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Securitization, Risk Management and Bank Capital - PowerPoint PPT Presentation

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Securitization, Risk Management and Bank Capital. Ashish Dev Executive Vice President Group Head, Enterprise Risk Management KeyCorp [email protected] Introduction. What is Securitization?

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Securitization, Risk Management and Bank Capital

Ashish Dev

Executive Vice President

Group Head, Enterprise Risk Management


[email protected]

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  • 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.

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  • 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.

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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.

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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.

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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.

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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

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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

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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

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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

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Supervisory Formula Approach

  • Capital charge: area under the curve between tranche bounds

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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)

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Ratings Based Approach

  • Basel Committee has made an attempt to incorporate the effects of thickness, seniority and granularity into the RBA

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Comparison of Models

  • SFA and RBA are calibrated to different models

    • but the models can be calibrated to yield similar capital charges

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  • 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.