What Is Securitization?

2001/01/11

Typically, investors in corporate bonds are repaid from an issuer's general revenues. In contrast, investors in securitized bonds, also called structured financings, are repaid from the cash flow generated by a specific pool of assets. An originator sells its assets to a trust or corporation, which then issues securities backed by these assets. The securities are usually obligations that have been issued by these special-purpose entities. In a traditional securitization, investors do not usually have recourse to the seller of the assets, only to the assets contained within the trust.

The first security backed by residential mortgages was sold in the U.S. by Government National Mortgage Association (Ginnie Mae), a U.S. government agency, in 1970. Then, in 1977, Bank of America sold the first "private label" RMBS. The transaction did not have a credit rating because it lacked hazard insurance, but the second RMBS transaction, in 1978, was rated. It was sold by Home Savings & Loan Association of California, and rated 'AA' by Standard & Poor's. Investors were attracted to the Ginnie Maes because they provided attractive returns and, moreover, they were guaranteed by the full faith and credit of the U.S. government. But the private-label securitizations did not have the advantage of a guarantee from a federal agency. Investors were looking for some sort of guidelines to help them judge the creditworthiness of these privately issued securities.

Credit rating services such as Standard & Poor's began to scrutinize the value of the underlying assets, the strength of the cash flows they produced, and the stability of the transaction's legal structure to properly assess the issuer's ability to pay its debts. They assigned ratings to these securitizations, thus enabling investors, such as pension funds and insurance companies, to gauge the risk of these securities accurately and quickly, without tying up valuable resources.
The RMBS market picked up speed when two government-sponsored entities hit the scene. Federal Home Loan Mortgage Corp. (Freddie Mac) initiated its securitization program in August 1981, and the Federal National Mortgage Association (Fannie Mae) followed four months later.

In 1985, after securitizing their residential mortgage loans, regional banks and private lending companies began to securitize other assets they had previously been holding on their balance sheets, beginning with auto loans, which were ideal because they were secured, amortizing instruments. Toward the late 1980s, as investor acceptance grew and the market developed more sophisticated approaches to structuring cash flows, credit cards quickly became the dominant asset. Manufactured housing loans, student loans, equipment leases, and synthetic securities also gained importance. Since then, tax liens, mutual fund fees, pools of corporate bank loans called collateralized loan obligations, and other new instruments with predictable cash flows have all emerged as significant underlying assets.

At the beginning of the ABS market's development, Standard & Poor's established guidelines and procedures for rating ABS transactions that were consistent with those used to rate the debt obligations of corporations and state and local governments. Philosophically, ratings on structured securities are no different than those of other debt securities. They are designed to withstand certain adverse and stressful default and loss conditions that are both external and internal to the securities. If these conditions deteriorate to such a degree that ratings can no longer be sustained, the ratings will be downgraded. Conversely, if conditions improve such that the ratings no longer reflect the improved credit quality of the securities, upgrading will ensue.

However, because securitizations are backed predominately by the cash flows of the underlying assets-whether they are residential mortgages or equipment leases-two aspects fundamental to their ratings separate them from other types of bond ratings: the stress test of the cash flow generated by the underlying assets, and the rating multiples of the expected losses of various assets.

The cash flows of the underlying assets are tested under various stressful default and loss scenarios; these stress tests are the backbone of structured finance ratings. Through simulations, the test first examines the magnitude of defaults and losses of assets individually. From this, it is possible to establish the level of protection that will be needed so that, even under stressful conditions, the underlying assets will still collectively generate enough cash flow to protect the various credit classes against default.

In general, without any other credit enhancement-such as a corporate-parent guarantee, a letter of credit, surety bonds, or their combinations-the loss coverage for securities rated 'B', a speculative credit class with a high probability of default, is an amount modestly higher than the expected loss of the underlying assets. Therefore, the rating multiple for a 'B' rated security has a narrow range of 1 times (x) to 1.25x the expected loss. The expected loss is the cumulative loss, net of recovery, that is expected for the life of the assets. Successively higher ratings, which have incrementally lower default probabilities, require coverage that is an incrementally higher multiple of the expected loss. In the case of an 'AAA' security, which has the lowest default probability, the multiple is the highest, ranging generally from 3x-5x the expected losses. However, this range is a guideline and may not apply to all transactions of varying assets.

The multiples for the same rating of different underlying assets vary because of their different actual losses, and the volatility of the losses. In general, an asset with a lower expected loss will have a higher multiple than an asset with a higher expected loss. The thinking is that the lower expected loss potentially has a higher loss volatility in the future and, therefore, requires a higher multiple to achieve the same credit rating. For example, the 'AAA' coverage for ABS backed by a pool of prime auto loans, which have lower expected losses, can be as high as 5x, whereas the coverage for ABS backed by a pool of subprime auto loans, with substantially higher expected losses, will have a multiple of only 3.5x or less to achieve the same credit rating.

The absolute level of the expected loss is important in determining the multiple because, at higher expected loss rates, a higher stress factor may be too onerous. An extreme example of this thinking would be a portfolio with expected losses of 25%. Obviously, a multiple of 5x would not be realistic.

The multiple also varies by the quality of information that is used to project the expected loss, and the consistency of underwriting standards of the underlying assets. In general, the more limited the information provided, the more conservative, or higher, the loss coverage multiple will need to be. In many cases, historic portfolio performance is used as a indicator of future performance to forecast the expected loss. However, if underwriting standards change, historic performance will become less predictive and a higher multiple may be used.