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. A Mortgage dyoungil.choi%40moodys.com+the industry continues to look for new assets to securitize such as auto leases, small-business loans and "stranded cost recovery" ABS. (The latter refers to bonds backed by fees some newly deregulated utilities have won authority to include in future billings as an offset of previous investment.) How Securitization Works ABS and MBS represent an interest in the underlying pools of loans or other financial assets securitized by issuers who often also originate the assets. The fundamental goal of all securitization transactions is to isolate the financial assets supporting payments on the ABS and MBS. Isolation ensures payments associated with the securities are derived solely from the segregated pool of assets and not from the originator of the assets. By contrast, interest and principal payments on unsecuritized debt are often backed by the ability of the issuing company to generate sufficient cash to make the payments. Origination and Servicing The assets used in securitizations are created—or originated—in a number of ways. When a lender extends a loan or acquires another revenue-producing asset such as a lease, they are creating assets that can be securitized. Other assets, such as the balances due on credit card accounts or a corporation's accounts receivable can also be securitized. Because they initiate the securitization chain, the lenders, credit card companies and others are also called originators. Originators often retain a connection to their assets following a securitization by acting as a servicer—the agent collecting regular loan or lease payments and forwarding them to the SPV. Servicers are paid a fee for their work. Some originators contract with other organizations to perform the servicing function, or sell the servicing rights. Asset Transfer or the "True Sale" In the vast majority of securitizations, it is critical that the transfer of assets from the originator to the SPV is legally viewed as a sale, or "true sale." The proceeds of the securities are remitted to the originator as the purchase price for the assets. If the asset transfer is not a "true sale," investors are vulnerable to claims against the originator of the assets. The cash flows backing the securities or the assets themselves could be ruled a part of the originator's estate and used to satisfy creditors' claims if a true sale did not occur. Legally separating the assets also protects the originator. Investors can turn only to the SPV for payments due on the ABS and MBS, not to the general revenues of the originator. 4 zycnzj.com/

zycnzj.com/ www.zycnzj.com Special Purpose Vehicle and the Trust The SPV can either be a trust, corporation or form of partnership set up specifically to purchase the originator's assets and act as a conduit for the payment flows. Payments advanced by the originators are forwarded to investors according to the terms of the specific securities. In some securitizations, the SPV serves only to collect the assets which are then transferred to another entity—usually a trust—and repackaged into securities. Individuals are appointed to oversee the issuing SPV or trust and protect the investors' interests. The originator, however, is still considered the sponsor of the pool. Underwriter Underwriters—usually investment banks— serve as intermediaries between the issuer (the SPV or the trust) and investors. Typically, the underwriter will consult on how to structure the ABS and MBS based on the perception of investor demand. The underwriter may, for example, advise the SPV to issue different tranches each with specific characteristics attractive to different segments of the market. Underwriters also help determine whether to use their sales network to offer the securities to the public or to place them privately. Perhaps most importantly, underwriters assume the risk associated with buying an issue of bonds in its entirety and reselling it to investors. Credit Enhancement Credit enhancement is common in securitization transactions. Depending on the nature of the transaction and the type of assets, the securitization pool may need such support to attract investors. Enhancement or support can come from the assets themselves or from an external source. Examples of internal enhancements include subordinating one or more tranche, or portion, of the securities issued. This practice places the claims of one tranche over another. Any defaults affecting the securities must be absorbed by a subordinate tranche before the senior tranche is affected. Over-collateralization of asset pools is also used to enhance credit. This occurs when the amount of assets placed in a securitization pool exceeds the principal amount of bonds issued. External credit enhancements can include a surety bond or a letter of credit from a financial institution. Both options serve as guarantees that investors will receive the payments associated with the securities. GSEs enhance the credit of the MBS they issue by guaranteeing the timely repayment of principal and interest. Credit Rating Virtually all ABS and MBS are rated by independent rating agencies whose analyses is watched closely by investors as a guide to the credit quality of the securities. In almost all cases, rating agencies monitor the performance of the securities on an ongoing basis. 5 zycnzj.com/

zycnzj.com/ www.zycnzj.com Dealers Just as in other bond markets, dealers play an important role once an issue is initially distributed. For most bond investors, liquidity—the ability to easily buy or sell a security—is an important characteristic. By offering prices at which they will buy or sell bonds to the investment community, dealers provide this service. Bonds typically trade more actively closer to their date of issue. Because bond investors—usually institutional investors such as pension funds and insurance companies—hold most bonds to maturity, trading in bonds declines as they draw nearer to their stated maturity date. The issuance volume of a certain bond, a bond's credit rating and whether it was issued publicly or privately can also affect liquidity. All ABS and MBS are traded on the dealer-based, over-the-counter markets so liquidity depends in part on the ability and willingness of dealers to maintain an inventory, or make a market, in a certain bond. Benefits of Securitization Less Expensive, More Broadly Available Credit The public benefits of securitization are evident in a number of ways. Chief among these is the contribution of securitization to lower borrowing costs both for individuals and corporations. The existence of a liquid secondary market for home mortgages increases the availability of capital to make new home loans. Financial institutions that realize the full value of their loans immediately can turn around and re-deploy that capital in the form of a new loan. This is often the most efficient way to raise new funds in the capital markets and the savings are passed on to the borrower. Consumers other than homebuyers also benefit from lower borrowing costs. Securitization can lower a firm's financing costs as well. MBS and ABS are often designed to carry a higher credit rating than the originating firm would otherwise realize for other types of bonds. Higher credit ratings mean the security is less risky and translates into a lower interest rate for the originator as investors do not demand the same risk premium. The originator passes the savings on to the consumer in the form of lower lending rates. Securitization also aids in the geographic dispersion of capital to areas that may otherwise be deprived of credit options. Traditionally, depository institutions have provided credit in the areas where they accepted deposits. By securitizing loans, however, the lender generates capital for new loans that may come from a different location. This linkage to the capital markets broadens the range of regions where depository institutions obtain capital to provide credit. By subjecting the lending decisions of financial institutions to valuation by the capital markets, securitization also encourages an efficient allocation of capital. Financial institutions and others who securitize assets depend, of course, on investors. Investors seek an appropriate return based on a level of risk. If the asset pools are not of a 6 zycnzj.com/