Parties Involved In Securitization Process
The securitization process redistributes risk by breaking the traditional role of banks into specialized functions: originator, servicer, credit enhancer, underwriter, trustee, and investor.
Borrowers
The borrower plays a crucial role in the performance of asset-backed securities because they are responsible for repaying the underlying loans. Often, borrowers are unaware that their loans have been sold to investors, allowing the original bank to keep managing the customer relationship.
Credit Quality Categories
In terms of credit risk, securitization has led to the practice of categorizing borrowers into different quality ratings. Below is an example of generic borrower descriptions used by Duff and Phelps Credit Rating Corporation in rating mortgage borrowers. At the top of the scale, 'A'-quality borrowers have excellent credit histories, while 'D'-quality borrowers have poor credit histories. This classification helps investors assess the risk associated with different pools of loans.
Originators
Originators are the entities that create and manage the assets used in asset-backed securities. They include various types of organizations such as auto finance companies, banks, insurance firms, and commercial businesses.
Types of Originators
Auto Finance Companies: These companies are major players in the securitization market for car loans. They specialize in creating securities backed by automobile loans.
Thrifts and Banks: Thrifts focus on securitizing residential mortgages through methods like pass-throughs and mortgage-backed bonds. Commercial banks, on the other hand, handle a broader range of assets including auto loans, credit card receivables, trade receivables, and mortgages.
Commercial Businesses: Companies in sectors like technology and airlines also use securitization to manage receivables from their regular business activities, turning their sales into securities.
Servicer
The servicer manages the securitized assets after they are sold. The originator/ lender of a pool could act as the servicer as well. They are responsible for:
Customer Service and Payment Processing: The servicer manages interactions with borrowers, processes payments, and addresses payment issues.
Default Management: They handle default situations and may liquidate collateral to recover funds.
Administrative Support: The servicer supports the trustee by preparing monthly reports, sending payments to the trust, and providing management instructions.
Reporting: Servicers provide monthly reports on asset performance and administration, which are distributed to investors, the trustee, rating agencies, and credit enhancers.
Trustee
The trustee is a third party hired to manage the trust that holds the assets backing an asset-backed security. Their primary duty is to protect the interests of the investors. They are responsible for:
Administration and Oversight: The trustee manages the trust according to the trust agreement, ensuring that cash flows are distributed as specified and that all parties comply with the agreement’s terms.
Monitoring and Reporting: The trustee monitors the performance of the servicer and credit enhancer, reviews periodic financial reports from the servicer, and checks that the assets generate sufficient cash flow.
Problem Resolution: If issues arise, the trustee focuses on resolving problems with the servicer and other parties, including declaring events of default and replacing the servicer if necessary.
Credit Enhancer
Credit enhancement protects investors by ensuring that they receive timely payments of interest and principal, even if the cash flows from the underlying assets are insufficient. This method improves the security’s credit rating, making it more attractive and marketable.
Types of Credit Enhancement
Third-Party Credit Enhancement: This involves using external support, such as letters of credit or surety bonds from highly rated banks or insurance companies. These third-party enhancers must have credit ratings that match or exceed the rating sought for the security. They provide a guarantee that in case of any shortfall in cash flows, they will cover the interest and principal on the asset-backed security.
Internal Credit Enhancement: Due to the limited availability of highly rated third-party enhancers, internal methods are often used. One common approach is the senior/subordinated structure. In this setup, cash collateral accounts and junior classes of securities absorb losses before impacting the senior classes. This internal support helps ensure that the senior securities continue to receive their payments.
Rating Agencies
Rating agencies play a crucial role in structured finance by assessing the credit quality of asset-backed securities. Their evaluations help investors determine the safety of these investments.
Areas of Review
Rating agencies evaluate four main aspects:
Quality of Assets: The overall quality and reliability of the assets backing the security.
Originator/Servicer Abilities: The strength and capabilities of the originator and servicer managing the assets.
Transaction Structure: The robustness of the transaction’s overall setup and how it is designed to manage risk.
Credit Support Quality: The effectiveness and reliability of any credit enhancements or support mechanisms in place.
Underwriter
The underwriter of asset-backed securities plays a key role in the creation and sale of these securities. Their primary responsibilities include advising the seller on the best way to structure the security, setting its price, and marketing it to potential investors.
Expertise and Relationships
Underwriters are chosen for their strong connections with institutional investors and their ability to provide guidance on market terms and pricing. They also have a deep understanding of the legal and structural requirements that regulated institutional investors must follow.
Investors
The main investors in asset-backed securities include pension funds, insurance companies, fund managers, and, to a lesser extent, commercial banks. These institutional investors are drawn to asset-backed securities for their potential to provide attractive returns.
Investment Appeal
The primary attraction of asset-backed securities is their high rate of return compared to other investments with similar credit risk. This makes them a popular choice for investors seeking better yields in their portfolios.
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