The process through which various different kinds of debt that is initiated and managed through contracts is pooled into a financial product is known as securitization. This financial pooling can consist of debt instruments such as commercial mortgages, loans for automobiles, residential mortgages and the obligations that result from credit card debt. This securitized pool of debt can then be sold as various different kinds of bonds, securities that are known as pass-throughs, or even CMOs or collateralized debt obligations. The level of principal payment and interest payment which underlies this type of security is subsequently paid back to the investors who buy these instruments on a regular basis. The securities that are backed up by the receivable amounts of different underlying mortgages are known as MBSs or mortgage backed securities, and the other types of receivable debt backed securities are known under the catch all term of ABSs or asset backed securities.

There are critics who have postulated that the level of complexity which is present within these types of securitized debt obligations can impose a limitation on the capacity an investor has to moderate and even be fully aware of the level of risk that they can be taking. There has also been the suggestion that the markets for securitized assets of this nature, competitive as they are between the various securitizing organizations, can be prone to sacrificing their underwriting standards sharply as the competitive pressure grows among them. The formation of these types of securities within the exceedingly competitive private companies that most often partake in this kind of activity are believed to have contributed to a great extent to the subprime crisis in mortgages within the United States.

Above and beyond this, the treatment of securitizations as an item that is not counted on a balance sheet combines with various guarantees an issuer can present to cover up the degree to which leverage is used within the securitizing company. This type of camouflage from several different angles can hide a high level of risk within a company’s entire capital structure, and this can also lead to a reduced price based on the genuine level of risk that these companies’ credit can impose. The securitizations off the balance sheet may very well have been a substantial part of the excessive level of leverage that became very common prior to the crisis in the global financial system. This exceedingly high degree of leverage led to serious systemic issues within companies that resulted in the need to be bailed out by the U.S. federal government.

The exceptionally granular nature of these different securitized pools of debts can produce a slight degree of mitigation on the overall level of risk that such a security can possess. Thus, the individual borrowers who are each a part of such a security can be somewhat made up for by differentials between individuals. While the normal debt of a company may be somewhat stationary, the structure of debt in a securitized context can be fluid, as can the time schedule for its initialization and its payment plan. These and other factors can contribute greatly to a less than stationary nature for securitized debt, which can also influence the overall quality that such debt possesses. If such a transaction is structured in an effective way overall, everything may very well perform as it is expected to do. If everything does as it should, the perception of credit risk on the entirety of the structured debt may very well improve. However, if the structure of such a debt instrument is not put together well, every tranche of the instrument itself may substantially deteriorate, with the potential for heavy losses mounting.

The methods that are involved in the securitization process are far different from how they began during the late 1970s, with a steady evolution from a fairly small part of business into a $10.24 trillion size within the U.S. market and $2.25 trillion within the various nations of Europe by the time the 2nd quarter of the year 2008 rolled around. In the year 2007, the issuance level of ABSs was up to $3.455 trillion within the United States and also represented a level of $652 billion within the countries of Europe. The level of whole business securitization or WBS types of arrangements began within the UK during the 1990s, and this gradually evolved to be a common occurrence within the different legal systems within the entire Commonwealth. In this system as it is nowadays, senior creditors that have lent to insolvent businesses essentially take over these indigent companies by right of owning them for all intents and purposes.

In the month of February in the year 1970, the United States’s HUD crafted the earliest known transaction that included a security that was backed by mortages. GNMA, which is also known as Ginnie Mae or the Government’s National Mortgage Association subsequently began to sell the types of securities that are backed up by the various mortgage loans that are within its portfolio.

In order to enable the securitization of other types of assets besides mortgage notes, the businesses involved began to substitute in credit enhancements from the private sector. To begin with, these businesses collateralized various pools of different assets. In a short period of time after that, these businesses further built upon the structure and the third party support. In the year 1985, the various techniques used for securitization which had come about over time within the market for mortgages also found an application within another kind of class. These various types of assets were not mortgages, but were instead the notes for automobiles. This type of asset based pool became second in volume only to mortgage notes, and they held a variety of different factors that made them all but idyllic. For one thing, they held a considerably shorter period until their maturity date. For another, car loans allow the cash flow’s timing to be a more predictable quantity. Beyond those two factors, car notes also held the appeal that the statistically long histories of being solid methods of earning cash flow gave a great deal of confidence to most investors considering them.

The earliest of car note deals came about in the form of a $60 million deal to securitize, and it was put together through the Marine Midland Bank. This deal was further securitized in the year 1985 through the Certificate of Automobile Receivable Trust.

The largest of the very early credit card sales from banks approached the market in the year 1986 using the privately placed $50 million level of some various bank card notes that were outstanding at the time. The sheer size of transaction lent some legitimacy to the investors, since it was theoretically possible to support a higher level of losses and more costs for administrative needs than the mortgage market would be able to bear. The credit card loans were able to maintain this standard and remain reasonable to sell because of the sheer interest rate level of return that they were able to generate, and thus they statistically earned at least as much interest as the more stable mortgages could even in spite of taking losses. In this type of sale, there was no type of contract that obligated the seller to offer up any kind of recourse if there was a default. This allowed any given bank to receive the benefits on their regulatory and accounting treatment of such assets from a sales perspective. This was far easier on the banks’ balance sheets, and it also relaxed the required levels of capital that would be needed for such types of securitized debt. While this was happening, it was also possible for banks to continue to originate and service the notes and receive the commensurate fees for doing so. When this early transaction was successful in the initial phase, it became a more common practice for the investors to take on the receivables of credit cards as a form of collateral. As this became commonplace, the banks adapted by developing some new structure to make the cash flow levels more normal and routine.

As the 1990s began with a few of the earliest of privately initiated transactions, the technology of securitization began to be applied within a large group of different sectors within the different kinds of markets, which included insurance and reinsurance. These types of insurance and reinsurance were particularly focused on the catastrophe and life markets. Such activities began to grow until they reached a level of approximately $15 billion of total issue levels in the year 2006, which followed the disruptive market conditions that went along with both Regulation XXX and Hurricane Katrina. The most key factors within the activities of the alternative transfer of risk included the catastrophe type of bonds, the securitization of life insurance and the sidecars of reinsurance.

The earliest known examples of a public loan that came under the aegis of the CRA of Securitization of Comminity Reinvestments Act began to happen in the year 1997. These types of CRA notes are the types of loans which target the moderate and lower income levels of both individuals and the neighborhoods in which they live.

It has been estimated within the Association that regulates the bond market within the United States that the ultimate amount of such outstanding bonds was up to $1.8 trillion by the end of the year 2004. Such an amount amounts to roughly 8 percent out of the total number of all outstanding types of debt within the bond markets, which adds up to $23.6 trillion. This is the same as roughly 33 percent within the debt types involved in mortgages, which total up to be around $5.5 trillion. This even amounts to what would be around 39 percent within the world of corporate debts, which altogether add up to around $4.7 trillion within the U.S. As it can be expressed nominally, within the past decade of time during the years between 1995 and 2004, the amount of total ABSs grew to the level of around 19 percent per year, and both the corporate debts and the debt involving mortgages grew at a level of roughly 9 percent. The issuance of total ABSs within the public sector grew to a very strong gross level, and in a great number of years even set still higher records. In the year 2004, the issuance level reached a record for all time with roughly $.9 trillion being created.

By the end of the year 2004, the greater sized sectors of the markets broke down to being primarily the credit card types of securities at roughly 11 percent of the total, the types involving the use of home equity at around 25 percent, the securities that were backed up by automobiles at 13 percent and the obligations that involved collateralized debt at 15 percent. Within the various other kinds of market segments were the types of securities that were backed up by student loans at 6 percent, the leasing of various types of equipment at 4 percent, the manufacturing of some types of housing at 2 percent, loans to the different kinds of small businesses like gas stations or convenience stores and the leasing of aircraft.

The various types of securitization only began to reach the shores of Europe during the later part of the 1980s, as the first types of securities based on mortgages began to appear within the UK. This type of technology truly began to take off during the later part of the 1990s, however, with the real main thrust coming about during the early part of the 2000s because of the greater levels of innovation that came for the structures throughout the various asset classes. These newer types of structures for debt instrument based investment took on forms such as the Master Trusts of Mortgages within the UK, which had been imported and based very closely on the credit card securitizations from the U.S.; the transactions based on insurance, including the ones that a guru within the insurance securitization world known as Emmanuel Issanchou pioneered; still more esoteric types of classes of assets, which included the lottery receivables from within the government of Greece, which were executed by an individual known as Pilippe Tapernoux.

Because of the precipitation of the ensuing credit crunch brought about due to the crisis within the subprime mortgage market, the total market for any kinds of bonds that were backed up by loans that had been securitized became extremely weak during the year 2008, with the caveat that bonds with some degree of backing from the federal government or one of its agents held some degree of marketability. Owing to this, the result was that the rates of interest began to rise for the kinds of loans that had at one point been securitized, with some examples being the mortgages of homes, the loans of students and cars, and the mortgages on commercially used structures.

The Pool and the Transfer

The original owner of the assets that are in some way involved in the deal is the originator of the loan. As a general rule, this type of company is typically out to do one of several different things, with a particular emphasis on generally adjusting the financial strength it holds, restructuring its corporate debt or raising some capital for any of a variety of different reasons. Through the more traditional types of corporate finance and the concepts inherent to them, this type of company only had three primary different options for the raising of new capital: taking on some kind of loan, issuing bonds or issuing some shares of stock ownership. In spite of this, the offerings of stock that a company can put forward can further dilute the ownership of the existing owners, and this can also change the total balance of the company’s control structure. At the same time, taking out any kind of loan or issuing any kind of bond can in many cases be expensive to the point of being prohibitive because of the level of credit that the company itself carries. Paying the levels of interest rates that could be required for many types of corporate bonds can ultimately make the company far weaker than simply not raising the capital in the first place.

The consistent nature of the revenue generation within a company can have a much greater rating for its credit than the rest of the company or even the entire company in aggregate may have. An example of this can be a company that leases as it primary business model can have a $10 million value nominally speaking within the leases it has reported, and over the term of the five years yet to come this company may receive a level of cash flow from the operation of these leases. There is no potential to demand an early repayment of the money owed for these leases, so the company will not be able to access its money early on if such a thing could be necessary. If the company were able to sell the rights to the flow of cash from these leases to another interested party, on the other hand, the leasing company has the capacity to convert the stream of income that they are likely to produce into a lump sum of cash right now. In essence, this allows a company to receive right now the entire present amount of the cash flow that will arrive in the future. In some cases, the originator may be either a bank or another kind of organization which has to meet a certain level of requirements for its adequacy of capital. In such a case, the structure of the debt instrument which would be created can become a great deal more complex due to the separate nature of the company that may potentially purchase the asset in question.

A reasonably large level of portfolio of different kinds of assets may be pooled together and subsequently transferred into being what is known as a specialized purpose vehicle, otherwise known as an SPV. This can become the issuer and be formed up as a non taxable trust or company that was formed explicitly to fund this kind of asset. Once such an asset is in the hands of the issuing party, the originator will typically no longer have any kind of recourse available. The issuing party is in a state of being that is known as being bankruptcy remote, and this means that in the event that the originator of the loan happens to fall into bankruptcy, such assets as might normally be transferred to a creditor will not be available for any kind of distribution to the originator’s creditors. To get to this kind of arrangement, the documents that govern the issuer from a business perspective restrict the level of activities only to the ones that are needed in order to make sure the issue of securities is completed in a successful way.

It comes down to the types of accounting standard that govern the time period in which a transfer of this type is either a sale, a partial sale, a financing arrangement or some kind of hybrid between a financing arrangement and a sale. If the deal is a sale, the originator does have the option to take out the assets that are transferred from its own balance sheet. However, if the deal turns up as a financing, these assets remain as the documented property of the company that originated this type of securitization throughout the deal. Going by the most common types of accounting standards within the U.S., the originator is able to get a sale put together through being far enough away that the issuer can be qualified to be a qSPE or a qualified specialized purpose entity. This requires being at some distance, so they are not considered to be the same company.

Due to the structural requirements of issuing a security in this manner, as a general rule the originator has to have the help of a bank that works in the investment field. In such an instance, the bank is known as the arranger because of its role in constructing the entire structure that makes the transaction into a valid one.

The Issuance Itself

In order to be able to purchase such an asset from its originating company, the SPV originating it has to issue securities which can be traded in order to finance this type of purchase. The investors will buy these types of securities, and there are two primary ways to do so: either through the open type of market or through an offering that is held privately that targets the investors of institutions. The performance level of these types of securities can subsequently be linked in a completely direct manner to the underlying asset performance within its structure. The agencies that rate the credit levels of companies will grade the securities that are produced and then subsequently issued for sale in order to give the investors an outsider’s perspective on the level of liability that has been created, and in order to assist the investors in making the most informed choice they possibly can.

In a transaction that involves a type of static asset class, the depositing party assembles any collateral which may be needed to underlie the security. Beyond that, the depositor will also assist in correctly structuring the securities themselves and labor in the markets where the securities will ultimately be sold in order to successfully sell them to investors. Depositors will typically also take on the additional level of significance that comes under what is known as Regulation AB. As a general rule, the depositor possesses 100% of the beneficial interest in the entity that is issued, and will typically also be either the parent of the entirely owned subsidiary company of the company that began the transaction in the first place. In a transaction that involves an actively traded or managed type of asset, the managers of these assets will generally put together all of the collateral that must underlie the security, assist in properly structuring the securities themselves and work in selling these securities once they are properly set up.

There are an assortment of different deals that can also feature a third party that in turn either guarantees or partially guarantees the assets, known as the guarantor. The guarantor also tends to guarantee the interest payments of the security and its principal in exchange for a fee.

The type of securities that are issued can have this done to include a fixed rate of interest or a rate that floats along under what is known as the system of currency pegging. An ABS that features a fixed rate will set what is called the coupon or the rate during the time when it is issued, in much the same way as a T-Bill of a corporate bond would set it at the outset. By contrast, a security that features a floating rate can be backed up through both assets that amortize and those that do not amortize, and function within what is called the floating market. Set apart from the type of securities that feature floating rates, these “floaters” can adjust during different periods in an upward or downward motion based upon a particular index, with some of the more popular ones being either the United States’s Treasury rate or the LIBOR, also known as the London Inter-bank Offering Rate. This floating type of rate will typically show the movement level of the index itself, as well as some additional level of fixed margin that covers the additional level of risk.

The Enhancement and Tranching of Credit

By contrast to the conventional type of corporate bond, which is an unsecured type of loan, the types of security that are generated through deals involving securitization are what is called credit enhanced. This means that the quality of credit that is present within such a security is above the normal level of unsecured debt that the originating company’s credit or the underlying pool of assets could generate. The fact that this kind of debt is of a higher quality further grows the level of likelihood of an investor receiving the level of cash flow to which he or she is entitled. Because of this higher likelihood of being paid, this type of security tends to possess a higher rating of credit than its issuing company. There are some kinds of securitizations which use an enhancement of the credit level from the outside which is provided by various types of third parties, and these types of external enhancements can include parental guarantees or surety bonds. However, this can also create some conflicts of interest.

The individual types of securities can frequently be split into what are known as tranches, and may also be placed into different categories that can carry a variable degree of subordinance. Every tranche possesses its own individual credit protection level and its own level of exposure to risk versus all of the others. As a general rule, there are what are called senior or A class securities, and at least one variety of subordinates or junior class securities that follow the alphabet. Each lower layer serves a protective function for both the A class of securities and for those above itself. In almost every case, any cash that is received by the SPV is first given to the more senior classes, with the most senior class getting paid before any others and the payment working down the list. Due to this cascade between the various different classes, the entire system is often called a water fall of cash flow. If something ever goes bad enough within the underlying pool of assets that they are no longer able to make payments to fund the security, such as when there are defaulted loans inside of the loan claim portfolio, this loss is first absorbed lowest on the proverbial totem pole. The lowest tranches are the first to go unpaid. Until a certain level, the highest tranches are not affected by such an issue until such a time as there is a sufficiently high level of losses that they are above the full amount that would be paid by the lower ranking tranches. As a general rule, only AAA rated securities qualify for the highest senior ranking because of the lower risk that is expected at that level. With lower credit ratings that signify a higher risk of default come the lower, subordinated ranks within the security echelons.

The lowest ranking of all the classes, which is sometimes referred to as the equity class is the most vulnerable to not being paid. There are many cases where this is an entirely different type of instrument that the originator retains for the purpose of potentially achieving profit flow. There are also cases in which the equity class does not get any kind of coupon, of the floating or the fixed variety, but does receive any kind of cash flow that may be residual after every other class has received its share of payment.

In some cases, a special class can exist which can absorb any repayment that could arrive early within the assets that are underlying this type of security. This tends to happen in cases in which the assets that underlie are mortgages, since this is a type of asset that receives full payment whenever the property on which the mortgage is placed gets sold to a new owner. Due to the fact that any kind of repayment will be passed to this particular class, every other investor receives a fairly predictable level of cash flow from this type of investment.

In the cases where an underlying asset is a mortgage or another type of loan, there may actually be two different and distinct water falls due to the fact that both the principal receipt and the interest receipt can be easy to allocate and match up. However, in a case such as that of an income based asset transaction, including a deal for a rental, it may be impossible for any differentiation to occur. This is because of the percentage of income that is actually income versus the amount of cash flow that is simply the repayment of the principal sum. Often the income tends to be used as the payment method of the cash flow that is supposed to be paid on the bond whenever such cash is due to the investor.