Structured finance Q&A, or securitization for beginners

THEORETICAL ASPECTS OF STRUCTURED FINANCE

What is securitization and structure finance?

Securitization is a method of refinancing illiquid assets that generate cash flow by converting them into liquid assets that are traded in the financial market. The conditions for issuing these instruments usually include an issue structure (for example, division into tranches with different priorities for the fulfillment of obligations), therefore they are also called structured finance instruments, which means that the concepts of securitization and structured finance are generally synonymous.

The economic essence of securitization is the separation of assets on the balance sheet of a special purpose vehicle, which acts as an issue of notes secured by claims under the assets. The cash flow generated by the collateral portfolio is used by the issuer to make coupon payments and repay the principal of the notes.

In Russian practice, the issuer is usually established as an independent financial organization under external management, in the form of a mortgage agent (MA) or a specialized financial company (SFC). The choice of the type of organization depends on the type of securitized assets¹.

¹ In single-asset securitization transactions as part of project finance, the issuer may be established in the form of a specialized project finance company (SPFC).

What is the difference between structured finance and structural finance?

Structural notes in Russian legislation are a wide range of instruments, the fulfillment of obligations under which depends on third-party events. For example, coupon on nominal payments for structural notes may depend on the event of default on third-party obligations or fluctuations in the consumer price index, inflation, stock market indices, etc. At the same time, the underlying asset, risk or price characteristics that serve as the grounds for making a decision on the execution of obligations for structural notes does not usually act as their collateral.

The issue conditions may include the possibility of partial fulfilment of obligations for these instruments — for example, only a share of the nominal value of the notes may be guaranteed to be paid, and the payment of the remaining share depends on the underlying (reference) asset.

Structured finance instruments, in turn, are always backed by real assets and the fulfilment of obligations under these notes is fully guaranteed and depends on the cash flow generated by collateral².

² Some securitization instruments may be called structured due to legal requirements. For example, in the context of project finance, an SFC may not acquire existing financial obligations, but instead issue a loan, which, according to the law, means that notes secured by claims on such a loan must be recognized as structured, although the main terms of issue and redemption of these notes do not differ from standard securitization instruments.

What assets can be securitized?

Any financial assets that are sources of cash flows can be securitized. They include:

• Retail and corporate loans (mortgages and auto loans, consumer loans, SME loans, debt of major corporate issuers, syndicated loan tranches);

• Lease contract obligations;

• Commercial mortgages and associated rental payments;

• Bonds;

• Guarantee liabilities;

• Diversified cash flows (utility payments, mobile communication payments, etc.;

• Project finance debt.

How is the risk of securitized assets separated from the creditworthiness of third parties?

Securitization involves the actual sale of assets from the balance sheet of the original lender or originator to the balance sheet of an independent issuer. The term “actual sale” means the separation of the credit risk of the originator from the risk of securitized assets. In particular, in the event of a default of the original creditor, the sold assets cannot be included in its bankruptcy estate. If the originator, however, carries out the function of a service agent, all the portfolio servicing processes are transferred to a different servicing agent. In the same way, any other participant of a transaction, who for some reason cannot carry out their functions, can be replaced. These participants include asset management companies acting as a sole executive body, as well as accounting firms that provide accounting services to an issuer.

Therefore, the credit quality of securitization instruments depends solely on the size of the credit risk of the collateral portfolio and not on the creditworthiness of thirds parties³.

Therefore, the credit rating of these instruments may be considerably higher than the rating of the asset originator, which considerably widens the pool of potential investors and helps reduce the cost of attracted funds.

³ An exception is made for transactions with suretyship or guarantees for the fulfillment of obligations on issued notes, if the credit rating and structure of the issue were determined based on the creditworthiness of the guarantor or surety.

What are the main mechanisms for enhancing and maintaining the credit quality of securitization instruments?

Multi-tranche securitization involves the use of a subordination mechanism, the key function of which is to enhance the credit quality of senior issues and provide protection to senior investors at the expense of junior ones. The mechanism is implemented by dividing the issue into several classes of notes with different priorities for the fulfillment of obligations. Cash received from borrowers to meet loan obligations in a securitized portfolio is distributed primarily among senior investors. The risk of portfolio losses, which in practice means a reduction in the volume of cash flow, is assumed by the holders of junior tranches. The higher risk of junior and mezzanine (middle) tranches is compensated by their higher yield.

Multi-tranche securitization transactions may have, in addition to a subordination mechanism, a number of additional mechanisms to enhance and maintain the credit quality of issued financial instruments:

• Excess spread — the difference between the lower coupon rate on the senior notes and the higher average interest rate on the collateral portfolio, which is used to offset current losses on the portfolio;

• Reserves guaranteeing the implementation of coupon payments for a period of three to six months even in the complete absence of cash flows;

• A register of shortfalls in receipts on the principal (RSRP)⁴;

• Excess collateral;

• Triggers for accelerated amortization of notes in case of deterioration in the credit quality of the collateral portfolio;

• The originator’s right to repurchase defaulted assets.

Why does structured finance matter to the economy?

Structured finance instruments are an important source of long-term liquidity for both the banking industry and the real sector of the economy. Thanks to the securitization mechanism, economic entities are able to diversify risks, increase the availability of credit, and reduce interest and regulatory risks for banks. Institutional and private investors are able not only to invest in reliable, high-yield structured finance instruments, but also to participate in the development of priority sectors of the economy, while benefiting from a multi-level investment protection structure.

⁴ The RSRP mechanism assumes regular redemption of notes in the amount of defaults in the collateral portfolio at the expense of interest income, which ensures that the par value of the notes corresponds to the volume of high-quality (non-default) assets.

Figure 1. Volumes of the Russian securitization market (RUB bln)

Why has securitization not yet become widespread in the Russian financial market?

The Russian structured finance market shows limited growth (Fig. 1) both in the mortgage securities sector, where DOM.RF holds a monopoly position, providing guarantees for mortgage-backed securities issued by LLC “DOM.RF MBS SPV”, and in the non-mortgage securitization segment, where the number of issues initiated mainly by large banks has grown in recent years. However, the potential of securitization has not yet been revealed due to a number of reasons, including the following:

• Incomplete recognition of structured finance credit ratings from Russian rating agencies, which limits the range of potential investors; in particular, institutional investors regulated by the Bank of Russia are allowed to invest exclusively in financial instruments secured by mortgages or liabilities of SMEs, which are assigned the highest credit rating on the structured finance scale;

• Perceived complexity and relatively high arrangement costs of the first issues of securitization instruments; on the other hand, modern IT solutions can significantly simplify the preparation of asset portfolios for securitization, and the experience gained by market participants makes it possible to use almost ready-made solutions to speed up the procedure and minimize costs (the greatest efficiency from securitization is achieved when this mechanism is used on a regular basis);

• Skepticism of financial market participants mostly caused by insufficient awareness of the principles and benefits of structured finance; this factor, in turn, hinders the development of the secondary market for securitization instruments.

PRACTICAL ASPECTS OF SECURITIZATION IN RUSSIA

Figure 2 shows a classic two-tranche structured finance transaction, which is the most common type of securitization in the Russian financial market, regardless of the type of underlying asset.

The standard list of participants in these transactions includes:

• Initial creditor or originator of securitized assets who assigns these assets to the issuer;

• Issuer, an independent special purpose vehicle established for a specific transaction with the sole statutory purpose of purchasing the securitized portfolio of assets and issuing notes secured by this portfolio;

• Servicer or service agent who services the securitized assets, including monitoring the current amount of liabilities, collecting payments from borrowers, and collecting overdue payments (this function is usually performed by the originator);

• Issuer’s account bank that provides cash settlement services to the issuer;

• Managing and accounting company that acts as the sole executive body and maintains accounting and tax records, as well as prepares the relevant financial statements of the issuer;

• Specialized depository that stores and records mortgage certificates in mortgage-backed securitization transactions;

• Calculation agent who determines the amount of periodic payments on the notes and other obligations of the issuer based on the amount of available funds and the procedure for their distribution; the calculation agent also discloses regular reports for investors;

• Legal adviser who prepares the issue and contract documentation for the transaction, as well as provides a legal opinion;

• Audit firm that verifies the pool of securitized loans for accuracy;

• Rating agency that assigns a credit rating to the notes issues based on an assessment of expected losses on the collateral, issue structure, and investor protection mechanisms⁵.

⁵ For more information on rating securitization transactions, see Securitization in questions and answers: rating analysis of structured finance instruments from December 19, 2022.

How long does it take to arrange the first securitization transaction?

ACRA’s experience shows that, with a professional approach to transaction arrangement, the average preparation time is four to six months, with a downward trend for each subsequent transaction. This period includes the following main stages:

• Selecting, preparing and verifying the securitized portfolio;

• Optimizing the originator’s and/or servicer’s IT systems and business processes for assignment and out-of-system maintenance of the securitized portfolio;

• Shaping the transaction infrastructure — establishing the issuer and its founders, opening bank accounts;

• Drawing up, approving and signing legal documentation;

• Rating analysis;

• Filing issue documentation;

• Organizing note issuance.

ACRA’s practices show that optimization of transaction logistics can reduce the preparation time for subsequent transactions to two or three months for the originator.

• Selecting, preparing and verifying the securitized portfolio;

• Optimizing the originator’s and/or servicer’s IT systems and business processes for assignment and out-of-system maintenance of the securitized portfolio;

• Shaping the transaction infrastructure — establishing the issuer and its founders, opening bank accounts;

• Drawing up, approving and signing legal documentation;

• Rating analysis;

• Filing issue documentation;

• Organizing note issuance.

ACRA’s experience shows that optimization of transaction logistics can reduce the preparation time for subsequent transactions to two or three months for the originator.

How are assets selected to form a securitized portfolio?

One of the factors that makes it possible to improve the credit quality of securitization instruments is the eligibility criteria for assets in the collateral portfolio. These criteria are set both for individual assets and for the weighted average indicators of the portfolio. For example, the transaction criteria may include a minimum interest rate on individual assets, time elapsed from the issue date to the assignment date of loans, maximum duration of historical delinquencies, average interest rate on the portfolio, maximum weighted average loan-to-value ratio, etc. Standardized asset selection criteria based on the historic experience of Russian securitization transactions makes it possible to significantly limit the credit risk of the collateral portfolio over the entire life of financial instruments. This has a positive effect on the credit quality of notes and has a direct impact on the degree of investor protection.

Can the composition of the securitized portfolio be updated after note issuance?

Securitization of loans with long maturities and relatively low levels of early repayment (such as mortgage loans) rarely involves the possibility of updating the portfolio after note issuance. These structured finance transactions are often static. Amortization of the notes begins on the first coupon payment date, and its rate depends on the rate of amortization of the collateral portfolio.

Securitization transactions of shorter-term assets (loans to SMEs, consumer and car loans) are usually dynamic. The terms of these transactions provide for a refinancing period, also called a revolving period, during which funds from the amortization of the securitized portfolio are used by the issuer to purchase new loans and replenish collateral. This period is generally one to three years, with the possibility of early termination in case of breach of the requirements to the collateral portfolio’s quality. Amortization of notes in dynamic securitization transactions begins after the end of the revolving period.

How is the note issue structure determined?

The proportions of tranches of the notes issued in the securitization transaction depend on the amount of the expected losses on the collateral portfolio, as well as on the target credit rating of the senior notes. A simplified initial calculation of the structure is usually carried out by the originator or the arranger of the transaction, but the final decision on the amount of subordination and reserves is made by the originator only based on the results of contacts with a rating agency.