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Securitization 201 Analytics for Cash
Securitization American Securitization Forum
Education Institute Seminar January 2006
CONFIDENTIAL
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Table of Contents

• Executive Summary
• Issuer Considerations
• Traditional Structure and Enhancements
• Investor Considerations
• Spread Methodology and Valuation Analysis
• Model Input Assumptions and Results
• Appendix
• Rating Agency Consideration

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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)

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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)
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Traditional Structure and Enhancements
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Traditional Structure
Originator(1)(2)
Internal Credit Enhancement

Assets
True Sale
Trustee Fee
Services
Bankruptcy Remote Special Purpose Vehicle (SPV)
Trustee
Servicer(1)
Service Fee
Services
Principal and Interest

Investors
External Credit Enhancement
(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 todays
  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.

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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
Contraction Risk
Extension Risk
Decrease Interest Rate Environment
Increase Interest Rate Environment
Collateral Cash Flow

• Increased prepayment risk refinancing
• Increased reinvestment risk at lower rate

• Reduced prepayments competitive rates
• Inability to reinvest to generate higher return

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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 (1im)6 1 where
• Im Yield
• Assume monthly yield 0.6
• BEY 2 x 1 0.066 -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

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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 _at_ 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

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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

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Appendix
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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
Passthrough
100MM
Each certificate 1/10,000 of the Cash flow
10,000 Certificates
Paythrough
100MM
A-2 _at_ 50MM
A-1 _at_ 30MM
Ability to bifurcate senior note to further
redistribute credit and repayment risk
Subordinate 1st loss position
B _at_20MM
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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