 million in equity and provides $10 million in credit enhancement. The SPE issues $79 million in subordinated debt and $20 million in senior debt.
In reinsurance terms:
- The originator retains the $11 million deductible (equity plus C/E)
- Subordinated debt holders cover the $79M excess of $11M layer
- Senior debt holders cover the $10M excess of $90M layer
Senior debt has 90% credit enhancement. And the worst possible loss for senior holders is half their principal (there’s only $100 million in assets to default on).
From MBS to ABCP to CDO
The chapter closes with a brief history of securitized products.
Mortgage-backed securities (MBS): First issued in 1970 by GNMA. GSEs like Fannie Mae and Freddie Mac buy mortgages, pool them, and issue pass-through securities. Because the GSEs guarantee the P&I, these are not really “credit” products. Investors bear prepayment and interest rate risk instead. CMOs and REMICs are multi-class MBS structures that allocate prepayment risk across tranches.
Non-mortgage ABS: First issued in 1985 (computer leases). Toyota Motor Credit’s 2001 auto loan ABS is a clean example: $1.5 billion in fixed-rate auto loans, senior fixed-rate debt, subordinated floating-rate debt in three classes, plus an interest rate swap to manage the fixed/floating mismatch.
Asset-backed commercial paper (ABCP): Developed in the early 1980s when banks couldn’t compete with the CP market due to Basel capital requirements. ABCP conduits let corporate clients securitize receivables into short-term paper. Often multi-seller programs with continuous asset purchases and rolling CP issues. Liquidity support is critical because of the maturity mismatch between assets and liabilities.
All of this sets the stage for collateralized debt obligations. That’s next.