A

PRIMER
SECURITIZATION
by
2000 JUNE
This booklet is a collection of four securization articles published in the Canadian
Treasurer Magazine between August 1999 and February 2000. It is intended as a
tutorial to familiarize corporate issuers (sellers) and investors on the mechanics and
fundamentals of securitization in Canada.
1
SCOTIACAPITAL
This report has been prepared by SCOTIA CAPITAL INC. (SCI). Opinions, estimates and projections
contained herein are our own as of the date here of and are subject to change without notice. The information
and opinions contained herein have been Compiled or arrived at from sources believed reliable but no
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report is not, and is not to be construed as,an offer to sell or solicitation of an offer to buy any securities
and/or commodity futures contracts. SCI, its affiliates and /or their respective officers, directors or employees
may from time to time acquire, hold or sell securities and/or commodities and/or commodity futures contracts
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express consent of SCI. SCI is a wholly owned subsidiary of a Canadian chartered bank. Issued and approved
by SCI. SCI is regulated by SFA for conduct of investment business in the UK. U.S. Residents: Scotia Capital
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terms and limitations set out above. Any U.S. person wishing further information or to effect transactions in
anys ecurity discussed herein should contact Scotia Capital (USA) Inc. at 212-225-6500.
22 CANADIANTreasurer AUGUST/SEPTEMBER 1999
In Canada, the top five Schedule 1
banks have been in the forefront of se-
curitizing their assets in the capital
markets. Most readers probably have
credit cards, mortgages or loans from
one or more of the big banks. If you do,
theres a real possibility that one of
your loan balances has been sold to a
third party. As the end obligor, you
would never know this, since the bank
that lent you the money would still ad-
minister your loan.
Through their investment-dealer
subsidiaries, each bank has also estab-
lished multi-seller securitization con-
duits to assist corporate clients in raising
money through the sale of assets.
What is securitization? While there
is no denition in the dictionary, secu-
ritization can be described as the
monetization of financial assets.
Such assets can be short-term, such as
trade receivables, or long term, such as
residential mortgages. The sale of
these assets is considered a true sale
for legal purposes, but there are strings
attached, which make the transaction
feel more debt-like.
An alternative, more technical
definition of securitization is an off-
balance-sheet, fully secured, limited-
recourse financing. Although there is
an official sale of the assets to a spe-
cial-purpose entity, usually a securi-
tized trust, the seller usually is given
and maintains a residual interest in the
entity. The trust is primarily financed
from the issuance of notes, which have
a senior claim on all assets and the
cashflow from the assets. The sellers
interest is subordinated to the senior
notes claim and to all other claims
against the trust (i.e. trust expenses,
swap costs, etc.).
As a simplified example, lets as-
sume that the seller sells $1 MM worth
of loans (say, for simplicity, mortgages
with an aggregate principal balance of
$1 MM) into the trust, which then is-
sues $1 MM of notes into the CP or
bond market. The trust turns around
and pays the seller $950, 000 of the
note proceeds plus a residual note with
a $50,000 face value. The amount of
upfront proceeds from the sale de-
pends directly on the quality of the as-
sets. The rest of the cash remains in the
trust for credit enhancement. The
residual note also entitles the seller to
receive all excess interest cashflows
from the loans and its $50,000 face
value after all principal has been re-
deemed from the other, more senior
notes. This effectively means that the
residual noteholder will be the rst to
be affected by losses on the assets and
the last to be paid back its interest and
principal. (Figure 2 illustrates the
structure.)
On a month-to-month basis, the
trust receives all interest and principal
payments from the loans and uses
them to pay down the notes, principal
for principal (that is, the equivalent
amount of principal repaid on the
mortgages is paid down on the note
principal). The interest from the assets,
being at a higher yield than the coupon
(or yield if discounted) on the notes,
should be more than sufficient to pay
down the notes; the excess interest
spread ows back to the seller. The ex-
T
nr CnNnninN srcuni1izn1ioN rnnxr1, rNcornssiNc uo1n
commercial paper and bonds, has grown from just $2 billion
in issued notes at the beginning of the 1990s to over $48 bil-
lion as of February, 1999. This remarkable growth reflects the in-
creasing sophistication of nanciers and investors alike in meeting
their objectives. Securitizing assets has enabled corporations to tap
into new, cheap funding sources that do not have the negative im-
pact of leverage on their balance sheets. On the flip side, institu-
tional investors have been able to add high-yielding and
high-grade securities to their portfolios in their quest to beat their
performance benchmarks.
FEATURE/SECURITIZATION
A securitization
primer: Part one
In the rst of a four-part series on the fundamentals of securitization,
the author discusses the basic principles of the procedure in the
Canadian market.
By Andrew Lin
CANADIANTreasurer AUGUST/SEPTEMBER 1999 23
cess spread also covers trust expenses
and any cashow shortfall caused by a
defaulting mortgagor. If a default oc-
curs, it reduces the amount of excess
spread cashflow going to the seller or
residual noteholder.
Aside from ancillary expenses, the
trust pays down its funding cost of the
notes over the life of the assets and re-
turns the upside to the seller. The mag-
nitude of that upside depends on the
assets generating the promised cash-
flow. In other words, we hope that the
obligors dont default. The extent of the
downside for the seller is its residual in-
terest returning nothing. The key here
is that the seller is not obligated to
cover losses in the trust above what it
has invested in its residual note.
In effect, its as if the seller is funding
himself with a loan, at a rate equal to
the trusts funding rate plus some other
expenses. If the trust is structured
properly and fairly, the losses on the
loans should affect the residual interest
but not the primary noteholders.
Therefore, losses should affect the sell-
er in the same way, whether it owned
the assets or securitized the assets and
held onto a residual note. Since the sell-
er is also usually the administrator of
the assets, its almost as if the seller still
owned the assets and is getting a cheap
source of funding.
What is not Securitization? Al-
though weve established what securiti-
zation is, it also makes sense to dene
what it is not. In particular, factoring
and secured nancing two methods
of raising funds using a companys as-
sets may be considered the prede-
cessors to securitization.
Factoring is a common term among
managerial accountants in troubled
companies trying to boost cashflow. It
is an outright sale of short-term assets,
such as accounts receivable, at a dis-
counted price to a third party like a col-
lection agency. It is similar to
securitization, since there is a sale of -
nancial assets, but it is less efficient.
The company retains no interest in the
receivables and no longer controls the
collection of the cashow, and the dis-
count may be signicant if the compa-
ny is cash-strapped or in distress.
Secured nancing is similar to secu-
ritization in that a company leverages
its financial assets in raising low-cost
funds. Also, the company receives all
the upside of the assets cashflows.
However, the company does not sell the
assets; they remain on the borrowers
balance sheet. Unlike securitization,
this procedure attracts capital tax and
increases debt and leverage ratios. The
assets are used as collateral only, and, if
the borrower defaults, secured credi-
tors can sue for amounts owing above
and beyond the value of the collateral.
Securitization evolved from these
two forms of raising funds, enabling
firms to accomplish the same goals
without the associated consequences.
As with factoring, the company sells as-
sets; but it also maximizes sale pro-
ceeds. Like secured financing,
securitization is a form of low-cost bor-
rowing, but without the negative tax
and debt-leverage effects.
Securitizable Assets: Table 1 lists
the most common securitized assets.
The main qualities that a portfolio of
assets should have before it can be se-
curitized are :
1. Stability of Cashflows: Investors
are essentially buying a set of cash-
flows, and therefore, understandably,
they want to know with some certainty
when theyll receive those cashows. In
the case of securitized bonds, any pos-
sibility of variance from the schedule
24 CANADIANTreasurer AUGUST/SEPTEMBER 1999
will throw off the pricing of the bonds.
Prepayment on a loan portfolio is a pri-
mary culprit in causing deviations from
a set principal amortization schedule.
2. Certainty of Cashflows: Even
more important to investors than the
timing of the cashflows is whether or
not the cashows will be realized at all.
Therefore, a portfolio of assets being
securitized must have an acceptable
level of predicted loan losses that are
fully neutralized by the credit enhance-
ment mechanisms of the trust.
3. Historical Default and Prepay-
ment Data: An abundance of statistical
data is usually needed as proof that the
assets have the two cashflow qualities
noted above. Usually, the extreme
points reached in a full business cycle
of default and prepayment statistics are
used to stress test the securitized trust
structure.
4. Large Diversied Portfolio: Usu-
ally, the portfolio of assets to be securi-
tized must exceed a certain size in
terms of number of loans and loan
amounts. A widely diversified portfo-
lios future default and prepayment
rates will be better correlated to the his-
torical experience (all other economic
and business variables being the same)
than a non-diversified portfolio with
asset concentrations of one character-
istic or another.
These qualities are not prerequisites
for securitization, but they make the se-
curitization easier to execute and more
efcient for the seller. If the asset does
not have these qualities, then the struc-
ture needs more credit enhancement,
which comes at the expense of the sell-
er (i.e. the seller might have to fund a
higher reserve and therefore receive
less up-front sale proceeds). If the asset
is too risky and the timing of the pay-
ment too volatile, then the credit en-
hancement becomes so great that the
transaction is uneconomical.
Assets that generate future cashow
streams can be placed on a spectrum of
securitizability. Conservative assets
such as mortgages and auto loans
would be at one end (most securitiz-
able) and more risky and volatile assets
such as junior oil income trust units
would appear at the other end (least se-
curitizable).
The waterfall: The waterfall denes
the order of cash distributions to the
various stakeholders of the trust. It sets
the priority of each stakeholder in re-
ceiving funds generated by the assets at
any time and under any circumstance.
Just like a real waterfall that ows down
a series of steps, with a little water
being trapped at each step, the asset
cashflows get distributed in order of
priority to fulll various claims. This is
done at the end of each interest-pay-
ment period (usually every month)
throughout the life of the asset.
Typically, trust expenses such as ad-
ministration fees and trustee fees are
paid rst. Next, stand-by fees for liquid-
ity lines and/or letters of credit are paid
down. Then swap expenses along with
repayment of principal and interest on
various classes of notes are paid down,
followed by top-up amounts needed to
fund any cash reserves in the trust. The
excess, if any, would then flow back to
the seller. (Alternatively, the trust may
be structured so that excess cashflow
flows to the most junior noteholder,
which is often the seller/administrator).
There should be sufficient cash
owing down the waterfall to pay down
all expenses to keep the trust running
and all notes that represent the trusts
cost of funds. Each class of noteholders
can look to the next lower class of note-
holders, the excess spread and the re-
serve, if any, as credit support.
Andrew Lin, P. Eng., MBA, CFA, is a secu-
ritization structuring specialist in the
Structured Finance & Securitization
Group of ScotiaMcLeod Inc. in Toronto.
Part two of this series will appear in the
next issue of Canadian Treasurer.
Figure 2 Typical Securitization Schematic
Seller retains subordinated
Interest ($0.5 MM)
Liquidity agreement
and/or Letter of Credit
Swap Agreement with
notional reset option
$1 MM Note
Proceeds
TRUST
$0.95 MM
proceeds of
note issuance
$0.5 MM Proceeds
of note issuance
R-1 (high) CP Notes
($1 MM) Mortgage
Receivables
Financial
Institution
Swap
Counterparty
Seller
Money Market
Investors
Cash Reserve
Account
Figure 1 The Securitization Process
Non-investment
Grade
Investment Grade
Seller assets
Loan to value
Spread accounts
Lock-up events
Letter
Liquidity line
Swap
Loans
Conduit
Credit
enhanced
Money
Market/Bond
Desks
Commercial Paper/Bonds
Table 1: Conventional Financial
Assets Being Securitized in Canada
Auto Loans
Credit Card Receivables
Commercial Mortgages
Equipment Leases
Mutual Fund Deferred Sales
Commissions
Personal Lines of Credit Balances
Department Store Card Balances
Residential Mortgages
Reverse Mortgages
Secured Commercial Loans
Auto Leases
14 CANADIANTreasurer
OCTOBER/NOVEMBER 1999
For c issuance, there must be suf-
cient liquidity in the market so that the
notes can be rolled over on maturity
dates that is, payment can be made
on maturing notes by the successful is-
suance of new notes. In addition, the
trust should not be able to expose itself
to market risk. The following three
components of credit enhancement,
liquidity lines and swaps are three im-
portant elements that help to bullet-
proof the trust (and therefore, its
notes) against risk.
Credit Enhancements: The common
theme of all forms of credit enhance-
ments is the increase of the collateral
against which the notes are secured.
This can be done through (1) subordi-
nated note tranching, (2) using a de-
ferred seller payment to fund a reserve,
(3) using the excess interest spread to
cover losses and fund a reserve, (4) in-
corporating a letter of credit, or (5) im-
plementing a lock-up mechanism.
1. Subordinated Note Tranching: The
notes issued by the securitized trust to
fund the purchase of the assets are typ-
ically arranged in a hierarchy of classes
with the senior class being by far the
largest. The senior note is rated nnn (or
equivalent by different rating agencies)
if in the form of a bond, or
R-1 (high) (or equivalent) if in the form
of c. They are typically supported by
one or more subordinated classes; the
most junior, the residual note, may be
kept by the seller. Each successive class
usually has a lower rating than the one
preceding it, and the residual note, at
the bottom, is usually unrated. The
most senior notes have the entire
trusts assets as security for the amount
lent, providing them with significant
overcollateralization. Similarly, the
next most senior notes have a de-
creased amount of overcollateraliza-
tion. The residual note has little or no
overcollateralization.
2. Deferred Seller Payment for Re-
serve: One of the most common meth-
ods of providing credit enhancement is
by holding back some of the asset sale
proceeds. The seller typically receives
90% to 99% of the sale price, while the
rest is held in a reserve account of the
trust. Instead of receiving the rest of
the cash, the seller receives a subordi-
nated interest in the trust assets, which
entitles it to the contents of the reserve
after all more senior claims on the trust
have been satisfied. This interest is
subordinated to all other notes inter-
ests and other claims and takes the
form of a note, certicate, retained co-
ownership interest or even an iou. Oc-
casionally, a seller may wish to sell its
subordinated interest in the form of a
note, so that no component of the se-
curitization remains on its balance
sheet. However, the market for the sub-
ordinated interest is very small in
Canada. The residual note is usually a
risky asset, being the rst note to be af-
fected by losses and the last to be paid
back its principal.
3. Excess Spread for Losses and Re-
serve: Excess interest spread is dened
as the difference between the interest
rate generated on the securitized as-
sets over the cost of funds of the trust -
that is, the weighted average yield on
the notes issued. Alternatively, it can
be seen as the dollar value of the inter-
est income over the interest expense.
Out of the excess spread are paid the
expenses of the trust. The net excess
spread after trust expenses is then usu-
ally used to further fund the reserve (if
initially funded by the deferred seller
payment), with the rest going to the
residual noteholder.
4. Letter of Credit: A letter of credit is
usually used in place of subordinated
S
nrr1v or oNrs iNvrs1rrN1 is nnnrouN1 iN 1nr uncnnsr or
asset-backed notes. However, timeliness of investment return
is also a critical factor. A securitization structure must not
only guarantee the safety of investors money, but it must also en-
sure that the notes can be paid when due.
FEATURE/RISK MANAGEMENT
A securitization primer:
Part two
Having explored the basic principles, the second of a four-part series
on the fundamentals of securitization discusses the structural components and
decisions involved in a securitization program
By Andrew Lin
CANADIANTreasurer DECEMBER 1998/JANUARY 1999 15
notes or, if the quality of the assets is
low, in conjunction with subordinated
notes, providing collateral to the note-
holders, since it would serve as a guar-
anteed source of funds from a nancial
institution. It can be drawn upon by the
trust if a shortfall in cashow from the
assets is larger than the excess spread
and the reserve can sustain.
5. Lock-up Mechanism: This mecha-
nism works in combination with the
excess spread. When defaults reach a
certain level, the trust becomes locked
up so that the residual noteholder no
longer receives any cash, and all cash
from the excess spread is used to pay
down the principal of the noteholders
as quickly as possible. In a lock-up, the
funds in the reserve account are also
used to pay down note principal. In
structures with several tranches of
notes outstanding (besides the resid-
ual note), most lock-up mechanisms
change the priority between the vari-
ous note tranches. All cash is used to
pay down all interest; then principal on
the most senior note, before any inter-
est, is paid on the next most senior
note (which must accrue the interest).
Through this payment acceleration,
the note liability of the trust decreases
faster than the assets, creating addi-
tional overcollateralization. This is also
known as turbo-ing the principal.
Liquidity Lines: CP, not bond issuance,
provides liquidity of the notes issued by
the trust. The c-based trust rolls over
c every few weeks or months, each
time redeeming a small portion of the
notes in proportion to the asset princi-
pal being amortized down.
To receive the R-1 (high) rating, its
not enough that the assets backing the
notes are of the highest quality. In-
vestors must also be able to realize
their return upon the agreed upon ma-
turity.
The trust faces a small amount of
uncertainty each time it refinances, as
it must nd new buyers to purchase the
notes and use the proceeds to pay the
maturing notes. A liquidity line is a
promise from a financial institution
that, in the event of a market-wide dis-
ruption where the issuance of c isnt
possible, the financial institution will
purchase the notes so the trust can pay
its maturing notes.
Interest Rate Swaps: Interest-rate
swaps must be applied to the trust if
the interest income and the interest
expense (cost of funds) of the trust are
not both fixed or both floating. In the
case of the c-based securitization,
the funding of the trust will always be
floating. If the assets are fixed-rate,
like mortgages, then it is necessary to
incorporate a fixed-to-floating swap
for the principal amount. Similarly, if
the securitized trust is issuing fixed-
rate bonds but has floating-rate inter-
est revenue from its asset, then it is
necessary to incorporate a floating-to-
fixed swap for the principal amount of
the loans.
Interest-rate swaps are generally
done using bankers acceptances (uns)
as the oating benchmark. This means
that, even if the trust is overlaid with a
swap to fully hedge the x/oating risk,
there still exists the basis risk between
c and [Link] cun spread has gener-
ally been quite stable over the past few
years. It will continue to reect the dif-
ference in risk between the financial
health of banking institutions versus
Canadian blue-chip corporations.
Swap desks at several nancial institu-
tions and investment dealers have the
capability of overlaying a basis swap to
cover the c-to-un risk, but the cost is
fairly high.
The bottom line on structure: All the
components discussed above help to
make the structure robust and give
greater assurance to investors to buy
the securities. However, there are costs
to each of them. Swap lines may be
costly, especially if theyre non-stan-
dard (i.e. based on CP instead of BA).
Liquidity lines and letters of credit have
stand-by fees. Lock-up mechanisms
accelerate the repayment of low-inter-
est notes, thereby leaving the trust
funded by the higher-interest notes. All
these cut into the excess spread going
back to the seller (or residual notehold-
er), lowering its return. Investors like
these mechanisms but sellers know
theyre costly. The bottom-line is that it
affects the bottom line.
9. Other Seller Decisions
The structural components discussed
in the previous section form the
essence of a securitization transaction.
They determine the quality and the rat-
ing of the securities that will be issued
from the trust. However, there are other
aspects of the trust itself that the seller
has to decide upon. These issues dont
affect the quality of the security that the
investors hold, but theyre important in
the management of the trust itself.
Term vs. cp: Most trusts will issue
predominantly either c or term debt.
Some that have multiple tranches may
issue a combination of the two, but
each tranche would likely issue only
term or c (i.e. senior c notes support-
ed with subordinated term notes - but
wed consider these c trusts, since the
subordinated notes make up a very
minor part of the debt). Some trusts
have been structured so one
class/grade of notes can issue both c
and term notes, but the management
of these trusts tends to get complicat-
ed, especially in a lock-up situation.
In general, its a good idea to struc-
ture a c-based trust if the assets being
securitized are short-term or floating-
rate. Conversely, a term-based trust
works better for assets with a longer life
and low prepayment volatility.
Single-Seller vs. Multi-Seller
Trusts: A single-seller trust is a securi-
tized trust designed for one seller and
usually for one specific asset of that
seller. A multi-seller trust, usually run
by an investment dealer that also dis-
tributes the securities, contains pools
of different assets that have been sold
by different sellers. Each has its own de-
gree of credit enhancement depending
on the quality of the pool. The identi-
ties of the sellers are not publicly dis-
closed, although the type of assets in
the trust is. This anonymity is impor-
tant to the sellers, who view their secu-
ritization activities as a competitive
advantage in their industry. Whereas
the single-seller trust is customized to a
client of a certain size, the multi-seller
trust is a standardized conduit for
clients large or small. Table 1 outlines
the main differences.
Andrew Lin, [Link]., MBA, CFA, is a secu-
ritization structuring specialist in the
Structured Finance & Securitization
Group of ScotiaMcLeod Inc. in Toronto.
Part three of this series will appear in
the next issue of Canadian Treasurer.
Multi Seller Single Seller
Lower up-front costs Flexibility, but more costly
Anonymity / Condentiality Public Prole
CP-based only Ability to issue term debt as well as CP
Investors buys the Program, not Greater administration requirements
individual deals for the Seller
Table 1 : Trust Types
16 CANADIANTreasurer
FEATURE/RISK MANAGEMENT
DECEMBER 1999 / JANUARY 2000
Depending on the size and com-
plexity of the transaction, investment
bankers, the main facilitators and
managers of the transaction, may ask
for a structuring fee above and be-
yond the distribution fee that their
dealer networks would charge to dis-
tribute the asset-backed paper into
the capi tal markets.
Lawyers fees can add be-
tween $50,000 and several
hundred thousand dollars,
dependi ng on the com-
plexity of the structure and
the uniqueness of the fi-
nancial asset, since every
detail must be reflected in
the legal documentation.
Other third-party fees can
double this amount.
Lastly, since the seller usually con-
tinues to be the administrator of the
securitized assets, ongoing adminis-
trative activities must be performed
for the life of the securitization. The
sold assets must be tracked and man-
aged separately from the rest of the
companys assets, with regular report-
ing to the trustee and other third par-
ties. This may demand modifications
to corporate information systems,
which may place a burden on systems
resources.
SO WHY SECURI TI ZE?
Each potential seller makes a quantita-
tive and/or qualitative assessment of
the benefits derived from a
securitization and weighs
them against the transac-
tion and on-going costs. If
the benefits outweigh the
costs, then it makes sense
for the securitization to pro-
ceed. The benefits are var-
ied, but usually involve the
following:
Maximization of Proceeds:
Sometimes companies just need to sell
assets to raise money. Perhaps the
company is in distress; perhaps its
protable but faces a tempoXrary cash
crunch because its growing too fast. Or
perhaps the company just thinks it can
realize a better return in some other in-
vestment with cash raised from the
asset. In many cases, securitization is
the most efcient way of monetizing a
nancial asset such as a loan or mort-
gage. A lender may consider such an
asset to be somewhat illiquid, since it
cant simply call its loan or liquidate
the collateral to which its secured. It
has the rights only to a future cashow
stream unless the borrower breaches
the loan agreement. The market for the
financial asset may also be illiquid if
the assets potential buyers are also
competitors who arent inclined to ac-
commodate the seller. Securitization
addresses these hurdles by giving a
company access to buyers in the
broader capital markets.
Although most sellers are healthy,
on-going concerns, one can see how a
receiver/liquidator of a bankruptcy
would be especially attracted to secu-
ritization instead of selling at dis-
tressed prices. Credit-rating agencies
factor heavily on the performance of
the assets instead of the company.
During the early 1990s, the Resolution
Trust Corporation (n1c) in the U.S. was
given the mandate to sell the commer-
cial mortgage assets of hundreds of
defunct savings & loans companies. By
amassing pools of good mortgages
and securitizing them, the n1c pio-
neered the commercial mortgage-
backed security (crus) market.
Instead of selling the mortgages at
bargain-basement prices in the
whole-loan market, the n1c tapped
into the debt capital markets by selling
certificates backed by large pools of
commercial mortgages. It could create
the crus market because it had a criti-
cal mass of securitizable assets. Such
P
rnronriNc n srcuni1izn1ioN cnN ur IoNc, rxrNsivr nNn
structurally challenging. A working group of professionals
from within the seller organization, along with the invest-
ment bankers/dealers, lawyers, internal and external accountants
and auditors, rating agencies, trustees, consultants and other third
parties can make for expensive meetings if theyre being paid by
the hour.
A securitization primer:
Part three
After reviewing the basic principles of securitization and the structural components of a
securitization program in two previous articles, this installment explains why sellers undertake
the exercise in the rst place and why buyers are attracted to securitized assets.
by Andrew Lin
In many cases,
securitization is
the most ef-
cient way of
monetizing a -
nancial asset
such as a loan or
mortgage
CANADIANTreasurer DECEMBER 1999 / JANUARY 2000 17
critical mass provided sufficient asset
diversification to back the securities
and enough pools of cruss to create a
liquid secondary trading market both
elements being critical factors in an in-
stitutional investors decision to buy
the security.
Balance Sheet and Income
Statement Impact: Just as important as
maximizing sale proceeds are the ef-
fects of the securitization on
the financial statements of
the seller. You will recall that
securitization results in a
true sale for accounting and
tax purposes, even though
the seller continues to ad-
minister the assets. If the
seller uses the proceeds to
pay down outstanding debt,
both assets and liabilities de-
crease by the same amount,
resulting in de-leveraging.
This improves the debt/eq-
uity ratio of the seller.
Securitization can also affect the
bottom line, so that the income state-
ment shows a reduction in capital tax
and a gain on the sale of the asset. The
Large Corporations Tax is a federal tax
on Canadian companies based on a
percentage of their total capitalization.
By reducing the debt or equity out-
standing with the securitization pro-
ceeds, the capital base of the company
decreases and, therefore, capital tax
also decreases. Note that, for financial
institutions, the law is slightly different.
In the case of financial institutions,
capital tax is generally based on its
share capital.
In addition to Ic1, Canadian compa-
nies are also taxed on their capital at
the provincial level, with the rate vary-
ing depending on the jurisdiction.
Together, Ic1 and provincial capital tax
can add 50 to 90 basis points (pre-tax)
to the cost of funding with on-balance-
sheet debt.
Note that Schedule I and II banks are
the exception to the rule here as well.
Banks face a more onerous hurdle than
other nancial institutions. A bank can
recognize the gain only if it holds no re-
tained interest in the transaction.
Otherwise, it can recognize that gain
only when the retained interest cash-
ow is realized.
Capital Relief for Banks: Given the
extra hurdles imposed on banks to gain
the benefits of securitization, the con-
cept shouldnt seem attractive. Yet
Canadas largest banks have recently
been the leading securitizers in the
country. The reason becomes apparent
when we analyze what securitization
does for the capital adequacy ratios of
the banks that is, their risk-weighted
ratios or Tier 1 and Tier 2 ratios. The
Office of the Superintendent of
Financial Institutions (osri), the regu-
latory agency for banks and other fi-
nancial institutions, has provided that
all deposit-taking banks must set aside
a certain amount of equity capital as a
percentage of the assets
(mostly loans) that banks
hold. Therefore, if a bank
wants to make more loans,
it has to issue more stock or
otherwise let its capital ade-
quacy ratios decline. Since
securitization officially re-
moves assets from the bal-
ance sheet and shifts risk
from the banks depositors
to the securitization vehi-
cles investors, it increases
the banks capital adequacy
ratios, thereby creating capital relief for
the bank.
Reduced Cost of Funding: For many
small to mid-sized companies, securiti-
zation can offer the least expensive
source of funding. A small car-leasing
company facing a line of credit from a
bank at the prime rate plus some
spread could turn to securitizing its
auto leases and face an effective fund-
ing rate of the going commercial paper
(c) rate plus some spread for the pro-
gram fee of a multi-seller conduit.
Alternative Source of Funding: For
banks and large companies with invest-
ment-grade credit ratings, the cost of
raising funds in the c or bond markets
compared to securitization depends on
a combination of short-term rates,
long-term rates, credit spreads, swap
spreads and set-up costs. However,
even at times when on-balance-sheet
borrowings are more attractive, some
rms may choose to securitize to diver-
sify their funding sources. Through
such a strategy, a company avoids a
cash crunch if one market or another
faces a liquidity crisis, as in August
1998, when credit spreads increased
dramatically in the bond markets.
Conduit Strategy: Lastly, some
companies securitize not to raise funds
by selling nancial assets but to enable
them to put more of the same assets on
their books. A financing company, for
example, faced with limited sources of
funds, can continually originate loans
and subsequently securitize them into
a trust serving as a conduit. The com-
pany can make prots on the differen-
tial in the interest income from the
loans versus the cost of funds of the se-
curitization. It can also earn fees
through the management and adminis-
tration of the loans, while keeping its
origination and administration staff
employed.
WHY I NVESTORS BUY
Weve discussed the many and complex
reasons that sellers securitize assets. In
contrast, the reasons that investors buy
securitized assets are much simpler.
Portfolio managers tend to look for new
names to put into their portfolios be-
cause of concentration limits imposed
on them by their mandates. Securities
issued by a trust backed by assets sold
by a bank would be considered to be a
different borrowers debt in a portfolio
than the direct debt of the same bank,
since the trust is an arms-length third
party to the bank. This helps the in-
vestor achieve the goal of portfolio di-
versification. In the money market,
asset-backed c programs usually have
greater flexibility in maturity dates in
which investors may want to buy to
balance their portfolio or take an inter-
est-rate view.
By far the greatest reason for buying
is the extra yield that the notes offer. In
the competitive bond market, where
even the passive index outperforms a
majority of active portfolios, investors
are keen to invest in high-grade instru-
ments paying a premium over conven-
tional securities of the same rating. In
the money market world, money man-
agers not only have to beat their perfor-
mance benchmark, but at the same
time, execute cash-management duties
of the corporate treasury. As a result,
the manager faces two conflicting ob-
jectives: providing liquidity for day-to-
day cash needs while still trying to
realize a decent return on the funds.
R-1 (high) asset-backed commercial
paper issued by multi-seller conduits
have recently been issued at 8-10 bps
over BAs, which are rated only R-1
(mid). Recently AAA-rated credit-card-
backed ve-year bonds have been trad-
ing at about the same spread over
AA-rated senior bank paper of the same
term.
Investors continue to be offered se-
curitized notes of a higher rating at the
same or higher spreads than the under-
lying banks own paper of a lower rat-
ing. Why does this inconsistency
persist? In the past, the illiquidity asso-
ciated with the private-placement na-
ture of the securities and a large supply
Securitization
ofcially re-
moves assets
from the
balance sheet
and shifts risk
from the banks
depositors to
the securitiza-
tion vehicles
investors
18 CANADIANTreasurer
from banks and other nancial institu-
tions contributed to the situation. Both
factors have diminished in importance.
Most issues are now public securities,
and issuances have moderated.
However, the most significant rea-
son for the reluctance of investors to
wholeheartedly embrace securitization
is the structural complexity of the
notes. After all, the concepts are not
easy to understand. The life of the trust
is usually limited to the life of the as-
sets. It winds down instead of being a
real going concern that is, a corpora-
tion with products, management strat-
egy and growth prospects. Credit
support in the structure is
determined by historical
data, with a large dose of
complex statistical analysis.
Some portfolio managers
have stated that theyd
rather put their money in a
real corporation, with all the
risk involved, than into
what they perceive to be a
black box.
As with all new asset
classes, time and experi-
ence are the best educators.
Sellers and structurers are responding
to investor concerns of transparency to
demystify the black box for investors.
Over time and with greater acceptance
and understanding, we can expect
spreads on securitized paper to narrow.
In the meantime, portfolio managers
who dare to educate themselves on the
structures of securitizations have
found a way of enhancing return and
beating their benchmarks.
FUTURE ASSETS TO BE
SECURI TI ZED
As if the present set of securitization of-
ferings on the market werent enough to
satisfy investor demand, several struc-
tured bonds have recently been done,
and there are others on the horizon that
use the cutting edge of securitization
techniques. These include:
Bonds backed by Single-Obligor
Payment Streams: The assignment of
single-obligor payment streams to back
a structured bond is not, strictly speak-
ing, a securitization, but it uses securi-
tization techniques to achieve similar
goals. In this scenario, a company or or-
ganization with an investment-grade
credit rating that doesnt want an asset
and the associated debt (which would
be incurred to buy the asset) on its bal-
ance sheet would set up a trust to ac-
quire the asset instead of buying the
asset itself. Then the company would
lease the asset from the trust. At the
same time, the trust would issue bonds
in the capital markets to raise the nec-
essary funds to acquire the asset. These
bonds would be backed by an assign-
ment of the lease cashflows coming
from the lessee. Since the lease obliga-
tion would rank parri passu with any
other general obligation or debt of the
lessee, the lease-backed bond should
have the same credit rating as the
lessee.
The concept of single-obligor lease
securitization, or Credit Lease bond, is
not a new one and has been used by
commercial landlords for
years to raise money by issu-
ing private-placement notes
backed by the long-term
leases of major, high-credit
corporate tenants or by
pledging the rental stream
as security for bank loans.
Now this concept has been
extended to governments
and corporations for the ac-
quisition of all kinds of long-
term, infrastructure-type
assets, and they are execut-
ed in the public capital markets.
Milit-Air, the Toronto Hospital and
Borealis Infrastructure Trust have all is-
sued bonds secured by federal or
provincial governmental payments. In
May 1998, Milit-Air was formed to pro-
vide aircraft, ight simulators and other
equipment and facilities to train ghter
pilots for the Canadian Air Force and
the military of other allied countries as
part of the Nn1o Flying Training in
Canada (Nr1c) program. It issued
bonds backed by 20-year pilot tuition
payments by the Canadian government
for the use of the facilities. In November
1998, the Toronto Hospital issued
bonds secured by payments from the
Province of Ontarios Ministry of Health
to fund a major redevelopment and
renovation project, although there was
no lease obligation by the Province in
this case. Very recently, in June 1999,
Borealis issued bonds backed by the
Province of Nova Scotias lease pay-
ments for the use of a group of new
schools. The proceeds were used to
fund the development of those schools
for use by the government. Lastly, sev-
eral railway companies in North
America (including c and cN) have en-
tered into long-term leasing agree-
ments to use rail cars and locomotives,
financed by asset-backed bonds (in a
variation called a synthetic lease).
In the cases involving leasing
arrangements, the lessee does not pro-
vide a guarantee on the bonds.
However, the structure imposed on
them through the terms of the lease,
and the assignment of the rights of the
lessor with regard to the lease to the
bondholders, make the obligation of
the bond effectively that of the lessee,
without having to state it on the lessees
balance sheet.
In the single-obligor lease structure,
the conventional securitization con-
cept of diversication as a primary risk
mitigant is absent. In its place is the
good underlying credit of the lessee
backing the debt. In conventional secu-
ritizations, the vast majority of the debt
issued in each case is rated R-1 (high)
or AAA, with such notes being credit-
enhanced by some small amount of
lower-rated subordinated notes or
other mechanisms. In the single-oblig-
or lease structure, the rating of the
whole debt is usually the same as that
of the underlying lessee. However, the
common theme of both this new struc-
ture and the conventional structure is
the fundamental concept of packaging
a future cashflow stream into an asset
to back a debt security.
Intellectual Property Rights: Back
in the conventional world of securitiza-
tion, investment bankers and corporate
lawyers are searching to find new and
wonderful asset classes to securitize.
The emerging class of intellectual prop-
erty rights has turned into the new
frontier of modern securitization prac-
tice. Intellectual property rights, from a
financial point of view, can be consid-
ered to be any creation or discovery
that can be legally copyrighted or
patented and can generate a future
cashflow stream. This group includes
music royalties, publication rights and
patent rights.
In addition to nerdy number-
crunchers, even David Bowie has got-
ten into the securitization act. The
popular singer securitized the future
royalty stream from his catalogue of
past recordings in a securitized bond
DECEMBER 1999 / JANUARY 2000
In addition to
nerdy number-
crunchers, even
David Bowie has
gotten into the
securitization
act.
In Los Angeles, they talk the
language of the 21st century. In
Cologne or Strasburg, the
argument revolves around the
35-hour week, retirement at 50,
and who gets what subsidy.
Paul Johnson, The Spectator
Did you know?
CANADIANTreasurer DECEMBER 1999 / JANUARY 2000 19
offering in 1996. These Bowie Bonds
were rated A and had a principal size of
US$55 million. In comparison, a rela-
tively small collection of non-nancial
corporations in Canada are rated A or
above.
The extent of Bowies work and the
future royalty stream associated with it
easily justied the size of the issue. You
may also recall from one of the previous
issues that one of the important char-
acteristics of a securitizable asset is a
steady, predictable cashflow stream.
The track record of Bowies record sales
is unparalleled in this area. His Iggy
Stardust album has generated a steady
stream of sales, year in and year out, for
the past two decades. Its this kind of
strong statistical payment pattern in
which investors take comfort. In a nut-
shell: Bowie has staying power one of
the unique and necessary ingredients
in the securitization of music royalty
streams.
If that isnt enough to reaffirm the
coolness of securitization, James
Brown, the godfather of soul, recently
announced that he, too, will securitize
his music royalty stream. (Asked what
he felt about securitizing his music, he
is suspected to have replied Ah FEEL
GOOD!).
Related to music royalty streams, but
not as glamorous, are royalty streams
from books and novels by authors such
as Tom Clancy and publishers such as
Simon & Schuster. Securitizing publica-
tion royalties may be easier than music
royalties, because publishers usually
have large catalogues of books to which
they own the rights. (Many authors sell
ownership of their books to the publish-
ing companies because of cash con-
straints). Therefore, publishers may
have the widely diversied portfolio of
assets needed for securitization. Note
that although Bowie and Brown may
have large portfolios of songs that
would t a securitization, not many en-
tertainers do. Similarly, very few indi-
vidual authors can claim to have a large
enough portfolio of work to be consid-
ered diversied but most major pub-
lishers do.
Lastly, patent rights, especially as
they pertain to drugs, may become the
next big securitizable asset class. Small
biotechnology companies spend most
of their money on nxn. By the time a
company brings its drug through the
testing stage to regulatory approval, it
may have little money left to market
and mass-produce it. A biotech firm
must often work in partnership with a
large pharmaceutical company to prof-
it from its discovery. Securitization
would allow the rm to tap into a new
source of funding and gain a greater
measure of independence.
Securitizing drug patents does have
some drawbacks. For one thing, it
wouldnt t the usual criteria of a secu-
ritization. The asset would have no
cashflow track record, and the poten-
tial cashflow stream could be quite
volatile. There would also be very little
diversification, as the biotech firm
woul d not l ikel y have many mar-
ketable drugs in its portfolio at any
particul ar time to be securitized.
Despite these drawbacks, you can be
assured that there will be great securi-
tization potential for a blockbuster
drug, such as an ni ns vaccine, the
minute that its announced.
Andrew Lin, [Link]., MBA, CFA, is a secu-
ritization structuring specialist in the
Structured Finance & Securitization
Group of ScotiaMcLeod Inc. in Toronto.
Part Four of this series will appear in the
next issue of Canadian Treasurer.
CANADIANTreasurer FEBRUARY/MARCH 2000 11
Transparency and Reporting: Investors
need to understand what theyre buy-
ing. In the past, they have voiced strong
concerns that the securitization struc-
tures that back the notes are big black
boxes. Although they understand the
general structure of the trusts that hold
the assets and protects their interests,
the governing legal documentation
such as the trust indentures or the mas-
ter co-ownership agreements, together
with the nancial models, are often the
proprietary property of the sellers.
Information on the on-going perfor-
mance of the trusts is also difficult to
obtain. Monthly servicer reports reveal
scant information or are not widely dis-
tributed to the public.
Although most investors simply look
to the credit rating agencies to monitor
and assess the health of on-going secu-
ritizations, more tenacious investors do
their own homework. They prefer not
to rely on third parties such as rating
agencies that have no legal liability to
investors in their published rating
opinions. They look for variances be-
tween expected and actual prepay-
ments and losses, levels of cash re-
serves for credit enhancement and the
degree that swap positions taken by the
trust are in or out of the money to as-
sess counterparty risk. These investors,
as portfolio managers, answer to their
clients and investment committees
who may be wary about investments
such as securitizations that are not in-
tuitive. They need this type of informa-
tion to perform the analysis to defend
their investment decisions.
Sellers have been reluctant to dis-
close all details about the assets that
they have sold into securitizations and
that they are still administrating. This is
especially true for private companies
that have low levels of reporting and dis-
closure responsibilities. Such informa-
tion could be considered competitive
information. Delinquency and loss data
on loan assets could reflect upon the
sellers underwriting competency.
Recognition of gains on sales may lead
to criticisms of aggressive accounting by
competitors. Instead, sellers have tradi-
tionally used rating agencies to monitor
their securitizations and to give their
stamp of approval to investors.
However, sellers are increasingly ac-
knowledging the need of investors for
more disclosure. They are preparing
more detailed information on their
monthly servicer reports and adding
investors to monthly mailing lists at
their request. With the sellers permis-
sion, several investment dealers are
publishing monthly reports summa-
rizing the performance of the securi-
tized trusts and increasing the level of
disclosure. In multi-seller conduits,
where anonymity is one of the main
advantages for the sellers, the monthly
reports will not likely reveal their iden-
tity. But the reports usually give more
information on the make-up of the
asset classes in the conduits and the
performance of each class.
With increasing transparency, in-
vestors will gain greater comfort in
buying securitizations. This should re-
sult in greater demand for asset-
backed products and tighter spreads in
capital markets.
Non-Investment Grade/Non-Sequen-
tial Bond Tranches: In the money mar-
kets, securitizations have generally
been well accepted because of the high
level of safety inherent in short-term,
high-quality commercial paper.
Interest-rate risk ([Link] hedging of
fixed-rate assets funded by floating-
rate CP) and prepayment risk on the se-
curitized assets are generally placed
with other parties such as swap coun-
A
srcuni1izn1ioN wonxs oNIv wnrN srIIrns nNn uuvrns
both participate. Buyers must be convinced that the under-
lying asset backing the security is a good one, that the
trusts credit-enhancement structure is sufficient to protect their
interests, and that the incremental return on the security is worth
their while. Securitizers (sellers) must also believe that the transac-
tion is worth their time, that they will receive an attractive price for
the assets sold into the trust, and that they will receive the neces-
sary accounting and tax treatments as a result of the transaction.
A securitization primer:
Part four Issues facing the
industry
Several issues of concern to buyers and sellers of securitized assets have to be
resolved before the market will live up to its full potential.
By Andrew Lin
FEATURE/CAPITAL MARKETS
12 CANADIANTreasurer FEBRUARY/MARCH 2000
terparties, liquidity lenders or the seller
itself. By contrast, a securitization in the
bond market usually passes on these
risks onto the bond investor, making the
risk/return analysis more complex.
Whereas a CP securitization may
raise the bulk of its nancing (i.e. 90% or
more) in R-1 (high) notes, a complex
bond securitization, say a CMBS (com-
mercial mortgage-backed security),
may raise a lower amount (i.e. 75%) in
triple-A bonds (usually because of the
greater credit risk of the underlying
asset). The rest of the bond financing
would be in subordinated sequential
tranches spanning the range of ratings
from AA to B (or lower). Each tranche
would typically pay down its principal
sequentially (in order of seniority), and
each would enhance the credit of the
tranches more senior to it. However, un-
like the U.S. market, which has more
depth and breadth, the Canadian mar-
ket for non-investment grade (i.e. below
BBB) bonds in Canada is very small.
Sellers often must sell the non-invest-
ment grade tranches at a huge discount
or keep the notes themselves, an option
that jeopardizes the argument that the
securitization is a true sale.
To add to the complication, there
may be non-sequential tranches, such
as an interest-only tranche, to deal with
the excess spread from the assets. In the
U.S., where multiple bond tranching of
securitization is more advanced, there
are even innovative tranches, such as a
Jump-Z tranche or companion tranch-
es, both of which are designed to deal
with unexpected prepayments that
would otherwise adversely affect the
return of the sequential tranches.
These more exotic instruments are rare
in Canada because of the markets
much smaller size and the more con-
servative nature of Canadian investors.
Nevertheless, this lack of investor in-
terest in non-investment grade and
non-sequential bond tranches will not
prevent the Canadian securitization
market from maturing. Other innova-
tions will likely materialize to accom-
modate the distinct nature of Canadian
capital markets, perhaps through de-
rivatives or increased credit enhance-
ments, which will mitigate the risks
that Canadian investors try to avoid.
Risk Transference and Capital Relief:
The previous two sections dealt with
investor-oriented issues, but sellers
also have on-going concerns about se-
curitization. One of the tasks that a sell-
er must face is convincing its auditor
that the sale of its assets is a true sale for
accounting purposes. The seller usually
retains a residual interest in the securi-
tization for credit enhancement of the
structure. The greater the interest, the
greater the support to the structure and
the easier it becomes to sell the rest of
the securitization to investors.
The problem is that the greater the
support given by the seller, the greater
the risk that the auditor will not regard
the transaction as a sale. The auditor
could conclude that there has been no
transfer of risk to the buyer (the trust)
and, therefore, there is no actual sale.
From a Canadian GAAP perspective,
the prime test of a true sale is a transfer
of the beneficial interest in the asset,
with the seller retaining the lesser of:
(1.) a 10% interest, or (2.) whatever is
considered reasonable to show true
transference of the risk and rewards of
ownership. The seller could meet this
criterion by showing that the size of its
residual interest would be completely
offset by predicted losses on the asset
The investors concern with this ar-
gument is that it doesnt allow much
room for a margin of error before their
investments are affected. If the seller
provides only a minimal credit en-
hancement to satisfy the auditors, in-
vestors will have less interest in the
notes of the securitization. The key in
structuring a securitization is finding
the enhancement level that balances
the interests of the seller, the auditor
and the investors.
Banks have an additional risk-trans-
ference problem when it comes to rat-
ing agencies. The banks, as
deposit-taking institutions, must
achieve acceptable capital adequacy
levels. OSFI, the regulatory agency for
financial institutions, acknowledges a
banks sale of assets under a securitiza-
tion, accepting the resulting increase in
the banks capital ratios, thereby pro-
viding the bank with capital relief.
However, rating agencies generally do
not view securitization so positively.
Although the bank may show a true sale
and risk transference from an account-
ing point of view, rating agencies, in
most cases, will not agree that signifi-
cant risk has really been transferred.
The rating agencies feel that, in most
securitizations, the seller is transferring
only catastrophic risk and this is not
sufficient risk to warrant off-balance
sheet treatment. In such cases, rating
agencies mitigate the effects of securiti-
zation, adding back all or most of the
assets to its balance sheet before calcu-
lating capital ratios. Thus, the bank
tends not to receive capital relief for its
efforts in its credit rating.
Rating agencies would recognize the
securitization as a true sale of assets
only if the bank sold off its residual inter-
est in the securitization and relin-
quished its role of servicer (which would
likely go to the new owner of the residual
interest), thereby disassociating itself to-
tally from the securitized assets. This
would be difficult for the bank, since
buyers of residual interests are rare and
it would not likely want to extricate itself
from the administration of the assets,
since no one else would be able to ad-
minister the assets as efciently).
Legal Rights and Bankruptcy
Remoteness: The last topic in this arti-
cle is the independence of the trust and
its assets from the seller. Ofcially, the
trust is an independent third party from
the seller. Officially, the trust owns the
assets, although the seller is often hired
by the trust as the servicer of the assets.
This means that, if the trust is dis-
pleased with the servicing of the assets
or if the seller/servicer goes into bank-
ruptcy, the trust has the right and au-
thority to transfer the assets to another
servicer. If this were to happen, all
obligors of the loans (the assets) would
be notied and instructed to send their
payments to the new administrator.
This presents a concern. If the seller
in bankruptcy administers the assets of
the trust, the assets may be deemed to
belong to the seller and may be consoli-
dated with the sellers remaining assets,
leaving the noteholders of the trust as
general creditors of the seller. This con-
cern was allayed in the initial bankrupt-
cy hearing, in 1997, of Eatons. Eatons
had securitized its credit-card receiv-
ables in a trust. The trust continued to
use Eatons as the servicer, because
Eatons was inextricably linked with the
credit-card operations. But the trust ob-
tained a court ruling that the credit-
card receivables belonged to the trust
and therefore were not to be consolidat-
ed with the assets of Eatons, thus pro-
tecting them from the stores creditors.
This ruling upheld the robustness of
the trust and the validity of the securiti-
zation structure. However, the courts to
date have issued only this single prece-
dent, and each ruling must look to the
legal documentation of the trust to de-
termine the validity of its third-party
nature. Only time and more bankrupt-
cies will tell if securitization is as robust
as we think it is.
Andrew Lin, [Link]., MBA, CFA, is a secu-
ritization structuring specialist in the
Specialized Finance Group of Scotia
Capital Inc. in Toronto. This is the nal
installment of a four-part series.
TrademarkofTheBankofNovaScotia. [Link]
businessesofTheBankofNovaScotia,[Link](USA)Inc.-allmembersoftheScotiabankGroup.
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