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CONTENT
Background
Traditional and Synthetic Securitization
The Process
Classification
Risk Analysis
The Objectives
Comparison with Traditional Securitization
BACKGROUND
A bank is an entity that borrows money from people and companies that have
money they do not presently need and lends the same money to people and
companies that have a need for money they do not presently have.
A problem with this model is that the bank’s borrowers do not always pay back
their debts.
In the early 1980s, bank regulators became concerned by the state of banks’
capital bases
and Between 1974 and 1983, the banking regulators of the G7 reached an
agreement on the minimum capital requirements for their home banks. Published
in May 1983, the Basle Concordat prescribed a minimum capital requirement of 8
percent of risk-weighted assets
BACKGROUND
From this situation a market based on the transfer of assets emerged: the securitization market.
Through securitization the banking system as a whole has developed a method by which it could focus on its main task , that is lending money, financing at the same time its assets packaging up pools of loans and getting rid of the risk associated with them by selling them to the capital markets.
Through credit derivatives, the banks have crafted a supremely flexible tool to remove credit risk from their balance sheet.
The drawback of securitization is that it lacks of flexibility, a feature more difficult to achieve in some jurisdictions, moreover, the credit derivative market is an exclusive inter-bank market in which other actors are usually banned.
BACKGROUND
At that time what was required was to mix these financial instruments so as to
enable financial institutions to transfer their unwanted credit risks onto the
capital markets, with all the flexibility associated with credit derivative
instruments.
This is exactly what synthetic securitization began to achieve in 1998.
Its success can be measured by the growth of this financial product: in 1999, in
the U.S. alone, it represented a $1 trillion market; by 2000 it had already grown
to $1.5 trillion.
TRADITIONAL SECURITIZATION
Financial operation that consists in the transfer upon payment of a portfolio of
bank loans or other financial non-negotiable assets (often in pool) capable of
generating cash flows.
Assets are transferred from the sponsor (usually a Bank) to a Special Purpose
Vehicle (SPV), which, against the sold assets, issues negotiable securities to be
placed on the national or international markets.
The recovery of the value of such property or assets should guarantee the
repayment of capital and interest coupons mentioned in the bond. If such
recovery is not possible, those who bought securities incur in the loss of both the
paid-up capital and the interest due. The bonds are divided into classes
according to rating.
TRADITIONAL SECURITIZATION
ASSETS SPV INVESTORS
ORIGINATOR Transfer of assets ABS /CDO/ MBA
Protection Protection
SYNTHETIC SECURITIZATION
Synthetic securitization is the process of artificial securitization of the pool of
debt obligations, without transferring underlying credits from the balance sheet.
Transfer through Credit defaults swaps to a SPV only of the risk associated with
of a pool of assets. The SPV will then issue Credit linked notes to repay the
originator.
The securitized assets are retained in the financial statements of the Originator
but not their economic effect.
Synthetic securitization overcomes the shortcomings of the traditional structure
of the transaction by combining credit derivatives with a synthetic structure.
THE PROCESS
1. The originator identifies the portfolio whose risks he intends to transfer.
2. The originator turns to a rating agency to divide it’s portfolio.
In general, the risk of the securitized portfolio is ideally divided into three
tranches of risk:
SENIOR
TRANCHE:
is the tranche
that has the
highest level
of credit
enhancement.
MEZZANINE
TRANCHE:
is usually divided
into tranches
with various
degrees of risk,
and thus
different rating
levels.
JUNIOR
TRANCHE:
is the riskiest
part of the
portfolio.
Usually held by
the sponsor
itself.
THE PROCESS
3. The protection seller and the protection buyer reach an agreement where
if a credit event occurs in relation to a reference entity the protection seller will
make a payment to the protection buyer.
In exchange of this payment, the protection buyer must deliver to the protection
seller either
(i) an obligation of the reference entity in an amount equal to the amount to be
paid by the protection seller (either a loan or a bond), or
(ii) (ii) an amount of cash equal to the difference in the present market value of
the reference obligation and the original amount which must be the market
value of the obligation at the time the swap was entered into.
THE PROCESS
4. In exchange for providing the protection, the protection seller receives a
premium either upfront or over the life of the Credit default swap.
5. The SPV issues Credit linked notes and sells them to several investors:
in this way each note holder becomes a protection seller and the notes issuer
becomes a protection buyer.
6. The amount raised through CLNs is usually invested in a credit-free risk
investment by the SPV, such as government securities, which work as a
collateral.
THE PROCESS
7. The protection buyer pays the agreed premium to the SPV and, in addition,
the SPV earns a interest coupon from the credit-free investments
8. If the credit event does not take place, the investors receive the return of the
collateral plus the risk premium agreed
9. Upon the occurrence of the credit risk, the SPV will have to sell the collateral
to the extent required to make payment to the protection buyer
THE PROCESS
Junior and Mezzanine tranches
The transfer concerning the junior and mezzanine tranches takes place using the
combination of two credit derivatives tools:
Credit Default Swap. It does not imply cash flow (Unfunded);
Credit Linked Note. It implies cash flow (Funded).
THE PROCESS
Junior and Mezzanine tranches
The first tranche that bears losses is the junior tranche, that, after being
transferred through CDS to the SPV, is purchased back by the sponsor by means of
CLNs, and reducing, in this way, the credit risk associated.
The risks of mezzanine tranches is shifted to the investors of the Credit linked
notes, who, by signing these debt instruments, assume the risk that net losses
may exceed the amount of the junior tranches. The holders of credit-linked
notes are, therefore, sellers of protection toward the SPV.
Through this mechanism, the SPV acts as a mere intermediary without assuming
any risk
THE PROCESS
Junior and Mezzanine tranches
The cash the SPV receives from investors is usually reinvested in high rating
securities that serve as collateral transaction (e.g. government bonds).
In case of losses in the securitized portfolio, the securities that serve as
collateral are sold and the amount received is used by the SPV to meet its
obligations with the sponsor by transferring to it an amount equal to the
overall net loss.
The subscribers of Credit linked notes are residually satisfied through the
payment of any recovery value.
THE PROCESS
Senior tranche
The risk of the senior tranche is instead covered by the sponsor directly selling
Credit default swaps to a counterpart, usually a Bank.
The seller of protection on the senior tranche suffers losses only if the
percentage of the net losses on the portfolio exceeds 10%.
THE PROCESS
Senior Tranche
Mezzanine
Tranche
Junior Tranche
Bank
SPV
Collateral
AAA Notes
AA Notes
A Notes
BB Notes
Investors
CDS
CDS CLNs
s
CLNs
Protection
Protection
CLASSIFICATION
Synthetic securitization transactions can be classified into different types
depending on the characteristics of the structure adopted.
The characteristics chosen have a direct impact on the risk/return profile of the
structure.
1. Existence of securities listed on regulated markets
2. Types of assets
3. Static or dynamic portfolio
4. Types of credit events
5. Methodology of Regulation
6. Level of credit enhancement
7. Eligibility criteria
CLASSIFICATION
1. Existence of securities listed on regulated markets:
The structure of the standard synthetic securitization usually involves the issue
of notes by the SPV that are sold to investors and listed on a regulated market.
There may be, however, alternative structures that provide coverage of the risks
through simple credit default swaps entered into directly between sponsors and
other counterparts.
2. Types of assets:
The portfolio of the sponsor may be composed of various types of income: credit
lines used even partially, bonds, collaterals, credit derivatives and so on.
CLASSIFICATION
3. Static or dynamic portfolio:
The securitized portfolio can be static or dynamic, depending on whether or not
the sponsor can make substitutions of the risks initially present in the operation
(substitutions) and make changes in the amount of each nominal risk than
initially exists (replenishments). If the sponsor can not make these changes is
static, otherwise it is dynamic.
4. Eligibility criteria:
The eligibility criteria determines the standards by which the sponsor can make
substitutions or replenishments within the portfolio (if dynamic).
They are an essential part of the evaluation of the structure operated by rating
agencies and in the pricing, could refer to:
The minimum rating required
The distribution of the rating classes
Minimum number of reference entities
CLASSIFICATION
6. Level of credit enhancement :
The level of credit enhancement determines the level of coverage available to
investors of the mezzanine and senior tranches.
The minimum level depends on the Duration of the operation, Average credit
quality portfolio and on the Degree of portfolio diversification.
5. Types of credit events:
With regard to credit events, there are only two alternatives available to the
sponsor:
• The less risky choice for investors involves the insertion of only two credit
events: bankruptcy and failure to pay.
• In addition to these two credit events there can be added a. Repudiation :Disputing the validity of a contract and refusing to honor its terms,
b. Obligation acceleration:the relevant obligation becomes due as a result of a default by
the reference entity before the expected time,
c. Restructuring: consolidate and adjust the terms of the debt in case of financial trouble.
CLASSIFICATION
7. Methodology of Regulation:
1) Cash-settled: the investor, in case of credit event, suffers a loss whose
amount is determined by means of an evaluation based upon the risks prices
verified in the market after the event.
2) In other cases the loss suffered by the investor is based upon the losses really
recorded by the sponsor when the credit is realized (Realized loss).
RISK ANALYSIS
Synthetic securitization, unlike the traditional securitization, faces only the
credit risk.
Inside of synthetic securitisations, the main risks are:
The risk profile of the sponsor;
The collateral of the operation
The risk profile of the sponsor
It is the main risk of the whole operation, and it has consequences that affect
both the SPV and other investors.
Mechanism to protect investors:
1. Insurance contracts with third parties who pay the interest due to investors in
the event of insolvency of the sponsor
2. Acceleration: the anticipated payment with respect to the dates originally
planned of the premiums that the sponsor due to the SPV
3. Overcollateralization of the notes: posting more collateral than is needed
In general, such mechanisms are provided in case of drop of the rating of the
sponsor below a given threshold.
The collateral of the operation
The collateral, as well as to provide protection to the sponsor from any losses on
the portfolio, is used to service the debt issued by the SPV in the form of notes.
To decrease the risk related to the collateral is suggested to:
Ensure separation between the sponsor and the collateral
Use some techniques:
a) Margin call (to deposit additional money or securities)
b) Hedging agreement (allows the SPV to sell the collateral to the sponsor or to other
counterparts )
c) Overcollateralization
THE OBJECTIVES
The main targets of the synthetic securitizations are:
Transferring the credit risk of the reference entities of the portfolio, retaining
at the same time the securities in the balance sheet (and thus maintaining
the ability to directly manage the statements)
Freeing the credit capacity towards counterparties considered as strategic by
reducing the risk related to them and allowing in this way, to improve the
business relationship with them.
COMPARISON WITH TRADITIONAL
SECURITIZATION With synthetic securitization the sponsor does not need to sell its assets to an
SPV to transfer the credit risk of the portfolio securitized
Although the sponsor can eliminate the risk related to certain exposures in
the portfolio, it does not undertake administrative and legal problems related
to the transfer of ownership of the loans to the SPV, neither suffers the costs
related to the traditional securitization
The lack of an actual sale allows the sponsor to securitize assets that can not
be transferred through a traditional securitization
COMPARISON WITH TRADITIONAL
SECURITIZATION
In traditional securitizations the SPV transfers the risk to investors through
Mortgage backed securities, Asset backed securities and Collateralized debt
obligations, while in synthetic securitization it uses Credit linked notes
Administrative and management processes of the operation are more flexible
With traditional securitization the sponsor can transfer all the risks attached
to the assets (credit risk, market risk, operational risk), while with synthetic
securitization credit risk is the only risk transferred, therefore synthetic
securitizations are easier to perform
CONCLUSIONS
The securitization transactions offer investors:
· Ability to create a rating / performance profile ad hoc
· Optimization of returns for the level of risk assumed
· Diversified exposure
· Protected exposure
· Improved stability of ratings
that is why synthetic securitization transactions are becoming
increasingly important and spread among countries.
