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(1) Basic Cash Flow Analysis Recognize that transaction cash flow analysis can be thought of as equivalent to creating a series of pro forma income statements.

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Presentation on theme: "(1) Basic Cash Flow Analysis Recognize that transaction cash flow analysis can be thought of as equivalent to creating a series of pro forma income statements."— Presentation transcript:

1 (1) Basic Cash Flow Analysis Recognize that transaction cash flow analysis can be thought of as equivalent to creating a series of pro forma income statements for the issuer. Recognize that, because cash flow analysis is based on projections of what may occur in the future rather than a reporting of what occurred in the past, assumptions are a critical component in the analysis. Recognize that the assumptions used must be appropriate to the situation. Be able to identify which components of collateral cash inflows the issuer actually owns. Distinguish between a variety of cash flow allocation rules and payment patterns. Be able to identify the purpose of "triggers" in transaction structures. Upon completion of this module you will be able to: Introduction cf100 (2) Click on the Continue button below to begin an exploration of basic cash flow analysis.

2 The Issuer's Pro Forma Income Statements Click on the Continue button to learn why assumptions play such an important role in any cash flow analysis. cf200 Pro forma income statement First, estimate, period by period, the cash inflows that the issuer will receive. From those amounts, subtract any expenses that the issuer must pay, which may or may not include required debt service payments. Revenues Expenses (1) (2) (3) If debt service is not included in expenses, compare revenues after expenses with required debt service payments. (4)

3 Assumptions Are a Critical Component Click on the Continue button to make sure you’re starting in the right place, with just the cash flow stream to which the issuer has access and nothing more. cf300 (1) Image of a person looking into either a crystal ball or into the far distance using a telescope (1a) Based on the recent performance of this originator’s loans, defaults are likely to be higher than normal. (1c) A rapidly rising interest rate scenario will put maximum stress on the ability of the fixed-rate asset cash flow to support floating-rate debt service payments. (1b) Even if default rates remain low, very little is likely to be recovered when obligors default. Keep the following points in mind when you think about whether assumptions are appropriate or not: The scenarios that you construct should not produce "expected case" results. Unless you are testing a transaction at the ‘B’ or ‘BB’ rating category, your assumptions may seem harsh. But don’t be flustered if someone tells you that your assumptions are out of the realm of modern experience. Remember: a ‘AAA’ depression is also out of the realm of modern experience, so when you are testing a transaction against a ‘AAA’ stress scenario, it is very likely that the securities with lower ratings will not be paid in full. Your assumptions should be internally consistent. For example, assuming that prepayment speeds will be very high would be consistent with assuming that interest rates will fall to historically low levels; it would be inconsistent with assuming that interest rates are rising and will remain at higher-than-current levels. Sometimes, in order to maintain this internal consistency, it may be necessary to do two separate cash flow analyses based on two separate sets of assumptions that stress the cash flow in different ways. (2)

4 Which Cash Flows Does the Issuer Actually Own? cf400 = Portion of each asset retained by seller This type of retained interest is quite different from a deeply subordinated class which provides credit support to other more senior classes of securities and which the originator/sponsor may take back. This type of retained interest is, in fact, senior to all of the securities, regardless of their rating, because the cash needed to satisfy it comes out of the asset cash flow before anything is allocated to the issuer. Before we start thinking about stressing the cash flows, we need to understand what cash flow has actually been sold or pledged to the issuer and what cash flow has been retained by the seller. It is common for the seller of the assets to retain a portion of the cash flow that the assets are expected to generate. (3) (1) (2) = 1/12 of 1% times principal balance of each contract (4) (5) (6) Click on the Continue button to learn how to figure out what the issuer owns.

5 cf500 Your best guide to figuring out what has been sold or pledged is the basic transaction document. If the rated securities are some form of debt, either notes or bonds, this document is likely to be the indenture, although it may be the related sale and servicing agreement or purchase and sale agreement; if the securities are some form of trust certificates, this document is the pooling and servicing agreement or sometimes the trust agreement. The section that you will need to refer to is often found in Article II of the document and is usually titled "Conveyance of the Assets." This portion of the document defines exactly what assets are being transferred to the issuer and what portion of the assets is not included in the transfer. Click on the Continue button to practice what you’ve learned so far. How Do I Know Which Cash Flows the Issuer Owns?

6 Practice: What Does the Issuer Own? Click on the Continue button when you are finished to see what other guidance you can derive from the transaction documents. cf600 The following is the first paragraph of Section 2.1, "Sale and Conveyance of Assets," from a Purchase and Sale Agreement. In this case, what has not been sold to the Issuer? Click on one of the boxes below to indicate your answer. In consideration of the Issuer’s delivery to, or upon the order of, the Seller of Notes and Certificates, the Seller does hereby sell, transfer, assign, set over and convey without recourse to the Issuer, but subject to the terms and provisions of this Agreement, the Trust Agreement and the Indenture, all of the right, title and interest of the Seller in and to the Group 1 and Group 2 Mortgage Loans, together with any amounts received after the Cut-off Date with respect to the Initial Mortgage Loans or after a Subsequent Cut-off Date with respect to the Subsequent Mortgage Loans (other than the Seller’s Yield), all of the rights of the Seller under the Mortgage Loan Purchase Agreement and all other assets of the Trust Estate other than any rights under the Cap Agreements. The Seller shall assign all of the right, title and interest of the Seller under the Cap Agreements to the Issuer pursuant to the Class 1A Assignment Agreement and the Class 2A Assignment Agreement. Seller’s Yield Seller’s rights under the Cap Agreements Seller’s rights under the Mortgage Loan Purchase Agreement Seller’s right, title, and interest in and to Group 1 Mortgage Loans, other than the Seller’s Yield with respect to the Group 1 Mortgage Loans

7 In consideration of the Issuer’s delivery to, or upon the order of, the Seller of Notes and Certificates, the Seller does hereby sell, transfer, assign, set over and convey without recourse to the Issuer, but subject to the terms and provisions of this Agreement, the Trust Agreement and the Indenture, all of the right, title and interest of the Seller in and to the Group 1 and Group 2 Mortgage Loans, together with any amounts received after the Cut-off Date with respect to the Initial Mortgage Loans or after a Subsequent Cut-off Date with respect to the Subsequent Mortgage Loans (other than the Seller’s Yield), all of the rights of the Seller under the Mortgage Loan Purchase Agreement and all other assets of the Trust Estate other than any rights under the Cap Agreements. The Seller shall assign all of the right, title and interest of the Seller under the Cap Agreements to the Issuer Pursuant to the Class 1A Assignment Agreement and the Class 2A Assignment Agreement. Seller’s Yield Seller’s rights under the Cap Agreements Seller’s rights under the Mortgage Loan Purchase Agreement Seller’s right, title and interest in and to Group 1 Mortgage Loans, other than the Seller’s Yield with respect to the Group 1 Mortgage Loans

8 Use the Transaction Documentation as a Guide Click on the Continue button to review the components of incoming cash flow. cf700 The documentation for any transaction includes sections outlining what cash is expected to be received and how that cash should be allocated between: Expenses, Debt service, and Distributions to holders of the issuer’s equity. These sections can serve as a useful guide to possible sources and uses of funds, but don’t fall into the trap of assuming that the list included in the documents is exhaustive. As you read documents produced by a variety of law firms, it will become obvious that different firms have different drafting styles; some are very detailed in their drafting while others rely heavily on generalities and catch-all phrases. You need to bear this in mind in deciding whether the description of sources and uses found in the transaction documents is adequate. But, as you become more experienced, you will also recognize that the way in which some documents are drafted leaves much to be desired, and your comments on the documents will include suggestions as to where additions and/or corrections should be made. Pro forma income statement Revenues Expenses Issuer’s expenses Debt service Distributions to holders of equity (2) (3) (4) (1)

9 Components of Incoming Cash Flow Click on the Continue button to consider what interest cash flow is expected to be received in a relatively simple case. cf800 Interest Principal Fees (1) We have emphasized over and over again that the securitized assets are the issuer’s only source of cash flow. While that is basically true, unless overcollateralization is the only source of credit enhancement and liquidity support, it is likely that there will also be non-asset cash flow coming in to the issuer’s accounts. For example, if there is a liquidity mechanism, your cash flow analysis will need to take into account cash inflows, either from servicer advances or from draws on a reserve fund or a letter of credit, that compensate for asset- level delinquencies. And if there is third-party credit enhancement or if a reserve fund supplies all or a portion of the credit support, the analysis should reflect non-asset cash inflows at the point when defaulted assets are written off and losses are taken. But before we get ahead of ourselves, let’s focus first on the factors that can affect the flow of scheduled interest and principal even if there are no delinquencies and no defaults because you will need to incorporate assumptions about these factors into your analysis. (2) (3)

10 For certain asset classes, such as residential mortgage loans, interest is probably the most straightforward component of the asset cash flow: so long as an asset is outstanding and not in default, it should generate interest income equal to the outstanding principal balance of the asset multiplied by the then-current interest rate applicable to the asset. The result of this calculation is then divided by the appropriate number of months to arrive at the amount of interest earned during one month or one quarter rather than an entire year. Let’s concentrate on the simple case first: fixed-rate assets. Click on the Start button to begin. Incoming Interest Cash Flow: The Simple Case cf900 = Outstanding principal balance X Current interest rate Number of months since last payment Interest earned since last payment Start Click on the Start button to begin. When you have finished, click on the Continue button to consider the case of floating-rate assets.

11 For certain asset classes, such as residential mortgage loans, interest is probably the most straightforward component of the asset cash flow: so long as an asset is outstanding and not in default, it should generate interest income equal to the outstanding principal balance of the asset multiplied by the then-current interest rate applicable to the asset. The result of this calculation is then divided by the appropriate number of months to arrive at the amount of interest earned during one month or one quarter rather than an entire year. Let’s concentrate on the simple case first: fixed-rate assets. Click on the Start button to begin. cf900a = Outstanding principal balance X Current interest rate Number of months since last payment Interest earned since last payment Even in the case of fixed-rate loans, describing the interest computation is easier than actually modeling it when you are dealing with a pool of hundreds or even thousands of assets! Unless all of the assets had the same interest rate, which is almost never the case, you would have to model the scheduled cash flow for each asset separately in order to arrive at a very precise estimate of aggregate scheduled interest payments. If, instead, you were to estimate scheduled interest using the weighted average coupon of all of the assets in the pool as of the date when the related transaction closed, you would lose some degree of precision, because, as assets are prepaid voluntarily and as defaults occur, the weighted average coupon will change. 1 of 2Use the forward and back arrows to navigate. When you have finished, click on the Continue button to consider the case of floating-rate assets. Incoming Interest Cash Flow: The Simple Case

12 For certain asset classes, such as residential mortgage loans, interest is probably the most straightforward component of the asset cash flow: so long as an asset is outstanding and not in default, it should generate interest income equal to the outstanding principal balance of the asset multiplied by the then-current interest rate applicable to the asset. The result of this calculation is then divided by the appropriate number of months to arrive at the amount of interest earned during one month or one quarter rather than an entire year. Let’s concentrate on the simple case first: fixed-rate assets. Click on the Start button to begin. cf900b = Outstanding principal balance X Current interest rate Number of months since last payment Interest earned since last payment When you have finished, click on the Continue button to consider the case of floating-rate assets. 2 of 2 Use the forward and back arrows to navigate. The preferred alternative is to divide the pool into sub-pools, called rep lines, grouping together assets with similar interest rates and payment terms. For example, for a pool of fixed rate auto loans, the loans with an APR of between 6% and 7% and a remaining term to maturity of between 55 and 60 months might be aggregated into Rep Line 1; loans with an APR of between 6% and 7% but a remaining term of between 61 and 66 months might be aggregated into Rep Line 2; and so forth. The number of rep lines depends upon how diverse the pool is, but 5 to 10 rep lines is typical. Cash flows for the entire pool are generated by treating each rep line as a single loan. The interest component attributable to each rep line is calculated using the weighted average coupon for all of the loans that make up that rep line’s sub-pool and assuming the weighted average remaining term for those loans. The results are not as precise as those that would be produced by using a loan-by-loan model, but they are adequate. Incoming Interest Cash Flow: The Simple Case

13 An even thornier modeling problem is posed by assets with variable or floating interest rates. What should you assume about the level to which these rates may rise or fall over the life of the transaction? Click on the Start button to learn why there is no easy answer to this question. Incoming Interest Cash Flow: Floating-Rate Assets cf1000 When you have finished, click on the Continue button to learn about portfolio yield, the credit card equivalent of interest income. Start Click on the Start button to begin.

14 An even thornier modeling problem is posed by assets with variable or floating interest rates. What should you assume about the level to which these rates may rise or fall over the life of the transaction? Click on the Start button to learn why there is no easy answer to this question. Incoming Interest Cash Flow: Floating-Rate Assets cf1000a The downside of higher rates is that they are likely to lead to an increase in defaults because they will make it more difficult for obligors to meet their payment obligations. But the upside is that they should produce more interest income which the issuer can use to pay interest on the securities. So, which aspect of the transaction should you stress? The ability of the credit enhancement to handle more defaults triggered by higher interest rates? Or the ability of the current level of interest cash flow to satisfy the issuer’s payment obligations? Use the forward and back arrows to navigate. 1 of 3 When you have finished, click on the Continue button to learn about portfolio yield, the credit card equivalent of interest income.

15 An even thornier modeling problem is posed by assets with variable or floating interest rates. What should you assume about the level to which these rates may rise or fall over the life of the transaction? Click on the Start button to learn why there is no easy answer to this question. Incoming Interest Cash Flow: Floating-Rate Assets cf1000b In the case of residential mortgage loans, the choice is an easy one: you should stress the credit enhancement by stressing the ability of the obligors to make payments based on higher interest rates. In most cases, the securities issued in connection with securitizations of variable or floating rate assets also have variable or floating rates. So, when the index to which the coupons on the underlying assets are tied rises, it is likely that the index to which the securities are tied is also rising. Consequently, the extra interest income produced by higher rates on the underlying assets isn’t fluff in the transaction; the issuer needs those additional funds to cover its obligations that are now higher as well. Use the forward and back arrows to navigate. 2 of 3 When you have finished, click on the Continue button to learn about portfolio yield, the credit card equivalent of interest income.

16 An even thornier modeling problem is posed by assets with variable or floating interest rates. What should you assume about the level to which these rates may rise or fall over the life of the transaction? Click on the Start button to learn why there is no easy answer to this question. Incoming Interest Cash Flow: Floating-Rate Assets cf1000c Often, the general practice is to assume that the interest rates applicable to all of the underlying loans increase to their caps as quickly as possible. If the loans do not have interest rate caps, there may be a generic assumption used for that type of assets in that particular market. For example, the assumption made with respect to uncapped residential mortgage loans in most European countries is that the rate rises rapidly to 15% and remains at that level for several years. In some instances, it may be necessary to model the path of an interest rate index more specifically. We’ll cover the topic of interest rate modeling when we discuss floating rate securities. Use the forward and back arrows to navigate. 3 of 3 When you have finished, click on the Continue button to learn about portfolio yield, the credit card equivalent of interest income.

17 Portfolio Yield Click on the Continue button to learn about the assumptions made with respect to portfolio yield in modeling most credit card transactions. cf1100 Finance Charges Fees Interchange Portfolio yield is a concept that is applied primarily to credit card transactions and is the credit card equivalent of interest income. Portfolio yield generally consists of three types of income; in some instances, it may include two additional components. Click on each of the terms to the left to read about the categories of income that make up portfolio yield. Recoveries Receivable Discount Click on each of the terms to the left. There is considerable month-to-month variability in the "interest" component of credit card collections. For example, yield tends to be higher in January and February because cardholders are more likely to leave balances outstanding for longer periods of time following the year-end holidays. Portfolio yield is also affected by the percentage of "convenience user" accounts in a pool. In addition, the portfolio yield earned by one credit card issuer can be significantly different from the yield earned by competing credit card issuers. These differences grow out of differences in pricing, product mix, and account solicitation strategies. You will need to factor originator-specific portfolio management choices into the assumptions you use in modeling the cash flows for each transaction.

18 cf1100 cont. Finance charges: The finance charge billed to an individual obligor represents the amount of interest due on the obligor’s unpaid account balance at the end of the grace period. Fees: Fees include annual membership fees, late payment fees, and other penalty fees assessed for such things as charges in excess of an obligor’s credit limit. Interchange: Interchange represents the fee collected by the issuer of the credit card for taking credit risk and for funding the receivables balances during the cardholder grace period. This concept is best explained using an example. Suppose that you paid for a meal in a restaurant with a credit card, and the total bill came to $100. The contractual agreement between the restaurant that accepted your credit card in payment for the meal and the card system may allow the credit card issuer to pay the restaurant 98% of the amount charged rather than 100%. Thus, the credit card issuer pays the restaurant $98. When the credit card issuer receives payment from you, it is for the full amount that you charged, or $100. The credit card issuer gets to keep the $2 difference for taking the risk that you would not make your payment and for paying the restaurant in advance of receiving payment from you. That $2 represents the "interchange" on your $100 transaction. Depending on the rating of the credit card issuer, Standard & Poor’s may give partial credit to interchange income in rating a credit card transaction. Because interchange is typically reported as a component of yield, credit for interchange income is reflected as an adjustment to the assumption made with respect to the credit card issuer’s steady-state yield. Recoveries: Recoveries are amounts that are ultimately received with respect to charged-off receivables. Receivable discount: The credit card issuer may reclassify a portion, usually between 1% and 5%, of principal collections as finance charge collections. This reclassification, known as discounting, is only made with respect to principal collections that are not needed either to be reinvested in additional receivables during the revolving period or to be used to pay down securities. As is the case with regular finance charges, reclassified principal collections can be used to cover servicing fees, interest, and defaults.

19 Portfolio Yield Assumptions cf1140 In recent years, competition among issuers of credit cards has put downward pressure on portfolio yields. Periodic campaigns have also been mounted to put a legal cap on the amount of interest that issuers of credit cards can charge to cardholders. These factors mean that, in modeling the cash flows for a credit card transaction, it makes sense to assume that, during periods of stress, the amount of interest available might be substantially reduced. In most cases, portfolio yield is limited to 11% or 12% in ‘AAA’ scenarios and to 12% in ‘A’ scenarios, and little credit is given to an issuer’s ability to charge higher interest rates in a stressed economic environment. At the ‘BBB’ category, however, if the pool is well-managed and geographically diversified, you would expect there to be less pressure on price in a rising loss environment. It is likely that the entire industry would be suffering and that price competition would abate, allowing credit card issuers to raise their APRs in order to offset losses. For this reason, in a ‘BBB’ combined-stress scenario, portfolio yield is assumed to be 75% of its expected steady-state level over an 18-month period. Portfolio yield is limited to: 11% or 12% in ‘AAA’ scenarios 12% in ‘A’ scenarios 75% of steady-state level in ‘BBB’ scenarios As you will soon see, the assumption you make about portfolio yield for a credit card transaction is particularly important because yield dictates not only how much income is available to the issuer to cover expenses and interest on the securities, but also whether the structure is robust enough to cope with shortfalls related to delinquencies and defaults. Click on the Continue button for a practice exercise on portfolio yield.

20 Practice: Portfolio Yield Click on the Continue button to move on to the principal component of cash inflows. cf1150 Finance charge Interchange Recoveries Receivable discount A series of definitions will appear in the box below. Match the corresponding term with the definition by dragging the term into the box. If your choice is correct, it will be accepted, and you can click on the Next button to continue with the practice. If your choice is not correct, the term will bounce back to the list, and you must try again. Click on the Start button to begin. Start Click on the Start button to begin. Next

21 Finance charge: The amount of interest due on the obligor’s unpaid account balance at the end of the grace period. Interchange: The fee collected by the credit card issuer for taking the risk that the cardholder will not honor his or her obligation to make payments on the account and for reimbursing vendors in advance of receiving the corresponding payments from cardholders Recoveries: Amounts received after the related receivables have been charged off Receivable discount: A portion of principal collections that is reclassified as finance charge collections

22 Principal payments on the underlying assets are treated differently depending on whether the structure is amortizing or revolving: In an amortizing structure, whatever principal is received must be used to pay down the principal balance of securities. In a revolving structure, during the revolving period, principal receipts are re-invested in new assets; thereafter, principal receipts are used to pay down the balance of the securities. Incoming Principal Cash Flow cf1200 Click on the Continue button to take a closer look at principal receipts in the context of a revolving structure.

23 Click on each of the topics below to learn more about assumptions that apply during the revolving period. Revolving Structures During the Revolving Period cf1300 (c1300c) Purchase Rate (c1300a) Introduction (c1300b) Reinvestment Example (c1300d) Example Continued (c1300e) Negative Arbitrage When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends. When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. (c1300f) Purchase Rate Assumptions

24 Introduction The "new" assets that are added to a revolving pool during the revolving period are, in one sense, not new at all: they do not represent amounts owed by brand new obligors whose accounts were not included in the original pool; instead, they represent the new balances owed by all of the same obligors with respect to the accounts that were included in the original pool. Let’s look at a hypothetical credit card transaction to see how this works. Click on the next topic. Revolving Structures During the Revolving Period cf1300a (c1300a) Introduction (c1300d) Low Purchase Rate Example When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. (c1300c) Purchase Rate (c1300b) Reinvestment Example (c1300e) Negative Arbitrage (c1300f) Purchase Rate Assumptions When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends.

25 At issuance Revolving Structures During the Revolving Period cf1300b (c1300a) Introduction When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. Balance of receivables as of cut-off date $150,000,000 Original principal balance of securities issued $150,000,000 First month’s activityPrincipal collections received in first month after securitization $1,500,000 New purchases made by cardholders in first month after securitization..$1,800,000 Principal collections invested in "new" cardholder balances in first month after securitization $1,500,000 Balance of receivables after reinvestment $150,000,000 Principal balance of securities at end of first month $150,000,000 Seller’s interest at end of first month $300,000 (1) (2) (3) (4) (5) (6) (7) (8) (c1300c) Purchase Rate (c1300b) Reinvestment Example (c1300e) Negative Arbitrage (c1300f) Purchase Rate Assumptions When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends. (c1300d) Low Purchase Rate Example Reinvestment Example

26 Purchase Rate Clearly, the relationship between the rate at which the underlying obligors pay off their balances and the rate at which they make new purchases is critical to maintaining the level of assets in the pool during the revolving period. The rate at which the obligors make new purchases and incur new charges on their accounts is referred to as the purchase rate. If the aggregate purchase rate falls below the aggregate repayment rate, the issuer will be forced to hold some or all of the repaid principal in a short-term account, the funds in which can only be invested in relatively low-yielding investments. As a result, it may become impossible for the issuer to cover its interest expense using interest earned on the pool of assets plus the account balances. If this were to occur, it would be necessary to terminate the revolving period ahead of schedule. This situation highlights the fact that maintaining equality between the assets and the liabilities of a securitization is not necessarily sufficient to keep the transaction afloat. Normally, the balance of the issuer’s assets must be greater than or equal to the balance of the outstanding securities. But, in any event, the assets must be capable of generating interest income that, in the aggregate, is sufficient to cover the interest that is accruing on the outstanding securities. Let’s continue our example to see what would happen if the purchase rate were lower. Revolving Structures During the Revolving Period cf1300c (c1300a) Introduction (c1300d) Low Purchase Rate Example When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. (c1300c) Purchase Rate (c1300b) Reinvestment Example (c1300e) Negative Arbitrage (c1300f) Purchase Rate Assumptions When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends.

27 Revolving Structures During the Revolving Period cf1300d (c1300a) Introduction (c1300d) Low Purchase Rate Example When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. (c1300c) Purchase Rate (c1300b) Reinvestment Example (c1300e) Negative Arbitrage (c1300f) Purchase Rate Assumptions When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends. Low Purchase Rate Example Second month’s activityPrincipal collections received in second month after securitization $4,500,000 New purchases made by cardholders in second month after securitization.$2,000,000 Principal collections invested in "new" cardholder balances in second month after securitization $2,000,000 Remaining principal collections $2,500,000 Principal collections deposited in reserve account in second month after securitization $2,500,000 Balance of receivables after reinvestment $147,500,000 Balance of reserve account $2,500,000 Principal balance of securities $150,000,000 (1) (2) (3) (4) (5) (7) (8) (9) Status at end of second month after securitization (6)

28 What we have just described is often referred to as negative arbitrage or negative spread or negative carry. All of these terms refer to situations in which the issuer’s assets cannot support the outstanding securities. Sometimes, this occurs because the asset balance drops below the liability balance; at other times, it occurs because, in the aggregate, the interest earned on the collateral is not sufficient to support the interest owed on the securities. Revolving Structures During the Revolving Period cf1300e (c1300a) Introduction (c1300d) Low Purchase Rate Example (c1300e) Negative Arbitrage When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. (c1300c) Purchase Rate (c1300b) Reinvestment Example (c1300f) Purchase Rate Assumptions When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends. Negative Arbitrage

29 Revolving Structures During the Revolving Period cf1300f (c1300a) Introduction (c1300d) Low Purchase Rate Example (c1300e) Negative Arbitrage When you are evaluating a revolving structure, you will need to make a series of assumptions about the amount of principal cash flow that will be available for re-investment during the revolving period. Click on each of the topics below the slider bar to learn more about these assumptions. (c1300c) Purchase Rate (c1300b) Reinvestment Example (c1300f) Purchase Rate Assumptions The purchase rate assumption that you make for modeling a credit card transaction will vary based on pool characteristics, the historical purchase rate achieved by the originator, and the account management strategies used by the servicer. Under stressful scenarios associated with a general economic recession, you might expect consumer purchases to decline, so you will probably select an assumed purchase rate that is below the originator’s historical average purchase rate. But because an insolvency of the originator could adversely affect its ability to originate and transfer receivables to the issuer, the purchase rate assumption should also be related to the unsecured credit rating of the originator. A bank rated in an investment-grade category is generally assumed to be able to originate and transfer sufficient receivables to maintain the principal balance of the asset pool throughout the revolving period. Weaker originators, however, may not be able to survive a severe downturn in the economy. Thus, for a non-investment-grade originator, it may be necessary to assume that the purchase rate is zero and that the transaction begins to amortize immediately after it closes. Principal Allocations Following a Bankruptcy (c1300f_pop) When you have reviewed the treatment of principal during the revolving period, click on the Continue button to take a look at what happens to a revolving structure once the revolving period ends. Purchase Rate Assumptions

30 cf1300f pop Principal Allocations Following a Bankruptcy You should also be aware that, if the originator of the receivables were to become insolvent, the issuer might not have an ownership interest or a perfected security interest in receivables originated after the insolvency. Because of this, transaction documents generally stipulate that, following the originator’s bankruptcy or insolvency, the servicer must allocate collections to the issuer’s estate as if the issuer’s estate owned all of the receivables originated from the designated cardholder accounts, regardless of when the related charges were incurred. If the servicer is legally prevented from following this allocation rule, the documents normally require all collections from each of the designated cardholder accounts to be used to pay down the oldest balances first; this provision is generally referred to as the "FIFO allocation“. Assuming that there should be no question as to the issuer’s ownership interest in the oldest balances, this allocation should produce a more advantageous result for the issuer than a pro rata allocation between the issuer and the originator. Principal Allocations Following a Bankruptcy You should also be aware that, if the originator of the receivables were to become insolvent, the issuer might not have an ownership interest or a perfected security interest in receivables originated after the insolvency. Because of this, transaction documents generally stipulate that, following the originator’s bankruptcy or insolvency, the servicer must allocate collections to the issuer’s estate as if the issuer’s estate owned all of the receivables originated from the designated cardholder accounts, regardless of when the related charges were incurred. If the servicer is legally prevented from following this allocation rule, the documents normally require all collections from each of the designated cardholder accounts to be used to pay down the oldest balances first; this provision is generally referred to as the "FIFO allocation“. Assuming that there should be no question as to the issuer’s ownership interest in the oldest balances, this allocation should produce a more advantageous result for the issuer than a pro rata allocation between the issuer and the originator. Close

31 Negative arbitrage may also arise if the revolving period is followed by a controlled accumulation period. You will recall that, in order to improve the predictability of principal repayment, some originator/sponsors have adopted a controlled accumulation structure in which investors receive a single lump-sum payment of principal on an expected payment date. Click on the start button for a detailed discussion of negative arbitrage and controlled accumulation periods. Negative Arbitrage and Controlled Accumulation Periods cf1400 Click on the Continue button to read about prefunding accounts, another feature of many transactions which can lead to situations in which negative arbitrage is a concern. Start Click on the Start button to learn more.

32 (1)Negative arbitrage may also arise if the revolving period is followed by a controlled accumulation period. You will recall that, in order to improve the predictability of principal repayment, some originator/sponsors have adopted a controlled accumulation structure in which investors receive a single lump-sum payment of principal on an expected payment date. Click on the start button for a detailed discussion of negative arbitrage and controlled accumulation periods. Negative Arbitrage and Controlled Accumulation Periods cf1400a Principal funding account Click on the Continue button to read about prefunding accounts, another feature of many transactions which can lead to situations in which negative arbitrage is a concern. (2)Ordinarily, the controlled accumulation period starts one year before the expected payment date. (3)Each month thereafter, the servicer deposits a specified amount of principal collections in a "principal funding account" so that, at the end of the controlled accumulation period, there will be sufficient funds in the account to make a "bullet" payment to investors of the full principal balance of their securities. 1 of 2Use the forward and back arrows to navigate.

33 Negative arbitrage may also arise if the revolving period is followed by a controlled accumulation period. You will recall that, in order to improve the predictability of principal repayment, some originator/sponsors have adopted a controlled accumulation structure in which investors receive a single lump-sum payment of principal on an expected payment date. Click on the start button for a detailed discussion of negative arbitrage and controlled accumulation periods. Negative Arbitrage and Controlled Accumulation Periods cf1400b While principal is being accumulated, funds in the account can only be invested in high-quality, short-term investments. There is likely to be a negative spread between the rate earned on funds in the principal funding account and the rate owed on the securities. As a result, transactions structured with controlled accumulation periods generally are required to include reserves to cover the shortfall. A typical transaction might require a reserve equal to 50 bps of the initial aggregate invested amount. The sizing of the reserve is based on an extremely conservative scenario in which the principal funding account is funded very quickly once the revolving period ends, causing the period during which there is negative spread to be maximized. Click on the Continue button to read about prefunding accounts, another feature of many transactions which can lead to situations in which negative arbitrage is a concern. 2 of 2Use the forward and back arrows to navigate.

34 The use of prefunding accounts can give rise to problems similar to those created by requiring the reinvestment of principal receipts in revolving structures. In the case of many transactions, particularly those based on consumer assets, the entire asset pool may not have been assembled at the time the transaction closes. The following example illustrates how a prefunding account operates. Click on the Start button to begin. Prefunding Accounts cf1500 Click on the Continue button to learn more about the assumptions that you should make about prefunding accounts. Start Click on the Start button to see an illustration of how prefunding accounts operate.

35 The use of prefunding accounts can give rise to problems similar to those created by requiring the reinvestment of principal receipts in revolving structures. In the case of many transactions, particularly those based on consumer assets, the entire asset pool may not have been assembled at the time the transaction closes. The following example illustrates how a prefunding account operates. Click on the audio button to begin. Prefunding Accounts cf1500 Click on the Continue button to learn more about the assumptions that you should make about prefunding accounts. (1) (2) (3) Until the issuer has acquired the additional assets, it is likely that there will be a negative spread between the interest earned on the amount in the prefunding account and the interest owed on the issuer’s securities. This may be a source of stress on the transaction cash flow. (4) Desired transaction size $500,000,000 Principal balance of accumulated loans $350,000,000 Original principal balance of securities issued $500,000,000 Uses of issuance proceeds Purchase of existing loans $350,000,000 Deposit to prefunding account $150,000,000 (5) (8) (7)Once additional loans have been made and funded, use amounts in prefunding account to purchase additional loans (7) Review

36 In modeling cash flows for a transaction that involves a prefunding account, you should assume that newly originated loans are added to the asset pool at a delayed rate or at the end of the prefunding period, depending on the rating category. In addition, while cash is sitting in the prefunding account, you should assume that it will earn interest at a relatively low rate. The combination of these two assumptions will probably result in a shortfall, indicating that a reserve must be created to cover the maximum cumulative interest deficiency through the prefunding period. The amount held in the reserve can be allowed to decline over the prefunding period based on the remaining cumulative deficiency calculated every month. Assumptions for Transactions with Prefunding Accounts cf1600 Alternative Ways to Cover Negative Spread (c1600_pop) Click on the Continue button to explore the merits of principal prepayments.

37 cf1600_pop Alternative Ways to Cover Negative Spread Although we have talked exclusively about covering negative spread using reserve funds, there are other alternatives for dealing with this risk. For example, the originator might provide a letter of credit from a bank rated as highly as the securities with the highest rating. In some transactions, the seller’s share of asset collections can be allocated to covering negative spread, provided that the seller is rated at least ‘A-1’. Alternative Ways to Cover Negative Spread Although we have talked exclusively about covering negative spread using reserve funds, there are other alternatives for dealing with this risk. For example, the originator might provide a letter of credit from a bank rated as highly as the securities with the highest rating. In some transactions, the seller’s share of asset collections can be allocated to covering negative spread, provided that the seller is rated at least ‘A-1’. Close

38 The answer to this question is, "It depends." You might think that repayments of principal ahead of schedule must be a good thing from a credit perspective. The faster principal is received, the faster the securities will be repaid and, therefore, no longer susceptible to losses as a result of credit problems. While that is true, it may also be true that the more creditworthy obligors are the ones who are more likely to prepay. If the "better" assets in the underlying pool are prepaid, leaving the pool with more concentrated credit risk, then the holders of the securities that have not been retired using the prepaid principal cash flow may be subject to more risk in the future, not less. Principal Prepayments: Good or Bad? Nevertheless, rapid prepayments can have negative implications for any structure that depends on the availability of excess spread. Click on the Continue button to learn why. cf1900 This effect is often referred to as adverse selection, meaning that, as a result of prepayments, particularly prepayments associated with lower interest rates, there is an automatic self-selection process which causes the risk profile of an asset pool to deteriorate over time. The potential for adverse selection is considered a very real risk to certain pools of residential mortgage loans. By contrast, adverse selection is not seen as a risk for auto loan transactions. Most auto loan prepayments occur because borrowers sell or trade in the vehicles that had been financed by the prepaid loans. People are less likely to decide to prepay their auto loans simply because of a drop in market interest rates. Little would be gained from refinancing due to the low balance and short term of the loans. Thus, prepayments are assumed to occur among all classes of borrowers, and a large number of prepayments is not seen as an indication that the credit quality of a pool of auto loans may be deteriorating. (1)

39 Rapid prepayments can have negative implications for any structure that depends on the availability of excess spread to absorb credit losses directly or to accumulate in a reserve fund that can be used to absorb losses at a later point. This is true regardless of what type of assets forms the collateral for a transaction. Click on each of the buttons below to see how the availability of excess spread is tested for residential mortgage loan transactions and auto loan transactions. Prepayments and Excess Spread When you have finished reviewing the impact of prepayments on the availability of excess spread, click on the Continue button to consider what principal payment rate you should assume for a pool of credit card receivables. cf2000 Click on each button for information on how excess spread is tested. Residential Mortgage TransactionsAuto Loan Transactions

40 Rapid prepayments can have negative implications for any structure that depends on the availability of excess spread to absorb credit losses directly or to accumulate in a reserve fund that can be used to absorb losses at a later point. This is true regardless of what type of assets forms the collateral for a transaction. Click on each of the tabs below to see how the availability of excess spread is tested for residential mortgage loan transactions and auto loan transactions. Prepayments and Excess Spread When you have finished reviewing the impact of prepayments on the availability of excess spread, click on the Continue button to consider what principal payment rate you should assume for a pool of credit card receivables. cf2000a Residential Mortgage TransactionsAuto Loan Transactions If the general level of interest rates declines, loans with higher fixed interest rates or higher margins are likely to be prepaid at a faster rate than loans with lower fixed rate or lower margins. This phenomenon may cause the weighted average coupon of the loans in a transaction pool to decline over time, with the result that the amount of interest available to the issuer will also decline. To factor this into the cash flow analysis, the weighted average coupon of the loans is modeled as being artificially reduced by between 14 bps and 60 bps at the ‘AAA’ rating category. The more extreme reduction applies to pools that have a high weighted average coupon at the time of securitization. The effect of this reduction in coupon is to limit the amount of excess spread that is available to absorb losses or to fund a reserve to cover future losses.

41 Rapid prepayments can have negative implications for any structure that depends on the availability of excess spread to absorb credit losses directly or to accumulate in a reserve fund that can be used to absorb losses at a later point. This is true regardless of what type of assets forms the collateral for a transaction. Click on each of the tabs below to see how the availability of excess spread is tested for residential mortgage loan transactions and auto loan transactions. Prepayments and Excess Spread When you have finished reviewing the impact of prepayments on the availability of excess spread, click on the Continue button to consider what principal payment rate you should assume for a pool of credit card receivables. cf2000b Residential Mortgage TransactionsAuto Loan Transactions To stress the transaction’s ability to rely on excess spread as credit support, auto loan transactions are tested at high voluntary prepayments speeds relative to historical experience. Statistical data indicates that auto loan prepayments generally peak within the first year after loan origination, but that the timing of prepayments differs by market segment. Consequently, the specific prepayment speeds used to test a particular transaction will depend on the seasoning of the loans and the type of loans, as well as the rating categories being tested. But auto loan transactions often include at least one class that has a very short final maturity date. Because voluntary prepayments accelerate the payment of principal and amortization of the securities, it becomes relatively easy to meet the final maturity for each class under fast prepayment scenarios. So, to test the ability of the cash flow to repay the securities by their legal final maturity dates, a second series of cash flows is run in which voluntary prepayments are set at a rate slower than historical prepayment rates, generally between 0% and 0.5% absolute prepayment speed or ABS.

42 We noted earlier that there is considerable month-to-month variability in the interest component of credit card collections. Well, the principal payment rate associated with credit card balances is also highly variable. One way to deal with the variability of principal collections is to determine an originator/sponsor’s steady-state payment rate, meaning the average rate at which principal payments are received. The assumptions used in stressed cash flow runs should fall below this steady-state rate. For example, for a ‘AAA’ scenario, you might assume a principal payment rate equal to 45%-55% of the originator/sponsor’s steady-state payment rate. Exactly where within this range the assumed rate falls will depend on factors such as historical average payment rates, the volatility of historical payment rates, recent trends in the payment rate, and servicing practices. The rate used in the ‘A’ scenario is typically 10% faster than the ‘AAA’ rate, generally in the range of 50%-60% of the steady-state rate. The rate used in a ‘BBB’ scenario is between 70% and 75% of the steady-state rate. Credit Cards: Slowing Down Receipt of Principal Click on the Continue button to read about reserve funds and other invested cash, which is occasionally a source of additional income for an issuer. cf2200

43 Interest on Reserve Funds and Other Invested Cash Click on the Continue button to learn what assumptions are usually made with respect to the interest earned on invested cash balances. cf2300 You might also expect to see cash coming into a transaction as a result of interest earned on invested funds. As you learned in the last module, if a reserve fund forms part or all of the credit enhancement for the transaction, the funds in the reserve are typically invested in low-risk, short-term investments which can be expected to earn interest. Even asset cash flow, most of which comes into the issuer’s accounts and goes out again fairly quickly, is not allowed to remain idle; it is invested, sometimes over just one night, in interest-bearing investments. Often, these investment earnings are not available to the issuer. For instance, interest earned on invested asset cash flow is usually retained by either the servicer or the trustee as part of its compensation. Because it is usually not taken into consideration in determining how much must be deposited into a reserve fund that will provide credit enhancement or liquidity support, interest earned on such a reserve is typically owed to the party that made the initial deposit of funds in the reserve. But, in some cases, earnings on invested cash are an additional source of cash flow available to help to satisfy the issuer’s obligations. For example, the interest earned on a reserve established to cover the interest deficiency caused by "prefunding" assets is typically added to the amount held in the reserve and is available to cover the related shortfall; in this case, by giving up interest earnings on the reserve, the originator is able to minimize the initial deposit to the reserve.

44 If interest earnings can be used to help satisfy the issuer’s obligations, you need to make an assumption about the interest rate that can be earned on invested funds. These assumptions are often specific to the relevant jurisdiction, but the assumed reinvestment rate is typically pegged to a benchmark risk-free rate. Click on each of the country buttons below to read about reinvestment rate assumptions for these three jurisdictions. Assumptions About Interest on Invested Cash Balances cf2400 If the source of the interest income is a reserve fund that provides credit enhancement or liquidity support, you also need to make assumptions about the usage of funds in the account and the balance available for investment. Clearly, this set of assumptions is directly related to your assumptions about the rate and timing of defaults and the severity of losses, our next topic. U.S. U.K. Australia Click on each of the country buttons on the map to read about reinvestment rate assumptions for these three jurisdictions. But first, click on the Continue button to practice what you've learned about assumptions related to incoming cash flows.

45 If interest earnings can be used to help satisfy the issuer’s obligations, you need to make an assumption about the interest rate that can be earned on invested funds. These assumptions are often specific to the relevant jurisdiction, but the assumed reinvestment rate is typically pegged to a benchmark risk-free rate. Click on each of the country buttons below to read about reinvestment rate assumptions for these three jurisdictions. Assumptions About Interest on Invested Cash Balances cf2400a If the source of the interest income is a reserve fund that provides credit enhancement or liquidity support, you also need to make assumptions about the usage of funds in the account and the balance available for investment. Clearly, this set of assumptions is directly related to your assumptions about the rate and timing of defaults and the severity of losses, our next topic. Australia In general, for transactions denominated in U.S. dollars, unless there is a guaranteed investment contract in place from an institution rated at least as highly as the rating on the securities with the highest rating and promising a higher rate, the assumption is that all cash accounts earn interest at the rate of 1.25%. The minimum reinvestment rate assumption was lowered at least twice in 2001 as a result of the dramatic decline in short- term interest rates in the U.S. In light of the recent volatility of interest rates, it is wise to check the Criteria Encyclopedia periodically to make sure that you are using the correct reinvestment rate assumption. U.S. U.K. But first, click on the Continue button to practice what you've learned about assumptions related to incoming cash flows.

46 If interest earnings can be used to help satisfy the issuer’s obligations, you need to make an assumption about the interest rate that can be earned on invested funds. These assumptions are often specific to the relevant jurisdiction, but the assumed reinvestment rate is typically pegged to a benchmark risk-free rate. Click on each of the country buttons below to read about reinvestment rate assumptions for these three jurisdictions. Assumptions About Interest on Invested Cash Balances cf2400b If the source of the interest income is a reserve fund that provides credit enhancement or liquidity support, you also need to make assumptions about the usage of funds in the account and the balance available for investment. Clearly, this set of assumptions is directly related to your assumptions about the rate and timing of defaults and the severity of losses, our next topic. Australia In the UK, where many GIC providers are still rated ‘A-1+’, it is very common to have cash balances invested under a guaranteed investment contract. If this is the case, you can assume that cash balances will earn interest at the GIC rate for 12 months and at a stressed GIC rate thereafter. Most GICs offer a rate of LIBOR less between 25 bps and 50 bps; therefore, a stressed GIC rate is typically LIBOR less something between 150 bps and 250 bps. U.S. U.K. But first, click on the Continue button to practice what you've learned about assumptions related to incoming cash flows.

47 If interest earnings can be used to help satisfy the issuer’s obligations, you need to make an assumption about the interest rate that can be earned on invested funds. These assumptions are often specific to the relevant jurisdiction, but the assumed reinvestment rate is typically pegged to a benchmark risk-free rate. Click on each of the country buttons below to read about reinvestment rate assumptions for these three jurisdictions. Assumptions About Interest on Invested Cash Balances cf2400c If the source of the interest income is a reserve fund that provides credit enhancement or liquidity support, you also need to make assumptions about the usage of funds in the account and the balance available for investment. Clearly, this set of assumptions is directly related to your assumptions about the rate and timing of defaults and the severity of losses, our next topic. Australia The reinvestment rate assumptions for Australia vary, depending on the amount invested: For amounts under A$500,000, the reinvestment rate is assumed to be the bank bill rate less 5%. For amounts over A$500,000, the reinvestment rate is assumed to be the bank bill rate less 1%. In either case, the minimum reinvestment rate is assumed to be 2%. A higher minimum rate may be assumed, depending on whether the party responsible for managing the issuer’s investments actively manages the cash and has a defined strategy for cash management. The assumption also depends on the ratings of the securities in question. U.S. U.K. But first, click on the Continue button to practice what you've learned about assumptions related to incoming cash flows.

48 c2450 Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your response. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. Start Click on the Start button to begin the exercise.

49 c2450a Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your answer. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. TrueFalse 1) The controlled accumulation period at the end of a revolving transaction usually lasts for twelve months. Next

50 c2450b Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your answer. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. TrueFalse 2) In order to stress a proposed credit card transaction during the revolving period, you should assume a purchase rate well above the originator’s historical purchase rate. Next

51 c2450c Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your answer. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. TrueFalse 3) The term “negative arbitrage” refers to a situation in which the issuer’s assets exceed its liabilities. Next

52 c2450d Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your answer. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. TrueFalse 4) In most cases, when modeling cash flows for a ‘AAA’ scenario, you should assume that the funds held in a prefunding account will not be invested in newly originated assets until the last day of the prefunding period. Next

53 c2450e Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your answer. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. TrueFalse 5) Falling interest rates are likely to trigger a wave of auto loan prepayments. Next

54 c2450f Practice: Assumptions About Incoming Cash Flows You will be presented with several statements related to incoming cash flows and the assumptions you will be required to make about the behavior of those cash flows. Decide whether each statement is true or false and click on the appropriate button to indicate your answer. Click the Start button to begin. When you have completed the practice, click on the Continue button to see how defaults are incorporated into the cash flow analysis. TrueFalse 6) Standard & Poor’s changes its minimum reinvestment rate assumptions periodically in response to changes in market conditions. Next

55 Think back to Module Six and our discussion of the process of quantifying credit risk. There, we said that, for certain types of secured assets such as residential mortgage loans, the risk could be broken down into a foreclosure frequency percentage and a loss severity percentage; for other asset classes, because the loss severity is almost always close to 100%, the foreclosure frequency itself defines the risk and is equivalent to the loss rate. Just as you use those percentages to determine how much credit enhancement is required to compensate for the credit risk embedded in a particular pool of assets at a particular rating category, you use the results of the same analysis in determining what assumption to make about the level of defaults that will occur under a scenario related to a specific rating category. Click on each of the buttons below for a quick refresher on default rate assumptions for pools of residential mortgage loans and auto loans. Default Rates Click on the Continue button to see how the same principle applies to the timing of defaults. cf2500 Residential Mortgage Loans Auto Loans Click on each of the buttons to the left for a quick refresher on default rate assumptions.

56 Think back to Module Six and our discussion of the process of quantifying credit risk. There, we said that, for certain types of secured assets such as residential mortgage loans, the risk could be broken down into a foreclosure frequency percentage and a loss severity percentage; for other asset classes, because the loss severity is often close to 100%, the foreclosure frequency itself defines the risk and may be equivalent to the loss rate. Just as you use those percentages to determine how much credit enhancement is required to compensate for the credit risk embedded in a particular pool of assets at a particular rating category, you use the results of the same analysis in determining what assumption to make about the level of defaults that will occur under a scenario related to a specific rating category. Click on each of the boxes below for a quick refresher on default rate assumptions for pools of residential mortgage loans and auto loans. Default Rates Click on the Continue button to see how the same principle applies to the timing of defaults. cf2500a Residential Mortgage Loans Auto Loans The ‘AAA’ foreclosure frequency that you used to determine the ‘AAA’ credit enhancement required for a pool of residential mortgage loans is the default rate you should use when testing the cash flows of a transaction backed by those same residential mortgage loans at the ‘AAA’ rating category. You will remember, for instance, that when we finished our credit analysis of a pool of residential mortgage loans in Module Six, we determined that the appropriate foreclosure frequency for this pool was 15% at the ‘AAA’ rating category: Aggregate Original Principal Balance of Pool $250,000,000 x 15% = $37,500,000 Aggregate Balance of Defaulted Loans x = Foreclosure Frequency Assumption If you were to test the cash flows of a transaction backed by this pool, you would want to make sure that 15% of the original principal balance of the pool, or a total of $37,500,000 in loans, went into default over the life of the transaction.

57 Think back to Module Six and our discussion of the process of quantifying credit risk. There, we said that, for certain types of secured assets such as residential mortgage loans, the risk could be broken down into a foreclosure frequency percentage and a loss severity percentage; for other asset classes, because the loss severity is often close to 100%, the foreclosure frequency itself defines the risk and may be equivalent to the loss rate. Just as you use those percentages to determine how much credit enhancement is required to compensate for the credit risk embedded in a particular pool of assets at a particular rating category, you use the results of the same analysis in determining what assumption to make about the level of defaults that will occur under a scenario related to a specific rating category. Click on each of the boxes below for a quick refresher on default rate assumptions for pools of residential mortgage loans and auto loans. Default Rates Click on the Continue button to see how the same principle applies to the timing of defaults. cf2500b Residential Mortgage Loans Auto Loans Similarly, the ‘AA’ net loss rate that you derived for a pool of auto loans should become the net loss rate assumption under the ‘AA’ cash flow scenario for a securitization of those auto loans. Because the recovery rate assumption is usually 50%, the ‘AA’ default rate assumption is generally two times the ‘AA’ net loss rate assumption. For example, if you concluded that the net loss rate for a pool of auto loans should be 18% at the ‘AA’ rating category and if you were satisfied that a 50% recovery rate could be achieved even under poor economic conditions, you would assume a default rate of 36% in testing the pool at the ‘AA’ level: Net Loss Rate of 18% Aggregate Default Rate of 36% = Recovery Rate of 50%

58 Timing of Defaults cf2600 While defaults inevitably mean that less cash flow is being generated by the underlying assets, a transaction’s liquidity mechanism may make up for the shortfall. When you have reviewed the material on the timing of defaults, click on the Continue button to consider how the liquidity mechanism may affect your cash flow analysis. (c2600d) Credit Card Receivables (c2600c) Auto Loans (c2600a) Introduction (c2600b) Residential Mortgage Loans Another element about which you must make assumptions is the timing of defaults. Do they occur all at once, or should they be spread over the life of the transaction? Click on each of the topics below the slider bar to learn why different assumptions are used for different types of assets. Click on each of the topics below to learn more about assumptions related to the timing of defaults.

59 Timing of Defaults cf2600a The most conservative approach would be to assume that all of the defaults occur simultaneously immediately after the transaction closes. Such a scenario would put the maximum amount of stress on the cash flow and the credit enhancement mechanisms, but it would also be completely unrealistic, even in a worst case. Most securitizations involve newly originated assets; and, while there will always be a small number of first-payment defaults, even obligors who will eventually have difficulty repaying their loans usually manage to make their first few payments. Furthermore, unless the originator of the assets was completely negligent in underwriting the credit risk, you should be able to assume that defaults will not begin immediately. The assumptions used with respect to the timing of defaults differ from asset class to asset class. Typically, these assumptions are chosen based, in part, on the timing that will be most stressful for the transaction and, in part, on the historical pattern of defaults experienced by similar assets. (c2600d) Credit Card Receivables (c2600c) Auto Loans (c2600a) Introduction (c2600b) Residential Mortgage Loans While defaults inevitably mean that less cash flow is being generated by the underlying assets, a transaction’s liquidity mechanism may make up for the shortfall. When you have reviewed the material on the timing of defaults, click on the Continue button to consider how the liquidity mechanism may affect your cash flow analysis. Another element about which you must make assumptions is the timing of defaults. Do they occur all at once, or should they be spread over the life of the transaction? Click on each of the topics below the slider bar to learn why different assumptions are used for different types of assets. Introduction

60 Timing of Defaults cf2600b In the case of residential mortgage loans, defaults have tended to occur during the six years following loan origination, although relatively few defaults occur during the first year. Given this pattern, the seasoning of the loans in a pool has a lot to do with when defaults are likely to occur. The default curves laid out in the table below demonstrate how seasoning is taken into account in the assumptions made regarding the timing of defaults: (c2600d) Credit Card Receivables (c2600c) Auto Loans (c2600a) Introduction (c2600b) Residential Mortgage Loans While defaults inevitably mean that less cash flow is being generated by the underlying assets, a transaction’s liquidity mechanism may make up for the shortfall. When you have reviewed the material on the timing of defaults, click on the Continue button to consider how the liquidity mechanism may affect your cash flow analysis. Another element about which you must make assumptions is the timing of defaults. Do they occur all at once, or should they be spread over the life of the transaction? Click on each of the topics below the slider bar to learn why different assumptions are used for different types of assets. Percentage of Total Defaults Beginning in This Month Months After Transaction ClosingLoans Seasoned Less Than 12 MonthsLoans Seasoned 12 Months or More Residential Mortgage Loans

61 Timing of Defaults cf2600c In the case of auto loans, the timing of defaults for cash flow modeling purposes is based upon the originator’s loss curve. As we saw in Module Six, if the originator cannot provide enough historical performance data to enable you to construct an originator-specific loss curve, you will need to estimate a curve using the loss curves of comparable originators. Below you see the smoothed loss curve constructed for a pool of Ready Credit’s auto loans. (c2600d) Credit Card Receivables (c2600c) Auto Loans (c2600a) Introduction (c2600b) Residential Mortgage Loans While defaults inevitably mean that less cash flow is being generated by the underlying assets, a transaction’s liquidity mechanism may make up for the shortfall. When you have reviewed the material on the timing of defaults, click on the Continue button to consider how the liquidity mechanism may affect your cash flow analysis. Another element about which you must make assumptions is the timing of defaults. Do they occur all at once, or should they be spread over the life of the transaction? Click on each of the topics below the slider bar to learn why different assumptions are used for different types of assets. Auto Loans 2/5/02 JK: Verified with Nancy, chart is sufficient as originally storyboarded.

62 Timing of Defaults cf2600d For credit card receivables, the level of defaults is discussed in terms of expected steady-state losses. The expected steady-state loss figure is the credit-card equivalent of the base-case loss number that we developed for an auto loan portfolio. In a ‘AAA’ scenario, credit card losses are assumed to start at the steady-state level; from there, they rise gradually to a level that is 3 to 5 times higher than what it is under the expected steady state, with charge-offs peaking 12 months after the transaction closes. In the ‘A’ scenario, ultimate charge-offs are assumed to reach 2 to 3 times the steady-state level after rising for 12 months. At the ‘BBB’ rating category, losses peak 18 months after the transaction closes, when they are assumed to have reached a level that is 1.5 to 2 times higher than the expected steady-state level. (c2600d) Credit Card Receivables (c2600c) Auto Loans (c2600a) Introduction (c2600b) Residential Mortgage Loans While defaults inevitably mean that less cash flow is being generated by the underlying assets, a transaction’s liquidity mechanism may make up for the shortfall. When you have reviewed the material on the timing of defaults, click on the Continue button to consider how the liquidity mechanism may affect your cash flow analysis. Another element about which you must make assumptions is the timing of defaults. Do they occur all at once, or should they be spread over the life of the transaction? Click on each of the topics below the slider bar to learn why different assumptions are used for different types of assets. Credit Card Receivables

63 You will recall that, in Module Seven, we said that before loans and other receivables go into default, they are delinquent. For most asset classes, it takes several months to determine that the obligor is not just late in making payments but has, in fact, defaulted on the loan or receivable. Liquidity support mechanisms are designed to cover temporary shortfalls in cash flow associated with delinquencies and, in some cases, with defaults as well. If the transaction that you are analyzing has a formal liquidity support mechanism, such as servicer advancing or a letter of credit, you should expect to see additional cash inflows from the liquidity source. These additional inflows should almost exactly offset the shortfalls caused by delinquencies and defaults; any difference between the two should be attributable to the fact that the servicer is usually not entitled to collect a servicing fee except with respect to payments that are actually collected. If, instead of a formal liquidity mechanism, the transaction relies on excess cash flow, there will be no additional inflows. Liquidity Cash Flow Click on the Continue button to read about recoveries. cf2700

64 Depending on the asset class, once a default is resolved, cash flow may be available as a result of the liquidation of the loan or receivable or as a result of selling the underlying asset. Here, again, your assumption as to the amount recovered following each liquidation should be related to the credit analysis of the underlying assets. For example, if you determined that the average recovery rate on auto loans is 50% of the balance as of the date of default, you would assume a 50% recovery rate for a transaction collateralized by auto loans. Recoveries Click on the Continue button to consider the implications of the timing of recoveries. cf2800

65 Timing of Recoveries cf2900 Click on each of the buttons above to learn about assumptions made with respect to the timing of recoveries. If a transaction involves third-party credit support, it’s time for the credit enhancer to come to the rescue! When you have completed your review of assumptions about the timing of recoveries, click on the Continue button to cheer for the credit support. Residential Mortgage Loans Auto Loans Click on each of the buttons to learn what implications your assumptions about the timing of recoveries has on the cash flow analysis. Again, our examples are drawn from the criteria applied to residential mortgage loans and auto loans.

66 Timing of Recoveries cf2900a In the case of first-lien residential mortgage loans, the foreclosure and liquidation process is usually assumed to take twelve months. As a result, recoveries are assumed to be received twelve months after the initial delinquency that signals a default. For example, if the loans in a pool have relatively little seasoning and the first wave of defaults is assumed to occur in Month 7, you should expect to see substantial inflows attributable to principal twelve months later in Month 19. The second wave of defaults is assumed to begin in Month 12, so you should see a second round of involuntary "prepayments" in Month 24. The recoveries should continue through Month 84, lagging the defaults to which they are related by 12 months. Residential Mortgage Loans Auto Loans Image of a house with a sign on the front lawn that reads "Foreclosure Sale". Click on each of the buttons to learn what implications your assumptions about the timing of recoveries has on the cash flow analysis. Again, our examples are drawn from the criteria applied to residential mortgage loans and auto loans. Regional Differences (c2900a_pop) If a transaction involves third-party credit support, it’s time for the credit enhancer to come to the rescue! When you have completed your review of assumptions about the timing of recoveries, click on the Continue button to cheer for the credit support. Click on the globe to learn more about regional differences.

67 cf2900a_pop Regional Differences in Assumptions This is an appropriate place to point out that there may be regional differences in the assumptions that are made about the timing of defaults and recoveries. Such differences are intended to reflect differences in the economic and legal environment from country to country. For example, in Australia, residential mortgage loan defaults are assumed to occur over a 5-year period. If the loans are relatively unseasoned, the first defaults occur in Month 7 of the transaction, and the final defaults occur in Month 60. Recovery periods range from 12 months to 18 months, depending on loan size and the geographic locations of the properties securing the loans, as well as the historical performance and collections procedures of the originator. Close

68 Timing of Recoveries cf2900b In the case of auto loans, lagging recoveries has the effect of stressing a transaction’s cash flow because it results in negative carry: The pool balance is reduced when the defaulted loans are written off, but there is no cash flow immediately available to pay down the securities balance by a similar amount. This should not result in a default on the senior securities, however, so long as credit support is still available; despite the write-offs, there should be enough on-going cash flow to pay current interest to the holders of the senior securities. Whatever amounts are recovered upon liquidation of the vehicles financed by defaulted loans are assumed to be received three to four months following the related write- offs; the exact timing of recoveries depends upon: The originator/sponsor’s historical experience, Whether the repossessed vehicles are sold at an auction or on a retail basis, and The rating category. In the meantime, there will be less excess spread available. If the transaction is heavily dependent on excess spread for credit support, a delay in the receipt of recoveries can have a lasting impact on the credit strength of the transaction. Residential Mortgage Loans Auto Loans Image of a car with a repossessed sign over it. Click on each of the buttons to learn what implications your assumptions about the timing of recoveries has on the cash flow analysis. Again, our examples are drawn from the criteria applied to residential mortgage loans and auto loans. If a transaction involves third-party credit support, it’s time for the credit enhancer to come to the rescue! When you have completed your review of assumptions about the timing of recoveries, click on the Continue button to cheer for the credit support.

69 If all or a portion of the credit enhancement for a transaction is external, you should expect to see cash inflows from the third-party credit support provider. The timing of these inflows should coincide with or closely follow the recognition of losses related to asset defaults. Until the credit enhancement has been fully depleted, the amount made available to the issuer from these sources should be equal to the amount of each loss. Cash Flow From Third-Party Credit Enhancers Click on the Continue button to move on to an exercise on cash flow following defaults. cf3000

70 Practice: Cash Flow Following Defaults cf3050a Typically, how long after the initial delinquency of a first-lien residential mortgage loan would you assume amounts representing a recovery following a default would be received? 7 months 12 months 18 months SubmitNext This practice involves two multiple-choice questions. Click the check box next to your answer and then click on the Submit button. If your choice is correct, you can click on the Next button to continue with the practice. If your choice is not correct, you must try again. Click on the Start button to begin. Start Click on the Continue button to move on to a discussion of the uses to which an issuer puts its cash flow.

71 Practice: Cash Flow Following Defaults cf3050b On what factors should your assumption about the timing of recoveries for auto loans depend? Choose all that apply. The originator/sponsor’s historical experience The maturity of defaulted loans Whether repossessed vehicles are sold at an auction or on a retail basis The number of loans in the pool at the time of the defaults The rating category for which you are constructing a cash flow test Submit Click on the Continue button to move on to a discussion of the uses to which an issuer puts its cash flow. This practice involves two multiple-choice questions. Click the check box next to your answer and then click on the Submit button. If your choice is correct, you can click on the Next button to continue with the practice. If your choice is not correct, you must try again. Click on the Start button to begin.

72 Having identified all of the possible sources of cash inflows and all of the risks that may cause those inflows to be reduced or delayed, we’re ready to turn our attention to how the issuer will use its cash flow. Before thinking about how that cash will find its way to investors, however, we need to make sure that the issuer’s expenses can be covered. That’s our next topic. Outgoing Cash Flows cf3100 Click on the Continue button to read about expenses for securitizations.

73 The ongoing expenses of most securitizations fall into the following categories:  (1) Servicing fees,  (2) Trustee fees,  (3) Accounting fees, and  (4) General administrative expenses. Generally, the servicer’s fee is deducted from the asset cash flow as soon as payments are received from the underlying obligors. Thus, the cash flow that is available to the issuer is already net of the servicing fee. Typically, the normal servicing fee is only due with respect to payments that are actually collected. (There may be other fees due with respect to defaulted loans or contracts; these are often referred to as special servicing fees.) The implication is, of course, that the servicer should not be deducting a servicing fee from asset cash flow with respect to any payments that are delinquent. Even if the servicer or some other party is making advances to cover delinquencies, the amount advanced will undoubtedly be equal to the delinquent payments, net of the servicing fee. Expenses cf3200 Click on the Continue button to read about what it is that you are trying to determine by analyzing a transaction’s cash flow.

74 This last phrase–"in accordance with their terms"–is an important one. Remember, for example, that subordinated securities are designed to absorb cash-flow shortfalls so that more senior classes of securities do not suffer losses. Thus, the payment terms of subordinated securities must acknowledge that holders of those securities may not always be paid in full. That does not mean that securities rated ‘B’ because of explicit subordination provisions should not be downgraded to ‘D’ in the event that holders of those securities are not paid and there is virtually no possibility that they will ever recover the unpaid amounts. But it does mean that, if the transaction documentation correctly describes the extent to which those securities are subordinated with respect to their right to receive distributions of asset cash flow, you should be able to count on the credit support that those subordinated securities provide to other more senior securities. What Does the Cash Flow Analysis Test? Click on the Continue button to see how the outcomes that you are testing using cash flow analysis are related to the ratings definitions used by Standard & Poor’s. cf3400 Graphic of a contract titled "Terms and Conditions". The presence of credit enhancement alone is generally not enough to guarantee that holders of the rated securities will be paid, particularly if the credit enhancement mechanism provides relatively illiquid support or if it is accumulated gradually out of asset cash flow. In most cases, you will need to go to the next level and ask whether the credit enhancement mechanism can be relied upon to generate sufficient funds to enable the issuer to make payments on the securities in accordance with their terms.

75 Standard & Poor’s ratings address the likelihood that holders of securities will receive "timely" payment of interest and "ultimate" repayment of principal. This is an important distinction. It means that, in evaluating cash flow runs, you should be looking for situations in which holders of rated securities receive less than the full amount of the interest payment that is currently due to them and situations in which the entire principal balance is not repaid by the legal final maturity date. Now, obviously, if you are looking at a ‘AAA’ scenario, it is likely that any class of securities rated below that rating category will experience shortfalls and may even incur losses. But, for example, if you are looking at a ‘BBB’ scenario, all classes rated ‘BBB’ and above should receive all amounts of interest as promised in the transaction documents and full repayment of principal by their legal final maturities. Keep in Mind What the Ratings Mean Click on the Continue button to review typical payment patterns found in the cash flow waterfall. cf3500

76 In Module Seven, we introduced the concept of the cash flow waterfall. This term refers to the set of rules by which the issuer’s cash flow is allocated between the various classes of securities issued in connection with a transaction. The rules under which payments are made follow two general patterns: Typical Priorities of Payment Click on the Continue button to learn why the less common payment priority can lead to problems. cf3600 Most Common Pattern  (1) Interest  (2) Interest  (3) Principal  (4) Principal Less Common Pattern  (5) Interest  (6) Principal  (7) Interest  (8) Principal

77 This second payment priority, the "interest-principal-interest-principal" pattern, can lead to problems. Let’s look at an auto loan example to see why. Click on the Start button to begin. Payment Priorities Can Create Problems Click on the Continue button to read about trigger events. cf3700 Start Click on the Start button to begin.

78 Principal This second payment priority, the "interest-principal-interest-principal" pattern, can lead to problems. Let’s look at an auto loan example to see why. Click on the Start button to begin. Payment Priorities Can Create Problems Click on the Continue button to read about trigger events. cf3700a 1 of 2Use the forward and back arrows to navigate. Class A Rated ‘AAA’ Senior Reserve Fund Class B Rated ‘A’ Subordinate (1) (2) (3) Interest (6) (5) (4) (7) Click on the forward arrow to further explore this topic.

79 This second payment priority, the "interest-principal-interest-principal" pattern, can lead to problems. Let’s look at an auto loan example to see why. Click on the Start button to begin. Payment Priorities Can Create Problems Click on the Continue button to read about trigger events. cf3700b 2 of 2Use the forward and back arrows to navigate. Even though this may be a short-term problem which will correct itself when liquidation proceeds or additional excess spread become available, it would nevertheless constitute a default under the terms of the Class B securities which are, after all, rated in an investment-grade category. This problem could be overcome by establishing a reserve account; such a reserve might be dedicated specifically to keeping the Class B current with respect to interest, or it might be intended to serve a variety of purposes. The transaction documents would typically require that the reserve be replenished each month out of available cash flow. The amount required to be deposited into the reserve would depend on the results of cash flows modeled on the assumption of monthly spikes in charge-offs at various stages over the transaction’s life.

80 If a trigger event occurs, it usually causes the transaction’s priority of payments or structure to be altered in some way. For example, in an auto loan transaction, the occurrence of a trigger event may result in a change in the cash flow allocation rules so that all excess cash flow is used to "turbo" the most senior class. Alternatively, the funding requirement for the reserve account may be reset at a higher level if performance begins to deteriorate. This second type of trigger response may add strength to the structure if it causes excess spread, which would otherwise leave the transaction, to be captured in the spread account. But, if losses mount very quickly, as would be likely to occur in a worst-case scenario, the actual incremental excess spread captured would be of marginal benefit. Furthermore, the tripping of a trigger can usually be "cured," after which the additional excess spread that was captured may be released from the transaction. In a bond-insured transaction, the bond insurer usually has the option of waiving the change mandated in the documents by tripping a trigger. As a result, the existence of one or more triggers in a transaction structure usually has a minimal effect on the required credit enhancement. Trigger Events and Responses The more important application of trigger events is in causing transactions to enter early amortization. Click on the Continue button to learn more about early amortization events. cf3800 Trigger events act as early warning signals of deteriorating performance. The most common "triggers" are tied to the three-month rolling average delinquency rate, the three-month rolling average net loss rate, and the cumulative net loss rate. For triggers to be effective, they should be set as close as possible to the expected case.

81 Early amortization events include: (1) The insolvency of the originator of the loans or receivables, (2) Breaches of representations or warranties, (3) A servicer default, (4) Failure to add receivables to the pool as required, and (5) Asset performance-related events. Early Amortization Events Click on the Continue button to learn how the risks associated with floating rate securities are taken into account in the cash flow analysis. cf3900 For credit card transactions, early amortization will also be triggered if the annualized three-month average excess spread falls below zero. This is known as a base rate payout event. In this instance, "excess spread" is generally defined as finance charge collections minus certificate interest, servicing fees, and charge-offs. Some transactions define a base rate payout event as occurring even before excess spread declines to zero, for example, if net portfolio yield dips below the base rate plus 1%. This builds in a cushion, triggering rapid amortization before losses and expenses have exhausted excess spread completely. A transaction with a tighter trigger is structurally stronger and may require less credit enhancement than one with a standard base rate trigger. All credit card structures incorporate a series of early amortization provisions, which are a form of trigger. If early amortization is triggered, the revolving period ends immediately, and principal collections are distributed to investors on a monthly basis, without waiting for the beginning of the controlled amortization period or for the scheduled payment date.

82 Well, in some transactions the risk is "capped." This means that, although the interest rate paid on the securities is allowed to float based on the movements of an index rate, there is a maximum rate above which the coupon on the securities cannot go. If the net interest rate on the underlying assets is at least as high as this cap rate, the problem should be solved. Unfortunately, this is rarely the case: usually, the net interest rate on the assets is well below the cap, and you will need to assume that the interest rate with respect to the securities gradually increases to the cap rate. The imposition of a cap rate is not common in retail auto securitizations, but it is one of the most popular ways of eliminating interest rate risk in wholesale auto, student loan, and manufactured housing transactions. Floating Rate Securities and Interest Rate Risk Click on the Continue button to learn where to go when you need to forecast the path of future interest rates. cf4000 In recent years, the securities issued in connection with most credit card securitizations have been floating rate, and floating rate securities are common in other types of securitizations as well. In the last module, we talked a bit about using interest-rate hedges to overcome the risk that the underlying assets are paying interest based on fixed rates and interest on the securities is accruing at floating rates. But what if there is no external hedge against this risk? Cap Rate Index Rate plus Margin Time Interest Rate Owed on Securities

83 But what if there is no interest rate hedge and no cap on the interest rate paid to investors? What assumptions should you make about the relationship between the interest earned on the underlying assets and the interest owed on the floating rate securities? In situations where it becomes necessary to forecast future interest rates, you should use the "STIRME Model." This tool, based on a Monte Carlo simulation that incorporates historical interest rate movements, will provide you with vectors that describe the future paths of interest rates (or interest rate spreads) at different rating categories. You can then incorporate these vectors into your cash flow analysis. The STIRME Model can be downloaded from G:\parisi\stirme\install. Once you have downloaded the application, you can run it using "stirme41b.exe." Forecasting Future Interest Rates Click on the Continue button for a practical application of the cash flow modeling techniques that we have been discussing. cf4100 Image of crystal ball with the words "STIRME Model" floating inside

84 A Practical Application of Cash Flow Modeling cf4200 Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line Click on the Continue button to read about other factors that add even more complexity to the analysis. (c4200f) Enough for ‘AAA’?

85 A Practical Application of Cash Flow Modeling cf4200a $94,000,000 Class A Rated ‘AAA’ Senior 1% Reserve Fund $6,000,000 Class B Rated ‘A’ Subordinate (1) (2) (3) Principal Interest $100,000,000 in auto loans (5) (6) (4) Excess spread Does this structure provide sufficient total credit support to rate the Class A Certificates ‘AAA’? (7) Proposed Structure Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’? Click on the Continue button to read about other factors that add even more complexity to the analysis.

86 A Practical Application of Cash Flow Modeling cf4200b (5) (7) Weighted average original term60 months Weighted average remaining term59 months Weighted average seasoning1 month Weighted average coupon10.75% per year Expected case voluntary prepayment speed1.3% ABS (3) (1) Collateral Characteristics (9) (2) (4) (6) (8) (10) Click on the Continue button to read about other factors that add even more complexity to the analysis. Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’?

87 A Practical Application of Cash Flow Modeling cf4200c (3) (1) Credit Support Requirements Cumulative base-case loss estimateRequired ‘AAA’ credit support 2.2% 11.00% X = (5)(4) (2) 2.2% ‘AAA’ multiple 5 Cumulative base-case loss estimate Click on the Continue button to read about other factors that add even more complexity to the analysis. Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’?

88 A Practical Application of Cash Flow Modeling cf4200d (5) (7) (3) (1) Excess Spread Calculation (9) Weighted average collateral coupon Less: weighted average certificate rate Net weighted average collateral coupon Excess spread Less: servicing fee, trustee fee, and other administrative expenses 10.75% 1.00% 9.75% 6.50% 3.25% - - (6) (8) (4) (2) (10) Click on the Continue button to read about other factors that add even more complexity to the analysis. Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’?

89 A Practical Application of Cash Flow Modeling cf4200e The expected-case cash flow runs, using a prepayment speed of 1.3% ABS, indicate that the reserve account will reach its cap of 2.5% by Month 7. This time frame is considered short enough to give full credit to the buildup of spread captured in the reserve account. Based on ‘AAA’ stressed cash flows, using a somewhat higher 2% ABS prepayment speed, the cumulative excess spread in the structure is 3.5%. We have already given credit to the 1.5% of excess spread that will be captured in the reserve account (taking the initial deposit of 1% to the proposed 2.5% cap). So what about the remaining 2% of excess spread that is “uncaptured”? Because the transaction has been modeled using relatively severe ‘AAA’ stresses, it is likely that substantial credit would be given to this “uncaptured” excess spread as well. In this case, for example, you might assume that, at a minimum, 75% of the “uncaptured” excess spread would be available to absorb losses. This would yield an additional 1.5% of credit support. Click on the Continue button to read about other factors that add even more complexity to the analysis. What the Cash Flows Show Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’?

90 A Practical Application of Cash Flow Modeling cf4200f Enough for ‘AAA’? Let’s figure out how much credit support we have at this point. Enter the correct percentages in the boxes below. Once you’ve entered a number in each of the boxes, click on the Submit button, and the total will appear at the bottom. If you entered an incorrect percentage in any of the boxes, you can get the correct number by rolling over the box. Click on the Continue button to read about other factors that add even more complexity to the analysis. Subordinated certificates Initial deposit to the reserve fund Excess spread deposited to the reserve fund over time “Uncaptured” excess spread % % % % Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. Submit (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’?

91 A Practical Application of Cash Flow Modeling cf4200f Enough for ‘AAA’? Let’s figure out how much credit support we have at this point. Enter the correct percentages in the boxes below. Once you’ve enter a number in each of the boxes, click on the Submit button, and the total will appear at the bottom. If you entered an incorrect percentage in any of the boxes, you can get the correct number by rolling over the box. Click on the Continue button to read about other factors that add even more complexity to the analysis. Subordinated certificates Initial deposit to the reserve fund Excess spread deposited to the reserve fund over time “Uncaptured” excess spread 6.0% 1.0% 1.5% Total available credit support 10.0% We’re still 1% short of the 11% credit support needed to assign a ‘AAA’ rating to Class A! 1.5% Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’? Nancy S. Olson: This slide shows the correct answers in the boxes and the total that should be displayed once the user has entered numbers in the other boxes. Also, when the total is shown, have text at bottom of screen appear.

92 A Practical Application of Cash Flow Modeling cf4200g The Bottom Line Based on what we have seen thus far, an additional 1% of “hard” credit support will be needed at closing to bring the total to the 11% required to rate the Class A certificates ‘AAA’. The originator/sponsor might provide this additional credit support by increasing the amount of the initial deposit in the reserve from 1% to 2% and also agreeing to raise the level to which the reserve will be funded out of excess spread from 2.5% to 3.5%. But the shortfall cannot be addressed by simply raising the maximum amount to be deposited to the reserve over time, because the current cap amount of 2.5% is reached by Month 7, which is very close to the maximum time allowed for reserve fund accumulation. Alternatively, the originator/sponsor might agree to a reduction in the size of the senior class from 94% to 93% and an increase in the size of the subordinated class from 6% to 7%. But remember that the originator/sponsor has indicated that it intends to have the Class B rated ‘A’. Depending on how much credit enhancement is required to support Class B at that rating category and the results of the cash flow analysis for Class B, it might be necessary to create an unrated tranche which is subordinate to Class B. An unrated tranche would also contribute to the support of the Class A certificates. Click on the Continue button to read about other factors that add even more complexity to the analysis. Before we wrap up, let’s spend a few minutes on one very practical application of cash flow modeling: determining how much credit should be given for the accumulation of a reserve fund based on the availability of excess spread. Click on "Proposed Structure" below the slider bar to begin. (c4200e) What the Cash Flows Show (c4200b) Collateral Characteristics (c4200d) Excess Spread Calculation (c4200a) Proposed Structure (c4200c) Credit Support Requirements (c4200g) The Bottom Line (c4200f) Enough for ‘AAA’?

93 In evaluating the results of your cash flow analysis, you need to keep the interplay of multiple variables in mind. Click on each of the buttons below to review examples of some of these variables. Both examples are related to the extent to which you should give credit to the accumulation of excess spread in a reserve. Further Complexities cf4300 The case that you examined in the last few screens illustrates the complexity of the analysis required to evaluate the credit quality of securities created in connection with securitizations. There are no easy answers, and there is no magic formula. But, by the same token, structured finance is not rocket-science: for the most part, the principles that you need to apply are based on common sense. If you keep that in mind and persevere, you will be a successful credit analyst. Click on each of the buttons to the left to review examples of other variables that you need to keep in mind in evaluating excess spread. Example One Example Two Click on the Continue button to move on to the end-of-module exam.

94 Further Complexities cf4300 Example One Example Two The cap that applies to most excess spread reserve funds is based on the declining balance of the underlying collateral pool. In the case that you just looked at, the provision requiring excess spread to be deposited to the reserve might be written to require such deposits until the amount in the reserve had grown to 2.5% of the outstanding principal balance of the loans in the pool. That cap amount would have been a healthy $2,500,000 at the time of the transaction’s closing, but once the underlying loans have been paid down by 50%, a cap defined in these terms would have declined to $1,250,000. By contrast, the loss coverage that you determined was required to rate the Class A certificates ‘AAA’ was sized as a percentage of the initial collateral balance! This may be an issue if you have any concerns about the effects of adverse selection on the credit quality of the pool or if the assets are short-term, and it is one of the reasons for limiting the credit given to excess spread even when it is being trapped in a reserve fund. The case that you examined in the last few screens illustrates the complexity of the analysis required to evaluate the credit quality of securities created in connection with securitizations. There are no easy answers, and there is no magic formula. But, by the same token, structured finance is not rocket-science: for the most part, the principles that you need to apply are based on common sense. If you keep that in mind and persevere, you will be a successful credit analyst. Click on the Continue button to move on to the end-of-module exam. In evaluating the results of your cash flow analysis, you need to keep the interplay of multiple variables in mind. Click on each of the buttons below to review examples of some of these variables. Both examples are related to the extent to which you should give credit to the accumulation of excess spread in a reserve.

95 Further Complexities cf4300 The age of the underlying assets may also be a factor in how much credit you give to excess spread. It makes sense to give more credit if the assets are newly originated, particularly if cash flows modeled on base-case assumptions indicate that you can reasonably expect the excess spread reserve to be funded in full shortly after the transaction closes. On the other hand, a somewhat more seasoned pool, in which the loans are six to eight months old, may be about to enter its peak loss period. If the underlying pool is more seasoned at the point of securitization, it is likely that most of the excess spread will be needed to cover losses and, therefore, will not be available to be deposited in the reserve. In this situation, you should probably give less credit to the issuer’s ability to fund the reserve over time, and a larger proportion of the total credit support should be in place up front. Example One Example Two The case that you examined in the last few screens illustrates the complexity of the analysis required to evaluate the credit quality of securities created in connection with securitizations. There are no easy answers, and there is no magic formula. But, by the same token, structured finance is not rocket-science: for the most part, the principles that you need to apply are based on common sense. If you keep that in mind and persevere, you will be a successful credit analyst. Click on the Continue button to move on to the end-of-module exam. In evaluating the results of your cash flow analysis, you need to keep the interplay of multiple variables in mind. Click on each of the buttons below to review examples of some of these variables. Both examples are related to the extent to which you should give credit to the accumulation of excess spread in a reserve.

96 c4400 Wrap Up Congratulations! You have completed the Analytical Fundamentals of Structured Finance course. Module One: Introduction Module Two: Legal Analysis: Bankruptcy-Remoteness Module Three: Legal Analysis: Asset Transfer Module Four: Originator/Sponsor and Investor Motivations Module Five: Securitization Product Overview Module Six: Credit Analysis of Collateral Module Seven: Credit Enhancement Basics Module Eight: Rating Dependencies Module Nine: Basic Cash Flow Analysis (1) (2) (3) (4) (5) (6) (7) (8) (9)


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