Asset Backed Securities: A Practical Guide for ... - Securitization.Net

Asset Backed Securities
PRACTICAL GUIDE FOR INVESTORS
This guide is an introduction to ABS, presented from the point of view of the investor. It
proposes a breakdown in simple notions, which enable a partial reading. A glossary, in
the last page, regroups the main technical terms and indicates where they appear for
the first time in the text (also outlined in italic)
.
I
What is an ABS?
ABS (Asset Backed Securities) are
experiencing strong growth on the capital markets.
These financial instruments enable companies to
raise capital using the securitisation method
described below.
Securitisation. Securitisation is a way for
companies to raise capital and consists in using one
of the company's financial assets to guarantee a
security issued on the capital markets.
Let us take the example of an industrial
manufacturer with an average credit rating, who is
experiencing difficulties in obtaining financing from
banks. This manufacturer has sold capital goods to
customers with a strong credit rating. The idea
behind securitisation is to structure a financing
package backed by these high quality trade account
receivables. In this way repayment no longer
depends on the manufacturer, but only on the
customers' ability to pay for the goods.
A company is created for this purpose (SPV
or Special Purpose Vehicle). The manufacturer (the
Seller) sells the portfolio of trade account receivables
(the underlying asset) to the SPV. The SPV then
refinances this purchase by issuing rated securities,
with repayment of these debts depending on the
customers' (the final debtors') ability to pay.
ABCP, MBS and ABS. Securities issued using
the securitisation method are called "Term Deals" if
they are offered to the markets as a long-term bond
and "Conduits" if they are short-term.
ABCP. Conduits are mainly refunded by
issuing commercial paper. These securitisation
programmes, known as Asset Backed Commercial
Paper (ABCP) accounted for a total outstanding of
more than USD 500bn in the US in 1999, (i.e. more
than a quarter of the US commercial paper market).
MBS. Term deals where the underlying assets
comprise mortgage loans are called Mortgage Backed
Securities. These represent a highly specific market
and are mainly traded on the US domestic market.
MBSs are generally fixed rate and their risk is
principally linked to early repayment of the
underlying mortgage loans. More than USD 400bn
MBSs were issued in the US in 1999.
ABS. ABSs are all the Term Deals which do
not fall under the MBS category: unlike MBSs, ABSs
are mostly floating rate notes and principally carry a
credit risk. In 1999, approximately USD 350bn of
ABSs (excluding MBS) were issued.
HEL
AUTO
USD assets only
Graph 1 : ABS issued in 1999
14%
25%
OTHERS
14%
CARD
15%
7%
CMBS
CBO/CLO
25%
TOTAL ABS $ 350 Billion
Fast-developing. Since 1996, ABSs have
accounted for one of the strongest growth segments
in the capital markets and are also developing
outside of the US (issuance volume on the European
market was USD 75bn in 1999).
On the whole, this trend can be explained by
increasing pressure from shareholders, which leads
more and more companies to deconsolidate financial
or property assets in order to optimise their Return
On Equity (ROE).
In the same way, information on ABSs is
increasingly available and transactions are
progressively standardised, leading to more
transparency.
Finally, ABSs are often sold as variable rate
securities, and benefit enormously from growth in
the credit market, while offering an attractive means
of diversifying investments, especially in Europe.
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 1

Market segments. Each securitisation is, to
a large extent, characterised by its underlying asset.
According to this criteria, the ABS market can be
divided into several segments:
US household debt (around USD 5000bn)
represented the first pool of securitisable assets
which gave rise to MBSs and to the main ABS
categories, according to the type of asset: Credit
Cards, Home Equity Loans or HEL (consumer loans
secured by mortgages), Auto Loans, and Student
Loans.
The "Credit Card" type of ABS has
experienced steady growth over the last ten years
and account for the most mature and standardised
segment of the market, with USD 50bn of new issues
in 1999. US consumer loan organisations do not
dispose of a large amount of capital and securitise
their outstanding credit card debt heavily: they turn
to the markets several times a year and each time sell
a portfolio of around USD 1bn of outstanding on
thousands of individual debtors over the entire US.
Since 1996, the increase in ABSs has been
greatly helped by CLO, CBO and CMBS securitisation
types: to maximise their capital, financial institutions
have proceeded with a large scale deconsolidation of
their loan portfolios (Collateralised Loan Obligation
or CLO), security portfolios (Collateralised Bond
Obligation or CBO), or commercial property
portfolios (Commercial Mortgage Backed Securities or
CMBS). By way of example, the volume of CBOs and
CLOs issued worldwide in 1999 was almost twice the
volume of of "Credit Card" type ABSs issued.
II
5 stages in
evaluating an ABS
The main difficulty faced by an investor lies
in evaluating the offered security within a reasonable
time frame. This section suggests a method of
breaking down an ABS into its five component parts:
underlying asset, credit enhancement, cashflow
mechanics, legal structure and links with the seller.
Stage 1: Underlying assets
In a securitisation, the analysis of the
underlying asset is crucial: whether the issued
securities are repaid depends in the first instance on
its strong or weak performance. The main points to
study are: the quality of the final debtors, the
monitoring of the portfolio the maturity of the
receivables, and finally how these loans were set up.
Debtors. It is possible to distinguish
between securitisations where the final debtors are
individuals, and those which have companies as the
final debtors. Risk linked to a portfolio containing
many hundreds of thousands of US households'
consumer loans can be seen as purely statistical and
strongly linked to the economic environment,
whereas a portfolio of, for example, twenty company
loans needs to be analysed debtor by debtor, since
each one accounts for a larger proportion of the
underlying asset.
The credit risk of securitisations backed by
individuals is little correlated to securitisation
backed by companies.
Reporting. When a transaction is set up,
credit rating agencies require frequent reporting,
following a predetermined set of criteria, to assess
the development quality of the underlying asset. For
household consumer loan portfolios, global
statistical data is enough to describe the portfolio
(net yield rate, geographical distribution of debtors).
Conversely, ten office blocks will need detailed
asset-by-asset reporting (vacancy rate, description of
the tenants, rents).
The Diversity Score is a standardised
indicator to measure the diversity of a corporate loan
portfolio: if, for example, a portfolio of 200 loans has
a score of 50, this means that the portfolio is
equivalent to a hypothetical group of fifty loans to
uncorrelated companies. This calculation, made by
credit rating agencies, is based on the correlation
between different economic sectors.
Maturity. To fully understand an underlying
asset, a distinction needs to be made between longterm
and short-term assets: in order to be refunded
by a long-term bond, a portfolio of 30-day
commercial debts should be renewable. This means
that with the repayments, the SPV will buy new debts
from the seller over, for example, a five year
reinvestment period.
On the contrary, a portfolio of 15-year
mortgage loans does not require a reinvestment
period. This portfolio is referred to as static: it does
not change during the course of the transaction and
is amortised with each repayment. A static portfolio
has the advantage of being completely transparent
from the beginning of the transaction.
For a renewable portfolio, agencies
safeguard against a deterioration in quality of the
original portfolio by imposing stringent criteria on
reinvestments. The more short-term the asset, the
greater the turn-over, which in turn makes for more
dynamic structure management, thus guarding
against a deterioration in quality by adding superior
quality investments.
Origination. Origination covers the entire
process for setting up a new loan. In most cases
financial assets are created during the day-to-day
business of the seller: consumer loans, syndicated
loans to leading companies, and trade account
receivables following the sale of capital goods. By
studying the procedure for granting loans
(circulation of the credit profile, scoring method), it
is possible to see how the final debtor's credit risk
was calculated and checked by the seller. The more
selective the origin, the easier it is to get an idea of
the underlying asset.
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 2

The origination is more important when the
transaction includes a reinvestment phase in new
assets, due to be generated at a later date. Certain
ABSs, of the "Future flows" type, are securitisations of
future receivables which do not yet exist: for
example, an oil company can securitise income in
dollars, received in exchange for expected oil sales
over the next two years. To take this extreme
example, the securitised portfolio is only described
by the asset creation procedure, i.e. a description of
the oil selling process.
Stage 2: Credit enhancement
To optimise refunding costs, securities sold
on the market are generally awarded a high credit
rating from credit rating agencies: for example AAA,
the highest rating, means that there is only a slight
possibility of default on the security. It is rare to find
an underlying asset in a securitisation which has
sufficient quality of its own, to obtain this rating. A
portfolio of several thousand debtors will inevitably
contain some defaults in payment.
Credit enhancement is a means of absorbing
these defaults, in such a way that they do not affect
the quality of issued securities. The more the
security benefits from credit enhancement, the less
the risk of default. In a transaction comprising
several risk profiles, the senior tranche is the one
with the most credit enhancement.
Methodology. A credit rating assesses the
ability of issuers to withstand worst case scenarios.
Therefore, to designate an AAA rating to the senior
tranche of an ABS, the credit rating agencies demand
that the overall structure is able to withstand a
worst-case increase in defaults in the underlying
portfolio, without the senior tranche being subject to
default.
For a diversified portfolio, historical
statistical data (standard deviation) can be used to
predict worst-case scenarios: for example, to obtain
AAA status, the SPV should be able to fully repay
senior debt obligations, even if the underlying asset
experiences a sudden default on payment equal to
[4] times the annual loss rate, the highest over the
last [5] years. These scenarios are even more relevant
given that a reliable database exists, which is the
case for US consumer loans. If the credit rating
agency does not have access to reliable historical
data, this does not imply that the AAA rating cannot
be achieved, but simply that the agency insists on a
larger multiplier coefficient.
This statistical approach is generally
complemented by an asset by asset approach, paying
particular attention to debtors with a substantial
concentration of debts or debtors with a high risk
profile. This approach is used with CLOs where the
underlying asset is comprised of loans to final
debtors, rated by agencies or scored by the seller
bank. In this case the credit rating agency demands a
worst-case scenario which takes the form of a
simultaneous default of all debtors who account for
more than [1%] of the portfolio, as well as all debtors
with a rating below [BBB-].
Finally, the credit report level required to
obtain AAA status, depends on more qualitative data,
which in turn depends on the nature of the assets
and more generally on the technical and legal
securitisation environment.
All credit rating agencies have teams of
analysts specialised in structured finance, and follow
market developments with the publication of
increasingly standardised quantitative and
qualitative methods. However, the agency still
examines each transaction on an individual case
basis, with a due diligence visit to the seller, to
guarantee reliability of the credit rating.
In order to withstand the worst-case
scenarios predicted by the agencies, a securitisation
structure can use several credit enhancement
techniques. The main ones are:
Subordination (see graph 2). To finance a
portfolio of 100, the issue will be composed of a
rated tranche of 92 (senior tranche). The remaining 8
will be financed by a non-rated subordinated tranche,
that is, repayable only after other senior debts have
been repaid in full. Therefore, the subordinated
tranche absorbs the first losses on the underlying
asset, up to 8, without the senior tranche being
affected.
In addition to the senior tranche (often
called "Class A") and the most subordinated tranche
(sometimes incorrectly referred to as "Equity"), the
structures often contain several intermediary
tranches ("mezzanines"), called Classes B, C, D,
according to their subordination level. Each of these
classes can be split into several tranches of different
maturities (for example tranches A-1 and A-2 of class
A), however, the level of risk remains the same.
Excess Spread (see graph 2). This is the
spread between the yield of the underlying portfolio
(for example Libor+1.00%)and the interest payable to
holders of the rated tranches (for example
Libor+0.10%). In theory, providing all goes well,
residual flow surplus is paid to the holder of the
most subordinated tranche in payment for risks
taken (in our example 0.90%p.a.). However, this
payment depends on whether the structure is
performing well: in the event that the performance of
underlying assets falls below a predetermined level,
the Excess Spread is used to repay the rated
tranches, and in this respect, represents an
additional credit support.
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 3

Graph 2 : Credit enhancement
SPV
Underlying
debtors
Libor + 1.00%
Assets
Liabilities
Senior 92
Collateral 100
Subordinated 8
A1+/ P1 Assets 0.5 Cash Deposit 0.5
Libor + 0.10%
Excess Spread
0.90% p.a.
Senior
investors
Subordinated
investors
Subordination : 8%
Cash Deposit : 0.5% => Total credit enhancement : 9.40%
Excess Spread : 0.90% p.a.
Cash deposit (see graph 2). On the whole
credit rating agencies require the seller to pay a cash
deposit to the SPV, repayment of which is ranked the
same as the most subordinated tranche. The SPV will
then reinvest this amount in liquid financial
instruments rated A1+/P1 (for example treasury
bills), which can then immediately be cashed to pay
the holders of the senior tranches, if necessary.
Certain structures sometimes allow for part of the
Excess Spread to pay the Cash Deposit.
Guarantee. Certain structured transactions
use credit enhancing guaranteed by a third party (a
bank, an insurance company): in case of default, the
guarantor is substituted for the issuer of the security
and is obliged to repay. US insurance companies,
generally rated AAA (the monolines) expanding in
financial insurance: they insure payment of a
security on a specific date, which is also ranked AAA,
by the insurance company. In general they only
insure risks already considered as investment grade
(i.e. of minimum ranking BBB-/Baa3): for a
securitisation, if the underlying asset has a lower
average ranking, it needs to be upgraded by other
means to BBB status before the monoline will
guarantee it, and accord the security a AAA rating.
For example, a BB portfolio will have a credit
enhancement using a subordinated tranche in order
to achieve a BBB rated senior tranche: this tranche
will be guaranteed by the monoline.
Stage 3: cashflow mechanics
The SPV's only source of income is the flow
of payments from final debtors related to the
underlying asset. Payments originating from the
redemption in capital of debtors are entered in the
accounts as principal collections. Interest collections
include the interest paid by debtors, but also,
overdue penalties and operating costs (particular
case: the trade receivables do not bear interests,
however, a receivable with a value of 100 to be
received in 3 months, will be sold 99 to the SPV,
which enable to consider 99 in principal and 1 in
interest).
The allotment of incoming payments is set
out in full in the legal documentation. It is important
to understand the principles of payment allocation
as the order of subordination of the various tranches
depends on this.
Reinvestment. If the structure is
rechargeable, the period of reinvestment needs to be
analysed separately from the period of repayment.
During the initial phase, principal collections are
reinvested in new eligible assets in order to ensure
the consistency of the quality of the underlying.
During this phase, and similarly, during the
phase of amortisation, interests and fees collections
are mainly allocated to the interest payments of
securities in the order of subordination of the
various tranches.
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 4

Repayment. After the reinvestment phase,
if there is one, and otherwise from the outset,
principal collections are used to repay the different
tranches.
When the underlying asset consists of a
large number of debtors, principal collections are
daily. These amounts are placed by the SPV in highly
liquid A1+/P1 rated assets, in preparation for
payment, to take place on a coupon due date (usually
monthly or quarterly).
A security to be repaid on a pre-determined
date is known as a Hard Bullet: if the security is not
repaid on this date, this constitutes a default. Unlike
standard bond issues, the Hard Bullet is very rarely
used in securitisation operations.
The Soft Bullet (see graph 3) is one of the two
most frequently employed repayment methods: all
principal collections are placed in one of the SPV's
accounts. Only when there is sufficient capital in the
account will the A tranche be repaid, in one
instalment. Subsequently, the process of
accumulation will continue in order to repay the B
tranche afterwards, then C, and so on.
A Pass-Through type redemption is one
where principal collections are fully repaid on the
next coupon due date to holders of class A securities,
and when these have been repaid in full, to holders
of class B securities. This method is generally used
when the rate of principal collections is slower (for
example, long-term assets) in which case it would be
uneconomical to accumulate the reinvested amounts
in low-yielding instruments while awaiting a bullet
payment.
Some structures make use of Controlled
Amortisation. which is a type of Pass-Through
repayment. However, if payment in principal is
greater than expected over a certain period, a
specific amount is retained in the structure. This
enables smoothing of the repayment profile to make
it as linear as possible.
Rapid amortisation. Throughout the entire
life span of the transaction, the quality of the
structure is monitored by regular reports submitted
to credit rating agencies. Each indicator in the report
has a threshold level (a Trigger). If this level is
reached it triggers a further sequence of allocation of
flows so as to maintain the quality of the rated
tranches:
If triggering takes place during the
reinvestment phase (see graph 4), this phase will
come to an end, and the amounts paid in principal
will be used to repay bondholders in a pass-through
mode (to avoid to retain cash in the structure). At the
same time, the Excess Spread will no longer be paid
to holders of the lowest ranking tranche, but will be
used to repay holders of rated tranches. As a general
rule, all amounts received will be used to repay the
tranches as fast as possible.
Repayment date. The Expected Maturity is
the most likely repayment date according to
simulations carried out on the structure. When
securitisation takes place, the effective repayment
date of securities may differ from the expected
maturity without constituting a default clause. The
legal cut-off date for repayment of securities is said
to be Legal Final. On this date, if securities have not
yet been repaid, default is declared and the structure
is liquidated to cover securities which are as of yet
unpaid, according to the predetermined order of
payment.
The first factor causing deviation between
the expected and actual repayment date is the
variation in the rapidity of repayment of debtors in
relation to the original scenario. This risk is
important for MBSs, and investors generally have a
chart linking expected maturity to the early
repayment rate of underlying debtors. On the other
hand, this is fairly unlikely in the case of a shortterm
asset (such as credit card receivables), or when
the underlying debtors do not possess an early
repayment option (such as syndicated corporate
loans to businesses). Securitisations of long term
assets often incorporate a Clean-up Call, i.e. the
possibility of liquidating the structure when the
outstanding falls below 10% of initial value.
Outstanding
Graph 3 : Soft bullet repayment
Outstanding
Graph 4 : Rapid amortisation (Pass through)
100
100
Tranche A
senior
cash
Tranche A
senior
cash
Tranche B
mezzanine
Tranche B
mezzanine
Tranche C subordinated
Tranche C subordinated
0 1 2 3 4 5 6 7 Years
0 1 2 3 4 5 6 7 Years
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 5

The second factor contributing to
uncertainty hinges on early repayment should an
emergency procedure be triggered. This scenario
appears under extremely precise circumstances, and
depends on legally predetermined trigger targets. To
date, early repayment has never affected standard
ABS categories such as credit cards. If the emergency
procedure is triggered, this indicates abnormal
deterioration of the underlying, which is better than
a default. In general, triggers apply to averaged
figures, to avert the triggering of early repayment by
an insignificant poor performance over a month.
For each transaction, repayment risk should
be examined in each individual case. However, a
distinction is being made with increasing frequency
between pure credit products such as ABSs, where
uncertainty is reduced by a maximum, and MBSs
where repayment risk is an important factor in price
mechanisms: CMOs (Collateralised Mortgage
Obligation), securitisations of MBS portfolios, are
transactions which offer investors high profit
profiles by exerting a leverage effect on the
repayment rate of underlying debtors.
Master-Trust: this is a super SPV, which can
be re-used for several consecutive transactions, by
issuing individualised series (for example "serie 98-
1" represent the first transaction in 1998 for this
seller). Each serie is backed by the same underlying
receivables pool, and each time the seller carries out
a new securitisation, he add underlying assets to the
total portfolio. Collections in principal and interest is
allocated pro rata in each serie.
Each serie then has its own cashflow
mechanics and amortisation profile. The use of a
universal structure enables amortisation of fixed
costs, but above all, the constitution of an extremely
large and diversified underlying portfolio developed
over consecutive operations. This technique is
mainly employed by credit card institutions which
frequently turn to the markets for financing: some
Master Trusts contain over 30 series.
With the exception of the underlying asset,
each serie may be analysed in financial terms as a
separate SPV. However, some Master Trusts establish
solidarity between series: if a serie defaults, the
Excess Spread of another, stronger serie may be used
to support the weaker series.
Stage 4: Legal structure
ABS transactions are often given outlandish
names, ranging from the name of a flower to an
unpronounceable sequence of letters. This name
refers to the legal structure which issues the
securities and which has been created specifically to
this effect.
Special Purpose Vehicle (SPV) The
securitisation structure is a company specifically
created for this purpose, whose assets consist of the
disposed underlying asset and which is refinanced
by issues of securities. Some countries benefit from
legal securitisation structures; as in France (Fonds
Communs de Créances (FCC)). However, most
securitisations are issued by offshore vehicles which
side-step the restrictions of domestic legislation.
(The laws ruling FCCs have recently been relaxed,
showing increasing resemblance to Anglo-Saxon
style SPVs).
SPVs are established in Jersey, in the
Cayman Islands, and in Delaware, for technical
reasons: ease of registration, absence of the need for
a physical board of directors, reduced costs, and
uniformity of structure. The use of tax havens is not
motivated by the desire to hide from the domestic
legislator: the practice of offshore securitisation is
widely recognised by most major states, as in any
case, the operation must be approved by the local
authorities, which decide on the deconsolidating
nature of the structuring (i.e. the possibility of offbalance
sheet accounting for the seller).
Underlying
portfolio
Collection
principal & interest
Graph 5 : Master Trust
ASSET
% prorata
LIABILITY
Serie 98-1
Futur serie
Seller's interest
(part not yet financed)
Class A
senior
Class B
mezzanine
Class C
subordinated
class A
class B
class C
class D
Documentation. The SPV is legally
independent of the seller: when the SPV is
established as a company, its ownership is
established by a symbolic company capital held by
the Board of Directors. In the majority of cases, the
SPV is established as a Trust, which means that the
company's capital is maintained and managed by a
professional Trustee, who acts in the interest of
bondholders.
Although independent, the trustee does not
have total freedom of hand, as each event which
takes place during the company's life is clearly
stipulated in the legal documentation: cash
management, allocation of flows, third-party default
and so on.
investors
investors
seller
Seller
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 6

The most important legal document relating
to offshore structured financing is the Security Trust
Deed, which clearly lays out the circumstances of
default and the way in which the Trustee should
liquidate assets for distribution to bondholders.
As everything is legally predetermined, one
aspect of the SPV is known as "Bankruptcy Remote",
which means that it can only be liquidated by the
Trustee. This aspect is what makes securitisations
longer-lasting than certain companies, whose
financial strength may be abruptly undermined, for
example, by a court case or embezzlement by a
director.
True sale. The most important legal aspect
of securitisation is the quality of asset transfer from
the seller to the SPV. As a general rule, credit rating
agencies require a True Sale, which means that once
the underlying has been disposed of, it is wholly
possessed by the SPV. For example, should the seller
default, his creditors no longer have any right to the
underlying assets and have no right on the SPV. This
principle clearly establishes that there is no direct
seller risk.
The True Sale aspect is validated by a legal
opinion given by the firm of lawyers having set up
the initial legal framework. From time to time,
securitisation operations make use of an
intermediary SPV which intervenes between the
seller and the issuing SPV so as ensure that disposal
and decorrelation with the seller is as complete as
possible.
Default. When a securitisation operation is
set up, the main objective is to avoid as far as
possible the risk of default on tranches with the
highest ratings. Default follows an early repayment
event, if all overcollateralisation resources have been
exhausted. Default clauses are defined precisely in
the legislation, being objective events (for example,
the non payment of interest on rated securities for
over seven days) which authorise the liquidation of
the structure. In the case of an SPV set up as a trust,
the trustee recovers possession of the assets and is
responsible for their liquidation for distribution to
bondholders according to the order in which the
tranches are subordinated.
Stage 5: Links with the seller
In the majority of securitisation operations,
asset disposal is a True Sale, which clearly indicates
that the quality of the underlying portfolio does not
depend on the quality of the seller. Even if the seller
remains involved in the operation, back-up measures
are implemented so that the structure is able to
withstand straightforward default by the seller. It is
not unknown to see AAA rated securitisations whose
seller is close to liquidation.
Servicing. In general, the seller wishes to
maintain a business relationship with final debtors.
As such, he remains the Servicer , which means that
he continues to manage the receivables on behalf of
the SPV (collection of receivables, administration). In
many cases, the end debtor is not even aware that his
debt has been securitised. In most cases, the seller
retains the most subordinated tranche, which serves
as motivation to pay back as much as possible of the
amounts due to the SPV: each dollar of lost payment
is endured by the seller, as the subordinated tranche
absorbs all initial risks.
Structures generally allow for a certain level
of deterioration in the quality of the seller (for
example, downgrading of his rating to below BBB), at
which point a Back-Up Servicer takes over. This
replacement will quickly come into effect if there are
few debtors or if they are clearly identified, such as
bank CLOs whereby the majority of debtors are
major corporates known throughout the financial
community. On the other hand, for individual
portfolios involving hundreds of thousands of
debtors, the Back-Up Servicer is named at the
beginning of the transaction, and regularly receives
the necessary computer files so as to be quickly
operational, if necessary.
Commingling. As a general rule, the seller
collects the receivables on his own account. The end
debtor may have two receivables, one securitised, the
other not, but he will discharge both directly to the
seller. The next day, the seller pays back to the SPV
the amounts paid to the order of the securitised
receivables. This presents the risk of Commingling,
i.e. the risk that the accounts of the seller will merge
with those of the SPV.
This is a contained risk, as, in the event of
the occurrence of the slightest anomaly, or
deterioration of the seller's financial strength, the
SPV maintains the right to notify the end debtor that
amounts due should be paid directly to the SPV.
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 7

Swaps. In most cases, ABSs give exposure to
underlying credit without enduring foreign exchange
or interest rate risk. Where necessary, underlying
interest is transformed by the SPV into the rate and
the currency of issue via a swap. Credit rating
agencies generally require the rating of the
counterparty of the swap to be at least A1+/P1. When
the seller is a highly rated financial counterpart, the
bank will often provide the swap.
For the holder of senior equity, the risk on
the counterpart of the swap is extremely indirect:
before loss can be recorded, the counterpart of the
swap must default despite his high rating, the
replacement cost (mark-to-market) of the swap must
be positive, and the mark-to-market must be higher
than the level of overcollateralisation of the senior
tranche. This indirect risk is often further reduced by
the existence of a trigger, which obliges the SPV to
reassign its swap (i.e. change counterpart) as soon as
the counterpart falls below A1+/P1.
Spread
(BP)
90
80
70
60
50
40
30
20
10
0
Graph 6 : Credit card Spread over Libor
(Senior tranche AAA, 3 years)
jan-92 jan-93 jan-94 jan-95 jan-96 jan-97 jan-98 jan-99
Annual
volume
(USD BN)
50
45
40
35
30
25
20
15
10
5
0
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 8

III
Why purchase
ABSs?
Despite the increasing standardisation of
transactions and amount of available information,
the purchase of an ABS still requires a little more
analytical effort, in order to understand the
structure, than a plain vanilla security.
However, more and more investors are
creating dedicated teams, specialising in ABSs and
credit products in general. This trend may be
explained in a generalised fashion by the following
reasons:
Diversification. ABSs provide a means of
diversifying a portfolio into low risk products
offering exposure to a diversified portfolio.
Financial strength. The hypotheses of
credit rating agencies are extremely conservative
and depend for the most part on extremely objective
and quantitative criteria. Unlike companies, SPVs are
not as sensitive to subjective and volatile criteria,
such as corporate image.
Stability. Overcollateralisation is a dynamic
element: the structure adapts to maintain the same
risk quality. Unlike corporates, the security is not
sensitive to unexpected dramatic events, such as the
departure of a key member of staff or poor strategic
choices.
Recovery rate. As the underlying assets are
diversified, clearly identified and lodged as collateral
in the best interest of holders of the securities, rating
agencies judge that the recovery rate for holders in
case of default (which remains theoretical) is
extremely high.
Standardisation.
Increasingly,
securitisation and ABSs in particular are becoming
standard forms of structured financing, and
information about them is more and more widely
available. This enables enhanced visibility when
drawing comparisons between transactions.
Liquidity. Securitisation has become a big
industry: in the US in 1997, 50% of domestic US
issues (excluding T-bills) took the form of
securitisation. Liquidity is increasing in the major
segments such as ABS Credit Cards and financial
CLOs, where the issue volume of USD 45bn is
constantly increasing. Even during the credit crunch
in October 98, credit cards have remained actively
traded assets ( graph 6).
Return. With equal ratings, ABSs generally
provide interesting margins for long term investors.
In addition, the new asset classes offer spread
narrowing potential: for example, in tandem with the
development of this market segment, spreads on
credit cards have narrowed by around 80bp since
1992 ( graph 6).
Olivier MELENNEC
European ABS Group, SG
Paris: 33 1 42 13 80 51
London:44 20 7676 7649
E-mail:olivier.melennec@socgen.com
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 9

GLOSSARY
Asset Backed Securities : I- Introduction
Asset-Backed-Commercial-Paper : I- ABCP, MBS and ABS
Auto Loans : I- Market segments
Back-up Servicer : II- Stage 5- Servicing
Bankruptcy Remote : II- Stage 4- Documentation
Cash deposit : II- Stage 2- Cash deposit
Class : II- Stage 2- Subordination
Clean-up Call : II- Stage 3- Repayment date
Collateralised Bond Obligation : I- Market segments
Collateralised Loan Obligation : I- Market segments
Collateralised Mortgage Obligation : II- Stage 3- Repayment date
Commercial Mortgage Backed Securities : I- Market segments
Commingling : II- Stage 5- Commingling
Conduits : I- ABCP, MBS and ABS
Controlled Amortisation : II- Stage 3- Repayment
Credit Cards : I- Market segments
Credit enhancement : II- Stage 2- Credit enhancement
Diversity Score : II- Stage I- Reporting
Equity : II- Stage 2- Subordination
Excess Spread : II- Stage 2- Excess Spread
Expected Maturity : II- Stage 3- Repayment date
Final debtors : I- Securitisation
Fonds Communs de Créances : II- Stage 4- Special Purpose Vehicle
Future flows : II- Stage I- Origination
Hard Bullet : II- Stage 3- Repayment
Home Equity Loans : I- Market segments
Interests collections : II- Stage 3- Cashflow mechanics
Investment grade : II- Stage 2- Guarantee
Legal Final : II- Stage 3- Repayment date
Legal opinion : II- Stage 4- True sale
Master-Trust : II- Stage 4- Master Trust
Mezzanines : II- Stage 2- Subordination
Monolines : II- Stage 2- Guarantee
Mortgage-Backed-Securities : I- ABCP, MBS and ABS
Offshore : II- Stage 4- Special Purpose Vehicle
Origination : II- Stage I- Origination
Pass-Through : II- Stage 3- Repayment
Principal collections : II- Stage 3- Cashflow mechanics
Reinvestment period : II- Stage I- Maturity
Renewable : II- Stage I- Maturity
Reporting : II- Stage I- Reporting
Return On Equity : I- Fast-developing
Scoring : II- Stage I- Origination
Securitisation : I- Securitisation
Security Trust Deed : II- Stage 4- Documentation
Seller : I- Securitisation
Senior : II- Stage 2- Introduction
Servicer : II- Stage 5- Servicing
Servicing : II- Stage 5- Servicing
Soft Bullet : II- Stage 3- Repayment
Special Purpose Vehicle : I- Securitisation
Static : II- Stage I- Maturity
Student Loans : I- Market segments
Subordinated : II- Stage 2- Subordination
Term Deals : I- ABCP, MBS and ABS
Trigger : II- Stage 3- Rapid amortisation
True Sale : II- Stage 4- True sale
Trust : II- Stage 4- Documentation
Trustee : II- Stage 4- Documentation
Underlying asset : I- Securitisation
SG does not make any representations or warranty, express or implied, as to, nor does it assume any responsibility or liability
for, the authenticity, origin,validity or completeness of, or any omissions in any information contained in this document.
SG ABS RESEARCH – updated 15/05/2000 10