Banking

and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Assets Securitization: An Overview

Asset securitization is the process that transforms financial assets, such as home mortgages,
automobile loans, credit card receivables, etc. into Securities that can be traded in the financial
markets. The securities that result from this process are typically called asset-backed securities.
In the words of John Reed, former Chairman of Citibank, Asset Securitization is the substitution of
more efficient public capital markets for the less efficient, higher cost financial intermediaries in the
funding of debt instruments.
Asset securitization was conceived decades ago to resolve some very basic issues embedded in the
balance sheet of several financial institutions:
Most loans are long term in nature whereas the liabilities that are sourced by financial
institutions to fund those loans are short to medium term in nature
This implies an embedded interest rate risk and liquidity risk in the balance sheet of these
financial institutions
The process of securitization enables these financial institutions to sell the long-term loans and
consequently, the embedded interest rate risk and liquidity risk, to participants in the financial
markets such as insurance companies and pension funds whose liabilities are long term in nature.
As a result, Asset Securitization Markets have grown exponentially over the years. However, such
rapid growth of the Asset Securitization Markets in an uncontrolled and unregulated manner
eventually resulted in the 2008 global financial meltdown.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Assets Securitization: Basic Attributes, Cash Flows, Steps and Structure

Basic Attributes of Asset Securitization
Assets that can be securitized are always characterized by future receivables. Hence, any portfolio of
assets that is to be securitized is evaluated for the following attributes:

Quality of the
underlying
assets as well
as the future
receivables

Average size Periodicity

of the
of the future
receivables receivables
in the
por9olio

Homogeneity
of the assets
that make up
the por9olio

The Maturity
composi@on
of the future
receivables
against those
assets

Steps involved in securitization

All securitization transactions go through the following process from origination to final placement in
the financial market:
1. The originator, that is, the financial institution that has disbursed the loans, creates a
portfolio of such loans that are to be securitized, including the associated future receivables.
2. A special purpose vehicle is formed, commonly referred to as SPV, to manage this
securitization portfolio. The SPV acquires the future receivables attributable to those assets
at the discounted value, (i.e. the present value of future receivables), and converts those
receivables into asset backed securities.
3. The SPV then issues these asset-backed securities either directly to the investors in the
financial markets or back to the originator, who then takes it to the market.
4. The servicing agent for the securitization portfolio, normally the originator, is charged with
the responsibility to collect the receivables (i.e. repayments against the loan) at specified
periodicity in an escrow account and hand off the collections to the SPV.
5. The SPV in turn passes these cash flows to the investors in the securitization portfolio using
different payment structure such as pass through, pay through and pay down
structures, as per the agreed terms for that securitization portfolio.
6. In case one or more of the originators, whose loans are part of that securitization portfolio,
defaults on their repayment obligation, the SPV will call on the servicing agent to initiate
appropriate action as per the agreed terms for that securitization portfolio.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Cash flows in Securitization

Every securitization portfolio has several cash flows through its life, from the perspective of the
originator of that portfolio. These cash flows include:

Ini+al Cash Flow

1) Discounted value of future
receivables (e.g. future mortgage
payments)

Recurring Cash Flow

1) Expenses incurred in
collec+ng the receivables

Terminal Cash Flow

Originator

2) Ini+al expenses, including payment

1) Redemp+on of
for legal fees, stamp duty, credit ra+ng, 2) Servicing fees (inow), junior/residuary

if the originator is also
etc.
interests of the
the servicing agent
securi+za+on porQolio
3) Ini+al corpus to set up the SPV
3) Cost of credit
2) Buyback of the tail
4) Subscrip+on to any junior/residuary
enhancements
cash-ows
notes
5) Tax on accelerated income

Structuring a Securitization Portfolio

Structuring a securitization portfolio involves several entities and steps:

Ini$al Feasibility
Key Appointments: Investment Bankers, Credit
Ra$ng Agency and Legal Advisors
Asset Analysis and Selec$on of the PorColio
Legal and Financial Feasibility
Due Diligence Audit
Credit Ra$ng
Determining The Structure
Pass Thru / Pay Thru
Pay Down Structures
Credit Enhancements
Nature and Cons$tu$on of the SPV
Legal Structure of the PorColio

Appointment of the Servicer/Administrator

The primary responsibility to set up the securitization structure rests with the Originator.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Asset Securitization: Payment Structure

Investors in a securitization portfolio receive cash flows periodically whenever the original borrowers
(whose loan make-up the securitization portfolio) meet their periodic loan repayment obligations.
The servicing agent (mostly the originator) receive these payments from the original borrowers and
turns them over to the SPV, who in turn credits the proceeds from such repayments to the investors
in the securitization portfolio.
There are three types of payment structures associated with securitization:
1. Pass-through structure: In this structure, the proceeds from (a) repayment against the
loans on the due date and (b) any prepayment/pre-closure of loans are received by the SPV
from the servicing agent and immediately passed through to the investors after deducting
expenses that the SPV may have incurred.

In the event some borrowers defaults on their repayment obligations, the SPV instructs the
originator to make good the loss by invoking the available credit enhancement such as cash
collateral, guarantees, etc. All proceeds so realized will also be remitted to the investors
immediately.

2. Pay-through structure: In this structure, payments are effected to investors only on prespecified dates. Hence this structure functions more like coupon payments in the case of
bonds.

Payments realized by the originator (a) on the due date, as per the loan repayment schedule
and (b) on account of pre-payment/pre-closure of the loans are remitted to the SPV, who in
turn invests these in pre-approved asset classes such as government securities, AAA-rated
corporate bonds, etc. On the pre-specified payment date, the payments are released to the
investors by liquidating the above investments, after deducting expenses that the SPV may
have incurred.

3. Pay-down structure: In this structure, the interest payments and principal payments are
handled differently.

The interest cash flows are used to meet the SPV expenses, and the balance is paid to
investors in proportion to their holdings in that securitization portfolio.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

The repayment of principal would be handled in any of the following ways:

a. Sequential pay down: Nothing is paid to the junior tranche until the immediate senior
tranche is paid off fully
b. Fast payslow pay: Both the senior and junior tranches receive payments, but more to
the senior tranche and less to the junior tranche.
c. Pro-rata pay down: The collected amount is paid out in proportion to the investor's
holding in that securitization portfolio

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Asset Securitization: Credit Ratings and Credit Enhancements

Securitization portfolios are almost always subject to credit rating by accredited credit rating
agencies.
The originators, i.e. the issuers of the loan, would obviously be more aware of the underlying risks in
the portfolio than the prospective investors. However, the investors in the securitization portfolio
carry all the risks embedded in the securitization portfolio and would therefore want to know the
extent of risks embedded in that portfolio. Hence, the imperative need for credit rating every
securitization portfolio by accredited credit rating agencies.

Credit rating involves a detailed assessment of the following aspects of the securitization portfolio:

Quality Of
Loans
That make
up the
securi7za7on
por9olio

Solvency

The
nancial
stability of
the issuer

Legal
Structure
To ensure
adequate
protec7on to
the investors

Sovereign Risk

Prepayment Risk

The likely impact on

future cash ows to
the investors should
the underlying loans to
be prematurely closed

The perceived
risk of the
country where
the issuer is
domiciled

Based on the credit rating, investors in virtually all securitization portfolios normally seek a
protection against potential default by the borrowers (whose loans make up that securitization
portfolio). This protection is referred to as Credit Enhancement.
Credit Enhancement are structured in several ways:
1. Cash collateral: The originator provides or sets aside cash as a collateral based on an
assessment of the probability of default and expected losses given that probability of
default.

2. Guarantees: The originator seeks a third party, such as:
a. An insurance company to provide a credit insurance or
b. A bank to provide a bank guarantee.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

3. Structural credit enhancement: This involves splitting the securitization portfolio into three
or more classes with varying levels of guaranteed return in keeping with the extent of risk
that each class is expected to absorb. This structure is commonly referred to as
subordinated structure. Since each lower class investor provides protection to the next
senior class, the returns are top-down, i.e. the senior-most class gets the lowest return
(because they take the least amount of risk on that portfolio) and the junior most class gets
the highest return, as this class is expected to absorb the first risk of default.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Asset Securitization: Types of Securitization

Residential Mortgage-Backed Securities (RMBS) are backed by a large number of home mortgages
assembled into a mortgage pool. Special purpose vehicles or SPVs, (also called trustees in the
context of RMBS) serve as custodians of the mortgage pool held as a collateral for the RMBS
transaction. Most RMBS transactions adopt the pass-through certificate structure to transfer cash
flows from the borrowers to the investors.
Government agencies, such as Fannie Mae in the United States, often act as market- makers by
underwriting the securitization tranches.
Insurance companies, pension funds and other entities that enjoy long-term liabilities on their
balance sheet invest actively in RMBS, both for long-term holding and for short-term trading.
RMBS carry both default risk and interest rate risk.
Default risk is mitigated in a number of ways:

Cash Collaterals Subordinated Structure Insurance/Guarantee Credit Deriva/ves

By the mortgage
ins/tu/on, i.e.
the originator of
the loans

Junior class investors

provide protec/on to the
next senior class; senior
most gets the lowest return

Tradi/onal insurance
by insurance company
or guarantees provided
by the banks

Credit Default
Swaps (CDS)
very commonly
used

Interest rate risk is manifested in RMBS
in the same way as corporate bonds.
However, an additional (unique) interest
rate risk associated with RMBS is
prepayment risk, arising from any
borrowers decision to pre-close or prepay the loan.

Mortgages are
prepaid for
Fall in interest rates
Home owner reloca6ng
to another city

Pre-payment of
mortgages result in

Accelerated cash inows

Reduc6on in future
interest income

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

To protect themselves against loss in income arising from prepayment of loans (prepayment risk),
returns on RMBS is computed taking into consideration:
Scheduled repayment
Projected default rate
Projected prepayment rate
The monthly mortgage payments are adjusted accordingly for the above.

Credit Card Securitization

Most companies that issue credit cards rely on securitization as their main source of funding because
traditional banks and financial institutions are generally very cautious (even reluctant) to lend to
credit card companies for several reasons, as shown in this diagram.

Unsecured
Loans

Carry a High Level

of Default Risk!

Not Backed by
any Collateral


However, there are several advantages too, although credit card receivables (which are at the core
of credit card securitization) appear very short term like an overdraft loan:
Credit card receivables are revolving in nature
Delinquency is managed proactively in the credit card business
The risk reward structure can be changed dynamically at any point in time for every
customer
The fee income stream in the credit card business is very well defined

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Structuring a Credit Card Securitization Portfolio

A credit card securitization portfolio structure is very different to other securitization portfolios
(such as mortgage-backed securities, automobile loans, etc.).
a. Credit card issuers create a master trust which is an umbrella structure covering several
tranches of credit card securitization.
b. Credit card companies issue a fresh credit card securitization tranche periodically under the
same master trust.
c. The credit card receivables continue to increase in value terms, since almost all credit card
companies issue more and more credit cards almost every day.

Terminologies unique to the credit card securitization

1. Sellers' interest - Sellers' interest is the amount of receivables sold in excess of the
outstanding amount in any credit card securitization tranche. This is necessary, to provide
adequate cover particularly during festive seasons when credit card outstandings tend to
go up significantly.
2. Payment rate - This refers to the amount paid on an average every month by the
cardholders against their credit card outstandings. A higher payment rate is a strong
attribute of the portfolio.
3. Charge-off - This represents the bad debt that will have to be written off, i.e. the
outstanding credit card receivables that are overdue for a long time and unlikely to be paid
by the credit card holders.
4. Portfolio yield - This comprises all revenues realized by the issuer (i.e. the credit card
company) net of charge-off.
5. Coupon payable - This is the interest paid at specific periodicity by the issuer of the credit
card securitization portfolio to the investors in that securitization portfolio.
6. Excess spread - This represents the net income from the credit card portfolio, (usually
computed on a three-month rolling average), computed as portfolio yield minus the chargeoff minus the coupon payable to the investors.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

10

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Credit Enhancements using Credit Default Swaps (CDS)

Credit Default Swaps are over-the-counter bilateral contracts to transfer the credit risk (associated
with any asset) from one counterparty to another, without transferring the ownership of the
underlying asset.

Structure of Credit Default Swap

A Credit Default Swap is a privately negotiated contract between a protection buyer (i.e. the entity
that wishes to shed the risk associated with an asset) and the protection seller (i.e. the entity that is
willing to take on the risk that the protection buyer wishes to shed). The reference entity is the
entity that is likely to default on its repayment obligations.
The protection buyer pays a premium or a fee to the protection seller as a protection against losses
that might be incurred due to a credit event.
A credit event could arise for one or more of the following reasons:

CREDIT EVENT!
Failure to Repay

The reference en1ty failing to eect the repayment of

the principal and interest rate on the loan

Bankruptcy
Declared

The reference en1ty becoming insolvent or planning to

le for bankruptcy

Restructuring of
the Loan

A change in the terms of repayment arising from a

deteriora1on in the credit quality of the reference en1ty

Repudia1on /
Moratorium

Applies to sovereign reference en11es; reference en1ty

disarms, disclaims or otherwise challenges the validity
of the payment obliga1on

Uncontrolled and unregulated use of credit default swaps to provide credit enhancements to the
ballooning RMBS market created a serious moral hazard that contributed significantly to the global
financial crisis of 2008.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

11

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Collateralized Debt Obligations

Collateralized debt obligation (CDO) is a structure that invests in debt instruments (often high yield),
based on liability support from investors with varying risk appetite. In this structure, therefore, the
junior tranche of investors absorb the losses arising from mark-to-market losses on the high yield
portfolio in which the CDO has invested. Hence more senior the tranche, lesser the risk and
consequently, lower the returns or the coupon rates.
CDOs are structured on several asset classes:

Collateralized
Loan Obliga1on

Collateralized Bond
Obliga1on

Collateral Mortgage
Obliga1on

Backed by a
por7olio of loans

Backed by high yield

bonds

Backed by mortgage
backed securi1es

CDOs can either be balance sheet based or arbitrage driven:

Balance Sheet
Used by banks to ooad
their risk-weighted assets
Obtain relief from
regulatory capital

Arbitrage
Comprise high yield
instruments
Structured and issued by
CDO managers

In both cases, the liabilities side of the CDO's balance sheet comprise debt issued by the CDO
(usually with guaranteed returns or coupon rates) under a subordinate structure.
Intrinsically CDOs, particularly arbitrage CDOs, are vehicles of very high leverage. An
overcollateralization test or OC test is often used to measure the extent of leverage relative to
every subordinate structure in the CDO.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

12

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary Week Five

Overcollateralization Test (OC test):

A CDO manager would invest the funds raised from investors in different class or tranches in highyield (or high risk) assets. Recall that the junior tranches provide protection to the senior tranches
in the event of erosion in value of the assets. Should the mark-to-market value of the assets in which
the CDO manager has invested fall, the OC test benchmark is breached. This breach reflects how
vulnerable are the investors in the CDO to potential loss, starting with the junior most tranche.
In case the markets fall further and the value of the assets continuously drop then the OC test is
further breached and hence impact investors in the senior class as well.
Worst case, if the OC value goes below the benchmark for even the senior most tranche, all the
investors in the CDOs would lose the money that they had invested initially. This is exactly what
happened in the 2008 crisis.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

13