Structuring the Transaction

Before loans can be turned into securities, they need to be structured in a way that modifies the risks and returns for the final investors. This structuring involves several steps:

Segregating the Assets

Securitization involves separating assets from the originator or seller so that investors can assess the security's quality independently of the seller's credit quality.

Transferring Receivables

The seller transfers receivables (the money owed by borrowers) to a trust that represents the investors. For revolving assets, such as credit card debts, this transfer includes receivables from specific accounts up to a cutoff date. The trust may also purchase any new receivables arising after this date.

Ensuring Eligibility

The transferred accounts and receivables must meet specific eligibility criteria and follow the seller's promises and guarantees to protect investor interests.

Choosing Accounts — Initial Pool Selection

The seller decides which accounts' receivables will be sold to a trust, aiming to create a portfolio with predictable performance and consistent quality.

Designating Accounts: The first step is to determine which accounts are eligible to be included in the trust. For example, receivables that are overdue might be included, but accounts with defaults or write-offs may be excluded. Some issuers may include written-off receivables so that any recovered funds become part of the trust’s cash flow. Other criteria for selecting accounts could be based on geographic location, maturity date, size of the credit line, or how long the account has been active.

Selecting Assets: The next step is to choose which assets to include. This can be done randomly to create a mix that represents the total portfolio, or all qualifying receivables can be included. In random selection, the issuer determines the number of accounts needed to meet the security's target value and selects accounts randomly, like picking every sixth account from the eligible pool.

Managing Account Changes

In securitization, especially for trusts with revolving assets like credit cards or home equity lines of credit, the seller may need to add or remove accounts from the trust.

Adding and Removing Accounts

The seller might be required to add more accounts to the trust if their retained interest in the receivables falls below a level specified in the pooling and servicing agreement. Conversely, the seller may also reserve the right to remove some previously designated accounts. When these changes exceed certain limits (like 15% of the balance from the previous quarter), the rating agencies are often notified to ensure that the changes do not affect the security's rating.

Creating Securitization Vehicles

To structure asset-backed securities (ABS), banks use various types of trusts—such as grantor trusts, owner trusts, and revolving asset trusts—to protect the assets from creditors and obtain favorable tax treatment.

• Grantor Trusts: In this structure, investors are treated as the beneficial owners of the assets, with income taxed on a pass-through basis, as if investors directly owned the receivables. The trust must remain passive (not actively managing the assets) and cannot have multiple classes of interest. Grantor trusts are used for assets like installment loans, where payments are predictable.

• Owner Trusts: These trusts can issue securities in multiple series, each with different terms like maturity dates or interest rates. The trust is treated as a partnership for tax purposes, passing income and deductions directly to investors. Owner trusts are used when cash flows need to be actively managed to create "bond-like" securities.

• Stand-Alone Trusts: These involve a single group of accounts whose receivables are sold to a trust and serve as collateral for a single security. Each new issuance requires setting up a new trust.

• Master Trusts: Evolved from stand-alone trusts, master trusts allow for multiple securities to be issued over time from the same trust. All securities share the same pool of receivables as collateral, offering greater flexibility, lower costs, and easier credit evaluation. This structure is especially suited for revolving assets like credit cards or home equity lines of credit.

Providing Credit Enhancement

In securitization, credit risk is typically divided into multiple layers, or tranches, each designed to absorb varying levels of risk. This process ensures that different parties, according to their risk appetite, handle portions of the credit risk.

Tranches of Risk:

• Senior Tranche (First Loss Tranche): This tranche absorbs all initial losses up to a certain level, usually the expected or normal rate of credit loss. The originator of the securitized assets typically covers this tranche, using excess cash flow from the portfolio after expenses.

• Mezzanine Tranche (Second Loss Tranche): Covers losses that exceed the first tranche's cap. This level is usually handled by a credit enhancer, such as a high-grade institution, and is capped at a multiple of the expected losses (commonly three to five times the expected losses).

• Junior Tranche (Third Loss Tranche): Managed by the investors purchasing the asset-backed securities (ABS). While these investors are exposed to other risks (e.g., prepayment or interest rate risk), senior-level ABS classes typically have minimal exposure to credit loss.

Issuing Interests in the Asset Pool

When a securitization transaction closes, the receivables are transferred from the seller to a special-purpose vehicle (SPV), such as a trust. The trust then issues different types of certificates representing ownership interests in the asset pool.

Types of Certificates

1. Investor Certificates:

   Investor certificates represent the interests of those who buy into the securitization, either through public offerings or private placements. The proceeds from these sales, minus issuance expenses, go back to the seller. There are two primary types of investor interests:

   • Discrete Interest: Represents a specific ownership interest in particular assets, suitable for asset pools that match the maturity and cash flow characteristics of the security issued.

   • Undivided Interest: Represents a shared interest in a pool of assets, commonly used for short-term assets like credit card receivables or home equity line advances. As receivables liquidate, new receivables are added to the pool, and the investor’s undivided interest automatically applies to these new receivables.

2. Seller’s Interest:

   The seller's interest, also known as the transferor’s interest, is not allocated to investors. It serves two key purposes:

   • Provides a cash-flow buffer when payments on accounts fall short.

   • Absorbs reductions in the receivable balance due to factors like dilution or non-complying receivables.