Literature Review
Introduction
When different kinds of receivables, such as leases, loans, debts, etc. are funded with the help of a specific method, it has been referred as Securitization. On a portfolio of receivables, free trading of the asset-back securities can be performed in such a method. However, rating agencies have specified some rules and regulations that cannot be met by every individual. In this regard, credit enhancement facility for the Issuer plays a vital and crucial role in the provision of rights to be a part of the asset-backed securitization. In finance, when a method involves pool of assets for the creation and distribution of a note or a bond, such process is known as asset-back securitization. (Kirsch, pp. 19-21, 1999)
In other words, when underlying assets are utilized to acquire cash flows, the experts have deemed it as asset-backed securitization. In addition, a broader set of investors can acquire investment opportunities with the help of available assets of securitization. Some of the practical examples of asset pools are mortgages, movie revenues, loans, etc. Typically, highly confidential nature has been shown by the securitized assets in the past. In some cases, a security is created by the utilization of securitized assets for the credit enhancement. In the result, a lower rate of interest is confronted by the individual in case of securitized assets, as compared with the interest rates of any other loan of debt issuance. (Zoupounidis, pp. 50-53, 1997)
History
According to the literature, early 1970s can be associated with the process of asset-backed securitization. The Government National Mortgage Association was associated with the pool of mortgage loans at that time, which was followed by the Federal Home Loan Mortgage Corporation, as well as, the Federal National Mortgage Association, which demonstrated its involvement in the early years of 1980s. At that time, some of the government and private agencies played the role of trustees for the backing of new securities. In the result, a high level of credit rating was given to these securities due to the abovementioned guarantees by the respective agencies.
However, more technological innovations were required by the capital markets for the satisfaction of the investors. In the result, a diverse and matured mortgage product was introduced in the market, which was referred as asset-backed securities or the process, asset-backed securitization, which has been referred as ABS. (Fabozzi, pp. 20-23, 1996)
Nowadays, the total amount of transactions of asset-backed securitization can be calculated by the consideration of its staggering level of more than a trillion dollars. One of the major characteristics of such amount of issuance of ABS is its maturity and diverse options that are provided for the effective cash flow with low interest rates.
Structure
In the month of January 2005, a final definition of Asset-backed Securitization or Securities was provided in the regulation of the Securities and Exchange Commission of the United Kingdom. According to this definition, cash flows of a distinct pond of receivables examine the security. Moreover, a finite time is given to the individual for the repayment of cash in fixed or revolving transactions. Historical interpretation of the phrase of ‘conversion of cash according to the terms’ has been performed by the staff of SEC. One of the reasons of such interpretation is the exclusion of assets that require positive actions for their realization.
Lease-backed Securities
Lease-backed securities have also been included in the definition of asset-backed securitization due to the abovementioned new regulation of the SEC. However, a condition has been imposed on the lease-backed securities that the outstanding price of the leased property should be less than fifty percent of the original pool balance that has been securitized by the individual.
Delinquent and Non-performing Assets
The innovative regulation has considered that a security can be referred as an ABS, if the fundamental asset pool has total negligence of more than fifty percent at the time of the projected contribution. However, current practices have shown that twenty-percent of the original asset pool should be constituted in the neglected assets to acquire shelf registration. Moreover, if the charge-off policies of the sponsors are satisfied by asset, it can be referred as a non-performing asset. (Fabozzi, pp. 30-31, 1998)
Exceptions
The staff position of the SEC has been codified by the implementation of new regulation in such a way that a security can be referred as an asset-backed security, if a discrete pool of assets is available for its backup. However, some of the exceptions have been established by the new regulation for the addressing of market practices. The definition of an asset-backed security can be fulfilled, if a master trust structure has been used for the issuance of that security. Moreover, securities with a prefunding period of more than a year can also be included in the asset-backed securities, and successive purchases of pool assets can be done with more than fifty percent of the offering earnings. (Stone, pp. 67-70, 2005)
Major Players in Securitization
Securitization usually has engaged a wide range of counterparties, as well as, advisers during its realization. A few years ago, six law firms, three accountants, an investment bank, twelve underwriters, and an insurance broker were involved in a particular complex transaction. However, some of the major players involved in the process of securitization are the originator and administrator that play a vital role in the fulfillment of requirements on the core level. Subsequently, the issued debt by the SPV is purchased to the lead underwriter, which then involves investors, particularly Eurobond investors for the selling of this debt.
A structuring team is involved in a particular asset-backed securitization, which constitutes of three to four lawyers, as well as, different associated members of the lead underwriters, and advisers that may be specialized in the securitization. In addition, the interests of the note holders are represented with the involvement of trustee or their lawyers. The consequent pre and post effects of the transaction are analyzed by these lawyers, in order to acquire the interests of the note holders. Every asset-backed security transaction involves some amount of risk that is analyzed by the undertaking of rating agencies, which plays the role of a credit checker of the debt that has been issued to the individual.
Accounting treatment of transaction should be agreed by the accountants of the originator for the verification of analysis of the involved assets in the transaction. Moreover, solvency can also be achieved with the help of these accountants, as the undertaken work is usually confirmed by such personnel. Some of the risks associated with the assets are generally confronted by a third party that is involved in the asset-based security transaction, and such parties have been referred as credit enhancement providers. When the abovementioned service of the accountants and lawyers shows incompetency, alternative servicers manage the assets of the particular event with the help of their standby lawyers. Nowadays, the asset-backed transaction has mandated the requirement of standby services and their lawyers.
Bank accounts of the issuer, as well as, the originator is managed by the clearing banks and their lawyers, who are also considered as the parties involved in the asset-backed securitization. Normally, bank agreements, new mandates, implementation of different regulations are created and performed with the help of these clearing banks. Sometimes, additional banking facilities are required for the guaranteeing of deposit arrangements, etc, which is fulfilled and provided by the banking facility providers, as well as, their lawyers. Some form of prevarication is often required in the ABS, which is fulfilled by the services of hedging providers and their lawyers.
Furthermore, different responsibilities of Euro market are performed by a number of organizations, such as agent banks, paying agents, etc. Lastly, the prospectus is created and produced with the help of different printers. The literature has observed that transactions are often failed due to the selection of wrong printers. Thus, it is very important to choose an effective printer for the production of the prospectus. (Kimber, pp. 23-25, 2003)
Types of ABS
Home Equity Loans
Currently, one of the largest asset classes with the market of asset-backed securitization is the home equity loans that collateralize most of the securities. Typically, the home equity loans are also referred as non-agency loans by most of the investors in the market. While home equity loans are taken as second lien subprime mortgages, the majority of issuance is not made up by first-lien loans. In addition, it has been observed that higher interest rates are confronted by the borrowers of subprime mortgage, as compared with the interest rates confronted by a normal agency borrower. In addition, LTV loans-and-scratch and dent loans are consisted in the home equity loans. Such loans are some of the most effective techniques for the consolidation of debt.
Auto loans
Auto loans have captured second largest subsector in the market of asset-backed securitization. Principal pools of auto-related loans are utilized by the auto finance companies for the backing and issuance of securities. In specific, three categories have been classified in the auto asset-backed securities, which are subprime, nonprime, and prime categories. Specifically, individuals with impressive credit histories are able to borrow prime auto ABS. On the other hand, lesser quality consumers in terms of their credit history are provided with prime auto asset-backed securities. Lastly, individuals with lower incomes, no credit history, etc. are able to acquire subprime auto loans. (Murinde, pp. 77-79, 2003)
Credit Card Receivables
Since the year 1987, the credit card subsector of the asset-backed securitization market has advanced rapidly in terms of the number of securities backed by the receivables of credit card. A credit limit is assigned to the credit card holders based on the revolving repayment schedules. In addition, principal and interest rates are decided by the individual according to his/her capacities and capabilities to pay off the debt. Moreover, most of the banks now require a minimum monthly imbursement from the borrowers. In the credit card loans, an actual maturity date cannot be found due to the non-scheduling of repayment of principal amount. Therefore, a number of asset-backed securitization specialists have deemed it as a non-amortizing loan.
The de-linked master trust is one of the most common master trusts that are utilized for the issuance of asset-backed securities with the help of credit card receivables. In specific, subordinated or senior bonds are trenched from a static pool of receivable that is consisted in separate trusts. As the quantity of receivables increases, the same trust can be used by a master trust for the issuance of multiple deals, which is one of the advantages of the master trust. The senior and subordinated series is separated by the issuers with the help of delinked structures. In the result, different points in time can be issued within a trust by an issuer. Moreover, a larger pool of loans is used by the investors for acquiring greater benefit with the help of latter two structures, rather than the utilization of one static pool of the loans.
Student Loans
One of the four core asset classes is comprised in the asset-backed securities that are collateralized by the student loans. In this regard, one of the most common forms of student loans is the Federal Family Education Loan Program, and the Department of Education of the United Kingdom has played the role of a guarantee in that case. Moreover, it has been observed that a very good performance has been shown by the student loans, which has resulted in a high turnover of the investors. In the last few years, the UK government has passed a legislation that has resulted in the reduction of lender special allowance payments. Moreover, the exceptional performer designation has been eliminated, and lender insurance rates have been increased for specific loans. (Baums, pp. 63-65, 1996)
In addition, private student loans are another major portion of the student loan market that has shown immense growth in the last few years. As earlier mentioned in the paper that borrowing limits have been increased by the implementation of a new legislation, alternative lenders are being searched by the students due to an increment in the tuition fees. In this regard, the additional costs of the education are borne by the utilization of private loans by the students, as the borrowing of student loans through governmental programs does not fulfill the requirement of the students.
Stranded Cost Utilities
The competition in the European electricity market was increased by a number of Policy Acts in the 1990s, which resulted in the creation of rate reduction bonds. Recovering of certain transition costs during the moving to a competitive market has been possible due to the provision of such utilities over a period. Since utility bills are paid by the consumers on time, low charge offs have been observed in the historical statistics. In this regard, reasonable liquidity has been created in the aftermarket by the offerings of rate reduction bonds.
Others
A number of assets for the production of cash flows have been observed in the market, such as aircraft leases, royalties, equipment leases, housing loans, etc, which have played a vital and crucial role in the provision of cash flow to millions of borrowers around the globe.
Collateralized Debt Obligation
One of the major types of structured credit product and asset-backed securities is the collateralized debt obligations in the financial markets. A portfolio of fixed-income assets is utilized for the construction of collateralized debt obligations. Different tranches have been created for the division of these assets, such as senior tranches, equity tranches, and mezzanine tranches. Higher interest rates are offered by the equity tranches that has low level of seniority in terms of losses. Similarly, low level of interest rates is offered by senior tranches to the borrowers. It has been observed that fixed-income assets have been funded effectively with the help of collateralized debt obligations. (Borod, pp. 24-27, 1991)
Often, the complexity of products of collateralized debt obligations has been blamed for the financial anguishes of the last few years, which has been given by news and media commentaries. Moreover, lacking of controlling and tracking the credit performance by some buying institutions has resulted in the unavailability of expected cash flows. In the year 2007, substantial write-downs were led by the collapse of liquidity in some of the products due to the abovementioned lacking of such institutions. In the last few years, confidence in assigning credit ratings to collateralized debt obligations has been lost at a higher extent.
Advantages
The provision of a pool of financial assets is one of the significant benefits of asset-backed securitization. In other words, capital markets can be preferred for the selling of a large collection of the illiquid assets from the ABS. Moreover, credit risk of the assets has become very easy for the investors due to the remoteness of bankruptcy of the asset-backed securitization. Moreover, marketing of the bonds to investors has been facilitated by the different instruments for their utilization in the capital markets, which has become possible due to the asset-backed securitization. Asset-backed securities facilitate the instigators of the loans to benefit from most of the reimbursements of providing money without deportment the involved risks. In this regard, some of the advantages have been observed in the available literature.
In this regard, some of the significant advantages of asset-backed securitization are that the risk-weighted assets are reduced by the selling of the financial assets to the pool. In the result, the capital is freed up, and can be used in the profit-making ventures. Secondly, risk is very low in the asset-backed securitization, as in extreme cases, the price of bankruptcy has to be confronted by the owner of asset-backed securitization, rather than the originator. (Fabozzi, pp. 59-63, 2005) Moreover, origination of loans, as well as, servicing the assets results in the earning of fees by originators.
The monetary organizations that create the finances, sell a pool of assets that can produce cash flows to a particularly formed third party, which has referred as a special-purpose vehicle. In addition, this vehicle is intended to protect investors from the credit risk of the initiated monetary organization. Then, the vehicle trades the shared loans to a trust that allow interest-bearing securities for the achievement of a credit rating distinct from the monetary organization that creates the loan. The characteristically senior credit rating is specified because the securities for the funding of securitization depend exclusively on the cash flow produced by the assets.
The monthly expenditure from the fundamental possessions usually consists of the primary amount and the interest amount, with principal being planned or spontaneous Cash flows formed by the fundamental possessions can be owed to backers in a number of ways. Cash flows can be unswervingly conceded to the investors following organizational costs are deducted. Thus, results in the creation of a navigational sanctuary. On the other hand, cash flows can be imprinted according to the particular regulations and market stipulations, thus creating prearranged securities. (Davidson, pp. 41-45, 2003)
Risks
Credit Risk
Matter of credit risk is taken as a commercial matter by most of the rating agencies in the Europe, as well as, in different parts of the globe. Rating agencies play a crucial role in the assessment and analysis of credit risk associated with the asset-backed securitization, as serious costs for the structure can be involved by the outstanding concerns of the asset-backed securitization. (Kravitt, pp. 33-34, 1997)
Solvency
Rating agencies should experience a contented environment, in terms of solvency of the seller of the assets. Moreover, a period of two years from the date of the transaction is considered for the solvency of the owner by the rating agencies. In this regard, it cannot be a straightforward exercise to acquire the solvency in the asset-backed securitization. Moreover, it can be lengthy exercise to define the solvency in legal terms, which can be quite meandering for the analysts. Furthermore, it is essential to consider dependent assets, as well as, liabilities for a detailed analysis of the true solvency. In addition, the rating agencies require balance sheets and cash flows for the comprehensive analysis of the solvency in the asset-backed securitization, which can result in the confrontation of a number of risks associated with the process.
Special Risks
Every arrangement has to deal with a number of tribulations. Sometimes, the risks cannot be analyzed without the empirical observations, which can be costly in terms of money. However, legal analysis is required in study of some of the points associated with the asset-backed securitization.
Cross-Border Securitization
Actor-based opportunities for the development of expertise in different parts of the process are offered by the securitization. Similarly, structuring of different transactions in various locations around the world is facilitated by the offering of asset-backed securitization. In this regard, credit enhancement mechanisms are reduced in terms of cost, and become efficient by the implementation of cross-border securitization, which results in the reduction of cost of the capital.
For instance, cost of the evaluation of domestic borrowers by the foreign investors is very high, as compared with the cost associated with the utilization of a convincing domestic organization that can offer facilities of credit enhancement to their investors. In the end, the sponsors, borrowers, as well as, investors can share the savings from the process. In other words, efficiency of expertise can be optimized by the cross-border securitization due to the segmented features of the asset-backed securitization. (Rosenthal, pp. 72-74, 1998)
Rating Agencies
In the United Kingdom, asset-backed securitization and associated transactions have been analyzed and commented on by four rating agencies in the region. In this paper, we will try to discuss two of the four rating agencies, Moodys and Standard & Poors. Distinctive styles can be seen in the other two agencies as well, however, the below-discussed approaches are quite similar to the approaches of the other two rating agencies.
Standard and Poors
It has been observed that a weak-link approach is favored by the Standard & Poors. In this approach, the weakest link of the structure has been given due significance, as compared to the strongest link of the structure. According to the exercises of the Standard & Poors, all the components of the structure of asset-backed securities should be AAA, if an AAA rating is required by a borrower. However, the Standard & Poors focuses on the learning of the elements that may result in the disqualification for the required rating. In this regard, Standard & Poors solely analyzes the poorly rated elements during the credit rating services in the process of asset-backed securitization. (Kellerer, pp. 46-49, 2004)
Moodys
In many respects, an opposite position has been taken by the Moodys. The increasing strengths of a structure should be assessed in detail for the analysis of a rating according to the Moodys, which facilitates based on a building block approach. Additionally, bond values are also assessed during the analysis of a Moodys rating. In other words, a variety of stress environments is quantified with the retuning value to the note holders, which are considered for the analysis of the rating. In this regard, Moodys have employed quite different and diverse approach, as compared with the Standard & Poors; however, these two credit rating agencies have been able to cater the needs and requirements of all the parties involved in the process of asset-backed securitization. (Fishman, pp. 98-100, 2000)
Conclusion
Conclusively, the paper has defined, discussed, and analyzed different aspects of asset-backed securitization that are available in the existing literature related to the topic. The literature seems to be equipped with immense knowledge related to asset-backed securitization, and the process has facilitated a number of organizations and individuals for the effective flowing of their balance sheets in different continents of the globe. In specific, the paper has reviewed the literature of asset-backed securitization with respect to its activities in the European continent. It is hoped that this literature review will facilitate the students, teachers, and professionals in the better understanding of the role of asset-backed securitization.
References
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