Introduction to Securitisation

Contents

This paper starts with a section explaining what securitisation is, and how it works.

It then goes onto discuss some of the issues associated with securitisation, in particular:

• the number of counterparties who can become involved (section 3)
• the need to negotiate a path through the rating agencies (section 4)
• the number of structural alternatives which originators may use (and the possible implications of each) (section 5)
• the implementation of systems in order to run a securitisation (section 6);
• failure to carry out the necessary preparations properly (section 7).

Several key points should be made:

• Although the internal and external costs of a transaction are high, securitisation can raise significant amounts of funds. As a result, the costs are generally worth bearing (and when amortised, are not significant).
• Securitisation appears to be complicated to the uninitiated. However, once the basic principles have been learned and an appropriate transaction structure designed, most clients wonder what the fuss was all about.
• Transactions are generally easy to administer (and to repeat), provided they have been correctly structured. Most of the work from an originator's perspective is involved in: (i) setting up systems and procedures before transactions are launched, (ii) ensuring the legal and tax neutrality of the transaction and (iii) assisting in the delivery of a transaction which meets the originators commercial objectives.

Selecting the advisers with the skills to design, negotiate and support the transaction from a number of different perspectives is therefore critical. Securitisations involve many different facets of an originator's activities: credit, tax, legal, systems, ratings, banking relationships, project management, accounting and so on. Ensuring that each area understands its role in the delivery of the whole is the key to a successful transaction.

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 which is illustrated in the following diagram.

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

• to improve their return on capital, since securitisation normally requires less capital to support it than traditional on-balance sheet funding;
• 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);
• 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;
• to diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced;
• 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);
• 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;
• 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.

CORPORATE CREDITS

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.

SPV CREDIT ANALYSIS

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

• the collection of cash each day;
• operating bank accounts;
• enforcing agreements with the underlying debtors (eg: collecting on security and chasing borrowers who are in arrears);
• company secretarial matters (managing licences, producing statutory returns);
• accounting;
• taxation (in the UK this normally extends to Corporation Tax, Advance Corporation Tax, VAT, MIRAS, withholding taxes, and Stamp Duty);
• reporting - to investors, rating agencies and trustees;
• pool management (dealing with requests for additional funds, changes to the asset contracts etc..);
• management of related insurance (MIG, buildings insurance, payment protection and so on).

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.

Securitisation normally involves a wide variety of counterparties and advisers. On one particularly complex transaction a few years ago there were 6 law firms, 3 firms of accountants, 1 insurance broker, 1 investment bank, 1 consultant and 12 principals (banks, originators, administrators, credit enhancers, underwriters and so on).

A transaction normally involves the following parties:

• Originator and Administrator
• Lead Underwriter ­ who purchases the debt issued by the SPV (and sells it to eurobond investors)
• Structuring Team ­ either involving personnel from the lead underwriter and/or other advisers
• Two sets of lawyers, at least one of whom is a securitisation specialist
• Trustee and Trustee's lawyers ­ representing the interests of the noteholders in the event that there is (a) an enforcement event (things go wrong) or (b) any requirement to change or amend the documents or procedures after the transaction completes;
• Rating Agencies ­ required to undertake an analysis of the risks associated with the transaction and to award a credit rating to the debt issued
• Originator's accountants ­ to agree accounting treatment for the transaction, to verify the analysis and existence of the assets involved and to confirm work undertaken to show solvency
• Credit Enhancement Providers and their lawyers ­ transactions often involve a third party fronting some of the risks associated with the assets
• Standby Servicer and their lawyers ­ a third party prepared to administer the assets in the event that the existing servicer fails or is incompetent; this is now becoming a requirement for all transactions where the administrator does not already have at least an A1/P1 short term rating
• Clearing Bank and its lawyers ­ running the originator's and the Issuer's bank accounts, all of which normally require new mandates and a Bank Agreement is also set up to regulate the operation of all aspects of the accounts
• Banking Facility Providers and their lawyers ­ often there are requirements for additional banking facilities, eg: liquidity facilities or guaranteed deposit arrangements ("GICs")
• Hedging Providers and their lawyers ­ assets often need some form of hedging, either using swaps, caps or both
• Paying Agents, Agent Banks, Common Depositary etc.. a whole host of organisations with mysterious Euromarket responsibilities
• Printer ­ to produce the prospectus (choosing the wrong printers can cause the transaction to fail)

There are four rating agencies who comment on asset­backed transactions in the UK:­ Standard & Poors ("S & P"), Moodys, Fitch and Duff & Phelps ("D & P"). This note focusses on the approaches of S & P and Moodys. The other two agencies have their own distinctive styles but their analytical approach tends to be based upon those of S & P and Moodys.

A rating normally covers the FULL and TIMELY payment of interest and principal on the rated notes. The "full" part means that investors get all of their money back; the "timely" part means that the money is paid on time. These two elements equate to credit risk and liquidity risk.

S & P

S & P have a more formal approach than Moodys, and there is a greater certainty of result (since the rules are more explicit and therefore easier to abide by).

S & P favour a weak­link approach ­ the strength of the structure is as good as it's weakest link. If a AAA rating is required, then all of the elements of the structure should be AAA. However, as with all rules, the first thing that has to be learned is when it does not apply. With some fancy footwork, it is possible to engineer a AAA rating from only A1+ rated facilities and assets. Additionally, some elements can be poorly rated (or unrated) ­ for instance the administrator does not have to have a formal credit rating.

The perverse result of these rules means that (i) if an entity performing a role is not rated (and a rating is required for that part of the structure) then that entity cannot be used ­ so if your favourite bank is rated Aaa by Moodys and does not have an S & P rating, too bad, or (ii) worse is if such entity is on credit­watch ie: it has a rating but that rating is currently being questioned ­ then again, no reliance can be put on it.

Another interesting result is that, because all of the elements are rated to a sufficiently high level, S & P is not normally interested in the position AFTER an event of default ­ such an event is assumed not to happen. One client of mine has managed to push this rule to its ultimate extreme ­ on their transactions an event of default only occurs if you had the money but did not pay it (eg: you forgot) ­ mere failure to pay because you did not have the money is not an event of default.

MOODYS

Moodys take an opposite position in many respects. A rating is derived from an assessment of the cumulative strengths of a structure: the "building block approach". An additional feature of a Moodys rating is that the analysis is supposed to be based upon an assessment of bond values: that is that the value returned to the Noteholders is quantified in a variety of different stress environments ­ Moodys will tend to look at the position in the transaction after default as well as before it.

Perversely, just as S & P do not require a rated administrator, Moodys do require a rated administrator, or a rated standby administrator.

A consequence of this "noteholder value" approach, is that it is much harder to deal with Moodys with any certainty. With S & P it is possible to determine the relative strengths and weaknesses of a transaction, and to assess the likely rating (almost without talking to them) ­ their rules are not written down, but are well known. With Moody's it is possible that they could re­assess the position at the last minute and change their mind, with potentially disastrous consequences for the transaction.

CREDIT RISK

Rating Agencies really only deal with credit risk as a commercial matter (ie: they will make an assessment of credit risk). All other risks have to be structured out, dealt with beyond doubt or shown to be sufficiently remote. Sufficiently remote normally means inconceivable. Any residual concerns which are not specifically analysable as credit risks will involve serious costs for the structure (eg: corporation tax and VAT risks).

SOLVENCY

Both rating agencies need to feel comfortable that the seller of the assets is solvent and is expected to remain solvent for a period of two years from the date of the transaction. Proving solvency to this standard is not a straightforward exercise. The legal definition of solvency is a 20 page paper, and the tests which are necessary to show that a company is solvent can be tortuous. A true solvency analysis will also take into account contingent assets and liabilities (including deferred tax) which are not normally shown on the face of a balance sheet, and will require a comprehensive and detailed analysis of the balance sheet and projected cash flows.

TAX RISKS

The rating agencies require tax, accounting and actual cash surpluses to be in step (or to the extent out of step, so that it does not matter) throughout the transaction and in a variety of tax, interest rate and credit environments.

Corporation tax

Since the Inland Revenue does not give advance rulings on the likely tax treatment of different structures, the rating agencies normally require the structures to be analysed across all potential tax treatments.

On the Anglo transaction, for instance, it was determined that there were 9 different potential tax treatments for the transaction. Each had to be analysed, and the 3 principal tax treatments had to be modelled in detail.

VAT

The key issue is ensuring that the Issuer does not become responsible for the VAT liabilities of the rest of the originating group (eg: by being grouped for VAT purposes), and that there is the potential to recover VAT bad debt relief. There are more subsidiary issues relating to VAT on fees.

Stamp duty

If stamp­able transfers are involved, then it would be normal for the transfers to be completed off­shore. However, the rating agencies normally consider that the assets could be repatriated (if the trustee was required to enforce the security) and therefore provision has to be made to pay any stamp duty which COULD then become payable. If more than one transfer has been made, then double, or even triple stamp duty provision can be needed. This is a real capital cost to the transaction, but careful management and structuring can enable the capital so required to be used efficiently.

SPECIFIC LEGAL RISKS

This is an area which the lawyers specialising in securitisation will be able to advise on more fully. These are normally dealt with by either investigation or by the production of an opinion. However, a thumb­nail sketch follows:

Title

Nothing must be capable of upsetting the title to the assets which the Issuer is acquiring. Dealing with these concerns is often not straightforward. No charges (actual or implied) must be capable of operating so as to restrict the originator's ability to sell the assets, in particular in existing banking facilities. This means a thorough review of any likely source of implied right to the assets is required.

Consequently, if the assets have passed through a number of hands prior to the securitisation, then each transfer has to be considered. Portfolios purchased from other companies raise particular problems.

The question as to the solvency or insolvency of any company involved at any stage with the receivables has to be addressed.

Contractual

All of the agreements must be binding upon all of the parties. The Issuer must be properly constituted etc....

Statutory

CCA regulated agreements in particular cause problems of their own. A full CCA review of the documents is normal practice.

Similarly, product liability issues need to be analysed out or shown to be de minimis.

SPECIAL RISKS

Each structure has to address different problems. Sometimes the answer to these problems is empirical (ie: the risk is included in the analysis of the transaction and quantified). However, some points can only be dealt with by legal analysis and an opinion. The extent to which the law firm involved is prepared (on occasions) to be slightly "sporting" can be critical.

Set off and related risks

Set off can occur in a variety of ways ­ for instance: lessees could have deposited money with an originator of the assets (who then becomes insolvent), or lessees could have paid for maintenance of equipment (which is then not carried out). Even if there is no legal justification for the set off (ie: the lessor is wrong), it may still have to be taken into account in the structure.

Similar risks relate to the position of the Issuer in the event that there is a liquidation of the administrator. A critical aspect of the structure will be the consideration of the liquidator's rights in this circumstance ­ can the collection of the Issuer's receivables (and their payment to the Issuer) be interrupted or stopped?

Executory contracts

Contracts which impose obligations upon the lessor are not generally securitisable. An example of an obligation would be procuring that maintenance is carried out, or agreeing to collect funds on behalf of a third party. The concern arises from a view that, were these obligations to be carried out poorly, then the lessor would be in default, which could then permit the lessee to avoid his obligations. A lessee may also have the right to reject the replacement of the lessor with a third party. Essentially the problem is that the contract becomes personal to the particular lessor and not generic.

However, there are certain techniques and credit enhancement structures which could be used in these circumstances.

Unsecured creditors

The rating agencies are also concerned to ensure that either the Inland Revenue or HM Customs do not become unsecured creditors to any part of the transaction structure ­ in other words, that there are known liabilities to either body which might not be met at any future point. This is considered to give an excuse to "go after" the Issuer or the structure as a whole to try to recover assets which have been sold to the Issuer and unravel the deal.

A detailed investigation of the deferred tax positions of the originator and any group companies is therefore required. Plans have to be made to show how any resulting liabilities are proposed to be paid, given certain assumptions about origination levels and credit losses.

Contractual failure

Even if a party has committed in contract to do XYZ, will they actually do it? On the Anglo transaction, officers of both the trustee and the clearing bank were required to confirm separately to Moodys that if their respective organisations agreed in contract to do something, then they would actually do it.

REQUIRED STEPS

Review / presentation

The rating agencies will wish to visit the originator/administrator to assess the quality of the management, the way that the company is set up and to review the administrative procedures.

Prior to the visit, it is normal practice to prepare a file on the company including financial information, procedures, company history, senior staff biographies and example contracts. Collating and preparing this information normally takes several weeks.

Asset analysis

This is the one risk which the rating agencies are prepared to take a commercial view on. This view is based upon an analysis of the asset pool proposed to be securitised, and a review of the historical performance of the originator's assets based upon certain assumptions. Generally the golden rules are:

• present your data appropriately (detailed advice is required on this point, since the exact approach should be closely linked to the way that the transaction is to be structured), and
• generate as much data as possible ­ irrelevant data can be discarded, but data which is missing is impossible to replace; rating agencies, in the absence of data, make conservative guesses (eg: 100% default rates, no recoveries etc..).

Once they have reviewed this information, the rating agencies will make an assessment of their worst case expectations as to the performance of the portfolio (normally absolutely dismal, of course). The structure then has to be designed to ensure that, should these losses appear, the rated debt is paid in full and on time.

Models are used differently by the two rating agencies: S & P require that the model demonstrates that noteholders will receive all amounts due on time using the appropriate stress assumptions for that rating. The model normally has to be audited, and S & P require a copy of it which they review in detail.

Moody's will not normally rely on models produced by third parties, and would seek to write their own. However, lease transactions are too complex to permit them to take this approach. On the Anglo transaction, for instance, they used our model, but treated its results with some circumspection. Their view seemed to be not that the structure had to meet certain minimum levels of stress (as S & P) but that the structure should be set up to deal with a variety of combinations of assumption, and that in certain circumstances, these assumptions could show a default.

S & P's approach means that, once the structure and the model is agreed, it is possible to be reasonably certain as to the required levels of credit enhancement for each rating level. Moody's approach is less empirical, and this means that there can be no certainty that the credit enhancement levels are appropriate.

Legal and tax

It is now normal for the rating agencies to require detailed opinions on the transaction addressing both legal and tax risks. These opinions are extremely difficult documents for lawyers to write, since the levels of comfort required are higher than those which would be necessary from a commercial perspective. This is one of the expensive elements of a transaction.

For the ALPS transaction (aircraft leases), for instance, a separate legal opinion had to be procured for each jurisdiction in which an aircraft could land ­ result: 118 legal opinions. From a rating perspective, the intrinsic value of the aircraft was a key part of the credit analysis ­ and therefore the aircraft have to be demonstrated to be recoverable if there is a default on the lease.

On the Anglo transaction, the tax analysis was so complex that the only way that sufficient comfort could be given was to offer nine alternative tax treatments for the transaction. The relevant partner of Clifford Chance was fairly happy (at a commercial level) as to the likely tax treatment of the transaction ­ but at a rating level (100% certainty), he could only be certain that it would be one of the nine. This meant that the tax opinion ended up the wrong side of 80 pages.

The rating process is complicated, but not too mysterious. Managing the rating process is a key element in the control of the transaction. Our advice is always that it is the originator who should control this process. As a result, the selection of the originator's advisers is a crucial element in ensuring a successful and controlled transaction - since it is through the assistance of these persons that the rating agency relationship is maintained. Several transactions which we have worked upon have changed radically as a result of the mismanagement of the rating process by third parties over whom the originator had no control.

This is a brief over view of the sorts of decisions which face a potential issuer of an asset­backed security.

There are four basic ways which can be used to uplift the credit quality of a portfolio of assets to a highly rated level; often these are used in combination:

It has been our experience that senior­subordinated structures are the easiest to implement, (provided that the computer modelling work is done well), for the simple reason that the real risk takers in the transaction structure (the Mezzanine Noteholders) are not present at the negotiations.

Securitisation structures can be designed to achieve different aims. A key structural issue is the extent to which the originator of the assets is prepared to sacrifice return on assets for taking less risk (and therefore putting up less capital).

The extreme position could be illustrated by examining some of the early mortgage­backed securities. By purchasing a pool policy from an insurer (a policy insuring the issuer against suffering credit losses) with a minimal deductible, it was possible to set the transaction up with virtually no capital commitment from the originator. The resulting gearing was normally in the region of 200:1. Clearly, the premium which had to be paid to purchase such a policy meant that the cost of funds associated with the transaction was higher than it might have been.

The alternative would be to retain all of the commercial risk associated with the assets by putting up a sizeable amount of capital. Since the credit enhancers are therefore taking less risk themselves, the cost of funds would be lower.

There are about a dozen ways to extract profit from a securitisation: these include use of receivables trusts, dividends, super­interest on loans, parallel loans, swaps, and simple fees. The key issues are: corporation tax, ACT, VAT and the timing and accounting treatment of the payments.

This is never a simple matter - profit extraction has to be considered for both the payer and receiver of the cash flows. It is generally possible for a "profit stall" to arise (as a result of the combination of a cash based profit extraction mechanism and initial delinquencies), which can cause adverse consequences for originators. Inevitably there are compromises to be made.

The key decisions relate to whether the transaction is to be on­balance sheet or to have a linked presentation, and how the investment (if any) in the Issuer is to be shown on the originator's balance sheet. This can become a critical area, particularly for banks and building societies, since the regulators normally follow the accounts in their treatment of the transaction, and for companies concerned about gearing.

The possible permutations of accounting treatments are governed by FRS5. A key problem with FRS5 is that it is aimed at reflecting the substance of transactions in Originator's balance sheets, rather than the form ­ and hence value judgements are inevitably involved. As a result, it is usual for the Originator's accountants to have to read certain transaction documents, and for their views as to the likely implications of FRS5 to be important.

A number of transactions have now been completed within the auspices of FRS5, most recently for Gracechurch Mortgage Finance No.2 (a securitisation of first mortgages by Barclays, referred to as GMF2). Already a number of aspects of FRS5 have had to be blurred ­ and parts of the GMF2 deal had to be reviewed directly with the ASB.

The Issuer will normally only assume the credit risk on the receivables. All other risks usually remain with the originator. The warranties given on the sale of the receivables to the Issuer are therefore normally rather more extensive than those given on a commercial transaction. For instance, warranties are given about legal risks (eg: relating to the CCA) and enforceability (that the contracts are enforceable in accordance with their terms). The originator therefore often needs to be prepared to concede what appears to be a variety of unreasonable and non­commercial points.

The exact allocation of risk between originator and Issuer is also a function of the type of credit enhancement chosen. If a senior­subordinated structure is used, then the amount of risk which remains with the originator is normally higher than if, for instance, a financial guarantee structure is used. If the originator is paying a premium to a third party specifically to assume risk in the transaction, it would be reasonable to expect the assumption of more than mere credit risk by that party.

However, it should always be remembered that in commercial terms, the SPV is an extension of the originator - and so fighting risk allocation battles can often mean taking funds from one pocket and putting them in the other. Getting the balance right is the key - too little risk transfer, and the transaction will be on-balance sheet, too great and the transaction may not complete!

Whatever the characteristics of the assets, sufficient hedging has to be in place to permit the full and timely payment of the Issuer's rated obligations. With fixed rate leases and floating rate notes, for instance, a number of hedging structures are required to ensure that the Issuer is not exposed to interest rate movements.

Accurate and efficient hedging forms a critical part of the transaction economics. The Anglo transaction was a first, not only in terms of involving leased assets, but also in the hedging structure used, which was designed by Risk Limited. Previous transactions had used caps or strips of swaptions to achieve what is considered by the rating agencies to be a "perfect hedge". However, we were able to demonstrate that, for the Anglo transaction, no interest rate options of any kind were required, saving option premiums and reducing the capital needed in the transaction by several million pounds.

Tying the Issuer back into the group tax affairs efficiently is a necessary part of the structuring process. Securitisation should be tax neutral.

The first issue is ensuring that the existence of the Issuer, and the contractual arrangements contemplated, do not involve either significant tax advantages or costs. Tax advantages are likely to give the Inland Revenue the excuse to challenge the structure, and these tend to give the rating agencies the opportunity to raise concerns about the structure as a whole.

This is principally an issue with leasing transactions. Two structures have broadly been used in public transactions: the DAF structure and the Anglo structure.

There is quite a contrast between the DAF structure and the Anglo structure as regards the tax effects. In DAF, the lease agreements were effectively re­characterised as simple receivables and the leased assets (the vehicles) became treated as stock (with no resulting capital allowances). The entire basis for the taxation of the leases was changed.

For Anglo, the overall amount of tax paid by the group should not change as a result of the transaction, since the securitised leases are still expected to be taxed as leases (with another part of the group claiming the tax allowances).

As a result of the perverse application of some of the Inland Revenue's dicta, it is also conceivable that tax losses can get stuck in the Issuer ­ which could produce a real tax cost for the transaction. The key debate centres around whether the Issuer is a trading company or an investment company for tax purposes ­ or in the case of the Anglo transaction, which of the 9 potential tax treatments is most likely to arise.

Tax planning is a large part of the structuring process. The rating agencies will assume that the worst possible tax treatment of the Issuer will apply in their analysis.

HOSEPIPES

These are facilities which are designed to change the nature of the Issuer's receipts, so as to deal with a tax risk which the rating agencies perceive to be a real concern. This is very much a technical issue which does not require a full explanation in this forum. Avoiding the use of a hosepipe can be important, especially for a leasing transaction. No hosepipe was used in the Anglo transactions (since the structure was designed to work without one), and a more efficient version of the hosepipe was developed by Clifford Chance for the SABRE transaction. This is one area of transaction structure which can be expected to change over the next few years - and an area in which any originator contemplating a securitisation requires some detailed advice.

GROUP RELIEF

The rules governing the availability of group relief in a securitisation are complex, and, rather odd. In the Anglo transaction we persuaded the rating agencies to allow the Issuer to surrender losses (for minimal consideration) subject to certain conditions. However, the ability to integrate the Issuer into the tax affairs of the originating group may not always be so straightforward, and is a direct function of other aspects of the structure.

Setting up the internal procedures to set up the transaction and then to run it is a time consuming process ­ and could be the subject of a detailed paper all of their own.

The big topics which need to be covered are:

Risk Limited has a standard process which it uses to accelerate the process of implementing a securitisation capability, and there are many simple solutions to the above systems issues, some of which are highlighted in the next section.

These are numerous and complex and largely depend upon the precise transaction structure contemplated, the nature of the assets and the nature of the Originator's business. A typical summary of systems and processes involved would be as follows:

• Analyse the assets prior to completion of the transaction, select provisional lists.
• Manage the audit process (provision of information, reports, liaison with auditors).

• Select the final list of assets, reflect the ownership change in the system, produce completion reports, post accounting entries. Repeat processes required for substitution.

• Store the ownership of the receivables showing clearly which receivables are securitised and which are not.
• Set up a reconciliation process to manage the first few days of the transaction whilst cash payments are not being correctly directed (for instance, it takes 3 days for transmissions to BACS to be updated to reflect the change in ownership of the assets).
• Separate cash receipts relating to securitised receivables from those which belong to the originator (for direct debits, possibly separating receivables at the point of transmission to BACS).
• Split cash receipts into different types (principal, income and other amounts: VAT service charges and so on). Track payments received in advance of their due date, and allocate the same to outstanding payments at the appropriate time.
• Store transactions between Originator and the SPV (date of sale, price paid, amount outstanding, accrued interest, arrears of income).
• Deal with changes to any of the underlying receivables contracts (which may change a contract's value, outstandings or payment profiles). This can then result in a requirement to make incremental provisions, cash payments to the SPV or simply to reverse the change (some are likely not to be permitted under the terms of the Transaction documents).
• Establish procedures to track any assets sold in breach of warranty, to calculate the repurchase price and to effect the repurchase.
• Run the securitisation provisioning policy, which will normally be different to that of the Originator.
• Ensure that the accounting requirements can be met. These typically require that the SPV's accounts can be produced using the SPV's accounting policies, and also that the consolidated or linked presentation accounts can also be produced using the Originator's accounting policies. Often there are different accounting bases used which means that adjustments are required (for instance, between the rule of 78 and constant yield accounting methods).
• Update financial control processes so that they operate on a multi-company basis rather than on a single company basis, particularly in relation to bank reconciliations.
• Set up a periodic (usually quarterly) reporting cycle to produce the required administrator's reports and to complete the calculations typically required in order to run the transaction (ie: manage the liabilities of the SPV). This involves systems time, the production of dedicated reports, and the attention of key personnel within the organisation.
• Set up reconciliation systems to allow the amount of cash profit extraction from the securitisation to be reconciled to the amount of originator's own profit recognition policy (which will, in all likelihood, be a different amount).

This section examines which aspects of the systems are likely to be relevant to a securitisation transaction.

Running a portfolio of receivables normally involves four basic systems which are referred to in this document as "customers", "collections", "asset management" and "accounting". Some of these functions may be embedded in one system, but the principles tend to remain the same nevertheless.

This arrangement of the systems is typical but not universal. However, in order to write some general comments it is necessary to make some assumptions, and this note is based upon the above understanding as to how receivables processing systems usually work.

COLLECTIONS SYSTEMS

For originators without a branch network, the collection process is often not a separate system, but an interface to BACS together with an [automatic] payments reconciliation system.

For an originator with a large branch network (eg: a bank or building society) the collections system is often a significant and complex affair dealing with over-the-counter payments and relationships with the clearing system in general.

Collections can be split into those which are originator generated (eg: direct debits) from those which are customer originated (eg: standing orders or cheques).

These are systems which typically record the amount owed by each customer of the originator by reference to an "account". The system is usually single company, that is there is no concept that more than one person might own any of the receivables which are managed by it.

Most receivables systems store the amount owed by the customer, the amounts of any payment arrears, the date of the last payment, the date of the next payment, the remaining amounts due, the yield or rate applied to the account and so on. There are usually several deficiencies. In particular, that the system is unlikely to track principal and interest amounts separately (ie: to record the principal amount owing by the customer rather than the simply the total amount owing (which can include arrears of interest and other fees)).

ACCOUNTING

Usually the accounting systems are simply mechanisms for storing information generated by other systems. For instance, it usually the receivables administration system which calculates interests and posts it onto borrower's accounts. The aggregate amount of interest then debited is posted to the general ledger as one figure spanning the entire book. The general ledger system usually only stores summary level information about the receivables book (eg: total principal balance, total arrears and so on).

The general ledger is usually already multi-company - in that it is possible to set up more than one chart of accounts to receive postings from other systems.

CUSTOMERS

Relations with customers are often handled outside the receivables administration system, as customers can have more than one relationship with the originator.

Generally the customer relationship is not affected by securitisation, and so this system is not directly relevant. There are exceptions, for instance, if the originator is a bank, it may be inappropriate to encourage securitised accountholders to make deposits (since there are usually controls on the extent to which securitised borrowers are depositors with the originator). Another example would be a building society where a securitisation caused borrowers to lose membership rights (and so mailing borrowers with notices of AGMs would be inappropriate).

INTERFACES

The databases described above usually rely on a series of interfaces between them to run the administrative operation. Most of the work for securitisation is in the interfaces between the different systems, rather than changes to the systems or databases themselves.

There are three important interfaces: between the receivables system and the collections system, the receivables system and the general ledger and between the general ledger and the collections system.

One of the main financial controls will be in the general ledger, to compare information from the collection system with information from the receivables system. These controls (and the accompanying reconciliations) are usually single company. One of the principal tasks for the systems' administrators is to amend these processes to give effect to a multi-company posting and a multi-company reconciliation.

Over the last few years, Risk Limited has advised a wide variety of originators on securitisations. These have spanned organisations with systems which are good (and not so good), a range of asset classes, and originators with different credit profiles.

The following methodology is typically adopted as the basis of the originator's approach to a securitisation transaction:

1. Establish the rationale for the transaction within the originator.
2. Consider the extent to which originator credit risk can be left in the transaction (and therefore the amount of low-level systems work which can be avoided). Generally, the poorer the originator's credit, the more work is required as:

• cash has be to identified more quickly;
• less reliance is allowed on representations and warranties so a fuller data analysis and audit has to be undertaken;
• little or no credit risk is acceptable on the originator for payments received in advance and in relation to set off risks (eg: credit balances on deposit accounts or amounts which could arise with respect to the originator's other relationships with the customer); and
• tight restrictions are placed upon permitted adjustments to contracts (which in some deals can be absorbed into the transaction structure).

1. Determine the high-level requirements of the transaction (see further below). In particular, it is important to gauge the extent to which certain risks can be accommodated within a structure - for instance, conduit transactions (a particular financing technique) can usually accept a higher level of practical risks than a public securitisation. This is a result of the role which the banks play in conduit transactions.
2. Undertake a systems and procedures review (see further below). Allied to this will be a determination as to the appropriate resources to involve and the amounts of (and timings of) effort which will be required.
3. Produce implementation documents and a structure note (see further below).

Following the above process, in our experience, results in transactions which complete faster and are easier to administer. Generally they are also cheaper to execute.

HIGH LEVEL REQUIREMENTS

Securitisation transactions are basically cash flow driven. This even extends to the way in which the SPV's accounts (in the UK) tend to be produced. Consequently, in attempting to determine exactly what is required of systems and processes it is usually best to start with a definition of the cash flow receipts and cash flow payments to be involved.

For instance, in the UK a typical mortgage-backed security will have a quarterly payment cycle of payments of principal and interest (based upon 3 month libor). The assets underlying this transaction (mortgages) will have monthly payments, some fixed and some variable, of principal and interest, generally calculated (in systems terms) by reference to some originator controlled base rate.

Other high level attributes of the transaction also need to be determined, for instance:

• Only certain assets will be selected for securitisation.
• The debt issued will be placed in the euromarkets.
• An SPV will be used requiring various licences.
• Credit enhancement will be provided by senior-subordination.
• Profit extraction will be effected by means of a receivables trust.
• Interest rate swaps will be required.

and so on.

The above listing can usually be derived from standard heads of terms documents prepared by the relevant investment bank.

With this document in place, it is already possible to distill a variety of practical requirements. For instance, the reporting cycles can be distinguished into daily and periodic work loads, daily to match the collections cycle on the assets and quarterly to match the payments cycle on the liabilities. If a UK tax resident SPV is to be involved, then splits of receipts into principal and interest will be required.

Particular points which can have a significant difference on the amount of work in a transaction are:

• Whether the SPV is likely to have a different accounting policy to the originator at an asset-by-asset level?
• Is a formal separation of principal and income required?
• Is future business with a customer to be included or excluded from the transaction (eg: further advances on a mortgage)?

SYSTEMS AND PROCEDURES REVIEW

Having established some ground rules for the transaction, it is then sensible to analyse the way in which the originator actually carries out its business and operates its systems. NOTE: This section only summarises some of the work involved.

In our experience, the best way to achieve this is to examine the variety of interest groups which typically make up the originator's administrative team. The size of organisation is also relevant - and the larger the operation, the more important it is to be disciplined about the process. It is surprising how little some companies know about the real details of their systems. Discrepancies will also arise in descriptions as to how systems and processes work across different areas of the originator, in particular as to the amount of discretion which is afforded to operators of the systems!

The typical high level interest group structure for a medium-sized organisation would be:

• asset & liability systems
• accounts and financial control
• asset administration

In a large organisation it is possible that some 10 different groups can be identified who may have information relevant to the transaction contemplated.

With each group, the asset life-cycle needs to be plotted and the work flow of the group determined in relation to each stage. For most transactions, the way in which assets are created can be largely ignored (since, securitisations normally deal with assets which have been in existence and "seasoned" on the originator's balance sheet).

In system terms, one of the most interesting pieces of information is the listing of permitted transactions which can be passed across the receivables financing database (that is transactions in the systems sense of the word). A map of the relationships between the systems is needed, together with an indication as to the fields which drive the key interfaces (since these usually need to be changed or amended).

The exact fields which are maintained need to be considered, and whether any of the data fields in the system are unreliable. The ability of the system to produce reports showing receipts by account is also important, and the way in which the overnight accounting and batch processes operate needs to be flexible enough to allow reports to be added.

The best starting point is generally with the bank accounts - how often are they reconciled and typically how great is the amount of "unreconciled" items? To the extent that there are problems or issues with the BACS interface, or any issues with the quality of the main receivables financing system, they usually surface in the financial control process. The extent to which manual reconciliations are carried out is also important. In a securitisation transaction, the amount of reconciliation work inevitably increases.

The accounting policies of the originator need to be established, especially if profit recognition is not on a conventional actuarial basis. Are accruals of income daily or monthly? How are they effected? What is the carrying value of the assets in the chart of account? Are the different classes of assets distinguished by product codes? How does the interface with the receivables financing system work? How does the provisioning policy work (general and specific)? and so on.

All of the above need to be related back to the entries made on the system at the asset level. Typically these should be feeding the general ledger directly via the interface from the receivables financing system. Often there are different product codes or account number structures which are used to drive different accounting policies and postings within the interface. If this is the case, then the securitisation will involve amending these codes and using the existing interface structure to direct the securitisation postings to another part of the general ledger.

The asset life cycle needs to be explored with a particular emphasis on both normal running of an asset and any unusual or discretionary activity which is permitted. For the latter, it is important to find out how the discretion is exercised in systems' terms - since this information can be used later to specify exactly how transactions on the receivables financing system should be related to information to be produced on reports to run the deal.

It is also important to establish the extent to which the terms of the assets can be varied in the course of the administration - for instance, contracts extended or payments forgiven. Often certain elements of the collections process are initiated and managed on other systems which cannot easily pick up information on which account is securitised and which is not. Consequently, there may be a need to revisit the transaction structure to remove certain cash flow items from the deal. On one transaction, the administration of defaulting assets was transferred to another system completely separated from the main receivables financing system. The originator therefore required that the recoveries on enforcement were excluded from the transaction and significant structural changes flowed from this requirement.

Once all of the aspects of the transaction have been considered in the context of the originator's existing capabilities, it is then possible to produce a working document which describes how each part of the transaction will work. The elapsed time to this point can be as little as 1 week and as much as 1 month. It largely depends upon the complexity of the transaction and the way in which the originator's systems and processes work.

In our experience, it is usual for the originator to drive the details of the implementation process based upon their level of knowledge and experience of what is possible. Even with our involvement, this is still very much the way in which transactions proceed - it is simply that Risk Limited can provide technology, experience and knowledge as to what can be accommodated by other elements of the transaction structure.

Risk Limited would typically produce a range of documents which are used by different parts of the organisation and by the originator's professional advisers. There are normally two key elements: a structure note and implementation notes.

This is a document which covers all of the cash flow, legal, tax and accounting issues associated with the transaction. It would usually contain the principal definitions associated with the cash flow mechanics of the transaction, including definitions of principal, income, losses, provisions and the ways in which these amounts flow through any bank accounts involved. A complete analysis of the collections process would also be included.

These are a series of documents which covers the reporting cycles, timetables, and forms the basis of system specifications and enhancements and the procedures for a transaction. These are derived from the structure note and represent internal memoranda for the specialist interest groups identified during the process reviews. It is Risk Limited's practice to take responsibility for the production of these notes, although they rapidly become adopted by the originator directly.

COMPLETING THE TRANSACTION

If the preparation set out above is effectively carried out, it is possible to ensure that even the most complex transactions are completed within short time frames and with a minimum of risk to the originator.

As legal documentation starts, the structure note rapidly becomes less important. It is usual for the note to be updated at the completion of the transaction to reflect any changes which occurred during negotiations.

The principal risks with most transactions are:

• over-engineering the systems solution for asset selection and analysis; and
• under-specifying the work required to run the transaction leaving key financial control issues and reports until after the transaction has closed (when the requirements creep up on the originator who is left to sort out the mess).

Dealing with these is generally a case of ensuring that the relevant areas within the originator are suitably informed as to what is needed of them - and that all requirements and actions are documented in full and in detail.

The work involved can be examined from the perspective of changes to tables and interfaces, and then in terms of the reports and information which can then be produced from the system. There is no panacea however.

The following sections outline the typical nature of the reports required and do not focus on where the changes have to be made in systems terms. The reports can be related to the list of securitisation requirements in section 2 above. By examining the arrangement of the typical originator's systems, it is also possible to see how the reports can be produced from the systems involved.

EXECUTION AND STRUCTURING PROCESS

The amount of systems work during this phase is dependent largely upon the asset class involved.

Unsecured assets will require a considerable amount of analysis. This is best done using static pools of loans (cut by origination month or quarter) and then tracking their performance over time. It is necessary to establish benchmark levels for historic losses, prepayments and delinquencies.

Mortgage assets have their own specialist requirements. As owners of the system normally used by Standard & Poors to analyse mortgage pools outside the US, Risk Limited is ideally placed to advise on the details of what is required.

There are usually also requirements for tables to go into public documents which then have to be audited. Establishing what is needed for these is a matter of precedent (what has been done before) and negotiation with the lead underwriter.

CLOSING A TRANSACTION

This is usually a matter of asset selection (applying pre-defined criteria to pick a portfolio of assets to be securitised), asset-flagging (reflecting the sale transaction and storing relevant information) and the reporting on the assets so chosen.

It is Risk Limited's practice to negotiate a number of concessions to the usual arrangements to protect the originator in terms of potential systems risks during the closing process. This can involve an analysis of possible systems problems and their consequences to ensure that the reports can be produced to the right place at the right time. Without the reports, the transaction normally cannot close.

DAILY REPORTS

A report is required each morning which sets out the cash transactions of the previous day as they relate to the securitisation by payment source, with credits and debits separately shown. This will then be used to make payments to the SPV's bank accounts and as part of the bank account reconciliation process. The report should also show the non-securitised cash movements by source in the same way.

A daily report is usually required setting out unusual financial activity on the receivables financing systems. This is a report which looks for particular transactions being processed against securitised accounts. Each line on the report would provide information allowing the recipient (typically in financial control) to make adjustments and payments into the SPV as a result.

These are produced to allow the calculations necessary to run the securitisation. In the UK, these would be produced quarterly. It is Risk Limited's practice to provide originators with a spreadsheet which contains all of the calculations necessary to run the deal. In this way, the periodic process is simply a matter of collating information from the systems.

If there are differences between accounting policies, profit recognition arrangements, definitions of principal and interest between the transaction and the SPV, then they are typically dealt with at this point (see the next section).

Over the last few years Risk Limited has developed a number of structural features which have proven to be invaluable in saving time and costs for originators. The following list sets out some examples of our approach and the value which they offer.

FAIL-SAFE CLOSINGS

Most securitisations are extremely complex, and so usually fail to close within normal banking hours. It is usual for an originator to tranche in funds to the closing date so that on the morning of closing the originator pays away with the expectation of receiving the proceeds of the securitisation in the afternoon. If the transaction fails to close in good time, the originator is left with a significant overdraft and the originator's clearer is unhappy (and may end up with Bank of England problems as a result).

The alternative is to tranche into the day after closing - but there are problems with banks in doing this because the proceeds of sale will end up on deposit (likely to be in one place) and so can break the large exposures rules. In addition, the deposit is typically made late in the day and receives a poor rate.

Risk Limited has a solution to the above allowing the originator (bank or otherwise) to tranche into the sale date safely and ensures that all necessary deposits are placed into the market early in the morning so that good rates are earned. This is an entirely controlled process which is not affected if there are problems closing the deal.

Splitting receipts into principal and income is usually difficult - since most systems work on an accruals basis. Risk Limited has pioneered the use of the "declining balance" method of cash-type recognition. This is a complex area, but it is possible to achieve remarkable functional results with little or no changes to the operation of the main systems. In order to use these methods it is necessary to structure the transaction documents carefully - and it is usually possible to spot deals which have used this approach from the way in which the prospectus is written!

PROVISIONAL LIST / FINAL LIST MANAGEMENT

Rigid application of the rules about links between Provisional Lists (assets selected at the start of the structuring process) and Final Lists causes a considerable amount of systems work. Risk Limited has successfully negotiated a relaxation of the rules relating to these processes for a number of transactions - considerably simplifying the work required.

FRS5 / LINKED PRESENTATION MANAGEMENT

For transactions that used to be off-balance sheet, FRS5 now stipulates that the SPV's accounts be consolidated with the originator's - albeit shown via a "linked presentation". This can result in a requirement for a dual-accounting process which requires congruent applications of different accounting principles to the same underlying transactions Using techniques pioneered on the Anglo Leasing and Prospect securitisations, it is possible to provide the necessary accounting functions without amending core originator accounting systems.

On these transactions, the SPV's accounts are produced from a series of reports using both accounting and portfolio information. The originator's accounts (in particular the SPV element of them) is produced from the existing accounting systems. Again, it is necessary to reflect the approach adopted in the transaction documents.

CREDIT CARD TRANSACTIONS

Risk Limited has designed and pioneered the use of "disaggregated" structuring technology and has a proprietary interest the only structure successfully used in the market. Further information is available from Risk Limited.

Other Related Work

Risk Limited's Typical Role

Clients / transactions