Introduction to Securitization

Stuart M. Litwin
Mayer, Brown, Rowe & Maw LLP

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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What Is A Securitization?

• A security or other investment

• Payable from the issuer’s assets
• Structured to avoid sponsor’s bankruptcy
risk
• Investors can focus solely or primarily on
specific risks

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done

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The Issuer’s Motivations

• Accounting treatment
• Lower cost of funds
• Alternative funding source
• Other motivations

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Balance Sheet Accounting Treatment
LIABILITIES &
ASSETS EQUITY

Rec. $ 50 Rec. Loan $ 50

PP&E $ 50 Bonds $ 30
Equity $ 20
Total $100 Total $100

Debt/Assets = 80%

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Accounting Treatment - Balance Sheet
(After Securitization)
LIABILITIES &
ASSETS EQUITY

Bonds $ 30
PP&E $ 50 Equity $ 20
Total $ 50 Total $ 50

Debt/Assets = 60%
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Accounting Treatment - Income
Statement
• Record a Receivable equal to present value
of expected future cash flows, net of losses
• Receivable gets bigger as excess spread
increases
• For $100 of securitized receivables, $90
cash plus $12 PV Receivable results in gain
on sale

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The Issuer’s Motivations

• Accounting treatment
• Lower cost of funds
• Alternative funding source
• Other motivations

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Lower Cost Of Funds

• Isolation of assets from bankruptcy risk of

sponsor
• Enables unrated companies to issue
securities at triple-A rates

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The Issuer’s Motivations

• Accounting treatment
• Lower cost of funds
• Alternative funding source
• Other motivations

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Alternative Funding

• Securitization is an alternative to traditional

debt markets
• For banks, securitization is an alternative to
deposits
• ABCP is an alternative to term securitization
• Some structures allow tranching to reach
different investor groups

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Tranching

• Example: A 60 month loan @ $100/month

• Alternatives:
ƒ One $6,000 security
ƒ Sixty $100 securities
ƒ Five sequential $1,200 securities
• Sequential: pay one before the next
• First class usually is for money market funds

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The Issuer’s Motivations

• Accounting treatment
• Lower cost of funds
• Alternative funding source
• Other motivations

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Other Motivations

• Match funding of assets

• Originate/ service more receivables, leading
to economies of scale
• Regulatory capital relief for banks
• Obtain financing in times of financial stress
• Demonstrate balance sheet liquidity to rating
agencies

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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Isolating The Assets

• Removing assets from seller’s bankruptcy

estate
• Form of transferee

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Removing Assets From Seller’s
Bankruptcy Estate
• Example: $100 million notes
secured by $200 million of treasury
securities

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Isolation is Important Because:

• Automatic stay
• A bankruptcy court can:
ƒ Say that you are oversecured and reduce the
receivables that secure your debt
ƒ Substitute different kinds of collateral (e.g., an
obsolete manufacturing plant)
ƒ Reject leases
ƒ Do lots of other bad things
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Removing Assets From Seller’s
Bankruptcy Estate
• The goal: to isolate assets from the
bankruptcy risk of the originator
• How? a “true sale” to a “bankruptcy remote
entity”

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If You Want a Higher Rating than
the Originator, You Must Have a
“True Sale” to a “Bankruptcy
Remote Entity”

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True Sale Issues

• Recourse
• Example: sale of $100 of receivables vs.
loan secured by $100 of receivables
• Bankruptcy court may find sale with recourse
is, in substance, a secured loan

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True Sale Issues

• Implicit recourse
ƒ Seller gets to keep excess cash flows
ƒ Contingent purchase price
• How to spot a true sale issue: if seller does
worse if the assets don’t perform, you have
an issue to consider

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Bankruptcy remote entities

• Structured not to become subject to:

ƒ Their own bankruptcy
ƒ Sponsor’s bankruptcy

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Bankruptcy Remote Entities

• Structuring to decrease likelihood of own

bankruptcy
ƒ Special purpose
ƒ Non-petition covenants
ƒ Assets, liabilities and cash flows designed to
avoid bankruptcy
ƒ Protection against “remote” risks

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Bankr. Remote Entities

• Not likely to be subject to sponsor’s

bankruptcy
ƒ Basic Principle: Independence before
bankruptcy leads to independence in
bankruptcy
• Formalities observed
• Indicia of independence: independent directors,
stationary, phone number
• Creditors not looking primarily to sponsor’s credit

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Bankr. Remote Entities

• Not likely to be subject to sponsor’s

bankruptcy
ƒ Transactions with sponsor on an arms length
basis
ƒ Most important: adequate resources to meet
reasonably foreseeable obligations with a
reasonable degree of certainty

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Non-consolidation Issues

• Guarantees
• SPE obligations for which there is
inadequate capital

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Typical Two-step Structure

Originator • Step one:

true sale to
Underwriters,
SPE
SPE Investors or
Securitization
• Step two:
Trust either/or

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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Credit and Liquidity Enhancement

• Primary risks in a typical securitization:

ƒ Obligors don’t pay at all
ƒ If they pay, it’s not on time
ƒ They pay at times different from required
payments on ABS
• Credit enhancement - nonpayment
• Liquidity - payment at wrong time

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Credit Enhancement

• Investors or rating agencies must evaluate

creditworthiness of the assets
• Credit enhancement is sized for to achieve
the appropriate level of creditworthiness

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Primary Forms of Credit
Enhancement
• Extra assets:
ƒ Overcollateralization
ƒ Reserve accounts
• Third party support
ƒ Bond insurance
ƒ Letters of credit

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Amount of Credit Enhancement

• Depends on several factors:

ƒ Creditworthiness of assets
ƒ Obligor concentrations
ƒ Volatility of payment history
ƒ Trends in the business or portfolio

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Liquidity Enhancement

• Servicer advances
• Liquidity facilities
ƒ Often present in ABCP conduits
• Extendible Notes

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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Servicing

• Servicer collects payments, enforces the

contracts
• Most deals are serviced by the
originator/sponsor

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Servicer Risk

• Three kinds of companies: Categories 1, 2

and 3
• Some deals have master or backup
servicers
• “Hot” vs “cold” backups
• Control of cash vs commingling

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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Designing the Securities

• Most common: structure the securities to

match the assets
ƒ Long term assets (e.g., HELs, autos) tend to
have longer maturities
ƒ Short term assets (e.g., credit cards, trade
receivables) tend to be revolving
ƒ Fixed rate assets tend to have fixed rate funding

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Designing the Securities

• Mismatches create risks which require

protection
ƒ Hedges
ƒ Enhancement
• Common mismatches
ƒ Long term deals into ABCP conduits
ƒ Tranching

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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Ratings

• ABS deals are complicated

• Many investors don’t have the time or ability
to evaluate or monitor
ƒ Specialization is required
ƒ For many investors, rating is just part of due
diligence

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done
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Types of Execution

• Public
• 144A market
• Private placement
• ABCP conduit

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Securities Laws

• Exemption or registration

• Two Big Developments Since Dec. 2005

ƒ Offering Reform – Effective 12/1/05
ƒ Regulation AB – Effective 1/1/06

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Securities Offering Reform

ƒ Greatly liberalizes ability to communicate

during the offering process

ƒ Rule 159
• Ignore anything first delivered to investor
after contract of sale
• Can’t fix problems in final prospectus
• Best Practice: Don’t take it out of oven until
it’s baked

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Regulation AB
ƒ Establishes written framework for ABS
disclosure and reporting for first time
ƒ Shelf registration or discrete offering
• Definition of “asset backed security” under
Regulation AB
– Discrete Pool - Prefunding and Revolving
– Financial Assets – Leases with Residuals
ƒ “Death Penalty” for failure to timely file 1934 Act
reports during the preceding twelve months

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Static Pools
ƒ Which portfolio is better, one with 1% annualized losses
or one with 2% annualized losses?
ƒ Annualized numbers for growing portfolios tend to hide
losses and trends because new originations are
included in the denominator.
ƒ Static pools look at losses, delinquencies and
prepayments in prior deals or vintage origination years
ƒ Static pool information is required by Regulation AB to
the extent material

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Credit Scores

• Regulation AB requires disclosure of credit

scores unless not material
• FICO or something else?

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Credit Enhancers and Swap
Counterparties
• Expanded Disclosure, including audited
financial statements if 20% significance
ƒ Can you just provide the Parent’s financials if
the Parent fully guarantees the swap
subsidiary? ISDA/TBMA/ASF letter
• Significance percentage must be tested in
future and financial information must be
updated in Form 10-Ds.
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Servicer Disclosure
• Expanded disclosure, including material
servicing changes in last three years
• Annual attestations and CPA Reports by all
“parties participating in the servicing
function” for at least 5% of pool assets
• Outsourcing Arrangements
• It’s important to think about reporting before
you launch your deal

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Introduction to Securitization
• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done

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Other Issues

• Tax Issues
ƒ Nontaxable entity - Disregarded entities, LPs, LLCs,
Trusts, etc.
ƒ Debt for tax
ƒ State taxes
• Investment Company Act
• ERISA
• Bank regulation
• Many, many others
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Introduction to Securitization

• What is a Securitization?
• The issuer’s motivations
• Isolating the assets from sponsor’s bankruptcy
• Credit and liquidity enhancement
• Servicing
• Designing the securities
• Ratings
• Securities laws
• Other Issues
• Getting the deal done 55
Getting the Deal Done

• Costs
• Picking your parties and professionals
• Controlling your process

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External Securitization Costs
• Bankers/Investment Bankers
• Legal
• Accounting
• Printing
• Rating Agencies
• Trustees
• Marketing and roadshow expenses
• Bond insurers
• Backup Servicer

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Internal Securitization Costs

• Systems improvements
• Data collection
• Reporting
• Servicing changes
• Additional personnel

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Getting the Deal Done

• Costs
• Picking your parties and professionals
• Controlling your process

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Picking Bankers and Deal Structure
• Shop!
• Understand structure and important business terms
ƒ Bankers will educate you in everything before you
select the winner
• Know whether you are a Category 1, 2 or 3
company
• Avoid getting tied up
• Remember: Your bargaining power is greatest
before you select

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Picking Lawyers and Other Professionals

• Relevant experience is more important than

fee quote (within limits)
ƒ Best lawyer for mortgages is rarely the best
lawyer for a CDO
• Make all parties buy into fee quote
assumptions

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Getting the Deal Done

• Costs
• Picking your parties and professionals
• Controlling your process

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Controlling the Process
• Detailed term sheet before you pick banker
• If you are a weak company, pick only your
most important issues to negotiate
• No more than three drafts of any agreement
ƒ Make sure everyone comments or signs off on
the first draft
ƒ Negotiate everything before turning new drafts
• Get accounting signoff early

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Controlling the Process
• If you’ve already done a deal, do repeats rather than
entirely new structures and terms
• Deal with regulatory restrictions promptly
• Cross border legal, tax and accounting
• Prepare drafts of subsequent reports before you close
• Enforce your timeline
• Term deals: It’s better to get everything done before
launching the deal into the market
ƒ New Rule 159 - Misstatement or omission will no longer be cured
by corrections in the final prospectus

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Introduction to Securitization

Stuart M. Litwin
Mayer, Brown, Rowe & Maw LLP

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