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70-459: The typical structure for the securitization of commercial real estate loans is a real estate mortgage investment conduit (REMIC), a creation of the tax law that allows the trust to be a pass-through entity which is not subject to tax at the trust level. Many American CMBS transactions carry less prepayment risk than other MBS types, thanks to the structure of commercial mortgages. Commercial mortgages often contain lockout provisions (typically

140-450: A " qualifying special purpose entity " or " qSPE ". Because of these structural issues, the originator typically needs the help of an investment bank (the arranger ) in setting up the structure of the transaction. To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors ) or on

210-432: A block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business. Off balance sheet : Derivatives of many types have in the past been referred to as " off-balance-sheet ". This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there

280-427: A company would have three options to raise new capital: a loan , bond issue , or issuance of stock . However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates. The consistently revenue-generating part of the company may have a much higher credit rating than

350-431: A high cost. Securitization allows such banks and finance companies to create a self-funded asset book. Lower capital requirements : Some firms, due to legal, regulatory , or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining

420-490: A higher rate of return (on a risk-adjusted basis) Opportunity to invest in a specific pool of high quality assets : Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to

490-427: A larger pool of investment options. Portfolio diversification : Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities. Primary servicing The term primary servicer refers to companies that monitor and manage loans. The primary servicer of

560-412: A loan can be the loan originator, the mortgage banker or a third party and maintains direct contact with the borrower. If the loan falls into default or needs special attention, a special servicer would undertake this role. The latest Mortgage Bankers Association end of year survey shows the top CMBS servicers and servicing volumes within the industry. Total C/MF Loans Secured by Collateral OUTSIDE

630-421: A lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk. The most junior class (often called the equity class ) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only

700-418: A period of 1–5 years where there can be no prepayment of the loan) which they can be subject to defeasance , yield maintenance and prepayment penalties to protect bondholders. European CMBS issues typically have less prepayment protection. Interest on the bonds may be a fixed rate or a floating rate, i.e. based on a benchmark (like LIBOR / EURIBOR ) plus a spread. The following is a descriptive passage from

770-437: A revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to

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840-434: A security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can make the securities more attractive. In addition to subordination, credit may be enhanced through: A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be

910-648: A senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities. Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in

980-430: A trust. The trust issues a series of bonds that may vary in yield, duration and payment priority. Nationally recognized rating agencies then assign credit ratings to the various bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is subordinate to the lowest rated bond class. Investors choose which CMBS bonds to purchase based on

1050-509: Is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of

1120-575: Is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In

1190-412: Is a true sale, a financing, a partial sale, or a part-sale and part-financing. In a true sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator. Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as

1260-422: Is a well-known example. A controlled amortization structure can give investors a more predictable repayment schedule, even though the underlying assets may be nonamortising. After a predetermined "revolving period", during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event

1330-454: Is commonly referred to as the "B-piece buyer". B-piece buyers generally purchase the B-rated and BB/Ba-rated bond classes along with the unrated class. The trustee’s primary role is to hold all the loan documents and distribute payments received from the master servicer to the bondholders. Although the trustee is typically given broad authority with respect to certain aspects of the loan under

1400-493: Is essential. CMBS has become an attractive capital source for commercial mortgage lending because the bonds backed by a pool of loans are generally worth more than the sum of the value of the whole loans. The enhanced liquidity and structure of CMBS attracts a broader range of investors to the commercial mortgage market. This value creation effect allows loans intended for securitization to be aggressively priced, benefiting Borrowers. Mortgage-backed securities can be distinguished by

1470-455: Is generally a senior ("A") class of securities and one or more junior subordinated ("B", "C", etc.) classes that function as protective layers for the "A" class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have been repaid. Because of the cascading effect between classes, this arrangement

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1540-464: Is generally referred to as the "waterfall". If there is a shortfall in contractual loan payments from the Borrowers or if loan collateral is liquidated and does not generate sufficient proceeds to meet payments on all bond classes, the investors in the most subordinate bond class will incur a loss with further losses impacting more senior classes in reverse order of priority. The typical structure for

1610-481: Is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes. Reduces funding costs : Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This

1680-430: Is often referred to as a cash flow waterfall . If the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities might be AAA or AA rated, signifying

1750-493: Is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur. In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations that master trusts sometimes do, that requires each issued series of securities to have both

1820-453: Is the hard bullet , which guarantees that the principal will be paid on the scheduled maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee. Securitizations are often structured as a sequential pay bond , paid off in a sequential manner based on maturity. This means that

1890-462: Is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points . For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of

1960-413: Is the risk of the debt being retired early. On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet , meaning that the final bullet payment is not guaranteed to be paid on the scheduled maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure

2030-399: Is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default . When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of

2100-541: Is usually essential in securitizations, especially if it is an atypical securitization. Size limitations : Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions. Risks : Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips. Opportunity to potentially earn

2170-425: The credit quality of securitized debt is non- stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss. Securitization has evolved from its beginnings in

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2240-550: The " coupon " (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-amortizing assets in the floating market. In contrast to fixed rate securities, the rates on "floaters" will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects

2310-677: The "Borrower Guide to CMBS" published by the Commercial Mortgage Securities Association and the Mortgage Banker's Association : Commercial real estate first mortgage debt is generally broken down into two basic categories: (1) loans to be securitized ("CMBS loans") and (2) portfolio loans. Portfolio loans are originated by a lender and held on its balance sheet through maturity. In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled and transferred to

2380-671: The "earning power" of the assets. Locking in profits : For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on. Transfer risks ( credit , liquidity , prepayment , reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing

2450-546: The Pooling and Servicing Agreement (PSA), the trustee typically delegates its authority to either the special servicer or the master servicer. There will be as few as one and as many as four rating agencies involved in rating a securitization. Rating agencies establish bond ratings for each bond class at the time the securitization is closed. They also monitor the pool’s performance and update ratings for investors based on performance, delinquency and potential loss events affecting

2520-410: The assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors. Unlike corporate bonds, most securitizations are amortized , meaning that the principal amount borrowed is paid back gradually over the specified term of

2590-558: The book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates. May reduce portfolio quality : If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk. Costs : Securitizations are expensive due to management and system costs, legal fees , underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs

2660-417: The borrower may deal with a primary servicer that may also be the loan originator or mortgage banker who sourced the loan. The primary servicer maintains the direct borrower contact, and the master servicer may sub-contract certain loan administration duties to the primary or sub-servicer. (Also see special servicer ) Upon the occurrence of certain specified events, primarily a default, the administration of

2730-471: The case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets. Earnings : Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often

2800-438: The company as a whole. For instance, a leasing company may have provided $ 10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today

2870-734: The earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis. In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses

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2940-403: The first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth. Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security. Some originators (e.g. of mortgages) have prioritised loan volume over credit quality, disregarding

3010-401: The flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically

3080-435: The investors. A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors and potential receivables. A third risk

3150-403: The issuance of securities. Many issuers are typically "orphaned" . In the case of certain assets, such as credit card debt, where the portfolio is made up of a constantly changing pool of receivables, a trust in favor of the SPV may be declared in place of traditional transfer by assignment (see the outline of the master trust structure below). Accounting standards govern when such a transfer

3220-692: The late 18th century to an estimated outstanding of $ 10.24 trillion in the United States and $ 2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $ 3.455 trillion in the US and $ 652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain

3290-436: The level of credit risk/yield/duration that they seek. Each month the interest received from all of the pooled loans is paid to the investors, starting with those investors holding the highest rated bonds, until all accrued interest on those bonds is paid. Then interest is paid to the holders of the next highest rated bonds and so on. The same thing occurs with principal as payments are received. This sequential payment structure

3360-406: The loan is transferred to the special servicer . Besides handling defaulted loans, the special servicer also has approval authority over material servicing actions, such as loan assumptions. The most subordinate bond class outstanding at any given point is considered to be the directing certificate holder, also referred to as the controlling class. The investor in the most subordinate bond classes

3430-495: The loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralised by fully amortizing assets, such as home equity loans , auto loans, and student loans . Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed to try to define common prepayment activity. The PSA prepayment model

3500-506: The loans within the trust. Securitization Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities , which may be described as bonds , pass-through securities , or collateralized debt obligations (CDOs). Investors are repaid from

3570-463: The long-term risk of the assets they have created in their enthusiasm to profit from the fees associated with origination and securitization. Other originators, aware of the reputational harm and added expense if risky loans are subject to repurchase requests or improperly originated loans lead to litigation, have paid more attention to credit quality. A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has

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3640-442: The movement in the index plus an additional fixed margin to cover the added risk. Unlike conventional corporate bonds which are unsecured, securities created in a securitization are " credit enhanced ", meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive the cash flows to which they are entitled, and thus enables

3710-399: The open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision. In transactions with static assets, a depositor will assemble the underlying collateral, help structure

3780-484: The originator would continue to service the receivables, in this case the credit cards. There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have

3850-500: The originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle. The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses

3920-474: The parent company. Admissibility : Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset. Liquidity : Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once

3990-404: The present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets. A suitably large portfolio of assets is "pooled" and transferred to a " special purpose vehicle " or " SPV " (the issuer ), a tax-exempt company or trust formed for

4060-458: The principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS). The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general corporate debt ,

4130-460: The repayment structures of these securities can differ significantly due to the nature of the residential versus commercial real estate markets. The master servicer’s responsibility is to service the loans in the pool through to maturity unless the borrower defaults. The master servicer manages the flow of payments and information and is responsible for the ongoing interaction with the performing borrower. (Also see primary servicer ) In some cases

4200-422: The residual cash flow (if any) after all the other classes have been paid. There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid whenever the properties are sold. Since any early repayments are passed on to this class, it means the other investors have a more predictable cash flow. If

4270-419: The right to control the company. The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances (but also includes businesses established specifically to generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under traditional corporate finance concepts, such

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4340-413: The securities and work with the financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB . The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble

4410-444: The securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest). The issued securities are often split into tranches , or categorized into varying degrees of subordination . Each tranche has a different level of credit protection or risk exposure: there

4480-423: The securitization of commercial real estate loans is a real estate mortgage investment conduit (REMIC). A REMIC is a creation of the tax law that allows the trust to be a pass-through entity which is not subject to tax at the trust level. The CMBS transaction is structured and priced based on the assumption that it will not be subject to tax with respect to its activities; therefore, compliance with REMIC regulations

4550-439: The specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is " bankruptcy remote", meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete

4620-403: The strength of the underlying collateral and other credit enhancements. Reduces asset-liability mismatch : "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis." Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at

4690-450: The type of real estate behind the collateral: The characteristics of Commercial MBS vary depending on the term. While the longer-term loans (5 years or longer) often have fixed interest rates and restrictions on early repayments, shorter-term loans (1–3 years) usually have variable interest rates and free early repayments. Commercial Mortgage-Backed Securities (CMBS) and Residential Mortgage-Backed Securities (RMBS) are distinct primarily in

4760-537: The underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals one cannot categorise the revenue so easily between income and principal repayment. In this case all the revenue is used to pay the cash flows due on the bonds as those cash flows become due. Credit enhancements affect credit risk by providing more or less protection for promised cash flows for

4830-468: The underlying assets that support them. RMBS are securities backed by a home or residential apartment loan bundle, allowing investors to benefit from mortgage payments and homeowners' interest. On the other hand, CMBS is supported by loans on commercial properties such as office buildings, retail stores, shopping centers, or other commercial spaces. It provides investors with cash flow from the income these commercial properties generate. The risk profiles and

4900-441: The underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors. Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee. The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system. Fixed rate ABS set

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