Securitization is the financial practice of pooling various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations, and selling the pooled debt as securities to investors. Cash collected from the underlying debt, including interest and proceeds from the repayment of the debt, is paid to the investors in the securities. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are called asset-backed securities (ABS).
Securitization can provide many advantages, such as lower cost of capital, diversification for investors, enhanced liquidity and others. However, critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the US subprime mortgage crisis.
In addition, off–balance sheet treatment of securitizations along with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an underpricing of credit risk. Off–balance sheet securitizations are believed to have played a large role in the high leverage level of US financial institutions before the financial crisis and in the need for bailouts.
The granularity of pools of securitized assets mitigates the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.
Securitization has evolved from its tentative beginnings in the late 1970s to an estimated outstanding $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the United States and $652 billion in Europe. Whole-business securitization (WBS) arrangements, in which senior creditors of an insolvent business effectively gain the right to control the company, first appeared in the United Kingdom in the 1990s and became common in various Commonwealth legal systems.
- 1 History
- 2 Structure
- 3 Special types of securitization
- 4 Motives for securitization
- 5 Recent lawsuits
- 6 See also
- 7 References
- 8 External links
Examples of securitization can be found at least as far back as the 18th century. Among the early examples of mortgage-backed securities in the United States were the farm railroad mortgage bonds of the mid-19th century, which contributed to the panic of 1857.
In February 1970, the US Department of Housing and Urban Development created the first modern residential mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.
To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets—automobile loans. As a pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.
This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).
The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than were found in the mortgage market. Sales of this type—with no contractual obligation by the seller to provide recourse—allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while also allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.
Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets, including life and catastrophe. This activity grew to nearly $15 billion of issuance in 2006, following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of alternative risk transfer include catastrophe bonds, life insurance securitization, and reinsurance sidecars.
As estimated by the Bond Market Association, in the United States, the total amount outstanding at the end of 2004 was $1.8 trillion. This amount represented about 8% of total outstanding bond market debt ($23.6 trillion), about 33% of mortgage-related debt ($5.5 trillion), and about 39% of corporate debt ($4.7 trillion) in the United States. In nominal terms, between 1995 and 2004, the ABS amount outstanding grew by about 19% annually, with mortgage-related debt and corporate debt each growing at about 9%. Gross public issuance of asset-backed securities was strong, setting new records in many years. In 2004, issuance reached an all-time record of about $0.9 trillion.
At the end of 2004, the larger sectors of this market were credit card–backed securities (21%), home equity–backed securities (25%), automobile-backed securities (13%), and collateralized debt obligations (15%). Among the other market segments were student loan–backed securities (6%), equipment leases (4%), manufactured housing (2%), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.
Modern securitization took off in the late 1990s and early 2000s, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (a concept imported from US credit cards), insurance-backed transactions, and more esoteric asset classes like the securitization of lottery receivables.
As the result of the credit crunch precipitated by the subprime mortgage crisis, the market for bonds backed by securitized loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. As a result, interest rates rose for loans that were previously securitized, such as home mortgages, student loans, auto loans, and commercial mortgages
Pooling and transfer
The originator initially owns the assets engaged in the deal. This is typically a company looking to raise capital, restructure debt, or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, a bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the company's credit rating and the associated rise in interest rates.
The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided leases with a nominal value of $10 million and would receive a cash flow from these over the next five years. It cannot demand early repayment on the leases and so cannot get its money back early. If it can sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.
A suitably large portfolio of assets is "pooled" and transferred to a special purpose vehicle (SPV): the issuer, a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote," meaning that if the originator goes into bankruptcy, the issuer's assets will not be distributed to the originator's creditors. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.
Accounting standards govern whether such a transfer is a sale, a financing, a partial sale, or part sale and part financing. In a sale, the originator is allowed to remove the transferred assets from its balance sheet; in a financing, the assets remain the property of the originator. Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" (qSPE).
Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.
To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities that are issued to provide an external perspective on the liabilities being created and help investors make more informed decisions.
In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities, and work with financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent that initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities, and work with financial markets to sell the securities to investors.
Some deals may include a third-party guarantor that provides guarantees or partial guarantees for the assets, the principal, and the interest payments, for a fee.
The securities can be issued with either a fixed interest rate or a floating rate under a currency pegging system. Fixed-rate ABS set the "coupon" (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating-rate securities may be backed by both amortizing and non-amortizing assets in the floating market. In contrast to fixed-rate securities, the rates on "floaters" periodically adjust up or down according to a designated index, such as a US Treasury rate or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.
Credit enhancement and tranching
Unlike conventional corporate bonds, which are unsecured, securities generated in a securitization deal are "credit enhanced," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).
Individual securities are often split into tranches or categorized into varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure than another: there is generally a senior ("A") class of securities and one or more junior subordinated ("B," "C," etc.) classes that function as protective layers for the "A" class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascading effect between classes, this arrangement is often referred to as a "cash flow waterfall". In the event that the underlying asset pool becomes insufficient to make payments on the securities (e.g., when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities are typically rated AAA, signifying a lower risk, while the lower–credit quality subordinated classes receive a lower credit rating, signifying a higher risk.
The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument that is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating) but only the residual cash flow, if any, after all the other classes have been paid.
There may also be a special class that absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages that, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.
If the underlying assets are mortgages or loans, there are usually two separate "waterfalls", because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions, such as rental deals, it is not possible to differentiate so easily between how much of the revenue is income and how much is repayment of principal. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.
Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.
In addition to subordination, credit may be enhanced through:
- A reserve or spread account, in which the funds remaining after expenses like principal and interest payments, charge-offs, and other fees have been paid off are accumulated, and can be used when SPE expenses are greater than its income
- Third-party insurance, or guarantees of principal and interest payments on the securities
- Over-collateralization, usually by using finance income to pay off principal on some securities before principal on the corresponding share of collateral is collected
- Cash funding or a cash collateral account, generally consisting of short-term, highly rated investments purchased either from the seller's own funds or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows
- A third-party letter of credit or corporate guarantee
- A backup servicer for the loans
- Discounted receivables for the pool
A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and wants to ensure that loan repayments are paid to the SPV.
The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs, and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements, and the probability of default.
When the issuer is structured as a trust, the trustee is a vital part of the deal, as the gatekeeper of the assets being held by the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the originator, the trustee has a fiduciary duty to protect the assets and those who own them, typically the investors.
Unlike corporate bonds, most securitizations are amortized, meaning that the principal borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralized by fully amortizing assets, such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activities. The PSA prepayment model is a well-known example.
A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be non-amortizing. After a predetermined "revolving" period during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.
On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.
Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal; and so forth. Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.
Structural risks and misincentives
Originators (e.g., of mortgages) have less incentive toward credit quality and greater incentive toward loan volume since they do not bear the long-term risk of the assets they have created and may simply profit from the fees associated with origination and securitization.
Special types of securitization
A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust, and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, the originator typically continues to service the receivables, in this case the credit cards.
There are various specific risks involved with master trusts. One is that the timing of cash flows promised to investors may be different from the timing of payments on the receivables. For example, credit card–backed securities can have maturities of up to 10 years, but credit card–backed receivables usually pay off much more quickly. To solve this issue, these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.
A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. To solve this, language is typically written into the securitization to protect the investors and potential receivables.
A third risk is that payments on the receivables can shrink the pool balance and under-collateralize the total investor interest. To prevent this, often there is a required minimum seller's interest, and in the case of a decrease, an early amortization event would occur.
In 2000, Citibank introduced a new structure for credit card–backed securities, called an issuance trust, which does not have limitations (like master trusts sometimes do) that require each issued series of securities to have both a senior and subordinate tranche. There are other benefits to issuance trusts: they provide more flexibility in issuing senior/subordinate securities; they can increase demand, because pension funds are eligible to invest in investment-grade securities issued by them; and they can significantly reduce the cost of issuing securities. As a result, issuance trusts are now the dominant structure used by major issuers of credit card–backed securities.
Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to the pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. The principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.
In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk, and return profiles of issued securities to investor needs. Typically, any income remaining after expenses is kept in a reserve account up to a specified level, and all additional income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.
Motives for securitization
Advantages to issuer
Reduces funding costs: Through securitization, a company rated BB but with AAA-worthy cash flow may be able to borrow at AAA rates. This is the primary reason to securitize a cash flow, and it can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be several hundred basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile-backed securities issued by Ford Motor Credit in January 2002 and April 2002 continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.
Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis." Essentially, in most banks and finance companies, the liability book or the funding comes from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.
Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range on their permitted leverage. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms are able to remove assets from their balance sheets while maintaining the "earning power" of the assets.
Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company. As a result, the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear them to one that does. Two examples of this are catastrophe bonds and entertainment securitizations. Similarly, by securitizing a block of business, thereby locking in a degree of profits, a company effectively frees up its balance to go out and write more profitable business.
Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term implies that the use of derivatives has no impact on the balance sheet. While there are differences among the various international accounting standards, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. It is also a generally accepted principle that, where derivatives are used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain or loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly credit default swaps, now have more or less universally accepted market standard documentation. In the case of credit default swaps, this documentation is formulated by the International Swaps and Derivatives Association, which for a long time provided documentation on how to treat such derivatives on balance sheets.
Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets in order for the "true sale" to stick, and thus this sale is reflected on the parent company's balance sheet, boosting earnings for that quarter by the amount of the sale. While not illegal, this practice distorts the true earnings of the parent company.
Admissibility: Future cash flows may not receive full credit in a company's accounts (life insurance companies, e.g., may not always receive full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.
Liquidity: Future cash flows may simply be balance sheet items that are not currently available for spending, whereas once the book has been securitized, the cash is available for immediate spending or investment. This also creates a reinvestment book that may be at better rates.
Disadvantages to issuer
May reduce portfolio quality: If the AAA risks, for example, are securitized out, this leaves a materially worse quality of residual risk.
Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees, and ongoing administration. An allowance for unforeseen costs is usually essential in a securitization, especially if it is atypical.
Size limitations: Securitizations often require large-scale structuring and thus may not be cost efficient for small- and medium-sized transactions.
Risks: Since securitization is a structured transaction, it may include par structures and credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.
Advantages to investors
Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)
Opportunity to invest in a specific pool of high-quality assets: Due to the stringent requirements for corporations to attain high ratings, there is a dearth of highly rated entities. Securitizations, however, allow for the creation of large quantities of AAA, AA, or A rated bonds, giving risk-averse institutional investors or investors that are required to invest in only highly rated assets access to a larger pool of investment options.
Portfolio diversification: Depending on the securitization, hedge funds and other institutional investors may prefer investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities.
Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, it may be possible for a securitization to receive a higher credit rating than the "parent" because the underlying risks are different. For example, a small bank may be considered riskier than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).
Risks to investors
Credit/default: Default risk is generally accepted as a borrower's inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security's default risk is its credit rating. Different tranches within an ABS are rated differently, with senior classes usually receiving the highest rating and subordinated classes receiving correspondingly lower credit ratings. Almost all mortgages, including reverse mortgages, and student loans are now insured by the government, meaning that taxpayers are on the hook for any of these loans that go bad, even if the asset is massively over-inflated. In other words, there are no limits or curbs on overspending or the liabilities to taxpayers.
However, the credit crisis of 2007–8 exposed a potential flaw in the securitization process: loan originators retain no residual risk for the loans they make but collect substantial fees on loan issuance and securitization, which does not encourage improvement of underwriting standards.
Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
Currency interest rate fluctuations: Like all fixed-income securities, the prices of fixed-rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating-rate ABS prices less than they affect fixed-rate securities, as the index against which the ABS rate adjusts reflects interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.
Moral hazard: Investors usually rely on the deal manager to price the securitizations' underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.
Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.
Recently there have been several lawsuits attributable to the rating of securitizations by rating agencies. In July 2009, the largest public pension fund in the United States filed a suit in California state court in connection with $1 billion in losses that it says were caused by "wildly inaccurate" credit ratings from the three leading ratings agencies.
- Collateralized debt obligation, securitization vehicle for corporate debt securities
- Collateralized fund obligation, securitization vehicle for private equity and hedge fund assets
- Collateralized mortgage obligation, securitization vehicle for mortgage-backed securities
- Collateralized loan obligation, securitization vehicle for corporate loans
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