Using Securitization as a Corporate Funding Tool

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					Using Securitization as a Corporate Funding Tool
by Frank J. Fabozzi


Executive Summary
 •     Securitization involves the creation of one or more securities backed by a pool of loans or receivables.
 •     Securitization is an important vehicle for raising funds that are used by nonfinancial and financial firms.
 •     The motivation for the use of securitization rather than the issuance of a secured corporate bond is the
       potential to reduce funding costs, particularly for firms that have a low credit rating.
 •     Another reason for the use of securitization is to manage corporate risk.
 •     The securitization process involves the creation of a special-purpose vehicle and the transference of
       assets to that entity.
 •     All securitization transactions require one or more forms of credit enhancement to obtain a credit rating.


Introduction
Securitization is the process of creating securities backed by a pool of loans or receivables. For a
corporation, securitization is an alternative fund-raising process to the issuance of secured corporate bonds.
The securities issued via the securitization process differ from traditional secured corporate bonds, where
it is necessary for the corporate issuer to generate sufficient earnings to repay the bondholders. So, for
example, if an equipment manufacturer issues a bond in which the bondholders have a first mortgage lien on
one of its plants, the ability of the manufacturer to generate cash flow from all of its operations is required to
pay off the bondholders. In contrast, in a securitization transaction, the burden of the source of repayment
to those holding the created securities shifts from the cash flow of the corporate issuer to the cash flow of a
pool of loans or receivables, and/or to a third party that guarantees the payments if the asset pool does not
generate sufficient cash flow.
Although securitization was first used in the late 1960s by US government entities to create mortgage-
backed securities, it was not used by nonfinancial corporations (i.e., corporations whose principal activity is
the production of goods and nonfinancial services) to raise funds in the public market until March 1985 when
Sperry Lease Finance Corporation (now Unisys) issued securities backed by a pool of lease receivables.
Despite a major setback in the securitization market due to problems with one asset class—residential
mortgage-backed securities backed by subprime borrowers—securitization continues to be an important
funding alternative for nonfinancial corporations.


Types of Assets Securitized
The types of assets that have been securitized can be divided into four general categories: Mortgage loans,
retail loans, wholesale loans, and operating revenue.
The securities created by securitization of a pool of mortgage loans are referred to as mortgage-backed
securities (MBS). Those backed by a pool of high-quality residential mortgage loans are called residential
mortgage-backed securities, and those backed by a pool of commercial loans (i.e., mortgage loans for
income-producing properties such as apartment buildings, office buildings, and shopping centers) are called
commercial mortgage-backed securities. These securitized products are typically used as funding vehicles
for financial entities such as depository institutions (banks and savings and loan associations) and finance
companies. For nonfinancial entities the bulk of securitizations use account receivables.
When securities are backed by a pool of retail loans, they are referred to as asset-backed securities (ABS).
The major types of retail loans securitized include credit card receivables, home equity loans, automobile
loans, and student loans. In fact, the largest sector of the asset-backed securities market is the mortgage-
related asset-backed securities market, the sector that saw a major meltdown starting in the summer
of 2007. The wholesale market includes commercial loans and bonds. The security created from the
securitization of these types of debt instruments is called a collateralized debt obligation. Finally, a special
area which has been used primarily in Europe is the securitization of operating revenue.

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The Securitization Process
To explain the securitization process and the parties involved, we will use an illustration of a hypothetical
corporation, which we call HCE, Inc., which manufactures heavy construction equipment. Although some
of this firm’s sales are for cash, the bulk are in the form of installment sales contracts. Effectively, an
installment sale contract is a loan to the buyer of the equipment who agrees to repay HCE over a period of
time specified in the contract. For purposes of this illustration, it is assumed that the loans are all for four
years. The collateral for the loan is the equipment purchased by the borrower. The loan specifies an interest
rate that the buyer pays.
The credit department of HCE makes the decision as to whether to extend credit to a customer. It receives
a credit application from a customer and, on the basis of criteria established by this manufacturer, decides
whether to extend a loan and the amount that will be lent. The criteria for extending credit or a loan are
referred to as underwriting standards. Because HCE is extending the loan, it is referred to as the originator of
the loan.
Moreover, HCE may have a department that is responsible for servicing the loan. Servicing involves
collecting payments from borrowers, notifying borrowers who may be delinquent, and, when necessary,
recovering and disposing of the equipment if the borrower defaults on its obligation. The servicer of loans
need not be the originator of the loans, but in our illustration we are assuming that HCE is the servicer.
Let us now examine how these loans can be used in a securitization transaction. Figure 1 summarizes the
transaction. We will assume that HCE has more than $300 million of installment sales contracts. This amount
is shown on the corporation’s balance sheet as an asset, or more specifically as a receivable. We will further
assume that HCE wants to raise $300 million and that HCE’s treasurer decides to raise that amount by
securitizing these receivables.




Figure 1. Illustration of securitization of $300 million of installment sales contracts
To do so, HCE will set up a legal entity, referred to as a special-purpose entity (SPE) or special-purpose
vehicle (SPV). For now, we’ll postpone explaining the purpose of this legal entity, but it will be made clearer
later that the SPE is critical in a securitization transaction. Let’s assume that the SPE that is set up by our
hypothetical manufacturer is Construction Asset Trust (CAT). HCE will then sell to CAT $300 million of the
loans and, in exchange, will receive from CAT $300 million in cash, the amount that HCE’s treasurer wanted
to raise. CAT obtains the $300 million to pay for the pool of loans by selling securities that are backed by
the pool of loans acquired. It is these securities issued by CAT that are called asset-backed securities.
The asset-backed securities issued in a securitization transaction are also referred to as bond classes or
tranches.
A simple transaction can involve the sale of just one bond class with a par value of $300 million. We will call
this Bond Class A. Suppose that 300,000 certificates are issued for Bond Class A with a par value of $1,000
per certificate. Then, each certificate holder would be entitled to 1/300,000 of the payment from the collateral
after expenses and fees are paid. Each payment made by the borrowers (i.e., the buyers of the equipment)
consists of principal repayment (i.e., amortization) and interest.
The typical securitization transaction has more than one bond class. For example, there can be rules for
distribution of principal and interest other than on a pro rata basis to different bond classes. It may be difficult
to understand why such a structure should be created. What is important to understand is that there are
institutional investors who have needs for bonds with different maturities and credit ratings. A securitization

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transaction can be designed to create bond classes with investment characteristics that are more attractive
to institutional investors to satisfy those needs.
An example of a more complicated transaction is one in which two bond classes are created, Bond Class
A1 and Bond Class A2. The par value for Bond Class A1 is $130 million and for Bond Class A2 it is $170
million. The priority rule can simply specify that Bond Class A1 receives all the principal that is paid by the
borrowers until all of Bond Class A1’s $130 million has been paid off, and then Bond Class A2 begins to
receive principal. Bond Class A1 is then a shorter-term bond than Bond Class A2.
As will be explained later, there are typically structures where there is more than one bond class, but the
two bond classes differ as to how they will share any losses resulting from defaults of the borrowers in the
asset pool. In such a structure, the bond classes are classified as senior bond classes and subordinate
bond classes, and the structure is referred to as a senior subordinate structure. Losses are realized by the
subordinate bond classes before there are any losses realized by the senior bond classes. For example,
suppose that CAT issued $250 million par value of Bond Class A, the senior bond class, and $50 million par
value of Bond Class B, the subordinate bond class. As long as the aggregated defaults in the asset pool do
not exceed $50 million, then Bond Class A will be repaid its $250 million in full.


Potential for Reducing Funding Costs
To understand the potential for reducing funding costs by securitizing corporate assets rather than issuing
a corporate bond, consider once again our hypothetical manufacturer, HCE, Inc. Suppose that this
corporation’s credit rating as assigned by the three major rating agencies (Fitch Ratings, Moody’s Investors
Service, and Standard & Poor’s) is triple-B. If HCE’s treasurer wants to raise funds of $300 million and
it issues a corporate bond, its funding cost would be whatever the benchmark Treasury yield is plus the
prevailing yield spread for triple-B issuers in the bond market. Suppose, instead, that the treasurer utilizes
$300 million of its installment sales contracts as collateral for a bond issue. In that case, the cost will be the
same as if it issued a standard corporate bond, because if HCE defaults on any of its outstanding debt, the
creditors will go after all of the corporate assets, including the loans to HCE’s customers.
Now instead suppose that HCE creates CAT (the SPE) and sells the loans to that entity as explained in the
previous section. If the sale of the loans by HCE to CAT is done properly—that is, the sale of the loans is at
the fair market value—CAT, not HCE, is then the legal owner of the receivables. This means that if HCE is
forced into bankruptcy, its creditors cannot recover the loans sold because they are legally owned by CAT.
The implication is that if CAT sells the asset-backed securities that are backed by the pool of loans, investors
interested in buying the bonds will evaluate the credit risk associated with the pool of loans independently
of the credit rating of HCE. The credit rating that will be assigned to the securities issued by CAT will be
whatever CAT wants the credit rating to be! It may seem odd that the issuer (CAT) can get any credit rating
it wants, but that is the case. The reason is that CAT will show the characteristics of the collateral for the
securities (i.e., the loans it will acquire) to a credit rating agency. In turn, the rating agency will evaluate the
credit quality of the loan pool and inform CAT what must be done to obtain a desired credit rating.
More specifically, the issuer will be asked to “credit enhance” the structure. There are various forms of credit
enhancement that we will review in the next section. Basically, the rating agencies will look at the potential
losses from the loan pool and make a determination of how much credit enhancement is necessary for the
securities issued to achieve the targeted rating sought by the issuer. The higher the credit rating sought
by the issuer, the more credit enhancement a rating agency will require. Thus, HCE, which we assumed is
triple-B rated, can obtain funding using the loan pool as collateral to obtain a better credit rating for the bonds
issued than its own credit rating. In fact, with enough credit enhancement, it can issue a bond of the highest
credit rating, triple A.
The key to a corporation issuing bonds with a higher credit rating than the corporation’s own credit rating is
the SPE. Its role is critical because it is the SPE that legally separates the assets used as collateral from the
corporation that is seeking funding.
It would seem natural that a corporate treasurer would always seek the highest credit rating (triple A) for the
securities backed by the collateral in a securitization transaction. However, the awarding of a targeted credit
rating requires sufficient credit enhancement, and this does not come without a cost. As described in the
next section, there are various credit enhancement mechanisms, and they increase the costs associated

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with borrowing via a securitization. So, when seeking a higher rating, the corporate treasurer must assess
the trade-off between, on the one hand, the additional cost of credit enhancing the securities to be issued by
the SPE and, on the other hand, the potential reduction in funding cost by issuing a bond with a higher credit
rating.
A case study of the use of securitization to reduce funding costs is provided by Ford Motor Company. In
2001, the auto manufacturer was facing the downgrade of its credit rating to that of noninvestment grade
status (more popularly referred to as “junk bond” status). As a result, in early 2002 its wholly owned financing
subsidiary, Ford Motor Credit (FMC), increased its issuance of asset-backed securities backed by auto loans
rather than issue corporate bonds. For example, in the first two weeks of 2002, FMC issued $5 billion in
asset-backed securities. In fact, because of the concern with downgrading, from 2000 to mid-2003, FMC
increased securitizations to $55 billion (28% of its total funding) from $25 billion (13% of its total funding).
Also, while the ratings of the auto manufacturers were downgraded in May 2005, the ratings on several of
their securitization transactions were actually upgraded due to high subsisting levels of credit enhancement.


Securitization as a Tool for Risk Management
The potential to reduce funding costs is the main reason why nonfinancial corporations will use
securitization, but another important reason is that it provides a risk management tool. More specifically,
once the loans or receivables are sold to the SPE, the risks associated with those assets are transferred to
the SPE and, ultimately, to the owners of the asset-backed securities. One major such risk is credit risk—the
risk that the borrower will default.
A case study of how securitization has been used as a risk management tool is once again provided by Ford
Motor Credit. Automobile loans are assets on the firm’s balance sheet and subject the firm to the risk that
borrowers will default on their obligations. On the use of securitization by Ford Motor Credit’s chief financial
officer, David Cosper, the following comment appeared in a BusinessWeek article:
“Overall, Ford Credit’s balance sheet is shrinking as it implements its lower-risk strategy. The pool of loans
that it manages is expected to drop from $208 billion at the end of 2001 to $180 billion to $185 billion by
the end of this year. ‘We have put the brakes on the business,’ says Cosper. That smaller portfolio is better
managed and suffers fewer losses, boosting profits. Credit losses in the first quarter totaled $493 million,
down from $912 million in the final quarter of 2001.”


Credit Enhancement
There are two forms of credit enhancement—external and internal. External credit enhancement involves
third-party guarantees such as insurance or a letter of credit. Internal credit enhancement includes
overcollateralization, senior subordinated structure, and reserves. Securitization transactions will often have
more than one form of credit enhancement. The rating agencies specify the amount of credit enhancement
required to obtain a specific credit rating. Based on prevailing market conditions, the issuer must assess
each form of credit enhancement to determine the most cost-effective credit enhancement mechanism or
combination of mechanisms. In general, when deciding to improve the credit rating on some securities in a
structure, the issuer will evaluate the trade-off associated with the cost of enhancement versus the reduction
in yield required to sell the security.
Below we describe the various forms of credit enhancement mechanisms.

Third-Party Guarantees
Until the difficulties encountered by monoline insurers, the most common form of third-party guarantee
was insurance wherein, for a premium, an insurance provider agrees to guarantee the performance of a
certain amount of the collateral against defaults. The rating agencies decide on the creditworthiness of the
insurance provider to determine the credit rating of the asset-backed securities to be issued. Perhaps the
biggest perceived disadvantage to this form of credit enhancement is so-called event risk. Triple A rated
bondholders, for example, may only be able to enjoy triple A status for as long as the enhancement provider
retains its triple A credit rating status. If the credit enhancement provider is downgraded (i.e., its credit rating

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is lowered by a rating agency), the bonds guaranteed by the enhancement provider are typically downgraded
as well unless the performance of the collateral warrants no downgrade.

Overcollateralization
Overcollateralization, a form of internal credit enhancement, is provided by issuing securities with a par value
that is less than the par value of the loans or receivables in the asset pool. For example, if there are $300
million of loans in an asset pool and the issuer wanted to use overcollateralization for credit enhancement
to achieve, say, a triple A credit rating for the securities to be issued, the issuer would obtain from the rating
agencies an indication as to how much par value of securities it could issue versus the $300 million par value
of loans in the asset pool to obtain the target rating. Depending on the characteristics of the loans and their
perceived creditworthiness, the rating agencies might allow, say, $285 million of par value of securities to be
issued. The cost of this form of credit enhancement is implicit in the price paid for $300 million par value of
collateral versus the proceeds of issuing only $285 million par value of securities.

Senior Subordinate Structure
The senior subordinate structure, which was mentioned earlier, involves the subordination of some bond
classes for the benefit of attaining a high investment-grade rating for other bond classes in the structure. On
the basis of an analysis of the collateral, a rating agency will decide how many triple A bonds can be issued,
how many double A bonds, and so forth down to nonrated bonds.
The cost of this form of credit enhancement is based on the proceeds that will be received from selling the
bonds, which is in turn determined by the demand for the bonds. The yields that must be offered on the bond
classes are affected by the yields demanded by investors. The lower the credit rating of the bond class, the
more yield is demanded and the lower will be the proceeds received by the SPE from the sale of the bonds
for that bond class.

Reserve Funds
Reserve funds come in two forms: Cash reserve funds and excess spread. Cash reserve funds are straight
deposits of cash generated from issuance proceeds. In this case, part of the profits from the deal are
deposited into a fund and used to offset any losses. Excess spread accounts involve the allocation of excess
spread into a separate reserve account after paying out the coupon to bondholders, the servicing fee, and all
other expenses on a monthly basis.


Making It Happen
Using securitization as a funding vehicle requires an understanding not just of the transactions but also of
the implementation issues. These include:
 •     having the ability to analyze alternative securitization structures in order to maximize the proceeds
       received from the sale of the loans/receivables (i.e., best execution);
 •     determining whether, given market conditions, the issuance of secured debt or asset-backed
       securitization is the better funding vehicle;
 •     having a relationship with an investment banker that can structure the transaction based on prevailing
       market conditions and the characteristics of the collateral, as well as negotiating with the rating
       agencies regarding credit enhancement;
 •     having the ability to service the loans and report on the assets in the pool, or identifying other entities
       capable of doing so;
 •     having an organizational structure and staff that will allow frequent securitizations.


Conclusion
Securitization, the process of creating securities backed by a pool of loans or receivables, has become an
important funding source for both financial and nonfinancial corporations. In addition to the potential for
reducing funding costs, securitization can be used as a risk management tool. The key in a securitization
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process is the role played by the SPE. In a properly structured securitization transaction, investors in the
securities issued by the SPE, called asset-backed securities, can only look to the cash flow of the loan pool
held by the SPE to repay the debt obligation and not to the general assets of the seller/originator of the loans
or receivables.
In a securitization transaction, to obtain a credit rating that will allow the sale of the asset-backed securities,
the structure must be credit enhanced. Credit enhancement provides protection of varying degrees for the
bond classes in the structure. Credit enhancement mechanisms include third-party guarantees such as
insurance or a letter of credit (external credit enhancement) and overcollateralization, senior subordinated
structure, and reserves (internal credit enhancement).


More Info
Books:
 •     Davidson, Andrew, Anthony Sanders, Lan-Ling Wolff, and Anne Ching. Securitization: Structuring and
       Investment Analysis. Hoboken, NJ: Wiley, 2003.
 •     Fabozzi, Frank J. (ed). Issuer Perspectives on Securitization. Hoboken, NJ: Wiley, 1999.
 •     Fabozzi, Frank J. (ed). Accessing Capital Markets through Securitization. Hoboken, NJ: Wiley, 2001.
 •     Fabozzi, Frank J., and Vinod Kothari. Introduction to Securitization. Hoboken, NJ: Wiley, 2008.
 •     Kothari, Vinod. Securitization: The Financial Instrument of the Future. 3rd ed. Hoboken, NJ: Wiley,
       2006.
 •     Peaslee, James E., and David Z. Nirenberg. Federal Income Taxation of Securitization Transactions.
       3rd ed. New Hope, PA: Frank J. Fabozzi Associates, 2001.

Articles:
 •     Fabozzi, Frank J., and Vinod Kothari. “Securitization: The tool of financial transformation.” Journal of
       Financial Transformation 20 (2007): 33–45. Online at: tinyurl.com/3ahfwdv [PDF].
 •     Roever, W. Alexander, and Frank J. Fabozzi. “A primer on securitization.” Journal of Structured
       Finance 9:2 (Summer 2003): 5–19. Online at: dx.doi.org/10.3905/jsf.2003.320307

Websites:
 •     Vinod Kothari’s securitization website: www.vinodkothari.com
 •     Federal Income Taxation of Securitization Transactions website: www.securitizationtax.com


See Also
Best Practice
 •  Credit Ratings
 •  Securitization: Understanding the Risks and Rewards
Checklists
 •     The Bond Market: Its Structure and Function
 •     How to Use Credit Rating Agencies
 •     How to Use Receivables as Collateral
 •     Understanding Capital Markets, Structure and Function
 •     Understanding Debt Cover

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