1 CONTENTS

2 Securitization ...................................................................................................................... 2
2.1 Historical Context ....................................................................................................... 2
2.2 Process Of Securitization ............................................................................................ 2
2.2.1 Creation of a security ........................................................................................... 2
2.2.2 Riskiness - Tranches ............................................................................................ 3
2.2.3 Examples of Assets that are securitized ............................................................... 3
2.3 Why Securitization? .................................................................................................... 4
2.3.1 The Issuer ............................................................................................................ 4
2.3.2 The Investor ......................................................................................................... 4
2.4 Risks Involved ............................................................................................................. 4
3 Credit Default Swaps .......................................................................................................... 5
3.1 What is a CDS? ............................................................................................................ 5
3.2 Modelling of defaultable loans - Bonds ...................................................................... 6
3.2.1 Pricing of default free zero coupon bond ............................................................. 7
3.2.2 Pricing of zero coupon bonds with default no recovery ................................... 7
3.2.3 Pricing of zero coupon bonds with default and recovery ....................................8
3.2.4 Example of Credit Default Swap ..........................................................................8
3.2.5 Development and Application of CDS ................................................................. 9
3.2.6 Riskiness of CDS .................................................................................................. 9
4 References: ....................................................................................................................... 10
2 SECURITIZATION

Securitization is the process of taking an illiquid asset, or group of assets, and through
financial engineering, transforming them into a security. This security is an interest bearing
security. Thus the process helps in promoting liquidity in the market (illiquid to liquid). The
interest and principal payments from the assets are passed through to the purchasers of the
securities.

2.1 HISTORICAL CONTEXT

Securitization got its start in the 1970s, when home mortgages were pooled by U.S.
government-backed agencies. In February 1970, the U.S. Department of Housing and Urban
Development created the first modern residential mortgage-backed security. Starting in the
1980s, other income-producing assets began to be securitized. For example bank loans. In the
1990s securitization was applied in the sectors of reinsurance and insurance. By 2004, market
was dominated by credit card-backed securities (21 percent), home-equity backed securities
(25 percent), automobile-backed securities (13 percent), and collateralized debt obligations
(15 percent). Among the other market segments were student loan-backed securities (6
percent), equipment leases (4 percent), manufactured housing (2 percent), small business
loans (such as loans to convenience stores and gas stations), and aircraft leases. Recently in
the US, securitization has been proposed and used to accelerate development of solar
photovoltaic projects. (For example, SolarCity offered the first U.S. asset-backed security in
the solar industry in 2013)

2.2 PROCESS OF SECURITIZATION

2.2.1 Creation of a security

Terminologies:
Originator: The entity that originally holds the assets.
Issuer: Issues tradable securities an SPV (Special Purpose Vehicle - a legal framework)
The originator initiates the process by selling the assets to a legal entity, an SPV, specially
created to limit the risk of the final investor vis--vis the issuer of the assets. Then, depending
on the situation, the SPV either issues the securities directly or resells the pool of assets to a
trust that, in turn, issues the securities. Investors purchase the securities, either through a
private offering or on the open market. The performance of the securities is then directly
linked to the performance of the assets. Credit rating agencies rate the securities which are
issued to provide an external perspective on the liabilities being created and help the investor
make a more informed decision. The investors receive fixed or floating rate payments from a
trustee account funded by the cash flows generated by the reference portfolio. In most cases,
the originator services the loans in the portfolio, collects payments from the original
borrowers, and passes them onless a servicing feedirectly to the SPV or the trustee.
(Source: IMF)

2.2.2 Riskiness - Tranches

The reference portfolio is divided into several slices, called tranches, each of which has a
different level of risk associated with it and is sold separately. Both investment return
(principal and interest repayment) and losses are allocated among the various tranches
according to their seniority. The least risky tranche, for example, has first call on the income
generated by the underlying assets, while the riskiest has last claim on that income. The
conventional securitization structure assumes a three-tier security designjunior, mezzanine,
and senior tranches. This structure concentrates expected portfolio losses in the junior, or first
loss position, which is usually the smallest of the tranches but the one that bears most of the
credit exposure and receives the highest return.

2.2.3 Examples of Assets that are securitized

Residential mortgage loans Student loans

Commercial mortgage loans Credit-card debt (Future Cash Flow)

Bank loans to businesses Automobile loans

Commercial debt
2.3 WHY SECURITIZATION?

The economic rationale behind securitization is that it enables the construction of new
securities with a broad range of risk profiles.

2.3.1 The Issuer

Reducing Cost of Capital for the issuer of the underlying securities (By increasing the
cash flow of the security)
Detach the underlying asset from the originator companys balance sheet.
A company with a lower credit rating can raise funds by selling securities of higher
credit rating. (As assets are detached)

2.3.2 The Investor

A wider range of assets to invest on. Portfolio diversification

The investor need not buy the underlying asset but still be able to trade on it.
Opportunity to invest in a specific pool of high quality assets
Opportunity to potentially earn a higher rate of return (Equity Tranche)

2.4 RISKS INVOLVED

Information Asymmetry :

The issuer of the securities knows much more about what he is really selling than the
investor does. As long as the securities issued behave as indicated in the brochure, all
is well and nobody asks any questions. But as soon as problems begin to arise for
certain types of securities, people become suspicious of any product falling within that
category since you really need to be an expert to be able to evaluate a securitization
program and suddenly nobody wants to buy them anymore.

Moral hazard:

Investors usually rely on the deal manager to price the securitizations underlying
assets. If the manager earns fees based on performance, there may be a temptation to
mark up the prices of the portfolio assets. Moral hazard also extends to credit ratings
agencies who relax the stringency of rating of the securities for benefits to be gained
elsewhere.
3 CREDIT DEFAULT SWAPS

3.1 WHAT IS A CDS?

CDS is like an insurance. It is a financial swap agreement that the seller of the CDS will
compensate the buyer (usually the creditor of the reference loan) in the event of a loan default
(by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against
some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS
"fee" or "spread" just like premium of an insurance) to the seller and, in exchange, receives a
payoff if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994.

Cash Flow chart:

N Nominal Value of the loan

R Recovery Rate

Premium leg:
The buyer of CDS pays the premium a series of cash flows - until the credit event.

Protection Leg:
The issuer of the CDS, pays the buyer the face value of the loan adjusted for the recovery rate.
Recovery rate is the fraction of the face value agreed to be recovered on default.
3.2 MODELLING OF DEFAULTABLE LOANS - BONDS

As seen above in the case of the CDS, there exists a series of constant cash flows till the date
of default.
This is similar to that of a cash flow from a bond:
Characterized by:

Coupon c
Face value F
Recovery value R = random fraction of face value recovered on default

The probability of default between time t and t+1 is given by:

h(t) = Q(bond defaults in [t, t + 1))

The price of a bond depends on the prevailing interest rates. Thus if we know the term
structure of interest rates, by finding the NPV of the price of the bond at each point of time we
can get the current bond price.
The term structure of interest rates can be modelled by a binomial lattice model.

Combining this information with the probability of default, we get two additional states in the
binomial lattice model:

(Binomial Lattice with Default)

3.2.1 Pricing of default free zero coupon bond

(Discounting with risk free rate rij)

3.2.2 Pricing of zero coupon bonds with default no recovery

No recovery implies cash flows at default is zero.

3.2.3 Pricing of zero coupon bonds with default and recovery

Consider recovery at default is R

3.2.4 Example of Credit Default Swap

Basic model of CDS:

3.2.5 Development and Application of CDS

Although a CDS can be used to protect against losses it is very different from an insurance
policy.

A CDS is a contract that can be written to cover anything.

Can buy protection even when one does not hold the debt.
CDS are easy to create and (until recently) completely unregulated.

Investing (speculation) quickly became the main application

Unfunded way to take a credit risk leverage possible.

Tailor credit exposure to match precise requirements.
Taking views on the credit quality of an reference credit.
Buying protection is easier than shorting the asset.
Arbitrage between the reference bond coupon and CDS spreads.

3.2.6 Riskiness of CDS

CDS positions are not transparent.

Riskiness of financial intermediaries cannot be accurately evaluated.
Threatened trust in all counterparties since no one knew who faced losses.
CDS trades are conducted on an OTC market.
Impossible for any dealer to know the previous deals of a customer.
Result: AIG was able to leverage its high credit rating to sell approximately $500
billion worth of CDS.
Allowed a small number of CDS dealers to take a huge amount of risk.
The interconnected obligations of the dealers let to worries about contagion.
CDS can be adversely affect the cost of borrowing of a firm or a country.
Speculators purchase CDS without holding underlying debt naked CDS.
This drives the spread higher, i.e. the firm starts to appear riskier.
The cost of borrowing of the firm increases, and can lead to its collapse.
4 REFERENCES:
Investopedia
Wikipedia
Coursera Columbia University course on Financial Engineering
IMF