Securitization Of Assets: ABS and Mortgage-Backed Security [MBS]

By Ibrahim Usman Wali

In this brief primer, we will discuss the concept of
securitization and the basis for their use, as well as their impact
on the economy.

1.0       The Concept of
Securitization.

Securitization is well established and practiced in the global
debt capital market. Some sources describe it as the practice where
issuers merge different financial assets into one unit, thereby
creating a single financial instrument.

Securitization is a process by which a company assembles its
different financial assets/debts to form a consolidated financial
instrument which is issued to investors.

Similarly, it is the process of selling assets and generating
cash flows from a company to another company specifically set up
for that purpose. Subsequently, the receiving company issues out
notes to the company from which the assets or cash flow generated
was received. The cash flows from the sale of the assets back up
these notes.

Securitization has also been employed as part of asset and
liability management, in handling balance sheet risks. Sundaresan
defines it as:

“A framework in which some illiquid assets of a
corporation or a financial institution are transformed into a
package of securities backed by these assets, through careful
packaging, credit enhancements, liquidity enhancements and
structuring.”

The practice of securitization allows institutions like
Corporates and Financial Institutions to modify the assets that
cannot be readily marketable to rated securities tradeable in the
secondary markets. Residential mortgages and car loans are a
typical example of these types of assets. This allows investors to
gain access to these types of original assets which would not have
otherwise been accessible. This merger and packaging process
creates asset-backed bonds, which are debt instruments
created from a smorgasbord of loan assets from which interest is
payable on a floating basis.

2.0      ESSENCE OF
SECURITIZATION?

The fundamental reason behind securitization is the need for
institutions to derive value from the assets on their balance
sheet. These assets could be residential mortgages, corporate
loans, debt instruments, among others.

Some of the factors that necessitate securitization include:

1. Where size of assets is decreasing and revenues are not
   realised from them, it could lead to an increase in the return on
   equity ratio.
2. The capital expended in managing balance sheets would reduce,
   which will aid costs savings and allow the institution to put the
   capital in another profitable venture.
3. The interest payable on Asset-backed securities is usually
   lesser than other underlying loans, therefore creating surplus cash
   for the original entity.

Summarily, banks securitize for three reasons; funding its own
assets, managing its balance sheet, and risk management.

The benefits of securitization to investors in the ABS market is
considerably high. Through ABS, investors can diversify their risk
and sectors of interest, they can access an array of risk-reward
profiles and importantly, access markets that are otherwise closed
off for them. Securitised notes habitually offer a better
risk-reward performance than corporate bonds of the same maturity
and therefore offer assurance to investors.

3.0     
     The Securitization Process

The securitization exercise involves different components. There
is the original company or institution (the originator) whose
assets are being securitized. The process involves an issuer buying
off these assets from the originator.  This issuer is usually
an SPV created specifically for that purpose and is usually
domiciled off shore. The purpose of the SPV is to ensure that these
assets are held separate from the other assets of the originator.
So for instance, where the originator is declared bankrupt or is
facing a liability claim, the assets in the SPV would not be
affected. This is called being ‘bankruptcy-remote’. On the other
hand, if the assets in the SPV do not yield, investors cannot claim
against the originator. Where these assets are held in an SPV
structure, the financial ratings of the originator become totally
irrelevant to the bond-holder.

The process also involves credit enhancements, where a third
party guarantees the credit quality of the SPV, therefore giving
the issued notes strong investment grade ratings. The SPV is
structured in a way that the issued notes carry lower costs than
the assets of the SPV. This allows the originator to secure
lower-cost funding otherwise unavailable in the unsecured markets.
This is particularly more beneficial for institutions with a low
credit rating.

Figure 1 The process of securitization.

4.0     Mechanics of
Securitization

Securitization reflects a true sale of the assets of an
originator on its balance sheet. This is why the SPV, being a
separate legal entity is required to play the role of note issuers.
The securitised assets are sold into the SPV’s balance sheet, and
therefore divorced from that of the originator. The process
involves:

• Due diligence on the prospects of the assets
• Setting up an SPV and transferring of assets to it
• Underwriting of loans for credit quality and servicing
• Determining the nature and structure of the note; is it going
  to be issued in series or at once
• Rating of the notes by one or more credit rating agencies
• Placing the notes on the capital market.

In order for the transfer of the assets to the SPV to be legally
recognised, the assets must be ‘sold’ to the SPV. Another major
consideration for an originator is the choice of its underwriting
bank, who will have to structure the deals and place the notes.

5.0     SPV structures:

There are usually three types of securitization structures being
employed; amortising, revolving and the master trust.

5.1     Amortising
Structures

The Amortizing Structure, which simply means periodical
pays off of principal and interest, pays the principal and interest
to investors on a coupon-by-coupon basis throughout the lifespan of
the security. Their pricing is subject to their expected maturity.
This is also called the pass-through structure, and are more
commonly used in residential and commercial mortgage backed
deals.

5.2    Revolving Structures

The Revolving Structure is designed in a way that allows for the
principal of the assets to be revolved. The collections on the
principal are used to purchase new receivables that fulfil the
necessary criteria. This structure is usually used for short term
assets having high pre-payment speed, such as credit card debts and
car loans. Principal payments are paid to investors either in a
series of instalments in equal value or as a lump sum at the
maturity of the notes.

5.3      Master
Trust

Master trusts are more frequently used in the United States and
the UK. It allows a single SPV to issue multiple securitizations.
The originator transfers the assets to the master SPV, where then
notes are issued out of the asset pool based on the investorv’s
demand. It is mostly used by mortgaged based securities and credit
card ABS originators.

6.0     Credit
Enhancement

The credit strength of the SPV and the backed assets are vital
in influencing investor decisions. Credit enhancement are measures
initiated so that the issue notes acquire the necessary credit
status to woo in investors. It can be done through the following
means:

• Over-collateralisation: – where the value of the asset is more
  than the value of the issued notes.
• Pool insurance: – an insurance policy from a reputable
  insurance firm to cover the risks around the pool.
• Classification of notes: – notes can be classed into junior and
  senior classes where the notes of a junior class owner is
  subordinated to the rights of a senior owner.
• Margin step – up: – a number of issuers include a step-up
  feature in the coupons, which served as incentives for
  investors.
• Excess spread: – excess spread is usually the difference
  between the interest payable on a note and the return on the
  underlying assets. These are periodically used to cover expenses
  and losses.

Whichever structure is used; the cash waterfall process remains
the preferred return model. All cash generated by the asset pool is
paid in order with pre-arranged payment priority. Senior
obligations are met before the junior ones. An independent
valuation expert is usually retained to value the asset and
determine whether it can service all the vehicle’s obligations.

7.0   Impact on balance sheet

Securitization has an effect on the liability side of an
originator’s balance sheet. From the process, some identified
assets have been removed from the balance sheet, although the
originator retains the first-loss piece. The first-loss amount is
then deducted from the originator’s capital position. For example,
let’s imagine a bank has N100 million worth of assets that have
been risk-weighted, with a target Basel ratio of 12% (under Basel
III, the minimum capital ratio a bank must maintain in 8%, but they
prefer to set aside an amount in excess), and it goes on to
securitize the entire N1oo million worth of assets. It retains the
first-loss series which is 1.5% of the total issue. The other 98.5%
is then sold in the market. The bank still has 1.5% of the capital
reserved against possible future losses, but is now free of the
remaining 10.5% of the capital.

8.0   Conclusion

Securitisation occurs where some assets of a company are lifted
from its balance sheet and are funded by third party investors. The
investors in return, receives financial instruments evidencing the
investment and doing away with a lending institution. As
derivatives of the conventional secured debt instruments,
structured financing instruments are supported by a lien on
selected assets or by a credit enhancement scheme such as a
guarantee. In traditional secured bonds, the primary source of
repayment of the bond remains the liquidity and cash flow of the
issuer. With securitised transactions, that burden of repayment on
the bonds shift from the issuer to a pool of assets which have been
securitised.

Written by: IBRAHIM USMAN WALI

PROFESSIONAL EXPERIENCE

 Ibrahim is an associate at Omaplex Law
Firm and member of the Capital Markets team of the firm. He covers
a range of securities products, including debt and equity, high
yield, structured finance and derivatives, securitization,
corporate trust among others. He has advised high profile clients
comprising global investment banks, SEC and Nasdaq-listed
corporates, sovereigns and private individuals alike.,
ibrahim.wali@omaplex.com.ng

By Ibrahim Usman Wali

In this brief primer, we will discuss the concept of
securitization and the basis for their use, as well as their impact
on the economy.

1.0       The Concept of
Securitization.

Securitization is well established and practiced in the global
debt capital market. Some sources describe it as the practice where
issuers merge different financial assets into one unit, thereby
creating a single financial instrument.

Securitization is a process by which a company assembles its
different financial assets/debts to form a consolidated financial
instrument which is issued to investors.

Similarly, it is the process of selling assets and generating
cash flows from a company to another company specifically set up
for that purpose. Subsequently, the receiving company issues out
notes to the company from which the assets or cash flow generated
was received. The cash flows from the sale of the assets back up
these notes.

Securitization has also been employed as part of asset and
liability management, in handling balance sheet risks. Sundaresan
defines it as:

“A framework in which some illiquid assets of a
corporation or a financial institution are transformed into a
package of securities backed by these assets, through careful
packaging, credit enhancements, liquidity enhancements and
structuring.”

The practice of securitization allows institutions like
Corporates and Financial Institutions to modify the assets that
cannot be readily marketable to rated securities tradeable in the
secondary markets. Residential mortgages and car loans are a
typical example of these types of assets. This allows investors to
gain access to these types of original assets which would not have
otherwise been accessible. This merger and packaging process
creates asset-backed bonds, which are debt instruments
created from a smorgasbord of loan assets from which interest is
payable on a floating basis.

2.0      ESSENCE OF
SECURITIZATION?

The fundamental reason behind securitization is the need for
institutions to derive value from the assets on their balance
sheet. These assets could be residential mortgages, corporate
loans, debt instruments, among others.

Some of the factors that necessitate securitization include:

1. Where size of assets is decreasing and revenues are not
   realised from them, it could lead to an increase in the return on
   equity ratio.
2. The capital expended in managing balance sheets would reduce,
   which will aid costs savings and allow the institution to put the
   capital in another profitable venture.
3. The interest payable on Asset-backed securities is usually
   lesser than other underlying loans, therefore creating surplus cash
   for the original entity.

Summarily, banks securitize for three reasons; funding its own
assets, managing its balance sheet, and risk management.

The benefits of securitization to investors in the ABS market is
considerably high. Through ABS, investors can diversify their risk
and sectors of interest, they can access an array of risk-reward
profiles and importantly, access markets that are otherwise closed
off for them. Securitised notes habitually offer a better
risk-reward performance than corporate bonds of the same maturity
and therefore offer assurance to investors.

3.0     
     The Securitization Process

The securitization exercise involves different components. There
is the original company or institution (the originator) whose
assets are being securitized. The process involves an issuer buying
off these assets from the originator.  This issuer is usually
an SPV created specifically for that purpose and is usually
domiciled off shore. The purpose of the SPV is to ensure that these
assets are held separate from the other assets of the originator.
So for instance, where the originator is declared bankrupt or is
facing a liability claim, the assets in the SPV would not be
affected. This is called being ‘bankruptcy-remote’. On the other
hand, if the assets in the SPV do not yield, investors cannot claim
against the originator. Where these assets are held in an SPV
structure, the financial ratings of the originator become totally
irrelevant to the bond-holder.

The process also involves credit enhancements, where a third
party guarantees the credit quality of the SPV, therefore giving
the issued notes strong investment grade ratings. The SPV is
structured in a way that the issued notes carry lower costs than
the assets of the SPV. This allows the originator to secure
lower-cost funding otherwise unavailable in the unsecured markets.
This is particularly more beneficial for institutions with a low
credit rating.

Figure 1 The process of securitization.

4.0     Mechanics of
Securitization

Securitization reflects a true sale of the assets of an
originator on its balance sheet. This is why the SPV, being a
separate legal entity is required to play the role of note issuers.
The securitised assets are sold into the SPV’s balance sheet, and
therefore divorced from that of the originator. The process
involves:

• Due diligence on the prospects of the assets
• Setting up an SPV and transferring of assets to it
• Underwriting of loans for credit quality and servicing
• Determining the nature and structure of the note; is it going
  to be issued in series or at once
• Rating of the notes by one or more credit rating agencies
• Placing the notes on the capital market.

In order for the transfer of the assets to the SPV to be legally
recognised, the assets must be ‘sold’ to the SPV. Another major
consideration for an originator is the choice of its underwriting
bank, who will have to structure the deals and place the notes.

5.0     SPV structures:

There are usually three types of securitization structures being
employed; amortising, revolving and the master trust.

5.1     Amortising
Structures

The Amortizing Structure, which simply means periodical
pays off of principal and interest, pays the principal and interest
to investors on a coupon-by-coupon basis throughout the lifespan of
the security. Their pricing is subject to their expected maturity.
This is also called the pass-through structure, and are more
commonly used in residential and commercial mortgage backed
deals.

5.2    Revolving Structures

The Revolving Structure is designed in a way that allows for the
principal of the assets to be revolved. The collections on the
principal are used to purchase new receivables that fulfil the
necessary criteria. This structure is usually used for short term
assets having high pre-payment speed, such as credit card debts and
car loans. Principal payments are paid to investors either in a
series of instalments in equal value or as a lump sum at the
maturity of the notes.

5.3      Master
Trust

Master trusts are more frequently used in the United States and
the UK. It allows a single SPV to issue multiple securitizations.
The originator transfers the assets to the master SPV, where then
notes are issued out of the asset pool based on the investorv’s
demand. It is mostly used by mortgaged based securities and credit
card ABS originators.

6.0     Credit
Enhancement

The credit strength of the SPV and the backed assets are vital
in influencing investor decisions. Credit enhancement are measures
initiated so that the issue notes acquire the necessary credit
status to woo in investors. It can be done through the following
means:

• Over-collateralisation: – where the value of the asset is more
  than the value of the issued notes.
• Pool insurance: – an insurance policy from a reputable
  insurance firm to cover the risks around the pool.
• Classification of notes: – notes can be classed into junior and
  senior classes where the notes of a junior class owner is
  subordinated to the rights of a senior owner.
• Margin step – up: – a number of issuers include a step-up
  feature in the coupons, which served as incentives for
  investors.
• Excess spread: – excess spread is usually the difference
  between the interest payable on a note and the return on the
  underlying assets. These are periodically used to cover expenses
  and losses.

Whichever structure is used; the cash waterfall process remains
the preferred return model. All cash generated by the asset pool is
paid in order with pre-arranged payment priority. Senior
obligations are met before the junior ones. An independent
valuation expert is usually retained to value the asset and
determine whether it can service all the vehicle’s obligations.

7.0   Impact on balance sheet

Securitization has an effect on the liability side of an
originator’s balance sheet. From the process, some identified
assets have been removed from the balance sheet, although the
originator retains the first-loss piece. The first-loss amount is
then deducted from the originator’s capital position. For example,
let’s imagine a bank has N100 million worth of assets that have
been risk-weighted, with a target Basel ratio of 12% (under Basel
III, the minimum capital ratio a bank must maintain in 8%, but they
prefer to set aside an amount in excess), and it goes on to
securitize the entire N1oo million worth of assets. It retains the
first-loss series which is 1.5% of the total issue. The other 98.5%
is then sold in the market. The bank still has 1.5% of the capital
reserved against possible future losses, but is now free of the
remaining 10.5% of the capital.

8.0   Conclusion

Securitisation occurs where some assets of a company are lifted
from its balance sheet and are funded by third party investors. The
investors in return, receives financial instruments evidencing the
investment and doing away with a lending institution. As
derivatives of the conventional secured debt instruments,
structured financing instruments are supported by a lien on
selected assets or by a credit enhancement scheme such as a
guarantee. In traditional secured bonds, the primary source of
repayment of the bond remains the liquidity and cash flow of the
issuer. With securitised transactions, that burden of repayment on
the bonds shift from the issuer to a pool of assets which have been
securitised.

Written by: IBRAHIM USMAN WALI

PROFESSIONAL EXPERIENCE

 Ibrahim is an associate at Omaplex Law
Firm and member of the Capital Markets team of the firm. He covers
a range of securities products, including debt and equity, high
yield, structured finance and derivatives, securitization,
corporate trust among others. He has advised high profile clients
comprising global investment banks, SEC and Nasdaq-listed
corporates, sovereigns and private individuals alike.,
ibrahim.wali@omaplex.com.ng