Securitization

In an effort to reduce their regulatory capital costs, banks also use various specialpurpose
vehicles (SPVs) and securitization techniques to unbundle and repackage
risks to achieve more favorable capital treatment. Initially, for corporate exposures,
these securitizations have taken the form of collateralized loan obligations (CLOs).
More recently, however, banks have explored ways to reduce the high costs of CLOs,
and have begun to consider synthetic securitization structures.
Asset securitization allows banks to sell their assets and use low-level recourse
rules to reduce RWA. Figure 11.5 illustrates a simple asset securitization, in which
the bank retains a $50 ‘first loss’ equity piece, and transfers the remaining risk to
bond investors. The result of the securitization of commercial credit is to convert
numerous individual loans and/or bonds into a single security. Under low-level
recourse rules,10 the bank’s capital requirements cannot exceed the level of its
risk, which in this case is $50. Therefore, the capital requirement falls from $80
($1000î8%) to $50, or 37.5%.

The originating bank in a securitization such as a CLO retains the equity (first
loss) piece. The size of this equity piece will vary; it will depend primarily on the
quality and diversification of the underlying credits and the desired rating of the
senior and junior securities. For example, to obtain the same credit rating, a CLO
collateralized by a diversified portfolio of loans with strong credit ratings will require
a smaller equity piece than a structure backed by lower quality assets that are more
concentrated. The size of the equity piece typically will cover some multiple of
the pool’s expected losses. Statistically, the equity piece absorbs, within a certain
confidence interval, the entire amount of credit risk. Therefore, a CLO transfers only
catastrophic credit risk.11 The retained equity piece bears the expected losses. In this
sense, the bank has not changed its economic risks, even though it has reduced its
capital requirements.
To reduce the cost of CLO issues, banks recently have explored new, lower-cost,
‘synthetic’ vehicles using credit derivatives. The objective of the synthetic structures
is to preserve the regulatory capital benefits provided by CLOs, while at the same
time lowering funding costs. In these structures, a bank attempting to reduce capital
requirements tries to eliminate selling the full amount of securities corresponding to
the credit exposures. It seeks to avoid paying the credit spread on senior tranches
that makes traditional CLOs so expensive.
In synthetic transactions seen to date, the bank sponsor retains a first loss
position, similar to a traditional CLO. The bank sponsor then creates a trust that
sells securities against a small portion of the total exposure, in sharp contrast to the
traditional CLO, for which the sponsor sells securities covering the entire pool.
Sponsors typically have sold securities against approximately 8% of the underlying
collateral pool, an amount that matches the Basel capital requirement for credit
exposure. The bank sponsor purchases credit protection from an OECD bank to
reduce the risk weight on the top piece to 20%, subject to maturity mismatch
limitations imposed by national supervisors. The purpose of these transactions is to
bring risk-based capital requirements more in line with the economic capital required
to support the risks. Given that banks securitize their highest quality exposures,
management should consider whether their institutions have an adequate amount
of capital to cover the risks of the remaining, higher-risk, portfolio. 333