Securitization, Risk Management and Bank Capital

1. Securitization, Risk Management and Bank Capital Ashish Dev Executive Vice President Group Head, Enterprise Risk Management KeyCorp ashish_dev@keybank.com

2. Introduction • What is Securitization? • An entity pools together identifiable cash flows over time and packages the pool of collaterals into notes, with explicit priority of payments and sells them to investors. • Thus securitization is, first and foremost, a financing mechanism for the issuer of the collaterals. • The tranche structure makes securitization interesting, in terms of risk.

3. Introduction • Size and Growth of the Market • The total Securitization market in the world stands at about US $ 3.0 trillion. • The US market is by far the largest in volume. • High growth in European and Asian markets in recent years. • As capital markets develop in countries around the world, securitization market is likely to take off in the near future.

4. Types of Securitizations • Securitization types are defined based on the type of the underlying pool of assets • mortgage loans ==> MBS • consumer loans ==> ABS • corporate loans ==> CLO • corporate bonds ==> CBO • Mortgage backed securities (MBS) were the first ones and are still the most predominant type of securitization.

5. Securitization Tranches • Securitization (of a pool of loans) allocates interest income and principal repayments from the underlying pool to a prioritized collection of securities notes called tranches. • Cash-flow waterfall: senior notes are paid before mezzanine, and mezzanine notes before first-loss (equity) position. • Waterfall defines loss on a given tranche from the loss in the underlying pool.

6. Illustration of Tranches

7. Prepayment Risk in Securitizations • Prepayment risk: potential loss due to full or partial prepayment of the outstanding balance by borrowers • Important for Mortgage backed securities. • Prepayments happen when interest rates are low. • MBS issued by government agencies, credit risk is negligible and prepayment risk is the predominant risk. • In case of Credit cards, issuer replaces prepaid balances by new set of credit card receivables.

8. Credit Risk in Securitizations • Credit risk: potential loss due to defaults by borrowers in the pool • Credit risk is driven mostly by • probabilities of default by individual borrowers • recoveries in the event of borrowers’ default • correlations in default behavior between different borrowers • Extent of over-collateralization

9. Loans/Bonds vs. Securitizations • Similarities • Similar principal and interest cash flows in the event of no loss • Both are rated by agencies • Differences • Generally, credit risk models designed for loan/bond portfolios are not applicable to securitization tranches

10. Models of Credit Risk for Securitizations • Economic capital for securitizations should be determined from a dedicated model that • treats tranche as part of the investor’s portfolio • derives tranche loss from the loss distribution of the underlying pool • Recent credit risk models for securitizations • Pykhtin & Dev (RISK, May 2002): granular pools • Pykhtin & Dev (RISK, January 2003): non-granular pools • Gordy & Jones (RISK, March 2003): granular and non-granular pools

11. Basel II and Securitizations • Capital charge is determined by Standardized or IRB approach • IRB approaches include • Ratings-based approach (RBA) • calibrated to Pykhtin-Dev model • applied whenever external rating available • Supervisory Formula approach (SFA) • based on Gordy-Jones model • applied when external rating is not available • Internal assessment approach (IAA) • applied to Asset Backed Commercial Paper conduits only

12. Supervisory Formula Approach • Capital charge: area under the curve between tranche bounds

13. Ratings and Required Capital • Agency ratings are based on either expected loss (Moody’s) or probability of default (S&P) • Generally, economic capital for a tranche cannot be determined from the credit rating alone. • Other determinants of economic capital or regulatory minimum capital • Tranche thickness and seniority • Granularity of underlying pool (i.e., effective number of assets)

14. Ratings Based Approach • Basel Committee has made an attempt to incorporate the effects of thickness, seniority and granularity into the RBA

15. Comparison of Models • SFA and RBA are calibrated to different models • but the models can be calibrated to yield similar capital charges

16. Conclusions • As capital markets develop in countries around the world, Securitization is likely to be one of the fast growing financial instruments. • For purposes of Credit Capital, Securitization Tranches should not be treated similar to loans and bonds -- they require a model based on the loss distribution of the underlying pool. • Economic or Regulatory Capital cannot be determined from rating alone. • Development of recent models and their adoption in Basel II have significantly enhanced understanding of risk in Securitizations.