Introduction to Securitization

IDENTIFICATION OF RISKS

The next task after the selection of the assets to be included in the asset pool is the analysis of the risks associated with the pool and the proposed structure. These risks include credit risk, interest rate risk, prepayment risk, delayed payment risk, exchange-rate risk, servicing risk, legal risk, and tax risks.

Credit risk is the risk that the obligor will default by either refusing to pay or declaring bankruptcy. The end result of the investigation of credit risk is to develop based on empirical analysis a cumulative loss percentage of the pool, referred to as the expected loss²⁶. The investigation begins with an examination of what happens in the case of the failure of an obligor to pay. If the delinquency is treated as a default, the procedure for recovery is set forth in the servicing agreement and depends on the nature of the asset. For example, the process for recovery as set forth in the servicing agreement may require that the delinquent receivables be sold to a specialized servicer (who may be the originator, his affiliate, or a third party) at a particu- lar value, or a foreclosure action may be followed. To estimate the expected loss the following must be quantified (1) the default rate (i.e., the percentage of loans that go into default); (2) the timing of the defaults or default rate over time; (3) the recovery rate; and (4) the recovery delay (i.e., the time between recognition of a default and actual recovery).

When assets are included ...