Securitization 201:Analytics for Cash Securitization

American Securitization Forum – Education Institute Seminar

January 2006

CONFIDENTIAL

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Executive Summary

Issuer Considerations

Traditional Structure and Enhancements

Investor Considerations

Spread Methodology and Valuation Analysis

Model Input Assumptions and Results

Appendix

Rating Agency Consideration

Table of Contents

Executive Summary

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Executive Summary

The objective of this sessions is to present the framework and pricing analysis for most types of cash structure securities

The presentation will cover the following items:

Rating agency considerations and collateral level risk measurements as inputs

Issuer considerations and benefits of issuing asset backed securities

Investor considerations for purchasing asset backed securities

Valuation of structured securities for amortizing and non-amortizing asset types

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Asset Backed Securities – Amortizing Loans

Credit Sensitive structured products – must deal with credit and prepayment risk

Amortizing Loans (Mortgages, Auto)

Borrowers make periodic monthly payments over the life of the loan that includes scheduled and unscheduled principal and interest

Set Repayment schedule – Amortization Schedule

Projection of cash flow requires projection of non contractual prepayments (excess principal payments) and defaults

Recovery of defaults will lead to prepayments (“involuntary prepayment”) of the principal balance

Defaults can lead to decrease of cash flow due to non payment though only after recovery has been received

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Asset Backed Securities – Revolving Loans

Revolving Loans (Credit Cards, Trade Receivables)

Do not have a schedule for the periodic payment

Instead borrower makes a minimum periodic payment

If payment less than the interest than the outstanding balance will increase

If payment is greater than the interest or additional borrowings than the outstanding balance will decrease

The concept of prepayment does not apply (e.g. Credit Cards)

Issuer Considerations

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Benefits of issuing an asset backed security

The creation of a bankruptcy remote Special Purpose Vehicle (“SPV”) allows for higher credit rating based on the credit quality of the isolated asset in a stand alone entity compared to the corporate issuer leading to a lower cost of funds

SPV requirements

Bankruptcy remote/non consolidation opinion– based on legal opinions

True Sale of Asset to separate legal entity – validates sale of asset

Based on credit enhancement will be rated by the rating agency for collateral and enhancement levels and not corporate issuer

A sub-investment grade originator may issue at AAA if they have the appropriate enhancement level and legal structure

Ratings Factors

Credit quality of the collateral based on the historical default and recovery rates

Longer external and/or internal credit enhancements

The quality of the Seller/Servicer

Cash flow and stress payment structure – model to assess cash flow deviation from the payment schedule (may be as simple as historical pattern or as extensive as a macroeconomic model)

Legal Structure

Facilitates the liquidity and growth of certain consumer finance products (Credit Card, Mortgages)

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Corporate Bond vs. Asset Backed Securities Credit Analysis

Only requirement is evaluation of cash flows under certain stressed scenarios to determine the timing and magnitude o f shortfalls on schedule cash receipts

Delinquencies

Defaults/Recoveries

Prepayments

In a true securitization repayment is not dependent on the ability of the Servicer to replenish the pool with new collateral or to perform more than routine administrative

functions (1)

(1) Standard and Poors, “Rating Hybrid Securitizations” Structured Finance (October 1999)

Traditional Structure and Enhancements

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Traditional Structure

Bankruptcy Remote

Special Purpose Vehicle (“SPV”)

Originator(1)(2)

TrusteeServicer(1)

Investors

Internal Credit Enhancement

External Credit Enhancement

True Sale

Services

Service Fee

Trustee Fee

Services

$ Assets

$Principal

and Interest

(1) Originator and Servicer often are the same entity(2) Sometimes Servicer/Originator may take a subordinate position in the pool

providing some of the structural credit enhancement

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Revolving Structures

Structured securities from revolving, not amortizing pools of collateral, tend to fall into one of four categories

Credit Card Series

Collateralized Debt Obligation

Single Seller Conduits

Asset Backed Commercial Multi-Seller Conduits

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Credit Enhancement Mechanics

External – 3rd party guarantee

Parental guarantee (this jeopardizes the possibility to issue debt rated above the parent rating)

Letter of Credit (provided by Banks, tied to the Banks Rating)

Bond Insurance (Monoline)

Disadvantage to external credit enhancement is the subjectability to the credit risk of the 3rd party (“weak link” test)

Internal

Reserve Fund

Cash reserve fund (cash deposit invested in eligible investments)

Excess Servicing Spread Account (allocation of the excess spread into a reserve account)

Overcollateralization – Seller Interest taken by the Originator

Amount of collateral in excess of the amount of the liability

Senior/Sub Structures

Most popular form

Level of protections changes over time due to prepayments

Shifting interest mechanisms may offset prepayment but need to assess contraction vs. credit risk

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Cash flow and Payment Structure

Passthrough

Senior Tranche and the CF distributed pro rata to the bond holders (e.g. participation certificates)

Paythrough

Senior tranches divided into additional tranches that follow different payment priorities from the cash flow of the collateral

Cash flow needs to pay the following:

Principal

Interest

Fees (Servicer Fee, Credit Enhancement, Trustee Fee etc.)

Agency will analyze if the Cash flows match the obligations and stress the cash flow by shocking the following:

Losses (seasoned loss curves): Delinquencies, Gross Losses and Net Losses

Interest rates

Prepayments (CPR, MPR, SMM)

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Rating Agency Risk Measurement Framework

Two parallel risk measurement systems have evolved within the rating agency world for securitization, one focused on defaults, the other focused on loss or yield. And so there are at least three types of scores at use in today’s market:

Defaults: the cash runs out and the investor is not paid in full;

Expected Losses: the shortfall by which the initial bond price exceeds the present value of cash flows to the investor, discounted at the promised level of yield; or

Structuring a transaction means selecting the metric by which to rate the deal, obtain cash flow results from different scenarios, and use the score as an internal feedback to develop a final transaction structure.

Two traditions of scenario analysis have developed alongside the two philosophies of risk scoring.

In one tradition, stresses are developed based upon a consensus determination of what severity means in historical terms, and they are used to make the structure bullet-proof.

In the other tradition, a microstructure of risk is ascribed to the collateral, and a simulation of the impact of the asset risk microstructure on liability cash flows is examined in a simulation framework.

Investor Considerations

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Investor Considerations

Upside

Relative Value return for Investor

Ratings needs, Insurance companies need the NAIC bands

Payback/paydown needs

Appetite for prepayment and interest rate risk - need compensation for negative convexity effect on HELOC and MBS related products

Better security through direct claim to assets

Rating resilience

Higher rating stability than comparably rated corporates

Key Reason for subordinated investors is the possibility of upside

Existence of a legally binding payment waterfall in a structured transaction

Trustee controlling money

High standard of ongoing data disclosure

Orderly transition of certainty in bond performance with the passage of time from less certain to more retain

Downside

Uncertainty of cash flows

Modeling – specialized knowledge required in some sectors

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Extension and Contraction Risk for Amortizing Asset

Increased prepayment risk – refinancing

Increased reinvestment risk at lower rate

Reduced prepayments – competitive rates

Inability to reinvest to generate higher return

Contraction Risk Extension Risk

Decrease Interest Rate Environment

Increase Interest Rate Environment

t0tn tn

CollateralCashFlow

Methodology and Valuation Techniques

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Valuation Methodology

Yield to Maturity (“YTM”) = interest rate that makes the Present Value of the expected Cash flow = Market Price

The benchmark for an amortizing asset is based on the weighted average life and not the maturity

Bond Equivalent Yield allows comparison of Yield to Treasury

For Bonds 2X Semi-annual which is not true for ABS/MBS due to monthly cash flow and ability reinvest

Bond Equivalent Yield = 2 [(1+im)6 – 1] where

Im= Yield

Assume monthly yield 0.6%

BEY = 2 x [1 + 0.06%]6 -1] = 0.0731 = 7.31%

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Limitations to Cash flow yield curve

For YTM (“IRR”) as a measure the investor must assume

Reinvest the coupon payments at a rate equal to the Yield to Maturity

Requirement to hold the bond until maturity

YTM for long term bonds say little since reinvestment is a big (potentially over 60%) of the potential $ value

Reinvestment Risk

Risk may exist to reinvest at a lower rate then computed yield

Interest Rate Risk

Risk associated with having to sell a security before its maturity date at a price less than purchase price

Uncertainty of Cash flow

May shift due to changes in the actual cash flows due to:

Prepayment

Default

Recovery

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Limitations to Cash flow yield curve

Given YTM and zero coupon rate Longer maturity the more the bonds total $ return is dependent on reinvestment income to realize the YTM at time of purchase

and therefore has a greater reinvestment risk. (Z-spread)

Given YTM and maturity for a coupon bond Higher coupon will lead to more risk of the reinvestment of the coupon payment at the coupon in order to produce the YTM

A bond selling at premium will be more dependent on reinvestment income than a bond selling at par because reinvestment has to make up the capital loss when holding the bond to maturity. In contrast, bond selling at par because of capital gains to be realized at maturity.

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Types of Spreads – Nominal, Z-Spread, Option Adjusted

Nominal Spread

Difference between the cash flow yield and the benchmark Treasure yield based on the weighted average life of the bond

Zero Volatility Spread - Z-Spread

Measure of spread the investor would realize over the entire Spot Rate Curve if the Bond was held to maturity. It is not the spread at one point of the yield curve as the nominal spread

Option Adjusted Spread – OAS

The constant spread added to all 1 year rates on the binomial tree that creates the arbitrage free value equal to the market price

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Nominal Spread

Nominal Spread

This spread masks the fact that a portion of the nominal spread is compensation for the prepayment risk. A support tranche may have a high nominal spread that may not be collected if repayments occur.

Nominal Spread includes

Credit Risk

Liquidity Risk

Option Risk

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Zero Volatility Spread – Z-Spread

Z-Spread

Measure of spread the investor would realize over the entire Spot Rate Curve if the Bond was held to maturity. It is not the spread at one point of the yield curve as the nominal spread

Calculated as the spread that will make the PV of the CF from the non-treasure bond when discounted at the treasure spot curve rate plus the spread, = the market price of the bond

Determination of the Z-Spread for an 8%, 10-year Non-Treasury Isue Selling at $104.19 to yield 7.4%

Period Years Cash flow ($) Spot Rate (%) 100 bp 125 bp 146 bp1 0.50 $4.00 3.0000 3.9216 3.9168 3.91272 1.00 $4.00 3.3000 3.8834 3.8240 3.81623 1.50 $4.00 3.5053 3.7414 3.7277 3.71634 2.00 $4.00 3.9164 3.6297 3.6121 3.59735 2.50 $4.00 4.4376 3.4979 3.4767 3.4596 3.00 $4.00 4.7520 3.3742 3.3497 3.32937 3.50 $4.00 4.9622 3.2565 3.2290 3.20618 4.00 $4.00 5.0650 3.1497 3.1193 3.0949 4.50 $4.00 5.1701 3.043 3.0100 2.982610 5.00 $4.00 5.2772 2.9366 2.9013 2.871911 5.50 $4.00 5.3864 2.8307 2.7933 2.762212 6.00 $4.00 5.4976 2.7255 2.6862 2.653713 6.50 $4.00 5.6108 2.621 2.5801 2.546314 7.00 $4.00 5.6643 2.5279 2.4855 2.450415 7.50 $4.00 5.7193 2.4367 2.3929 2.356816 8.00 $4.00 5.7755 2.3472 2.3023 2.265217 8.50 $4.00 5.8331 2.2593 2.2137 2.175818 9.00 $4.00 5.9584 2.1612 2.1148 2.076619 9.50 $4.00 6.0863 2.0642 2.0174 1.97920 10.00 $4.00 6.2169 51.1833 49.9638 48.963

Total 107.5910 105.7166 104.2144

Present Value assuming Spread of

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Zero Volatility Spread – Z-Spread

Represents risk for Credit

Liquidity

Option

Z-Spread can be set to any benchmark

Libor

Treasury

Issuer

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What does the Z-Spread mean

When benchmark is the Treasury Spot Curve

Z-Spread incorporates

Credit Risk

Liquidity Risk

Option Risk

When benchmark is the spot rate of the issuer

Z-spread incorporates

Liquidity risk of the issuer

Option risk

For the issuer rate as a benchmark the credit risk is not incorporated in the spread

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Divergence Z-Spread and Nominal Spread

Typically for standard non coupon paying bonds with a bullet maturity the z-spread and nominal spread will not differ significantly

Divergence function of

Term structure of interest rate

Short term issue has small divergence due to shape of the yield curve

Steeper spot curve leads to divergence in spread

Basically flat yield curve uses the same discount rate as the YTM

Characteristics of security

Coupon rate

Time to maturity

Z-spread greater at steep yield curve environment due to reinvestment of the payments

Type of principal repayment provision (amort or non-amort)

Increased divergence for principal payment over time instead of as a bullet at maturity

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Option Adjusted Spread - OAS

Option Adjusted Spread

Developed as a measure of the yield spread to allow conversion of price differences to yield spread to determine relative value. Gives you a basis for comparing bonds after eliminating the cost of the prepayment option the structure has

If on the run Treasury is used as a benchmark the OAS measures Credit Risk

Liquidity Risk

OAS can be set to any benchmark when you bootstrap the curve to maturity

To compare need to review OAS assumptions since very dependent on valuation model

Volatility assumptions

Benchmark curve assumptions (Treasury Spot Curve, Libor, Issuer)

i-rate volatility big driver

Higher interest rate volatility leads to a lower OAS, option to structure is worth more

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Option Cost

Option Cost = Z-Spread – OAS

At no volatility (static) interest rate environment no option cost exists

For most MBS/ABS the option cost is positive because borrowers ability to alter the cash flow will result in an OAS less than the z-spread.

Option Cost

Positive

Investor sold option to Borrower/Issuer

Negative

Investor has purchased an option form the borrower or issuer

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Pitfall of the nominal spread

Z-spread = OAS + Option Cost

Z-spread = nominal cost @ short term flat yield therefore

Nominal Spread = OAS + option cost

High amount of nominal spread could include significant amount of option cost – spread investor has given the issuer/borrower

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Valuation of ABS and Spread Utilization

Two approaches to value ABS transactions

Zero Volatility Spread - Z-Spread

Option Adjusted Spread – OAS

ABS has one of the following three characteristics

The ABS does not have a prepayment option (e.g. Credit Card, Trade Receivable)

Z-Spread – since no prepayment there is no option cost and the OAS and Z-spread are equal

The ABS has a prepayment option but borrowers do not exhibit a tendency to prepay when refinancing rates fall below the loan rate (e.g. Auto Loans)

Z-Spread – since no prepayment there is no option cost and the OAS and Z-spread are equal

The ABS has a prepayment option and borrowers do exhibit a tendency to prepay when refinancing rates fall below the loan rate (e.g. Mortgages)

OAS – Prepayment and therefore interest path dependent - option cost needs to be assessed

Model Input Assumptions and Results

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Model Cash Flow

Cash flow is generated by incorporating

A monthly interest rate to discount the cash flow

Incorporate a refinance/prepayment rate

Loss/recover assumptions (cumulative loss curve)

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Cumulative Loss Curve

Construct for analyzing the credit deterioration is the cumulative loss curve

Losses reduce the return principal and interest for investors

The cumulative loss curve plots the cumulative losses/charge offs to the initial outstanding loan balance of the pool

Relation between prepayment and expected loss

As obligors prepay , even though the charge off rate rises, the cumulative loss rate slows down

In such cases, it is important to examine the hazard rate, the rate of charge off relative to the then outstanding loan balance

To normalize spikes a 6-month time horizon is recommended

For a typical portfolio, the hazard rate ascends as the portfolio seasons; however, the cumulative loss rate tends to flatten as the impact of the ascending rate is reduced by the reduction in the pool size

Since corporate bonds do not amortize the loss curve or a similar performance matrix does not exist

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Model Assumptions - Payment Rate

Credit Cards

MPR = Monthly Payment Rate

MPR = Collections / Beginning Debt Balance for the month

Auto Loan

ABS = prepayment as % of original collateral amount

SMM = prepayment based on prior months balance (i.e. monthly CPR) (includes impact of seasoning)

ABS = SMM / [1 + [SMM x (M -1)]]

Mortgages

CPR = Conditional Prepayment Rate

Determined based on prepayment and default model

% per annum (physical calculation does not factor in seasoning)

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Prepayment impact

Prepays principal and reduces total interest (excess spread)

Reduces the weighted average maturity of the pool (duration)

May impact the quality of the pool

Introduces callability risk

May increase Reinvestment rate or lead to extension risk

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Duration - Measuring Interest Rate Risk

Duration and convexity is used to estimate the interest rate exposure to parallel shifts in the yield curve

Duration measures the price sensitivity to changes in the interest rate

Duration = (V- + V+) / 2 x V0 (y)

Where

y = change in rate used to calculate new values (i.e. change in interest rate)

V+ = estimated value if the yield is increased by y

V- = estimated value if the yield is decreased by y

V0 = initial price (per $100 of par value)

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Model Outputs

Rating Agencies

Analyze credit quality of the collateral

Assess required credit enhancement for rating levels through

selecting the metric by which to rate the deal

obtain cash flow results from different scenarios

use the score as an internal feedback

Issuer

Determine credit enhancement to analyze transaction cost

Investor

Verify credit

Verify yield assumptions - price yield curve

Estimate duration

Appendix

Rating Agency Considerations

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Credit Quality of the Collateral

Analyzed by asset type

Evaluation of borrowers’ ability to pay its obligation

Review of originators collection and underwriting experience in the asset class to assess default probabilities and loan characteristics (i.e. standard or customized)

Review Pool diversification for concentration risk

Greater concentration may lead to more default risk and increase credit risk

Limit concentration based on credit risk based concentration limits

Can be geographic, industry, individual obligor, collateral type, maturity, interest. Agencies have requirements by asset type

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Quality of Seller/Servicer

Agencies require all loans to be serviced

Servicing involves

Collection and application of monies to SPV

Delinquency notification

Recovery and Liquidation of collateral

Administration of the loan portfolio including

Distribution of proceeds according to the payment waterfall

Reporting

In many transactions the Servicer is the Originator

A backup or specialty Servicer may be required if Originator is of low credit quality

The role of the Servicer is critical in an Asset Backed Transaction since the issuer is not a corporation with employees but simply loans and receivables

Rating Agencies will review the following to determine if Servicer is acceptable or not

Backup Servicer may be requested if not

Servicing History and experience in the asset class

Underwriting Standards

Servicing capabilities and scalability – available human resources

Financial condition

Growth and competitive business environment

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Corporate Bond vs. Asset Backed Securities Credit Analysis

Significant difference due to required cash flow analysis

Management of the corporation must undertake necessary activities to generate and collect revenues and incur costs for creating new products and services

Corporate Bond Analysis needs to include:

Issuers Character

Quality of Management and track record

Strategic position

Financial philosophy

Control Systems

Analysis of the Capacity to pay

Industry trends

Regulatory environment

Operating and competitive position

Financial position and sources of liquidity based in financial ratios

– Profitability Ratios (ROE, profit margin, asset turnover)

– Debt coverage analysis (short term solvency (current ratio,) leverage ratios (Debt to Cap), coverage ratios (Ebit to interest)

Company structure (parent company support, priority of claim)

Special event risk

Cash flow

Inability to pay increases reliability on external financing further enhancing obligations and inability to pay - CFO

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Payment Structure

$100MM

10,000 Certificates Each certificate 1/10,000 of the Cash flow

A-2 @ 50MM

$100MM

A-1 @ 30MM

B @20MM

Ability to bifurcate senior note to further redistribute credit and repayment risk

Subordinate 1st loss position

Passthrough

Paythrough

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Legal Structure

In general a corporation will utilized structured financing to seek a higher credit rating through the utilization of certain assets as collateral instead of the general credit of the issuer

Agencies want to make sure that corporate creditors do not have access to the collateral in the event of a bankruptcy

SPV is established to create bankruptcy remote legal entity

Legal opinion required

The SPV is set up as a wholly owned sub but treated as a separate legal entity

Via a true sale the assets are transferred to the SPV and held for the benefit of the investors