Conclusion
In this last (fourth) part of my notes, let me dwell on how a credit rating agency might analyze the credit quality of the financial assets that go into the “pool of assets” that back the payments (returns) on the securitized products or the securitization issue.
It is, of course, elementary that asset-backed securities (ABS), which are the securitized issues, are as investment-worthy as the credit quality of the financial assets that back them up. This note will hopefully give a better appreciation of how credit ratings can help an investor decide on a securitization issue.
The basic credit-quality determinants are (a) the nature and characteristics of the receivables or obligations themselves; (b) the character and characteristics of the obligor of the receivables; (c) the terms of payment; (d) the amount still collectible on a receivable as against the amount already collected; (e) the efficiency of the collection system; and (f) the adequacy of the documentation and consequent enforceability of the obligation.
Let us remember, we are talking here of the receivables (the financial assets) that were originated by the originator, who now sells these to the special purpose vehicle to form part of the “pool of assets” that back up the securitization issue.
Typically, the pool of assets is predetermined and already identified and of one asset kind. For example, these assets may be “Contract to Sell Receivables” of condominium units being sold by a property developer. Or these assets could be home mortgages, or auto-loan receivables, or credit-card receivables.
What the credit-rating agency evaluates is the probability of these assets being converted to cash in the normal course of business. It is the performance of the whole pool of assets that is being evaluated as being adequate to cover the whole asset-backed securities issued.
Where the originator/seller in a securitization issue is in the continuing business of generating/originating receivables (again, for example, a property developer), the securitization transaction may involve the securitization of a pool of “revolving financial assets”. In this case, the credit quality of the pool changes as the component receivables are collected and the pool contents are reduced; or as the pool is augmented by new receivables; or as the original receivables are replaced. The credit characteristics of the pool of assets will accordingly change, for better or for worse. As a consequence, the ABS issued against that pool will also change in its credit quality.
On another perspective, if the size or amount of the ABS outstanding changes, bigger or smaller, against a static pool of assets, the credit quality of the whole ABS also changes. If the size of the ABS and, at the same time, the size and/or quality or nature of the pool of assets change, the credit quality of the ABS would also be affected, and would change.
As these variables change, singly or collectively, i.e., (a) size of asset pool; (b) nature of assets in the pool; and (c) mix of assets included in the pool; there will be changes in the credit quality that have to be determined, monitored and evaluated.
Models of credit-quality evaluation using different assumptions, particularly on (a) delinquency and (b) rates of recovery after a delinquency, would have to be developed under different scenarios. Ideally, the assumptions should be based on experience with such receivables.
There’s more to write about securitization. For now, it is enough we have a little more appreciation of securitization as an alternative way of raising funds through the capital market that can serve well the originator/seller and the investor and the capital market.
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The opinions expressed here are the views of the writer and do not necessarily reflect the views and opinions of Finex.