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Describe

how a typical securitization process works. Which are the main risks arising from a securitization
for the main involved parties (originator, SPV, investors)?
Securitization is a very affective instrument aimed at transferring credit risk. It transforms non marketable
securities in marketable securities, which maybe sold to investors in capital markets. In a securitization, the
cash flows generated by a portfolio are exclusively used to meet the obligations arising from new securities,
issued in the market and structured according to the issuer needs and the investor preferences.
The process of securitization is relatively easy. First, an entity (the originator) desiring financing identifies
an asset that is suitable to use. Loans or receivables are common examples of payment streams that are
securitized. Second, a special legal entity or Special Purpose Vehicles ("SPV") is created and the originator
sells the assets to that SPV that issues the marketable securities, named ABS (Asset Backed Securities). The
funds arising from the ABS issue are used to pay the portfolio purchasing price to the originator. Therefore,
the originator sells a portfolio of assets that generally cannot be sold (for example mortgages, lease
contracts, loans to consumers). The assets that best suit a securitization are the assets that provide good
regular and stable cash flows over a long term with predictable default rates. Mortgages portfolios, for
example, fully meet these requirements.
This effectively separates the risk related to the original entities operations from the risk associated with
collection. When done properly the loans owned by the SPV are beyond the reach of creditors in the case
of bankruptcy or other financial crisis; i.e. the SPV is bankruptcy remote. The objective is not to allow
creditors of the originator to ask for a refund on the sold portfolio from one side, and, not to allow
investors buying the ABS to ask for the due payments to the originator. The originator insolvency,
therefore, does not affect the proper execution of the obligations on the ABS, but the asset portfolio is the
only collateral for investors buying the ABS. The originator has no responsibility for any insolvency in the
asset portfolio once the portfolio is sold to the SPV.
The originator continues to manage the relations with its customers, which may be not aware their position
has been sold to the SPV. For this service, the SPV receives a fee.
To raise funds to purchase these assets the SPV issues asset-backed securities to investors in the capital
markets in a private placement or pursuant to a public offering. These securities are structured to provide
maximum protection from anticipated losses using credit enhancements like letters of credit, internal credit
support or reserve accounts. The securities are also reviewed by credit rating agencies that conduct
extensive analyses of bad-debts experiences, cash flow certainties, and rates of default. The agencies then
rate the securities and they are ready for sale - usually in the form of mid-term notes with a term of three
to ten years. Finally, because the underlying assets are streams of future income, a Pooling and Servicing
Agreement establishes a servicing agent on behalf of the security holders. The services generally include:
mailing monthly statements, collecting payments and remitting them to the investors, investor reporting,
accounting, collecting on delinquent accounts, and conducting repossession and foreclosure proceedings.



Describe how a typical credit derivative (a CDS in particular) works. Which are the main risks arising
from CDS for both the involved parties?

Credit derivatives are over the counter (OTC) contracts whose payoff depends on the credit risk of a
specified issuer, which may not be one of the parties in the agreement. These contracts well suit the needs
of financial institutions as banks, insurance companies, reinsurers, hedge funds, asset managers, with a
view to transferring credit risk.
Credit default swaps (CDS) are the most frequently used credit derivative contract. They are similar to an
insurance contract as they transfer the credit risk against a premium payment. In case of a credit event
(debtor insolvency or downgrade), the protection seller has to make a stated payment, equal to an agreed
amount or to the notional credit amount less a recovery value.
If a bank intends to reduce its exposure to a specific counterparty credit risk without losing the customer or
to limit the exposure on a risky portfolio (an high yield bond portfolio, for example) or to reduce its asset
risk in order to increase its free capital, CDS are particular appropriate.

Explain how the large investment in CDS led to the AIGs crises.
AIG wrote insurance in the form of credit default swaps, meaning it offered buyers insurance protection
against losses on debts and loans of borrowers, to the tune of $447 billion. But the mix was toxic. They also
sold insurance on esoteric asset-backed security pools securities like collateralized debt obligations
(CDOs), pools of subprime mortgages, pools of Alt-A mortgages, prime mortgage pools and collateralized
loan obligations. The subsidiary collected a lot of premium income and its earnings were robust.
When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures.
The mortgage pools AIG insured began to fall in value. Additionally, the credit crisis began to take its toll on
leveraged loans and it saw mounting losses on the loan pools it had insured. In 2007, the company was
starting to feel serious heat.