Taurus 2015-2 DEU
Olivier Toutain
2017-02-08
Commercial mortgages are financing instruments - loans - dedicated to the financing of non-residential properties, be it for construction, acquisition or refinancing. Two notions are key here:
the ‘mortgage’ notion, distinct from the legal instrument known as the loan, this corresponds to a lien on the underlying property,
the ‘commercial’ notion defining what type of property we’re speaking about:
Retail (Grocery-anchored shopping center, unanchored shopping center, regional mall, single tenant),
Office (including medical office)
Multifamily (apartment, condos, mobile home ?)
Industrial warehouse (office, self-storage, distribution)
Hospitality (hotels, extended stay, resorts)
Special purpose (Nursing facility, Senior, R&D).
A commercial mortgage has also an interest for the lender, as it will allow him to take only a specialised risk and to focus not on the business activity/continuity of a company but only on the value of the property per se.
A Commercial Mortgage loan has several main characteristics:
Maturity (shorter than residential mortgage)
Amortisation period and profile (existence of balloon payment, interest-only loans)
Interest Rate
Loan-to-Value as key element of the underwriting (in general lower than 80%)
Prepayment penalties
Recourse provisions (Borrower is not liable for the lender’s losses following a foreclosure of the property)
The core of the risk analysis (and even of a pricing) is the projection of cash flows coming from the underlying properties. The flow from each property will then be aggregated at the loan level and then at the CMBS level. Such cash-flow projection start with the tenants and their lease terms, and subsequently takes on board information on the property costs and finally the loan terms themselves.
The risk analysis will be quite different depending on the granularity of the underlying pool of properties:
if the pool is composed a few properties (or even one in our case), then a thorough understanding of the specificities of the property is necessary (leases conditions, tenants, etc…)
if the pool is granular, then the systemic risk factos will be the main drivers of the credit risk: proportion of vacancy, global market conditions, etc…
For each property a net cash-flow (NCF) or at least a net operating income (NOI) should be defined as:
Rental Income, depending on:
the leases in place: their tenants (and credit quality of those), their expiries and potential breaks, the rental arrangements,
the new leases: the likelihood of the lease renewal, the market rents, the typical market lease terms, the attractiveness of the property and the potentail vacancy be it strutural or cyclical.
Expenses:
Maintenance cost, including some capex to maintain he building in a comfortable status,
Void cost
Management Cost
The projection of cash-flows will enable us to compare the to he debt servicing but can also serves as a basis for the market value of the property by discountig them.
The default on the loan used to finance the building/acquisition of the property can occur either during the term of the loan, or at maturity. Indeed those loans are in general balloon, ie there remains at maturity a large proportion of the principal to be repaid. Such balloon structure will lead to a refinancing risk.
The term default risk is mainly driven by the capacity to pay any required installements corresponding to the servicing of the debt (interest and principal). Such capacity at the start is summarised by the DSCR (the Debt Service Coverage Ratio). However during the life of the loan, such capacity to pay can be jeopardised by a default of the tenants, a long vacancy, a change in the interest rate, a cross default, or the legal structure of the borrower.
The refinancing default risk is the inability for the borrower to repay the remaining principal at loan maturity. The primary driver will the Loan-To-Value ratio (LTV) at maturity, which compares the principal amount to be repaid (on the loan and any associated loans) with the property value. Such property value at maturity will depend on:
the property quality (physical qualities and location),
the expected tenancy and lease conditions at loan maturity (including lease expiry profile),
in some cases the property value assuming vacancy may need to be considered,
stability and granularity of the expected cash-flows,
or more generally the property market at that time.
A Company needs capital to develop. Such financing can come under different forms:
Equity: most expensive form of capital and risk of losing control;
Unsecured Credit: up to the maximum leverage allowed by banks;
Secured Credit: need for sufficient good quality assets and the cost will still be high;
or Structured Finance as a way to avoid the burden of the bankruptcy process.
The Volkswagen case is extremely interesting due to the scandal that broke in September. Following such the VW senior unsecured spread went up to almost 200bps, whereas the spread on is senior tranche increased only from 25bps to 60-70bps.
Structured Finance covers several areas which have in common a strong debt component and the objective to modify the balance-sheet of a company. Structured Finance is also referred to as ‘Off-Balance Sheet Financing’, it covers the following different areas:
Securitisation;
Project Finance;
Leasing;
or Acquisition Finance (LBO).
Such type of financing use Special Purpose Vehicle/Entities to segregate part of an activity/project/pool of assets. Those SPVs may also be used to obfuscate the real balance sheet of a company:
Enron created SPVs in order to front ther sale of energy to increase their revenue;
before the subprime crisis, banks used them to invest on subprime securitisation in order to arbitrage capital regulations.
Securitisation is the process by which we transform asset/pool of assets into securities. This is also referred to as ‘structured finance’ due to its financing nature.
Securitisation started to develop in the US at the end of the eighties on pool of mortgage loans, for Fannie Mae and Freddie Mac. Initially for those two entities, those instruments were purely financing tools but there was no transfer of credit risk to the investors, contrary to the current securitisations.
In Europe the market started to develop at the end of the 90s.
Debt securitization: the asset is composed of a portfolio of debt.
RMBS: Residential Mortgage Backed Securities,
CMBS: Commercial Mortgage Backed Securities,
CLO: Collateralised Loan Obligation,
ABS: other consumer loans, auto loans, leases, etc…. .
Market securitization: the asset are composed of financial securities (excluding debt) or physical wares.
CFO: Collateralised Fund Obligation (for hedge fund shares or private equity fund shares),
A stock (Champagne/Whisky/Diamonds/…).
Future flows securitization:
Tobacco Settlements,
Movies rights and other intellectual property (David Bowie).
Insurance securitization: the transfer of insurance risk from an insurance/reinsurance company to financial markets.
For a non-financial corporate:
Optimising its capital structure (secured financing vs unsecured) or lower its total cost of financing,
Diversifying its source of capital and its investor base, as securitisation as been shown to be more resilient to event risk than traditionnal financing (see Volkswagen in 2015),
Getting a financing (for a company with a downgraded financial structure), or
Transferring a risk (mainly for an insurance securitisation).
For a financial institution, we may have all of the previous, plus the following:
Optimising its source of financing (e.g. Northern Rock used to securitise a large portion of its mortgage book),
Regulatory arbitrage (Basel 2 or currently Basel 3), ie to reduce the amount of regulatory capital to set aside against a lending book,
Financial arbitrage (Subprime or Synthetic CDOs), this notion covers not only th capture of a difference in price between two different markets but also the creation of a market.
The corporate entity in deciding which financing tool to use will have regard to the following points:
the cost of financing (e.g. spreads of the debts instruments),
the diversification of its investor base,
the signal sent to the market (e.g. a cutting-edge issuer), aka a marketing signal.
Currently if we take the examples of banks (the largest type of sponsor of securitisation), they have several tools available to finance themselves:
covered bonds,
securitisation,
pledging collateral to the Eurosystem.
Intellectual Property: A rated bonds backed by future royalties of songs (David Bowie / James Brown);
Taxes: Securitization of tax liens in Jersey City to transform future property tax receivables into cash (see also specific tax in Genoa - Monti);
Diamonds: A Belgium diamond company offered a securitization of its entire stock of rough and polished diamonds;
Train Lease: Bonds services by rental income from leases of trains to the train operators;
Oil: The Colombian nationalized oil company issued bonds backed by the future sales of crude oil;
The FIFA World Cup: the risk of cancellation of the World Cup was also securitized.
Financing the housing bubble
Within the continuum of instruments available to bank entities to finance themselves, some cnfusion may exist regarding covered bonds. We list here the main difference between a securitisation and a covered bond:
covered bond are governed by a specific law (contrary to most of the contractual securitisation),
there exist a dual recourse on covered bond, indeed they are issuance of a specific company subsidiary of the bank and guaranteed by the bank itself,
the underlying portfolio of collateral is constrained by law, this is a revolving portfolio with a repurchase by the bank at maturity,
The securitisation is created/implemented through a set of contracts between the different parties to the transaction. Those contracts should not only define the flows of the transaction but they should also control the reaction of the transaction to several events: the transaction will be on auto-pilot mode. However reality shows that this is still an utopia.
The skeleton of a securitisation relies on:
the creation of a special purpose entity (SPE) or special purpose vehicle (SPV), or for countries with a securitisation law a specific entity governed by such law;
the transfer of the assets from the cedant/sponsor to the SPE; and
the issuance of debts by such vehicle to finance the acquisition of those assets.
The set of contracts intially signed are sometimes referred to as the “Bible”.
A ‘Special Purpose Entity’ is in general defined as a (very) thinly capitalized corporate entity, with the following characteristics (see (???)):
no independant management or employees,
no premises,
their only assets are the assets of interest for the securitisation,
their administrative functions are performed by third parties following prespecified rules.
For the purpose of a securitization, several countries (e.g. France, Italy and Spain) have introduced laws governing securitization of debts and creating a specific vehicle for such.
The main purpose of the legal structure of a securitisation is: first to protect the special purpose entity against the bankruptcy risk of the cedant, and second not to introduce any additionnal risks. Such protection is based on two pillars:
the Bankruptcy-remoteness of the SPE,
the True Sale of the assets.
A third element is also necessary but less legal: the insulation of the operationnal process from the bankruptcy/default of a counterparty (servicer/financial counterparty/etc…).
In addition, but depending on the structure or on the country, other legal points may need to be reviewed:
Commingling Risk,
Set Off Risk,
Consequences of the Originator Bankruptcy in the case of leases, etc…
All the points mentionned here are relevant for the structure itself, but there may exist other legal issues pertaining to the underlying loans themselves (bankruptcy code, foreclosure process, etc..)
One the innovation of securitization is to separate the initial owner of the assets from the actual issuer of notes (the SPE). However in order to avoid the creation of additionnal risks, such SPE needs to be bankruptcy-remote (bankruptcy-immune is not achievable except in those countries where there exist a securitisation law):
Restrictions on objects, powers and purposes, which will be limited to the strit minimum necessary for the transaction;
Limitations on ability to incur indebtedness, in order to limit the indebtness tothe issued notes;
Prohibitions on merger, consolidation and amendements of the organizational documents;
Covenants restricting dealings with parents and affiliates, if any does exist;
Nonpetition language (to avoid involuntary bankruptcy);
An independent director whose consent is required for the filing of a voluntary bankruptcy.
In addition the SPV clearly states within each of its contract that all payments will be paid in accordance to a detailed allocation. Such payments will be always non-recourse.
In addition to the creation of an SPE, a security will be created over all the assets of the SPE for the benefit of the Noteholders and other parties to whom the SPE may owe something (swap counterparty, servicer for fees, …). A Security Trustee will be appointed to take care of the security (in general it has other responsabilities in addition).
The security enforcement will be triggered by what is knwown as the ‘Issuer Event of Default’, defined as:
a failure to pay interest on the most senior notes when due, or principal of the most senior notes on the legal final maturity of the transaction;
the Issuer fails to perform any of its material obligations for a duration of at least 30 days;
it is unlawfull for the Issuer to perform any of its obligations under any transaction documents; or
the start of any bankruptcy proceedings against the Issuer.
For countries with a securitistion law an additional security won’t be necessary, however some of the mechanism presented here will be implemented: e.g. the ‘Issuer Event of Default’ will be replaced by an acceleration of the notes repayment.
The insulation of the SPE from the potentiel bankruptcy of the sponsor is also based on the conveyance of the assets to a separate legal entity in a true sale that extinguishes any remaining property interest of the transferor in the assets.
the buyer must pay for the asset, at arm’s length ie at commercial prices;
the buyer expect to enjoy the benefit of the property; and
the buyer assumes the burden of ownership, this can be an issue in case of the existence of a potential recourse to the seller that may lead to a recharacterization as a loan (or the existence of an option for the SPE to put back the loans to the originator).
Some securitisation do not rely on True Sale if there exist other legal mechanism to protect Noteholders from the originator default or if the securitisation is strongly linked to the originator. However in such last case this is clearly viewed as a weakness of the transaction structure.
When the pool consists of secured loans, the transfer should be concerning both the loans and the title to the underlying assets to be correct.
The commingling risk is the credit risk arising from the fact that the amount (principal and interest) collected by the servicer are deposited in its own accounts. Such proceeds are not paid directly by the underlying borrowers to the SPE accounts (No preliminary notice of transfer of the loans, only ex-post). However on a frequent basis the servicer will be obliged to transfer those amounts to the SPE account. Such collection process implies the existence of a credit exposure on the servicer.
Such risk is mitigated by:
the frequency of transfer (from a monthly transfer to a daily one),
a rating trigger on the servicer such that a breach of such rating trigger will cause:
either the posting of a collateral amount corresponding to the expected flows (slightly overestimated),
or the replacement of the servicer,
the use of a dedicated account which is insulated from the bankruptcy estate in case of the servicer bankruptcy (see the french “Compte d’Affectation Special”).
The attached paragraphs are extracted from Rating Agency reports (here Moody’s and Standard & Poor’s) on the level of existing Commingling Risk and the mitigant put in place to control the risk. Different solutions do exist.
In case an underlying borrower has a deposit (or another claim like salaries, insurance premiums, etc…) by the originator, in case of a default of the originator, the loan amount due by such borrower may be in jeopardy. Indeed the borrower has then the possibility (depending on the insolvency law of the country) to net the amount he owes under the loan: this is the Set-Off risk.
Such risk can be mitigated by:
the exclusion from the pool of borrowers having a deposit by the originator (or similar claim),
or the posting of a collateral amount corresponding to the potential set-off risk.
In Europe, that risk is particularly acute for Dutch RMBS transactions.
The attached paragraphs are extracted from Rating Agency reports (here Moody’s and Standard & Poor’s) on the level of existing Set Off Risk and the mitigant put in place to control the risk.
LTV Steel was a US company that implemented two securitization: one of its receivables and one of its inventory. In 2000, LTV filed for bankruptcy protection and requested the court to allow them to use the cash generated from LTV’s securitizations in order to stay in business. Its main point supporting such motion was that the asset transfers in fact had been disguised financings and thus remained in its bankruptcy estate. Its request was dismissed but this was a test of a contractual securitisation.
In the Kingston Square case, a SPV was formed for the purpose of securitizing mortgages (CMBS). Unanimous vote of the board of the SPV was required to file a voluntary bankruptcy petition. The board was mainly composed of directors loyal to the sponsor of the transaction. Mortgages began to default and the investors started the foreclosue process on the underlying properties. The sponsor decided to thwart this action in order to preserve some value for the equity owners. It organised the filing of an involuntary bankruptcy proceedings.
We will look at the specification within the prospectus:
p15 a general description of the transaction,
p98 the statistical description of the data,
p134 the description of the origination and servicing process,
p143 the terms of the notes issued.
More specifically:
The liabilities of the SPE differ from several aspects, either their interest rate type (fixed/floating or frequency), currencies, repayment profile (amortising, bullet) or (most important) their credit risk profile. Such menu is necessary to suit potential investors needs. The structure of the liability of the SPE will be defined by:
the different classes of Notes issued (also refered to as Tranches),
the allocation of asset flows between the classes, also referred to as the priority of payments of the ‘waterfall’; and
the existence of additionnal protection mechanism:
a liquidity facility,
a reserve fund,
or the distribution of excess spreads to the most senior tranches.
The allocation of flows from the asset to the liabilities of the SPE are governed by the priorities of payment. In the case of a debt securitisation, the waterfall can be quite complex contrary to other type of securitisation (market or insurance-linked). Their main specifics are:
whether or not the interest and principal flows are mixed or separate (single or dual waterfalls);
the type of principal allocation:
sequential,
pro-rata, or
constant leverage;
the potential capture of excess spread, through:
either a PDL (Principal Deficiency Ledger, attached to a specific class): such ledger start at zero, is increased by any principal loss on the asset, decreased by any repayment of the class under consideration, its value then represent any principal shortfall for the tranche protection;
or an OC ratio (OverCollateralisation Ratio): such ratio compares the nominal of the asset to the nominal of the liabilities.
the usage of such excess spread in case a test is met (see above): either to repay some classes (in general starting with the most senior) or to fund a Reserve Account to be used at a later date.
PSA
Celtic
CLO
Main drivers of risks:
Auto loan performance correlates with changes in labor market conditions, but credit standards can weaken when competition for loans heats up,
Several indicators of the borrower credit worthiness are of importance (credit score, income or debt ratios, employment history, home ownership),
Some of the loan characteristics can help too (LTV, maturity, interest, payment frequency, balloon features), and
the specifics of the underlying vehicle (new or used, recreational vehicles).
Static or revolving pools (at most 4 years),
Credit Risk benchmark data:
Recoveries are around 30% for most of the european countries except Italy where recoveries are lower (around 10%) due amongst others to the lack of access to the car (no pledge, nor retention of title).
Prepayments: CPR are between 5% and 15%.
The pool of mortgage loans have in general the following characteristics (prime loans here):
Mostly Owner-Occupied;
High proportion of Interest-Only loans, for tax reasons (soon to be changed by law), those are associated with a saving vehicle;
Mostly fixed-rate loans;
The LTV is quite high, the weighted average LTV of a new transaction is around 90%.
The mortgage loan of a borrower will be structured into several loans with different amortising profile and interest rates (level and reset frequency).
In addition, there exist a lender’s guarantee (the Nationale Hypotheek Garantie - NHG, a provided by a government sponsored entity rated AAA), which is widely used. However credit risk remains beacuse such guarantee amortises on a 30-year annuity basis and thus does not follow the actual amortisation profile. Only loans meeting certain criteria are eligible to such program.
The pool of prime mortgages have in genral the following characteristics:
A large proportion of Owner-occupied loans,
Large proportion of IO-loans but already declining;
The LTV is reasonnable, being around 60%-65% for recent transactions;
Delinquencies are higher than those of other large RMBS market, being at around 3% versus below 1% for other markets (Netherlands, Japan, Australia)
In Europe, the issuance are either retained or placed at close, ‘retained’ meaning that the transactions are kept by the originator for liquidity purpose (to be used as collateral for EuroSystem, or in a swap for LCR eligible assets). A large proportion of the european transactions are bought by banks, however there exist approximately 20 investors (funds from big asset management names) active in the european market.
The secondary market for securitistion is still highly illiquid except for a subset of the asset classes. The largest transactions (placed) for the relatively safest asset class are indeed the exception (English Master Trust, Dutch RMBS).
The quote are only available OTC through a direct contact with the market makers and for small size (around 5M). As an example for French securitisations, only some auto transaction do exhibit (limited) liquidity.
The ABS market is far fom being a liquid market,thus the pricing of the different securities will be done mostly through a relative value analysis. However the computation of the price will require additionnal steps:
A projection of the cash-flows, and
a margin to be applied in addition to the forward rate to compute the price as the present value of the flows.
The projection of the cash-flows of the tranche of interest is defined based on the contractual mechanism of the transaction on one hand and a projection of the asset cash-flows on the other hand, including:
the loan-by-loan scheduled amortisation;
assumptions on the default rate (which can be expressed as CDR - Conditionnal Default Rate), default timing, recovery rates and recovery lag;
assumptions on the prepayment rate (expressed as CPR - Constant Prepayment Rate on an annual basis).
The margin, also called the Discount Margin, is used in the computation of the present value of the flows (in addition to zero-coupon rates). Such Discount Margin depends largely on the asset type, the asset’s country, the originator, the issuance year and the current rating of the tranche.
Three tools are mostly used by practionners to compute the prices (the projection of cash-flows being the complex part): Intex (mostly by the market makers), ABSNet/MoodysAnalytics (mostly by the buy side) or Bloomberg.
CPR will be depending on the type of loans and the current level of interest rate (or more specifically the recent evolution of interest). It will be more or less smoothed depending on the horizon used. They are presented on an annual basis.
CDR are defined as the proportion of the remaining loans that will go in default over a defined horizon. They are presented on an annual basis.
The class of debt issued by the vehicle will be analysed by investors/traders along several axis:
the asset risk (in most cases credit risk on a portfolio of debts), by defining projections of future default rate, recovery rates;
the legal risk of the structure, as described in the previous legal section (Bankruptcy-remoteness, True Sale, Set-off, Commingling);
the counterparty risk: the credit or operationnal risk raised by a default of a counterparty on its obligations,
the operationnal risk.
The typology of securitization will determine the analysis to be applied:
Debt Securitization: a classical credit risk analysis, but again with differing approaches according to the underlying exposures.
Market Securitization: a market risk analysis.
Intellectual Property or Future Flows Securitization: an ad-hoc analysis (based mostly on stress tests).
Insurance Securitization: an actuarial analysis.
Within the scope of a debt securitization, the focus is on the overall credit risk of the portfolio of debts. Such analysis will be based on three dimensions for which assumptions are necessary.
the probability of default of each obligor: this can use the rating of the obligor (or market informations like spreads) or be computed from each loan’s characteristics.
the credit correlation: in general such assumption is not explicit (except for CLOs and some SME ABS) but it is implicit within either an assumption on a stress default probability, or an assumption on the default volatility; and
the recovery rate on each debt.
However such detailed analysis is feasible where there is sufficient information for all obligors. If this is not the case, an historical analysis is necessary.
The different Credit Rating Agencies have developped similar approaches to the analysis of an Auto loan transaction, according to the following steps:
Determination of the pool risk:
Compliance of the legal structure with the CRAs criteria:
Ancillary risks
Historical default rate on retail loans (consumer loans, auto loans or sometimes for mortgage loans…) are generally presented in a triangular table: for each cohort (a set of loans originated during the same period, a month, a quarter, a year), such table gives the cumulative default rate with the passage of time. The same principle can be sued to show recovery rates evolution.
Three elements need to be explored through such a table:
the time-evolution of the cumulative default rate,
the importance of the origination date (as a proxy for the underwriting conditions), and
the influence of the economic conditions.
Such knowledge will help us forecast the future evolution of such default rate through an extrapolation of the economic conditions, the underwriting conditions being already reflected in the existing performance of the cohorts.
In addition to the vintage tables, the analysis of the different delinquency buckets could be helpful to identify early any worsening symptoms.
The delinquency buckets do represent the balance of loans being late in their payment. They will be differentiated according to the extent of the lateness, with the following buckets mostly used: zero to 30 days, 30 to 60 days, 60 to 90 days, 90 to 180 days, above 180 days or defaulted.
The roll rates are defined as the proportion of loans transitionning from one bucket to the other. All roll rates will define a transition matrix from one status (including performing loan bucket) to another. Any increase in the proportion of loans staying late or going to default will be an early warning signal of the worsening performance of the pool.
| Date | Arrears30d | Arrears60d | Arrears90d | Arrears120d | Arrears150d | Arrears180d | ArrearsDef |
|---|---|---|---|---|---|---|---|
| 2014-02-27 | 0.745 | 0.408 | 0.163 | 0.1137 | 0.0828 | 0.0591 | 1.147 |
| 2014-03-25 | 0.985 | 0.386 | 0.180 | 0.0928 | 0.0921 | 0.0655 | 1.218 |
| 2014-04-25 | 0.899 | 0.467 | 0.184 | 0.0999 | 0.0847 | 0.0629 | 1.311 |
| 2014-05-27 | 0.951 | 0.456 | 0.182 | 0.0955 | 0.0866 | 0.0574 | 1.414 |
| 2014-06-25 | 1.057 | 0.503 | 0.184 | 0.0991 | 0.0827 | 0.0644 | 1.503 |
| 2014-07-25 | 1.031 | 0.476 | 0.225 | 0.1068 | 0.0809 | 0.0645 | 1.599 |
| 2014-08-26 | 0.888 | 0.392 | 0.245 | 0.1151 | 0.0716 | 0.0689 | 1.688 |
| 2014-09-25 | 0.809 | 0.397 | 0.198 | 0.1236 | 0.1010 | 0.0522 | 1.785 |
| 2014-10-27 | 0.908 | 0.375 | 0.174 | 0.1205 | 0.0897 | 0.0664 | 1.839 |
The analysis for a pool of mortgage will be different mostly because both default rates and recovery rates are strongly linked to house prices. Thus instead of relying exclusively on historical data CRAs will assume certain stresses on the future evolution of house prices. Default rates and recovery rates are determined as a function of those stressed house prices level on a loan-by-loan level. In addition ajustments are taken into account according to the characteristics of each loan, e.g.
the type of property (flat, house),
the usage of the property,
the employment type of the borrower,
the amortisation profile.
In addition to the collateral risk, the structure may be exposed to the credit risk of several of its counterparties, amongst other the credit risk of :
the Servicer:
either due to the commingling risk, or
due to the operational issues raised by the bankruptcy of a servicer.
the Originator:
due to the set-off risk,
the protection given by the originator against its own representations regarding the collateral, or
a potential extension of its bankruptcy.
the hedge providers:
either due to the cost of a replcement hedge,
or because of the potential leaking of cash-flows if the acceleration of the hedge trigger a senior payment.
the accounts banks.
The table synthetises the different rating triggers put in place to control the couterparty credit risk (excerpt of the investor report of a french transaction).
ABS were at the core of the recent financial crisis, triggered by the subprime crisis. Following those events, regulators have put in place several elements to control the risk induced by a securitisation, in order to mitigate moral hazard (Risk Retention), to limit the complexity of the product (Simple Transparent Standard - STS), or to put higher capital weight to securitisation investment (Basel or Solvency II).
Risk Retention:
Liquidity Cover Ratios (LCR: Ratio of high quality liquid assets to 30-days net outflows):
Basel Securitisation Framework:
Solvency II
The transfer of a portfolio of loans from the cedant to the vehicle is governed by a contract (called as Loan Receivables Purchase Agreement - Sale Agreement - etc…). Such contract shall cover, inter alii:
representations and warranties of the cedant,
the recourse against the cedant if claims are not valid,
the existence of a clean-up call.
The perfection of a true sale may require that specific safeguards are put in place according to the country law (and jurisprudence):
Under the terms of a servicing agreement, the servicer, in most case the cedant, agrees to:
administer the portfolio of loans: to collect the loans payments;
repossess the collateral securing the loan if in default;
manage the cash, including the transfer of the collected cash to the vehicle’s account (see commingling risk).
This is a specific feature a contractual securitisation (versus securitisation executed within the scope of a specific law). A Trustee is appointed, which will be the representative of the Noteholders and other secured parties if any:
taking decisions on the potential amendments of the transaction documentation (having regard to the best interests of the Noteholders);
helding the security as a security trustee for the benefit of the secured parties, including foreclosing the security if need be;
taking care of the transaction in case of an Issuer Event of Default.
The risk analysis of a transaction should capture all dimensions of risks:
collateral risk.
counterparty risk.
the legal structure.
The granularity of a loan portfolio is generally measured across several dimensions:
the number of loans,
the aggregate balance of the top borrowers,
the most represented region,
finally the HHI index (a measure of diversification) or more accurately its inverse.
Several books are available on the subject: (Colla, Ippolita, and Li 2013), (Stone and Zissu 2005), (Fabozzi and Kothari 2008), and (Davidson et al. 2003).
Colla, Paolo, Filippo Ippolita, and Kai Li. 2013. “Debt Specialization.” The Journal of Finance 68: 2117–41.
Davidson, Andrew, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, eds. 2003. Securitization: Structuring and Investment Analysis. John Wiley & Sons, Inc.
Fabozzi, Frank J., and Vinod Kothari, eds. 2008. Introduction to Securitization. John Wiley & Sons, Inc.
Stone, Charles Austin, and Anne Zissu, eds. 2005. The Securitzation Markets Handbook. Bloomberg Press.