YaleICFWorkingPaperNo.

0707

Securitization:TheToolofFinancial
Transformation

FrankJ.Fabozzi,ProfessorinthePracticeofFinance,YaleUniversity,
SchoolofManagementandInternationalCenterforFinance

VinodKothari,IndependentFinancialConsultantandVisitingFaculty,
IndianInstituteofManagement

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Securitization:thetooloffinancialtransformation
FrankJ.Fabozzi,ProfessorinthePracticeofFinance,SchoolofManagement,YaleUniversity
Vinod Kothari, Independent financial consultant and Visiting Faculty, Indian Institute of Management,
Kolkata,India

Abstract
Securitization as a financial instrument hashad an extremely significant impact on the worlds financial
system. First, by integrating capital markets and the uses of resources such as mortgage originators,
finance companies, governments, etc. it has strengthened the trend towards disintermediation. Having
beenabletomitigateagencycosts,ithasmadelendingmoreefficientevidenceofthiscanbeobservedin
the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has
generated muchhigherlevelsofleverage and, thougharguably,greatereconomiesofscale.Combinationof
securitizationtechniques with credit derivatives andrisktransferdevices continuesto develop innovative
methods of transforming risk into a commodity and allow various market participants to tap into sectors
whichwereotherwisenotopentothem.
In its broadest sense, the term securitization implies a process by which a financial relationship is
converted into a transaction. A financial transaction is the coming together of two or more entities a
financial relationship is their staying together. For example, a loan to a corporation is a financial
relationshiponcetheloanistransformedintoatradablebond,itisatransaction.Wefindseveralexamples
inthehistory of the evolution of financeofrelationshipsthathave been converted into transactions.The
creation of stock, representing ownership in a corporation, is one of the earliest and most important
examples of this process because of its impact on the growth of the corporate form of business
organization.Theprocess of converting loans to corporations of high credit quality corporate borrowers,
andinthe1970sexpandingthatopportunitytospeculativegradecorporateborrowers,intopubliclytraded
bondsisanotherexampleofthis.Commercialpaperisanotherexampleofsecuritizationofrelationshipsas
itsecuritizesatradedebt.

Intodayscapitalmarkets,thetermsecuritizationhasacquireda morespecificmeaning,whichforthesake
ofdistinctionisreferredtoasassetsecuritization.Todaysecuritizationisunderstoodtomeanaprocess
bywhichanentitypoolstogetheritsinterestinidentifiablefuturecashflows,transferstheclaimsonthose
futurecashflowsto anotherentity thatisspecificallycreatedforthe sole purposeofholding thosefinancial
claims,andthenutilizesthosefuturecashflowstopayoffinvestorsovertime,eitherwithorwithoutcredit
supportfromasourceotherthanthecashflows.Asecuritizationtransactiontherebyachievesthepurpose
of providing financing, but in a unique way by sale of assets. While the result of a securitization
transaction is that financing is obtained, it is not financing as such because the entity securitizing its
assetsisnotborrowingmoneybutsellingastreamofcashflowsthatwasotherwisetoaccruetotheentity.
Theentitycouldbeacorporation(financialornonfinancial)oragovernmententity(nationormunicipal).

The purpose of this article is to describe the basic principles of securitization, the reasons for its use by
corporations,anditsimpactonfinancialmarkets.

Thesecuritizationprocess
We will use an example to explain the securitization process. Suppose a company has receivables on its
balancesheetthatrepresentinstallmentloansthatborrowersare repayingovertime.Becausethecompany
hasoriginatedtheloansitwillbereferredtoastheoriginatorcompanyorsimplytheoriginator.The
originator identifies a pool of receivables that satisfy certain features, described later, that make them
acceptabletobesecuritized.

This pool of receivables is transferred to a special purpose entity (SPE), also referred to as a special
purposevehicle(SPV).Generallyspeaking,thepoolofloans,whichwewillrefertoastheassetpool,is
transferredatparvalue thatistosay,itistransferred attheoutstandingprincipalofthe loansbeingpooled.
LetussupposetheassetpoolhasaparvalueofU.S.$100million.TherateofreturnthattheSPEwould
now receive on the loans is, of course,the weightedaverage of theinterest accruing ontheloans.In our
illustration,an8.55% weightedaveragerateofinterestforthatassetpoolwillbeassumed.

TheSPEholdsthe assetpool,payingforitbyissuingsecurities.The creditratingofthosesecuritieswillbe

basedsolelyonthestrengthoftheassetpool.Thatistosay,theassetpoolscashflowswillbeusedona
mutuallyexclusivebasistorepayinvestorsofthesecuritiesissuedbytheSPE.Bymutuallyexclusiveit
ismeantthattheoriginatorwouldnothaveanydirectclaimonthereceivables,norwouldtheinvestorsin
thesecuritiesissuedbytheSPEortheSPEitselfhaveanyclaimagainstthegeneralassetsoftheoriginator,
excepttotheextentofcreditsupportdescribedlater.

AsforthesecuritiesissuedbytheSPE,theyarestructuredintodifferentclassesofsecurities.Verysimply
speaking,thesesecuritiesmaybeseniorandjuniorortheymaybesenior,mezzanine,andjuniororthey
mayhavevariousclassessuchasclassA,classB,andsoon.Thesevariousclassesarecreatedinorderto
generatedifferentiatedinterestsinthepool,suchthattheseniorinvestorshavesuperiorrightsoverthepool
than the subordinated investors. In our illustration, we will suppose that three classes of securities are
created with followinginterestsinthe assetpool: class A95%(senior bond), class B2%(mezzanine
bond), andclassC 3% (juniorbond).
SinceclassAinvestorsaresenior,anylossesorshortfallsintheassetpooltosatisfytheobligationsofthat
bondclasswouldfirstbeabsorbedbyclassC,andthenbyclassB.ClassAwouldnotbe affectedbylosses
unless thoselosses exceed 5%. Therefore, class Ahas a cushion against losses provided bythe existence
and size of classes B and C. This allows class A to get a high rating from the rating agencies. In a
securitizationtransaction,theamountofclassBandC(referredtoinsecuritizationjargonasthesizing
ofsubordination)isdeterminedsoastoobtainatargetratingforclassA,thetargettypicallybeingatriple
Arating.Likewise,thesizingofclassCisdeterminedsoastoensurethetargetratingforclassB,say,an
investmentgraderating.Typically,classCwouldbeanunratedclass,andmaynotfindabuyer and,asa
result,isoftenretainedbytheoriginator.

Thethree classes of securities in our example will be offered at different couponrates, class A beingthe
lowestbecauseitcarriestheleastcreditriskandisthereforethecheapestfundingsourcefortheSPEclass
CwouldhavethehighestcouponrateandthereforethecostliestfundingsourcefortheSPEbecauseithas
thelowestcreditrating.Supposetheweightedaveragecostofthe three couponsis7%.

Aswillbeexplainedlater,theSPEisalmostlikeanonsubstantiveshellentity.Assuch,afteritacquires
theassetpoolfromtheoriginator,itdoesnothavethewherewithalrequiredtocollectthereceivables,and
therefore cannot perform the collecting and servicing function itself. Generally, the originator company,
whohasproximitywiththeborrowersandtypically hasaninfrastructureandsystemsinplacefordoingso,
retainstheservicingfunctiontheoriginatorcompanyisnowinaservicerroleinsteadof anownership role,
whichithadpriortothesecuritizationtransaction.Insomecasestheservicingfunctionmaybetransferred
toanindependentthirdpartyentitythatspecializesinservicingloans.Thedecisionastowhethertoretain
servicingwiththeoriginatorcompanyortohaveittransferredtoanindependentthirdpartyentitywillbe
drivenbyeconomics ratherthanbystructuralconsiderations.

Letusassumeinourillustrationthattheservicerispaidaservicingfeeof50basispointsperannum.The
differencebetweentheweightedaverageinterestaccruingontheloansof8.55%andtheweightedaverage
cost of thethree coupons plus servicing feeis 1.05%.This difference isreferredto as theexcess spread.
The SPE may issue residual income certificates or one or more interests that will sweep this residual
incomefromtheSPE.Theresidualinterestmaybeheldeitherbythe originatororsoldtowillingbuyers.

Letusseewhateachoftheparties realizedasaresultofthissecuritizationtransaction:
The originator received immediately after the transaction was consummated funding of U.S.$100
million. Assuming class C with a par value of U.S.$3 million was held by the originator, the actual
fundingtheoriginatorobtainsisonlyU.S.$97million.Inaddition,theoriginatorobtainedtheresidual
interestinthetransaction,representingthecashleftoverafterpaying the investorsinclassAandB.
Investorshadthe choice of threedifferent classes of securities from whichto select, each carryinga
different credit rating and coupon rate. These securities might also have other different investment
featuresbeyondthecreditrating,suchasdifferencesininterestraterisk(i.e.,durationandconvexity).
TheSPEwasacreaturedesignedforenablingthetransactionconsequently,therearenoregretsthat
theSPEgetsnothingatall.

WhilethepoolistransferredtotheSPV,asexplainedabove,it hasnoinfrastructuretoactually manage the

collections on the receivables. Logistically, the best party to continue to manage the collections is the
originatorcompanyitself,asithasanexistingfranchisewiththecustomers.Consequently,theoriginator
companytypicallycontinuestomanagethecollectionsandrenderotherborrowerservices1.Ofcourse,the
servicerwouldexpectaservicingfeefordoingso.Thecashflowscollectedeachmonthbytheservicerare
usedtorepaytheprincipal,aswellasinterest,for thesecuritiesissuedbytheSPE,eitherwithorwithout
theirreinvestment.

1
The services to the borrowers, collection of cash flows, and remittance of cash flows to investors, and
basicinvestorservices,arecollectivelyknownas theservicingfunction.
Whatisanassetbackedsecurity?
ThesecuritiesissuedbytheSPEarereferredtoasassetbackedsecurities2.Inourexample,classesA,B,
andCaretheassetbackedsecurities.Thesesecuritiesdifferfromausualcapitalmarketinstrumentwhich
is an exposure to the issuers business. An assetbacked security is simply an exposure to a pool of
specified assets. Returning to our earlier example, the investors who acquire classes A, B, or C arenot
concerned with the generic risks of the business of the originator company. Even the bankruptcy of that
companycannotaffect investors,though there will be some shock to the servicing function if it is being
performed by the originator company. The servicing will have to be transferred to another servicer, but
assumingthatcanbedonesmoothly,theinvestorswillcontinuetoenjoythecashflowsgeneratedbythe
assetpool.

The investors are,however, exposed to therisks of theasset pool. These risksmay be multifarious for
example, delays,defaults,prepayments, legalchallenges, andsoonandthey willbediscussedlater.What
iscriticaltounderstandisthatinvestorsintheassetbackedsecuritiesareexposedtotherisksoftheasset
poolnottherisksoftheoriginatorcompanysbusiness.Therefore,anassetbackedsecurityisnotaclaim
onanentitybutapoolof assets.

Twoimportantpointsarisehere.Firstly,thedistinctionbetweenclaimsonassetsandclaimsonentitiesis,
toanextent,ephemeral.Inthefinalanalysis,thetwoseemtomerge:anyclaimonanassetisaclaimonan
entity as no asset is a value by itself. Secondly, any claim on an entity is also ultimately a claim on the
assetsoftheentity,asallsuchclaimsarepaidofffromtheassetsoftheentity.Theveryconceptoflimited
liabilitycompaniesmakesallfinancialclaimsasclaimsonassets.

Tounderstandthesignificantdifference,andtoappreciatethebasicindifference,betweenanassetbacked
securityandatraditionalbond,letusexaminetheirnature.Inourexampleabove,wehadthreeclassesof
securities:classA[U.S.$95million],classB[U.S.$2million],andclassC[U.S.$3million].Theyareall
backedbythecommonpoolofassetsofU.S.$100million.SinceclassCisthejuniormosthere,itwillbe
the first one to absorb losses in the pool of assets. The first dollar of realized loss on the assets will be
allocatedtoclassC,whichmeansclassCwillsufferawriteoffofprincipaltotheextentofsuchrealized
loss.ClassCcontinuestoabsorblossesuntilitiswipedout,atwhichpointclassBstartssufferinglosses.
Inotherwords,theprobabilityofclassBsufferinglossesisthesameasthatofthelossesintheassetpool
exceedingthesizeofclassC.Likewise,ifthelossesexceedthecombinedsizeofclassesBandC,classA
woulddefault.

Let us now look at a corporate bond. Assume an entity having total assets of U.S.$100 million has the
following capital structure: equity of U.S.$3 million, preferred stock of U.S.$2 million, and senior
unsecuredbondsofU.S.$95million.Asitmightbeobvious,wehavecontrivedtoputthesamenumbers
here as in the example of assetbacked security, though it would be rare to see such a highly leveraged
company. Look at the moot question: when do the bonds in our example default? Obviously, when the
lossesoftheentityexceedtheequityandpreferredstock,whichisthesameastheprobabilityofclassA
defaulting in our example of assetbacked securities. We can use these parallels to appreciate the

2
There is no uniform name for the securities issued by the SPV, as such securities take different forms.
These securities could represent a direct claim of the investors on all that the SPV collects from the
receivablestransferredtoitinthiscase,thesecuritiesarecalledpassthroughcertificatesorbeneficial
interest certificatesas they imply certificates of proportional beneficial interest in theassetsheld by the
SPV. Alternatively, the SPV might be reconfiguring the cash flow by reinvesting it, so as to pay the
investorsonfixeddates,notmatchingthedateswhenthetransferredreceivablesarecollectedbytheSPV.
Inthiscase,thesecuritiesheldbytheinvestorsmaybecalledpaythroughcertificates.Alternatively,as
these securities are essentially the obligations of the SPVthatare discharged by thereceivables from the
assets transferred toit, the obligations could bereferred togenerically as assetbacked obligations,and
specificallyasassetbackedbondsorassetbackednotes.ThesecuritiesissuedbytheSPVcouldalso
benamedbasedontheirriskorotherfeatures,suchasseniornotes,juniornotes,floatingratenotes,andso
on.Yetanotherwayofreferringtoassetbackedsecuritiesisbasedonthetermofthepaperconcernedif
the paper is shortterm commercial paper, it is referred to as assetbacked commercial paper, otherwise
referredtoastermpaper.
indifferencebetweentraditionalbondsandassetbackedsecurities.Thecreationofstructuredsecuritiesof
differentclassesisnotuniquetosecuritization.Thereisa hierarchyofdifferentfinancialinstrumentsonthe
liabilitysideofacorporate balancesheetwhichhas differentlevelsofpriority.Allfinancialinstrumentsare
backedbyassets,andtherefore,inthe ultimateanalysis,allsecuritiesareassetbacked.

However,thereisasignificantdifferencebetweenassetsoftheentireenterpriseandthosethatare isolated
as a specific pool. The bond in question above is a claim on all assets of the entity. The assetbacked
securitiesareaclaimonanisolatedpool.Thesecuritizedpoolisalikeaminiaturecorporation itcameout
of the aggregateassets of theoriginator companys business. But once the isolation of the pool happens,
investors in the transaction are only impacted by the risks of those specific assets, and not the general
businessrisks of themortgagelender. Fromthe openended enterprise of theoriginator company, we are
nowfocusedonaclosedend,deconstructedasset pool.

This discussionleads toan important feature of anassetbacked security: whether assetbacked or entity
backed,thereisnovalueaddedmerelybysecuritizingassets.Theonlysourceofvalueaddedisbyasort
of intercreditor arrangement whereby an assetbacked investor is provided two advantages legal and
structuralpreferences.

Legalpreferencereferstothepreferencethatanassetbackedinvestorenjoysoveratraditionalinvestoras
aclaimantontheassetsoftheoperator.Atraditionalinvestoressentiallyhasaclaimagainsttheoperator.If
the operator were to run into financial problems, the investor's claim is subject to bankruptcy
administration, which in most countries is a timeconsuming process and might be legally preceded by
otherstatutoryclaims.Anassetbackedoperatorhasaclaimovertheassetsoftheoperator,asthoseassets
havebeenhivedoffandmadelegalpropertyoftheinvestors.Therefore,theseassetssubservetheclaimsof
the investors before they can be claimed by anyone else. Creating this legal preference is the key to
securitization.

Structuralpreferencereferstothestackingorderofmutualrightsamongthedifferentclassesofinvestors.
Inourexampleearlier,wehadthreeclassesofinvestors,whohadsoalignedtheirrightsthatonebecomes
saferatthecostoftheother.Theseniormost,classAissafestbypiggybackingonclassesBandC,and
likewise, class B piggybacks on class C.This structuring of mutual rights is not unique to securitization
sinceeverycapitalstructureofanycorporationhassomeliabilitieswhichareprioritizedtoothers,butthe
structuringbecomesmoremeaningfulincaseofsecuritizationinviewoftheisolationofentityrisks.

Weusedthetermintercreditorarrangementaboveasthegenesisofthetwopreferences.Thataninvestor
inan assetbacked securityenjoys bothalegal and structuralpreference over thetraditional investoris a
matterofmutualarrangementamongthevariouscreditors(including,forthispurpose,theassetbacked
investor)ofanentity.Apreferenceisunderstandablyanadvantagethatonehasovertheother,andlooked
attheotherwayaround,itisonlygainedbytheacceptanceofdeferencebytheothercreditors.Therefore,
theadvantagethatassetbackedinvestorsgainisattheexpenseoftheothercreditors.Doesthismeanthat
thesumofthepartsisnodifferentfromthewhole?

Legal preference by isolation

Asdiscussedearlier,thelegalpreferenceoftheassetbackedinvestoroveratraditionalinvestoriskeyto
theveryeconomicsofsecuritization.Muchoftheneedforthepresentdaymethodsofsecuritizationwould
disappear if it were possible to allow a certain group of investors a bankruptcyproofing device whereby
certain assets, if not all, of a corporation would first be used to paythem off3. One might argue that in
countries such as the United States there are rules for the priority of creditors in the case of bankruptcy
(rulesofabsolutepriority)thatcanbeusedtoprotectdifferentclassesofcreditorsbycreatingapreference
against a specific asset. However, as has been found in numerous studies [Merton (1977), Meckling
(1977)],theprincipleofabsolutepriorityistheexceptionratherthantheruleinaChapter11bankruptcy.
Thus,securitizationstrivesatarbitragingthelawbyensuringthatatleastsomespecificassetsare freefrom
anyotherclaimand canbeusedtopayoffonlytheassetbackedinvestors.

3
CoveredbondsaregenerallyusedinsomeEuropeancountriesandhavearguablyservedasaneffective
alternativetoisolationtypesecuritizationdevices.
Thedeviceusedforcreatingthislegalpreferenceissimple:transferofassets,oftenreferredtoasatrue
sale.Theoriginatorcompanyinourexampletransfersastreamofreceivables(i.e.,theloans)totheSPE.
This transfer should be a legally recognized transfer, such that the receivables now become the legal
property of the SPE. Being the property of the SPE, obviously, the receivables are not affected by any
bankruptcyoftheoperator,orclaimsofthegeneralcreditorsoftheoperator.

Insecuritizationparlance,thislegaltransferisoftenreferredtoasisolation.Isolationisonly aperfected,
irreversible legal transfer. That the receivables are isolated from the originator company means that the
receivables are beyond the legal powers of either the originator company, or the originator companys
liquidator,orcreditors,orforthatmatter,anyonewith aclaimagainstthe originatorcompany.

IntheUnitedStates,arecentlegalchallengethattheholdersofasecurityinasecuritizationareprotected
from the creditors of the originator company when there is true sale is the bankruptcy of LTV Steel
Company, Inc. (LTV). In this bankruptcy, filed in the United States Bankruptcy Court for the Northern
DistrictCourtofOhioonDecember29,2000,LTVarguedthatitstwosecuritizationswerenottruesales
butmerelydisguisedfinancingtransactions,whichmeantthatthecreditorsofLTVareentitledtothecash
flowsoftheassetsthatLTVallegedlymerelytransferredbutdidnotselltotheSPV.LTVinanemergency
motiontothebankruptcycourtinwhichitputforththisargumentaskedthecourtforpermissiontousethe
cashflowfromthetwosecuritizationswiththeprovisionthatLTVprovideadequateprotectiontoholders
of the securitiesissuedin the securitization. While inan interim order the bankruptcy courtgranted LTV
permissiontousethecashflowfromtheassetpoolsusedinthetwosecuritizations,becausethecasewas
settled, thebankruptcycourtdidnothaveto ruleonLTVs argumentofwhethertherewasatruesaleofthe
assets.Aspartofasettlement,therewasasummaryfindingthatLTVstwosecuritizationswereinfacta
truesale.Forinvestorsinthesecuritiesissuedinasecuritization,however,whatwastroublingaboutthis
case isthatthecourtdecidedtopermitLTVtousethecashflowspriortothesettlement4.

Useofspecialpurposevehicles
The dual objectives of transferring assets to investors and at the same time creating a capital market
instrumentcanonlybeachievedbyutilizingatransformationaldeviceknownasanSPV.Thelegalentity
is created for the single purpose of holding the assets sought to be transferred by the originator and the
subsequent issuance of securities suchthat the securities are no different froma claim over those assets.
Thus,investorsdonothavetoacquireorholdtheassetsoftheoriginatordirectly,buttheydosoindirectly
throughtheSPV.TheSPV,asanintermediarybetweentheoriginatorandtheinvestors,sitswiththeassets
asa sortoflegalizedfacadeforthemultifariousandnebulousbody,which aretheinvestors.

Structuredfinanceandsecuritization
The term structuredfinance refers,verybroadly,tofinancialsolutionsorproductswhicharestructuredto
meet specific needs. Inanarrow and more common sense,the word is usedalmost interchangeably with
securitization. We noted in the example above that one of the crucial features of securitization is the
creation of different classes of securities such thattheyareassigneddifferentratings.The seniormost of
thesecuritiesisquiteoftenratedtripleA.Thehighestratingfortheseniormostclassisexplainedbytwo
factors: isolation of the assets from the bankruptcy risks of the originator and hence originator
independenceandthecreationofacreditriskmitigationdevicebysubordinationofclassesBandC,such
thatthoselowerclassesprovidecreditsupporttoclassA.ItispossibletosaythatthesizeofclassesBand
C was so computed as to meet the rating objective for class A. Likewise, the size of class C was so
computed as to have class B accorded the desired rating. In other words, the entire transaction was
engineered,orstructured, tomeetspecificinvestorneeds.

It would be wrong to assume that investors are always interested in triple A rated securities. Quite
obviously,thesecuritieswiththisratingcarrythesmallestspreadtoTreasuriesorsomeotherbenchmark.

4
It should be noted that while true sale is a significant legal issue in securitization, the question is
whetherasaleintrue.Thisimpliesdeterminationofthetruthofwhatisapparentlyasalethequestionis
thereforesubjective.Whilemarketpractitionerstrytolearnfrompastexperienceandconstructtransactions
thatabidebycertaintruesaletests,therecannotbeanabsolutesafe harbour.
Investorshave differentriskreturn profiles, based on theirliability structures, and the objectives of their
respective investors or stakeholders. Hence, there might be yieldhungry investor looking for a triple B
ratedsecurity,butwithasubstantiallyhigherspread.Thus,useofstructuredfinanceprinciplesallowsthe
originatorcompanytocreatesecuritiesthatmeetinvestorneeds.Ratingisnottheonlybasisforstructuring
ofsecurities.Thereareseveralotherfeatureswithrespecttowhichsecuritiesmaydiffer.Interestsensitivity
(i.e., durationand convexity), maturity or average life, cash flow pattern,and prepayment/callprotection
arejustafew examplesofsuchfeatures.

Gettingintodetails
In this section we will take a closer look at securitization by reviewing asset pool characteristics, credit
enhancementmechanisms,liquiditysupport,and others.

Assetpoolcharacteristics
Whatexactlyisanassetpoolandwhatistherelevanceofhavinganassetpoolasopposedtoasingleasset?
One of the essential features of securitization we noted above was the creation of several classes of
securities, and the resulting upliftment of the rating of the senior classes. The whole concept of creating
classes or tranching is based on a probability distribution of default risk, such that the probability of
sufferingextremelosses,thatis,lotsofloansinthepoolgoingbad,is extremely low.

Figure 1 illustrates this point. The probability distribution curve shows the amount of losses and their
respectiveprobabilities.Theprobabilityofhavingnolossatallisabout13.6%.Theprobabilityof1%loss
in the pool is about 27%, and likewise, the probability of 2% of the pool being lost is also about 27%.
However,aswemovetotherighthandside,theprobabilitiesstartdecliningsharply.Theprobabilityofa
7%lossisonly0.3%,andthatoflosing10%is0.003%.Withthosenumbers,anoriginatorcompanycan,
viatheSPV, create fourclassesofsecuritiesasshowninthe Figure1 classDtakingthe bottom3%ofthe
liabilities, class C2% of the liabilities, class B 2% of the liabilities, and class A the balance 93%. Quite
obviously, losses up to 3% will be
ClassD ClassC ClassB ClassA Losses
takenbyclassD,lossesfrom3.01%
to 5% will be taken by class C, from
30.000%
5.01%to7%byclassB,andlossesin
excess of 7% will be taken by class 25.000%
Probabilities

A. 20.000%

15.000%
Theprobability distribution shown in
10.000%
Figure1istheverycruxofstructured
finance.Ifwehadjustoneloan,there 5.000%
is nothing like a probability 0.000%
distribution. There will be only two 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
possible occurrences: either the loan Losses
defaults or the loan survives. If the
loan defaults, most of the loan (1 Figure 1 Probability distribution for a pool of loans and the creation of
recovery rate) is lost. If the loan classesofsecurities
survives, the loss is zero. Hence, as
maybeunderstandablebyabitofreflection,thewholeconceptoftranchingdoesnotworkinthe caseofa
singleasset. Itwouldalsobeobviousthatinorderto developintothe kindofprobabilitydistributionthatis
presentedinFigure1,thepoolmustbediversified.Themorediversifiedandthemoregranularthepool,
themorefinewillbetherighthandsideoftheprobabilitydistribution,makingiteasytocreatetheclasses
ofsecurities.Thefeatureofahighlyconcentricpoolisverysimilartothatofasingleloantransaction.In
fact,thesingleloanmaybecomparedtoapoolwithacorrelationof1(i.e.,allloansaresocorrelatedthat
theloanseitherdefaulttogetherorsurvivetogether).

Whiletheguidingprincipleofdiversificationisunderstandable,howexactlyisthepoolcreated?Inother
words,howdowenarrowdownfromthewholeloanbooktocreatingasecuritizablepool? Recommended
practiceisthatapoolisnotcreatedbycherrypicking.However,elaborateselectioncriteriaisalwaysset
forthsoastoselectassetsthatqualifyfortheselectioncriteria.Thefixationoftheselectioncriteriaitselfis
consistentwiththedesiredqualityofthepool.Forexample,apoolofprimeloanswillnothaveloansthat
failthe prime criteria, but apool of subprime loans willobviouslynot have prime loans.Examples of
selection criteria may be the number of months in default at the time of transfer, number of months in
defaultatanytimeinthepast,minimumandmaximumrateofinterest,minimumandmaximumremaining
maturity,minimumandmaximumLTVratio,minimumandmaximumdebttoincomeratios,andsoon.

Credit enhancement
Having identified theasset pool, themost significanttaskis to understand therisks inherentinthe pool.
Whilethiswilldependlargelyonthetypeofcollateral,formostfinancialassetstherewillatleastbethe
following risk areas: credit risk, that is, the risk of default liquidity risk, that is, temporary shortfalls in
collections or cash flows, so that cash falls interest rate risk and in case of certain collateral classes,
principally those forlongtenures such asresidentialmortgageloansand commercial mortgageloans,the
riskofprepayment

Creditenhancementreferstothedevicesputinplacetomitigatetheriskofdefaultinthe assetpool.Aswe
have mentioned earlier, the sizing of credit enhancement is done so as to achieve a target rating for the
securities.Thecreditenhancementlevelforeachclassofsecurity isdifferent,asmightbeevidentfromthe
probabilitydistributioninFigure1.

ExcessspreadThemostbasicandthemostnaturalformofcreditenhancementforanypoolisthelevel
ofexcessspreadinherentinthetransaction.Excessspreadisthedifferencebetweentheweightedaverage
rateofinterestinherentinthereceivables(thisistrueforloansorloantypetransactions)andtheweighted
averagefundingcostofthetransaction.Sincethereceivablesaremostlytransferredatpar,theloanscarry
the same rate of interest at theSPV level as they carried at the originator level. The funding cost of the
transaction is the coupons payable on the different classes, which is obviously lesser than the weighted
averagerateofinterestontheloans,thusleavingtheexcessspread.

Oneofthemostbasicprinciplesofpricingofloansisthatthelenderchargesariskpremiumforcreditrisk,
thatis,theexpectedlosses ontheassetpool.Hence,theexcessspreadispresumablysufficienttoabsorb
the expected losses from the asset pool, and other forms of enhancement, noted below, are needed
essentially for unexpected losses. However, there are several situations where the excess spread is either
notenough,orismorethanenough,dueto,forinstance,movementsinratesofinterest,higherorigination
profits,presenceofsubventionorpromotionalloans,etc.

Excess spread is the most common form of basic credit enhancements in a securitization transaction.
However,excessspreadlevelsareaffectedbytherateofprepayment,sincecostlierloansintheassetpool
areexpectedtohaveahigherpropensitytobeprepaid.Hence,excessspreadlevelsmayfallovertime.In
rarecases,excessspreadlevelsmay dojusttheopposite.

Subordination Creation of a stacking order of liabilities is also the most common, almost universal,
featureofsecuritization.Inourearlierexample,classesA,B,C,andDrepresentthefourdifferentclasses.
ClassDisthe mostjuniorofall andisreferredtoas the firstlossclassthatis, itisthe firstclassofsecurity
to suffer losses if the losses exceed excess spreads. Class C has the benefit of subordination of class D
therefore, the credit enhancement at class C level is 3% plus the excess spread. Likewise, the credit
enhancementattheclassBlevelis5%plustheexcessspread,andthatoftheclassAlevelis7%plusthe
excessspread.

Overcollateralization In appropriate cases, the same impact as in the case of subordination can be
created by overcollateralizing theliabilities. For instance,if thetotal fundingraisedis U.S.$100 million
andifassetsbackingthemupareworthU.S.$105millionwehavea5%overcollateralization.Theover
collateralizedassetsareasortofsubordinatedshareoftheseller,whichisavailabletooffsetlossesinthe
pool.

External credit enhancements If the repayment of any of the classes of liabilities is guaranteed or
backed by the credit of a third party, that form of credit enhancement is referred to as external credit
enhancement. The most common form of such credit enhancement is the guarantee from a financial
guarantee company, or a monoline insurance company. Monoline insurance wraps or external
enhancements are most commonly used in transactions which have a strong originatordependence (for
example,servicingriskistoohigh),orwherethecollateralislocatedinjurisdictionswhichdonothavea
testedhistoryofeithersecuritizationorenforcementofclaims.

Liquiditysupport
Whilecreditsupportisneededtoabsorbdefaults,liquiditysupportisrequiredtomeettemporaryshortfalls
in collections such that the expected schedule of payments to investors may be maintained without
disruption.Themostcommonreasonfortheshortfallsisthemonthlyarrearsincollections,soverylikely
in case of retail pools. Themost common forms of liquidity support areservicer advances, cashreserve,
andexternallineofcredit. Cashreserve,itmay benoted,isbothaformofcreditandliquiditysupport.The
cashreserve might either be funded outright ormay be created by pooling excess profits until thetarget
amountofreserveiscreated.

Prepayment riskmitigation
Prepayments,thatis, therepaymentofaloanorpartthereofpriortoitsschedule,isquiteacommonfeature
inthecaseofassetpoolsbackedbyretailloans.Incaseofresidentialmortgageloans,aloanmaybepaid
before final maturity either because thehouse is sold or becausethe borrower finds it better torepay the
existingloantakenatahigherrateandrefinancethe property atalowerratethat may prevailinthemarket.

To the extent prepaymenthappens fornoneconomicreasons, such as thesale of theproperty, itwillnot

resultinanadverseeconomicoutcomefortheinvestoriftheprevailingmarketmortgagerateislessthan
thenote rate paid by the borrower. However, ifthe borrower elects to prepay because it is economically
beneficial because the prevailing mortgage rate is less than the note rate paid by the borrower, this will
haveanadverseeconomicconsequencefortheinvestor.Whileprepaymentisariskinallcaseswherethe
borrower is contractually permitted to prepay without marktomarket losses, it causes the maximum
damage in case of longtenure collateral classes such as residential mortgage loans and commercial
mortgage loans5. Therefore, prepayment protection devices are mostly limited to securitizations of these
typesofassetsonly.

A common prepayment protection device used in mortgage securitizations is the prepaymentprotected

classessuchasplannedamortizationclassstructures.Similartothewayinwhichthesubordinatedclasses
provide credit support to the senior classes, there is a support class that sweeps more than the expected
prepaymentandthusprovidesprepaymentprotectiontotheplannedamortizationclass.Yetanotherdevice
istodifferentiallyallocateprepaymentofprincipaltodifferentclassessuchthatoneclassismoresensitive
toprepaymentsthanothers.

Motivationsforusingsecuritization
Securitizationappealstobothnonfinancialandfinancialcorporations.The fourprimaryreasonsforraising
fundsviasecuritizationarereviewedbelow.6

Potentialfor reducing fundingcosts

The cost of funding depends on thecreditratingassignedto a debt obligation issued by an entity. Inthe
caseofacorporatebond,theratingwilldependonthecreditquality ofthecorporation.Inthecaseofan
SPV,becauseoflegalpreferenceanddeference,theratingagencieswillassignaratingtoeachsecurity ina
securitization based on the expected performance of the asset pool and the priority of a security in the
structure.WhatiskeyisthattheratingassignedtoeachsecurityissuedbytheSPVwillbeindependentof
the financial condition of the originator company. Consequently, the originator company can have a
speculativegraderatingbuttheSPVcanissueoneormoresecuritieswithamuchhighercreditrating.The
rating agencies evaluating the securities in the structure will advise the originator company on how the
transaction must be structured in order to obtain a specific rating for each security in the securitization.
More specifically, the issuer will be told how much credit enhancement is required in the structure in

5
Unlike residential mortgage loans, commercial mortgages have different forms of prepayment penalties
embeddedintheloanagreement.
6
For regulated financial entities there is another reason for securitization. It is a tool for managing risk
basedcapitalrequirements(i.e.,attainingoptimalcapitaladequacystandards).
order to achieve a specific credit rating for each bond class. The higher the credit rating sought by the
originatorcompany,themorecreditenhancementaratingagencywillrequirefora givencollateral.

Evenafterfactoringinthecostofcreditenhancementandotherlegalandaccountingexpensesassociated
withasecuritization, thebehavioroffirmsprovidessupportthat securitizationis lessexpensivethan
issuingcorporatebonds.Forexample,considertheautomanufacturers.In2001,theratingdowngradesof
thefirmsinthisindustrypushedFordMotor,GeneralMotors,andToyotaMotortoissueinearly2002
assetbackedsecuritiesbackedbyautoloans ratherissuecorporatebonds.ConsiderthecaseofFordMotor
Credit.ItissuedU.S.$5billioninthefirsttwoweeksof2002.Since2000whentherewasthefirstthreatof
theparentcompanyscreditratingbeingdowngraded,FordMotorCreditreduceditsexposurefrom
U.S.$42billionto U.S.$8 billion,substitutingthesaleofsecuritizedcarloansratedtripleA.Infact,from
2000tomid2003,FordMotorCreditincreasedsecuritizationsto U.S.$55billion(28%ofitstotalfunding)
fromU.S.$25billion(13%ofitstotalfunding).Itisnoteworthythatasthe ratingsoftheauto
manufacturersweredowngradedinMay2005,theratingsonseveraloftheirsecuritizationtransactions
wereactuallyupgradedduetohighsubsistinglevelsofcreditenhancement.

Diversifyingfundingsources
Corporationsseekingfundingintheassetbackedsecuritiesmarketmustbefrequentissuersinthemarket
inordertogettheirname recognizedintheassetbackedsecuritiesmarketandtocreateareasonablyliquid
aftermarketfortradingtheirsecurities.Onceanissuerestablishesitselfinthemarket,itcanlookatboth
the corporate bondmarket and the assetbacked securitiesmarketto determineits best funding source by
comparingtheallincostoffundsinthetwomarkets,aswellasnonquantifiablebenefitsassociatedwith
securitization. [Forafurtherdiscussion,seeChapter9inKothari(2006).]

Managingcorporaterisk
Securitizationisoneofseveralcorporateriskmanagementtoolsavailabletomanagement.Whenassetsare
sold in a securitization, the originating company no longer bears the interest rate or credit risk of those
assets. Ford Motor Credit offers a good example of this. Since 2000, management has employed
securitizationtoreduce thecreditriskofits carloanportfolio.

Achievingoffbalancesheetfinancing
If properly structured, securitizations remove assets and liabilities off the balance sheet of the originator
company.Theargumentputforthbythosewhoemploysecuritizationisthatthe reductionintheamountof
the originator companys onbalancesheet leverage can help enhance its return on equity and other key
financialratios. However,it is probably reasonable toassume that todaymany equity and corporate debt
analystsgiverecognitiontobothreportedandmanaged(i.e.,reportedplusoffthebalancesheet)leverage
intheiranalysisoffirmsthatutilizesecuritization,particularlyfollowingtheactionsbytheSecuritiesand
Exchange Commission (SEC)7 and the Financial Accounting Standard Board (FASB)8 regarding off
balancesheetfinancingaftertheEnronbankruptcy.

Itisimportanttonote,however,thatSPVsinsecuritizationhadnothingtodowithhowSPVswereusedby
Enron to mislead investors. Enrons management used SPVs for a variety of illegal purposes.
Unfortunately, this tainted the view of SPVs in the mind of the public despite the fact that SPVs for
securitizationsareusedinquiteadifferentwaythantheirabusiveusebyEnron.

7
More specifically, SECrequirements, Section 401(a) of the SaxbanesOxley Act of 2002 (SOX)andits
amendments deal with disclosure in periodic financial reports. With respect to offbalance sheet
transactions, SOX requires that a company in its annual and quarterly filings with the SEC discloses all
material offbalance sheet transactions, arrangements, obligations (including contingent obligations), and
other relationships of the issuer with unconsolidated entities or other persons, that may have a material
current or future effect on financial condition, changes in financial condition, results of operations,
liquidity,capitalexpenditures,capitalresources,orsignificantcomponentsofrevenuesorexpenses.
8
Thebasic financialreportingissue iswhetherornottheSPVshouldbeconsolidatedwiththecorporation.
The FASB on January 17, 2003 issued FASB Interpretation No. 46 (Consolidation of variable interest
entities), acomplexsetofrulesandprinciplesforconsolidationapplicableto SPVs.
Securitizationandfinancialdisintermediation
Withtheaidofsecuritizationcorporateborrowerscanobtainfundsdirectlyfromthecapitalmarketrather
than from financial intermediaries such as banks. In the absence of a public debt market, all financial
transactionsinvolvingcorporateborrowingaredonedirectlywithalender.Letusassumethatthepotential
lendersareindividual investorsand thereareno financialintermediaries. In this scenario, there will be a
direct lenderborrower relationship between the individual investor and the corporate borrower. The
individual investor must have the ability to analyze the financial condition of the corporate borrower,
preparethelegaldocumentationfortheloan,servicetheloan,and,iftheborrowerfailstoperform,institute
legalproceedingsagainsttheborrowertorecovertheoutstandingprincipalandunpaidinterestfortheloan.
Morethanlikely,anindividualinvestorwillnothavethecapabilityofperformingtheseservicesandmust
therefore engage third parties to undertake theseactivities,paying a fee forthese services. Moreover,the
lendermusthave sufficient funds to provide the full amount of the fundsrequested by the borrower and
agreetoaccepttheentirecreditrisk.Ofcourse,thelendercouldaskotherindividualstoparticipateaspart
of a lending groupto obtain a larger pool of fundsthat can be lent,as well as spreadthe creditriskand
othercostsassociatedwiththeloanamongthemembersofthegroup.

At least three problems arise in a world without public debt markets and financial intermediaries:
transactionaldifficulty,informationaldifficulty,andperceivedrisk.Transactionaldifficultyarisesbecause
an individual investor may not have sufficient funds to satisfy the amount needed by the borrower, nor
mightthetenureoftheloansoughtbytheborrowermatchwhattheindividualinvestoriswillingtogrant.
There is informational difficulty because the individual investor may not be capable of assessing the
creditworthinessoftheborrower.Finally,theindividualinvestorsperceptionoftheriskassociatedwitha
loan will be based on only the creditrisk of the borrowerwithno opportunity to diversify thatrisk over
otherborrowers.

Itisbecauseofthesedisadvantagesassociatedwithindividualinvestorslendingtocorporations,aswellas
lendingtootherindividuals,that thereisa needforfinancialintermediaries.Afinancialintermediaryraises
funds from individual investors and then uses those funds to lend to corporations and individuals.
Consequently, it can accommodate the demand for a larger amount of funds than a typical individual
investor. Financial intermediaries provide one or more of the following three economic functions: they
providematurity intermediation,reducerisk viadiversification,andmitigatethe costs of contractingand
informationprocessing.Let uslookateachofthese.

Afinancialintermediary,suchasabank, canprovideloansforalengthoftimethatcanaccommodatethe
needsofaborrower.Thisisdifficultforanindividualinvestortodo.Afinancialintermediarymakesloans
witharangeofmaturitiesdespitethefactthattheclaimsitissuesonitselfcanbeshortterm.Forexample,
abankcanborrowfundsbyissuingcertificatesofdepositwithmaturities rangingfromsixmonthstofive
yearsandyetmanageitsdurationriskexposuresoastobeabletoissuebankloansfromthreemonthsto
say10years.Thisroleperformedby financialintermediaries, referredtoasmaturityintermediation,has
two implicationsforfinancialmarkets.

Firstly,itoffersborrowersmorechoicesforthematurityfortheirloansandinvestorswithmorechoicesfor
thematurityoftheirinvestments.Secondly,itlowersborrowingcostsbecausewhileanindividualinvestor
maybereluctanttocommitfundsforalongperiodoftimeandtherebychargeborrowersahighercostto
extendmaturity,afinancialintermediaryiswillingtomakelongertermloansatalowercosttothe
borrower.Hence,borrowingcostsarereduced.

Individualinvestorswhohaveasmallsumto investwouldfinditdifficulttoachieve diversification. Yet

byinvestinginafinancialintermediary,individualinvestorscanattaincosteffectivediversification.

Financialintermediariesmaintainstafftohandlethetasksassociatedwithgranting aloan.Theseassociated
costs,referredtoas informationprocessingcosts,canbedonemoreefficientlybyfinancialintermediaries
thanbyindividualinvestors.Thecostsofwritingloancontractsandenforcingthetermsoftheloan
agreement,referred toas contractingcosts,canalsobedonemorecosteffectivelybyfinancial
intermediaries, as comparedtoindividualinvestors.Thisreducesthecostofborrowingforthoseseeking
funds.
Letusseehow securitizationcanfulfilltheseroles.Considerfirstmaturityintermediation.Aswehave
explained,apoolofassetscanbeusedtocreateassetbackedsecuritieswithdifferentmaturityranges.For
example,apoolof30yearresidentialmortgageloanscanbeusedtocreatesecuritieswithmaturitiesthat
areshort,intermediate,andlongterm.Diversificationwithinanassettypeisaccomplishedbecauseofthe
largenumberofloansinatypicalsecuritization.Finally,thecostsofcontractingandinformation
processingareprovidedinassetsecuritization.Thecontractingcostsareprovidedbytheoriginatorofthe
loans.Informationprocessingisprovidedattwolevels.Thefirstiswhenaloanisoriginated.Thesecondis
whenaratingagencyratestheindividualassetbackedsecuritiesinthetransaction.

Thereisoneactivitythatisperformedbysomefinancialintermediariesthatisnotreplacedby
securitization.Theassetbackedsecuritiescreatedfromasecuritizationtransactionmuststillbedistributed
tothepublicandasecondarymarketmaintained.Technically,thedistributionofsecuritiesandthe
maintainingofsecondarymarketsisnotaroleofafinancialintermediary.Rather,itistheroleplayedby
investmentbankers.Asmorecorporationsshiftfromborrowingfromfinancialintermediaries,theroleof
underwritingbyinvestmentbankswillincreasewhiletheirroleaslenderswilldecline.Thus,witha
securitization,thetypesoffeesgeneratedbyfinancialintermediarieswillchange.Feeincomefromloans
andthecorrespondingcostschargedingrantingthoseloans(whichareembeddedintheloanrate)willbe
replacedbyfeesfordistributingandmarketmaking.

A concern with financial disintermediation is that it may reduce the effectiveness of monetary policy
because banks derive more of their funding from capital markets likewise, disintermediation results in
more direct funding by capitalmarketsrather thanthroughbanks.Thus during periods of tightmonetary
policy,bankscanoriginateloansandthensecuritizetheloansratherthanholdingthemintheirportfolio.
This avoids the need for banks to fund theloans originated. Loutskina and Strahan (2006), for example,
showhowsecuritizationhasweakenedthelinkbetween bankfundingconditionsandcreditsupplyinthe
aggregate and asaresulthasmitigated thereal effects of monetary policy. Frame and White (2004) and
BankforInternationalSettlements(2003),forexample,haveshownthatthemortgagehedgingactivitiesof
thetwogovernmentsponsoredentities,FannieMaeandFreddieMac,haveattimesmovedTreasuryrates.
Two empirical studies by Federal Reserve economists support the view that based on mortgage loans
securitizationhashadasignificantimpactonmonetarypolicy[Estrella(2002)andKuttner(2000)].

Conclusion
Securitizationisasnecessarytoanyeconomyasorganizedfinancialmarkets.Ashasbeenexplainedinthe
article,securitizationresultsinthecreationoftradablesecuritieswithbetterliquidityfromfinancialclaims
that would otherwise have remained bilateral deals and been highly illiquid. For example, very few
individualinvestorswouldbewillingtoinvestinresidentialmortgageloans,corporateloans,orautomobile
loans. Yet they would be willing toinvest in a security backed by these loantypes. By making financial
assets tradable in this way, securitization reduces agency costs thereby making financial markets more
efficient and improves liquidity for the underlying financial claims thereby reducing liquidity risk in the
financialsystem.

A concern with securitization is that with lenders able to remove assets that they originate from their
balance sheet and therefore transfer credit risk via securitization, this process has motivated lenders to
originateloanswithbadcredits.Giventheabilityoflenderstopassalongsubprimeloansintothecapital
marketviacreditenhancementthatwehavedescribedinthisarticle,lendershavebeenviewedbycriticsof
securitizationasabandoningtheir responsibilityofevaluatingthecreditworthinessofpotentialborrowers.

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