Assets pools

Investors purchasing the issued notes can expect to receive interest and principal payments as long as the underlying asset pool does not experience default to any significant extent. 

Securitization involves several participants. The originator owns the securitized assets. These are typically acquired hy an issuer, which is usually a specialpurpose vehicle, or SPV, set up specifically for this purpose and domiciled offshore. Establishing an SPV ensures that the underlying asset pool is separate from the originator s other assets so that a bankruptcy or insolvency suf-... 

The frequency of defaults in the underlying asset pool and their severity, in terms of recovery rate, plus the impact of losses on investors principal... 

The contingent cash flows from any credit wrap or credit insurance on the underlying asset pool... 

The cash flows are tested to see how they are affected in both normal and stressed scenarios. The types of stress scenarios tested depend on the underlying asset pool. 

The senior tranches of a synthetic CDO, however, may be delinked from the bank s rating by using AAA-rated collateral and default swaps, as described above. The final rating is influenced by the credit rating of the default-swap provider and the extent to which the cash flows to investors are exposed to the risk of default by the asset pool. 

Liquidity facility. A facility is an arrangement to provide a borrower with credit support. In the case of a CDO, this arrangement involves the originating bank ensuring that, should the underlying asset pool experience a temporary cash shortfall, the notes interest and principal payments will still be made. 

Such an approach to modeling allows each asset to have its own scale parameter, Ui and degradation parameter thus acknowledging the heterogeneity within the asset pool due to variation in asset type and operational environment. 

When historical data indicates that failures are too infrequent to empirically estimate the model in Equation (1) for each asset, pooling the data available to obtain estimates is feasible but questionable when the assets represented by the model form a heterogeneous pool. Therefore we propose to use expert judgment to estimate the degr ation rate for each asset, fii, and use empirical Bayes methods to estimate the scale parameter by first pooling the empirical data to estimate the scale parameter across the pool and then adjust the estimate for each asset in-line with its experience. 

To the extent that securitization provides regulatory capital relief, it can be thought of as an alternative to capital raising, compared with the traditional sources ofTier 1 (equity), preferred shares, and perpetual loan notes with step-up coupon features. By reducing the amount of capital that has to be used to support the asset pool, a bank can also improve its return on equity (ROE) value. This will be received favorably by shareholders. 

As illustrated in Figure 15.1, in a securitization the issued notes are structured to reflect specified risk areas of the asset pool, and thus are rated differently. The senior tranche is usually rated AAA. The lower-rated notes usually have an element of overcollateralization and are thus capable of absorbing losses. The most junior note is the lowest rated or nonrated. It is often referred to as th.t first-loss piece, because it is impacted by losses in the underlying asset pool first. The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by the originator. 

All securitization structures incorporate a cash waterfall process, whereby all the cash that is generated by the asset pool is paid in order of payment priority. Only when senior obligations have been met can more junior obligations be paid. An independent third-party agent is usually employed to run tests on the vehicle to confirm that there is sufficient cash available to pay all obligations. If a test is failed, then the vehicle will start to pay off the notes, starting from the senior notes. The waterfall process is illustrated in FIGURE 15.2. 

The credit quality of the underlying asset pool is critical, since it determines the structures credit rating. It is common to allocate an average ratii to... 

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