As will be explained in Chapter 5, the credit quality of the securities can also be achieved by the use of a third-party guarantor.

See, for example, Meckling (1977) and Miller (1977).

Another reason for the comparison is that the factor becomes the credit and collection department of the client firm; in the case of securitization, the collection and servicing function is typically either originator-retained, or transferred to independent servicers.

The client firm is still responsible for the customer account if the nonpayment is due to reasons such as disputes over product specifications or quality of the product.

While true sale is a significant legal issue in securitization, it must be appreciated that the question is whether a sale is “true.” This implies determination of the truth of what is apparently a sale—the question is therefore subjective. While market practitioners try to learn from past experience and construct transactions that abide by certain true sale tests, there cannot be an absolute safe harbor.

For a further discussion, see Chapter 9 in Kothari (2006).

Qualifying SPEs defined in Para. 35 of FAS 140 are not required to be consolidated under FIN 46.

Basically, there are four questions that must be asked to determine if a consolidation is required: (1) Does the corporation have enough equity at risk in the SPV? (2) Is the corporation allowed to make decisions about the activities of the SPV by either voting rights or similar rights? (3) If the SPV incurs a loss, does the corporation have an obligation to absorb that loss? (4) If here are any residual economic benefits expected from the activities of the SPV, does the corporation has the right to receive them? If the answer to any of the above questions is affirmative, then consolidation is required.

Technically, only Ginnie Mae (the Government National Mortgage Association) is an agency of the U.S. government, being part of the Department of Housing and Urban Development. Fannie Mae and Freddie Mae are government-sponsored entities and the securities they issue are called conventional mortgage-backed securities. However in this chapter we refer to the securitization of these three entities as agency deals.

See Chapter 5 in Fabozzi, Bhattacharya, and Berliner (2007) for a further discussion.

Blum and DiAngelo (1998) discuss how an investment banker seeks to create an efficient structure.

More accurately, agency CMOs are backed by a pool of agency mortgage pass-through securities. Nonagency CMOs are backed by unsecuritized residential loans (whole loans).

In the earliest stages of the development of the MBS market, cash flows were calculated assuming no prepayments for the first 12 years at which time all the mortgages in the pool were assumed to prepay. This naive approach was replaced by the “FHA prepayment experience” approach, where FHA is an abbreviation for Federal Housing Administration. The prepayment experience for 30-year mortgages derived from an FHA table on mortgage survival factors was once the most commonly used benchmark for prepayment rates. It calls for the projection of the cash flow for a mortgage pool on the assumption that the prepayment rate will be the same as the FHA experience (referred to as 100% FHA), or some multiple of FHA experience (faster or slower than FHA experience). Despite the method’s past popularity, prepayments based on FHA experience were not necessarily indicative of the prepayment rate for a particular pool, mainly because FHA prepayments are for mortgages originated over all sorts of interest rate periods. Prepayment rates are tied to interest rate cycles, however, so an average prepayment rate over various cycles is not very useful in estimating prepayments. Moreover, new FHA tables are published periodically, causing confusion about which FHA table prepayments should be based on. 3 It is referred to as such because it is applied on the pool balance that remains after the previous period’s prepayment. It is not applied on the original pool balance—hence, it is not an absolute rate.

The PSA and the CPR approaches are not mutually exclusive alternatives but are mostly used together—the PSA to explain the ramp-up of the expected CPR over the initial months of seasoning. Thereafter, the pool undergoes a constant CPR.

Notice that for month 1, the SMM shown in Table 3.1 is for a passthrough that has been seasoned two months. This is because the WAM is 358 months.

In the absence of prepayments, this amount would be constant over the life of the pass-through security. The formula for calculating the total monthly mortgage payment can be found in Chapter 22 in Fabozzi (2006).

If the par value of the bonds exceeds the par value of the collateral, it would mean the excess spread inherent in the assets has been capitalized. This presupposes that there will not be any prepayment and the excess spread will be realized. As this assumption is impractical, transactions structures mostly do not allow monetization of the excess spread up-front.

Note that the average life is not the expected maturity. Assuming 100% PSA, for example, while bond class A’s average life is 4.7 years, it might still take roughly 10 years for bond class A to be completely repaid.

The PAC structure was first introduced in the mortgage-backed securities market in March 1987. The M.D.C. Mortgage Funding Corporation CMO Series 0 included a class of bonds referred to as stabilized mortgage reduction term bonds or “SMRT” bonds; another class in its CMO Series P was referred to as planned amortization class bonds or PAC bonds. The Oxford Acceptance Corporation III Series C CMOs included a class of bonds referred to as a planned redemption obligation bonds or PRO bonds. The name PAC is now used to describe these structures.

In the early days of the CMO market, floating rate bond classes were sold as part of the residual interest bond class in a structure.

See Jorion (1995) for a description of the Orange Country bankruptcy.

Inverse floaters with a wide variety of coupon leverages are available in the CMO market. Participants refer to low-leverage inverse floaters as those with a coupon leverage between 0.5 and 2.1; medium-leverage as those with a coupon leverage higher than 2.1 but not exceeding 4.5; and high-leverage as those with a coupon leverage higher than 4.5. The issuer develops the coupon leverage according to the desires of investors.

The exception is collateralized debt obligations that we discuss in Part Four of this book.

Accounting standards such as FAS 140 permit recognition of the excess profit as a gain on sale, subject, of course, to netting of all liabilities created in the process of securitization. Related international accounting standard IAS 39 also permits recognition of gain on sale where the transaction qualifies for off-balance-sheet treatment.

For instance, providing for capital for the first-loss risk retained by the originator/seller, or below-investment-grade securities bought by the seller, or liquidity risk in case of revolving securitizations.

Expected loss or base case loss is a sort of average loss, or a loss if the future is as predicted with maximum likelihood. The deviations from the average, that is, future loss rates exceeding the expected loss rates, lead to computation of the unexpected loss. In most pools that have an excess spread, the excess spread level should at least be expected to absorb the expected losses. Credit enhancements are normally put in place to absorb the unexpected losses. For a further discussion, see Chapter 5.

If, for instance, the transaction provides for a bullet repayment of the liabilities, the pay-down sequence does not just matter.

Note that in time tranching we explained what a sequential-pay structure is: paying off the most senior bond classes in sequence.

For a more detailed discussion, see Silver (2000).

A structure would rarely pay the excess spread up-front because the up-front payment of excess spread would imply capitalization of the expected profits. Leaving aside default rates, even prepayments can affect the expected losses—hence, transactions that pay excess spreads up-front may be left with principal losses due to prepayments.

There are various forms in which the originator/seller can receive this excess profit: as excess servicing fees; as super profits on the subordinated debts acquired by the originator itself; as interest on a subordinated loan; or the redemption price of a zero-coupon bond. For a discussion of these forms, see Kothari (2006).

For a further discussion see Kotecha (1998).

Warrent Buffett’s Berkshire Hathaway Assurance is licensed to provide financial guarantees (i.e., provide bond insurance).

Note that the cumulative loss for the asset pool cannot be found by the product of the annual default rate and the number of years. This is because due to amortization and prepayments, the loss rate is applied on an ever-reducing size of the asset pool.

This section and the discussion on the application of caps and corridors to securitizations draw from Fabozzi, Morel, and Grow (2005).

As a matter of fact, the negative cash flow impact of the swap payments on pre-2001 CBO transactions, and pre-9/11 aircraft ABS transactions are examples of how such derivatives can be a burden to these deals.

Using interest to pay down the principal of a bonds prior to the scheduled repayment date is referred to as “turboing” bonds.

An available funds cap is included in transactions backed by adjustable-rate residential mortgage loans because the loans are typically benchmarked to six-month LIBOR and the securities issued by the SPV are benchmarked to one-month LIBOR (hence there is basis risk). Hence, for any month the available interest from the loans may be less than the amount due the bondholders. The available funds cap restricts the amount due to the bondholders to the interest available.

For details, see Chapter 28 in Kothari (2006).

The full text of the SEC complaint is at www.sec.gov/litigation/complaints/comp19509.pdf.

For more details on the nature of capital recovery, see Kothari (1996).

Commercial paper might have different meanings in different countries. It is typically taken to mean funding for a term up to 270 days, in some cases, going up to 365 days. The definition of the word security is in the U.S. Securities Act and excludes securities with maturities up to nine months. Hence, CP of 270 days’ maturity is exempt from securities regulation. Commercial paper is issued mostly in the form of promissory notes.

We discuss CDOs in Part Four.

For a further discussion of each of these, see Standard & Poor’s (2005c).

An easy approach may be to know some standard deviations from the average of the inflows.

See FitchRatings: Note Acceleration in Whole Business Securitization, April 2, 2004, graphic giving scenarios where different senior securities will suffer downgrade.

For example, see the Integrated Prudential Sourcebook of the FSA, U.K., Annex 2G.

See Chapter 3.

See Appendix A for a discussion on credit derivatives.

The underlying argument is that presence of correlation in a pool makes lower tranches safer and senior tranches riskier. Thus, equity or junior investors are happier with correlation. Correlation trading is very common in the case of index trades.

If, on the intended bullet maturity, the assets have not fully amortized, the manager has the option to auction the assets of the CDO—this is called an auction call, similar to a cleanup call in the case of traditional ABS.

The entire text is available at https://www.federalreserve.gov/boarddocs/speeches/2005/20050505/default.htm.

For sizing up of the enhancements, relative to the target rating of a tranche, see Chapter 5.

For more on true sale in securitization transactions, see Kothari (2006).

For a detailed discussion on true sale issues, see Chapter 23 in Kothari (2006).

Obligor notification is a requirement in many countries, but it is seldom ever done in practice. Such countries still recognize the transfer as an “equitable transfer.”

This juniormost piece seldom takes the form of legal equity, but is nevertheless an economic equity of the SPV. The legal form can be preference shares with participation rights, subordinated loan, or zero-coupon bond.

In practice, the flexibility to an extent is retained by the originator retaining a call or substitution option for such assets needed back for obligor service. But the call back option is constrained by both legal and accounting restrictions, and is generally as complicated as the initial transfer itself.

For a detailed discussion of index trades, see Kothari (2008).

The Herfindahl Index is used by economists as a measure of competition in a given industry.

The use of automatic deleverage triggers has become almost universal in structured vehicles, such as structured investment vehicles, hedge funds, and CDOs. There is an apprehension that as these triggers require these vehicles a nondiscretionery, and hence, mindless liquidation of assets during a phase of market adversity, these triggers help intensify the cyclical effects of the downturn.

The rating agencies’ correlation assumptions have been critically reviewed in Fender and Kiff (2004).

A pay option adjustable-rate mortgage allows the borrower to select the payment method: fully amortizing over 15 years or 30 years, interest-only payments, or a payment based on a below market rate that results in negative amortization.

http://www.ustreas.gov/press/releases/hp808.htm

While bankruptcy is often a result of financial difficulties arising from problems in paying creditors, some bankruptcy filings are made prior to distress, when a large claim is made on assets (for example, class action liability suit).

For a further discussion, see Fabozzi and Modigliani (1992).

SR 97-21 (SUP), July 11, 1997.

S&P had projected a cumulative loss of 14.84% [see http://www2. standardandpoors.com/spf/pdf/media/Teleconference_final_072507.pdf]

The bankruptcy filing by New Century in April 2007 was also under investigation for securitization accounting practices, including gain-on-sale accounting and overvalued residual interests. New Century was one of the major subprime lenders in the U.S. market.

For further details see the investigation report of the Inspector General, FDIC: Issues Relating to the Failure of Superior Bank 6th, Febuary 2002, at http://www.fdicig.gov/reports02/02-005.pdf.

United States Gerneral Accounting Office, Analysis of the Failure of Superior Bank, FSB, Hinsdale, Illinois, Statement of Thomas J. McCool, February 7, 2002, pp. 7-8.