Securitisation basics

The bonds at the centre of the 2008 crisis were not issued by companies or governments. They were built out of thousands of American home loans. The same technique still funds car loans, credit cards and mortgages around the world. How does it work, and how did it go so wrong?

A bank that makes loans usually keeps them and waits to be repaid. SecuritisationTurning a pool of loans into bonds that are paid from the loans' cash flows. lets it sell them instead. The bank, the originatorThe lender that made the loans and sells them into the securitisation., gathers many similar loans into a pool and sells the pool to a special purpose vehicleSpecial purpose vehicle: a separate company set up only to hold the loans and issue the notes, so they are cut off from the originator's own failure. (SPV). The SPV pays for the loans by selling bonds, called notes, to investors. As borrowers make their payments, the money flows through the SPV to the noteholders.

Tranching. Each trancheOne slice of a securitisation's notes, with its own place in the queue for payments and losses. has its place in the waterfallThe order in which cash is paid out (senior first) and losses are absorbed (most junior first).. Payments flow down from the top; losses climb up from the bottom. The equity tranche takes the first losses, so it earns the highest return. The senior tranche is hit only after every tranche below it is wiped out, so it is the safest and pays the least. One pool of ordinary loans becomes bonds with very different risks, to suit different investors.

The family of products. The name depends on what sits in the pool:

Not the same as a covered bond. A covered bond (L1.4.02) also has a pool of loans behind it, but the loans stay on the bank's balance sheet and the bank still owes the money. In a securitisation the loans leave the bank, and investors can rely only on the pool.

What went wrong in 2007 and 2008. Lenders that sold every loan they made had little reason to check borrowers carefully: the “originate to distribute” model. Many US subprime mortgages were made on weak terms. Mezzanine tranches were themselves pooled and re-tranched, creating new “AAA” notes out of risky ones. The models assumed house prices would not fall across the whole country at once. When they did, losses climbed far higher up the structures than expected, and notes rated AAA lost value.

The fixes. Originators must now keep skin in the gameThe rule that the originator or sponsor keeps part of the credit risk (at least 5% in the EU, UK and US).: at least 5% of the risk. In the EU and UK, simpler deals can earn the STSSimple, transparent and standardised: an EU and UK label for securitisations that meet set criteria, which earns lighter capital treatment. label and lighter capital treatment. Disclosure on the underlying loans is far more detailed, and banks hold more capital against securitisations.

It opens on the worked example: £80m senior, £15m mezzanine, £5m equity, with £8m of losses. Push the losses to £25m. Then thicken the equity tranche and see how much safer the senior notes become.

A £100m pool of loans funds three tranches: senior £80m, mezzanine £15m and equity £5m. The senior notes lose nothing until pool losses pass 20%. Work out who loses what before revealing each step.

Banks that hold securitisation tranches follow the Basel securitisation framework, which sets capital by the tranche's seniority, thickness and the quality of the pool (L4.2). Re-securitisations, tranches of tranches, carry much higher charges.

Risk retention of at least 5% applies under the EU Securitisation Regulation (Regulation (EU) 2017/2402), its UK equivalent and the US rules introduced under the Dodd-Frank Act. The EU and UK STS label rewards simple, transparent and standardised deals with lower capital charges.

• Securitisation pools loans in an SPV and funds them by issuing notes paid from the loans' cash.
• Tranching slices the notes: cash flows down from the senior tranche; losses climb up from the equity tranche.
• ABS hold consumer loans, RMBS home loans, CMBS commercial property loans and CLOs corporate loans. Covered bonds keep the loans on the bank's balance sheet.
• Thin tranches can go from small losses to total loss quickly when pool losses rise.
• After 2008: risk retention (at least 5%), the STS label, more disclosure and more bank capital.

Securitisation

Turning a pool of loans into bonds that are paid from the loans' cash flows.

Originator

The lender that made the loans and sells them into the securitisation.

SPV

Special purpose vehicle: a separate company set up only to hold the loans and issue the notes, so they are cut off from the originator's own failure.

Tranche

One slice of a securitisation's notes, with its own place in the queue for payments and losses.

Waterfall

The order in which cash is paid out (senior first) and losses are absorbed (most junior first).

ABS

Asset-backed security: a bond paid from a pool of loans or receivables such as car loans, credit cards or student loans.

RMBS

Residential mortgage-backed security: paid from a pool of home loans.

CMBS

Commercial mortgage-backed security: paid from loans on offices, shops, hotels and other commercial property.

CLO

Collateralised loan obligation: paid from a managed pool of loans to companies, usually leveraged loans.

Risk retention

The rule that the originator or sponsor keeps part of the credit risk (at least 5% in the EU, UK and US).

STS

Simple, transparent and standardised: an EU and UK label for securitisations that meet set criteria, which earns lighter capital treatment.