Credit Analysis Of Securitized Debt

Securitized debt entails financing of specific assets (e.g., auto loans, credit card receivables, and mortgages) without financing the entire balance sheet (which would be the case with the general obligation nature of corporate and sovereign bonds). Secured debt is usually financed via a bankruptcy remote SPE. This isolation of securitized assets allows for higher leverage and lower cost to the issuer.

Investors also benefit from greater diversification, more stable cash flows and a higher risk premium relative to similarly rated general obligation bonds (due to higher complexity associated with collateralized debt).

Components of Credit Analysis of Secured Debt

Components of credit analysis of secured debt are as follows:

1. Collateral pool: Credit analysis of structured, securitized debt begins with the collateral pool. Homogeneity of a pool refers to the similarity of the assets within the collateral pool.

Granularity refers to the transparency of assets within the pool. A highly granular pool would have hundreds of clearly defined loans, allowing for use of summary statistics as opposed to investigating each borrower. A more discrete pool of a few loans would warrant examination of each obligation separately.

Short term granular and homogenous structured finance vehicles are evaluated using a statistical based approach. Medium term granular and homogenous obligations are evaluated using a portfolio based approach because the portfolio composition varies over time. Discrete and non granular portfolios have to be evaluated at the individual loan level.

1. Servicer quality is important to evaluate the ability of the servicer to manage the origination and servicing of the collateral pool. After origination, investors in secured debt face the operational and counterparty risk of the servicer.

A servicer’s past history is often used as an indication of servicer quality.

1. Structure determines the tranching or other management of credit and other risks in a collateral pool. One key structural element is credit enhancement, which may be internal or external.

Examples of internal credit enhancements include tranching of credit risk among classes with differing seniority (i.e., the distribution waterfall), overcollateralization, and excess servicing spread (whereby such excess collateral or spread becomes the first line of defense against credit losses). Third party guarantees (e.g., bank, insurance companies, or loan originators) are an example of external credit enhancements.

A special structure is the case of a covered bond. Issued by a financial institution, covered bonds are senior, secured bonds backed by a collateral pool as well as by the issuer (i.e., covered bond investors have recourse rights). Originated in Germany, covered bonds have spread to the rest of Europe, Asia, and Australia.

While the collateral (known as the cover pool) types vary by jurisdiction, common forms are commercial and residential mortgages and public sector loans. The cover pool is dynamic; the sponsor has to replace any prepaid or nonperforming asset in the pool so that the pool generates sufficient cash flow to service the bonds.

In the event the financial institution sponsor misses a payment, a soft or a hard bullet may be triggered. In the case of soft bullet covered bonds, the maturity date of the bond is extended up to one year and all payments are not immediately due. In the hard bullet covered bonds, the payments are accelerated.

Recovered source visuals