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Transfers of financial assets may involve special-purpose entities created for the sole purpose of purchasing and holding the financial assets, and issuing securities to finance the assets’ acquisition. Holders of those securities look to the cash flows expected to be collected from the acquired assets as the principal (or sole) source of repayment. At a high level, these entities are commonly referred to as a securitization or asset-backed financing entities.
ASC 860-10-20 defines "securitization" as the process by which financial assets are transformed into securities. Although the financial assets acquired by a securitization retain their identity and legal form (e.g., as receivables or loans), the securities issued by the entity are nevertheless considered surrogates of those financial assets–as the cash flows from those assets are intended to serve as the chief source for repaying those securities. Consequently, securities issued by these entities are often referred to as "beneficial interests" in the financial assets that collateralize them, a concept. Beneficial interests are defined in ASC 860 and discussed further in TS 3 and TS 4.

1.4.1 Shared structural characteristics

Figure TS 1-5, Figure TS 1-6, Figure TS 1-7, and Figure TS 1-8 illustrate the principal structural characteristics of common securitizations. The particulars of each structure, and roles and economic interests of the parties customarily involved with them, vary–sometimes significantly. Nevertheless, the four securitization platforms incorporate certain common characteristics driven by shared commercial and legal considerations that, in turn, have influenced the evolution of the sale accounting model in ASC 860 and how it is applied in practice. The common elements include:
  • Most securitizations use a "two-step" transfer construct. Under these arrangements, the transferor first sells the financial assets to a wholly-owned special-purpose entity intended to be bankruptcy remote (commonly referred to as a "BRE"). The BRE then transfers (sells) the assets to the securitization entity - the "second step" of the transfer. As discussed in TS 3, the two-step process is intended to "legally isolate" the transferred assets from the transferor in the event of the transferor’s bankruptcy or receivership–a condition of keen interest to rating agencies and investors.
    Figure TS 1-5, Figure TS 1-6, Figure TS 1-7, and Figure TS 1-8 illustrate the standard "two-step" transfer configuration seen in practice. The reference to "seller" encompasses both the originator and BRE unless otherwise indicated.
  • By design, most securitization entities do not have the right to freely pledge or exchange acquired financial assets–as the investors want assurance that the cash flows from those assets will be available to service their beneficial interests. Thus, financial assets acquired by the SPE typically can be disposed of only in limited circumstances prescribed in the controlling agreements. As noted above, beneficial interests in securitized financial assets are considered tantamount to the assets themselves. Accordingly, for purposes of one of ASC 860’s sale accounting requirements, interests issued by the securitization entity to third-party investors may serve as the "unit of analysis," as discussed in TS 3.

1.4.2 Participating interest considerations

Given the prescriptive (and potentially onerous) “participating interest” rules in ASC 860, transferors desiring sale accounting typically strive to ensure that the securitization entity acquires the entire financial asset transferred–in contrast to only a portion or a component of the asset. See TS 2 for an extended discussion of ASC 860’s participating interest rules and potential implementation pitfalls. Figure TS 1-5, Figure TS 1-6, Figure TS 1-7, and Figure TS 1-8 assume that the SPE in each instance acquires the entirety of the financial assets transferred to it, consistent with market practice.

1.4.3 Consolidation considerations

As discussed in TS 3, a transferor’s consideration of ASC 860’s sale accounting rules may be a moot exercise if the transferor is required to consolidate the transferee, based on applying the guidance in ASC 810, Consolidation. If the transferee is included in the consolidated financial statements of the transferor, the transferred assets continue to be reported on the consolidated entity’s balance sheet, and beneficial interests in those assets held by third parties are reported as liabilities.

1.4.4 Multi-seller asset-backed commercial paper conduit

To accelerate receipt of operating cash flows, companies sometimes transfer (sell) trade receivables or short-term consumer loans to a multi-seller asset-backed commercial paper conduit ("conduit"), a limited-purpose securitization entity sponsored and administered by a bank. As the name implies, these entities are structured to acquire receivables from numerous originators (sellers), financed by issuing commercial paper. Although cash collections on the acquired receivables are intended to fully repay the commercial paper, the sponsor bank (sometimes in tandem with other banks) provides liquidity support and credit enhancement to the vehicle. These facilities provide additional assurance to investors that the conduit will have the ability to redeem its commercial paper when due, even in the event of major market disruptions or if the conduit’s assets experience significant unanticipated credit issues. Each seller of receivables also provides credit support to the conduit through the deferred purchase price construct, discussed below.
For various reasons, a conduit typically does not directly purchase the receivables sold by each originator. Rather, as Figure TS 1-5 illustrates, the sponsoring bank of the conduit (or, if multiple conduits are providing financing, one of the conduits’ sponsoring banks), in its capacity as agent for the conduit, will acquire legal title to the receivables transferred by each seller. The agent bank holds the receivables for the benefit of the participating conduits, each of which in turn acquires a beneficial interest in the transferred receivables corresponding to its financing commitment.
In exchange for selling the receivables to the agent bank, the seller receives cash from the conduits for a portion of the purchase price, and a beneficial interest (an obligation of the conduits) for the remainder. This beneficial interest, which is subordinated to the conduits’ investment in the receivables pool, is commonly referred to as the "deferred purchase price," or DPP, in the industry. The DPP will absorb first any credit losses incurred on the receivables sold, as well as collection timing risk. The DPP is sized to ensure that, under virtually all scenarios, the conduit will not incur a loss on its investment in the receivables pool.
Most financing arrangements with conduits are "revolving;" that is, the seller continues to periodically transfer receivables to the agent bank in exchange for cash and DPP until the arrangement terminates at a prescribed date. Assuming the conduit has fully funded its contractual financing commitment, the cash component of the purchase price for these subsequent transfers can be funded solely from collections from receivables previously sold to the agent bank. The difference between the cash paid and the all-in purchase price of the transferred receivables is "funded" by a corresponding increase in the seller’s DPP.
At the termination date prescribed, the seller may no longer sell additional receivables to the agent bank, and the arrangement enters "amortization" status. Subsequent collections on the receivables previously transferred are used first to repay the conduit’s investment in the pool. Any remaining collections inure to the seller (return of its DPP). In certain cases, the seller may wind up the arrangement by exercising a servicer clean up call after the principal amount of the receivables pool has declined to a prescribed level.
The banking entity that sponsors a conduit is frequently its consolidator (primary beneficiary) under ASC 810, Consolidation, stemming from the bank’s involvement in the conduit’s design, bank-provided credit enhancements and liquidity facilities, and the bank’s role as the conduit’s administrator. Assuming that a conduit owns financial assets sourced from multiple sellers at any point in time, it would be rare for a seller to consolidate the conduit.
Figure TS 1-5 illustrates the typical conduit financing arrangement and the principal parties involved.
Figure TS 1-5
Multi-seller asset-backed commercial paper conduit
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(1) Multiple sellers will transfer eligible financial assets to the typical asset-backed commercial paper conduit; only one transferor is shown here for convenience.
(2) An agent bank (usually the sponsor of the conduit) acquires legal title to the financial assets sold by the BRE, and holds them for the benefit of the conduit, which funds the purchase price. If multiple conduits are involved, each will provide funding in proportion to its financing commitment.
(3) Typically, a limited-liability corporation established in Delaware.
(4) One or more banks will provide liquidity backup facilities intended to fund any cash flow shortfalls between maturing commercial paper and cash inflows from assets or newly-issued commercial paper.
(5) Program-wide credit enhancement, typically written by one or more banks, serves as a backup facility to fund any shortfalls remaining after liquidity facilities have been drawn.
(6) The conduit administrator (usually the sponsoring bank) directs the significant operations of the conduit, including negotiating with sellers, maintaining support arrangements, and managing the commercial paper program.
(7) Typically, a service company that provides officers and ensures that the conduit observes all corporate formalities. The owner receives dividends in exchange for its nominal equity investment.
(8) Each seller services the financial assets sold to the agent bank, and reinvests collections received on those assets to fund periodic sales of additional assets to the agent bank.

1.4.5 Securitizations of commercial loans (issuers of CLOs)

Issuers of collateralized loan obligations (CLOs) typically invest in non-investment grade loans made to commercial and industrial companies. Sponsors of CLO entities will typically acquire the loans from originating banks and hold ("warehouse") them until it is advantageous to securitize them. At that point, the loans are aggregated and sold to the securitization entity (typically incorporated in the Cayman Islands) in exchange for a series of tranched notes (the CLOs). The sponsor typically arranges for various underwriters to purchase the notes intended to be sold to investors ("offered notes"), while retaining certain of the notes to comply with federal credit risk retention rules and for commercial reasons.
Most CLO issuances have these features:
  • Reinvestment of collections: during the so-called reinvestment period, principal collections on the CLO’s loan collateral are used to purchase new loans from the sponsor or from the market. The reinvestment period typically encompasses the first three or four years of the CLO’s life. Thereafter, principal collections on the loans are used to repay the notes, in order of their seniority.
  • Optional redemption arrangements: after the so-called "non-call period" expires (typically, two or three years after the CLO has been launched), holders of a majority or super majority of the CLO’s subordinated notes can instruct the collateral manager to sell the CLO’s loan collateral, provided certain conditions have first been satisfied. The proceeds are used to redeem the senior notes at par and accrued interest; the remaining proceeds are distributed to the subordinated noteholders. This feature allows the holders of the subordinated notes (the CLO’s substantive equity, the debt-like form notwithstanding) to monetize their investment at an optimal time.
Figure TS 1-6 illustrates the typical CLO structure and the principal parties involved. As the diagram indicates, the sponsor of a CLO (or an affiliated entity) typically serves as the entity’s collateral manager. Consequently, because many sponsors also hold a consequential position in the CLO’s notes, they often consolidate the issuer. However, if a sponsor holds no interest (or only an insignificant interest) in a managed CLO, it may not be required to consolidate the entity under ASC 810. Strictly speaking, the term "CLO" refers to the notes issued by the securitization entity, collateralized by the loans held by the issuer. However, in practice, the term "CLO" is commonly used as a shorthand reference to the entity that issues these securities–not the securities themselves.
Figure TS 1-6
Securitizations of commercial loans (issuers of collateralized loan obligations)
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(1) Typically, the Issuer is an exempted company incorporated with limited liability in the Cayman Islands. The Issuer owns the Co-issuer, usually a Delaware limited liability company or limited partnership.
(2)Frequently an affiliate of the sponsor, the collateral manager directs the significant activities of the Issuer, including selecting loan collateral to be purchased by the Issuer, monitoring the loan collateral, and taking actions to preserve the collateral’s value.
(3)Issued for nominal consideration (and entitled to only insignificant economics), the Issuer’s ordinary shares are typically held in trust by an administrator domiciled in the Cayman Islands. The administrator provides various corporate management functions on behalf of the Issuer.
(4)The collateral manager’s fee consists of three components: a senior fee, subordinated fee, and an incentive fee. Receipt of the incentive fee is contingent upon the subordinated noteholders having received first a prescribed return on their investment.

1.4.6 Securitizations of credit card receivables

Banks and other financial institutions that issue credit cards frequently finance their outstanding balances by securitizing them under a master trust arrangement. Typically, on an ongoing (revolving) basis, pursuant to the terms of a forward contract, the sponsor-transferor sells new charges or advances on eligible accounts to the master trust immediately or shortly after the receivables have been originated. In exchange, the transferor receives cash (if available) and a corresponding increase in its interest in the master trust. Cash collections on transferred receivables are periodically disbursed to beneficial interest holders and various reserve accounts, all in accordance with contractual "waterfalls" (priority of payments) whose provisions can be complex.
Under the typical master trust arrangement, one or more issuing trusts will periodically issue securities to investors. Each issuing trust owns an interest in the master trust’s assets, frequently evidenced by a collateral certificate. The master trust remains the legal owner of the receivables acquired from the originator. The sponsor’s beneficial interests in the securitization typically include a transferor’s interest in the master trust, as well as a certificate issued by the master trust that provides credit enhancement to the issuing trust’s third-party investors.
A feature largely unique to credit card securitizations consists of removal-of-accounts provisions, or ROAPs. These arrangements allow a sponsor to periodically remove eligible transferred receivables from the master trust, subject to satisfying certain conditions, in exchange for a corresponding reduction in the sponsor’s transferor interest. The sale accounting implications of ROAPs are discussed in TS 3.
The sponsor/transferor frequently services the credit card receivables sold to the master trust (and thus makes decisions that significantly impact the trust’s economic performance), and holds interests in the trust that expose it to potentially significant benefits or losses. Thus, although transfers of credit card receivables are exchanges subject to ASC 860, sponsors of these securitizations frequently consolidate the master trusts under ASC 810.
Figure TS 1-7 illustrates the typical credit card securitization structure and the principal parties involved.
Figure TS 1-7
Securitizations of credit card receivables (revolving structure)
(1) The master trust typically issues a subordinated interest to the BRE that provides structural credit enhancement to the securities held by investors.
(2) Represents an undivided ownership interest in the assets of the master trust.
(3) Typically, the transferor or an affiliate of the transferor.

1.4.7 Securitizations of commercial real estate loans

In a securitization of commercial real estate loans, one or more loans are transferred to a trust (frequently a New York common law trust) created in accordance with a pooling and servicing agreement. The trust typically issues pass-through certificates (commercial mortgage-backed securities, or CMBS) to various investors. Certain of the securities are typically retained by the sponsor (or by a designated third-party purchaser) to comply with the federal credit risk retention rules.
Numerous parties are typically involved with directing or supervising the activities of the issuer of CMBS. This stems in large measure from the characteristics of the underlying loans and the collateral that secures them; real estate loans can be intrinsically complex, and any workouts or restructuring of these loans may entail considerable judgment and involve numerous parties. Consequently, to ensure that appropriate diligence and care is exercised in these circumstances (and in compliance with the provisions of the pooling and servicing agreement), the parties highlighted in the diagram–the special servicer, the directing certificate holder, and the operating advisor–are involved with these structures in a variety of capacities. These include decision-making, consultation, and review.
Figure TS 1-8 illustrates the typical structure for securitization of commercial real estate loans. As noted in Figure TS 1-8, typically the directing certificate holder must approve all significant decisions proposed by the special servicer. In addition, the directing certificate holder usually has the right to unilaterally remove the trust’s special servicer and appoint a replacement, subject to satisfying rating agency conditions. Accordingly, depending on the facts and circumstances, the directing certificate holder may be required to consolidate the trust under ASC 810.
Figure TS 1-8
Securitizations of commercial real estate loans
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(1) If a loan experiences a special servicing event, as defined in the pooling and servicing agreement (default, missed payments, etc.), the special servicer undertakes remedial action (loan workout, foreclosure, etc.) deemed most optimal to the trust (e.g., greatest net present value), subject to approval and oversight by the directing certificate holder.
(2) Typically appointed by a majority of the trust’s then-controlling class (one or more tranches of the subordinated certificates), the directing certificate holder must consent to (or advise with respect to) certain actions proposed by the special servicer. The directing certificate holder usually has the right to replace the special servicer with or without cause, and appoint a replacement.
(3) The operating advisor provides non-binding advice to the special servicer regarding potential loan remediation strategies, and reviews or prepares various reports as prescribed in the pooling and servicing agreement.
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