Pierpont Securities LLC
SECURITIZATION OVERVIEW SECURITIZATION Section I: Section II: Section III: Appendix: Definition Process Analysis Market Defined Terms P R O P R I E T A R Y A N D C O N F I D E N T I A L 2
TYPES OF INVESTMENTS Stocks Ownership interest in a business Bonds Also known as fixed income securities or debt securities Mutual Funds A collection of stocks and bonds Pooled money managed by an investment manager Alternative Commodities Foreign exchange Real estate Futures P R O P R I E T A R Y A N D C O N F I D E N T I A L 3
CHARACTERISTICS AND FEATURES Bond A bond is simply a loan to a company or government. Bonds are typically issued with a predetermined rate of interest and a schedule of principal repayment. Bonds are called fixed-income because the bond Face Amount is a fixed amount expected to be paid back by maturity. Characteristics and Features Face Amount / Par Value Coupon / Interest Rate Maturity / Amortization Issuer Rating P R O P R I E T A R Y A N D C O N F I D E N T I A L 4
TYPES OF BONDS Debentures: Bond backed by the credit of the issuer (company or government). - Corporate bonds - Senior / Subordinate / Convertible - Municipal bonds - General Obligations / Revenue Bonds / Assessment Bonds The Issuer is able to borrower money based for a specified time at a rate based on the Issuer s credit or ability to repay. *************************************************************** If a borrower, 1. does not have the capacity to borrow based on their credit worthiness, 2. is not inclined to or in the business of financing an asset in which they have interest, or 3. determines their required return of an asset they own is more than what the market deems is appropriate, the borrower should consider an alternative financing vehicle called Securitization. *************************************************************** P R O P R I E T A R Y A N D C O N F I D E N T I A L 5
SECURITIZATION Securitization The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace. http://www.investopedia.com/terms/s/securitization.asp#ixzz2lvritfpp An Issuer needs capital or would like specific risk transfer, but - cannot borrower as much money as needs based on credit profile and income alone, and - is willing to borrow money based on assets it owns, should consider asset-based financing through securitization. Borrower Asset Financing Lender Individual Car Auto Loan Bank/Finance Company Individual House Mortgage Bank/Finance Company Company Car Loans Asset-Backed Security Bond Investor Company Mortgages Mortgage-Backed Security Bond Investor P R O P R I E T A R Y A N D C O N F I D E N T I A L 6
RATIONAL / BENEFITS Issuer Benefits 1) Sale of Assets / Risk Transfer Can lead to an improvement in seller s debt and capital ratios. 2) Cost of Funds Total cost of funds is often less expensive than available alternatives; the isolation of the assets allows investors to focus on the risks associated with the assets. 3) Higher Advance Rate Maximize loan to value. 4) Diversification Access to new sources of capital and different investors. 5) Match Funding Naturally, assets and liabilities are matched in tenor and price. 6) Control Continued reporting and monitoring of assets through servicing and reporting without obligation. Investor Benefits 1) Credit Quality Able to analyze quality of investment based on historical loss and prepayment rates of underlying assets. 2) Yield Better investor return/return pay-off than bonds of comparable maturity. 3) Liquidity Most securities are actively traded on the secondary market and can be financed. 4) Predictable Cash Flows Prepayment uncertainty is reflected in price. 5) Transparent Risk Standard reporting and data available on most bonds. 6) Targeted Return Profile Risk / return options. P R O P R I E T A R Y A N D C O N F I D E N T I A L 7
SECTION II PROCESS P R O P R I E T A R Y A N D C O N F I D E N T I A L 8
PROCESS The process of converting a specific, typically homogeneous, pool of illiquid, cash flowing, receivables or assets into a security begins by isolating the Issuer from the bankruptcy risk of the seller and originator. Assets Identify Assets SPV Create SPV Sell assets to SPV Structure Bonds Estimate base cash flows Test credit enhancement options / bond tranching Measure all-in cost-of-funds Sell Bonds Issue debt securities Risk transfer to institutional investors P R O P R I E T A R Y A N D C O N F I D E N T I A L 9
PROCESS, IDENTIFY ASSETS 1) Identify Assets; determine pooled characteristics, concentrations and risks. In addition to the overall quality of the individual assets, considerations for ratings and investor interest include the availability of historical information, originator/servicer quality, predictable performance, and pool diversification. Various assets without hard collateral can also be securitized as long as they have a predictable stream of cash flows, including film royalties, energy efficiency loans, time shares and structured settlements. Collateral Characteristics Pooled Receivables -Credit Cards - Auto Loans -Tax Liens - Student Loans -Leases (small ticket, CTL, etc.) -Mortgages (residential, commercial) -Business Loans Type Mortgages Number of Assets: 400 Total Balance: $ 100 mm Average Balance: $ 250,0000 WA Interest Rate: 5.0% WA Amortization Term: 30 years WA Maturity: 28.5 years WA LTV: 78% Geographic Distribution: Top state < 5% WA FICO: 785 P R O P R I E T A R Y A N D C O N F I D E N T I A L 10
PROCESS, CREATE SPV 2) Sell the assets into a newly created special purpose vehicle ( SPV ). Seller / Servicer - Bank - Finance Company - Manufacturer - Business Owner SPV - Grantor Trust - Owner Trust - Master Trust Grantor Trust Owner Trust Master Trust Passive entity / Limited ability for time tranching Partnership structure / Tranching Flexible structuring / Lower cost for repeat Issuers P R O P R I E T A R Y A N D C O N F I D E N T I A L 11
PROCESS, BASE ASSUMPTIONS 3) Determine baseline asset cash flows using historical information, assumed performance and various asset characteristics relative to current market conditions. Prepayment rate / Extension probability / Default rate / Loss given default / Timing of recovery Monthly Coupon Interest Principal Cashflow Losses Balance Sched Prin Prepay Non-Perf Bal Recovery 4/25/13 3.68 2,000 9,600 11,600 0 636,900 900 8,700 3,300 0 5/25/13n 3.68 2,000 9,400 11,400 0 627,500 900 8,500 4,400 0 6/25/13 3.68 1,900 9,300 11,200 0 618,300 900 8,400 5,400 0 7/25/13 3.68 1,900 9,100 11,000 0 609,100 900 8,200 6,400 0 8/25/13n 3.68 1,900 9,000 10,800 0 600,200 900 8,100 7,400 0 9/25/13 3.68 1,800 8,800 10,700 0 591,300 900 8,000 8,400 0 10/25/13 3.68 1,800 9,500 11,300 300 581,500 900 7,800 8,300 800 11/25/13 3.68 1,800 9,400 11,200 300 571,900 900 7,700 8,100 800 12/25/13n 3.68 1,800 9,200 11,000 300 562,400 800 7,600 8,000 800 1/25/14n 3.68 1,700 9,100 10,800 300 553,100 800 7,400 7,900 800 2/25/14 3.68 1,700 8,900 10,600 300 543,900 800 7,300 7,700 800 3/25/14 3.68 1,700 8,800 10,400 300 534,900 800 7,200 7,600 800 4/25/14 3.68 1,600 8,600 10,300 300 526,000 800 7,100 7,500 700 5/25/14n 3.68 1,600 8,500 10,100 200 517,200 800 7,000 7,400 700 6/25/14 3.68 1,600 8,400 9,900 200 508,600 800 6,800 7,200 700 7/25/14 3.68 1,600 8,200 9,800 200 500,200 800 6,700 7,100 700 8/25/14 3.68 1,500 8,100 9,600 200 491,800 800 6,600 7,000 700 9/25/14 3.68 1,500 8,000 9,500 200 483,700 800 6,500 6,900 700 10/25/14n 3.68 1,500 7,800 9,300 200 475,600 700 6,400 6,800 700 11/25/14 3.68 1,500 7,700 9,200 200 467,700 700 6,300 6,600 700 12/25/14n 3.68 1,400 7,600 9,000 200 459,900 700 6,200 6,500 700 1/25/15n 3.68 1,400 7,500 8,900 200 452,200 700 6,100 6,400 600 2/25/15 3.68 1,400 7,300 8,700 200 444,700 700 6,000 6,300 600 P R O P R I E T A R Y A N D C O N F I D E N T I A L 12
PROCESS, STRUCTURE DEBT 4) Test credit enhancement features and use investor appetite to finalize waterfall and estimate cost-of-funds. Credit Enhancement - Subordination - Excess Spread - Over-collateralization - Letter of Credit - Bond Insurance - Reserve Fund - Hyper-amortization The asset cash flows collected monthly are distributed according to the priority of the trust, trust Waterfall. Flow of Funds Example: - Trust expenses - Servicer Fees - Trustee Fees - Senior Interest - Senior Principal - Mezz Interest - Mezz Principal - Subordinate Interest - Subordinate Principal P R O P R I E T A R Y A N D C O N F I D E N T I A L 13
PROCESS, OPTIMIZE ECONOMICS Factors that impact the amount and cost of financing include rating agency sentiment, investor appetite and Issuer objectives. The bonds are structured to accommodate investor s risk / return profiles. Pooled Assets Senior Security low risk / low return Monthly principal and interest collected on individual assets pooled together. $235 MM / 6.5% 85% @ 3.00% Mezzanine Security 10% @ 6.00% Excess Interest Subordinate Security 5% @ 12.00% high risk / high return P R O P R I E T A R Y A N D C O N F I D E N T I A L 14
RISK ASSESSMENT Risks associated with the quality of the underlying assets and concentrations in the portfolio will impact subordination levels and pricing of bonds. Risk Factor Asset Risk Historical Information Regulatory Risk Callability / Prepayment Liquidity Conflicts of Interest Example / Definition Basic characteristics and pool concentrations Limited data could impact ability to obtain reasonable leverage; future performance may vary greatly from historical May affect future liquidity and asset performance Timing of proceeds will affect investor yield Various events may affect investors ability to sell bonds Issuer or servicer conflict of interest if ownership interest in controlling class P R O P R I E T A R Y A N D C O N F I D E N T I A L 15
CREDIT ENHANCEMENT Structural can features within the trust can be used to offset the risks of the portfolio and thus, optimize the deal economics. The job of the structurer is to optimize the value of the assets by creating different risk profiles of the cash flows according to investors opinions. Credit Enhancement Subordination Excess Spread Over-collateralization Letter of Credit Event Triggers Hyper-Amortization Reserve Fund Example / Definition Senior securities get paid before mezz or junior Net rate on assets is greater than interest rate on bonds; excess interest can be used to pay principal Asset balance is greater than bond balance; can also be created through excess spread paying principal Issuer guarantee Upon specified event (i.e. asset performance) cash flows can hyper-amortize All cash collected (net of fees) used to pay senior interest then principal Initial cash reserve or reserve built over time P R O P R I E T A R Y A N D C O N F I D E N T I A L 16
SECURITZATION Receivables -Credit Cards - Auto Loans -Tax Liens - Student Loans -Leases (small ticket, CTL, etc.) -Mortgages (residential, commercial) -Business Loans Seller / Servicer - Bank - Finance Company - Manufacturer - Business Owner Credit Enhancement - Subordination - Excess Spread - Over-collateralization - Letter of Credit - Bond Insurance SPV - Master Trust - Grantor Trust - Owner Trust Institutional Investors Class A Class B Class C P R O P R I E T A R Y A N D C O N F I D E N T I A L 17
SAMPLE ECONOMICS Class Note Amount ($ 000s) Class Type Note Rate Initial CE Pricing Spread Pricing Yield Price Proceeds ($ 000s) WAL (yrs) Rating A1 50,000 Senior 2.50 % 14.9 % 225 / 2.50 % 100-00 50,000 3.5 AAA A2 150,000 Senior 3.25 % 14.9 % 265 / 3.25 % 100-00 150,000 5.5 AAA IO 235,000* Interest-Only 1.50 % n/a 5.00 % 3-24 8,813 n/a AAA B 25,000 Mezz 5.00 % 4.3 % 475 / 6.00 % 95-00 23,750 7.2 BBB C 10,000 Subordinate 5.00 % 0.0 % 12.00 % 70-00 7,000 7.8 NR R NR Total 235,000 6.50 % 101-30 239,563 Asset Basis: 100-00 Expense: 1-00 Execution: 101-30 Gain on Sale: 00-30 Net Proceeds: $ 2.2 mm P R O P R I E T A R Y A N D C O N F I D E N T I A L 18
SECTION III ANALYSIS P R O P R I E T A R Y A N D C O N F I D E N T I A L 19
ANALYSIS, INVESTOR PERSPECTIVE Question: What rate of return would you require to lend cousin Tommy $ 20,000 to buy a $ 25,000 motorcycle? Information you would likely want to know: - When will I get my principal back? - How easy is it to sell the motorcycle if he can t pay for it? - How does the value depreciate over time? - How much debt does cousin Tommy already have? Answer: Don t want the risk! P R O P R I E T A R Y A N D C O N F I D E N T I A L 20
ANALYSIS, INVESTOR PERSPECTIVE Modified Question: What rate of return would you require to lend 1,000 cousin Tommy s $ 20,000 to buy a $ 25,000 motorcycle, assuming that any one default would be absorbed by the equity? Information you would likely want to know: - When will I get my principal back? - How diverse is the pool of assets? - Historically, what is the default rate? - What happens if the borrowers prepay early? (More than 400 borrowers would have to default, assuming a loss severity of 50%, for your principal repayment to be at risk). Answer: It depends on how long my investment is. I am comfortable with the credit risk, but require a return that is a spread to government security with a comparable maturity. P R O P R I E T A R Y A N D C O N F I D E N T I A L 21
ANALYSIS, INVESTOR PERSPECTIVE Common institutional investors include: - Insurance Companies - Hedge Funds - Asset Managers - CLO Managers - Pension Funds - Endowments - Banks - Family Offices - Corporations Investment considerations: - Collateral review -Credit - Compliance - Value - Counterparty review - Structural protection - Prepayment / Extension Risk - Originator / Servicer History - Relative Value P R O P R I E T A R Y A N D C O N F I D E N T I A L 22
APPENDIX- MARKET MARKET P R O P R I E T A R Y A N D C O N F I D E N T I A L 23
MARKET Outstanding U.S. Bond Market Debt ($ trillions) Money Markets $2.4 Agency Securities 6% $2.4 6% Corporates $8.6 23% Asset-Backed $1.7 5% Municipal $3.7 10% Treasuries $10.7 28% Mortgage Related $8.2 22% As of Q3 2012, $37.7 trillion of U.S. bonds were outstanding. Source: sifma P R O P R I E T A R Y A N D C O N F I D E N T I A L 24
$ trillions MARKET 40.0 35.0 Outstanding U.S. Bond Market Debt 30.0 25.0 20.0 15.0 10.0 5.0 0.0 Source: sifma Asset-Backed Money Markets Fed Agency Securities Corp Debt Mtge Related Treasury Municipal P R O P R I E T A R Y A N D C O N F I D E N T I A L 25
MARKET Source: http://www.abalert.com/market_statistics.php P R O P R I E T A R Y A N D C O N F I D E N T I A L 26
APPENDIX- DEFINED TERMS DEFINED TERMS P R O P R I E T A R Y A N D C O N F I D E N T I A L 27
TERMS Bond Equivalent Yield: The yield calculated using semi-annual coupons with compounding in all periods and a 30/360 day type. Constant Prepayment Rate (CPR): Annualized equivalents of single monthly mortality (SMM). CPR attempts to predict the percentage of principal that will prepay over the next 12 months based on historical principal pay downs. CPR is measured on 1 month, 3 month, 6 month, 12 month, or since issue basis. Constant Default Rate (CDR): An annualized rate of default on a group of mortgages, typically within a collateralized product such as a mortgage-backed security (MBS). The constant default rate represents the percentage of outstanding principal balances in the pool that are in default, which typically equates to the home being past 60-day and 90-day notices and in the foreclosure process. Convexity: The second derivative of a security's price with respect to its yield, divided by the security's price. A security exhibits positive convexity when its price rises more for a downward move in its yield than its price declines for an equal upward move in its yield. Derivative: A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Duration: Also known as MacCauley's duration. The weighted average maturity of the security's cash flows, where the present values of the cash flows serve as the weights. The greater the duration of a security, the greater its percentage price volatility. P R O P R I E T A R Y A N D C O N F I D E N T I A L 28
TERMS Modified Duration: The percentage price change of a security for a given change in yield. The higher the modified duration of a security, the higher its risk. Ad/ModDuration = [duration / {1 + (IRR/M)}]; where IRR is the internal rate of return and M is the number of compounding periods per year. Original Issue Discount: A bond with its par value discounted at the time it is issued. The difference between the purchase price and the adjusted price is considered income in addition to any interest that may be paid. If held to maturity, no capital gains tax will be paid since the gain is considered interest. Premium: If a fixed-income security (bond) is purchased at a premium, existing interest rates are lower than the coupon rate. Investors pay a premium for an investment that will return an amount greater than existing interest rates. Tick: The minimum price movement of a trading instrument. Weighted Average Life: The average number of years that each dollar of unpaid principal due on the mortgage remains outstanding. Source: Bloomberg P R O P R I E T A R Y A N D C O N F I D E N T I A L 29