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III. CREDIT RISK III. 1. COUNTERPARTY CREDIT RISK .............................................................................................. 4 Counterparty Risk .................................................................................................................................................. 4 Potential future exposure (PFE) models ................................................................................................................. 5 Simulation engines ................................................................................................................................................ 6 PFE Models ............................................................................................................................................................ 7 Mean Loss Rate...................................................................................................................................................... 7 Market Value Of Credit Risk ................................................................................................................................... 8

III. 2. SECURITIZATION ........................................................................................................................ 9 Liquidity Risk ....................................................................................................................................................... 13

III. 3. A. EXTERNAL AND INTERNAL RATINGS ........................................................................... 16 Traditional Credit Analysis ................................................................................................................................... 16 Major Rating Agencies ......................................................................................................................................... 17 Rating Process ..................................................................................................................................................... 17 Rating Scales ........................................................................................................................................................ 18 Impacts ................................................................................................................................................................ 20 Through-the-Cycle ............................................................................................................................................... 21 Transition Matrices .............................................................................................................................................. 22 Impact of Rating Changes on Firm Value .............................................................................................................. 22 Internal Ratings and Score-Based Ratings ............................................................................................................ 23

III. 3. B. DEFAULT RISK: QUANTITATIVE METHODOLOGIES ................................................ 24 Structural (Merton-Type) Models ........................................................................................................................ 24 Credit Scoring Models .......................................................................................................................................... 29 Pattern Recognition ............................................................................................................................................. 29 Model Performance Measures ............................................................................................................................. 31

III. 3. C. LOSS GIVEN DEFAULT (LGD) ............................................................................................ 36 Default ................................................................................................................................................................. 36 Loss Given Default (LGD)...................................................................................................................................... 37 Recovery Measures ............................................................................................................................................. 37 Factors That Affect Recovery Rates ...................................................................................................................... 38 Using Functions to Estimate Recovery Rates ........................................................................................................ 40

III. 3. D. CREDIT RISK PORTFOLIO MODELS ............................................................................... 41 Reasons for Credit Portfolio Tools: ...................................................................................................................... 41 Classes of Models ................................................................................................................................................ 41 Commercial Models ............................................................................................................................................. 41 Measures of Portfolio Risk ................................................................................................................................... 47 Issues in Implementing the Standard Portfolio Approach .................................................................................... 49 Marginal Cost Pricing ........................................................................................................................................... 50 Risk-adjusted Performance Measures (RAPMs) ................................................................................................... 50

III. 3. E. CREDIT RISK MANAGEMENT & STRATEGIC CAPITAL ALLOCATION .................. 52 Strategic Capital Allocation .................................................................................................................................. 52 Methods for Allocating EC to Business Units (BUs) .............................................................................................. 53 Liquidity and Information .................................................................................................................................... 55 Dynamic Capital Allocation .................................................................................................................................. 55

III. 4. ECONOMIC CAPITAL ................................................................................................................ 57 Counterparty Credit Risk ...................................................................................................................................... 57 Measuring Counterparty Risk .............................................................................................................................. 58 Simple Transaction and Portfolio Simulation Methodologies .............................................................................. 59 EC for a Loan Portfolio ......................................................................................................................................... 60 EC for Counterparty Risk: Potential Default-Only Perspective.............................................................................. 60

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Potential Loss-of-Economic Value Perspective ..................................................................................................... 61

III. 5. A. CREDIT DERIVATIVES PRODUCTS ................................................................................. 62 Credit Derivatives ................................................................................................................................................ 62 Default Swaps (DS) .............................................................................................................................................. 62 Total Rate of Return (TROR) Swaps ...................................................................................................................... 66 Credit-Linked Note ............................................................................................................................................... 67 Credit-Spread Products ........................................................................................................................................ 67 Summary of risks ................................................................................................................................................. 69

III. 5. B. SYNTHETIC STRUCTURES ................................................................................................. 70 Synthetic Structures Segment Risk ....................................................................................................................... 70 Credit Linked notes (CLN) ..................................................................................................................................... 70 Collateralized Debt Obligation ............................................................................................................................. 71

III. 5. C. APPLICATION OF CREDIT DERIVATIVES ..................................................................... 75 Credit Derivatives to Hedge ................................................................................................................................. 75 For Yield Enhancement ........................................................................................................................................ 76 For Convenience and Cost Reduction ................................................................................................................... 77 To Arbitrage ......................................................................................................................................................... 77 Risk Weights under Basel II .................................................................................................................................. 79 Benefits of Using Default Swaps to Reduce Regulatory Capital ............................................................................ 79

III. 5. D. RISK MANAGEMENT WITH CREDIT DERIVATIVES .................................................. 80 Market VAR for Portfolio ..................................................................................................................................... 80 Credit at Risk (CAR) .............................................................................................................................................. 82 Credit Risk Models ............................................................................................................................................... 83

III. 6. A. CREDIT RISK: INDIVIDUAL LOAN RISK ........................................................................ 85 Definitions ........................................................................................................................................................... 85 Calculating the Return on a Loan ......................................................................................................................... 86 The Expected Return on a Loan............................................................................................................................ 86 Retail vs. Wholesale ............................................................................................................................................. 87 Qualitative Models (1

st Group of Default Risk Models) ........................................................................................ 87

Credit Scoring Models (2nd

Group of Default Risk Models) ................................................................................... 87 Newer Models (3

rd Group of Default Risk Models) ............................................................................................... 89

Probability of Default on a Multi-Period Debt Instrument ................................................................................... 90 Marginal Mortality Rate (MMR) Derivation of Credit Risk ................................................................................... 90 RAROC Models..................................................................................................................................................... 91 Option Models of Default Risk - Theoretical Framework ..................................................................................... 91

III. 6. B. CREDIT RISK: LOAN PORTFOLIO AND CONCENTRATION ...................................... 92 Models of Loan Concentration Risk ..................................................................................................................... 92 Modern Portfolio Theory (MPT) ........................................................................................................................... 92 KMV Portfolio Manager Model ............................................................................................................................ 93 Loan Volume-Based Models ................................................................................................................................ 94 Loan Loss Ratio-Based Models ............................................................................................................................. 94

III. 6. C. SOVEREIGN RISK .................................................................................................................. 95 Definitions ........................................................................................................................................................... 95 Credit Risk vs. Sovereign Risk ............................................................................................................................... 96 Debt Repudiation and Debt Rescheduling............................................................................................................ 96 Probability of Rescheduling .................................................................................................................................. 97 Pitfalls of Statistical CRA Models ......................................................................................................................... 98 Mechanisms for Dealing with Sovereign Risk Exposure ....................................................................................... 99

III. 6. D. LOAN SALES AND OTHER CREDIT RISK MANAGEMENT TECHNIQUES ................ 101 Loans with Recourse vs. Loans without Recourse .............................................................................................. 101 Types of Loan Sales ............................................................................................................................................ 101

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Types of Loan Sales Contracts ............................................................................................................................ 102 Buyers................................................................................................................................................................ 102 Sellers ................................................................................................................................................................ 103

III. 7. CREDIT RISKS AND CREDIT DERIVATIVES ................................................................... 104 Role of Credit Risk.............................................................................................................................................. 104 Merton model ................................................................................................................................................... 104 Valuation of Subordinated Debt ........................................................................................................................ 105 Effect on Price of Debt ....................................................................................................................................... 105 Limitations of Merton Model ............................................................................................................................. 106 Probability of Default (PD) and LGD ................................................................................................................... 106 Credit Risk Models ............................................................................................................................................. 107 Credit Derivatives and Credit Events .................................................................................................................. 108 CDS .................................................................................................................................................................... 109 Total Return Swap ............................................................................................................................................. 109 Vulnerable Option ............................................................................................................................................. 109 Credit Risk Exposure .......................................................................................................................................... 109

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III. 1. Counterparty credit risk LO 49.1: Define terms related to counterparty risk.

LO 49.2: Identify and explain the steps of using a Monte Carlo simulation engine to model potential

future exposure to a counterparty, and discuss considerations for applying such a model to

various market instruments.

LO 49.3: Identify and discuss the primary uses for potential future exposure models.

LO 49.4: Describe how a credit valuation adjustment is made to an over-the-counter derivatives

portfolio.

LO 49.5: Define a risk-neutral mean loss rate.

LO 49.6: Describe the procedures for computing the market value of credit risk when one or both

counterparties in the derivatives transaction has credit exposure.

Counterparty Risk LO 49.1 Define terms related to counterparty risk

Counterparty risk: The likelihood that a party in an over-the-counter (OTC) derivative contract will fail to meet a contractual obligation, causing losses to the other party. Losses are often quantified in terms of replacement cost of the defaulted derivative. Counterparty risks are bilateral: both parties face exposures.

Counterparty exposure: the maximum possible loss; i.e., if counterparty defaults with no recovery. Counterparty exposure = MAXIMUM[0, market value of the lost portfolio if counterparty defaults and recovery rate is 0%].

Current Exposure (CE): the current value of the counterparty exposure

Potential future exposure (PFE): the highest exposure expected on a some future date, with some specified statistical confidence level. The projected time-series of PFE is the PFE curve. The highest PFE over the contract life is called the maximum potential future exposure (MPFE)

Expected Exposure (EE): the average (or mean) exposure on a future date. The EE(t) curve is the “credit-equivalent” or “loan-equivalent” exposure curve.

Expected positive exposure (EPE): average EE(t) for t in a certain interval

Right-way (wrong-way) exposures: exposures that are positively (negatively) correlated with the credit quality of the counterparty.

Credit risk mitigants (CRM): components of the contract that are meant to reduce credit exposures. CRMs include netting rights, collateral agreements, and early settlement provisions.

Netting agreements: When payments between counterparties are offset to determine the “net amount:” only one party makes a “net” payment. For example, assume Counterparty X owes $1 million to Counterparty Y; and Counterparty Y owes $800,000 to Counterparty X. If they net, Counterparty X pays $200,000.

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Further, if Counterparty X defaults, Counterparty Y only loses $200,000 instead of the full $1 million.

Cross-product netting: A provision that allows counterparties to net payment across different products

Collateral agreements: These contracts/provisions require, should exposures exceed some threshold, that assets be transferred to the counterparty. The threshold is typically a function of the credit rating (quality) of the counterparty.

Liquidity puts: An early settlement agreement that gives the counterparties the right to settle and terminate trades on certain specified dates

Credit triggers: An early settlement agreement that requires counterparties to settle and terminate trades if the credit rating of a party falls below a certain level.

Potential future exposure (PFE) models

Derivatives dealers have developed systems that include

Databases

Monte Carlo simulations

Trade pricing calculators

Exposure calculators

Reporting tools

Monte Carlo Simulation Engine

LO 49.2 Identify and explain the steps of using a Monte Carlo simulation engine to model potential future exposure to counterparty…

The following steps can use a Monte Carlo simulation engine to model PFE to counterparty:

1. Initiate a new scenario

2. Simulate the net exposure of Counterparty A to default by Counterparty B

3. Simulate (i) whether or not A defaults and (ii) whether or not B defaults, at each date

4. If, at a given date, Counterparty B defaults and Counterparty A has not already defaulted, then simulate the fraction of the lost net exposure—obtained in the 2nd Step. This represents losses to A, for this scenario

5. Simulate the path of short-term interest rates

6. Discount to present market value the losses to Counterparty A

7. Return to the 1st Step, until a large enough sample has been generated

8. The average of the results in the 6th Step (over all scenarios) is the estimate of the market value of default losses to Counterparty A due to default by Counterparty B

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Simulation engines LO 49.2 (continued)… and discuss considerations for applying such a model to various market instruments

The specification of the stochastic process depends on the instrument. Interest rates are

typically modeled as normal (if rates are low) or lognormal diffusion (if rates are high) processes.

Foreign exchange rates are often modeled as lognormal diffusions. Emerging market or

pegged currencies are often modeled as jump-diffusion processes:

Interest rates in developing economies: normal (low rates) or lognormal distribution (high rates)

Foreign exchange rates: lognormal distribution (major currencies) or jump-diffusion (emerging markets)

Commodities : lognormal (high liquidity) or jump-diffusion (low liquidity)

Equities: lognormal (high liquidity) or jump-diffusion (low liquidity)

The average of the results in the 6th Step (over all scenarios) is the estimate of the market value of default losses to Counterparty A due to default by Counterparty B.

Return to the 1st Step, until a large enough sample has been generated

Discount to present market value the losses to Counterparty A

Simulate the path of short-term interest rates

If, at a given date, Counterparty B defaults and Counterparty A has not already defaulted, then simulate the fraction of the lost net exposure—obtained in the 2nd

Step. This represents losses to A, for this scenario.

For each date, simulate (i) whether defaults & (ii) whether B defaults

Simulate the net exposure of Counterparty A to default by Counterparty B

Initiate a new independently simulated scenario

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PFE Models LO 49.3 Identify and discuss the primary uses for potential future exposure models

The key uses of potential future exposure (PFE) models include:

Trade approvals against credit line limits: credit officers set limits on PFE profiles (when tend to be wider for short-terms and tighter for long-terms)

Credit risk valuation (if exposures are uncorrelated with credit quality of counterparty, the unconditional expected exposure profile is used for valuation)

Economic and regulatory capital: calculation of economic capital required to support the risk of a portfolio of counterparties

LO 49.4 Describe how a credit valuation adjustment is made to an over the counter (OTC) derivatives portfolio

The credit value adjustment (CVA) is the market value of the credit risk due to any failure of the

counterparty to deliver. This adjustment can be either positive or negative, depending on which

of the two counterparties bears the larger burden to the other of exposure and of counterparty

default likelihood.

For example, assume Party A is the yen receiver in a yen-US dollar currency swap, where the mid-

market valuation is 100. Assume this valuation already includes an effective market value of 2 for

the default risk to Party A, but the swap carries a net market value of default risk (to Party A) of 5.

Then the CVA is a downward adjustment of 3, leaving a fair market value of (to Party A) of 97.

Mean Loss Rate LO 49.5 Define a risk-neutral mean loss rate

The mean loss rate is the expected loss: the probability of default multiplied by the expected loss

(EL) given a default. For example, if the probability of default is 20% and the expected recovery

rate it 60%, then the EL equals 20% (1-60%) = 8%. If this applies to a short-term bond with a

face value of $100,000, then the EL is $8,000.

mean loss rate = PD(expected loss)

PD(1 - recovery rate)

However, investors are likely to attach a risk premium. For example, they may be willing to pay

only $90,000 instead of $92,000. In this example, 10% is the risk-neutral mean loss rate. The risk-

neutral mean loss rate is implied by the true risk-neutral preferences of investors.

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Market Value Of Credit Risk LO 49.6 Describe the procedures for computing the market value of credit risk when one or both counterparties in the derivatives transaction has credit exposure

One method is to sum the discounted risk-neutral mean default losses, period by period, over the

life of the positions between the counterparties. The total market value V(t) of default risk during

t,-the future time period, is calculated with the following steps:

1. Calculate EE*(t), the risk-neutral EE for period t, that is, the average of exposures weighted by their risk-neutral probabilities, over all possible scenarios. (The asterisk indicates risk-neutral, not actual expectations) This is the risk-neutral expected market value that would be lost with default during that period, with no recovery, given the effect of all applicable netting, collateral, and other credit enhancements. (This exposure measure, EE*(t), can be calculated from derivative pricing algorithms.)

2. Calculate the risk-neutral mean default loss rate L*(t) associated with the period, which is the product of the risk-neutral likelihood of default during the period and the risk-neutral mean fraction of exposure lost in the event of default.

3. Obtain C(t), the price of a default-free zero-coupon bond of maturity t.

4. Calculate V(t) = EE*(t) × L*(t) × C(t)

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III. 2. Securitization LO 48.1: Distinguish between loans that are sold with and without recourse

LO 48.2: Describe two major segments of the loan sales market

LO 48.3: Contrast the characteristics of loans sold as participations and those sold as assignments

LO 48.4: Identify the buyers and sellers of loans and briefly discuss their motives

LO 48.1 to 48.4 are located in III.6.D Loan Sales and Other Credit Risk Management

LO 48.5: Define securitization.

LO 48.6: Know and describe the role of each participant involved in the securitization process.

LO 48.7: Compare and contrast the mechanics of issuing securitized products using a trust versus a

corporation as the special purpose entity.

LO 48.8: List the four guiding principles of FAS140 and the conditions necessary to be a qualified

special purpose vehicle.

LO 48.9: Describe a typical Enron transaction that violated FAS140 and explain the anti-Enron rule,

FIN46R.

LO 48.10: Discuss the various types of internal and external credit enhancements and interpret a simple

numerical example.

LO 48.11: Explain liquidity risk in a securitized structure. Discuss the various types of internal and

external credit enhancements for providing liquidity support.

LO 48.12: Define interest rate and currency risk for a securitized structure, and list securities used to

hedge these exposures.

LO 48.13: Discuss the securitization process for mortgage-backed securities and asset-backed

commercial paper.

LO 48.5 Define securitization.

Securitization is when assets (financial or non-financial) are pooled and securities, that represent

interests in the asset pool, are issued to investors. The securities are collateralized by the principal

and interest (P&I) income on the original asset pool. The cash flows generated by the underlying

assets are used to pay principal and interest on the securities in addition to transaction expenses.

The securities themselves are “backed” or supported by the assets and are known as asset-backed

securities (ABS).

What can be securitized?

Any current or future cash flow that is generated by assets can be securitized. As the

securitization market has grown and become more sophisticated, the asset types have broadened.

The most common types include mortgage loans, auto loans, credit card receivables, and student

loans; aircraft, and equipment leases also lend themselves to securitization.

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LO 48.6 Know and describe the role of each participant involved in the securitization process.

Each securitization transaction has at least three players: an originator, an intermediary, and an

investor(s). An originator securitizes the assets; i.e., generates an asset whether it is a loan, lease,

receivable, or other payment stream. Originators include banks, finance companies, captive

finance companies, and to a lesser extent, industrial entities. Intermediaries structure a

securitization transaction and coordinate activities among the issuer, originator, servicer, lawyers,

rating agencies, and investors. Asset-backed investors include banks, insurance companies,

ABCP conduits, pension funds, and hedge funds.

The longer list of potential parties to securitization include:

Sponsor: the institution that starts the securitization. The sponsor may or may not own the asset sold in the securitization; the sponsor may just be an advisor.

Originator/transferor: The original owner of the asset. This institution wants to monetize credit-sensitive assets; i.e., convert such assets into cash.

Asset purchaser/Transferee/Securitized Product Issuer: The separate (third-party) legal entity that buys the asset from the originator. This transferee is “inserted between” the originator (original seller) and the buyer. If the structure is create solely for the purpose of buying assets in a securitization, it is called a Special Purpose Entity (SPE). The SPE can be a trust or a corporation.

Trustee: The trustee, who may also be the sponsor (see below), is charged with a fiduciary obligation to safeguard (watch over) the investors in the securitized product. Generally, the trustee is responsible for the assets pledged as collateral to back the new securitized product offering.

Custodian and/or Servicer: Traditionally, the custodian collected and distributed cash flows in addition to safeguarding the securities. More recently, the custodian has evolved to become more of a cash flow intermediary for owners of securities (e.g., collecting dividends and interest payments).

Structuring agent: The structuring agent is the advisor (like a general contractor) to the securitization process. This agent is largely responsible for the security design (e.g., maturity, credit enhancement) and modeling (forecasting) the interest rates and cash flows.

Underwriter: the underwriter markets and distributes the securities.

Rating agencies: Agencies such as Standard & Poor’s (S&P), Moody’s and Fitch that may (but are not required to) rate the structured product. Agencies typically rate both the issue (instrument) and the issuer (the institution or company).

Law firms: Outside counsel provides the ‘sound opinion’ that is essential to ensuring the securitization is properly structured.

Regulatory agencies: Varies but could include local, state, national or international regulators. Further, in the United States, the Securities and Exchange Commission (SEC) regulates securities underwriting.

External risk transfer an risk finance counterparties: Firms that may act as counterparties in the securitization.

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LO 48.7 Compare and contrast the mechanics of issuing securitized products using a trust versus a corporation as the special purpose entity.

The key difference is that a trust arrangement enables the originator to remove the assets to “off

balance sheet” status.

In either case, a special purpose entity (SPE) is typically created. When the SPE is a corporation,

the originator sells the assets the corporate SPE. The corporate SPE issues claims directly

against the assets. This corporate arrangement may not move the assets off the balance

sheet; i.e., they many not “create sufficient accounting distance.”

The trust arrangement, on the other hand, creates two SPEs: a master trust and a grantor trust.

The originator sells the assets to the master trust, which in turn deposits them in the grantor

trust. The master trust that has a “beneficial interest” in the grantor trust; such that claims on the

securitized assets are backed by the beneficial interest instead of the assets. That is, the claims are

indirect rather than direct. This arrangement typically creates sufficient “accounting

distance” to warrant off balance sheet treatment.

LO 48.8 List the four guiding principles of FAS140 and the conditions necessary to be a qualified special purpose vehicle.

The accounting motive for securitization is to gain “off balance sheet” treatment. This means the

liability does not get consolidated and does not count in metrics like the debt-to-equity ratio. In

order to receive such accounting treatment, the securitization must qualify as a true sale. The four

guiding principles are:

1. The SPE is bankruptcy remote and the assets in the SPE are sufficiently isolated from the originator to survive Chapter 7 or Chapter 11 bankruptcy.

2. Permissible activities of the SPE must be significantly limited, must be specified at deal inception/incorporation of the vehicle, and can be changed only with approval of a majority of interest holders other than the originator or its affiliates or agents.

3. The originator must surrender “effective control” over the assets

4. The SPE must have the right to pledge/resell/exchange the assets acquired from the originator. The buyer must have a “perfected interest” in the acquired assets.

Financial Accounting Standards No. 140 (FAS140) also defines a qualified SPE (QSPE) that is not

required to be consolidated by the originator. In order to receive QSPE status,

SPE must be “demonstrably distinct” from the originator and any of its affiliates

SPE may hold only passive financial assets and passive derivatives used for hedging

Sale or disposition of assets by the QSPE must be prescribed in deal documents and may never be discretionary

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LO 48.9 Describe a typical Enron transaction that violated FAS140 and explain the anti-Enron rule, FIN46R.

Enron securitized assets that were effectively under their control (see the third principle above).

As such, these assets should have been recorded on the balance sheet. Instead, Enron wrongly

recognized operating cash flows (OCF) that should have been recognized as term debt. As the

reading says, “Enron’s basic objective was to camouflage term debt as payment received for the

sale of an asset in a securitization.”

FIN46R is known as the Anti-Enron rule. FIN46R defines certain types of SPEs as variable

interest entities (VIEs) if the SPE is non-passive and requires subordinated financial support for

its activities above and beyond the equity issued by the entity. A variable interest (VI) in a VIE is

defined as any contract that changes in value when the net asset value of the VIE changes; e.g.,

equity, subordinated debt, subordinated interests and compensation, credit protection.

LO 48.10: Discuss the various types of internal and external credit enhancements and interpret a simple numerical example.

Internal credit enhancements are provided by somebody inside the structure; e.g., originator,

transferor, investors in the SPE. The most common internal credit enhancement is

overcollateralization (OC). Overcollateralization is when the value of the assets exceed the value

of the liabilities.

Internal credit enhancements:

Direct equity issue: when the SPE issues debt in a smaller notional (or par) amount than the amount of collateral. For example, if the SPE has $1 million in assets and issues $800K in debt, the other 20% could be direct equity.

Holdback: the SPE purchases the assets at a discount. The ‘holdback’ is the difference between asset value and purchase price

Cash collateral account: the originator can deposit cash into a cash collateral account (CCA). The CCA then serves a cash reserve against losses and provides a credit enhancement to the securities issued by the SPE.

Excess spread: the gross excess spread internal to a structure is the difference between interest earned on the collateral assets and interest paid on the debt liabilities of the SPE. The net excess spread is the gross excess spread minus senior fees and expenses. The excess spread is the cash flow equivalent of retained earnings for the structure. The excess spread can be diverted to service interest payments on the debt in the event that the cash flows on the assets are inadequate to service the debt.

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External credit enhancements represent credit risk transfer from the SPE to another firm.

Insurance, wraps and guaranties: the SPE buys a financial guaranty for the collateral assets. In the case of a wrap, the “wrapper” guarantees to make up the difference if the underlying assets drop below a certain value; in this way, senior bondholders are “kept whole.”

Letter of credit (LOC): The SPE obtains a letter of credit from a bank, which can be drawn on in the event of defaults

Credit default swap (CDS): the collateral assets serve as the reference portfolio. The credit default swap could then provide protection for losses that exceed some deductible amount.

Put option on assets: a traditional put option based on assets held by the SPE as collateral against the ABS issue

Liquidity Risk LO 48.11 Explain liquidity risk in a securitized structure. Discuss the various types of internal and external credit enhancements for providing liquidity support.

Liquidity risk is a major risk in many securitization structures. Liquidity risk is the risk that

sufficient cash is not generated to fund the principal and interest (P&I) obligations of the asset-

backed securities (ABS) issued by the transferee SPE. Liquidity problems arise from:

Delinquencies in underlying assets; e.g., receivables or mortgages are paid late, and this deprives the SPE of cash flow to fund obligations

Structural liquidity mismatches are built into the structure and inherently problematic. For example, an SPE that issues interest-bearing securities (pay now) but securitizes (is backed by) non interest-bearing securities.

Cash flow waterfall The SPE issues different layers (or tranches) of securities that represent a hierarchy of claims on the cash

flows that come into the SPE. The cash flow waterfall refers to these “cascading” claims. Senior classes

(or tranches) have priority claims on the cash, while junior classes have a subordinate status.

Internal liquidity support

Two internal methods:

Liability design and maturity structure: liability design is the structuring of different layers of subordination. But often liquidity risk is managed by structuring maturities. Maturity structuring is the deliberate matching of the timing of cash inflows and outflows. A more sophisticated example is an extendable note (EN). An EN is a note with a stated final maturity and an interim maturity date. At the interim date, the note is redeemed only if the cash flow “waterfalls” on senior securities are adequately funded. If not, the EN is automatically extended to the final maturity without triggering an adverse credit or liquidity event.

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Reserves: cash accounts set aside to ensure that interest and principal waterfalls always have enough cash on hand.

External liquidity support

Liquidity support is not the same as credit support. External liquidity support providers often do

not provide credit protection.

Two primary methods of external liquidity support are:

Letter of credit (LOC) with recourse: A bank extends a letter of credit (LOC) to the SPE. The SPE can draw on the line of credit for liquidity support. But this is not a credit instrument of the drawing institution. Instead, the bank holds a loan obligation. Under the original Basel Accord, banks did not have to hold capital against these LOCs if they had maturity of less than one year (<365 days). But Basel II requires that banks allocate capital against short-term LOC’s. Further, new accounting rules jeopardize the independence of SPEs. For these reasons, the traditional recourse LOC is nowadays less popular

Asset swaps: an asset swap can be used to alter the patter of cash outflows to investors. For example, a plain-vanilla interest rate swap trades floating-rate coupon payments for fixed-rate coupon payments. Using an asset swap purely for liquidity support: attach a provision that any defaulted collateral is subtracted from the notional principal amount of the asset swap.

LO 48.12 Define interest rate and currency risk for a securitized structure, and list securities used to hedge these exposures.

Interest rate risk arises when assets and liabilities have either a structural or maturity mismatch.

Structural mismatch: assets pay fixed-rate (floating-rate) but liabilities pay floating-rate (fixed-rate)

Maturity mismatch: assets and liabilities have different maturities. This is not per se problematic, but the net spread between them can change over time.

LO 48.13 Discuss the securitization process for mortgage-backed securities and asset-backed commercial paper.

Mortgage-backed securities (MBS) are backed by a pool of residential mortgages. In an MBS, a

loan is made by a bank originator to a borrower for the purchase of a loan; the home is the real

estate assets pledged as collateral for the loan (the P&I on the loan may be insured through either

a private label mortgage insurer or a government agency like the Veteran’s administration). The

originator exchanges the loan for a MBS (often a trust certificate) with a government-sponsored

enterprise (GSE).

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A pass-through is a single-class ABS; all holders of the same class of MBS have the same priority

and enjoy pro rata distributions of the underlying cash flows. Multiclass MBSs are a big part of the

MBS market. Multiclass MBSs include collateralized mortgage obligation (CMO) and real estate

mortgage investment conduit (REMIC).