Presentation to (Insert Company Name, NOT logo)

1
Securitization 201 Primer on Risk and
Value January 2006 Dennis F. Kraft,
Ph.D. Director, Structured Products Research
Please see the Disclosure Appendix for
certification and disclosure information.
2
What is Risk?

• Type RISK ltHELPgtltGOgt on Bloomberg
• 182 definitions are referenced
• American Heritage Dictionary
• The possibility of suffering harm or loss
  danger.
• The variability of returns from an investment.
• The chance of nonpayment of a debt.
• To expose to a chance of loss or damage hazard

3
What is Risk?

• Is there a Risk Free Asset?
• Assumed in Modern Portfolio Theory
• What makes the asset risk free?
• What is the risk of holding the risk free asset
  in a portfolio?
• Is Risk Relative or Absolute?
• What is cost (penalty) for being wrong if you
• Buy an underperforming asset?
• Buy an asset that is downgraded?
• Buy an asset that defaults?
• Drive while intoxicated?
• Challenge Mike Tyson to a boxing match?

4
What is Value?

• Type Value ltHELPgtltGOgt on Bloomberg
• 268 definitions are referenced
• American Heritage Dictionary
• An amount of goods, services, or money considered
  to be a fair and suitable equivalent for
  something else a fair price or return.
• A principle, standard or quality considered
  worthwhile.
• An assigned or calculated numerical quantity.
• To determine or estimate the worth or value of
  appraise.

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Rating Agency Process What is a Rating?

• A security rating is not a recommendation to
  buy, sell or hold securities and may be subject
  to revision or withdrawal at any time by any
  rating agency.
• The ratings on the certificates address the
  likelihood of the receipt by holders of the
  certificates of all distributions on the
  underlying mortgage loans to which they are
  entitled.
• They do not represent any assessment of the
  likelihood or rate of principal prepayments or
  the likelihood that any interest carry forward
  amount will be paid.

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What Does a Rating Agency Address?

• Can Differ by Asset Class or Specific Security
• Timely interest and principal?
• Timely interest and ultimate principal?
• Probability of loss?
• Expected loss?
• Probability that you get what you deserve?

7
What DOESNT a Rating Agency Address?

• Yield or Return realized by investor
• Rate of Principal Payments or Prepayments on
  Collateral
• Payment of Prepayment Interest Shortfalls
• Payment of Available Funds Cap Shortfalls
• Likelihood of Payments under internal Swap
  Agreements

8
Rating Agency Process

• Determine Cash Flow for Asset Pool
• Assess Credit Stressors and Risk to Asset Cash
  Flow
• Drivers of default on assets
• Interest rates, home prices, unemployment, etc.
• Determine appropriate stress cases for asset pool
• Cash flows assessed under variety of stress cases
• Stress could be on yield curve, payment rates,
  card utilization, recovery values of collateral,
  etc.
• Determine adequacy of structure
• Available forms of credit enhancement
• Required credit enhancement level for desired
  rating

9
External Credit Enhancement

• Bond Insurance
• Most common form of external enhancement
• Insured bonds typically have investment grade
  shadow rating
• Major providers
• AMBAC
• FGIC
• FSA
• MBIA
• XL Capital
• Letter of Credit
• Corporate Guarantee

10
Internal Credit Enhancement

• Subordination
• Collateral losses allocated to bond classes based
  on priority
• Lower rated bond classes receive losses before
  higher rated classes
• Excess Spread
• Interest received on assets exceeds interest due
  on liabilities
• Available to absorb first loss
• May be allocated to senior bond principal,
  building OC
• Overcollateralization
• Collateral amount exceeds bond balance
• Excess collateral absorbs loss before bonds
• May be funded at deal closing or dynamically from
  excess spread

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Internal Credit Enhancement

• Reserve Accounts and Cash Accounts
• Use varies by deal and asset class
• May support entire deal or only specific bond
  classes
• Use of funds may be limited
• Performance Based Cash Flow Allocation
• Cash Flow Waterfall change based on asset
  performance
• Early amortization triggers in Credit Card ABS
• Delinquency and/or Loss Triggers
• Servicer insolvency, bankruptcy or breach of
  covenant

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Card Performance Metrics

• Prime Credit Card Performance Indices

13
Auto ABS Performance Metrics

• Prime Auto Performance Indices

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Rating Transition
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Rating Transition
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Value Fundamentals

• How is value determined in the bond market?
• Present value of future cash flows
• Rates for discounting can be based on
• Treasury yields on the run or off the run
• Zero coupon or spot yields
• Swap curve
• Eurodollar curve

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Value Fundamentals Discounting Cash Flows

• 100 Bond
• Annual coupon of 5
• 3 year Maturity
• Assume 3 Year Treasury Yield 4.30
• Discount Cash flows at
• 4.50 (T 20)
• 5.00 (T 70)
• 5.50 (T 120)

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Value Fundamentals Discounting Cash Flows
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Value Fundamentals

• Discount rates are set as a spread to a benchmark
• Corporate bonds
• Quoted as spread to specific Treasury security
• Asset Backed Securities
• Quoted as spread to interpolated Swap yields
• Quoted to Weighted Average Life of ABS security
• Bond yield to maturity
• Single discount rate that equates discounted
  value of cash flows to full price
• Semi-annual compounding

20
Value Fundamentals

• P price
• CFi cashflow at period i
• y bond equivalent yield to maturity
• BYi benchmark yield at period i
• S spread to benchmark

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Value Fundamentals

• If BYi Benchmark Treasury yield for all i
• Then S Spread to Treasury
• If BYi Benchmark Swap yield for all i
• Then S Spread to Swaps
• If BYi Zero coupon Treasury yield at each
  period
• Then S Spot spread or Z spread
• If BYi Zero coupon Eurodollar curve
• Then S Eurodollar spot spread or E spread

22
Value Fundamentals

• BOND SPREADS Risk Premium vs. Benchmark
• Reflects market assessment of risks
• Basic comparison of relative value
• Benchmark Spread compared to Spot Spread
• Known as the drop
• Depends on cash flow timing
• Depends on shape of the benchmark yield curve
• Reflects value of bullet vs. amortizing cash flow

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Value Fundamentals
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Risk and Value Fundamentals

• Fundamental Questions for ABS
• What Risks are embedded in the ABS?
• How is Risk mitigated in the ABS structure?
• Is Value sufficient to compensate for Risk?

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Risks in the ABS Market

• Interest Rate Risk
• Cash Flow Timing
• Structural Risk
• Credit Risk
• Originator/Servicer Risk
• Liquidity Risk
• Event Risk

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Interest Rate Risk

• Duration Risk
• Duration mismatch versus a benchmark or a
  liability
• Duration drift of an asset or liability
• Basis Risk
• Mismatch of reset index between floating rate
  assets and liabilities
• Home Equity ABS (6-month Libor vs. 1-month Libor)
• Student Loan ABS (T-bill vs. 3-month Libor)
• Available Funds Cap Risk
• Mismatch of caps between assets and liabilities
• Home Equity ABS (fixed/capped loans vs. 1-month
  Libor)

27
Cash Flow Timing Risk

• Bonds With Embedded Options
• Cash flows depend on changes in interest rates
• Call and extension options will be exercised
  against security holder to advantage of obligor
• Option Adjusted Spread OAS net spread AFTER
  computing the value of embedded bond options
• Non-Option Related Cash Flow Timing Risk
• Performance Triggers
• Arise from structural features of bond
• Creates call or extension risk in another form
• Bifurcated cash flows

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Cash Flow Timing Risk

• Prepayment and/or Call Risk
• Bond issuer or underlying obligor owns call
  option, i.e. the right to prepay the obligation
• Bond cash flow either shortens or disappears
• Extension Risk
• Bond issuer or underlying obligor has option to
  extend maturity of the obligation
• Bond cash flow extends relative to expectations
• Examples
• Failure to exercise clean-up call
• Slower mortgage prepayments

29
Prepayment Risk

• Borrower prepayment option in underlying
  collateral
• Auto Loans
• Student Loans
• Mortgage Loans
• Mitigated in collateral by
• Prepayment Penalties
• Prepayment Lockouts
• Yield Maintenance and Defeasance (CMBS)
• Mitigated in bond structure by
• Cash flow allocation to protect specific bond
  classes
• Allocation of Yield Maintenance or Make-Whole
  premium
• rare in ABS

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Prepayment Risk Spectrum
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Prepayment Risk MBS Passthrough
32
Extension Risk MBS Passthrough
33
Prepayment Risk Generic AAA Home Equity
34
Extension Risk and Clean-Up Call
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Extension Risk and Clean-Up Call
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Bifurcated Cash Flow Example
A 10 equal principal payments B 5 year bullet
principal C 2 equal payments in years 1 9
A WAL 5 yrs B WAL 5 yrs C WAL 5 yrs
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Bifurcated Cash Flow Example 1 Year Later
A 9 equal principal payments B 4 year bullet
principal C 1 principal payment in years 8
A WAL 4 ½ yrs B WAL 4 yrs C WAL 8 yrs
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Bifurcated Cash Flow

• Bonds Roll Up the Curve
• Flat Yield Curve Environment
• Low economic cost
• Steep Yield Curve Environment
• High economic cost
• Stylized Example would suffer 3 point price
  decline using mid-January 2005 curve
• Caveat Emptor

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Bifurcated Cash Flow in Real Life

• Private Student Loan 2005-X

40
Structural Risk

• ABS Have Structural Complexity
• Traditionally traded at a spread premium to other
  asset classes
• Premium has dissipated in some sectors
• Asset performance
• Broader acceptance of asset class
• Complexity arises from
• Collateral characteristics
• Need to create internal credit enhancement
• Desire for bonds with specific cash flow profiles

41
Structural Complexity from Collateral

• Collateral Cash Flows
• May be fixed or floating rate
• May/may not be level pay
• Typically include principal and interest
• Principal may/may not fully amortize loan balance
• Student Loans
• Payment Schedule and Borrower Status
• In School and Grace Period
• Deferment or Forbearance
• Interest set annually
• Last auction of 91-day T-Bill prior to June 1
• Margin depends on origination date of loan

42
Structural Complexity from Collateral

• Hybrid ARMs
• Rate fixed for specific period
• Adjustable rate after initial period
• Rate Index Margin
• Index resets typically semi-annual or annual
• Rate resets subject to interim and lifetime caps
• Loan may/may not have interest-only period
• Loan may/may not allow negative amortization

43
Structural Complexity Credit Enhancement

• Base Case Cash Flow Allocation
• Interest allocated based on bond priority
• Principal allocated to senior bonds to build
  subordination
• Excess Spread allocated to build reserve account
  or OC
• Performance Based Cash Flow Allocation
• Cash Flow Waterfall change based on asset
  performance
• Early amortization triggers in Credit Card ABS
• Delinquency and/or Loss Triggers
• May lock-out subordinate bonds
• May redirect excess spread
• May rebuild credit enhancement

44
Cash Flows for Home Equity
45
Cash Flows for Home Equity
46
Credit Enhancement for Home Equity
47
Credit Enhancement for Home Equity
48
Timing of Losses and Credit Enhancement
49
Liquidity Risk

• Likelihood that cant sell quickly
• Likelihood that cant sell close to acquisition
  price
• Likelihood that cant sell at all

50
Liquidity Risk Real Life Example

• A mid-western life insurance company 1999
• Co-issued funding agreements with 7-day buyer put
  option
• Proceeds invested in BBB Home Equity CDO
• Co-issuer downgrade requiring company to take
  over obligations
• Company subsequently downgraded 3x in 2 weeks
• Investors exercised put options
• Company forced to liquidate holdings to redeem
  liabilities
• Company unable to liquidate quickly or near par
• Company taken over by regulator
• Assets liabilities purchased by large east
  coast insurer
• Entire timeline 4 weeks

51
Originator Risk

• Underwriting standards and criteria
• Always look good
• Exceptions may be the rule
• Standards may drift over time
• Due to volume pressure
• Margin pressure
• Examples include entire MH franchise loan
  industries

52
Servicer Risk

• Routing collection process procedures
• Lock box
• misdirected funds
• Delinquent collection policies
• Do they exist
• Are they followed
• Compliance with Fair Debt Collection Practices
  (FDCPA)
• Loss mitigation strategies
• Bankruptcy
• Fraud
• Servicing transfer risk

53
ABS Event Risk

• LTCM Liquidation
• ABS and CMBS markets shut down
• Failure of Home Equity and CMBS issuers
• unable to securitize or finance positions
• 9/11
• Aircraft travel plummets
• Aircraft leasing ABS cashflows impaired

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DISCLOSURE APPENDIX Additional information is
available on request About Wachovia
Securities Wachovia Securities is the trade name
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55
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