Securitization The Financial Instrument of the Future Securitization The Financial Instrument of the Future Vinod Kothari John Wiley & Sons (Asia) Pte Ltd Copyright © 2006 by Vinod Kothari Published in 2006 by John Wiley & Sons (Asia) Pte Ltd Clementi Loop, #02-01, Singapore 129809 All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte Ltd, Clementi Loop, #02-01, Singapore 129809, tel: 65-64632400, fax: 65-64646912, e-mail: enquiry@wiley.com.sg This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering professional services If professional advice or other expert assistance is required, the services of a competent professional person should be sought Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium Southern Gate, Chichester P019 8SQ, England John Wiley & Sons (Canada) Ltd, 5353 Dundas Street West, Suite 400, Toronto, Ontario M9B 6HB, Canada John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data ISBN-13: 978-0-470-82195-7 ISBN-10: 0-470-82195-4 Typeset in 10.5/13 points, Palatino by C&M Digitals (P) Ltd Printed in Singapore by Markono Print Media Pte Ltd 10 Anju and Vishes You bear a lot when I go into writing mode; I owe it to you Table of Contents Preface to the Second Edition xxx Preface to the First Edition xxxi Part I Securitization: Concepts and Markets Securitization and Structured Finance Basic meaning of securitization Asset securitization Some definitions of securitization Securitization of receivables Quick guide to jargon Securitization and asset-backed finance Securitization and structured finance Some quick features of securitization What receivables are securitizable Creation of security Special purpose vehicle Re-distribution of risks Rating The big picture of securitization of finance Changing structure of financial markets Securitization and financial disintermediation Securitization as a tool of risk management Economic impact of securitization Facilitates creation of markets in financial claims Disperses holding of financial assets Promotes savings Reduces costs Diversifies risk Focuses on use of resources, not their ownership Smooths the impact of recession The alchemy of securitization: Is the sum of parts more than the whole? The alchemy of structured finance Risks inherent in securitization Notes Securitization Terminology 4 10 12 13 14 14 15 15 16 17 17 17 22 25 26 26 26 26 27 27 27 27 28 28 30 36 39 viii Securitization: The Financial Instrument of the Future Securitization: Methodology, Structures, Motivators and Demotivators Modus operandi of securitization briefly explained Economic substance of securitization: Where does the alchemy lie? Features of securitization of receivables Mode of asset-based financing Mode of structured financing Securitization of claims against third parties Limited Recourse Asset features Originator features Issuer/SPV features Investor features Securitization and factoring Securitization and ring fencing Asset classes Balance sheet and arbitrage transactions Asset-backed securities and asset-backed commercial paper Broad types of securitization structures Cash vs synthetic structures True sale vs secured loan structures Pass-through vs collateral structure Discrete trust vs master trust Direct portfolio transfers Pass-through structure Pay-through structure Economic argument against pay-throughs Collateralized mortgage obligation bonds Refinements in CMO structure Revolving structure Impact and suitability of the revolving structure Future flows securitization Advantages of securitization for the issuer Advantages to the investors Threats in securitization Notes The World of Securitization History of securitization Deeper in history The U.S mortgage market Spreads over to non-mortgage assets Securitization through recession The life cycle of securitization Present state of securitization North America 59 59 62 63 63 64 64 64 65 69 70 71 72 72 73 74 74 75 75 76 76 77 77 79 84 86 87 89 91 92 93 97 102 104 106 108 108 109 109 110 111 111 112 112 Table of Contents Europe Central and South America Origin of securitization in Latin America Asia The Pacific Trends in global securitization Notes ix 115 147 147 152 179 183 186 Part II Financial Substance and Ratings 189 Structuring and Credit-enhancing Securitization Transactions 191 Basics of securitization structuring Structuring variables Asset pool Selection criteria Identification of risks Sources of credit support Size of credit support Financial structure – pass-through or reinvestment type Classes of liabilities Time tranching of liabilities Pay down of securities Liquidity support – need and sources Prepayment protection Mitigation of other risks Creation of cash reserve and investment Structural protection triggers Profit extraction methods Clean up call Parties involved Primary parties Supportive agencies Steps in a securitization transaction Initial feasibility study Key appointments Asset analysis and selection Due diligence audit Determination of the structure Credit enhancements Intervening reinvestments Fixing the legal structure Legal opinions Rating Offer Appointment of servicer/administrator Post-completion routines 191 193 193 194 195 196 196 196 197 198 198 198 199 199 199 200 200 200 201 201 201 202 203 204 204 205 206 206 207 207 208 208 209 209 209 x Securitization: The Financial Instrument of the Future Ongoing reporting Clean up call Credit enhancements First, second and subsequent loss Internal and external credit enhancements Originator credit enhancements Excess spread or profit Cash collateral Credit-enhancing IO strip Over-collateralization Structural credit enhancements Transaction-wide support vs structural support Third-party credit enhancements Sources of external credit enhancements Suitability of third-party enhancements Sizing of credit enhancements Confidence level for different ratings Stress testing of retail portfolios Sizing of enhancement for wholesale portfolios Stepping up credit enhancements Liquidity enhancements Pay-down structure Choice of the pay-down method Maturity of the securities Profit extraction devices Cash flow waterfall Notes Understanding the Nature and Risks of Asset-backed Securities Asset-backed securities and the underlying collateral Risks in asset-backed securities Will the cash flow come in, or the credit risks? Who will get the cash flows in or servicing risk? Timing of the cash flow or prepayment risk Liquidity of the transaction Interest rate and other volatilities Other risks Modeling of asset risks Understanding Prepayment Risk in Asset-backed Securities Prepayment as a risk Nature of the prepayment option Prepayment risk in asset-backed securities Additional factors that cause prepayment of asset-backed securities Analogy using callable securities 209 210 210 211 211 212 212 215 216 216 218 218 219 219 221 221 222 223 224 225 225 226 227 227 228 229 230 231 231 233 233 233 234 234 234 234 234 235 235 236 238 238 239 Table of Contents Impact of prepayment risk on the pool Prepayment risk in mortgage pools Turnover Refinancing Prepayment modeling Static prepayment models Annual and monthly prepayment rates Various static prepayment models The PSA prepayment model The CPR and other static models Dynamic or econometric prepayment models Establishing a relation between interest rates and prepayment rates Some econometric prepayment models Projection of interest rates Which interest rate matters? Interest rate models Prepayments for adjustable rate mortgages Prepayment model for commercial mortgages Prepayment models for non-U.S pools Notes Understanding Default Risk in Asset-backed Securities Nature of default risk – default as an option The option to default on mortgages LTV ratio Movement of the LTV ratio over time Prevailing mortgage rates Housing prices Cost of default Non-economic factors Default rates as a function of seasoning Default risk for different securities Note Cash Flow Modeling for Asset-backed Securities Constructing the cash flow model Audit checks Understanding the asset and its repayment over time The factors that affect asset cash flows Incorporating prepayment in cash flow Incorporating delinquency Incorporating foreclosures and recoveries Incorporating the impact of seasoning on foreclosure The factors that affect the factors that affect cash flow Interest rate volatility and prepayment Understanding liabilities xi 239 240 241 243 244 244 244 245 246 249 250 251 252 255 255 255 256 258 258 259 261 261 262 263 263 263 264 264 264 264 265 266 267 267 269 269 270 271 272 272 273 273 274 275 xii Securitization: The Financial Instrument of the Future Claims on revenue and claims on principal Manner of repayment of liabilities Loss allocation Understanding transaction structure Excess spread as a credit enhancement Pooling excess spread into a reserve Incorporating a clean-up call Modeling a real life case Example of an auto loan securitization Stress testing the model Level of stress to apply Securitization: Financial Evaluation for the Originator Securitization: The quantifiables and the non-quantifiables Securitization vs the unknown Securitization vs cost of borrowing What is equity in the case of securitization? Relevance of debt-to-equity ratio The NPV of originator’s residual interest A sequential pay-down example Proportional pay-down example Impact of prepayment Factors affecting originator’s residual interest Expected value of originator’s residual interest 275 276 276 276 276 278 279 279 279 283 284 285 285 286 287 289 290 291 291 293 293 295 296 10 Investor Evaluation of Asset-backed Securities 297 Spreads inherent in asset-backed securities Spreads for asset-backed securities Understanding of Z spread Comparing Z spread, NPV and yield Understanding of duration Understanding of convexity Impact of prepayment on ABS investments Impact of prepayment on duration Prepayment and yield Prepayment and negative convexity Prepayment and Z spread Computation of option-adjusted spread Understanding default risk Note 298 299 300 301 302 304 304 304 305 306 306 307 308 308 Rating of Securitization Transactions 309 Structured finance ratings vs other fixed income ratings Rating agency concerns The rating process 309 310 314 11 978 Securitization: The Financial Instrument of the Future of mortgages, and prepayment risk 240 see also Prepayment see also Prepayment risk Refinancing advantage computation of 243, 251 Refinancing rate and prepayment 251 see also Dynamic prepayment models Refinancing risk in CMBS 374 in CMBS, impact of capitalization rate 375 Regressand meaning of 251 Regression analysis meaning of 251 to establish relation between interest rates and prepayment 251 see also Dynamic prepayment models Regressor meaning of 251 Regular interests in REMICs, see under REMIC Regulatory arbitrage meaning 56, 926 securitization enabling 100, 185 generally 926 Regulatory capital (banks) 1988 capital accord 878 and economic capital 923 and economic capital, see also Economic capital and gain on sale 890 Basle I 878 Basle IA, see Basle IA Basle II 878, 882–905 Basle II, see also Basle II capital relief, under Basle II 886 generally 877–923 in Belgium 135 in Germany 121 in Hong Kong 923 in Italy 126 meaning of 54, 877 relief 54 under CRD of the EU 922 under FSA UK norms 915–922 under FSA UK norms, clean break policy 915 US requirements 905–912, 913 see also Basle II see also Capital relief Regulatory capital (Insurance) impact of embedded value securitization on 519 Regulation AB generally 854–874 overview 854 rule 144A 854 Reinstating assets and revolving transactions compared 894 meaning 54 see also Early amortization capital rules see also Revolving asset securitization Reinvestment of cash, in case of securitization 198, 207 options as to modes of 207 restrictions on, in case of SPVs 87 risks 234 Reinvestment period in CDOs 421 meaning 54 see also Revolving period REIT see under Real estate investment trust REMIC generally 749–750 history of 112, 330 meaning of 749 qualifying mortgages 749 regular interests 750 residual interests 750 tax principles of 750 types of interests in 749 REMICs see also Collateralized mortgage obligations REMIC structure meaning of 76 Remittance securitization see Financial future flows Removal of accounts provision and surrender of control 781 meaning of 781 REO see under Real estate owned Repackager and originator 10 Repackaging by securitization 101 Replenishing assets conditions for banks under FSA 919 see also Revolving assets Replenishment in revolving assets securitization, meaning of, 54 Representations and warranties and selection criteria 192 consequences for breach of 690 documentation of 680 in future 481 non-standard 910 standard 680, 909 when amount to recourse 909 Index Representative taxation see also Non-discretionary trusts see also Taxation of securitization Repurchase agreement and asset lending transactions 778 Reputation risk due to securitization 880 Resecuritization meaning 54, 441 see also Structured finance CDO Residential mortgage-backed Securities prepayment risk significant in case of 197 Residential mortgage-backed securitization agency market, see under Agency market case study of UK transaction 347 case study of US transaction 342 Fannie Mae structure 340 home equity loans, see under Home equity loans securitization in UK 343 investors in 353 investors’ risks in 354 market in Europe 338 market in UK 339 market in USA 332 mortgage funding systems non-agency market, see under Non-agency market performance of 935 prepayment modeling, see Prepayment modeling private label, see Private label size of, in USA 332 structuring of 339 synthetic structure 554 synthetic structure, see also Synthetic RMBS see also Mortgage backed securities see also Prepayment modeling Residual income and equity 289 double taxation of residual income 534 Residual interests and prepayment 293 and seller’s call option, in true sale analysis 593 and true sale 593 expected value of 296 factors affecting 295 in case of Superior Bank 35 in proportional paydown 293 in sequential paydown 291 meaning of 54, 910 taxation of 740 valuation of 291–296 Residual profit and equity 289 extraction of, see Profit extraction see also Residual interest Residual value risk in equipment lease securitization 411 Resolution Trust Corporation and CMBS 372 generally 507 Restructuring as a credit event 539 see Credit events Retail pools correlation in 223 features 223 Retained components see also Components approach Retained interest for accounting purposes 805 meaning of 54 Retained profit meaning 213 see also Excess spread Retained risks in securitization 35 in securitization, accounting angle 768 minimization of 195 Reverse mortgage loan meaning 54 Revocable transfer for accounting purposes 778 Revolving asset securitization acceleration of payments in 91 accounting for 829 and future flows 392 and reinstating transactions 894 and reinstating transactions, see also Early amortization capital rules capital rules under Basle II 893 capital rules under FSA rules 819 early amortization triggers 91 early amortization triggers, capital rules, see Early amortization capital rules 893 meaning of 55 meaning of 394 pool selection in 205 receivables in 67 structure, explained 91–92, 390 structure, in case of credit cards 388 use of 92 see also Credit card receivables securitization Revolving debt structure of, in case of credit cards 387 Revolving line of credit in case of revolving structures 92 979 980 Securitization: The Financial Instrument of the Future Revolving period meaning 91 Revolving structure in CDOs 107 see Revolving asset securitization Ring fencing and securitization 72 in synthetic securitizations 544 Risk alignment of, by capital markets 22 diversification of, by securitization 27 fraud, see Fraud risk securitization of, see Risk securitization see also Risks see also Insurance risk Risk management by securitization 25 Risk securitization generally 73 increasing use of 184 see also Synthetic securitization Risk transfer and capital relief 886 by synthetic securitization, see Synthetic securitization cross-sector 36 securitization as a device of 35 see also Alternative risk transfer see also Insurance risk securitization Risk weights under Basle II and 1988 standard 883 see also Basle II Risks compliance risk 884 credit risk 880 due to securitization 879 in asset-backed securities 233, 930 in mortgage backed securities 354 in securitization 30 in a securitization deal, identification of 193 in a securitization deal, mitigation of 197 in securitized assets 782 inherent in pool assets to be securitized 193 liquidity risk 881 redistribution of, in securitization 16 reputation risk 880 retention of, and capital relief 887 strategic risk 880 transaction risk 881 see also Credit risk see also Liquidity risk see also Prepayment risk see also Servicing risk Risks and rewards and true sale, see True sale as mutually supportive 594 retention of, in a true sale case 581 under International accounting standards 811 RMBS see Residential mortgage securitization ROAP see under Removal of accounts provision Royalty see under Intellectual property securitization Rule 3a-7 meaning 55 Rule 144A and private placements 854 S Safe harbor by legal certainty to true sale 590, 591 Delaware law 592 international law 592 to securitization 113 see also True sale Sale accounting for 764 from legal viewpoint, factors in determination of 596 from tax viewpoint, meaning of 733 of assets, as precondition for securitization 570 of financial assets, versus non financial assets, for accounting purposes 764 see also True sale versus loan, from accounting viewpoint 764 Sale of the asset as basis of securitization, see also True sale 571 see also Transfer of the asset Sale treatment and financing treatment, compared 732, 818 economic ownership and 735 meaning of 55 under accounting standards, see under Accounting for securitization versus financing treatment, from tax viewpoint 733 Savings and securitization 26 institutionalization of 17 shift in pattern of 18 Scaling credit enhancement in delinked master trust structure 392 Scheduled amortization meaning 55 Scheduled principal Meaning 55 Schuldschein meaning 55 Index SDA see also Standard Default assumption SDA model computation using 273 meaning of 263 Seasonality and turnover rates 243 Seasoning and default rate 264 and default rate, see also SDA model and foreclosure rate 273 and prepayment rate 244, 270 and prepayment rate, see also PSA model and selection of pool assets 192 and turnover rates, in mortgage pools 242 generally 67 meaning of 55 Second loss regulatory capital impact 921 Second loss risk meaning of 211 Secondary mortgage markets importance of 324–326, 327–8 in other countries 338 in USA 109, 328 meaning of 324 origin of 109, 328 see also Residential mortgage-backed securitization Secured lending impact of, on cost of finance 29 process used in secured loan structures 76 Secured loan as device of asset backed financing 12 structure in securitization 76 Secured loan structure and true sale structure 76, 494, 575, 623, 628 choosing between true sale and 624 creation of security interests in 76, 624 enforcement of security interest 625 fixed charge 624 floating charge 624 floating charge, see also Floating charge generally 623–628 in whole business securitization 485 off-balance sheet treatment in case of 628 true control in 624 Securities arbitrage conduits meaning 466 Securitization accounting, see under Accounting for securitization advantages of, to investors 102–104 advantages of, to issuer 97–102 advantages of, to originator 97–102, 285–296 alchemy of 62, 97 and asset-backed financing 12, 13, 63 981 and asset sales 15 and asset securitization and borrowing 286, 573, 576 and capital markets 8, 22 and collateralized lending 574 and covered bonds 357 and credit derivatives 25 and disintermediation 23,24 and factoring 72 and financial system 17 and financial intermediation 23 and financing 5, 286 and isolation of assets and limited recourse financing 574 and loans, compared 574 and ring fencing 72 and risk distribution 25 and secured lending 574 and structured finance 13, 64 arbitrage, see under Arbitrage securitization as funding device 201, 284 asset classes 59–107 asset securitization balance sheet, see under Balance sheet securitization cash 75 cost of borrowing, impact of, on 97 costs of 104 definition of 9, 55 disadvantages of 104–106 economic impact of 26–28 economics of 62 entities that may find relevant 14 feasibility of 201 history of 108, 116, 127 interest rate risk and 101 issuer analysis, see under Originator limitations of 104 meaning of 5, 9, 55 modus operandi explained 59–62 on balance sheet 185 origin of 116 originator analysis 285–296 originator analysis, see also under Originator parties involved 201–202 process of, explained 59–62 risk 73 risks of 30, 231 risks of, see also Risks secured loan structure 76 steps in, in detail 200 structures 191–230 structures, cash and synthetic 75 structures, true sale versus secured loan 76 synthetic 45, 75 see also under Synthetic Securitization 982 Securitization: The Financial Instrument of the Future threats in 104–106 trends 183 true sale structure 76 see also Asset backed security Securitization assets see Assets in securitization Securitization investors features of Securitization law detailed treatment of legal issues 571–651 in Belgium 133 in Italy 125 in Spain 139 in United Kingdom 117 Securitization market emerging markets 185 global 108–186 history of 108 in Asia 152–178 in Australia 179 in Austria 146 in Belgium 133 in Brazil 150 in Canada 114 in China 170 in Czech Republic 146 in Denmark 127 in Europe 115–147 in Finland 141 in France 130 in Germany 119 in Hong Kong 159 in Hungary 146 in India 175 in Indonesia 166 in Italy 125 in Japan 153 in Korea 168 in Latin America 147–152 in Latvia 144 in Luxembourg 142 in Mexico 148 in Netherlands 128 in New Zealand 181 in Pakistan 176 in Poland 145 in Portugal 136 in Singapore 157 in South America 147–152 in Spain 138 in Sweden 140 in Switzerland 142 in Taiwan 173 in Thailand 161 in Turkey 143 in United Kingdom 117 in United States 112 life cycle of 111 Securitization statistics see also Securitization market Securitization structure determination of 191–201, 206 Securitization volume see also Securitization market Securitized instrument meaning of 14 see also Asset backed security Security and securitization 5, 102 general meaning of meaning of, in legal sense 645 meaning of, as capital market instrument see also Asset backed security Security Interest enforcement of, in asset backed financing 12 in secured loan structure of securitization 76, 625 possessory 625 preferential claims 625 securitization based on, see Secured loan structure see also Fixed charge see also Floating charge Security trustee as a party to a securitization 199 See though entity for tax purposes 738, 743 from tax viewpoint, see Tax transparency Selection criteria and representations and warranties 192 for selecting receivables to be pooled 59, 192 generally 22, 203 in an auto loan securitization case 406 seasoning as 192 see also under Pool Seller’s interest in revolving asset securitization 92 Seller’s share and over-collateralization 391 as early amortization trigger 398 in master trust 77 in revolving asset securitization 92, 390 Senior bonds meaning of 11 Senior notes and Junior notes 11 Senior securities concept of 13, 55 in context of structured finance 13 Separateness covenants Index in special purpose vehicles 638 see also Special purpose vehicle Sequential pay illustration of 275 structure, meaning of 55 Sequential paydown and prepayment 292 and returns of the originator 288 generally 61, 82, 225, 552 impact of 225 in CMOs 88, 342 residual interest in case of 290 structural protection trigger to switch to 192 versus pro-rata paydown 61 see also proportional paydown Serial classes of liabilities 196 see also Time tranches Service fees see Servicing fee Servicer allocation of functions 712 appointment of 209 back up 712 capabilities of 209 duties of, in legal documentation 694 evaluation of 318 functions of 71, 715 generally 199 in commercial mortgage securitization 375 information about, under Regulation AB 867 limitations of 698 master 712, 719, 724 meaning of 55 organizational structure 713 Primary 375, 712, 718, 721 powers of, in legal documentation 697 qualities of 716, 925 specialized 712, 725, 728 strengths of 713 sub-prime 722 sub-servicer 375 systems 714 termination of 701 types of 711 see also Backup servicer Servicer advances as liquidity enhancement 225 capital rules under Basle II 893 documentation of 699 meaning 56 Servicer reporting documentation of 701 requirements as to 726 requirements as to, under Regulation AB 868 983 Servicing and origination, separation of 534 by the originator, in usual cases 60 by the seller, in true sale 595 covenants in legal documentation 695 disruption of 193 Standard 704 transfer of, to back up servicer 725 Servicing asset amortization of 802 as a component of financial assets 789 under FAS 156 834 under IAS 39 815 Servicing criteria under Regulation AB 872 under servicing agreement 875 Servicing fee and excess spread 211 and true sale analysis 596 documentation of 697 Excess 698, 792 in case of credit card receivables 399 meaning of 56 normal 792 taxation of 740 Servicing migration as a risk 193 Servicing risk and the originator 71 in asset-backed securities 234 in future flows 482 Servicing standard documentation of 694 Set off as affecting sale 600 as legal risk 312 meaning of 56, 602 see Supervisory formula Share see Equity Shelf registration made applicable to ABS 112 made applicable to MBS 112, 330 SIC 12 interpretation of international accounting standard 823 meaning 56 Significant obligors under Regulation AB 867 Silent assignment meaning 927 see also Obligor notification Singapore securitization market in 157 Single-family loans meaning of 335 984 Securitization: The Financial Instrument of the Future Single monthly mortality rate meaning of 245 Single purpose entity SPVs as 70 Sizing of liabilities in securitization 195 Sliding credit enhancement in delinked master trust structure 394 Slow pay structure meaning 56 see also Fast pay SMM see Single monthly mortality rate Soft bullet structure meaning 56 see also Hard bullet structure South America securitization market in 147–152 Sovereign risks in future flows 479 Spain securitization market in 138 SPC see Special purpose company Special purpose company meaning 11, 56 see also Special purpose vehicle Special purpose entity see also Special Purpose Vehicle Special purpose trust see also Special Purpose Vehicle Special purpose vehicle administration of 70 and operating company 16 as transformation device to issue marketable securities 15 asset limitations 639 avoidance of 107, 540 bankruptcy remoteness criteria 70 bankruptcy remoteness of 16, 636 bankruptcy remoteness, see also Bankruptcy remoteness Basle II requirements for 888 capitalization of 639 capitalization of, see also Thin capitalization choosing the form of 634 concept of 631 conditions for 543 consolidation, see Consolidation (legal) consolidation, see Consolidation (accounting) constitutional documents of 635 constitutional limitations on 634, 639 corporations as 632 criteria for 70 debt limitations 637 disclosures about, in offer documents, under Regulation AB 860 doing away with, in synthetic transactions 544 employees 70 features of, in securitization 543 free assets of 639 in synthetic transactions 542 in synthetic transactions, assets of 543 in whole business securitization 495 independence of 541, 638 independent directors, role of 637 investments by 87 legal considerations 631 LLCs as 635 meaning of 8, 11, 56, 633 merger restraint 638 multi-use vehicle 640 need for 11 need for, in securitization 15, 633 need for, in synthetic securitization 544 net worth of 639 non-petition agreement 637 non-SPV structures 544 objects of 636 organizational forms 632 ownership structure of 640 ownership structure of, see also Orphan Company powers of 636 protected cell companies as 636 reinvestment of cash flows by 87 restrictions on 87 see also Bankruptcy remote see also Qualifying SPE separateness covenants for 638 structure of 633–635 structure of, in UK 119 taxation, see under Taxation of securitization taxation of, in UK 118–9 trusts as 634 use of, in securitization Sponsor meaning 56 Spread in asset-backed securities 298 meaning 298 Z-spread 300 Spreads in securitization, general 103, 298 over swaps 299 over treasuries 299 Stamp duty applicability to securitization 613 avoidance of 614, 616 differential duty 614, 616 Index equitable transfer as way out for 614 generally 613–623 in Australia 179, 622 in Germany 124 in India 618 in Ireland 623 in Maharashtra 619 in Malaysia 621 in Singapore 623 in synthetic transactions 535 in UK 118 on electronic documents 615 on future flows 615 on oral transfers 614 on pass through certificates 615, 617 on revolving assets securitization 615 Standard default assumption meaning 56 see also SDA model Standardized approach basic understanding of 884 capital rules under 891 for revolving asset transactions 893 generally 891–896 liquidity facilities under 892 liquidity facilities, see also Liquidity facility risk weights under 891 servicer advances 893 see also Basle II Stated maturity meaning 56 Static pool and prepayment, impact of 240 information about, under Regulation AB 859 meaning 56 versus dynamic pool 194 see also Dynamic pool see also Pool Static prepayment model CPR model 246 meaning of 244 PSA model 245 see also Conditional prepayment rate see also Prepayment models Static spread and Z-spread 301 Statistical pool relevance of 192 Step up structure of credit enhancement 227 Stochastic interest rates meaning of 255 see also Interest rate models 985 Stress testing computation of credit enhancement 223–24 example of 283 meaning 56 Strips meaning 56 Stripped interest in pass throughs 83 Stripped mortgage backed securities meaning of 56 Structural credit enhancement meaning of 56 Structural protection triggers 198 triggers, and prepayment 239 Structural tests see also Over-collateralization test, Interest coverage test Structure of securitization see Securitization structure Structured credit risk transfer meaning 526 Structured finance alchemy of 28 and ratings 319 essence of 526 meaning of 13, 64 principles of, in corporate finance 62 principles of, used in securitization 62 principles of, used in synthetic securitization 527 ratings, versus corporate ratings 309, 316 securitization as a product of 13 Structured finance CDO growth of 441 generally 416, 441–443 meaning of 416 Structured investment vehicle meaning 57 Structured product meaning of 57 Structured product CDO see Structured finance CDO Sub participation as a method of transfer 605 Subordinated bonds meaning of 57 Subordinated securities see Subordinated bonds Subordination as credit enhancement 195 sizing of 195, 196 see also Credit enhancement see also Liability structure 986 Securitization: The Financial Instrument of the Future Sub-participation meaning of 57, 917 Sub-prime assets in securitization 66 Sub-prime lending and securitization 32 generally 329 Subprime mortgages and home equity 353 market in 336 meaning 336 Substance over form analysis of the question of 578 for accounting purposes 763, 774 from tax viewpoint 732, 736 of securitization 579 principle of, from different viewpoints 580 subjectivity of substance 580 under Basle II 886 see also Form versus substance Substantive consolidation see also under Consolidation see also Equitable consolidation Substantive financing treatment for tax viewpoint 736 Substantive sale from tax viewpoint 736, 737 see True sale Substitute servicer see Backup servicer Super senior swap in balance sheet transactions 547 and the cost of synthetic securitization 532 meaning of 530, 531 need for 530 nomenclature - purpose of 531 pricing of 530 provider of 532, 547 see also Credit default swap Superior Bank case study 35 failure of 32 Supervisory formula computation of 901 under IRB approach 900 see also Internal ratings based approach Support class meaning of 57, 89 Surrender of control call option 887 conditions for 773, 779 FAS conditions of 773, 779 IAS conditions for 781 meaning of 773, 778 removal of accounts provision and, see under Removal of accounts provisions under Basle II 887 see also Accounting for securitization see also Components approach Swap calculation agent in synthetic securitization 544 Sweden securitization market in 140 Switzerland securitization market in 142 Syndicated lending and securitization 77 Synthetic asset concept of 525 meaning 57 Synthetic CDO asset pool in 559 hybrid 419, 559 investing in 559–561 leveraged super senior 419 meaning 57, 416 see also Collateralized debt obligations see also Synthetic Securitization Synthetic CMBS case study 557 generally 557 see also Commercial mortgage securitization see also Synthetic Securitization Synthetic RMBS case study 554 generally 554 see also Residential mortgage securitization see also Synthetic Securitization Synthetic securitization accounting volatility avoided 535 advantages of, over cash transactions 530 and cash securitization compared 30, 75, 530, 537 and cash transfers compared 525, 530 arbitrage 538, 546 arbitrage, see also Arbitrage synthetic CDO auto loans, case study 558 balance sheet 540 balance sheet, see also Balance sheet synthetic CDO CMBS, see Synthetic CMBS cost of 530 credit default swap in 525 credit enhancements 528, 545 disadvantages of 536 evolution of 551 generally 73, 108, 184, 524–556 growth of 551 hybrid, see under Hybrid structure in France 132 in Germany 120 legal issues in 628 Index leveraged 528 limitations of 536 meaning of 25, 75, 524 modus operandi of 526 over-collateralization triggers in 549 paydown method in 550 retail assets 558 RMBS 554 risk premium in 528 sizing of credit enhancements in 543 special purpose vehicle in 540 taxation of 533, 734 see also Arbitrage synthetic CDO see also Credit derivatives see also Super senior swap see also Synthetic CDO Synthetic security meaning of 25 Synthetic structure versus true sale structure, from legal viewpoint 573, 628 see also Synthetic securitization Systems impact of securitization on 202 strength of the servicer 714 T Taiwan securitization market in 173 Target amortization class meaning of 57, 90 Tax haven jurisdiction domicile 746 permanent establishment 746 putting SPVs in, for tax neutrality 746 Tax neutrality explained 730 reasons for ensuring 730 threats to 732 Tax transparency conditions for 723, 735 explained 731 of SPVs, potential for misuse 730 Tax transparent entity background for 742 meaning of 48, 57, 742 see also Pass through entity Taxation of securitization as FASITs, see FASITs as non-discretionary trusts 752 as REMICs see REMICs debt equity distinction 745, 745 deductibility of expenses 755 double taxation of residual income 534, 744 generally 729–760 987 entity level 744, 754 impact of, on securitization costs 288 in Australia 179 in Belgium 136 in Europe 115–147 in France 132 in Germany 124 in Hong Kong 160 in India 752 in Indonesia 167 in Italy 127 in Netherlands 130 in New Zealand 183 in Pakistan 178 in Singapore 158 in synthetic securitization 535 in Taiwan 174 in Thailand 164 in UK 118 in USA 752 of investors 756 of originator 738 of special purpose vehicle 742 pass through treatment 738 representative taxation 742, 752 residual income 739 residual income, see also Residual income see also Withholding taxes servicing of equity 534 substantive financing treatment, rules about 732 thin capitalization rules, see Thin capitalization withholding taxes, see Withholding taxes see also Financing treatment see also Sale treatment Term paper and commercial paper 11 meaning of 75 Term structure of interest rates, meaning of 255 securitization transactions creating arbitrage based on 101 Term securitization and ABCP, see under Asset backed commercial paper Thailand securitization market in 161 Thin capitalization implications of, on debt-equity distinction 751 implications of, on related party transactions 751 rules for tax purposes 751 Third party credit enhancement in future flows 481 meaning of 57, 219 suitability of 221 988 Securitization: The Financial Instrument of the Future Tier capital see under Capital adequacy Time tranches see under Tranches Tobacco receivables securitization in the USA 515 Toll revenues securitization in Hong Kong 516 suitability of 481 Total rate of return swap in balance sheet transactions 538 meaning of 567 tax impact of 759 Tranches meaning of 57 time 82, 196 Transfer bankruptcy remote, see under Bankruptcy remote transfer Transfer of asset certainty of, as crux of securitization 572 methods of 916 versus transfer of income, for tax purposes 738 see also True sale Transfer of income versus transfer of asset, for tax purposes 738 Transfer of receivables and assignment 916 factors for a valid transfer 596 methods of 603, 916 see also Assignment see also Sale of the asset; True sale Transfer of risks see Risk transfer Trapping of excess spread, as a structural protection trigger 198 Trigger event meaning of 57 Triggers de-leverage, see under De-leveraging early amortization, see under Early amortization triggers interest coverage, see Interest coverage test over-collateralization, see Over-collateralization test structural protection 198 Trophy asset in a case study 376 meaning 57 TROR swap see Total Rate of Return swap True control in secured loan structure 625 True sale and accounting for securitization 773, 807 and secured loan, see also Secured Loan structure and true control 624 as basis of securitization 11 case law 580–592 case law from Canada 115, 586 case law from UK 587 case law from USA 596 deferred sale consideration and 588 Delaware law 592 difficulties in 531 factors in 596 fatal factors 584 form versus substance question 580 generally 578–596 in arbitrage transactions 649 in auto loans 403 in future flows 586 meaning 58 opinions, see Legal opinion reasons for questioning 576 recharacterization 577, 579 recourse, role of 581 recourse, see also Recourse requirements 531 residual interest, role of 594 risks and rewards and 594 safe harbor law 590, 591 safe harbor law, see also Safe harbor sale consideration and 596 securitization without 568 servicing fee and 595 servicing rights and 595 structure in securitization 76 True sale initiative in Germany 124 True sale structure And secured loan structure 494 Trust deed documentation of 674, 703 see also Legal documentation Trust preferred CDOs Generally 417 Trust structure see also Master trust Trustee duties of, in legal documentation 705 in CDOs 434 in synthetic securitization 545 role of, in operations 726 Trusts as special purpose vehicle 633 meaning of 634 relevance of, in securitization 633 Index Turkey securitization market in 143 Turnover (of houses) and equity extraction 241 and housing prices 242, 243 and location 250 and refinancing rates 244 and seasonality 243 and seasoning 243 factors affecting 241 in mortgage funding 240 sale of houses, in relation to prepayment 297 see also Refinancing U UNCITRAL model law on assignment 648 Unexpected loss and credit enhancement 214 and equity 289 for economic capital 924 meaning 924 Unfunded swap See under Credit default swap United Kingdom securitization law in 117 securitization market in 117 United States of America securitization market in 112–115 Unwinding of transfers in winding up, 58 see also Clawback USA mortgage markets in, historical development 109 secondary mortgage markets in 328 securitization market in 112–115 V Vacicek model of interest rates 256 Value added tax as a problem in securitization 69 Variable interest consolidation based on 827 meaning of 827 Variable interest entities at-risk capital in case of 824 Canadian accounting standard on 115 consolidation of 824, 825 meaning of 58, 824 meaning of variable interest 819 989 VIF value of in-force policies, see under Life insurance W Waterfall generally 229 meaning 58 see also Cash flows waterfall Weighted average coupon in synthetic transactions 528 meaning of 58, 528 Weighted average cost of funding, in case of securitization 30, 203 see also Costs of funding Weighted average foreclosure frequency meaning of 58 Weighted average loss severity meaning of 58 Weighted average maturity meaning of 58 see also Duration Weighted average rate of return from a pool, and prepayment 240 Whole business securitization administrative receivership as the basis 489, 491 and asset backed transactions compared 487 and borrowing, compared 577 bankruptcy remoteness in 489 case study of 496 cash flow waterfall 490 closer to corporate finance 483 covenants in a UK case 495 credit enhancements 489 fixed charges 493 floating charges 492 generally 65, 74, 184, 485–500 in UK 485 in USA 485 leveraged buyouts and 485 market development in 480 need for SPV in 496 rating transitions in 486 secured loan structure 486 structure 489 suitability of 494 Whole loans meaning of 58 Whole loan sales and securitization, see Direct Portfolio transfers Wholesale loan pools sizing of credit enhancement in case of 224 990 Securitization: The Financial Instrument of the Future see also Retail pools Withholding taxes exemption from 759 generally 680, 757 in UK 118 problems in securitization 68 Wrap see Insurance Y Yield and implicit rate of return 298 and prepayment 307 computation of 298 in credit card portfolios 395 meaning 298 Yield curve and prepayment in case of ARMs 257 and time tranching 198 meaning 298 Z Z class in collateralized mortgage obligations 87 Z-bonds see also Accrual Bonds Z-spread and prepayment 307 meaning of 310 Securitization: The Financial Instrument of the Future by Vinod Kothari Copyright © 2006 Vinod Kothari Title of Cases Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir 1988) 641 Avianca, unreported, proceedings before Southern Distt of New York (running) 647, 672 Agnew v Inland Revenue Commissioner, 2000 (7) SCC 291 493, 500 Endico Potatoes, Inc., and Others vs CIT Group/Factoring, Inc., Second Circuit Nos 1751, 1961 Decided: October 2, 1995 583 Estate of Mixon v United States, 464 F.2d 394, 402 (5th Cir 1972) 746 Evergreen Valley Resort, 23 B.R 659 (Bankr D Me 1982) 583, 589 Bank of Upper India v Fanny Skinner (1929) AIR 51 (All) 607 BC Tel’s case -see Metropolitan Toronto 588, 589 Bharat Nidhi Ltd v Takhatmal (1969) AIR (SC) 595 611, 647 Brandt v Dunlop Rubber Co [1905] AC 454 608 Buckhead America Corporation 161 B.R 11 (Bankr D Del 1993) 642 Fanmac Limited v Commissioner of Taxation 91 ATC 4703 22 ATR 413 755 Fish v East, 114 F.2d 177 (10th Cir 1940) 641 Forster v Baker (1910) KB 636 599 Frank Lyon Co v United States, 435 U.S 561 (1978) 735, 736 Canada Trustco v Port O’Call Hotel Inc (1996) 27 D.L.R (2nd) 147 (S.C.C.) 598 Canara Bank v Tecon Engineers 80 Comp Cas 325 (Ker.) 611 Commissioner Of Income-tax V Kamalini Khatau 209 ITR 101 (SC) 752 Commissioner v North American Bond trust, 122 F 2d 545 [4]-2 USTC 9644] 2d Cir 1941) cert Denied, 314 U.S 701 (1942) 748 Commissioner v Court Holding Co., 324 U.S 331, 334 (1945) 735 Commissioner v Duberstein, 363 U.S 278, 286 (1960) 735 Commissioner v P G Lake, Inc., 356 U.S 260, 266-267 (1958) 735 Commissioner v Sunnen, 333 U.S 591 (1948) 735 Commissioner v Tower, 327 U.S 280, 291 (1946) 735 Corliss v Bowers, 281 U.S 376, 378 (1930) 735 Cory (Wm) & Son Ltd v IRC [1965] AC 1088 615 Cosslett Contractors Ltd (in administration), in re (2001) BCC 740 493, 500 CWT v Trustees of H E H Nizam’s Family (Remainder Wealth) Trust [1977] 108 ITR 555 (SC) 752 Dearle v Hall (1828) Russ 608 Dorothy v Commonwealth Commercial Co116 NE 143 (Ill 1917) 596 Durga Singh v KeshoLal (1939) 18 Pat 839 599 George Inglefield Limited [1933 ] Ch 586, 587, 589, 595 Ghisulal v Gambhirmal (1932) 62 Cal 510 599 Golden Plan of California, Inc., 829 F.2d 705 (9th Cir 1986) 671 Helby v Matthews (1895) AC 471 (HL) 587 Helvering v Clifford, 309 U.S 331 (1940) 735 Helvering v Lazarus & Co., 308 U.S., at 255 735 Home Bond Co v McCheaney 239 US 568 (1916) 596 Indu Kakkar v Haryana State Industrial Development Corporation Ltd 1999 AIR 296 SC 601 Jaffer Meher Ali v Budge Budge Jute Mills Co (1906) 33 Cal 702 600 Jivraj v Lalchand and Co (1932) 34 Bom LR 837 610 Khardah Co Ltd v Raymon and Co (India) (P) Ltd AIR 1962 SC 1810; (1963) SCR 183 601 Kingston Square Associates, 1997 WL 594707; 214 B.R 713; (Bankr S.D.N.Y 1997) 573, 642 LTV Steel 2001 Bankr Lexis 131 (Bankr N.D Ohio) 585, 586, 643, 670 Madras Industrial Investment Corporation 225 ITR 802 (SC) 741 991 992 Securitization: The Financial Instrument of the Future Major’s Furniture Mart v Castle Credit Corp 602 F.2d 538 (3d Cir 1979) 581 Metropolitan Toronto Police Widows and Orpahs Fund vs Telus Communications 588 Octagon Gas Systems, Inc v Rimmer (In re Meridian Reserve, Inc 995 F.2d 948 (10th Cir 1993) 584 Orion Finance v Crown Financial Management [1996] BCLC 78 587, 588 Palmer v Carey, 1926 A.C 703 611 Performing Right Society v London Theatre of Varieties [1924] AC 608, 611 Perumal v Perumal (1921) AIR 196 (Mad.) 607 Provat Kumar Mitter v CIT 37 ITR 91 (Cal.) 741 Ragho v Narayan (1897) 21 Bom 60 609 Rajamier v Subramaniam (1929) 52 Mad 465 599 Re Steel Wing Co Ltd (1921) Ch 349, (1920) All ER Rep 292 599 SEC v W J Howey, 328 U.S 293 (1946) 645 Simon Thomas v State Bank of Tranvancore (1976) KLT 554 (FB) 610 Skipper and Tucker v Holloway and Howard (1910) KB 630 599 Steinhardt Group Inc V Citicorp 96-7757 (U.S Ct App 3rd Cir.) September 12, 1997 645 Tagore v Tagore (1872) Beng L R 37 611 Tailby v Official Receiver (1883) 13 AC 523 647 Three Rivers District Council V Governor And Company Of The Bank Of England [1995] All ER 212 611 Tolhurst v Associated Portland Cement Manufacturers (1902) KB 660 600 The ruling in Brumark’s case 493 Vacuum Oil Co Pty Ltd v Federal Commissioner of Taxation (1964) 110 CLR419 at 434 755 Vecco Construction Industries, B.R 407 (Bankr E.D.Va 1980) 641 Villa V Petley (1934) 148 IC 721 607 Vishwapriya Financial Services & Securities Ltd v ITO (1997) 60 ITD 401 (Mad.) 758, 759 Walter & Sullivan v J Murhpy Ltd (1955) All ER 843 599 Welsh Development Agency v Export Finance Co Ltd [1992] BCLC 148 588 ... xviii Securitization: The Financial Instrument of the Future 19 Future Flows Securitization What future flows are securitizable? Some key features of future flows deals Why future flow securitization? ... continue to grow – there is no doubt about the future of this instrument, dubbed in this book as the instrument of the future Securitization is a preferred form of funding – the preferential treatment... several of the oft-cited benefits, such as bankruptcy remoteness, offbalance sheet treatment and extended leverage Most of these are derived from the technicality of the instrument The history of the