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HG4028.A84F325 2008 332.63’2--dc22 2008014508 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 FJF To my wife Donna, and my children Francesco, Patricia, and Karly VK To Acharya Mahaprajna with deepest reverence Contents Preface xiii About the Authors xvii PART ONE Background 1 CHAPTER 1 Introduction 3 What Is a Securitization? 5 Illustration of a Securitization 8 Securities Issued in a Securitization 10 Key Points of the Chapter 11 CHAPTER 2 Issuer Motivation for Securitizing Assets and the Goals of Structuring 13 Reasons Securitization Is Used for Funding 13 Structuring Goals 21 Key Points of the Chapter 24 PART TWO Structuring ABS Transactions 29 CHAPTER 3 Structuring Agency MBS Deals 31 Prepayments and Prepayment Conventions 31 Sequential Pay Structures 38 Planned Amortization Class Bonds and Support Bonds 43 Targeted Amortization Class Bonds 50 vii viii CONTENTS Accrual Bonds and Accretion-Directed Bonds 50 Floating Rate Bond Classes 55 Notional Interest-Only Bond Classes 60 Key Points of the Chapter 61 CHAPTER 4 Structuring Nonagency Deals 65 Identifi cation of the Asset Pool 68 Selection of the Assets 69 Identifi cation of Risks 70 Determination of the Sources and Size of Credit Support 72 Determination of the Bond Classes 73 Time Tranching of Bond Classes 75 Selecting the Pay Down Structure for the Bond Classes 76 Determination of the Amount and Sources for Liquidity Support 77 Determining if Any Prepayment Protection Is Needed 78 Inclusion of Structural Protection Triggers 79 Key Points of the Chapter 80 CHAPTER 5 Credit Enhancements 85 Credit Enhancement Mechanisms 86 Sizing of Credit Enhancements 93 Key Points of the Chapter 97 CHAPTER 6 Use of Interest Rate Derivatives in Securitization Transactions 101 Interest Rate Swaps 101 Caps and Floors 115 Counterparty Risk 118 Key Points of the Chapter 120 CHAPTER 7 Operational Issues in Securitization 123 The Servicing Function 124 Types of Servicers 124 Contents ix Servicer Strengths 125 Servicer Qualities 128 Servicing Transition 141 Backup Servicer 142 Reporting by the Servicer 142 Role of Trustees in Operation of the Transaction 143 Fraud Risk 144 Key Points of the Chapter 145 PART THREE Review of ABS Collateral 147 CHAPTER 8 Collateral Classes in ABS: Retail Loans 149 Collateral Classes: Basis of Classifi cation 149 Collateral Classes: Main Types 152 Credit Card Receivables 153 Auto Loan Securitization 161 Key Points of the Chapter 165 CHAPTER 9 Asset-Backed Commercial Paper Conduits and Other Structured Vehicles 169 Types of ABCP Conduits 170 Traditional Securitization and ABCP 173 ABCP Collateral 174 Credit Enhancement Structure 174 Liquidity Support 177 Parties to an ABCP Program 178 Rating of ABCP Conduits 180 Key Points of the Chapter 182 CHAPTER 10 Securitization of Future Cash Flows: Future Revenues, Operating Revenues, and Insurance Profi ts 187 Future Revenues Securitization 187 Whole Business or Operating Revenues Securitization 195 x CONTENTS Securitization of Insurance Profi ts 204 Key Points of the Chapter 206 PART FOUR Collateralized Debt Obligations 209 CHAPTER 11 Introduction to Collateralized Debt Obligations 211 Why Study CDOs? 211 Terminology: CDO, CBO, CLO 212 Types of CDOs 213 Typical Structure of a CDO 217 Basic Economic Drivers of CDOs 220 CDO Market and the Health of Banking 224 Growth of the CDO Market 225 Key Points of the Chapter 227 CHAPTER 12 Types of Collateralized Debt Obligations 229 Balance Sheet CDOs 229 Arbitrage CDOs 243 Resecuritization or Structured Finance CDOs 249 Index Trades and Index Tracking CDOs 251 Key Points of the Chapter 252 CHAPTER 13 Structuring and Analysis of CDOs 255 Measures of Pool Quality 255 Asset and Income Coverage Tests 257 Ramp-Up Period 261 The CDO Manager 261 Investing in CDOs 265 Collateral and Structural Risks in CDO Investing 266 Key Points of the Chapter 270 Contents xi PART FIVE Implications for Financial Markets 273 CHAPTER 14 Benefi ts of Securitization to Financial Markets and Economies 275 Securitization and Funding Costs 277 Securitization and Financial Intermediation 281 Benefi ts of Securitization in an Economy 284 Key Points of the Chapter 288 CHAPTER 15 Concerns with Securitization’s Impact on Financial Markets and Economies 291 Reduces the Effectives of Monetary Policy 291 Adverse Impact on Banks 293 Lax Underwriting Standards and Poorly Designed Securities 294 Increases Opaqueness of Bank Risk 300 Key Points of the Chapter 302 APPENDIX A Basics of Credit Derivatives 305 Elements of a Credit Derivative Transaction 306 Bilateral Deals and Capital Market Deals 310 Reference Asset or Portfolio 311 Structured Portfolio Trade 312 Types of Credit Derivatives 321 APPENDIX B Valuing Mortgage-Backed and Asset-Backed Securities 325 Cash Flow Yield Analysis 325 Zero-Volatility Spread 327 Valuation Using Monte Carlo Simulation and OAS Analysis 328 Measuring Interest Risk 339 References 343 Index 349