Professional Certificate Program

‘Risk Management in Banking and Financial Markets’

- Prof. PC Narayan

Special Topics in Risk Management of

Banking and Financial Markets
Week 01 – Summary

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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,
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 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 Average size Periodicity Homogeneity The Maturity

underlying of the of the future of the assets composi on
assets as well receivables receivables that make up of the future
as the future in the the por olio receivables
receivables por olio 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.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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.

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
Recurring Cash Flow
receivables (e.g. future mortgage
1) Expenses incurred in
Terminal Cash Flow
payments) Originator
collec ng the receivables
2) Ini al expenses, including payment 1) Redemp on of
for legal fees, stamp duty, credit ra ng, 2) Servicing fees (inflo) , junior/residuary
etc. if the originator is also interests of the
the servicing agent securi za on por olio
3) Ini al corpus to set up the SPV
3) Cost of credit 2) Buyback of the tail
4) Subscrip on to anywjunior/residuary
enhancements cash-flows
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 Por olio
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 Por olio

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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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

pre-specified 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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 pay–slow 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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 Solvency Legal Sovereign Risk Prepayment Risk

Loans Structure •The likely impact on
•The •The perceived
•That make •To ensure future cash flows to
risk of the
up the financial adequate the investors should
country where the underlying loans to
securi za on stability of protec on to
the issuer the issuer is be prematurely closed
por olio the investors domiciled

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.

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’.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 Junior class investors Tradi onal insurance Credit Default
ins tu on, i.e. provide protec on to the by insurance company Swaps (CDS)
the originator of next senior class; senior or guarantees provided very commonly
the loans most gets the lowest return by the banks used

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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 borrower’s decision to pre-close or pre-pay the loan.

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 Carry a High Level

Loans 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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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
charge-off 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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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!
• The reference en ty failing to effect the repayment of
Failure to Repay the principal and interest rate on the loan

Bankruptcy • The reference en ty becoming insolvent or planning to

Declared file for bankruptcy

Restructuring of • A change in the terms of repayment arising from a

the Loan deteriora on in the credit quality of the reference en ty

Repudia on / • Applies to sovereign reference en es; reference en ty

disaffirms, disclaims or otherwise challenges the validity
Moratorium of the payment obliga on

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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

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:

CDOs can either be balance sheet based or arbitrage driven:

Balance Sheet Arbitrage

Used by banks to offload Comprise ‘high yield’

their ‘risk-weighted assets’ instruments

Obtain relief from Structured and issued by

regulatory capital 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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Overcollateralization Test (OC test):

A CDO manager would invest the funds raised from investors in different class or tranches in
high-yield (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 Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ 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 otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)