Securitisation is a method of funding receivables of whatever kind (mortgage debts, leases, loans, credit card balances etc...). It involves producing bearer asset-backed securities which can be freely traded (and which are normally rated) secured on a portfolio of receivables. Not all receivables can be securitised, and not all originators are capable of meeting the requirements of the rating agencies.

The basic technique requires the rights to the receivables to be transferred to a special purpose company (referred to as the "Issuer") which then purchases or arranges credit enhancement, and then issues rated debt (normally floating rate eurobonds).

There are a number of varieties of "securitisation" and a number of different structures. However, there is a common theme to all of these transactions.

1. Assets are originated by a company, and funded on that company's balance sheet. This company is normally referred to as the " Originator".

2. Once a suitably large portfolio of assets has been originated, the assets are analysed as a portfolio, and then sold or assigned to a third party which is normally a special purpose vehicle company (an " SPV") formed for the specific purpose of funding the assets. The SPV is sometimes owned by a trust, or even, on occasions, by the Originator. Administration of the assets is then sub-contracted back to the Originator by the SPV.

3. The SPV issues tradeable "securities" to fund the purchase of the assets. The performance of these securities is directly linked to the performance of the assets - and there is no recourse (other than in the event of breach of contract) back to the Originator.

4. Investors purchase the securities, because they are satisfied (normally by relying upon a rating) that the securities will be paid in full and on time from the cash flows available in the asset pool. A considerable amount of time is spent considering the different likely performances of the asset pool, and the implications of defaults by borrowers on the corresponding performance of the securities. The proceeds upon the sale of the securities are used to pay the Originator.

5. The SPV agrees to pay any surpluses which arise during its funding of the assets back to the Originator - which means that the Originator, for all practical purposes, retains its existing relationships with the borrowers and all of the economics of funding the assets (ie: the Originator continues to administer the portfolio, and continues to receive the economic benefits (profits) of owning the assets). As cash flows arise on the assets, these are used by the SPV to repay funds to the investors in the securities.

Securitisation is one way in which a company might go about financing its assets. There are generally seven reasons why companies consider securitisation:

1. to improve their return on capital, since securitisation normally requires less capital to support it than traditional on-balance sheet funding;

2. to raise finance when other forms of finance are unavailable (in a recession banks are often unwilling to lend - and during a boom, banks often cannot keep up with the demand for funds);

3. to improve return on assets - securitisation can be a cheap source of funds, but the attractiveness of securitisation for this reason depends primarily on the costs associated with alternative funding sources;

4. to diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced;

5. to reduce credit exposure to particular assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitisation can remove some of the assets from the balance sheet);

6. to match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitisation normally offers the ability to raise finance with a longer maturity than is available in other funding markets;

7. to achieve a regulatory advantage, since securitisation normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitisation as a means of managing the restriction on their wholesale funding abilities).

Establishing the primary rationale for the securitisation activity, is a vital part of the preparation for a securitisation transaction, since it influences the sorts of administrative tasks which need to be developed as well as the transaction structures themselves.

Assets which can be securitised easily have a number of characteristics:

Cash-flow

A principal part of the asset is the right to receive a cash flow from a debtor in certain amounts (or amounts defined by reference to a market or administered rate) on certain dates ie: the asset can be analysed as a series of cash flows.

Security

If the security available to collateralise the cash flows is valuable, then this security can be realised by the SPV. For instance, for a mortgage loan, there is security over the property and other collateral, which will make a significant contribution towards recovering any losses which might otherwise arise. Consequently, if there is a default, an effective method of ensuring that the SPV can gain the benefit of the security will be required (otherwise securitisation will be an uneconomic way of arranging funding).

Distributed risk

Assets either have to have a distributed risk characteristic or be backed by a suitably-rated credit support. For instance: a single retail loan is relatively small in value in the context of the available supply of retail loans to a single transaction (normally in the region of 4,000 mortgage accounts or 100,000 personal loans or small leases); in this way, the performance of one single asset is not likely to distort the performance of the entire portfolio. Consequently, the entire portfolio can be considered as a single asset, with a predictable performance. Concentrations of risk do not have this characteristic. If individual assets were to have a significant value in relation to the whole (eg: suppose only 100 mortgages were to be securitised) then a different approach has to be taken, and these individual assets have to be analysed individually and specific enhancement arranged.

Homogeneity

Assets have to be relatively homogeneous - this means that there are not wide variations in documentation, product type or origination methodology. Otherwise, it again becomes more difficult to consider the assets as a single portfolio.

No executory clauses

The contracts to be securitised must work, even if the Originator goes bankrupt. Certain clauses are therefore difficult to include in a securitisable contract -eg: in a photocopier lease, the inclusion of a clause stating that the Originator will maintain the photocopier would make that lease difficult to securitise. These sorts of contract are normally referred to as "executory contracts".

Capacity

It must be possible for the necessary transactions which are needed for the securitisation to take place in relation to the assets concerned - for instance, if the assets contain specific prohibitions against assignment, then they will not be securitisable in the traditional sense.

Independence from Originator

The on-going performance of the assets must be independent of the existence of the Originator. This tends to be a wider restriction than the example given above about executory contracts. A number of technical matters can arise, for instance, if asset yields are quoted only by reference to the Originator (eg; as the Originator's rate), then this will cause a structural difficulty in the event of the Originator's insolvency (ie: what now is the rate that the assets yield?).

Understanding why securitisation works is fundamental to understanding the nature of the task which has to be completed by the Originator.

Securitisation works because rating agencies are prepared to assign ratings to the liabilities of the SPV. As described above, the performance of these liabilities is determined by the performance of the assets which the SPV owns - hence the securities are normally described as "pass-through" securities (as the cash flows and credit risks are passed through from the assets to the securities directly. Consequently, the starting point for the credit analysis is an analysis of the assets.

Prior to the securitisation, the assets which are to be securitised form part of a corporate balance sheet. In simple terms, each company has a different "credit personality", which is a function of its own management style, the quality of the assets which make up the balance sheet and the types of liabilities which the company has. Taking these three items together establishes the credit standing of the company.

A normal company has very few restrictions upon its ability to do something rash - there are plenty of examples of companies which have prejudiced their own long-standing creditworthiness with an ill-judged acquisition or foray into an inappropriate market. Similarly, the mixture of assets which makes up a balance sheet may not be well understood (or fully analysed) by the market. There may be residual dependencies within the balance sheet which are not disclosed - as the amount of information about a company is often restricted to that required to be given by law. Finally, the balance sheet may be stable, but cash flow is critical - and there are often few restrictions on corporate liquidity management. A number of otherwise successful businesses have failed as a result of liquidity mismanagement.

There are a number of key criteria, which the SPV will adhere to, which are not attributes that apply to a normal company. Together these are referred to as the "SPC Criteria", (SPC is the same as SPV) which have been developed over the years by the rating agencies (SPC in rating terms is used to refer to a bankruptcy-remote special purpose company). Principally they relate to a series of activities and conditions which a securitisation company has to meet before a rating can be given to any liabilities issued by it. These include:

• prevention of trading outside funding the assets and servicing the securities - so that the SPV cannot endanger the transaction by introducing new and different risk factors;

• sub-contracting all services required to maintain the SPV and its assets - eg: administering its receivables, company secretarial work; SPVs are not permitted to have any employees or (normally) to have general fiduciary responsibilities to third parties (eg: acting as a trustee);

• any person who contracts with the SPV is required to agree not to sue the SPV in the event that the SPV fails to perform under the contract (unless that person is "senior" ranking and effectively rated);

• all of the SPV's liabilities (present and future) should be quantifiable, and shown to be capable of being met out of the resources available to it, including corporation tax, advance corporation tax and any value added tax;

• the extent to which the SPV is reliant on third parties to meet its obligations should be minimised (and in some circumstances limited to a reliance on either AAA-rated or on other bankruptcy remote companies only);

• funds which are due to the SPV have to be separated and ring-fenced as soon as they are received (to the extent that this is possible). In this way, assets which formed a part of a corporate balance sheet (supporting perhaps an overall credit at a low level) can be extracted, ring-fenced and put into a controlled environment, such that they are capable of supporting a AAA/Aaa rated transaction (the top ratings available from Standard & Poors and from Moodys).

• Since the SPV cannot have any employees, the administration of the SPV's assets has to be wholly subcontracted. One of the principal documents which regulates the SPV is therefore the Administration Agreement. This is a contract, normally between the SPV and the Originator (who acts also in an administrative capacity), which describes all of the different tasks which are necessary to permit the SPV to conduct its business.

These range from

1. the collection of cash each day;

2. operating bank accounts;

enforcing agreements with the underlying debtors (eg: collecting on security and chasing borrowers who are in arrears);

3. company secretarial matters (managing licences, producing statutory returns);

4. accounting;

5. taxation (in the UK this normally extends to Corporation Tax, Advance Corporation Tax, VAT, MIRAS, withholding taxes, and Stamp Duty);

6. reporting - to investors, rating agencies and trustees; pool management (dealing with requests for additional funds, changes to the asset contracts etc..);

7. management of related insurance (MIG, buildings insurance, payment protection and so on).

8. One of the reasons why the securitisation process is so difficult is the requirement to track through all of the ways in which the Originator conducts its business. This flows from the desire to understand all of the risk factors which can affect the SPV, and is also simply a result of the need to document that administrative process.