SECURITISATION NEWS AND DEVELOPMENTS

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April 2007 onwards

[This page lists news and developments in global securitisation markets – please do visit this page regularly as it is updated almost on a daily basis. Join our mailing list for regular news fed direct into your mailbox]

 

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ASF's subprime relief plan

The much awaited relief plan that seeks to save subprime mortgages from getting into inevitable foreclosure was unveiled by American Secuiritization Forum, having been endorsed by the Bush Administration.

The plan applies to mortgages that are ARMs, are subprime, were originated between Jan 1, 2005 to 31st July 2007, and have interest rate forthcoming between Jan 1 2008 to 31st July 2010.

Essentially, the plan classifies mortgages into 3 segments – (1) those that may qualify for refinancing under available mortgage lending plans, (2) those that are current, that is, not delinquent, and (3) those that are not current. In the first case, the servicer should educate the borrower and advise him to have the mortgage refinanced.

The second case is one of loan modification. Here, if on the reset date, the mortgage instalments would go up by 10% or more, and the borrower meets the FICO score test, the loan will be eligible for a fast track modification, under which the existing interest rate will be kept frozen over the next 5 years.

The third case is one where the loan is already delinquent. Here, the approach is one of loss mitigation. The servicer should take measures that would maximise the present value of the loan recovery. These include loan modification, forbearance, short sale, short payoff and foreclosure.

The complete ASF document is here.

Old habits of securitization world come to question 

Public charities, SPV ownership structures, etc. raise curious concerns

These may be absolutely normal for any securitization practitioner – so normal that one would not even have ever pondered for a second as to how unrealistic the whole setting of facts is, and these practices are now coming into sharp scrutiny.

In a typical securitization transaction, the almost-universal practice is to have a special purpose vehicle owned by a public charity. The legal domicile of the SPV is a tax haven, typically Cayman Islands. The public charity owns the nominal equity of the SPV – typically something like 1 dollar or 10 dollars. So, with a few dollars of capital, the SPV acquires assets of millions, and intends to do the good of mankind with the residual returns on equity that it would never get, since there is a residual income class that sweeps the entire profits of the SPV left after payment of coupons to the noteholders.

The superstition in the legal world is that with legal ownership of the SPV in the hands of a so-called public charity, that has done no charity ever, the SPV would be legally an orphan, that is, would not have any clear owner at all. While accounting standards have demolished this myth and are now looking at residual interest for consolidation purposes (Fin 46R and SIC 12), but for consolidation for bankruptcy purposes, it is still believed that the legal ownership in the hands of a charitable trust would be respected.

Guardian started a wave of investigations in Northern Rock's granite securitisation program. It carried an article titled A twisty trail: from Northern Rock to Jersey to a tiny charity. The article also says that the Charity Commission has started an investigation against Northern Rock.

While Guardian might have led to enthused investigations against Northern Rock, within the securitisation world, it is common knowledge that this structure is used by just everyone.

Bad news galore as securitization markets almost liquidate

Bad news continued to pour in during the week, with JP Morgan, Bank of America etc continued to post gloomy pictures of their Q3 losses and impending Q4 problems. Wall Street Journal is giving a quick summary of Q3 financials.

CDO rating downgrades continued. In almost a rare example, State Street Capital-managed CDO called Carina CDO Ltd fell from the roof and was downgraded from AAA to CCC. S&P justified the stern rating action on the ground that the senior investors had decided to liquidate the collateral at a time when the market was already bad, and therefore, the collateral might realise more losses than otherwise.

New issuance activity has come to a grinding halt. As per data on abalert.com, the new issuance in the whole of October was just about $ 34 billion whereas the same period last year saw a new issuance of $ 130 billion. The liquidity in the ABCP market is also completely dried up as the curve of outstanding ABCP continues to slide down steeply.

The barometer of credit default swaps on asset backed securities, ABX.HE, gives gloomiest picture ever. The AAA tranche of ABX.HE has reached a new low of 69.93, and in just a week's time, has fallen from 80.17. The poorer siblings – BBB and BBB- tranches, seem to be falling from a cliff, with prices of 20.79 and 19.36 respectively.

In a bad time such as this, the pains of the banking community are exacerbated by FAS 157 which becomes applicable from Nov 15, 2007 and would therefore apply to the next quarter. Under this standard, for computing fair value of assets, an entity must distinguish between assets where it applies market values (Level 1), model values based on observable facts (Level 2) and best estimates (Level 3). The new standard requires valuations to consider all risks in case of Level 3 assets.

UNCTAD paper takes stock of securitization risks

While there is no dearth of recent articles and write ups fuming and fretting against securitization, the UNCTAD recently put together a note on the risks facing the global financial economy, and spent a good part on the subprime crisis, and the risks inherent in securitization in general.

On the larger global economy risks, UNCTAD, like IMF and several others, paints a rather gloomy picture of the US economy and predicts three different scenarios – a benchmark scenario, benign scenario and a crisis scenario. In the benchmark case, a bleeding US economy will eventually cause losses to the emerging markets too.

As for securitization risks, the UNCTAD note takes the same line as BIS and FSA recently took – that the originate-and-distribute model on which banks work currently undermines credit underwriting discipline and hence affects the quality of assets. As one of the recommendations, UNCTAD even recommends a legislation that would require banks to keep some part of the assets they originate.

Rating agencies have a substantial role in the CDO market, and rating agencies' rebuttal that their ratings should not be used as the basis of investment decisions is completely unacceptable. The UN trade body recommends a relook at this scenario, including may be an oversight authority on the rating agencies.

The article, containing a complete dossier on the important events in the subprime crisis, also provides a quick view of important risks facing the financial system. The text of the article is here.

Securitisation: Article in The Economist sees it as a turning point

There is absolutely no dearth of harsh words and harsher voices against securitisation these days – you don't even have to dig the surface as it is all up there, all over the financial and general press. There are people who have called it a swindling game, conning game, outsmarting device, etc.However, The Economist has built its own gravity over the years of its readership.

The 20th Sept issue of The Economist carries an article titled When it goes wrong. It says a complete generation has prospered from the wholesale transfer of risk by way of securitisation. Now, it is paying the price.

See the text of the article here.

In the meantime, hearings before lawmakers are taking place on both sides of the Atlantic. The Senate Banking Subcommittee is continuing its hearings in Washington. In London too, the Financial Services Authority is continuing its investigations.

Special purpose vehicles to be put to acid test

As securitization is passing through the worst time over the 30 years or so of its practical history, the ubiquitous tool that enables securitizations – special purpose entities – will be passing through an acid test. If in the coming few months, courts or lawmakers do not make things extremely adverse for SPEs, they would be a part of the business world's toolbox for all time to come.

Special purpose vehicles are special in many ways – they have a legal existence but a substative void, There are no assets, risks or liabiliteis other than those involved in the given transaction. They have a management that is supposed to be independent, but they have nothing really to manage. They are independent, while the only reason why they exist is to enable a particular transaction. The most curious part of SPVs is their ownership by public charities which is virtually a shame on the grand name of charity. The device has been used to simply hive off an asset, transaction or relation and give it an incorporeal status.

The current crisis will put SPEs under very sharp eyes – public, legislative, judicial. The public is already outcrying and investigating the ownership structure of entities like Northern Rock's Granite securitizations.

However, here comes another very curious test – as hedge funds are filing for bankruptcy protection, the enigma is – should they file for protection under Chapter 15 of the US bankruptcy code as a case for cross border insolvency, or Chapter 9 or 11 as a case of US insolvency. In preliminary proceedings relating to Bear Stearns' hedge funds, a Manhattan bankruptcy court seems to have taken the view that while the hedge funds are registered in the Cayman, the Cayman office is nothing but a "letter box". As almost all the liquid assets of the hedge funds are in the US, they must come under Chapter 9 or 11 as US entities,

If this view prevails, the registered office of the hedge funds will be taken as irrelevant. The ruling may form the basis of tax, and on exttension, even regulation. Similar views were taken by the UK Court of Appeal in the case of Indofoods last year.

Links For more on SPVs, see our page here.

Moody's talks of new securitization risks

While lot of heat is turned on the rating agencies themselves, as to how is it that they are getting all this wisdom only now, here is some brilliant piece of wisdom from Moody's – it says it is for the first time since LTCM that the disintermediated financial markets have got their first stress test.

The originate-to-distribute model became particularly very strong over the last few years when banks stepped their originations that would not stay on their balance sheet – something that every underwriter in the bank would know.

Moody's wisdom is that the present crisis teaches us the same lessons that LTCM did – "The lessons to be learned are for a good part lessons to be learned again. Most of the deficiencies exposed by the current episode were identified in the aftermath of the Long-Term Capital Management (LTCM) crisis in 1998: the modern financial system over-relies on the presumption of li quidity; risk is increasingly difficult to localize; asset correlations increase in times of stress; and leverage changes the scale of market dynamics, on 
the upside as well as on the downside", says the article titled Stress-testing the Modern Financial System.

Moody's also blames the mark-to-market accounting system – "The world would be a much safer place if all securi ties were held by ?real money? buy-and-hold inves tors who did not have to mark to market, and who therefore did not have to make forced sales into panicked markets. Unfortunately, literally trillions of dollars of securities are now held by leveraged mark-to-market institutions relying on other peo ple?s money to finance sometimes opaque, complex and risky investments."

The article talks about several securitization risks that the current crisis has thrown up:

  • "Securitization relies upon historical relationships (e.g., subprime default and loss levels) that can change unexpectedly and by orders of magnitude. The proliferation of non-standard products has impeded the development of a liquid secondary market for many types of securitizations. As we are observing, there is no observable market price for a unique security.
  • Securitization creates an agency problem by separating the originator from the ultimate holder. While this is one of securitization's car dinal virtues, it is also a problem in that origina tors may be incentivized to maximize origina tion volume, instead of quality. And, as we see in subprime, some originators may be tempted to misrepresent the quality of loans being sold or, less sinisterly, originators are not motivated to care about the quality of loans because they 
    aren't owners of the assets for very long.
  • The opacity and/or complexity of some securiti zation products have led some investors to over-rely upon third-party credit analysis (i.e., ratings) without fully understanding what they are buying (and now what they own). And many 
    market participants have over-relied on ratings in determining appropriate price levels for such securities.
  • Some companies' business models were built on the presumption of securitization as a viable funding source. When certain asset classes fall out of favor, these actors may find themselves out of business.
  • Idiosyncratic risk is different for structured se curities than for corporate instruments. Idiosyn cratic risk in RMBS appears most visibly at the originator and vintage levels. Originator risk may be analogous to individual company risk, 
    but vintage risk is an overlay that has no corpo rate analog. And even with twin forms of idio syncratic risk, structured securities may exhibit fewer significant idiosyncratic attributes – causing more herd-like changes in creditworthiness –
    due to more limited operating characteristics and more homogenous assets.

Northern Rock's Granite RMBS still safe: rating agencies

While Northern Rock's ship is rocking, its RMBS transactions are not affected, say the rating agencies. While that may be good news for the securitisation investors as opposed to the depositors in the troubled UK mortgage originator, there are questions on the servicing risk, liquidity risk, etc which might affect the securitisation transactions as well.

Northern Rock, 4th largest UK mortgage originator, has been one of the leaders in UK RMBS supply. Under its Granite template, Northern Rock has some GBP 40 billion odd funding by way of RMBS. It has several covered bonds issuances too.

S&P issued a press release on 19th Sept affirming the ratings on the securitisation transactions despite the rating downgrade of Northern Rock. There are sufficient credit enhancements in the securitisation pools, and the pool is a prime RMBS pool. However, the as the originator faces severe liquidity problems, its servicing capabilities are unlikely to remain unaffected. In addition, people ha ve already started probing into the SPVs that have funded the securitisation transactions. In the present environment where SPVs are only again looking suspect, there might be probes into Northern Rock that might bring up some fundamental questions on securitisation structures.

If at all there is a servicer change, this might be one of few instances of servicer migration in the UK.

Today (20th Sept), BoE's Governor equated the current crisis in UK banking as the worst since 1973.

 

The bird in the Bush will now come out –
Prez to announce measures on subprime crisis

Today morning, US time, President Bush is expected to announce measures to contain the subprime crisis that actually continued to build like a toxic tank right under the nose of the Federal regulators ever since 2005, and finally burst and spread all over the World.

US press said Bush plans to announce a variety of measures in the Rose Garden on Friday morning that are designed to help struggling homeowners with subprime mortgages avoid foreclosure and will declare that lending practices need to be tightened. Presumably, bankers were all this while waiting for the Prez to ask them to tighten their lending practices.

The measures might include some tax relief to troubled borrowers to rework their loans. The measures are also affected to deal, at least in part, with securitization transactions, and perhaps will have some impact on the servicing industry and the rights of the servicers to modify terms of loans before they are in default.

While the Prez may not go into finer details at this time, gain-on-sale accounting practice may also come for question. The FASB is already considering proposals to replace the present accounting practice by one based on "linked presentation" that UK FRS 5 had several years ago.

Keep watching this site – we will bring further updates.

Bad news pours in – ABCP, student loans, aircraft leases 
– all seem to be going wrong at the same time

Suddenly, all seems to be going wrong. The institutions of structured finance that we nurtured over all these years, on which Wall Street investment bankers bagged fat bonuses every year, all seem to be looking suspicious. In India, they say – having burnt your lips with hot milk, you would even blow into buttermilk before taking a sip.

The supply in the asset backed commercial paper (ABCP) market is seemingly badly affected. ABCP conduits issue short term paper and were originally created to acquire trade receivables of their clinets, but over years, they have grown into mini off-balance sheet banks and acquire variety of credit assets including RMBS,CMBS, CDOs, trade paper, etc. The size of the ABCP market is nearly USD 1.2 trillion. While most of the paper that ABCP conduits buy has already been credit-enhanced to AAA levels, the issue of commercial paper is done expecting a roll-over funding. The sponsoring banks provide a stand-by liquidity support. As the investors have broadly retreated, liquidity lines of the conduits have been drawn up in some cases, and this has created another source of jitters in the market. Rating agency Fitch held a conference call last week highlighting the liquidity concerns, and resulting capital consequences and mark-to-market pressures.

Increasing consumer bankruptcy fears have also put questions on credit card ABS, one of the very safe collateral classes. According to Moody's Investors service, the bankruptcy filings this year are 30% higher than a comparable number last year.

Liquidity has dried up for student loan ABS also.Even as diverse an asset class as aircraft leases has been affected.

Needless to say, CDO issuance is almost completed dried up. The volumes for August 2007 reported on abalert.com add up to $ 7.8 billion whereas usual issuance in this month would have been nearly 5 times. The total US ABS issuance for August shows as a mere $ 4.5 billion, as opposed to $ 70 billion in the same month last year.

Will the Fed interfere to bail out mortgage markets?

Historically, when financial markets hit rocks, the US government has deployed the Federal agencies to bail them out. This happened in the case of LTCM, and Savings and Loans crisis. As the mortgage market troubles continue to jolt the global financial system, a key question is – will the Fed interfere? If so, will it be a day too late, or just in time?

Noises are doing rounds that the GSEs may be called upon to buy junked loans. If that is to happen, it must happen before it is too late, because it is clear that it would take days, not weeks or months, before the financial system would be in a deep mess.

The portents of the impending crisis are all but unclear. Lots and lots of funds world over are invested in the US mortgage market. Liquidity in the securitization market has dropped down drastically, even for asset classes traditionally regarded very very safe. The cost of borrowing via asset backed commercial paper has gone up by something like 50 bps. As investment funds face liquidity crisis, many of them have already blocked redemptions – the latest to do so was BNP.

The impact of the US meltdown is seemingly spoiling the party of global growth. The financial press is using words like "US exports poison" (BBC News), "Ugly American hits Europe" (BusinessWeek), etc.

Australian mortgage markets also catch cold: 
mortgage insurance claims rise 329%

The frenzied pace at which mortgages were created by banks was not limited to the US banks. Australia is another very well developed mortgage securitization market, and Australian banks were going high on mortgage origination too. Hence, it is not surprising that the spectre of increasing mortgage defaults has affected the Australian market too.

Australian Prudential Regulation Authority (APRA) reported that claims on mortgage insurance companies in 2006 were 329% higher, that is, more than 4 times the claims in 2005. It is a common practice among mortgage originators in Australia to buy pool mortgage insurance covers, and if the defaults happen on a pool, the insurance company faces claims.

The reports also indicated that the rate of increase on account of mortgage defaults was higher than any other insurance sector claims..

Australian stocks have been badly affected by the mortgage crisis, both local and global. Most of Australian banks have exposure in US markets too. Australian banks both originate and invest in CDOs. In fact, CDOs have even been sold to retail investors in Australia. Macquarie's mutual fund is supposed to have lost nearly 25% due to the mortgage meltdown.

Wall Street is now firing:
Securitisation and credit derivatives jobs are being cut

After several years of high-pay and high-stress jobs, investment bankers are now in a mood to fire. Wall Street is facing a lot of fire here, there and everywhere anyway.

Troubled Bear Stearns' president resigned; reports indicated that he was responsible for mortgage-related investments in the investment bank. Bear Stearns has said that it is facing the worst financial crisis over the past 20 years.

Nomura Securities' structured finance research team has been reduced substantially. Notable securitization expert Mark Adelson has left the firm, along with several of his team members.

In the mortgage sector, some 50000 jobs have been laid off in all, as per data on www.mortgagedaily.com.

Every year, leading investment banks hire finance, quant and trading experts from business schools world over. Investment banks are typically manned by young blood, who believe more in passion than in caution. This year, it seems recruitments in derivatives, investment banking and structured finance desks, particularly hedge funds and private equity, will be substantially reduced.

Crisis raises basic questions on securitisation; many funding plans disrupted
BAA's whole business securitisation may not fly

As is quite common behaviour, the subprime crisis has put some very basic questions on securitisation. In some of the blog sites [for example, cfo.com’s blog site], people are arguing about securitisation per se. As investors get securitisation-scary, funding plans of many are being disrupted.

Global issuance data on abalert.com shows a world-wide decline in the month of July – a rare occurrence after several years. As the after-effects begin to jell, there might be sharper decline in the current month. Spreads on ABS are also showing at 52 weeks' highest, with AAA home equity quoting at a whopping 170bps.

In the USA, alt-A mortgage securitization has completely stopped, says a report at marketwatch.com

Reuters came out with a big listof hedge funds who are reportedly or admittedly in trouble. Here is the list:

  • Bear Stearns Two Bear Stearns funds have filed for bankruptcy already. A third one has stopped redemptions.
  • Absolute Capital (Australia) – Half-owned by ABN AMRO. Temporarily closes two funds in late July with a combined A$200 million in assets amid problems with collateralized debt obligations.
  • Macquarie Bank (Australia) – The bank warns in early August that retail investors in two of its debt funds face losses of up to 25 percent. Note that this is a mutual fund and not a hedge fund.
  • Basis Capital (Australia) – Suspends redemptions on two of its funds in July. Presently conducting a fire sale of assets.
  • Oddo Asset Management (France) – in late July closes its Oddo Cash Titrisation, Oddo Cash Arbitrages and Oddo Court Terme Dynamique funds, which manage total assets of around 1 billion euros.
  • Sowood Capital Management (United States) – The hedge fund which managed money for Harvard University tells investors on July 30 that it will wind down after suffering losses of more than 50 percent which wiped roughly $1.5 billion in capital.

Among the casualities are the huge whole business securitisation announced by BAA earlier this year [see news on our site here]. Reports indicate that BAA may not be able to refinance its properties by arising GBP 4.5 billion, as proposed earlier, as liquidity in the market is quite tight and leveraged finance may drop down sharply.

Lot of fire, and lot of smoke all over: crisis spreads wider and deeper

The inevitable crisis in the subprime mortgage securitization segment is now spreading like wild fire. And it is difficult to say if the fire is more or the smoke, as crisis alarms have gone off everywhere.

Geographically, the crisis has already affected some European banks; some Australian hedge funds have also suspended redemptions, though they claim to be unaffected by the subprime crisis. Some more US hedge funds closed redemptions.

A third Bear Stearns hedge fund, Asset-backed Securities Fund, was reported by Wall Street Journal to be in trouble; has stopped redemptions. C-BASS, a mortgage investor, seems to have heavily lost money, and consequentially, MGIC and Radian have suffered losses of impairment. There are other subprime lenders who have suffered huge casualties, as reports indicated that subprime mortgage losses were not stopping. Mortgage insurers might have substantial liabilities.

Australian bank Macquarie's Fortress Funds might lose value upto 25%, though it is not reportedly connected with subprime losses.

German bank IKB was also reported to have suffered huge losses out of US mortgage market – its rating has already been downgraded by Fitch. In Paris too, Oddo and Cie, a fund manager, is reportedly shutting down two of its funds.

In the midst of the heightening worries in the subprime market, trades in credit derivatives on subprime securitizations found that the subordinated tranche of the ABX.HE index still meant some value – BBB- tranche of ABX.HE's 2007-2 run went up in value from its lowest point of 39.97 on 27th July to 41.22 on 31st. However, the senior-most tranche still lies at 94.5, its lowest since inception.

Updated August 2, 2007: The impact of the US securitization crisis is widening. Equity markets world-over reacted sharply with most indices taking a beating. Losses in market cap add up to billions of dollars. In the meantime, Bear Stearns hedge funds filed for bankruptcy, and investors have joined together to file litigation. Reports keep pouring about several European banks that would lose heavily in the subprime market.

Notably, the Macquarie Ban's fund reported to have lost nearly 1/4th of its capitalisation is a retail mutual fund.

Most other hedge funds have got margin calls from their banks, bringing liquidity to an all time low.

It is not a ripple effect; it is web effect

It would be wrong to call it a ripple effect: ripples get lighter as they spread. This one is a web effect, as the world of finance today is a complex web of one instrument heavily depending on the other. The crisis that originated in the subprime mortgage market brought CDOs to a complete halt (see report below and updates in this item). At the same time, hedge funds were hit as they continue to face losses either as purchasers of the ABX indices or as equity holders in CDOs. The CDO/CLO market was a big supplier of liquidity to the leveraged loan market – so, with the CDO machine halting, there is a sudden crisis of liquidity in the leveraged loans market. And it would continue to spread – to conduits, to private equity lenders, even to seemingly unconnected participants as insurance and reinsurance companies.

Market is abuzz with news of failed syndicated loan deals – be it refinancing of Cerberus' purchase of Chrysler,or Kolberg Kravis Roberts & Co.'s purchase of Alliance Boots.

Lots of investors have started doubting the veracity of the ratings – AAA ratings have fallen by several notches in the recent weeks, and the downgrades are not stopping. Investors are questioning as to whether the rating agencies could not have seen this when they rated the transactions in 2006 – credit enhancements levels were much lesser in those deals than the transactions structured in 2001 and 2002.

In the meantime, a new roll of ABX.HE, 2007-2, continues to slide. The safest tranche fell from 99.3 to 95.39 in matter of days, a decline of nearly 5%. The BBB- piece fell to as low as 40.39 from its inception price of over 50.

On the other side of the Atlantic, the iTraxx crossover index, an index of credit default swaps on entities that crossed over recently from investment-grade to below, has been crashing, taking along the confidence of the community that saw credit derivatives as a hedge against volatility. Today's Financial Times quotes Jim Reid of Deutsche Bank as saying this: "We should now be in little doubt over the power and influence of leverage, derivatives and structured products. They are not volatility dampeners, but volatility magnifiers".

CDS spreads on most of the leading Wall Street investment banks have risen sharply, which means their cost of capital will increase. As mortgage delinquencies continue to raise, and housing sales have been dropping, the portents are surely not good.

Links See Vinod Kothari's piece on two old risks of structured finance here.

CDO market comes to a grinding halt, says report

If, as 2006 volume statistics clearly show, 70% of CDO issuance was what is called structured finance CDOs, it is hardly surprising that with never-before concerns about the structured finance market, CDO issuance should have halted. International Herald Tribunequoted a JP Morgan report that the volume in July had come down to a mere $3.7 billion from $42 billion in June. The global CDO issuance data on abalert.com bears this out – the number for June 2007 is shown as USD 50.1 billion, whereas that for July to date (as seen on 24th July) is merely USD 1.9 billion.

CDO structurers were going gung-ho on structured finance transactions. A CDO would pick up BBB to BBB- pieces of asset backed transactions, mostly subprime and the likes. That is where the arbitrage lay. Till 2005, CDO structurers were making merry on CDO^2, which became unpopular thereafter.

The sqeeze of liquidity in the CDO market is also likely to be accompanied by similar shortage of funds in the private equity market.

On the other side, a new 2007-02 run of the ABX.HE index was launched. The BBB- tranche that started with a price of 50.33 slided to 47.86 in a matter of days. Even the AAA tranche fell from 99.33 to 98.03.

India's securities regulator puts up draft regulations on securitised instruments public offer and trading

There may not be much of securitisation happening in India these days, but that has not stopped regulators from coming up with elaborate rules, complete with licensing, eligibility conditions, rejection of application for registration, appeals, and so on.

The Parliament recently amended the law that deals with trades in securities – Securities Contracts Regulation Act – and made "securities" inclusive of securitised instruments. This was made out to be a boon for securitisation as it would permit public offers and exchange trading for securitised instruments. It was noone's case that lack of such listing or public trading was hindering the market in any substantial way.

That amendment having been through, the Securities Exchange Board of India [SEBI] which was empowered to write regulations for public offers and listing has now come up with draft regulations that have been put up on its site today.

Instead of falling in line with similar public offer rules for asset backed securities in other countries, for example, Regulation AB, SEBI has drawn heavily on its own template in context of mutual funds and similar market intermediaries. Thus, for a securitised instrument to be offered to public, there has to be a special puropse distinct entity (read SPV). While the normal concept of SPVs is a discrete body for each transaction, SEBI's idea seems to be some kind of a continuing umbrella entity that would serve several transactions in a sequence. Hence, there is a need for registration of such entity, and such registration must be maintained on a continuous basis. A single SPV can come up with several transactions of securitisation, called "schemes", again in line with mutual fund parlance. Hence, the SPV becomes a kind of protected cell or multi-segmented entity, though the law in India currently does not have any cell protection rules.

Once the SPV is registered, it can, over time, bring public offers by having an offer document which would also need to be registered with SEBI. There are scanty disclosure requirements in the offer document, which obviously indicates that SEBI did not have the benefit of similar disclosure requirements either from SEC USA or from industry bodies.

The draft rules are placed for public comments on SEBI site.

Subprime sorrows deepen with downgrades, 
defaults and hedge fund collapse

Financial press is full of stories about the sorrows of subprime lending. The news is coming from different quarters, and is constantly causing loss of nerve in the CDOs, ABX trades and the financial services industry in general. The news of the mounting delinquency rates in the US mortgage market (see news immediately below) was quickly followed by Moody's releasing its latest reseach report on the "challenged" market. Moody's downgraded 131 securities of the 2006 vintage and placed a good 136 on rating watch negative. While most of the downgraded securities had a rating of A or lesser, a small percentage had a Aa and Aaa rating also.

In the meantime, the market got further disturbing news about a 10-month old Bear Stearns hedge fund High-Grade Structured Credit Strategies Enhanced Leverage Fund was nearing collapse as investors were breaking gates for redemptions and the fund did not have liquidity to do so. The fund was focused on subprime market. The highly geared fund had a capital of about USD 640 mil, but borrowings of about USD 6 billion. There were reports about a bail out effort with additional capitalization from Bear Stearns or others.

In the meantime, the ABX.HE index continued to slide down. The BBB- piece reached an alltime low of 60.39 and the slide does not appear to have stopped.

The liquidation of the subprime MBS portfolio held by the BS hedge fund and others might soon exacerbate into a liquidity crisis in the market as most of the players are driven by mark to market practices and will have to report losses. The reported losses may reach deleverage triggers. In fact, most of the leveraged investment vehicles in the market has deleverage triggers that are ruthless and automatic. They require the fund to liquidate its assets when the times are bad, which sounds like counterintuitive.

While subprime servicers are exploring ways to resolve foreclosures by restructuring loans, one of the technical issues that have comes up is – does FAS 140 laying down conditions for QSPEs allow that discretion? Some democrats seems to have sought SEC clarification on this.

Updated 21st June 2007

Merrill Lynch, a lender to two of the Bear Stearns hedge funds that are nearing collapse, has reported seized USD 850 million of the assets of the hedge funds held as collateral by the former. Merrill has begun selling these assets, most comprised of CDOs and CDO^2.

In the meantime, ABX.HE fell below the 60 mark and the last quote went to 59.79. The expectations are that there will be further decline before the trading closes for the week.

In the meantime, SEC and FASB are meeting today to discuss whether a servicer can have the right to alter the features of a mortgage before it goes into a default. The critical question comes in context of the 2/28 ARMs that would start posting increased instalments from the end of the second year, fast approaching in case of mortgages written in 2005 and 2006. In the already weakened market, the increase of mortgage payments would be a hard blow

We will continue to provide more coverage on this very serious crisis facing the securitization market.

Mortgage woes hurt leading originators; 
foreclosure rates highest in last 50 years; ABX.HE starts sinking again

Several related things happened this week to hurt the sore spot of US banking – the mortgage market. Piggybacking on historically low interest rates, most US originators marketed mortgages aggressively enough, mostly with features that would look attractive enough upfront, but would be painful in the long run.

The US mortgage bankers body Mortgage Bankers Association of America reported that foreclosure rates in the 1st quarter of 2007 reached 1.28 percent of all loans outstanding at the end of the first quarter, an increase of nine basis points from the fourth quarter of 2006 and 30 basis points from one year ago. The Washington Post added that this was the highest in last 50 years.

The rate of foreclosures started on subprime ARMs jumped from 2.7 percent to 3.23 percent. The states mainly responsible for that increase were California, Florida, Nevada and Arizona. The reasons cited for the increase were decline in home prices and increase in unemployment rates.

In the meantime, the Goldman Sachs reported performance for the last quarter and its shares dropped 3%. Bear Stearns' earnings at Bear Stearns in the second quarter fell 10 per cent to $486m, with lower mortgage lending and securitisation volumes offsetting strong growth in other businesses, particularly investment banking, prime brokerage and wealth management.

The index of representative subprime securitization transactions, ABX.HE has started sliding again. The BBB- tranche fell to a price of 61.91, lower than the previous low reached in the 1st week of Feb this year.

More reports There are more related stories below.

UK FSA report exposes securitisation risks, loud and clear

There is a saying in rural India – If there is a theft at the village launderer's shop, everyone loses, except the launderer. Present day banking system relies heavily on the originate-and-distribute model for credit assets. The assets are distribute either by cash securitisation, or synthetically by structured credit trading. In either cases, the risks are dispersed in the capital market, with the banks merely making their originator profits. To Alan Greenspan, this was responsible for holding the entire banking system in good stead, but the UK FSA clearly warns that the systems has far thrived in benign credit markets; it has not faced the test of stressful times.

A phenomenal part of the latest Financial Stability Report of the the UK Financial Services Authority is dedicated to the risks of securitisation and credit derivatives market.

Taking a leaf from the troubled UK subprime mortgage market, the FSA argues that similar risks might be growing underneath the calm of the UK financial system too. It makes what seems like a very bold critique of the securitisation system:

  • Strong investor demand for securitised assets, combined with benign market conditions, has sustained a heavy
    issuance of both RMBS and CMBS. In turn, this seems to have led to an easing in underwriting standards, such as increasing ‘covenant-lite’ deals in the leveraged lending arena and weaker documentation requirements for CRE lending.
  • Given that risk is transferred to other market participants, there are concerns that the originate and distribute’ model might dilute incentives for the effective screening and monitoring of loans in the corporate market, as appears to have occurred in the sub-prime market.
  • Since lower tranches of securitisations are mostly taken to CDOs, the embedded leverage in CDOs is common across sub-prime, CRE and corporate credit markets and could magnify the market response if there was a particularly sharp deterioration in the performance of underlying assets.
  • The separation of the origination of risk from its ultimate incidence may mean that less information on underlying credit quality is available to the bearers of risk. In US sub-prime markets, end investors appeared not to be able to determine the credit quality of lending being securitised very accurately. Originators with incentives to sustain lending volumes originated poorer quality lending. While market mechanisms
    exist to maintain credit quality by ensuring that originators remained exposed to some of the potential credit loss, the high levels of arrears in recent vintages of US sub-prime mortgage lending raise questions about the effectiveness of those mechanisms.
  • Where risk transfer leads to a greater dispersion of individual credit risks across investors, the fixed costs of monitoring credit risk may mean that the standards of individual investors’ own credit risk assessments are lowered as they hold smaller exposures. In such circumstances, credit risk assessment is often partly delegated to third parties, including rating agencies, lead arrangers and managers of structured credit vehicles, such as CDOs. But there are risks that investors could become overly reliant on the assessment of others.
  • Recent events have also highlighted risks from excessive reliance on, or confidence in, historical credit-risk scoring models for credit assessment. Models can break down when the attitudes of borrowers towards default are shifting, as may have been the case recently in the UK unsecured lending market. And modelling risks will be heightened when these models are applied to new forms of lending

Links For full text of the FSR, see here.

Subprime debacle hardly surprising, says paper

Nomura Fixed Income Research's Mark Adelson and team came out with a very timely paper on the subprime debacle. As may be common intuiation, the subprime lending spree of 2005 and 2006 ignored some very basic principles of money lending and therefore, foreclosures were bound to rise with house values declining. The brilliant is just brilliant, and we bring below the key conclusions of the paper:

There is no sub-prime surprise. High delinquencies and defaults are an inevitable result of the kinds of loans made in 2005 and 2006. Ignoring the Three C's of lending could produce no other result. Moreover, the warnings were loud and clear. The warnings also were numerous and frequent. And they came from many diverse sources, including the general media.

The current flurry of activity to "do something" about the sub-prime mortgage situation is a day late and a dollar short. Policymakers and market participants who don't like the current situation should 
have acted sooner by taking obvious preventive measures. Both policymakers and market participants share responsibility for the current situation by having ignored the warnings and having failed to act sooner.

Unfortunately, some policymakers are trying to exploit the current situation by pandering to defaulted
borrowers. That conduct is counter-productive. Policymakers and market participants need to come to grips with reality. There likely will be an uncomfortably high level of foreclosures. Despite the best of intentions, rescue attempts on many loans probably will fail. And, lastly and most importantly, policymakers should refrain from taking drastic, ill-conceived actions that ultimately do more harm
than good by unduly reducing the availability of mortgage credit to American families.

 

Trade bodies release draft of self-regulatory non-mandatory guidelines
for retail structured products

While US congressmen continue to examine if things had indeed gone wrong in the way subprime mortgages were packaged and sold, trade bodies got into the act and released draft of self-regulatory non-mandatory guidelines for retail structured products.

The guidelines were released jointly by the Securities Industry and Financial Markets Association, European Securitisation Forum (ESF), the International Capital Market Association (ICMA), the International Swaps and Derivatives Association (ISDA), and the London Investment Bankers Association (LIBA).

The guidelines are applicable when structured products are delivered to retail investors. Retail structured products should always be distributed through distributors. The distributor should understand what he/she is distributing and should take responsibility for the contents of the term sheets. Product providers should likewise understand who the distributors are. Even the distributors should know who the product providers are. The essence is the same as in case of the general "know your counterparty" principles such that people do not hide behind their ignorance about the counterparty.

The guidelines are very general and do not say much that is not sheer commonsense. Like industry codes, they are perhaps overpowered by the desire not to restrictive at all. Like most self regulatory codes, they remain like holy principles of benign conduct which but for the code would be found in religious texts.

Links Full text of the guidelines in draft is here.

Home equity down surely, 
but ABS volumes are almost unfazed in Q1, 2007

With all the turbulence in the home equity market and the resulting impact on several CDOs, the volumes of ABS issued in 1st quarter 2007 is not much lower than the same quarter last year. Data on abalert.com, which compiles global data, shows that the volume for the 1st quarter was Usd 267.6 billion , compared to last year's 281.8 billion, roughly a decline of 5%. Given the fact that last year was an exceptionally good year, this decline is not very dampening. On the contrary, if one looks at the volume of CDO issuance for the 1st 3 months of 2007, it is USD 132.1 billion, as against only 69.9 billion last year.

A report on Bloomberg citing a Citibank source said the volume of home equity securitization was down sharply -with a decline of over 37%. This is clearly understandable, since, home was at no 1 position in asset backed segment last year, and this year seems to be the year of CDOs.

New Century files for bankruptcy

Even as New Century, one of the one-time leading lenders in the subprime mortgage market filed for bankruptcy protection, the key question in everyone's mind is – is that the worst? While S&P ran a comparison between subprime deals of 2000 and 2006 vintage, and estimated expected losses of about 7.5%, the worry is if with the lowering house prices, will the defaults increase beyond that level?

New Century, which has been in the news below for almost 2 months now, finally succumbed and filed for Chapter 11. It has set up a new sitehttp://www.ncenrestructuring.com/ where it intends to put further information on the restructuring plan. The company's press release says it has entered into an agreement to sell its servicing assets and servicing platform to Carrington Capital Management, LLC and its affiliate, subject to the approval of the Bankruptcy Court. The purchase price for the assets is approximately $139 million. In addition, New Century has agreed to sell to Greenwich Capital Financial Products, Inc. certain loans originated by the company, as well as residual interests in certain securitization trusts owned by the company, for an aggregate price of $50 million.

The subprime market has seen several sad spots over the last couple of months or so – see our comments below.

In the meantime, the subprime credit derivatives index ABX.HE BBB- was quoting at 66.59. It is not the least that it has recorded – there was a bit of revival from the trough of 62.25 quoted earlier.

See more of our notes and coverage below.

SECURITISATION NEWS AND DEVELOPMENTS

/in /by

Jan 2008 onwards

[This page lists news and developments in global securitisation markets – please do visit this page regularly as it is updated almost on a daily basis. Join our mailing list for regular news fed direct into your mailbox]

 

Read on for chronological listing of events, most recent on top:

See the latest news for 2009 here

Previous news pages

April 07 onwards…April 05-March 07.…Aug 04-March 05.…Dec 03-July 04.…July 03 – Nov 03.…Mar 03 – June 03.…Nov02- Feb 03.…Sept-Oct 02 ...June-Aug 02 ...May 02 ...Apr 02 ...Mar 02 .…Feb 02 .…Jan 02 .…Dec., 01.…Nov, 01 .…  Oct.,2001., Sep.,2001., Aug 2001… July, 2001, .June, 2001, May, 2001,… April 2001… March 2001 ..Jan. and Feb.2001  Nov. and Dec.2000 Sept. and Oct. 2000 July and August 2000 May and June 2000 April 2000  Feb and March 2000   
For all news added before 21 January, 2000, please click here   
For all news added before 9th November, please click here  
For News items added prior 3rd August, 1999, click here.

 

Mega US financial restructuring Bill mandates risk retention in securitizations

This is how lawmakers commonly react – to make up for lapses in shutting the door, they install a new door. In this case, they have put up several doors. In a massive exercise of lawmaking, the US draftsmen have presented a 1279 page bill that seeks to enact provisions in several of the sensitive areas of the recent crisis. It proposes a Financial Services Oversight Council, Office of Thrift Supervision be abolished and its functions be merged with those of Office of Comptroller of Currency, OTC derivatives to go through clearing houses and be traded on exchanges where possible, ‘stress tests’ and ‘living wills’ for risk firms and more. 

Specific to securitization, the Bill proposes a new Credit Risk Retention Act that primarily, as the name suggests, mandates retention of credit risk in securitization transactions. The 5% minimum risk retention that has been the central theme of regulatory discussions all over the world of last finds a place in the Bill as well, but with flexibility that permits appropriate regulatory authority to either reduce the minimum risk retention requirements in case of fully amortising loans, or in cases where the purchaser of the loans specifically negotiates for a first loss position. Such purchaser of first loss position must, however, provide due diligence on all individual loans covered in the pool. 

The standards subject to which the rules of risk retention will be framed would aim at improving underwriting standards, and encourage appropriate risk management by creditors. 

The above requirements apply in case of “asset backed securities”. The definition of the term “asset backed securities” has been imported from Regulation AB. As it stands today, the term “asset backed securities” includes only those securities that are serviced primarily from cashflows of defined assets. Hence, the term will not include any covered bonds, and will not include any synthetic securities as well. 

A new provision empowers the SEC to enact provisions pertaining to representations and warranties in case of securitization transactions.  

There are studies proposed about risk retention, and macro-economic impact of securitization transactions. 

Links: See the Text of the Bill here; Read our news on the similar provisions by EU here 

[Reported by: Vinod Kothari]

UK financial regulators propose amendments to capital regulations

12 December, 2009:  UK’s Financial Services Authority has issued a Consultation Paper on several far reaching amendments to Capital Requirements Directives (CRD). Consultation on the Paper will end on 10th March 2010, and the amendments will finally become effective 2011. 

The 360-page document contains proposed amendments relating to several areas – qualifying conditions for being part of hybrid capital, large exposures, risk management in case of securitisation, idea of a “college of supervisors” for cross-country exposures, higher capital requirements for resecuritisation, upgrading disclosure standards in case of securitisation, etc. 

The major amendments pertaining to securitisation are as follows: 

  • Firms investing in securitized products must do comprehensive due diligence. Those failing to do so with be penalized with heavy capital penalties. There is also a mandate not to invest in transactions where originator risk retention is not at least 5%. This is tune with changes proposed by the EU (see our news here) and similar changes proposed by US regulators (see our news here link).
  • In respect of resecuritisation, the FSA seeks to implement changes proposed in Basel II vide the amendments made in July 2009. This is higher risk weight, and greater chances of impairment losses.
  • Securitisation capital relief will be restricted to cases where firms can demonstrate that there is a “significant risk transfer” (SRT). Criteria are laid down in defining what is SRT. Illustratively, the originator does not hold more than 50% of mezzanine positions, or where there is no mezzanine position; originator does not hold more than 20% of senior positions, and so on. It is not clear how the requirement of SRT marry with the other requirement of originators maintaining a minimum 5% exposure, commonly understood to be 5% horizontal piece. 

Vinod Kothari comments – The securitisation market continues to remain very weak, and regulators’ approach of tackling the instrument, not the malaise, will only contribute to it. Investors will develop apprehensions of regulatory intensity in case of investments in securitized products – thereby deterring investments.

[Reported by: Vinod Kothari]

Consensus on OTC derivatives regulations

7 December, 2009: Several authorities over the past few months have been framing regulations to tame the OTC derivatives market.  The House of Agriculture Committee, the House Financial Service Committee had presented bills for regulating the OTC derivatives market and the Banking Subcommittee on Securities, Insurance and Investment, introduced the Comprehensive Derivatives Regulation Act of 2009 (See our report here). Now the House of Agriculture Committee and the House Financial Service Committee have reached an agreement on a bill to impose federal regulation for the first time on the over-the-counter derivatives market.  The OTC derivatives helps corporations, hedge against operational risks but post financial crisis the lawmakers have been wanting to tighten the regulatory noose to curb the speculative activities.

However there are two issues that are yet to be decided whether to limit ownership in swaps clearinghouses, and whether regulators would have the power to set margin and capital requirements on swaps traded by non-financial end users. The compromise bill includes that the standardized swaps will be traded on the exchange whereas there would be higher margin and capital requirement for customized swaps but registration of dealers and major market participants would be required to ensure transparency and record keeping in trading.

The bill is expected to come up for a vote on the House floor next week as part of financial regulation reform proposals. See the press release here.

[Reported by: Nidhi Bothra]

ASF official suggests Securitization regulatory reforms

American Securitization Forum’s (ASF) Executive Director, George P. Miller, delivered testimony on 7th October, 2009 at a hearing of the Senate Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance and Investment on “Securitization of Assets: Problems and Solutions.” 

Miller’s testimony sung paeans about the relevance of securitization, and lamented that since the mayhem in the financial markets, securitization has remained dormant. Lots of people have held securitization responsible for the subprime debacle, but according to Miller, the deficiencies are not inbuilt in securitization but the manner in which securitization was used by the market participants that led to the rigmarole. High leveraging caused significant increase in the demand much of which was artificial and not guided by the financing needs of the lenders and the borrowing needs of the consumer.

Miller also suggests that the policy reforms coupled with industry initiatives may help in reviving the securitization market, for a more stable environment these reforms should be coupled with integrity and reliability of securitization data and transaction structures coupled with enhanced operational risk. The reforms that Miller suggested are as below:

  • Increased Data Transparency, Disclosure and Standardization, and Improvements to the Securitization Infrastructure – ASF’s project on Residential Securitization Transparency and Reporting (“Project RESTART”) focuses on addressing the transparency and standardization deficiencies in the RMBS markets initially.
  • Required Risk Retention and Other Incentive Alignment Mechanisms – ASF supports the idea of risk retention as a means of aligning of the economic incentives of the transaction participants. However he does not rule out the possibility of having other forms of achieving effective means of alignment of interest of the transacting parties.
  • Increased Regulatory Capital Requirements and Limitations on Off-Balance Sheet Accounting – ASF believes that increase in the regulatory capital requirements should be introduced for certain securitization. Overall increase in the regulatory capital requirement may have a negative effect on the economic viability of securitization itself.
  • Credit Rating Agency Reforms – Credit rating agencies play a very important role in the securitization market and the reforms suggested to increase the quality, accuracy and integrity of credit ratings and the transparency of the ratings process are all welcomed. ASF supports the reforms for full and transparent disclosure on the basis for structure finance ratings so that the risk of securitization can be understood and differentiated from the risk presented by other types of credit instruments.

[Reported by: Nidhi Bothra]

 IMF recommends restarting securitization

IMF issued the Global Financial Stability Report on 21st September, 2009, which would give the securitization market and the industry analysts a reason to cheer. The chapter 2 of the report on ‘Restarting Securitization Markets: Policy Proposals and Pitfalls’ summarizes the rise and fall in the securitization market, analyses the recommendations made so far for the revival of the securitization market and lays emphasis that restarting of the securitization markets would be important for financial stability globally.

The Chapter brings out the flaws of the market before crisis that ultimately led to the debacle. Banks started holding the least risky tranches, originated by other banks including the sub prime exposure which reduced the risk dispersion that led to the market fallout. The report also talks about the ‘alphabet soup’ where demand for various structured products was instigated by the rating agencies willingness to give away their highest ratings coupled with the investors dependence on the ratings provided to these securities and inadequate information to assess or adjudge the ratings. The numbers prove the flaw where the report says that of all the ABS CDO tranches issued from 2005 to 2007 that were originally rated AAA, only 10 percent are still rated AAA by Standard & Poor’s, and almost 60 percent are rated single-B or less, well below the BBB-investment-grade threshold.

The report also recognizes that though most people were talking about what went wrong it was imperative to revive ‘sound securitization.’ The report stresses that the restarting private label securitization is vital to end the financial crisis. The report welcomes the changes brought with regard to securitization and presents its recommendations on implementation of the suggestive changes. Some of the recommendations are as below:

  • Credit Rating Agencies: Chapter 2 says that so far the investors had placed too much of reliance on the credit rating provided to the securitized products and under the issuer pay model, interest of the investors were ignored. The report recommends that as credit rating agencies have a vital role in the securitization process, elimination of the issuer-pay models, disclosing preliminary ratings to reduce ‘rating shopping,’ publishing performance data to enhance due diligence and competition among credit rating agencies be increased
  • Retention of risk by the originators: The report says that these requirements adopted by both US and European authorities should not be standardized. For diligent loan underwriting and monitoring, the report welcomes that there should be more “skin in the game” but the report says that the requirement should not be standardized and both size and the form of retention should be more flexible to achieve the broad based incentive alignment. The flexibility could be brought about by basing the retention policy on type and quality of the underlying assets, the structure of the securities, and expected economic conditions
  • Changes in the accounting standards and regulatory requirements: The report recommends that disclosure and transparency standards should be improved. Accounting standard changes brought in by FASB on elimination of gain on sale accounting treatment was welcomed by the report as it meant disclosure of income as and when received and not upfront, but the report also cautioned that the changes in the disclosure requirements should not be such that would burden the securitizers and investors. Loopholes of the Basel II regulatory capital requirement should be plugged too.
  • Standardization of the securitized products: To avoid problems relating to valuation and risk analysis the securitized products should be simplified and standardised. The report also mentions that some of the complex products like CDO2 should not re-emerge.
  • Covered Bonds: Covered Bonds are viewed as an alternative to risk retention policy adopted by both EU and US, but the report views covered bonds as a complementary form of capital market based funding and not as an alternative to securitization.

While the report is appreciative of the recent changes brought about but also state that if new rules are not implemented well it could have its side effects on the market and would slow down the market rather than reviving it, thereby defeating the purpose. The new regulations should not throttle the markets but should facilitate maintaining a firm ground and sustainable growth.

In times where securitization is looked upon as a taboo or a jinx of sorts, the report gives securitization its due.

[Reported by: Nidhi Bothra]

Yet another credit crisis ruling: Morgan Stanley, Rating agencies defence in SIV Cheyne compensation claim dismissed

It is the same story everywhere – when the Stamford court was ordering UBS (see the news item here) to set aside money for damages to Pursuit for selling CDO notes, SDNY judge Shira A. Scheindlin was writing order denying rating agencies’ and Morgan Stanley’s motion to dismiss investors’ claims for losses in structured investment vehicle (SIV).  

The suit, brought by Abu Dhabi Commercial Bank, charged the defendants for misrepresentation, fraud, breach of fiduciary duty, negligence, etc. Morgan Stanley and the rating agencies had filed a motion for dismissal on various grounds.  

Cheyne Finance Plc was a structured investment vehicle that is now in bankruptcy. Cheyne issued 3 types of notes – commercial paper, medium term notes, and mezzanine capital notes, all of which were rated by the rating agencies. This is the common structure of SIVs.  

The case brings to public light the role of rating agencies in structured vehicles such as SIVs. The rating agencies charged upwards of 10 basis points of the capital of the SIVs as their initial fees, and charged $ 1.2 million + 0.055% of the market value of the SIV’s assets. This means the rating agencies continued to gain as the SIVs continued to build more assets. Also, there is a startling fact that the rating agencies in case of SIVs get their fees only if the notes get the AAA ratings. The rating agencies claimed that their opinions are non-actionable – this argument was rejected by the court. “Rating agencies’ opinions are not mere opinions but actionable misrepresentations”, held the Judge. 

In summer of 2007, Cheyne SIV collapsed. In August 2007, it declared bankruptcy.  

The factual analysis reveals that while the SIV was required to limit its exposure to RMBS to 55%, Morgan Stanley and rating agencies were well aware that the actual investment was well above 55%. The SIV held New Century’s debt, and Morgan Stanley, as New Century’s 4th largest creditor, was aware of facts about New Century that were not in public domain.  The structure of the fees for the rating agencies created a conflict of interest as they were directly connected with the success of the vehicle and its size of assets. “Where both the Rating Agencies and Morgan Stanley knew the ratings were flawed, knew that the portfolio was not safe, stable investment, and knew that the Rating Agencies could not issue an objective rating because of the effect it would have on their compensation, it may be plausibly inferred that Morgan Stanley and Rating Agencies were disseminating false and misleading ratings.” 

[Reported by: Vinod Kothari]

Links: Text of the SDNY ruling is here:

For more on SIVs, see Vinod Kothari’s presentation here:

CDO investors continue to crowd courts: UBS charged for selling "crap" to Connecticut Hedge Funds

This is only one of the several rulings either already out of the legal press, or under publication. Law courts all over the US and some even in Europe are currently considering CDO/ MBS/ ABS investors’ claims as to fraud, mis-selling, misrepresentations and so on. In a ruling dated 8th Sept 2009, Justice Blawie of the Stamford’s  Superior Court ordered UBS to set aside money for pre-judgment damages, or face garnishee orders for recovery. 

In this case  brought by Pursuit Partners, a Connecticut-based hedge fund, UBS was charged for selling CDO tranches that were described in internal emails as “crap” and “vomit”, and were sold shortly before Moody’s downgraded the securities. All the CDOs were so-called bespoke CDOs structured to meet Pursuit’s needs of a triggerless, investment-grade piece that could be available at significant discount on face value. 

Moody’s and S&P have also been charged in the case, as there were allegations that UBS was privy to forthcoming changes in the rating methodology of Moody’s whereby the notes that were sold to Pursuit would cease to be investment grade. The change in methodology was the correlation assumption in CDO pools. 

The offer document, as is quite usual with transactions, said the transaction will be governed by New York law. However, the Connecticut court still assumed jurisdiction, ignoring the choice of law clause, on the ground that a choice of law by parties can  be ignored on ground of public policy. The Judge said: “To allow securities to be marketed, offered and sold in any or all of the 49 states outside of New York, and hold that no other jurisdiction’s laws can be enforced or invoked, or that Connecticut law must be ignored, even if a plaintiff can establish, as it has here, probable cause to support a cause of action under Connecticut law, the state where the solicitation was made, simply because of this choice of law provision, is not a proposition this court will or may accept, both as a matter of statute and public policy”. If this ruling is finally accepted at higher forums, then CDO marketers would have a real tough time defending suits all over the country. 

The notes were sold to Pursuit between 26th July 2007 and Oct 1, 2007. This was the beginning of the avalanche of CDO downgrades. Obvious enough, UBS would have sensed the impending downgrades, and therefore, internal emails of UBS indicated the need to clear the inventory of CDO tranches that UBS was carrying. This evidence led the court to find “probable cause to sustain the claim that UBS sold the Notes to Pursuit without disclosing the following material non-public information: (1) that the Notes would soon no longer carry an investment grade rating, as the ratings agencies intended to withdraw these ratings as a result of a change in methodology; and (2) that once the investment grade rating was withdrawn, the CDO Notes sold by UBS to Pursuit, being valued in the tens of millions of dollars, would thereby become worthless”. 

The court on analysis of facts, primarily emails of the CDO marketing team of UBS, that UBS was in superior knowledge of the facts, which were concealed from the buyer, which the buyer relied upon and was thus unduly affected by the representations of the seller.  Internal emails of UBS said they had sold more “crap” to Pursuit, etc., which led the court to apply the “superior knowledge” doctrine. The court noted that risk is something that attaches to all such investments. However, (t)hat is the difference between a risk that something might happen to change the value of an investment, which is both a fact of life and a risk shared by all parties to any securities transaction, and the undisclosed knowledge that something will happen. That type of nondisclosure, whether it is on the part of a seller or a buyer, can cross the line into actionable securities fraud, and the court finds probable cause to sustain a finding that it this instance, it did”. 

Vinod Kothari comments: The ruling above is a flavor of the times. Judges, like the financial press, common people and others, have been affected by the wave of sentiment that goes against people who marketed and sold CDOs. On objective analysis of the ruling above, the question to be asked is – if UBS sold crap to Pursuit, what else do you sell to someone who comes to buy crap? Pursuit wanted to buy investment grade, being sold at steep discount on face value. Which investment grade notes would sell at steep discount on face value, given the high return on face value itself that they carry? The notes in question were bought between July and October, 2007 when the subprime crisis had already started surfacing. Bear Stearns’ hedge funds had already imploded by then. Rating agencies had also started downgrading several CDOs. On our website here, on June 20, 2007, we had reported that securitisation market was looking like a sinking ship, and there was fire everywhere. The purchases were made by Pursuit in tranches upto 1 October, 2007, by which time the subprime story, and the impact of that on CDOs was spread all over the financial press. So, can Pursuit really contend that there was a “superior knowledge” that UBS had, which Pursuit could have had? Pursuit, as a matter of investment strategy, might have projected that that was the right time to buy CDOs at deep discount, as its investment team might have projected that the crsis will not last long. 

Offer documents contained a detailed description of what were the assets of the pools, and what risks they carried. The impending change in rating methodology of Moody’s was  in public domain as rating agencies had come up with public statements on the same. Pursuit has affirmed before the court that it had read the offer documents and understood the same. A hedge fund is not a lay investor – its sole USP lies in being able to make money by taking risks that lay investors do not or cannot take.  

If this ruling leads UBS to pay damages for the losses that Pursuit faced, almost every seller who sold bonds that went bad would, sooner or later.

[Reported by: Vinod Kothari]

 Insurance Securitisation important and growing: IAIS Report

International Association of Insurance Supervisors (IAIS) published its report on ‘Developments in (Re)Insurance Securitization’ on 26th August, 2009. The report recognizes insurance securitisation as a significant complement to traditional reinsurance: the market, though small, is growing at a discernible pace.

Insurance securitisation is used by property and casualty companies for seeking reinsurance capacity, and life insurance companies for seeking regulatory capital by embedded value encashment, or extreme mortality risk transfer.

The aggregate market for insurance linked securities (ILS) peaked up in 2007 with an issuance of $ 15.5 billion, including $ 7.6 billion of life, and 7.9 billion of non-life issuance. The market in 2008 was quite slow – due to a global retraction of investors from anything that was new or complex. 2009 so far has seen only some extent of activity. Volume is not the only indicator of the maturity of the market – there are several other parameters noted in the Report – including width of sponsors, nature of perils covered, maturity of transactions, and so on.

The Report notes the regulatory developments in various jurisdictions too – including laws related to special purpose reinsurance vehicles, subordination of investors’ claims to the cedants, and so on.

The Report notes examples of ILS that have gone under stress over time. The first bond that suffered losses was Georgetown Re in 1996 and the report studies the performance of various other bonds like Kamp Re and Avalon Re affected by 2005 USA hurricane season, Newton Re, Orkney Re and others affected by the current financial crisis. There are 4 transactions that were stressed due to the bankruptcy of Lehman as a counterparty.

The IAIS Standards and Guidance paper on reinsurance is to include the guidance on insurance securitization as well and is expected to be finalized in 2011.

Report says that the insurance securitization market remains largely untested but shall grow in the times to come, taking cues from the report the market is all geared up to tap the resources that went undermined so far.

[Reported by: Vinod Kothari]

Link: See the full text of the report here

Link: See our risksec page

Workshops: Vinod Kothari offers workshops on insurance securitization. For sample course outline of a workshop offered in Milan recently, see here 

IOSCO recommends securitisation and CDS regulations

The International Organisation of Securities Commissions’ (IOSCO) has published the ‘Unregulated Financial Markets and Products – Final Report’ prepared by the Task Force on Unregulated Financial Markets and Products  on the 4th of September, 2009. The Task Force had earlier, in May published its consultative report on the issue (see our news here) 

The Final Report recommends the regulatory actions to improve the transparency and oversight of the securitization and credit default swaps (CDS) markets.  

As regards securitisation, IOSCO’s recommendations are not lot different from what regulations in the EU and US have proposed – alignment of incentive in the securitization value chain, essentially implying retention of originator stakes in securitized pools. CDS issues relate to counterparty risk, operational risk and market transparency.  

The main securitisation-related recommendations are: 

  1. Consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation in order to appropriately align interests in the securitisation value chain;
  2. Require enhanced transparency through disclosure by issuers to investors of all verification and risk assurance practices that have been performed or undertaken by the underwriter, sponsor, and/or originator;
  3. Require independence of service providers engaged by, or on behalf of, an issuer, where an opinion or service provided by a service provider may influence an investor's decision to acquire a securitised product; and
  4. Require service providers and/or issuers to maintain the currency of reports, where appropriate, over the life of the securitised product.  

The main CDS recommendations are: 

  1. Provide sufficient regulatory structure, where relevant, for the establishment of CCPs to clear standardised CDS, including requirements to ensure:

a.       appropriate financial resources and risk management practices to minimise risk of CCP failure;

b.      CCPs make available transaction and market information that would inform the market and regulators; and

c.       cooperation with regulators;

  1. Encourage financial institutions and market participants to work on standardising CDS contracts to facilitate CCP clearing;
  2. The CPSS-IOSCO Recommendations for Central Counterparties should be updated and take into account issues arising from the central clearing of CDS;
  3. Facilitate appropriate and timely disclosure of CDS data relating to price, volume and open-interest by market participants, electronic trading platforms, data providers and data warehouses;
  4. Support efforts to facilitate information sharing and regulatory cooperation between IOSCO members and other supervisory bodies in relation to CDS market information and regulation; and
  5. Encourage market participants' engagement in industry initiatives for operational efficiencies.  

[Reported by: Nidhi Bothra]

Links – for text of the IOSCO report, see here

Yet another shock to bankruptcy remoteness

UK Chancery Court temporarily defends attack by Lehman’s counsels

Vinod Kothari

We have always contended that the concept of bankruptcy remoteness is a product of good times, and has not been tested in bad times such as these.

The latest in the series of shocks to bankruptcy remote vehicles is the contention of the counsels for Lehman before the UK Chancery Court in Perpetual Trustee Co. Ltd  v. BNY Corporate Trustee Services Ltd [2009] EWHC 1912 (Ch).

Transaction structure

The case pertains to a multi-issuer synthetic CDO program called Dante Program. The structure is the familiar synthetic CDO structure, wherein several Irish SPVs, in this case, Saphir Finance Public Limited Company, Zircon Finance Ltd and Beryl Finance Ltd, would issue notes to the investors and raise funding. The funding would be in government bonds or other secured investments (Collateral). The SPVs would enter into a swap (perhaps a credit default swap, or total rate of return swap) under which Lehman Brothers Special Financing (LBSF) would make periodic payments to the issuing SPV, which, in turn, would pay the coupon to investors in the notes.  The Collateral would be charged, first, in favour of LBSF as the swap counterparty, and thereafter, in favour of the investors of various classes in descending order of priority. The collateral trustee in the present case is BNY Corporate Trustee Services, and Perpetual and Belmont (Note Trustees) were the trustee for the noteholders based out of Australia, New Zealand and Papua New Guinea.

As Lehman filed for bankruptcy, the payments under the swap were not made. Hence, the swap payments were defaulted post 15th Sept 2008. Pursuant to this, the Note Trustees filed a claim against the Trustee, for realization of the collateral, as an event of default under the swap agreement had taken place. The terms of issue provided that the noteholders would have a priority over the swap counterparty, if an event of default on the part of the swap counterparty had occurred.

Contentions of LBSF counsel

LBSF denied the claim of the noteholders, taking shelter under sections 362(a)(3), 365(e)(1) and 541(c)(1)(B) of the US Bankruptcy Code. They also contended that the action of the Note Trustees be stayed until resolution of the matter by the Bankruptcy Court in the Southern District of New York (SDNY) where Lehman’s bankruptcy proceedings are going on. Section 362 of the US Bankruptcy Court provides for automatic stay on proceedings against the property of an entity after a bankruptcy petition has been filed. The section marks a significant difference between US and UK insolvency laws – the latter do not have a provision for automatic stay against creditors or security interest holders. Section 365 allows a bankruptcy trustee to disown onerous clauses in contracts of the bankrupt.

In essence, the Note Trustee pleaded that as an event of default had occurred, the interest of the noteholders overtook priority over that of LBSF, while on behalf of LBSF, it was pleaded that LBSF could take shelter under benevolent provisions of the US Bankruptcy code and prevent the subordination of LBSF.

LBSF has filed a motion in the SDNY Bankruptcy court which was due to come for hearing on 5th August 2009. Text of the motion is available here.

Contracting out of bankruptcy law?

The arguments in this case tread over a very significant topic in bankruptcy laws – is it possible for contractual clauses to override bankruptcy laws? In other words, can parties contract out of bankruptcy laws? For instance, bankruptcy laws provide for a particular manner of priority in distribution of the estate of a bankrupt. Could parties have provided by contract for a different order? The most logical answer would have been no, because if that was the case, bankruptcy laws would lose their meaning. But then bankruptcy proofing that structured finance transactions seek to attain, is actually, in a manner of speaking, contracting out of  bankruptcy laws.

Counsel for LBSF pleaded that a clause in the swap documents was void under English law. The clause (Clause 5.5 of the Supplemental Trust Deed) provided that the Collateral would be held by the trustee with first priority to the swap counterparty, unless the swap counterparty had committed an event of default.  Note that this clause is most usual clause in any synthetic CDO issuance, and is most logical and easily understandable. The CDO issuing SPV has obligations on account of the protection it sells to the swap counterparty, and obligation to pay interest and principal to the noteholders. The idea of holding the collateral with the SPV is that any protection sold by an SPV has no meaning unless it is backed by assets – therefore, the SPV backs the protection it sells to the swap counterparty with the collateral. The collateral will continue to enure  for the benefit of the swap counterparty, but if the swap counterparty has defaulted under the terms of the swap, the swap gets cancelled, and the collateral flows back to the investors. If this was not the case, the investors have no support of the collateral at all, and the investors have taken the risk of bankruptcy of the swap counterparty, whereas the very idea of interposing an SPV between the swap counterparty and the investors is that the investors remain immune from the bankruptcy risk of the swap counterparty.

In essence, what the counsels for LBSF were pleading was both against concept of bankruptcy remoteness and against common intuition. The counsels relied upon a ruling in Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd [2002] 1 WLR 1150. wherein a UK court had held that if a clause in a contract provides for deprivation of the property of someone upon bankruptcy, such a clause is invalid. In that case, the court had held: “There cannot be a valid contract that a man's property shall remain his until bankruptcy, and on the happening of that event go over to someone else, and be taken from his creditors.”

The ruling, for most part, has dwelt upon the breadth of the above principle in Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd. The counsel for the Note Trustees contended that if this principle was to be applied widely, it would frustrate myriad contracts in the commercial world, many of which contain re-alignment of priorities in the event of default of a party to the contract.

LBSF counsel relied upon an old English ruling in Ex parte Mackay (1873) LR 8 Ch App 643, wherein it had been held that “in my opinion a man is not allowed … to provide for a different distribution of his effects in the event of bankruptcy from that which the law provides. It appears to me that this is a clear attempt to evade the operation of the bankruptcy laws”.

LBSF counsel also cited from other English rulings. For instance,  Ex parte Jay (1880) 14 Ch D 19, holding as follows: “"a simple stipulation that, upon a man's becoming bankrupt, that which was his property up to the date of the bankruptcy should go over to someone else and be taken away from his creditors, is void as being a violation of the policy of the bankrupt law.”

The Chancery court, however, dismissed the arguments. The Chancellor held:

“In my view clause 5.5 of the Supplemental Trust Deeds is not contrary to public policy on the grounds relied on or at all. I reach that conclusion for a number of reasons. First it is necessary to consider the structure of the transaction as a whole, not the terms of clause 5.5 of the Supplemental Trust Deed in isolation. The security conferred by that clause is in respect of the collateral. The collateral was bought by the issuer with the money subscribed by the investors for the notes. In no sense was it derived directly or indirectly from Lehman BSF as the swap counterparty. Second, on general principles the court should not be astute to interpret commercial transactions so as to invalidate them, particularly when, as counsel for Belmont suggested, consequential doubt might be cast on other long-standing commercial arrangements. Third, the involvement of Lehman BSF is the consequence of the swap agreement under which it sought and obtained, in effect, credit insurance in respect of the Reference Entities. As long as that agreement was being performed it was appropriate for Lehman BSF to have security for the obligations of the issuer as the other party to the swap agreement in priority to security in respect of the issuer's obligations to the noteholders under the trust deeds and the terms and conditions of the notes. It is plain that the intention of all parties was that the priority afforded to Lehman BSF was conditional on Lehman BSF continuing to perform the swap agreement. Fourth, so regarded, the priority of Lehman BSF never extended to a time after the event of default in respect of which it was the defaulting party had occurred. Fifth, it follows that such beneficial interest by way of security as Lehman BSF had in the collateral was, as to its priority, always limited and conditional. As such it never could have passed to a liquidator or trustee in bankruptcy free from those limitations and conditions as to its priority”.

The reasons cited by the judge are most significant and appreciable. The collateral was sitting in the transaction to provide asset backing to both the investors and the swap counterparty. The swap counterparty was provided seniority during the performance of the payments by the swap counterparty. But obviously, the swap counterparty cannot contend that even if fails to make the swap payments, it must still continue to enjoy the collateral. The shifting of priorities is critical to the very nature of the transaction, which is to provide protection against bankruptcy of the swap counterparty. If the swap counterparty still has superior rights over the collateral despite  bankruptcy, there is no bankruptcy remoteness at all. What the counsels for LBSF were claiming would, if approved by the courts, terminate the whole concept of bankruptcy remoteness.

The present case was adjourned, in view of the pending proceedings in SDNY bankruptcy court. This was done in pursuance of the protocol under UNCITRAL’s model law on cross border insolvency.

Subsequent to the ruling of the Chancery court, the counsels for LBSF have applied to the US bankruptcy court to appoint LBSF as representative of the bankrupt’s estate and to seek the assistance of a foreign court in protecting the property of the bankruptcy.

It would be interesting to watch out for further developments in the case as this case would be one out of many where, post-credit-crisis, the concept of bankruptcy remoteness will face the tough test that it has been escaping all this while.

Important links:

See the Ruling of the Chancery court, Dated August 7, 2009

To know more about Special Purpose Vehicles see our page on SPVs here.

Department of Treasury proposes regulations for securitization and CDS transactions

It is always like this – things go wrong because of natural process of sheer over-exuberance, and we react with more rules and more regulations, as if it was lack of rules that caused the problem. Not unexpected at all, the Department of Treasury issued an 89 page report proposing several new regulations in the financial market. 

As for securitization transactions, it proposes originators to be mandated to keep at least 5% risk in the securitized portfolios – similar to what European counterparts have already imposed (See our news here). Recognition of upfront gain on sale should be eliminated, and off balance sheet treatment should be ruled out (see FASB’s new standards).  Originators should have fees or incentives based on actual performance of the pool. Originators should give representations and warranties as to performance of the pool – something which is today seen as violating the true sale condition. In short, the true sale business is clearly frowned upon in the report.  

SEC should continue its effort to regulate credit rating agencies. Ratings to structured products should be distinguished from other products – something which technically takes away the very comparability of ratings. Surprisingly, the report also says the regulators should reduce dependence on ratings for risk weights, and should think of different risk weights for structured and unstructured products. 

On credit derivatives, the Report has comprehensive regulation on all OTC derivatives, including credit derivatives. Clearing of all standard OTC derivatives should be required through centralized counterparties. [Reported by : Vinod Kothari] 

For full text of report, see here.

Over with off balance sheet securitization – FASB issues new standards on securitization accounting

As expected, last Friday, 12th June 2009, FASB issued new accounting standards (FAS 166 and FAS 167) that bring about very significant changes to the way securitization transactions have been accounted for under the US GAAPs. The IASB had already put up exposure drafts on the issue (see our news here). As (a) the new rules require that where there is continuing involvement of an originator in a securitization transaction, off balance sheet treatment will not be granted; and (b) continuing involvement is a reality with most securitization transactions world-over, it is almost clear that either securitization transactions will not be put off the books at all, or even they are put off the books, they will get consolidated back under the new consolidation regime. In essence, bye-bye off-balance sheet securitization.

The new regime may usher in a completely new thinking on bankruptcy-remoteness and ratings arbitrage. New devices of credit enhancement will be searched. Of course, there always will be asset-backed funding and asset-backed investing, but existing system of achieving isolation by a true sale would possibly get a hard re-look.

The new standards will be effective for accounting periods beginning after 15th Nov 2009. [Reported by : Vinod Kothari]

Links: For details of changes brought about by FAS 166 and FAS 167, see our page here

FASB's proposed changes to bring US GAAP securitization accounting close to IFRS

On 18th May 2008, the FASB concluded its deliberations on several crucial amendments to securitization-related accounting standards. Both FAS 140 and FIN 46R are slated to be amended. 

The proposed amendments to FIN 46R add a qualitative test to the criteria for consolidation of variable interest entities (VIEs). VIEs are special purpose entities – they are normally not controlled by their legal owners but by another entity or entities that hold the risks/returns of the entity (which is referred to as variable interest) either by holding a residual interest in the entity or by being exposed to variability in losses. Existing conditions for consolidation of VIEs are quantitative – holding majority of variable interest. The proposed changes add a subjective, qualitative test of “control” also to the consolidation criteria. That is, if the VIE is controlled by a particular entity, the controlling entity will consolidate the VIE. 

It is not usual for US GAAPs to have subjective tests such as control as the basis for consolidation – as US standard writers have mostly relied upon more specific “rules” than principles.  

The second package of changes will amend securitization accounting standard FAS 140.  

First of all, quite significantly, the existing exemption for qualifying special purpose vehicles (QSPEs) from FIN 46R will go away as the very concept of QSPEs is intended to be done away with. Existing rules provide an exemption to QSPEs from consolidation under FIN 46R, with the result that most RMBS and ABS SPEs that can qualify as QSPEs remain free from consolidation requirements. Now that the exemption will be removed, the position of US GAAPs on SPE consolidation will be similar to that of IFRS, where SIC 12 requires consolidation of most SPEs. Since the basis of consolidation is variable interest, it is almost unlikely that SPEs will not have someone holding majority of variable interest: hence, every SPE will require consolidation with someone or the other. The net result may be that off-balance sheet treatment for securitization may be effective over – a position that we have predicted will apply under IFRS as well.

Another change is to require that de-recognition standard will apply to a fraction of a financial asset only if such fraction is fully proportionate share of a financial asset. This is the position under IAS 39 currently: FAS 140 as it exists does have the possibility of elements of financial assets being taken as assets by themselves. 

Additional disclosures are going to be required for “continuing involvement” in securitization transactions. Notably, proposed changes in IAS 39 seek to deny off balance sheet treatment in case of continuing involvement. [Reported by: Vinod Kothari]

Links: see our page on accounting for securitization here.

General Growth CMBS SPEs file for bankruptcy: One more nail in the coffin of securitization

We have been contending on this site that the myth of special purpose vehicles, as entities with peppercorn capital and isolated from the originators with capital held by charities claiming to do the good of mankind, is all a legal superstition and is a product of good times. The presumption of bankruptcy remoteness is  valid only as long as any of the parties is not in bankruptcy. It is not that there have not been challenges to true sale before, but this one taking 166 SPVs for CMBS transactions into bankruptcy may be quite a big jolt. The worst part is that this may be a temptation for more such attempts by transactions facing rough weather.

In the present case, General Growth Properties Inc., a leading CMBS issuer in the US, filed for Chapter 11 protection last month, and also took 166 of SPVs for various CMBS transactions into bankruptcy. Since a bankruptcy filing would have been based on vote of directors, and SPVs typically do not have substantial originator presence on their boards, legal circles have a feeling that the originator strategically changed the composition of board of directors of each of the SPVs to introduce “convenient” who ultimately voted for the bankruptcy filing.

The bankruptcy filing has obviously rattled the securitization investors, not just in this transactions, but the entire market.

General Growth is the single largest CMBS borrower in the U.S. The CMBS market has grown up over the past two decades and was continuing  growing, until 2008, when securitization markets in general sank.

Reported by: Vinod Kothari

Links : see SPV page; true sale page 

European Parliament adopts new capital rules for banks

The Legislative Report amending the capital requirements for banks to improve transparency and supervision of the financial systems and to avoid future financial crisis was adopted in the Parliament with 454 votes in favor and 106 votes against the motion. The European Parliament, Council of Ministers and the European Commission delegations agreed to have the new legislation approved before the end of the current legislative term. The ‘Capital Requirements’ Directives, sought revision of the previous directives to improve crisis and risk management. The few notable points of the new legislation are:

  • Council to establish the colleges of supervisors to facilitate cooperation among national authorities dealing with cross-border financial institutions
  • The banks could not expose more than 25% of its own funds to a client or group of clients. The exception to this threshold limit will be exposure between credit institutions but capped to not more that Euro 150 million. This limit on the exposure will be subject to review by the end of 2011
  • In case of securitization the legislation mentions that a retention of 5% of the total value of the securitized exposure to be retained by the issuing institution, ensuring material interest in the performance of the proposed investments. This again was subject to review by the end of 2009.
  • With respect to Credit Default Swaps as well, there was a need felt for stricter regulations to bring about transparency in trade and to set up a central clearing house to be supervised by the European Union to reduce the risk of these instruments. The legislative proposal in this regard is to be out forth by the Commission by the end of 2009

The European Legislation, Councils of Ministers and the European Commission agreed on the insertion of the review clause and also to increase the retention rate by 31st December, 2009 after consulting the Committee of European Banking Supervisors. These legislations are to be complied with by the end of the year 2010. This is just a step in response to the present financial crisis. EU in the last month had also approved of the new rules for the Credit Rating Agencies (see report below) in a similar effort to improve transparency and to gain investors’ confidence.

Reported by: Nidhi Bothra

IOSCO recommends regulations of securitisation and credit-derivatives

The International Organisation for Securities Commissions’ (IOSCO) Technical Committee published a report on ‘Unregulated Financial Markets and Products – Consultation Report prepared by its task force.

Thankfully, in a period when lot of commentators are spitting venom at securitization as being the source of the present crisis, the Report recognizes the significance of securitization. “The absence of a well-functioning securitisation market will impact consumers, banks, issuers and investors. The price of credit is likely to be higher for the consumer and the availability scarcer. Banks will no longer have a tool to reduce risk and diversify their financing sources”, says the Report.  Credit default swaps, too, can serve as an excellent instrument for risk hedging and price discovery, but also have a potential to proliferate as a tool of speculative trading in credit.

Thus, the interim recommendations are aimed towards restoring transparency and investors’ confidence, promoting fairness and bringing about stability in the international financial markets. The interim recommendations on securitization include:

  • The originators or the sponsors to have longer term economic interest in the securitization transaction
  • Disclosures and the transparency norms to be made stringent to ensure that appropriate checks and assessments are done and the originator, issuer and underwriters have duly performed their duties.
  • Improving disclosure norms for the issuers on initial and continuing basis, giving out data on the underlying asset pool’s performance and so on.
  • Independence of experts used by issuers

In the CDS market, the task force recommended the formation of central counterparties to handle clearing of CDS contracts and for market participants to support the clearing process by developing a standardised CDS contract. The report is open for comments till the 15th June, 2009. See the full text of the report here.

Links: See news updates on credit derivatives here

Reported by: Nidhi Bothra  

Chase's $5 billion swells TALF ABS issuance to $11 billion for May

Since the launch of the TALF program in March the issuers have sold $11.4 billion of securities mostly backed by credit card and auto loans. Now with the Chase Issuance Trust coming up with a $5 billion ABS deal in the third round of TALF program; the supply figures come to a $9.5 billion in May alone. The Federal Reserves says that the investors have requested $10.6 billion worth of loans as against $ 4.7 billion in March and $ 1.7 billion in April round.

The Chase AAA rated securities are of 3 years maturity and are priced at 155 basis points over one month LIBOR rate. The other deals that will qualify for TALF financing in the month of May are a $760 million equipment loan deal from Case-New Holland (CNH), $500 million offering backed by motorcycle loans from Harley-Davidson, a $1.75 billion issue by Volkswagen and a $1.75 billion of auto ABS by Honda Auto, so the number of TALF eligible auto deals has come to a total of four. Apart from Volkswagen and Honda, Mitsubishi, Harley-Davidson also eyeing the market. A $1 billion offering of credit card securities from GE Credit sold at 210 basis points over one month LIBOR rate. So the TALF eligible new issuances stand at $11 billion for the month of May. There are reports of a $3.6 billion Sallie Mae deal materializing as well.

After a positive start and a disappointing dip in the issues in March and April respectively the third round has brought in strong sentiments of confidence as the issues are met with high demand for the securities and are oversubscribed. There are definite signs of revival of the securitization market.

Reported by: Nidhi Bothra

Is Securitization Islamic? IIFA to clear ambiguity

Is securitisation Islamic? There is controversy lingering on securitization where various scholars and schools of thought are diverse on their opinion – whether the act of securitization (tawriq) is permissible from the Islamic perspective or not.

In a securitization transaction there are selected debts that are permissible for securitization. For instance credit cards loans where there is a flat fee charged (rather than it being called interest charges) and the investors are paid dividend on their investments (dividends being the principal plus fees charged from the credit card holders). Presently banks securitize without considering the interpretations of the Holy Qur’an and make offerings to the customers ignoring the text that bans various provisions so incorporated. As a result there a lot of scholars who issue fatwa based on their opinion on the securitization transaction.

The International Islamic Fiqh Academy (IIFA) constitutes eminent scholars from various parts of the world and gives their recommendations on various financial matters. The Fiqh Academy will be taking up the issue of securitization and formulate a stance on the issue from the Islamic perspective. The responsibility dawned on IIFA is to bring all the schools of thoughts closer to the understanding and interpretation of the Ummah and abiding by it while dealing with the ambiguities related to the issue.

Reported by Nidhi Bothra

Vinod Kothari comments: Is securitisation Islamic? This question, and similar questions about lots of other present-day financial instruments, arise naturally because there is nothing like securitisation that would have prevailed during the time the key tenets of Islam were written. But then, the key principles of brotherhood and humanity, and being devoid of attachment to material possessions, were the basis for the riba that a Muslim will not charge interest from other fellow brothers, and that money does not have either intrinsic value or time value. However, the world we live in is quite different – here, greed and selfishness are the very basis of our existence, and money is the form in which we measure and satisfy our greed. Similar question recently arose in Malaysian courts about BBA, a form of deferred sale perceived widely to be an Islamic product, and the court ruled in the negative.

Links: see our page on Islamic Finance; workshops on sukuks – securitisation school 

Korea's Kookmin Bank brings Asia's first covered bonds

Is securitisation rising from its ashes like a phoenix? Though the structured finance markets globally still remain jittery, this deal, and the other story on projected issuance in USA under TALF certainly give reasons for cheers.

South Korea’s largest lender – Kookmin Bank is all set to bring out Asia-Pacific’s first covered bonds issue. These bonds are backed by a pool of residential mortgages and credit card obligations. The bonds are described as covered bonds – however, unlike most European jurisdictions, there is no law governing covered bonds in Asian markets. This might perhaps be a reason why a very complicated transaction structure has been used in this case – almost verging towards the true-sale-type.

No matter the lack of law, S&P has given a AA rating to the bonds, which is good 3 notches above the rating of Kookmin (A-). S&P had recently issued a draft methodology for covered bonds 4th February, 2009

Notably, the pool consists of residential mortgage loans and credit cards – in a normal securitisation transaction, this would have been a queer mix, but in covered bonds, all that matters is the value of the cover, as investors are not necessarily paid from the cover pool. The bonds have a maturity of 3 and 5 years – another distinguishing feature of covered bonds being maturity mismatch between underlying assets and investor cashflows. Credit enhancement comes from a substantial over-collateralisation, as well as obligation of Kookmin to repay the bonds. 

The transaction structure is complicated, and may be understood in following steps:
  1. Kookmin issues the bonds and gets $ equal to the senior interest of the loans.
  2. Kookmin entrusts the loans to a Korean Trust. This includes the overcolllaterlisation also. The Trust sells senior certificate to a Korean SPV, and junior interest back to KB. The Trust still has to pay money to Kookmin for the purchase of the senior interest (see Step 7).
  3. Korean SPV issues notes to Irish SPV equal to the senior interest. Irish SPV provides guarantee to bondholders for repayment of the bonds issued in step 1.
  4. Kookmin lends money under a subordinated loan to Irish SPV, equal to the senior notes. Kookmin has already got this money in Step 1.
  5. With this money, Irish SPV in step 4 pays for the Notes it buys from Korean SPV.
  6. Korean SPV in turn pays to the Trust in step 2 for the senior interest it bought.
  7. Trust pays the money to Kookmin – therefore, the proceeds of the notes issuance do a full round back to Kookmin.
Apparently, this is structured as a true sale – therefore, to the extent of the senior interest in the loans sold, the mortgage loans and credit cards must be replaced by the subordinated loan given to the Irish SPV. However, the transaction would almost inevitably carry a buyback option with Kookmin, thereby denying any true sale/ off balance sheet treatment. 

Reported by: Vinod Kothari

To learn more about covered bonds, see our page here 

Our Workshops: We discuss covered bonds full scale now in our 11th Securitisation and Covered Bonds School – for the forthcoming school in August 2009, click here
 

TALF backed issuances soon to pick up momentum

As the round three of TALF financing is nearing, US asset backed issuers have $3billion offerings for the investors in May, and in addition, there are more issues of indeterminate sizes that may be ramping up soon. This figure compares with funding of $ 2.7 billion under TALF-backed issuance in April.

For May, some of the TALF eligible offerings include Case New Holland, which has come up with $760 million ABS sale of securities backed by equipment loans Other issues like that of $1.125 billion Honda Auto deal and a $1 billion Volkswagen sale are issues backed by auto loans and will also be eligible for the TALF financing.

Among credit card deals JP Morgan is planning a $1 billion offering. Others like GE Capital, Harley Davidson also intend to be in the market. These and several other issuances are in the pipeline and considering the momentum that is picking up, the Fed is soon to come with two new interest rates for loans secured by asset backed securities with maturities of one and two years.

Further the Federal Reserve has also announced that it would extend loans against commercial mortgage backed securities in June for up to five years. TALF loans with maturities of five years will also be available for securities backed by students’ loan and loan from small businesses. An initial limit of $100 billion has been set for the five year loans and the limits are open for re-evaluation.

Reported by: Nidhi Bothra

EU approves new rules for Credit Rating Agencies

European Union approved the new rules on the Credit Rating Agencies (CRAs) that are designed to improve transparency provide information, integrity and impartiality to the investors. The general notion prevalent is that the CRAs have failed to duly warn the investors of the risks underlying the asset backed securities and has significantly affected the investors’ confidence while making investment decisions.

Under the new rules a firm seeking to issue credit ratings will have to get itself registered with the Committee for European Securities Regulators (CESR). Securities regulators grouped together are called a ‘college’ of regulators who shall be monitoring and supervising the activities on a day to day basis. The following are the specifications provided in this regard under the new rules

The key features of the rules are as follows: 

  • Disclosure of models, methodology and assumptions used in rating and instrument
  • Ratings of complex products to be differentiated by adding a specific symbol
  • Create an internal function to review the quality of ratings
  • CRAs are to publish an annual transparency report.
  • CRAs may not provide advisory services
  • CRAs to have two independent directors on their board

    • The remuneration paid to the directors will not be determined on the firm’s performance
    • The Directors can only be dismissed from the office in case of professional misconduct. 
    • The two directors will be elected for a term of 5 years and cannot be re-nominated.
    • One of the two directors needs to be an expert on securitization.

These rules are aimed to ensure that the rating agencies are cautious of the quality of the ratings and the methodology used for the same and that there is high level of transparency involved in their act to ensure that the ratings provided are of valuable use to the investors.

Reported by: Nidhi Bothra

The 2008 Global Securitization issuance down by 79% compared to 2007 – IFSL reports

The Murphy’s Law quite applies to securitization as well. The International Financial Services London came out with the Securitisation 2009 report. The report says that the Gross global securitization issue dropped from $3,817bn in 2007 to $2,777bn in 2008. The net global securitization issuance sold in the market and purchased by the investors dipped by 79% from $2,138bn in 2007 to $441bn in 2008 (Excluding securitization retained with the issuing banks, which are not included in the gross figures).

The sea plunge was visible in the quarterly issuance reports that the volumes fell from $149bn in Q1 to $60bn in Q4 2008. The first quarter of 2009 also indicates that securitization is at low ebb and that there is very little indication of recovery. The report provides a comparative view on the industry performance over the years world over. The report shares concerns by the leading industry groups in the securitization industry and talks about ‘restoring confidence in the securitization market.’ It lists out the multiple effects that lead to the debacle and also lists out few suggestive actions that the industry should consider. See full report here.

Reported by: Nidhi Bothra

FASB issues staff guidance on exceptions from fair value accounting in disrupted market conditions

The much awaited FASB Staff Position (FSP) on fair value accounting (FSB FAS 157-4) has been issued, quickly enough after the last FASB board meeting on 2 April decided to amend the provisions of the draft (FSP FAS 157-e – see our news item below). On 9th April, the FSP was issued, overriding FSB FAS 157-3 and providing guidance on departure from the “market value” rule in situations such as the present, where for many assets, markets have considerably thinned down or otherwise. For a background leading up to the FSP, see news item below.

The revised draft of the FSP, like the exposure draft, provides that where the volume or level of activity for an asset needs to be marked to market has come down as compared to “normal market activity” for the asset, then significant adjustments to the quoted prices may have to be made – indicating that the prevailing market price need not be taken as the basis of fair valuation, and other techniques of valuation may be employed. The other techniques of valuation include consideration of  the “transaction value” where the transaction may be taken to be conducted in “orderly” market situations; and  discounted values using discounting rates appropriate to the riskiness of the asset in question.

There is an illustration included in the FSP of junior tranche of an RMBS transaction involving alt-A mortgages. The examples comes up with a discounting rate of 12% for discounting the expected cashflows, while the quoted rates from reputable dealers implied yields of 15% to 17%. In other words, the value that the entity estimates is substantially higher than what is quoted in the market on the measurement date.

The IASB is also almost waiting to introduce similar guidance – see here.

The FSP introduces more subjectivity and more complexity in the already monumental fair value rules. The question at the end of the day is – what is the user getting out of this all? If the current market situation is not even representative of the exit price of the asset, why apply fair value at all. Standard setters have regrettably lost sight of the basic attribute of accounting statements – objectivity, as that comes from the FSP is a subjective valuation.

Reported by: Vinod Kothari

FASB to issue amended staff position on fair value accounting standard FAS 157

Mark-to-market accounting continues to remain the epicenter of this age of volatility. US standard setter FASB has responded to adverse industry comment on staff position paper FSP 157-e and voted, on 2 April 2009, to amend the proposed staff position.

An FSP is a statement of FASB staff views on an accounting standard. The relevant accounting standard here is FAS 157 dealing with fair value accounting. FAS 157 had required, effective from 15th Nov 2007 classification of assets and liabilities subject to fair value rules into 3 levels based on the transparency of such valuation. FAS 157 was issued in September 2006 when the goings-on were good. By the time of its implementation, markets had plunged into abysmal lows.

The markets that have prevailed over late 2007 to date easily qualify to be called “distressed” markets. The fair value accounting standards (both IFRS and FAS) contained an exception that in distressed (defined as not “orderly”) market conditions, the classification of assets as trading assets (which require daily mark to market) may be changed to assets that do not require mark-to-market.

FSP 157-e as proposed had suggested a two step approach to valuation in distressed markets. Step 1 contained an illustrative list of factors to consider markets as distressed. In step 2, there was a presumption that if the markets are distressed, then the quoted price is not representative of fair value. In that case, the FSP required the entity to use other methods for fair value determination, such as present value of expected cashflows.

The proposed draft of FSP 157-e was put for a 15-day comment period. As widely expected,  hundreds of comment letters were received. In response, the FASB decided to amend the FSP 157-e, to broadly incorporate more examples of situations in which the markets may be taken as distressed, and provide additional guidance on what fair value measures to use in such situations.

The FSP 157-e would  be reissued, and would be applicable for periods ending after 15th June 2009, with early adoption for periods ending after 15th March 2009. As markets for most of the sensitive assets such as derivatives may be taken as currently distorted (abnormal liquidity risk premiums or abnormal yields, abnormally wide bid-ask spreads, etc), this may be a relief for affected entities.

See the summary of the board's decision here

Reported by: Vinod Kothari

Islamic finance industry expected to grow to $1.6 trillion by 2012

With a 20% growth annually over the past several years, Islamic finance is growing at a fast pace with the estimates of the current asset ranging from $700 billion to $1 trillion. By a report from a consultancy firm, Oliver Wyman, the assets of the Islamic industry are further expected to grow to around $1.6 trillion by the year 2012 and that the biggest market for Islamic finance – Islamic wholesale banking will continue its strong growth to reach $1 TR with revenues of more than $60 BN.

The Islamic finance industry is still in its budding stage and there is a need for its banking sector to diversify to include other than generic sectors, like asset management, securitization etc. Islamic finance products are guided by the Sharia and Islamic laws and are open to wide interpretations. The conventional banking products can be dressed as per the Sharia requirements and can also accommodate the complexities of the conventional products, inspite the prohibitions and restrictions imposed by the Islamic laws.

The Islamic finance industry is in its nascent stage and countries with large Muslim population are awaiting development of the Islamic finance market. With the gloomy prospects of the revival of the dominant players in the near future and with countries like UK also tuning in to accept these unconventional products as ‘Alternative Finance Investment Bond’ the Islamic finance market is surely on its way to growth.

Reported by: Nidhi Bothra

Another bad news on the US ABS market

Where is the market heading? Probably this is the question that is playing on everyone’s mind and the unraveling quarter results are leaving people disheartened all the more. The existing credit crunch is acting as a catalyst to further unleashing misery, atleast the numbers tell such a tale.

The first quarter of 2009 reported a tremendous fall in asset backed securities issuances in the US as compared to the same period last year. The asset backed securities issuances stand at $13 billion at the end of the first quarter this year as against $61.9 billion in the same period last year, a 79% fall. The year on year comparisons on the ABS supply presents a gloomy picture as well. The final quarter for 2008 had a $3.6 billion ABS supply as compared to a total of $106.3 billion.

For more statistical information about ABS market click here.

End of off balance sheet for securitisation: IASB proposes changes in securitisation accounting norms

The international accounting standards setter IASB, on March 31, 2009 issued an Exposure Draft of changes in accounting standard IAS 39. The changes are focused on accounting for securitisation transactions. If the changes are carried out as proposed, this is like a clear end to off-balance sheet accounting for securitisation transactions.

The existing scheme of IAS 39 on securitisation accounting is like this: if risks/rewards in a financial asset are entirely retained, the transaction does not lead to off-balance sheet. On the other hand, if risks/rewards are entirely transferred, the asset is put off the books. These two extremes are most uncommon in real-life securitisation transactions. Hence, most cases involve retention of some risks/rewards and transfer of others. In such cases, the approach is one of partial de-recognition, and keeping the asset on books to the extent of “continuing involvement”. Continuing involvement is the stake of the transferor in the transferred asset – for instance, subordinated share, share in residual profits, servicing income, retention of significant options, etc. Most securitisation transactions have so far been qualifying for such partial derecognition, with only the retained components being put on the books, and the rest of the asset being de-recognised.

IASB now proposes to change the de-recognition algorithm, to provide that if there is a continuing involvement, there will be no off-balance sheet. Irony is that in most transactions, there is a continuing involvement. Under the proposed standard, de-recognition will be allowed only in 3 situations – (a) where all risks and rewards are transferred – which is almost never the case; (b) where the transferee has the practical ability to re-sell the asset for its own benefit – unlikely in case of any transfers to SPVs; and (c) where there is no continuing involvement at all. While the standard clarifies that mere retention of servicing by the seller is not a case of continuing involvement, clarificatory guidance on retention of subordinated investment and residual profits leaves no doubt that practically no securitisation transaction will qualify for off-balance sheet treatment.

Earlier, in Sept 2008, US standard setter FASB had likewise issued an exposure draft of changes in FAS 140. FASB has been waiting for IASB’s exposure draft, as the idea is to have convergent accounting principles on securitisation accounting.

It seems that we are heading towards end of off-balance sheet securitisation. To know more about accounting for securitisation click here.

Philippines comes out with its first RMBS transaction

The National Home Mortgage and Finance Corporation (NHMFC) with Standard Chartered Bank came up with the maiden 5 year RMBS issue worth 2.1 billion Pesos with a coupon rate of 8.4337 percent, 200 points above the five year bond benchmark. These bonds are called ‘Bahay Bonds’ and are backed by 12000 residential mortgage loans which originated from 1985 to 1996.

The bonds are exempted from withholding tax payments and are divided into two tranches and were rated by the Philippine Rating Services Corporation (PhilRatings). The AA rated senior notes of Pesos 1.754 billion and the BBB rated subordinated notes of Pesos 309.5 million. The sub notes are to be retained by NHMFC itself. The debt issue has several credit enhancement levels, apart from having a low loan to value ratio, the mortgage loan repayments are guaranteed by state run Home Guarantee Corp.

The first RMBS issue was well received by the investors and was over-subscribed. After the success of the first RMBS issue the government is eyeing more RMBS issues in the year. To know more about the story click here. To know more on the assigned ratings to the classes of securities click here.

Also see news on Indonesia’s first RMBS transaction here.

New reporting requirements for securitization SPVs in eurozone 

The European Central Bank has introduced new reporting requirements ‘financial vehicle corporation’ (FVCs) or SPV’s residing in the euro area. Under the new reporting requirements a FVC will have to notify the National Central Bank of its existence and make certain disclosures quarterly. The new quarterly reporting requirements will be applicable from December, 2009 but the notification requirements will apply from March, 2009 and will apply to all the FVCs incorporated or resident in euro area.

Apart from the disclosure requirements these regulations will also assist in data collection with regard to the securitization transactions. The ECB regulations are aimed at providing data on the financial activities carried out by the FVCs within the participating member states in the euro zone. These regulations also aim at aligning the reporting requirements with that of the Monetary Financial Institutions (MFIs). Integrating the reporting requirements of the two would make the disclosures more meaningful and useful. The ECB regulations define FVCs in article 1 and lays down details on reporting requirements some of the highlights are: 

  • Article 2 lays down that all FVCs residing in the territory of a participating member will form the reference reporting population
  • As per Article 4, the actual reporting population shall provide to the relevant NCB, data on end-of-quarter outstanding amounts, financial transactions and write-offs/write-downs on the assets and liabilities of FVCs on a quarterly basis as prescribed in the regulations
  • As per Article 7, FVCs shall comply with the reporting requirements to which they are subject in accordance with the minimum standards for transmission, accuracy, compliance with concepts and revisions specified in the annexure to the regulation

The European Securitization Forum has come together to actualize the requirements among the FVCs by organizing industry response, roping in interested market participants for their involvement and including common language in the transaction document to ensure that all FVCs comply with the new requirements. To read the more on the story and ECB regulations click here

Top economists suggest ways to 'smarter securitization'

As a part of Wall Street Journal’s, ‘Future of Finance Initiative’ eminent speakers Roger W. Ferguson Jr., President and CEO, TIAA-CREF and Myron S. Scholes, Nobel Laureate and Professor Emeritus of Finance, Stanford University; spoke on ‘The Future of the Credit Markets.’ The speakers discussed the problems confronting securitization and how with small reforms, ‘smarter securitization’ can be achieved.

In an effort to move towards ‘smarter securitization’ and to align the interest of the various parties involved in a securitization process few key areas of reform were addressed and improvisation on the same was suggested. In the discussion the speakers, named five areas where there was scope and need for change.

The speakers said that the disclosure norms needed revision; there was a strong need for the alignment of interest of the parties like the underwriters and the rating agencies. As the underwriters do not hold the resulting securities, the underwriting standards suffer. Similarly, as the investors are unwilling to pay for the ratings of the securities, it is in the interest of the rating agencies to be in the issuers’ camp. To increase transparency levels and do away with these problems it was aired that the interest of the various parties should be aligned. For the rating agencies to be more accurate a revision in the pay structure was suggested whereby instead of a one time payment, fees should be paid over a longer period of time. The next recommendation was on having constrained on the leverage which would mean increasing the capital requirements to match up the risk levels involved. The next recommendation was on amending the accounting standards to have a sensible set of accounting standards that would reflect value for financial reporting and capital purposes. The last recommendation was on reducing the role of the government in providing compensation to the companies in which it has a stake to ensure that the right kind of incentives were trickling down.

These recommendations aimed at reviewing the securitization market, rebuilding the financial systems and dealing with the present financial crisis. To read the full article click here. To read the full article on ‘The Future of Finance Report’ and related articles, click here.

ESF Principles on Transparency & Disclosures

The European Securitisation Forum published Principles for Transparency and Disclosures for Residential Mortgage Backed Securities issuers. These principles have been delivered to increase the transparency, improve reporting standards and formats and to assist the regulators and the speculators who play an active role in the securitization industry. The basic objective of these principles is to provide investors with a mechanism whereby they can independently adjudge the creditability of the transaction so as to reduce complete dependence on Credit Rating Agencies for investment decisions.

These are voluntary principles and are applicable for RMBS structures originating in European Economic Area (EEA). The principles deal with pre-issuance information disclosures in the form of issuance of prospectus and offer documents as well as post issuance information disclosures in the form of investor reporting and ad hoc disclosures. With enhanced levels of comparability disclosures, these principles will enable the investors to make informed decisions. These principles include two data reporting templates for the issuers – ESF Prime RMBS Standardised Reporting Template and a new combined uniform Credit Rating Agency Reporting Template for UK Non-Conforming RMBS.

These principles were released in response to the Ten Industry Initiatives to Increase Transparency in the Securitisation Market as committed to the European Commission and are in response to the challenges posed by the Financial Stability Forum and International Organisation of Securities Commissions’ recommendations to improve transparency and disclosures. These principles have been drafted to improve four aspects of data disclosures: transparency, accessibility, comparability and granularity and have been prepared in consultation with RMBS issuers and market participants.

To know more on the templates and disclosure norms, see here

UK's Asset Protection Scheme

As the losses on asset backed securities bought by banks over the past continued to mount, UK Treasury came up with a scheme that will suck out losses above particular levels, thereby maintaining the capital of UK institutions. The Asset Protection Scheme is about protecting the banks’ assets against losses (second level losses) exceeding levels that are to be fixed for each asset on case by case basis. The UK Treasury would be protecting the participating banks from such second level losses for a fee. The eligible assets would include Mortgage Backed Securities, CDOs and CLOs, certain Asset Backed Securities, corporate or leveraged loans and any closely related hedges, in each case, held by the participating institution or an affiliate as at 31st December 2008 and can be denominated in any currency. The Treasury may include such other assets on appropriate investigation for appropriate fees. The other features of the scheme briefly are as follows:

·        The Treasury will initially extend its protection offer to UK incorporated authorised deposit-takers (including UK subsidiaries of foreign institutions) with more than £25 billion of eligible assets and later extend it to other authorised deposit-takers as well. Other entities may be considered in the light of its assessment of the impact on financial market stability and the overall economy and the most effective possible use of public resources.

  • There will be a verifiable commitment agreed between the participating institution and the Treasury to support lending to creditworthy borrowers in a commercial manner. The commitment demanded from participating banks is to increase their lending to creditworthy homeowners and businesses.

    < > The Treasury expects to provide protection for those assets on an institution’s balance sheet  where there is the greatest degree of uncertainty about the future performance of those assetsThe management and control of the assets will remain with the participating banks subject to such conditions as considered appropriate by the Treasury to take the management and control in its own hands. The assets will remain on the Balance Sheet of the participating institutions but the actions taken in relation to these assets shall be monitored by the Treasury and under its appropriate controlThe duration of the scheme will be consistent with the tenor of the asset and will be not less than 5 years.here.

     

    US Federal Reserve to pump in $200 billion to spurt sagging ABS market

The US Federal Reserve and the treasury launched TALF (Term Asset backed securities Loan Facility) – asset securitized loans in an effort to help consumers avail loans and put the credit market on the roll. The USD 200 billion funding program intends to provide loan to the purchasers of AAA-rated securities of the newly securitized credit card, auto, students and small business loans. The interest rates will range from LIBOR plus 50 basis points for students loan to LIBOR plus 100 basis point for a credit card loan to the likes. The intent of the plan is to induce investors to asset backed securities which in turn generate more lending

The following are the features of TALF:

  • TALF loans will have a term of three years with monthly interest payments. These loans will not be subject to mark-to-market or re-margining requirements
  • Non-recourse to the borrower

·        Eligible Collateral: For ABS to be eligible collateral and the dates of origination for the underlying credit exposure will be as specified in the terms and conditions of the program. ABS used as collateral that has a credit rating in the highest long-term or short-term investment-grade rating category from two or more major nationally recognized statistical rating organizations (NRSROs) and do not have a credit rating below the highest investment-grade rating category from a major NRSRO. Eligible auto loan ABS and credit card ABS must have an average life of no more than five years.

  • The set of permissible underlying credit exposure of eligible ABS includes

    • Auto loans which will include retail loans and leases relating to cars, light trucks, recreational vehicles, or motorcycles, and will include auto dealer floorplan loans
    • Student’s loans will include federally guaranteed student loans (including consolidation loans) and private student loans
    • Credit Card Loans
    • Small business loans fully guaranteed as to principal and interest by the U.S. Small Business Administration
    • The set of permissible underlying credit exposures of eligible ABS may be expanded later to include commercial mortgages, non-Agency residential mortgages and/or other asset classes
  • Eligible borrower: Any US company as specified in the terms & conditions of the program that holds eligible collateral can borrow from TALF

·        For ABS benefiting from a government guarantee with average lives beyond five years, haircuts will increase by one percentage point for every two additional years of average life beyond five years. For all other ABS with average lives beyond five years, haircuts will increase by one percentage point for each additional year of average life beyond five years.

  • TALF loan subscription and settlement dates will be announced monthly

The first fund will be released by March end and TALF will cease making loans by December this year.

The ABS issuance in US has come down from US$ 906.6 billion in 2006 to US$ 151 billion in 2008. The three year low interest loan facility intends to churn credit and restart the securitization machine which has experienced heavy downturn in the recent years as indicated by the figures.

TALF has invited mixed bag reactions, where some are interested and keen on participating, others are of the view that there is a long way for securitization to make a come back. Read more on the Federal Reserve press release and the terms and conditions applicable on TALF here

Indonesia's first RMBS issue

On 11th February, 2009, PT Sarana Multigriya Finansial (Persero) or PT.SMF came out with its first RMBS issue. PT.SMF, a secondary mortgage corporation owned by the government of Indonesia, started operations in first half of 2006 and has been involved in developing the secondary mortgage market in Indonesia. PT.SMF is securitizing pool of mortgage loans receivables worth Rp 500 billion, originated by PT. Bank Tabungan Negara (Persero) ("BTN").

The securities will be issued in two series, the first issue being of Rp 100 billion of Class A EBA Certificates rated Aaa.id by Moody’s Indonesia. Moody’s ratings are based upon several factors including credit enhancement and liquidity available to Class A EBA by issuance of Class B EBA Certificates and a reserve fund, these loans have a low loan-to-value of 48.35% and long seasoning of 4.64 years, external factors like the economic environment and the real estate markets

The second deal which will be four times the debut transaction is expected to close around the third quarter in this year. With a positive beginning, there is a potential of more of these deals in the times to come by.

Links: For more on Securitisation in Indonesia, see our country page and to know more about RMBS transactions, see here.

Crisis spurts securitization litigation

As one would expect, a crisis time is a boom time for litigation lawyers. As pains of the crisis spread, people are exploring ways to lay blame on someone, somewhere else. Those who bought loans are  suing those who sold; those who insured securitizations are suing those who originated; servicers are suing trustees, and so on. As they say, it is trying time – so, lots of securitization questions are facing trial right now.

Insurance company MBIA has sued Residential Funding, a unit of GMAC. MBIA had also sued Countrywide, alleging that the transactions it insured made misrepresentations about quality of loans.

There have  been several cases relating to CDOs. A webpage by Nixon Peabody (here) says there has  been a surge in disputes relating to “waterfall”  clauses,  or between noteholders and swap or liquidity counterparties, regarding subordination and priorities of payment stemming from an event of default (EOD), acceleration of maturity, and liquidation of collateral under such indentures. The page refers to at least two cases: LaSalle Bank Nat’l Ass’n v. UBS AG and Merrill Lynch International, 08 CIV 3692 (S.D.N.Y., filed April 7, 2008), and a UK ruling relating to an SIV, Bank of New York v. Montana Board of Investments [2008] EWHC (Ch.) 1594 (Eng.),

In yet another case, Brooke Capital, a servicer, has sued the trustees for not paying the servicing fees.

There has been a series of cases where foreclosure actions by securitization trustees have been in various controversies.

New Century Bankruptcy examiner points several securitization accounting lapses

The report of the Bankruptcy Court-appointed Examiner in the bankruptcy of New Century, a subprime originator that filed for bankruptcy earlier last year, has pointed out several securitization accounting lapses. Fair value based accounting has become intensely subjective; it is a statement of opinions and not a statement of fact. Any opinion can be questioned, as on every issue, there is a minimum of two opinions.

The 581-page report goes into New Century’s business models, etc. and spends nearly 200 pages on securitization accounting issues – valuation of residuals, valuation of mortgage servicing rights, etc.

On securitization accounting, the Examiner commented that New Century was using antiquated Excel-based models whereas it ought to have used third-party vendor models. One of the key assumptions in valuation of residuals is the discounting rate. A risk-adjusted discounting rate is used which reflects the riskiness of the residual cashflow. New Century, the Examiner says, was using a discounting rate of 12-14% whereas peer firms were using 15-21% discounting rates. In addition, New Century wrongly made an assumption that on clean up of transaction when the pool value falls, the loans may be sold at par value.

There are similar allegations of flawed assumptions on valuation of mortgage servicing rights as well.

Links: See our securitization accounting page. For a US workshop where we focus on securitization accounting, see our workshops page.

 

Paulson Plan proposes Mortgage Origination Commission

US financial regulators presented, on 31st March 2008 a Blueprint for Modernized Financial Regulatory Structure, commonly referred to as the Paulson Plan in response to the ever-bludgeoning problems of the subprime crisis. The study distinguishes between short-term and intermediate term objectives, and presents what it calls an “optimal” objective-based model to regulate financial institutions. It recommends a threesome regulatory structure, splitting between (a) market stability regulation, (b) safety and soundness regulation, and (c) business conduct regulation.

Among the short-term objectives of relevance to the securitization industry, the following recommendations are notable:

There is proposed a Mortgage Origination Commission for licensing and regulation of agencies involved in the mortgage origination process. In addition, Federal laws should ensure consumer protection in mortgage origination.

Links The text of the Blueprint is here.

President's Working Group announces measures about securitization

The inter-agency group of financial regulators, President's Working Group on Financial Markets (PWG) announced some measures yesterday aimed at containing the fire that seems to be blazing the global financial markets, esepecially those in the US.

The PWG has proposed a range of measures to contain the crisis. Those pertaining to securitization can broadly be classed into two: 1.words of advice and some regulatory responsibility for market players, including mortgage brokers, rating agencies, originators and regulators; 2. Introduction of covered bonds and formalization of bankruptcy remoteness. From the second measure, it seems evident that the US will make positive moves towards on-balance sheet securitization in time to come.

Here are some extracts from the PWG report:

"Mortgage Brokers will be held to strong national licensing and enforcement standards. There will be stricter safeguards against fraud, and full and clear disclosure to borrowers about home loan terms, including long-term affordability.

Credit Rating Agencies will clearly differentiate structured product ratings from ratings for corporate and municipal securities. They will also disclose reviews performed on asset originators, and strengthen data integrity, models and assumptions.

Issuers of Mortgage-Backed Securities will disclose the level and scope of due diligence performed on underlying assets, disclose more granular information regarding underlying credits. And, if issuers have shopped for ratings, disclose the what and why of that as well.

Investors will conduct more independent analysis and be less reliant on ratings. They will require, receive and use more information and more clearly differentiate between structured credits and corporate and municipal securities.

xx

Regulators have a role to play in every change. They will issue new rules and seek regulatory authorities as needed, evaluate progress, provide guidance and enforce laws – to ensure that implementation follows recommendation.

Covered Bonds, which allow banks to retain originated mortgage loans while accessing financial market funding, are another alternative worth considering. Covered bonds may address the current lack of liquidity in, and bring more competition to, mortgage securitization. Rule-making, not legislation, is needed to facilitate the issuance of covered bonds. Through clarification of covered bonds' status in the event of a bank-issuer's insolvency, the FDIC can reduce uncertainty and consider appropriate measures that will protect the deposit insurance fund. These steps would encourage a covered bond market in the U.S.; similar changes in Europe have resulted in more covered bond activity".

 

ABS issuance falls 30% in 2007

2007 is, beyond doubt, one of the worst years in recent memory for financial services in general, but for securitization, it will go down in history as the worst, as, for the first time since its inception, issuance volumes took a deep dive of 30%.

Financial press cited Thomson Financial data to report a 30% decline in issuance volumes with the steepest decline, quite obviously, from the home equity segment (nearly 62%). According to Thomson Financial data, issuance in 2007 added up to $ 864 billion, compared to $ 1249 billion in 2006.

The data available on abalert.com shows worldwide ABS issuance added upto $ 996 billion, compared to last year's volume of $ 1322 billion.

The drying up of liquidity is also evident from the spreads on AAA home equity ABS – reported to be about 220 bps for 2 years and 280 bps for 5 years, whereas the average spread for 12 months is just 74 bps.

Financial press is abuzz with news stories about the death of securitization, but clearly, the originate-to-distribute model on which banks work today will continue in some form or the other. Hence, either in cash form or synthetic form, securitization would continue. Securitization is an excellent tool for integration of capital markets with asset markets – hence, its basic economic rationale is beyond question, though there might be rethinking on off balance sheet and special purpose entities. 2007 may prove to be the worst, and that is over.

 

News on Securitisation: China’s First Asset Securitisation in Auto Leasing

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China’s First Asset Securitisation in Auto Leasing

December 11, 2013

Xinjiang Guanghui Leasing Company the largest passenger vehicle leasing company in China, successfully issued its first asset securitization product, named the “the yuan issue”, of its specific asset management plan on December 5, marking the first domestic auto leasing company to finance via asset securitization. This was the fourth asset securitization product approved by the China Securities Regulatory Commission (CSRC) and also the first asset securitization product in the field of auto leasing.

By far, a total of 29 asset securitization programs have been under review, which indicates that the CSRC is making an all-out effort to promote the development of asset securitization in the mainland.

Reported by

Shambo Dey

Articles On Securitisation: Securitisation Primer

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By Vinod Kothari, ( finserv@vinodkothari.com)

CHAPTER 1

Just as the electronics industry was formed when the vacuum tubes were replaced by transistors, and transistors were then replaced by integrated circuits, the financial services industry is being transformed now that securitised credit is beginning to replace traditional lending. Like other technological transformations, this one will take place over the years, not overnight. We estimate it will take 10 to 15 years for structured securitised credit to replace to displace completely the classical lending system -not a long time, considering that the fundamentals of banking have remained essentially unchanged since the Middle Ages.

Lowell L Bryan

Technological advancements have changed the face of the world of finance. It is today more a world of transactions than a world of relations. Most relations have been transactionalised.

Transactions mean coming together of two entities with a common purpose, whereas relations mean keeping together of these two entities. For example, when a bank provides a loan of a sum of money to a user, the transaction leads to a relationship: that of a lender and a borrower. However, the relationship is terminated when the very loan is converted into a debenture. The relationship of being a debentureholder in the company is now capable of acquisition and termination by transactions.

Basic meaning of securitisation:

“Securitisation” in its widest sense implies every such process which converts a financial relation into a transaction.

History of evolution of finance, and corporate law, the latter being supportive for the former, is replete with instances where relations have been converted into transactions. In fact, this was the earliest, and by far unequalled, contribution of corporate law to the world of finance, viz., the ordinary share, which implies piecemeal ownership of the company. Ownership of a company is a relation, packaged as a transaction by the creation of the ordinary share. This earliest instance of securitisation was so instrumental in the growth of the corporate form of doing business, and hence, industrialisation, that someone rated the it as one of the two greatest inventions of the 19th century -the other one being the steam engine. That truly reflects the significance of the ordinary share, and if the same idea is extended, to the very concept of securitisation: it as important to the world of finance as motive power is to industry.

Other instances of securitisation of relationships are commercial paper, which securitises a trade debt.

Asset securitisation:

However, in the sense in which the term is used in present day capital market activity, securitisation has acquired a typical meaning of its own, which is at times, for the sake of distinction, called asset securitisation. It is taken to mean a device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collaterals, and thereby achieve the purpose of financing. Though the end-result of securitisation is financing, but it is not “financing” as such, since the entity securitising its assets it not borrowing money, but selling a stream of cash flows that was otherwise to accrue to it.

The simplest way to understand the concept of securitisation is to take an example. Let us say, I want to own a car to run it for hire. I could take a loan with which I could buy the car. The loan is my obligation and the car is my asset, and both are affected by my other assets and other obligations. This is the case of simple financing.

On the other hand, if I were to analytically envisage the car, my asset in the instant case, as claim to value over a period of time, that is, ability to generate a series of hire rentals over a period of time, I might sell a part of the cash flow by way of hire rentals for a stipulated time and thereby raise enough money to buy the car. The investor is happier now, because he has a claim for a cash flow which is not affected by my other obligations; I am happier because I have the cake and eat it also, and also because the obligation to repay the financier is taken care of by the cashflows from the car itself.

Blend of financial engineering and capital markets:

Thus, the present-day meaning of securitisation is a blend of two forces that are critical in today’s world of finance: structured finance and capital markets. Securitisation leads to structured finance as the resulting security is not a generic risk in entity that securitises its assets but in specific assets or cashflows of such entity. Two, the idea of securitisation is to create a capital market product – that is, it results into creation of a “security” which is a marketable product.

This meaning of securitisation can be expressed in various dramatic words:

  • Securitisation is the process of commoditisation. The basic idea is to take the outcome of this process into the market, the capital market. Thus, the result of every securitisation process, whatever might be the area to which it is applied, is to create certain instruments which can be placed in the market.
  • Securitisation is the process of integration and differentiation. The entity that securitises its assets first pools them together into a common hotchpot (assuming it is not one asset but several assets, as is normally the case). This the process of integration. Then, the pool itself is broken into instruments of fixed denomination. This is the process of differentiation.
  • Securitisation is the process of de-construction of an entity. If one envisages an entity’s assets as being composed of claims to various cash flows, the process of securitisation would split apart these cash flows into different buckets, classify them, and sell these classified parts to different investors as per their needs. Thus, securitisation breaks the entity into various sub-sets.

We will return to this specific, present-day meaning of securitisation. However, let us go back to the generic meaning of the term – that is, converting an asset or a relationship into a security, a commodity.

Very understandably, further developments in this area will continue to take place. More financial relations of today will in time to come be converted into and be transferable as “securities”.

In connection with securitisation, the word “security” does not mean what it traditionally might have meant under corporate laws or commerce: a secured instrument. The word “security” here means a financial claim which is generally manifested in form of a document, its essential feature being marketability. To ensure marketability, the instrument must have general acceptability as a store of value. Hence, it is generally either rated by credit rating agencies, or it is secured by charge over substantial assets. Further, to ensure liquidity, the instrument is generally made in homogenous lots.

The generic need for securitisation is as old as that for organised financial markets. From the distinction between a financial relation and a financial transaction earlier, we understand that a relation invariably needs the coming together and remaining together of two entities. Not that the two entities would necessarily come together of their own, or directly. They might involve a number of financial intermediaries in the process, but nevertheless, a relation involves a fixity over a certain time. Generally, financial relations are created to back another financial relation, such as a loan being taken to acquire an asset, and in that case, the needed fixed period of the relation hinges on the other which it seeks to back-up.

Financial markets developed in response to the need to involve a large number of investors in the market place. As the number of investors keeps on increasing, the average size per investors keeps on coming down -this is a simple rule of the marketplace, because growing size means involvement of a wider base of investors. The small investor is not a professional investor: he is not as such in the business of investments. Hence, he needs an instrument which is easier to understand, and is liquid. These two needs set the stage for evolution of financial instruments which would convert financial claims into liquid, easy to understand and homogenous products, at times carrying certified quality labels (credit-ratings or security ) , which would be available in small denominations to suit every one’s purse. Thus, securitisation in a generic sense is basic to the world of finance, and it is a truism to say that securitisation envelopes the entire range of financial instruments, and hence, the entire range of financial markets.

Following are the reasons as to why the world of finance prefers a securitised financial instrument to the underlying financial claim in its original form:

1. Financial claims often involve sizeable sums of money, clearly outside the reach of the small investor. The initial response to this was the development of financial intermediation: an intermediary such as a bank would pool together the resources of the small investors and use the same for the larger investment need of the user. However, then came the second difficulty, noted below.

2. Small investors are typically not in the business of investments, and hence, liquidity of investments is most critical for them. Underlying financial transactions need fixity of investments over a fixed time, ranging from a few months to may be a number of years. This problem could not even be sorted out by financial intermediation, since if the intermediary provided a fixed investment option to the seeker, and itself sought funds with an option for liquidity, it would get caught into serious problems of a mismatch. Hence, the answer was a marketable instrument.

3. Generally, instruments are easier understood than financial transactions. An instrument is homogenous, usually made in a standard form, and generally containing standard issuer obligations. Hence, it can be understood generically. Besides, an important part of investor information is the quality and price of the instrument, and both are far easier known in case of instruments than in case of underlying financial transactions.

In short, the need for securitisation was almost inescapable, and present day’s financial markets would not have been what they are, unless some standard thing that market players could buy and sell, that is, financial securities, were available.

So powerful is the economic logic for securitisation that the trend towards securitisation knows no limits. Capital markets are today a place where everything is traded: from claims over entities to claims over assets, to risks, and rewards.

One of the applications of the securitisation technique has been in creation of marketable securities out of or based on receivables. The intention of this application is to afford marketability to financial claims in the form of receivables. Obviously, this application has been applied to those entities where receivables form a large part of the total assets of the entity. Besides, to be packaged as a security, the ideal receivable is one which is repayable over or after a certain period of time, and there is contractual certainty as to its payment. Hence, the application was traditionally principally directed towards housing/ mortgage finance companies, car rental companies, leasing and hire-purchase companies, credit cards companies, hotels, etc. Soon, electricity companies, telephone companies, real estate hiring companies, aviation companies etc. joined as users of securitisation. Insurance companies are the latest of the lot to make an innovative use of securitisation of risk and receivables, though the pace at which securitisation markets are growing, the word “latest” is not without the risk of being stale soon.

Though the generic meaning of securitisation is every such process whereby financial claims are transformed into marketable securities, in the sense in which we are concerned with this term here in this book, securitisation is a process by which cashflows or claims against third parties of an entity, either existing or future, are identified, consolidated, separated from the originating entity, and then fragmented into “securities” to be offered to investors.

Securitisation of receivables is a unique application of the concept of securitisation. For most other securitisations, a claim on the issuer himself is being securitised. For example, in case of issuance of debenture, the claim is on the issuing company only. In case of receivable, what is being securitised is a claim on the third party /parties, on whom the issuer has a claim. Hence, what the investor in receivable-securitised product gets is a claim on the debtors of the originator. This may at times be further include, by way of recourse, a claim on the originator himself.

The involvement of the debtors in receivable securitisation process adds unique dimensions to the concept, of which at least two deserve immediate mention. One, the very legal possibility of transforming a claim on a third party as a marketable document. It is easy to understand that this dimension is unique to securitisation of receivables, since there is no legal difficulty where an entity creates a claim on itself, but the scene is totally changed where rights on other parties are being turned into a tradeable commodity. Two, it affords to the issuer the rare ability to originate an instrument which hinges on the quality of the underlying asset. To state it simply, as the issuer is essentially marketing claims on others, the quality of his own commitment becomes irrelevant if the claim on the debtors of the issuer is either market-acceptable or is duly secured. Hence, it allows the issuer to make his own credit-rating insignificant or less-significant, and the intrinsic quality of the asset more critical.

Though there is a complete terminology appended to this Chapter, this section will help the reader to quickly get familiarised with the essential securitisation jargon.

The entity that securitises its assets is called the originator: the name signifies the fact that the entity was responsible for originating the claims that are to be ultimately securitised. There is no distinctive name for the investors who invest their money in the instrument: therefore, they might simply be called investors.

The claims that the originator securitises could either be existing claims, or existing assets (in form of claims), or expected claims over time. In other words, the securitised assets could be either existing receivables, or receivables to arise in future. The latter, for the sake of distinction, is sometimes called future flows securitisation, in which case the former is a case of asset-backed securitisation.

In US markets, another distinction is mostly common: between mortgage-backed securities and asset-backed securities. This only is to indicate the distinct application: the former relates to the market for securities based on mortgage receivables, which in the USA forms a substantial part of total securitisation markets, and securitisation of other receivables.

Since it is important for the entire exercise to be a case of transfer of receivables by the originator, not a borrowing on the security of the receivables, there is a legal transfer of the receivables to a separate entity. In legal parlance, transfer of receivables is called assignment of receivables. It is also necessary to ensure that the transfer of receivables is respected by the legal system as a genuine transfer, and not as a mere eyewash where the reality is only a mode of borrowing. In other words, the transfer of receivables has to be a true sale of the receivables, and not merely a financing against the security of the receivables.

Since securitisation involves a transfer of receivables from the originator, it would be inconvenient, to the extent of being impossible, to transfer such receivables to the investors directly, since the receivables are as diverse as the investors themselves. Besides, the base of investors could keep changing as the resulting security is essentially a marketable security. Therefore, it is necessary to bring in an intermediary that would hold the receivables on behalf of the end investors. This entity is created solely for the purpose of the transaction: therefore, it is called a special purpose vehicle (SPV) or a special purpose entity (SPE) or, if such entity is a company, special purpose company (SPC). The function of the SPV in a securitisation transaction could stretch from being a pure conduit or intermediary vehicle, to a more active role in reinvesting or reshaping the cashflows arising from the assets transferred to it, which is something that would depend on the end objectives of the securitisation exercise.

Therefore, the originator transfers the assets to the SPV, which holds the assets on behalf of the investors, and issues to the investors its own securities. Therefore, the SPV is also called the issuer.

There is no uniform name for the securities issued by the SPV as such securities take different forms. These securities could either represent a direct claim of the investors on all that the SPV collects from the receivables transferred to it: in this case, the securities are called pass through certificates or beneficial interest certificates as they imply certificates of proportional beneficial interest in the assets held by the SPV. Alternatively, the SPV might be re-configuring the cashflows by reinvesting it, so as to pay to the investors on fixed dates, not matching with the dates on which the transferred receivables are collected by the SPV. In this case, the securities held by the investors are called pay through certificates. The securities issued by the SPV could also be named based on their risk or other features, such as senior notes or junior notes, floating rate notes, etc.

Another word commonly used in securitisation exercises is bankruptcy remote transfer. What it means is that the transfer of the assets by the originator to the SPV is such that even if the originator were to go bankrupt, or get into other financial difficulties, the rights of the investors on the assets held by the SPV is not affected. In other words, the investors would continue to have a paramount interest in the assets irrespective of the difficulties, distress or bankruptcy of the originator.

A securitised instrument, as compared to a direct claim on the issuer, will generally have the following features:

Marketability:

The very purpose of securitisation is to ensure marketability to financial claims. Hence, the instrument is structured so as to be marketable. This is one of the most important feature of a securitised instrument, and the others that follow are mostly imported only to ensure this one. The concept of marketability involves two postulates: (a) the legal and systemic possibility of marketing the instrument; (b) the existence of a market for the instrument.

As far as the legal possibility of marketing the instrument is concerned, traditional mercantile law took a contemporaneous view of marketable documents. In most jurisdictions of the world, laws dealing with marketable instruments (also referred to as negotiable instruments) were mostly limited in application to what were then in circulation as such. Besides, the corporate laws mostly defined and sought to regulate issuance of very usual corporate financial claims, such as shares, bonds and debentures. For any codified law, this is not unexpected, since laws do not lead commerce: most often, they follow, as the concern of the law-maker is mostly regulatory and not promotional.

Hence, in most jurisdictions of the world, well-coded laws exist to enable and regulate the issuance of traditional forms of securitised claims, such as shares, bonds, debentures and trade paper (negotiable instruments). Most countries lack in legal systems pertaining to other securitised products, of recent or exotic origin, such as securitisation of receivables. On a policy plane, it is incumbent on the part of the regulator to view any securitised instrument with the same concern as in case of traditional instruments, for reasons of investor protection.

However, it needs to be noted that where a law does not exist to regulate issuance of a securitised instrument, it is naive to believe that the law does not permit such issuance. As regulation is a design by humanity itself, it would be ridiculous to presume that everything that is not regulated is not even allowed. Regulation is an exception and freedom is the rule.

The second issue is one of having or creating a market for the instrument. Securitisation is a fallacy unless the securitised product is marketable. The very purpose of securitisation will be defeated if the instrument is loaded on to a few professional investors without any possibility of having a liquid market therein. Liquidity to a securitised instrument is afforded either by introducing it into an organised market (such as securities exchanges) or by one or more agencies acting as market makers in it, that is, agreeing to buy and sell the instrument at either pre-determined or market-determined prices.

Merchantable quality:

To be market-acceptable, a securitised product has to have a merchantable quality. The concept of merchantable quality in case of physical goods is something which is acceptable to merchants in normal trade. When applied to financial products, it would mean the financial commitments embodied in the instruments are secured to the investors’ satisfaction. “To the investors’ satisfaction” is a relative term, and therefore, the originator of the securitised instrument secures the instrument based on the needs of the investors. The general rule is: the more broad the base of the investors, the less is the investors’ ability to absorb the risk, and hence, the more the need to securitise.

For widely distributed securitised instruments, evaluation of the quality, and its certification by an independent expert, viz., rating, is common. The rating serves for the benefit of the lay investor, who is otherwise not expected to be in a position to appraise the degree of risk involved.

In case of securitisation of receivables, the concept of quality undergoes drastic change making rating is a universal requirement for securitisations. As already discussed, securitisation is a case where a claim on the debtors of the originator is being bought by the investors. Hence, the quality of the claim of the debtors assumes significance, which at times enables to investors to rely purely on the credit-rating of debtors (or a portfolio of debtors) and so, make the instrument totally independent of the oringators’ own rating.

Wide Distribution:

The basic purpose of securitisation is to distribute the product. The extent of distribution which the originator would like to achieve is based on a comparative analysis of the costs and the benefits achieved thereby. Wider distribution leads to a cost-benefit in the sense that the issuer is able to market the product with lower return, and hence, lower financial cost to himself. But wide investor base involves costs of distribution and servicing.

In practice, securitisation issues are still difficult for retail investors to understand. Hence, most securitisations have been privately placed with professional investors. However, it is likely that in to come, retail investors could be attracted into securitised products.

Homogeneity:

To serve as a marketable instrument, the instrument should be packaged as into homogenous lots. Homogeneity, like the above features, is a function of retail marketing. Most securitised instruments are broken into lots affordable to the marginal investor, and hence, the minimum denomination becomes relative to the needs of the smallest investor. Shares in companies may be broken into slices as small as Rs. 10 each, but debentures and bonds are sliced into Rs. 100 each to Rs. 1000 each. Designed for larger investors, commercial paper may be in denominations as high as Rs. 5 Lac. Other securitisation applications may also follow this logic.

The need to break the whole lot to be securitised into several homogenous lots makes securitisation an exercise of integration and differentiation: integration of those several assets into one lump, and then the latter’s differentiation into uniform marketable lots. This often invites the next feature : an intermediary to achieve this process.

Special purpose vehicle:

In case the securitisation involves any asset or claim which needs to be integrated and differentiated, that is, unless it is a direct and unsecured claim on the issuer, the issuer will need an intermediary agency to act as a repository of the asset or claim which is being securitised. Let us take the easiest example of a secured debenture, in essence, a secured loan from several investors. Here, security charge over the issuer’s several assets needs to be integrated, and thereafter broken into marketable lots. For this purpose, the issuer will bring in an intermediary agency whose basic function is to hold the security charge on behalf of the investors, and then issue certificates to the investors of beneficial interest in the charge held by the intermediary. So, whereas the charge continues to be held by the intermediary, beneficial interest therein becomes a marketable security.

The same process is involved in securitisation of receivables, where the special purpose intermediary holds the receivables with itself, and issues beneficial interest certificates to the investors.

  1. Meaning of security:
  2. Need for securitisation:
  3. Securitisation of receivables:
  4. quick guide to Jargon:
  5. Features of securitisation:
  6. Securitisation and financial disintermediation:

Securitisation is often said to result into financial disintermediation. This concept needs to be elaborated. The best way to understand this concept is to take the case of corporate debentures, a well-understood security.

As was discussed earlier, if one imagines a financial world without securities (and such world is only imaginary), all financial transactions will be carried only as one-to-one relations. For example, if a company needs a loan, if will have to seek such loan from the lenders, and the lenders will have to establish a one-to-one relation with the company. Each lender has to understand the borrowing company, and to look after his loan. This is often difficult, and hence, there appears a financial intermediary, such as a bank in this case, which pools funds from a lot of such investors, and uses these pooled funds to lend to the company. Now, let us suppose the company securitises the loan, and issues debentures to the investors. Will this eliminate the need for the intermediary bank, since the investors may now lend to the company directly in small amounts each, in form of a security which is easy to appraise, and which is liquid ?

Utilities added by financial intermediaries:

A financial intermediary initially came in picture to avoid the difficulties in a direct lender-borrower relation between the company and the investors. The difficulties could have been one or more of the following:

(a) Transactional difficulty: An average small investor would have a small amount of sum to lend whereas the company’s needs would be massive. The intermediary bank pools the funds from small investors to meet the typical needs of the company. The intermediary may issue its own security, of smaller value.

(b) Informational difficulty: An average small investor would either not be aware of the borrower company or would not know how to appraise or manage the loan. The intermediary fills up this gap.

(c) Perceived risk: The risk as investors perceive in investing in a bank may be much lesser than that of investing directly in the company, though in reality, the financial risk of the company is transposed on the bank. However, the bank is a pool of several such individual risks, and hence, the investors’ preference of a bank to the borrower company is reasonable.

Securitisation of the loan into bonds or debentures fills up all the three difficulties in direct exchange mentioned above, and hence, avoids the need for a direct intermediation. It avoids the transactional difficulty by breaking the lumpy loan into marketable lots. It avoids informational difficulty because the securitised product is offered generally by way of a public offer, and its essential features are well disclosed. It avoids the perceived risk difficulty too, since the instrument is generally well-secured, and is rated for the investors’ satisfaction.

Securitisation: changes the function of intermediation:

Hence, it is true to say that securitisation leads to a degree of disintermediation. Disintermediation is one of the important aims of a present-day corporate treasurer, since by leap-frogging the intermediary, the company intends to reduce the cost of its finances. Hence, securitisation has been employed to disintermediate.

It is, however, important to understand that securitisation does not eliminate the need for the intermediary: it merely redefines the intermediary’s loan. Let us revert to the above example. If the company in the above case is issuing debentures to the public to replace a bank loan, is it eliminating the intermediary altogether ? It would possibly be avoiding the bank as an intermediary in the financial flow, but would still need the services of an investment banker to successfully conclude the issue of debentures.

Hence, securitisation changes the basic role of financial intermediaries. Traditionally, financial intermediaries have emerged to make a transaction possible by performing a pooling function, and have contributed to reduce the investors’ perceived risk by substituting their own security for that of the end user. Securitisation puts these services of the intermediary in a background by making it possible for the end-user to offer these features in form of the security, in which case, the focus shifts to the more essential function of a financial intermediary: that of distributing a financial product. For example, in the above case, where the bank being the earlier intermediary was eliminated and instead the services of an investment banker were sought to distribute a debenture issue, the focus shifted from the pooling utility provided by the banker to the distribution utility provided by the investment banker.

This has happened to physical products as well. With standardisation, packaging and branding of physical products, the role of intermediary traders, particularly retailers, shifted from those who packaged smaller qualities or provided to the customer assurance as to quality, to the ones who basically performed the distribution function.

Securitisation seeks to eliminate funds-based financial intermediaries by fee-based distributors. In the above example, the bank was a fund-based intermediary, a reservoir of funds, whereas the investment banker was a fee-based intermediary, a catalyst, a pipeline of funds. Hence, with increasing trend towards securitisation, the role of fee-based financial services has been brought into the focus.

In case of a direct loan, the lending bank was performing several intermediation functions noted above: it was distributor in the sense that it raised its own finances from a large number of small investors; it was appraising and assessing the credit risks in extending the corporate loan, and having extended it, it was managing the same. Securitisation splits each of these intermediary functions apart, each to be performed by separate specialised agencies. The distribution function will be performed by the investment bank, appraisal function by a credit-rating agency, and management function possibly by a mutual fund who manages the portfolio of security investments by the investors. Hence, securitisation replaces fund-based services by several fee-based services.

Securitisation: changing the face of banking:

Note the quotation with which we began this Chapter – it says securitisation is slowly but definitely changing the face of modern banking and by the turn of the new millennium, securitisation would have transformed banking into a new-look function.

Banks are increasingly facing the threat of disintermediation. When asked why he robbed banks, the infamous American criminal Willie Sutton replied “that’s where the money is.” No more so, a bank would say ! In a world of securitized assets, banks have diminished roles. The distinction between traditional bank lending and securitized lending clarifies this situation.

Traditional bank lending has four functions: originating, funding, servicing, and monitoring. Originating means making the loan, funding implies that the loan is held on the balance sheet, servicing means collecting the payments of interest and principal, and monitoring refers to conducting periodic surveillance to ensure that the borrower has maintained the financial ability to service the loan. Securitized lending introduces the possibility of selling assets on a bigger scale and eliminating the need for funding and monitoring.

The securitized lending function has only three steps: originate, sell, and service. This change from a four-step process to a three-step function has been described as the fragmentation or separation of traditional lending.

Capital markets fuelled securitisation:

The fuel for the disintermediation market has been provided by the capital markets:

  • Professional and publicly available rating of borrowers has eliminated the informational advantage of financial intermediaries. Imagine a market without rating agencies: any one who has to take an exposure in any product or entity has to appraise the entity. Obviously enough, only those who are able to employ high-degree analytical skills will be able to survive. However, the availability of professionally and systematically conducted ratings has enabled lay investors to rely on the rating company’s professional judgement and invest directly in the products or instruments of user entities than to go through financial intermediaries.
  • The development of capital markets has re-defined the role of bank regulators. A bank supervisory body is concerned about the risk concentrations taken by a bank. More the risk undertaken, more is the requirement of regulatory capital. On the other hand, if the same assets were to be distributed through the capital market to investors, the risk is divided, and the only task of the regulator is that the risk inherent in the product is properly disclosed. The market sets its own price for risk – higher the risk, higher the return required.

Capital markets tend to align risks to risk takers. Free of constraints imposed by regulators and risk-averse depositors and bank shareholders, capital markets efficiently align risk preferences and tolerances with issuers (borrowers) by giving providers of funds (capital market investors) only the necessary and preferred information. Any remaining informational advantage of banks is frequently offset by other features of the capital markets: variety of offering methods, flexibility of timing and other structural options. For borrowers able to access capital markets directly, the cost of capital will be reduced according to the confidence that the investor has in the relevance and accuracy of the provided information.

 As capital markets become more complete, financial intermediaries become less important as cotact points between borrowers and savers. They become more important, however, as specialists that (1) complete markets by providing new products and services, (2) transfer and distribute various risks via structured deals, and (3) use their reputational capital as delegated monitors to distinguish between high- and low-quality borrowers by providing *third-party certifications of creditworthiness. These changes represent a shift away from the administrative structures of traditional lending to market-oriented structures for allocating money and capital.

In this sense, securitisation is not really-speaking synonymous to disintermediation, but distribution of intermediary functions amongst specialist agencies.

Securitisation is a “structured financial instrument”. “Structured finance” has become a buzzword in today’s financial market. What it means is a financial instrument structured or tailored to the risk-return and maturity needs of the investor, rather than a simple claim against an entity or asset.

Does that mean any tailored financial product is a structured financial product? In a broad sense, yes. But the popular use of the term structured finance in today’s financial world is to refer to such financing instruments where the financier does not look at the entity as a risk: but tries to align the financing to specific cash accruals of the borrower.

On the investors side, securitisation seeks to structure an investment option to suit the needs of investors. It classifies the receivables/cash flows not only into different maturities but also into senior, mezzanine and junior notes. Therefore, it also aligns the returns to the risk requirements of the investor.

Securitization is more than just a financial tool. It is an important tool of risk management for banks that primarily works through risk removal but also permits banks to acquire securitized assets with potential diversification benefits. When assets are removed from a bank’s balance sheet, without recourse, all the risks associated with the asset are eliminated, save the risks retained by the bank. Credit risk and interest-rate risk are the key uncertainties that concern domestic lenders. By passing on these risks to investors, or to third parties when credit enhancements are involved, financial firms are better able to manage their risk exposures.

In today’s banking, securitisation is increasingly being resorted to by banks, along with other innovations such as credit derivatives to manage credit risks.

Securitisation and credit derivatives:

Credit derivatives are only a logical extension of the concept of securitisation. A credit derivative is a non-fund based contract when one person agreed to undertake, for a fee, the risk inherent in a credit without acting taking over the credit. The risk could be undertaken either by guaranteeing against a default, or by guaranteeing the total expected return from the credit transaction. While the former could be just another form of traditional guarantees, the latter is the true concept of credit derivatives. Thus, if B bank has a concentration in say Iron and Steel segment while A bank has concentration in Textiles, the two can diversify their risks, without actually taking financial exposure, by engaging in credit derivatives. A can agree to guarantee the returns of B from a part of its Iron and Steel exposures, and B can guarantee the returns of A from Textiles (derivatives do not necessarily have to be reciprocal). Thus, A is now earning both from its own exposure in Iron and Steel, as also from the fee-based exposure it has taken in Textiles.

Credit derivatives were logically the next step in development of securitisation. Securitisation development was premised on credit being converted into a commodity. In the process, the risk inherent in credits was being professionally measured and rated. In the second step, one would argue that if the risk can be measured and traded as a commodity with the underlying financing involved, why can’t the financing and the credit be stripped as two different products?

The development of credit derivatives has not reduced the role for securitisation: it has only increased the potential for securitisation. Credit derivatives is only a tool for risk management: securitisation is both a tool for risk management as also treasury management. Entities that want to go for securitisation can easily use credit derivatives as a credit enhancement device, that is, secure total returns from the portfolio by buying a derivative, and then securitise the portfolio.

Securitisation is as necessary to the economy as any organised markets are. While this single line sums up the economic significance of securitisation, the following can be seen as the economic merits in securitisation:

-1 Facilitates creation of markets in financial claims:

By creating tradeable securities out of financial claims, securitisation helps to create markets in claims which would, in its absence, have remained bilateral deals. In the process, securitisation makes financial markets more efficient, by reducing transaction costs.

-2 Disperses holding of financial assets:

The basic intent of securitisation is to spread financial assets amidst as many savers as possible. With this end in view, the security is designed in minimum size marketable lots as necessary. Hence, it results into dispersion of financial assets.One should not underrate the significance of this factor just because most of the recently developed securitisations have been lapped up by institutional investors. Lay investors need a certain cooling-off period before they understand a financial innovation. Recent securitisation applications, viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to lay investors. But given their attractive features, there is no reason why they will not.

-3 Promotes savings:

The availability of financial claims in a marketable form, with proper assurance as to quality in form of credit ratings, and with double safety-nets in form of trustees, etc., securitisation makes it possible for the lay investors to invest in direct financial claims at attractive rates. This has salubrious effect on savings.

-4 Reduces costs:

As discussed above, securitisation tends to eliminate fund-based intermediaries, and it leads to specialisation in intermediation functions. This saves the end-user company from intermediation costs, since the specialised-intermediary costs are service-related, and generally lower.

-5 Diversifies risks:

Financial intermediation is a case of diffusion of risk because of accumulation by the intermediary of a portfolio of financial risks. Securitisation further diffuses such diversified risk to a wide base of investors, with the result that the risk inherent in financial transactions gets very widely diffused.

-6 Focuses on use of resources, and not their ownership:

Once an entity securitises its financial claims, it ceases to be the owner of such resources and becomes merely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine the idea of securitisation being carried further, and not only financial claims but claims in physical assets being securitised, in which case the entity needing the use of physical assets acquires such use without owning the property. The property is diffused over an investor crowd.In this sense, securitisation carries Gandhi’s idea of a capitalist being a trustee of resources and not the owner. Securitisation in its logical extension will enable enterprises to use physical assets even without owning them, and to disperse the ownership to the real owner thereof: the society.

  1. Securitisation and structured finance:
  2. Securitisation as a tool of risk management:
  3. Economic impact of securitisation:
  4. The alchemy of securitisation: is the sum of parts more than the whole?

An essential economic question often raised is: does securitisation lead to any overall social benefit? After all, all that securitisation does is to break a company, a set of various assets, into various subsets of classified assets, and offer them to investors. Imagine a world without securitisation: each investor would be taking a risk in the unclassified, composite company as a whole. So, how does it serve any economic purpose, if the company is “de-composed” and sold to different investors?

A New Zealand-based scholar takes the following example to illustrate the alchemy of securitisation:

To appreciate the underlying economics driving a securitisation, consider a hypothetical holding company XYZ Ltd, which has on its balance sheet nothing other than three wholly-owned subsidiaries, X, Y & Z. (The process of securitisation can be thought of as treating distinguishable pools of assets as if they were the wholly-owned subsidiaries, X, Y and Z.)

Assume X is 100% debt financed (5 year debentures issued at 9%) with its only asset a single 5 year loan to an AAA-rated borrower paying 10%.

Assume Y is a new software company with no earnings or performance history, but with projections for extremely attractive, albeit volatile, future earnings.

Assume Z is a well-known manufacturing company with predictable but unspectacular earnings.

If XYZ went to the debt markets seeking additional senior unsecured funding, potential investors would face the difficult task of evaluating its assets and assessing its debt repaying abilities. The assessed cost of marginal XYZ borrowing might consist of an “average” of the conservatively calculated returns on the assets of the segments that comprise XYZ. Note that this average would necessarily reflect known and unknown synergies, and costs and associative risks arising from the collective ownership of the constituent parts (i.e., the group’s imputed contribution for credit support, insolvency risk and liability recourse) and would likely include an “uncertainty” discount.

Now consider the probable outcomes if XYZ were to legally sell or “spin-off” the ownership of one or more of its “parts.” In exchange for the exclusive rights to the cash flows from X, investors would return to XYZ maximum equivalent value in the form of cash.

Such an offering:

    • appeals to a wide range of investors, including those with a preference for, and superior information regarding, the risk represented by X’s obligors and those new investors who have had an aversion for the risk presented by the associated costs and risks represented by Y and Z
    • returns to XYZ the full value the market attaches to the certainty of the information concerning X, now free of any discount imposed by the uncertainty of the information regarding Y and Z.

Admittedly, the value of the resulting XYZ shares depends in part on the disposition of the cash received from the spin-off. If XYZ retains the cash, there may be a discount or revaluation resulting from the market’s assessment of XYZ’s ability to achieve a return equal or better than it would have earned from keeping the asset.

There is always one clear collateral benefit to the resulting XYZ that derives from any divestment. The perceived value of the remaining components is relieved of any previously imposed discount for the disposed component’s credit support and insolvency risk.

Holding aside separate considerations of corporate strategy and intentional and coincidental internal synergies, to the extent that the consideration received from the divestment improves (in the perception of the market) the capital structure of the resulting XYZ and/or improves the marginal funding cost for the resulting XYZ, the decision to divest or securitise is simplified. If the information held by XYZ concerning any of its segments is not or cannot be fully disclosed, or when disclosed will not be fully or accurately valued, the correct decision is to retain the asset.

Without securitisation, XYZ’s bank or factor faces significant and largely irreducible costs of evaluating the marginal impact on XYZ’s borrowing cost from XYZ’s pledging of assets (receivables) and of evaluating similar information for each other borrower that the lender or factor finances. If the imposed cost of borrowing is to be judged solely on the assets (which is, as we’ve shown, the most efficient way to assess the true cost of asset based borrowing), evaluating each pool of assets and assessing the likelihood that the cash flows from them will be uninterrupted must be repeated for each borrowing.

By developing a market for asset-specific expertise (not the least of which is represented by the expertise of the rating agencies), and by relying on the capital markets to determine the best price for the rated asset-backed securities (such rating representing the expression of the information provided by the developed expertise), the cost of borrowings for issuers using properly organised securitisation structures has steadily decreased and is well below the cost of borrowing from a lending institution. 

Capturing scale and volume efficiencies

By aggregating similarly originated assets into a sufficiently large pool, the consequences of an individual receivable defaulting, and the levels of risk of default, are minimised. If we further collect and aggregate dissimilar pools of assets, and issue securities backed by the aggregated cash flows derived from the underlying assets, as a result of rules of probability and the basic principles of diversification, the marginal risk to the purchaser (investor) of such a security is significantly less than the risk of holding even a pool of individual receivables. And it is far less than the risk associated with a single receivable.

 If a borrower can identify, segregate and then satisfactorily describe for investors a pool of securitisable assets otherwise held on its balance sheet, the securitisation process can give that borrower a lower cost of funding and improve its balance sheet management. The borrower faced with such an opportunity who chooses not to securitise runs the risk of handicapping its ability to compete.

  1. risks and benefits of securitisation:

 The Bank for International Settlements in a 1992 publication titled Asset Transfers and Securitisation had the following to say on the risks and benefits of securitisation:

 The possible effects of securitisation on financial systems may well differ between countries because of differences in the structure of financial systems or because of differences in the way in which monetary policy is executed. In addition, the effects will vary depending upon the stage of development of securitisation in a particular country. The net effect may be potentially beneficial or harmful, but a number of concerns are highlighted below that may in certain circumstances more than offset the benefits. Several of these concerns are not principally supervisory in nature, but they are referred to here because they may influence monetary authorities’ policy on the development of securitisation markets.

While asset transfers and securitisation can improve the efficiency of the financial

system and increase credit availability by offering borrowers direct access to end-investors, the process may on the other hand lead to some diminution in the importance of banks in the financial intermediation process. In the sense that securitisation could reduce the proportion of financial assets and liabilities held by banks, this could render more difficult the execution of monetary policy in countries where central banks operate through variable minimum reserve requirements. A decline in the importance of banks could also weaken the relationship between lenders and borrowers, particularly in countries where banks are predominant in the economy.

One of the benefits of securitisation, namely the transformation of illiquid loans into liquid securities, may lead to an increase in the volatility of asset values, although credit enhancements could lessen this effect. Moreover, the volatility could be enhanced by events extraneous to variations in the credit standing of the borrower. A preponderance of assets with readily ascertainable market values could even, in certain circumstances, promote a liquidation as opposed to going-concern concept for valuing banks.

Moreover, the securitisation process might lead to some pressure on the profitability of banks if non-bank financial institutions exempt from capital requirements were to gain a competitive advantage in investment in securitised assets.

Although securitisation can have the advantage of enabling lending to take place beyond the constraints of the capital base of the banking system, the process could lead to a decline in the total capital employed in the banking system, thereby increasing the financial fragility of the financial system as a whole, both nationally and internationally. With a substantial capital base, credit losses can be absorbed by the banking system. But the smaller that capital base is, the more the losses must be shared by others. This concern applies, not necessarily in all countries, but especially in those countries where banks have traditionally been the dominant financial intermediaries.

The funny piece below seeks to capture the inherent risks of securitisation:

10 reasons as to why the Titanic was actually a securitisation instrument:

1) The downside was not immediately apparent.

2) It went underwater rapidly despite assurances it was unsinkable.

3) Only a few wealthy people got out in time.

4) The structure appeared iron-clad.

5) Nobody really understood the risk.

6) The disaster happened overnight London time.

7) Nobody spent any time monitoring the risk.

8) People spent a lot trying to lift it out of the water.

9) People who actually made money were not in original deal.

10) Despite the disaster, people still went on other ships.

The above highlights the risks inherent in securitisation. One of the biggest inherent threat in securitisation deals is that the market participants have necessarily believed securitised instruments to be safe, while in reality, many of them represent poor credit risks or doubtful receivables. For example, a growing section of securitisation market is sub-prime auto loans and home equity loans. Similarly, many of the health-care receivables or student loan receivables may not represent good credits.

One instance of a failure in securitisation deals in the USA is the securitisation of health care receivables by a company called Towers Financial. Its Chairman was later sentenced to 20 years in prison for fraud. In fact, the first bank to securitize credit-card payments–RepublicBank Delaware, in 1987–failed in 1988, and the Federal Deposit Insurance Corp. paid off investors early.

In an article titled On the Frontiers of Creative Finance: How Wall Street can Securitise Anything [Fortune, April 28, 1997] Kim Clark noted: ” Investors do need to beware, of course. Financial markets are notorious for pushing investment ideas into the absurd. Some of these exotic securities will undoubtedly collapse, which will undoubtedly cause a backlash.”

The revised article 9 of Uniform Commercial Code

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The revised article 9 of the Uniform Commercial Code of the United States of America deals with the creation, perfection, and priority of security interests in personal property including accounts receivables and intangibles. Though securitization is not a "security interest" as traditionally understood, yet the UCC article includes provisions relating to securitization.

As such, securitisation transactions are affected by the new article. In general, analysts believe that the new article is favourable for securitisation transactions.

To provide a comprehensive guide on the revised article 9, we provide these significant links:

SECURITISATION NEWS AND DEVELOPMENTS

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July – Nov 2003 onwards

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FASB staff issues FIN 46 clarification on collateral manager's fees

FIN 46, the accounting interpretation that tries to rope in special purpose entities on to the balance sheet of its primary beneficiaries, continues to invite confusion and clarification – arguably more of the former than the latter.

The latest staff position or FSP relates to whether the fees of the collateral manager will be treated as a part of the residual returns of the entity. The collateral manager for most CDOs is vested with discretionery powers of collateral management and can hence be treated as the "decision-maker". Resultantly the fees paid to the decision-maker are treated as a part of the residual returns. This has led to consolidation of many CDOs with their collateral managers as such fees constitute a majority of the residual returns so computed.

The instant clarification provides for the circumstances in which the fees paid to the collateral manager could be excluded residual returns. The FSP 7 provides for 4 cumulative conditions for the exclusion:

1. The fees are compensation for services provided and are commensurate with the level of effort required to provide those services.
2. The fees are at or above the same level of seniority as other operating liabilities of the entity that arise in the normal course of business, such as trade payables.
3. Except for the fees described in conditions 1 and 2, the decision maker and the decision maker's related parties1 do not hold interests in the variable interest entity that individually, or in the aggregate, will absorb more than a trivial amount of the entity's expected losses or receive more than a trivial amount of the entity's expected residual returns.
4. The decision maker is subject to substantive kick-out rights, as that term is described in this FSP. However, substantive kick-out rights alone are not sufficient to allow a decision maker's fees to be excluded from paragraph 8(c) in the calculation of an entity's expected residual returns.

Notably, Point 1 talks about the fees being commensurate with the "level of effort" and not the outcome thereof. Therefore, if the fees are structured or variable in any manner, it would be necessary to establish the link of the variability with the level of effort.

The kick out rights in Point 4 are the substantive rights of the investors or others (let us say, voting right holders) to remove the decision maker. These rights must be exercisable by majority of voters other than the decision-maker himself of his related parties, and there must not be significant barriers to exercise of the kick out option.

The FSP above is expected to be incorporated in the amendment to FIN 46, exposure draft of which has already been circulated.

Link: For more on FIN 46, see our new page on FIN 46 here. For more on accounting issues, see page here.

Hong Kong government to securitise toll revenues

The Hong Kong government is set to raise HK $ 6 billion by securitisation of toll revenues of brides and tunnels owned by it.

Securitisation is apparently high on the agenda of the government for its funding as a government spokesman outlined several securitisation plans: The government is budgeting HK$21 billion in revenue from the sale or securitization of state assets in this fiscal year. It has already made HK$4.8 billion this year from a sale of civil service housing loans to the Hong Kong Mortgage Corp. The government expects to realize another HK$10.9 billion this year from the sale of other loan assets, including home starter loans, to the Hong Kong Mortgage Corp.

For the toll revenues securitisation, reports say that HSBC has been selected as a the lead arranger. HSBC is among the top in bond league tables in Asia, and is prominent for securitisation programs.

The overall securitisation activity in Hong Kong has been subdued for a larger part of this year. There have been some synthetic securitisation deals from Hong Kong, including a synthetic securitisation of light bus and taxi receivables originated by HSBS itself.

Links For more on securitisation in Hong Kong, see our page here.

CDOs set to take off in Asia: experts

Finance Asia 30th Oct 2004 carries an interview of Richard Gugliada and Diane Lam of Standard and Poor's who contend that the CDO market is heating up in Asia. Gugliada says that there were only 9 deals upto Sept. last year, but this year, there have been 35, which is nearly 4 times.

On the type of deals, Gugliada says that the majority of the transactions have been synthetics and of this type, about two thirds have come out of Australia and most of these have been smaller two counterparty type deals. Deals like that are coming out of the rest of the region – especially Hong Kong, Singapore, Taiwan and Korea as well, but they are mostly privately placed. We're seeing some of the funded type structures and the larger, synthetic and syndicated type deals emerging as well.

The experts admitted that Asia has so far been a buyer of CDOs, rather than a seller – but that is how the market evolves.

Diane Lam says that there is a temporary lull in arbitrage activity: "People are using a lot of these structures for arbitrage purposes and trying to make money. What we're hearing is that it is very hard to structure a good, profitable deal right now because spreads have tightened so much recently. That's why we are seeing a pause at the moment. That being said, we've rated a number of transactions this year and with the right timing, deals go to market very quickly. With all the press attention on CDOs, investor awareness is very high in Asia at the moment." But, she continues, "It's a good time for Asia as we have the benefit of looking at deals that didn't happen in the past and we can understand why they did not work out. For instance there are things that we do not like to see in the documentation now that were there before".

Links For more on CDOs, see our page here.

FASB decides to issue draft of FIN 46 amendments: experts say most application difficulties not addressed

The FASB decided to issue an exposure draft of amendments to FIN 46 that will be on a "fast track" – meaning short comment period, and quick effective date. Experts who have been associated with the discussions have felt that most of the operative difficulties of the Interpretation remain unresolved. "For the most part, my personal opinion is that the nature of the modifications fall into the categories of technical corrections, clarifications or slight relaxations that impact only a minority of situations involving the application of fin 46", says Marty Rosenblatt.

By a vote of 4 to 3, the board rejected a suggestion that the proposed modifications not become effective until a complete package of necessary revisions or interpretations or reaffirmations of fin 46 are identified, debated, exposed and resolved. The amendments are likely to become effective Q1, 2004 for public companies.

The crux of changes relating to securitization transactions is as under:

1. Paragraph 8a and 8b which say that a variable interest entity's (VIE) expected losses or residual risk shall include the expected variability in the entity's net income or loss and the expected variability of the entity's assets if it is not included in net income will be replaced by to-be-drafted words intended to communicate something along the lines of: the expected variability in returns which would be available to the variable interest holders over the life of the VIE or perhaps, the life of the variable interests, if the VIE was required to prepare an income-like statement showing such returns, including fees to decision-makers and certain guarantors.

2. The following sentence from paragraph A5 of FIN 46 would be deleted: "If different parties with different rights and obligations are involved, each party would determine its own expected losses and expected residual returns and compare that amount with the total to determine whether it is the primary beneficiary." They would also delete the phrase "if they occur" from the first sentence in paragraph 14 (and other places) which presently reads: "An enterprise shall consolidate a variable interest entity if that enterprise has a variable interest (or combination of variable interests) that will absorb a majority of the entity's expected residual returns if they occur, or both." There has been much confusion in attempting to apply FIN 46 on the method (or methods) to be used to allocate expected losses to the variable interest holders and often the sum of the parts exceeds the whole. FASB has looked at a variety of methods proposed by constituents and thinks more than one might have conceptual support, but has not decided on a single, preferred method to date or whether they would express any preference or requirement. The modification to paragraph A5 is intended to accommodate some flexibility and to eliminate what some say is an internal conflict with paragraph 14 while the Board continues to study this issue, leading perhaps to the issuance of an FSP at some future date.

3. The Board rejected a suggestion to expand the proposed scope exception for situations in which the reporting entity is unable to obtain the necessary information ("the information-out") to also apply to entities created after February 1, 2003.

4. The Board agreed to delete the examples of different types of variable interests in appendix B of fin 46 since it has been pointed out that some of the examples could be viewed as conflicting with other parts of fin 46, were stated in absolute terms without the necessary context or were otherwise confusing or wrong. in its place, the staff will attempt to develop new commentary on examples of different types of variable interests for inclusion in a possible FSP.

Links For more on accounting issues including articles on FIN 46, see our page here. 

Panelists on FDIC roundtable laud CMBS for strong CRE performance

Recently, the US Federal Deposit Insurance Corporation (FDIC) organised a roundtable of commercial real estate (CRE) experts to take stock of the performance of CRE during a period of unprecedented weak fundamentals of CRE in the USA. Nevertheless, banks had weathered the storm with a remarkably strong performance in their portfolios. This was said to be partly answered by a large public ownership of CRE lending in form of CMBS transactions.

The FDIC's concerns against CRE lending were brought forcefully by Rich Brown, Chief Economist of FDIC. FDIC holds insurance funds to cover banks' lending losses, and "there is hardly a better way to lose a lot of money in a short period of time" for a bank than CRE lendings, as, "when they collapse, can result in losses of $10 to $20 million at a time".

The panel discussed wide range of issues relating to the CMBS industry – as to how the CMBS has changed the face of commercial mortgage lending. Unlike in RMBS business, in CMBS, there is no residual risk retention by the seller-servicer, as even the B-pieces are sold in the market. The panelists also said that the risks in a CMBS environment are considerably lesser than in the whole loan held by the originating bank.

For full text of the discussions at the roundtable, click here.

Links For more on CMBS, see our page here.

Securitisation without true sales work in Europe: can they work in the rest of the World?

Ian Bell, a legal expert with Standard and Poor's has written a thought-provoking article on the relevance of true sales in securitisation. True sales and securitisation are seen as so closely-knit together that most people in the structured finance market find it difficult to imagine a securitisation without a true sale. This is the legacy of the US securitization practice where, on commonly shared perception, transactions which are not true sales will not provide bankruptcy proofing under the US bankruptcy laws.

However, says, Ian Bell, "This is not what securitization is about. At the heart of securitization is the removal of the seller's corporate risk so that noteholders can measure their risk solely by reference to the relevant assets. Since only a true sale can achieve that result in the U.S., it became the hallmark of all securitizations…And yet, in Europe, transactions have been emerging without true sales, relying instead on various local law security interests." True sale or not, the idea of securitisation is to ensure that investors have unqualified, undeterred rights over certain assets in the event of bankruptcy – in European transactions, that result is achievable by creating security interests of various kinds.

Ian Bell cites the example of the landmark Marne et Champagne deal where security interest was created using the age-old French concept of "gage avec depossession", close to the British law concept of pledge. A pledge is a possessory security interest which common law systems have always held above any non-possessory security interests. The author cites more instances – for example, the Broadgate office buildings CMBS deal which also relied on security interests rather than true sales.

The author concludes to say that " in most European countries true sales are still the cleanest, most efficient way to remove the originator's credit risk. All transactions without a true sale are done for commercial, regulatory, or legal reasons. Second, the legal analysis required to show that the highest ratings can be assigned without a true sale is highly sophisticated. Nevertheless, these transactions are a testament to creativity and flexibility."

Vinod Kothari comments: I have raised a similar, though stronger, issue in a recent editorial – see here. Though most securitisation deals achieve a legally certified true sale, but the fact remains that from a risk rewards perspective, most of them have a financial substance. There are several instances spanning over some 200 years of legal thought that over time, Courts start questioning the spirit of such transactions – one can see the story of Bills of sales in England, hire purchase law all over common law countries, sale and leaseback deals in several countries, financial lease transactions, etc. Harping on the true sale aspects of securitisations is both unnecessary and undesirable: instead, the industry must try understand the basic objective: which is not sale of assets but isolation of assets from bankruptcy risks of the originator. If there are not sound means of achieving this isolation, without a transfer, under existing legal framework (which itself is a misnotion in my view), one must search for that legal framework that would allow isolation without transfers. It is not difficult to visualise such a structure – one where it is possible to create a protected cell within a corporation.

Links See our page on true sales here.

Asian securitisation market is stressed but surviving: Fitch

Rating agency Fitch recently published an overview of the Asian structured finance market. One has to strive to find optimism in the report. At the close of 2002, there were big hopes of repeat issuance and a geographically spreading market with new countries as well as all-time players: Korea, Singapore, Thailand, Malaysia, India and even Hong Kong. The volume for 2002 was estimated at USD 3.8 billion, and was expected to grow in 2003.

However, by end of Q3 of 2003, " it would appear that 2002 was a false dawn, with a flurry of unexpected events prompting a dearth of Asia-originated issuance, both domestic and cross-border. At the close of the first half of 2003, only two internationally-rated ABS transactions had been closed, with a further two unrated ABS
transactions with conduit execution completed in Korea." The only bright spot was the CDO market: "While the first half was fairly quiet in Asia’s securitisation/structured finance markets in general, the one exception was the CDO market, which saw the completion of five publicly announced (although not public in the true sense of the
word) transactions and an increasing interest in synthetic CDOs."

Fitch lists SARS related consequences as having the strongest adverse impact on the Asian securitisation market. In addition, recessionery trends prevailed in Korea, Taiwan, Hong Kong and Singapore. To add to this, the liquidity crisis in the Korean bond market led to ebbing of consumer finance based transactions from Korea. One of the credit card transactions, Plus One, entered into an early amortisation.

Fitch structured finance rating migration study: 2002 was bad

Rating agency Fitch recently published its own structured finance ratings migration report over a 12 year period upto 2002: and the results are not radically different from those published by other similar reports by S&P or Nomura.

As everyone knows, 2002 was a bad year in terms of rating migrations. The Fitch report says there were 747 downgrades, as compared to only 287 in 2001. An interesting feature of Fitch-rated transactions is also the sharp increase in number of upgrades: upgrades nearly quadrupled to 3,404, relative to 2001 levels. This startling upgrade jump is due to the performance of the RMBS segment, where historically low interest rates led to robust performance. Of the upgrades, nearly 3100 upgrades came from the RMBS market.

As for downgrades, the ABS section was responsible for 62% of the downgrades, and within ABS, major contribution came from the manufactured housing segment.

CMBS segment was expected to be affected by the prevailing economic uncertainties and falling occupancy rates: however, despite contrary expectations, CMBS remains extremely strong. Neraly 99% of the investment grade CMBS tranches were not downgraded.

At the end of the day, Fitch, like other rating agencies, concludes that rating stability is far higher in structured finance than in corporate finance: over the long term, Fitch structured finance ratings exhibited less negative rating volatility than corporates. This was especially true for investment-grade tranches, which saw few
incidences of downgrades over an average oneyear horizon through 2002. In fact, more than 97% of investment-grade rated tranches either maintained their rating or were upgraded over a one-year period.

Structured finance players are now concerned with end use of money: NYT article

As a fall out of the Enron debable, structured finance industry is now also concerned with the end-use of the money, says an article in New York Times. The article says that though the device of securitisation and special purpose vehicles was created with good intentions, over time, the device found a use in creating artificial asset sales to merely restructure balance sheets. "In essence, an ethereal marketplace had been created, with "sales" done for the benefit of the company often without a real buyer on the other side of the table. Banks and investment houses eagerly lent money, booking big fees as Enron and other companies used the deals to make their financial performance appear better than it actually was", says the article by Kurt Eichewald.

However, after the Enron story, investment bankers see a whole new layer of reputational risk in what is being done. Therefore, larger players like J. P. Morgan and Citigroup have established their own voluntary standards for structured deals. Transactions with no economic substance that might be used to make a company's performance look better come under tremendous scrutiny.

The pressure comes not only from the government, but from investors as well. Ultimately, the vast majority of structured finance deals are sold as securities to investors; indeed, many individual investors have indirect interests in them through instruments like money market accounts. Now, market participants said, sophisticated investors are playing a large role in pushing for standards and practices intended to reduce the chance that the market will be harmed by another corporation abusing structured finance.

FASB meeting agrees on several amendments to FIN 46

FIN 46 is far from FIN-al, and SPEs will continue to be the accountants' nightmare for several months to come. After months of having issued the accounting interpretation that seeks to rope in rudderless and driverless SPEs onto the balance sheet of the backseat driver (decision-maker), the FASB staff issued several FSPs giving the staff's views on certain contentious matters. However, on Wednesday afternoon, the FASB board sought to differ with the staff on some of these matters, and agreed to put up an exposure draft of amendments that would significantly change FIN 46. Thus, FIN 46 continues to sizzle on the front burner.

According to sources closely associated with the Board's FIN 46 deliberations, the Board decided to proceed towards the issuance of an exposure draft of a proposed interpretation modifying FIN 46 in the following ways:

  1. Providing a limited scope-exception for an entity that cannot ensure whose baby it is. This must be an existing SPE on Feb 1,2003 and after due efforts, is uanble to find out the holder of primary beneficial interest in the entity. This exemption comes under the pretention that several variable interest do not have the means to identify their primary beneficiaries as they are not privy to the requisite information.
  2. Specifying that under paragraph 8(c), if a decision maker has no exposure to the expected losses of the entity and no right to expected residual returns except a fee that has no expected variability (it is fixed and not subordinated), then such fee would not be considered part of the expected residual returns of a variable interest entity. The Board discussed but wants to wait until their re-deliberations after the comment period, to conclude on whether "fixed" means it has to be fixed in dollar amount or whether it could also be a fixed number of basis points of assets under management, and if the latter, should that be limited to amortizing pools whose principal amount will not grow. Notably, the FASB staff has issued an FSP on this issue, see report below.
  3. Specifying in paragraph 15 that whenever a variable interest holder acquires additional interests in the entity, it will have to reconsider whether it is the primary beneficiary, not just when such interests are acquired from the primary beneficiary.
  4. Clarifying in paragraph 16.d.(1) with respect to de facto agent status when one party can not sell, transfer, or encumber its interests in the entity without the prior approval of another party, the intent is that the agency relationship exists when the rights of the party holding the interests are constrained from realizing the benefits of that interest. Restrictions on sale so long as the interests can be monetized through a pledge would be OK as would conditions requiring approval of the other party so long as that approval can not be unreasonably withheld.
  5. Modifying the guidance in paragraph 17 to identify that the party in a related party group that should consolidate a variable interest entity if the aggregate interests of the parties would, if held by a single party, identify that party as the primary beneficiary would be the party whose activities are more closely related to the entity.
  6. Expanding the term investor in part (i) of the last sentence of paragraph 5 to include the investor's related parties as indicated in footnote 6.
  7. Changing the second reference to paragraph 5 in paragraph 11 (regarding development stage enterprises) to paragraph 5(a) to clarify that paragraph 11 does not exempt development stage companies from the requirements of paragraph 5(b.)

    There was no indication as to when the Exposure Draft would be available. There will be a 30-day comment period. It will be proposed that restatements of previously issued financial statements would be required upon the effective date of the new Interpretaion, but the Board will specifically solicit comments on whether some other form of transition would be more appropriate.

    The Board also directed the staff to issue a proposed FSP to defer the effective date of FIN 46 until the end of first interim or annual period ending after December 15, 2003, for an interest held by a public entity in a variable interest entity that was not created for a single specified purpose on behalf of a certain party (loosely referred to as not being a special-purpose entity ) and has assets that are predominately nonfinancial. Examples of the types of interest to be considered are franchise arrangements, supplier arrangements and troubled debt restructurings. The Board will continue to work with the staff to develop more precise wording of this limited-scope deferral.

    Sources indicate that two newest Board members (not on the Board when FIN 46 was issued) were vocal supporters of a broader and longer deferral period .

Links For more on FIN 46, see our page here.

Bangladesh grants tax immunity to securitisation vehicles

While a World Bank aided project to usher in securitisation and fixed income securities is yet to see the light of the day in Bangladesh, the government a major positive move. Daily Star Bangladesh reports that In order to facilitate securitised bonds, the government has exempted SPVs, from paying all kinds of taxes including value added tax (VAT), income tax and stamp duty. Three separate notifications of the Ministry of Finance granted these exemptions.

However, the exemption is not available generically: the SPV in question must have approval from the central bank for getting the tax exemption.

Vinod Kothari adds I have been associated as a trainer to several Bangladeshi banks, and have also conducted a course sponsored by the World Bank project mentioned above. The government's move to grant tax exemptions to SPVs is a major bold move and indicates the success of the Financial Insitutions Development Program being run under the aegis of the Bangladesh Bank itself.

With these notifications, the legal hurdles to securitisation are almost over. Hopefully the stamp duty notifications provide for duty relief for both transfers to and transfers by SPVs. With this step, the World Bank project must now be allowed to run in top gear and let transactions happen.

Hope Indian authorites are listening: usually Bangladesh follows Indian law making; this time, India must reciprocate.

Spiegel misreported ABS data, claims investigators

Yet another case goes into the securitisation "hall of shame". Spiegel, a well known US furniture retailer and "catalogue" supplier, was a repeat issuer of private label credit card ABS. Spiegel had earlier filed in March 2003 for bankruptcy protection and hence triggered early amortisation events under all its outstanding securitization deals.

Independent investigations launched at the SEC's behest have revealed that Spiegel misreported the performance of its ABS transactions to avoid hitting the early amortisation triggers, which would have only hastened the bankruptcy process by exacerbating the cash crunch. These observations were made by the independent investigator into Spiegel appointed by SEC.

Investors in Spiegel's ABS also face the decision of the Office of Comptroller of Currency to raise the servicing fees being charged by Spiegel from 2% to 3.5%, thereby squeezing the excess spread.

Links For more on securitisation sad episodes, please see our page here.

US regulatory agencies allow capital relief on ABCP FIN 46 consolidation

As a measure to save banks from having to provide regulatory capital for the ABCP conduits that come in for consolidation due to FIN 46, US bank regulatory agencies allowed banks capital relief.

The interim final rule allows sponsoring banking organizations to remove the consolidated ABCP program assets from their risk-weighted asset bases for the purpose of calculating their risk-based capital ratios.

A hint about this capital relief was given at a Standard and Poor's forum sometime back. The agencies justify the capital relief thus: "The agencies believe that the consolidation of ABCP program assets onto the balance
sheets of sponsoring banking organizations could result in risk-based capital requirements that do not appropriately reflect the risks faced by banking organizations that sponsor these programs. The agencies believe that sponsoring banking organizations generally face limited risk exposure to ABCP programs, which generally is confined to the credit enhancements and liquidity facility arrangements that they provide to these programs. In addition, operational controls and structural provisions, along with overcollateralization or other credit enhancements provided by the companies that sell assets into ABCP programs can further mitigate the risk to which sponsoring banking organizations are exposed. Because of the limited risks, the agencies
believe that it is appropriate to provide an interim risk-based capital treatment that permits sponsoring banking organizations to exclude from risk-weighted assets, on a temporary basis, assets held by ABCP programs that must be consolidated onto the balance sheets of sponsoring banking organizations as a result of FIN 46."

Simultaneously, the regulators have also proposed a revision of the capital rules for ABCP conduits carrying early amortisation triggers, and for liquidity facilities upto a period o 1 year. Under current rules, short term liquidity facilities do not require capital as the credit conversion factor is zero in such cases. However, now the agencies propose a conversion of short term liquidity facilities with 20 % credit conversion factor.

The agecies have also sought comment as to whether capital should be required against securitisations of revolving assets which carry an early amoritisation trigger, in line with the proposals from Basle II. The conversion factors are based on the excess spread or the net margin income, based on Basle II recommendations.

Links For more on FIN 46, see our page here.

Asian market generally dull, but rays of hope: S&P

Problems in the growth zones in Asia persist causing a sobering impact on the structured finance market, but Standard and Poor's sees rays of hope. Major volumes in ex-Japan Asia have been coming from Korea, Taiwan, Singapore and Hong Kong where activity levels have been low of late, due to slower generation of consumer financial assets.

However, S&P pockets of hope are – the new Taiwanese real estate securitisation law, and synthetic activity in Singapore.

Taiwan recently passed a real estate securitisation law that would promote REIT-type bodies in the country. S&P feels is optimistic about this law: "The impact of this new law is important for Taiwan's financial markets, since many of the nonperforming loans are backed by real estate and the financial industry is overweight with real estate," explained Ms. Daine Lam. "Drawing in new investors and having debt issues and REIT ratings would go a long way in restoring investor confidence in real estate, which has subperformed over the last 12 years due to a combination of economic changes and oversupply."

In Hong Kong, one of the traditional mainstays of Asian securitisation, economic worries continue to weaken securitisation prospects. "Unemployment continues to rise as property prices fall; recent political unrest is beginning to affect investor confidence; an increased percentage of mortgage loans are in negative equity; and most important, signs of increasing numbers of personal bankruptcies have yet to taper off. With this deterioration in consumer confidence comes a noticeable slowdown in issuance for securitization, particularly with mortgage loans and other consumer assets. "

Volumes have been receding in Korea too.

Other markets such as Malaysia, India etc are so far only meant for domestic investors.

Links For more on markets in Asia, see our site here. 

FASB issues several staff position papers on FIN46

They first make a rule, and then interpret it, and then interpret the interpretations, and then…Over the last few days, Financial Accounting Standards Board has come out with 4 draft FASB Staff positions (FSPs) relating to FIN46. FIN 46 is the interpretation issued by the FASB that applies special consolidation criteria to certain special purpose entities, known as variable interest entities. These FSPs are drafts and are placed for comments.

FSP d, issued on 10th Sept (comments deadline 10th October) outlines the computation of expected residual returns of a variable interest entity based on the fees payable to decision makers and guarantors. These fees will always be variable interests for the purpose of the interpretation, even if the amount of fees is fixed and is not based on a success rate or other variables. This FSP also includes several illustrations for computation of the amount of expected losses or expected residual returns.

FSP c clarifies that the option of the investors (or others) to remove the decision maker (kick out options) will not exclude the fees payable to the decision-maker from variable interest computation.

The other two FSPs defer the application of FIN 46 in certain cases.

Links For more on FIN 46, see our page on accounting issues. Vinod Kothari's Securitisation: The Financial Instrument of the New Millennium includes an elaborate chapter on accounting, including FIN 46.

Moody's publishes NPL securitisation criteria

If you ever wondered how bad apples can be turned into good apples or how you can spin gold from straw, you must look at the structure of a securitisation of non-performing loans. As yields in standard securitisation deals flatten out, there is an increasing urge for such transactions.

Seeing lots of these transactions happen in the World, particularly in Italy, rating agency Moody's has published rating criteria for NPL securitsations. Italy deserves a special mention due to the sheer scale of activity in the country: between the enactment of the securitisation law in June 1999 and April 2003, a total of approximately €31 billion (in gross book value, that is, nominal value of portfolio in originator's account) of NPL portfolios were securitised through 34 transactions, making Italy one of the world’s largest reference markets for this asset class.

The report discusses various types of NPL securitisation structures, including the levels of servicer advances and other collaterals in most transactions. Primarily, the collateral is either secured or unsecured. In case of secured collateral, cashflow modelling is based on the recovery rates and estimated time it would take in the process of recoveries. In case of unsecured collateral, the rating agencies use static pool data based on historical studies.

In either case, however, the key element is the servicer. Apart from the primary servicer, that is, the originator of the defaulted loan, most transactions rely on a special servicer, that is, a specialised recovery agency – there is an increasing trend towards the latter in Italian NPL securitisations.

In all NPL securitisations, credit enhancements are understandably quite high. To get a Aaa (equivalent to S&P AAA) rating, the enhancement in Italian transactions have ranged from 47% to 94%. These percentages are different for Japanese NPLs due to several factors, primarily the time taken in the legal process (converging at around 1 year, whereas it is 7 years in Italy).

Links: For more on NPL securitisation, see our page here.

Equipment leasing delinquency at its least, says Fitch

The leasing industry was once said to be passing through a perfect storm. The Equipment Leasing Association had conducted a study titled The Perfect Storm wherein it analysed the reasons why top 10 of the US leasing entities that failed really failed. A Fitch report now says that the industry is apparently emerging out of the storm. "The U.S. equipment lease and finance industry is
emerging from what the industry has dubbed “The Perfect Storm.” Industry bankruptcies, mergers, and acquisitions, combined with reduced and more costly funding sources during the economic slowdown created a ripe atmosphere for this storm."

That the landscape of the leasing industry is greatly changed is apparent from the following data: During the 1998-2001 period, approx. USD 45.2 billion volume of lease-backed securitisation was generated in the market, from 48 issuers. Of these, only 1/4th are in the securitisation market currently, though this percentage in volumes is 66.5%. The rest have either been wound up, or are no longer securitising. The volume in 2002 was only USD 7.9 billion.

The equipment leasing volumes themselves have been coming down – there was a decline in volumes consistently in 2001 and 2002.

Fitch, however, sees winds of change in 2003. As the leasing sector emerges from the storm that has plagued the industry for several years, positive trends continue to surface. Equipment ABS issuance of $5.9 billion for the first six months of 2003 compares favorably with $7.8 billion of equipment issuance for all of 2002. Consolidation, as well as the frequency and magnitude of equipment ABS rating actions, has slowed considerably."

Links For more on the leasing industry, see Vinod Kothari's website dedicated to leasing at: http://india-financing.com

Time to fix Fannie and Freddie, says columnist

The voices that advocate some sort of a revamping of Fannie Mae and Freddie Mac have been there for long time, but after derivatives accounting discrepancies were discovered in Freddie's reports, these voices have gathered a great force. Robert Stevenson, who writes a well-read column in Washington Post said that Freddie and Fannie are not exactly broke, but it is time that they are fixed.

Fannie Mae and Freddie Mac are the agencies supported by the US government (GSEs or government-sponsored enterprises) that are engaged in securitisation of residential mortgages – the third one being Ginnie Mae which is government corporation. Most of the residential mortgage loans that conform to their guidelines are securitised through the agencies.

The key note of Stevenson's argument is the size of the GSEs. "They have grown so large that if they ever experience serious financial problems, they will almost certainly have to be rescued by the government at immense cost. The potential exposure reflects their huge debt. At the end of 2002 Fannie's and Freddie's combined debt totaled $1.5 trillion. This is equal to almost half the publicly held federal debt, $3.7 trillion". The GSE debt itself is held by some 3000 US banks and the total holding is almost equal to their combined capital.

Stevenson says that the purpose of empowering Freddie and Fannie with special powers was to promote home lending which was a lopsided industry in the late 1960s and early 1970s. Today, securitisation is by itself a very strong market and the government support to the GSEs is not required. ".. paradoxically, Fannie and Freddie are no longer essential for strong housing finance. "Securitization" is now widespread. If Fannie and Freddie vanished, mortgages would still be packaged and bought by investors just as they already buy riskier securitized credits — credit-card debt and auto loans, for instance",says Stevenson.

Links There are more stories on GSEs on this website – use site search. For more on the US RMBS market, see our page here.

Fund managers to take micro credits into securitisation markets

For the first time, micro credits will be taken into the securitisation market by European and US fund managers. Micro credit is a concept of funding pioneered by Pro Mohammed Yunus of Bangla Desh and practiced by several institutions all over the World, with Bangla Desh's Grameen Bank being the model micro credit bank. A micro credit bank typically finances household entrepreneurs at the absolute micro level, such as women running a small household enterprise.

According to a report on Asia Times of Sept 9,in early 2004, Dexia Microcredit Fund of Luxembourg, and Developing World Market of Darien CT, will securitise micro credits and allow European and US investors to invest into the same.

The delinquency rates in micro credits have been something around 4-5%, which is much lower than that in subprime consumer lending in the US markets. Besides micro credit is taken as a device of women empowerment, since it essentially promotes householder enterprises.

National Century's former executive admits fraud

National Century securitisation-related fraud was a bad news to the securitisation industry in 2002: it highlighted how lack of proper surveillance over the cashflows could keep servicer-frauds under cover for quite some time.

As prosecutors are still chasing up the defaulters in this case, at least one of the officials has admitted role in the fraud: former National Century executive Sherry Gibson pleaded guilty to her role, including providing false information to investors. Gibson admitted that she was involved in hiding the shortfall in investors' funds by by shuffling funds between bank accounts and sending false reports to investors and auditors. Gibson faces up to five years in prison without parole, a $250,000 fine and three years of supervision following release.

The case reveals that such false reporting was going on since 1995.

The National Century case led to shortfalls of nearly USD 1 billion, on outstandings of nearly USD 3.5 billion in the ABS market.

Links For this and more sad episodes in the ABS market, see our page here.

Industry bodies submit joint response to Basle:

Several industry bodies joined to serve a joint response to Basle's Consultative Paper 3 (CP 3), comment period for which expired 31st July. These are the American Securitization Forum, the Australian Securitisation Forum, The Bond Market Association, the European Securitisation Forum, the International Association of Credit Portfolio Managers, Inc. the International Swaps and Derivatives Association, Inc. and the Japanese Bankers Association.

The industry bodies commented that the Basle's CP 3 proposals relating to securitisation shall, in many cases, cause a divergence between regulatory capital and economic capital. For one, the industry bodies are concerned that the risk-weights in case of ratings-based approach (RBA) are much higher than shown by calibrated results. The industry bodies said that the risk weights under the RBA were based on CDOs and corporate exposures, and they produce a highly exaggerated picture of the risks in case of most retail exposures such as credit cards, auto loans or RMBS deals.The bodies have submitted that Basle comes out with separate RBA tables for significant asset classes: (1) retail revolving credit cards, (2) other retail non-revolving/ auto loans, (3) residential mortgages, (4) corporate exposures / commercial mortgages and (5) collateralised debt obligations.

The bodies also submit that the BIS makes unreasonable discrimination against synthetic transactions while theoretically there is no reason for any such distinction. Current proposals for credit derivatives substitute the risk weight of the protection seller for that of the obligor, and therefore, lead to an exaggerated double-default probability.

The bodies also make suggestions for improvement of the capital treatment to ABCP and revolving credit.

Links Full text of the industry bodies' representation is here. For more on Basel norms, see our page here.

Industry learns tricks to live with FIN 46

The FASB is meeting on 13th August to consider several issues relating to FIN 46, among those, more importantly, whether the decision-maker's residual interest in the VIE should include fixed and unsubordinated fees paid by the entity. In addition, the FASB is also considering the situations important in identifying the holder of a variable interest. However, in the meantime, the market seems to have learnt devices to limit the impact of FIN 46.

A report in Financial Times dated 4 August says that Citigroup is expected to add $5bn to both assets and liabilities as a result of the new rule, down from the $55bn it had previously anticipated. This could obviously be achieved by restructuring the SPEs so as to come out of the definition of variable interest entities..

The report also says that everyone has not been equally successful in coping with FIn 46. General Electric, for example, is expected to consolidate some $51bn in its third-quarter results due to FIN 46. However, the banks' success in restructuring existing transactions means the new accounting rule has not decimated the asset-backed commercial paper market, as had been initially feared.

FIN 46 is an accounting interpretation that uses new consolidation criteria in case of certain entities, called variable interest entities (VIEs). SPEs, other than qualifying SPEs for securitization deals and other excepted ones, are likely to be treated as VIEs.

Links For more on variable interest entities, see our page here.

American securitization body opposes QSPE rules:
says this may be the end of QSPEs

Commenting on the exposure draft of changes to FAS 140 relating to qualifying special puropse entities, the American Securitization Forum (ASF) and The Bond Market Association put up a strong opposition to the proposed amendments. This was not unexpected, as the USD 6 trillion securitization industry in the USA rests largely on the idea of off-balance sheet, non-consolidated SPEs, and anything done to hook up SPEs is bound to raise opposition.

The key note of the joint representation is to oppose the pro-consolidation orientation of the exposure draft. Besides, if implemented literally as it stands, the exposure draft may completely eliminate QSPEs: "In fact, if the Exposure Draft is given its broadest reading, we doubt whether any current qualifying special-purpose entity would qualify under the proposed new standards", says the representation.

Qualifying SPEs are non-substantive, legal fictions which hold securitised assets, and do not come for consolidation under the accounting rules for consolidation, or under the new rule called FIN 46.

The ASF fears that under the garb of making reactive changes in response to experience gained in applying FAS 125/ FAS 140, the US standard setters are reversing the very approach of surrender of control/ financial components, on which the current US (and broadly, also International) accounting standards are based. In other words, the FASB seems to be leaning towards the risks-rewards approach: "The Exposure Draft substantially turns away from that approach (components approach) by importing a number of risks and rewards concepts that do not fit coherently with the basic control standard in Statement 140."

The ASF also made an alternative suggestion, should the FASB not be inclined to budge much. This, by itself is a brave approach: let the US standard-setters adopt the UK-type approach called linked presentation approach. Under the UK-type linked presentation approach, securitised assets generally do not off the books but are netted by amount of funding raised. There is no gain-on-sale booked. Under ASF's modified "matched presentation" approach, the SPE will not be off the balance sheet, but will be a separate section of the asset side of the transferor's balance sheet. Here, the gross assets of the SPE, less all non-recourse liabilities and external equity of the SPE will be reported. The issue of gain-on-sale under the ASF's modified approach remains to be resolved.

Will this brave new approach force the standard-setters at this stage to have a total review of FAS 140? SPEs and off balance sheet accounting have been the "hall of shame" of securitization industry, and may be, a suggestion to include SPEs on the balance sheet of the transferor might instantly appeal to the FASB.

Your comments please Do you have any views on the new approach suggested by ASF? Do write your views. Please see some thoughts and questions here for you.

Full text of the comment letter is here.

Related links Please see our page on accounting issues here.

Japanese structured finance market continues to grow

Total annual issuance volume in Japan's structured market could reach JPY5.5 trillion (US$46 billion) by year-end 2003, according to rating agency Standard and Poor's. Residential mortgage transactions, CLOs (both cash and synthetic) and securitisation of non-performing loans continue to dominate the scene in Japan. A positive thrust is expected to be given by the recent decision of the Bank of Japan to start investing in asset-backed securities.

The total annual volume rated by Standard & Poor's was about JPY4.7 trillion in 2002. The rating agency expects securitized transactions in Japan to gradually increase overall in the second half of fiscal 2003 toward the end of March 2004.

Another expected trend is an increase in transactions structured to be beneficial to both originators and investors, such as the master trust transactions. In addition, originators have been keen to structure new types of assets, such as whole businesses or future receivables, which suggests a further expansion of the market.

For the first half of 2003, Standard & Poor's in Japan rated a total of 90 securitized transactions, up 36% compared to the first half of 2002. The aggregate issue amount for these deals of JPY2.08 trillion was an increase of 20%. The first half performance results show that the entire securitization market continued to expand, in both number of transactions and issue amounts. However, in comparison with 2002, the rate of growth has slowed slightly.

In terms of products, ABS and ABCP achieved substantial growth, increasing by 47% or 2.4x in terms of issue amount from the same quarter last year. RMBS increased by 10% in terms of issue amount. One of the key transactions in this period was a CLO deal originated by Sumitomo Mitsui Banking Corp.This CLO is backed by a number of diversified loan receivables extended to SMEs.

Links For more on the Japanese securitisation market, click here

Securitisation funding for port development in Malaysia

Ringgit 1.31 billion will be raised by way of securitisation to development what is expected to be an A-grade trans-shipment hub in Asia. The securitisation exercise is structured following the sale of a piece of land belonging to Kuala Dimensi to Port Kelang Authority (PKA). Kuala Dimensi will undertake the development of the Transshipment Mega Hub. The port, which is modelled after the Jebel Ali Free Zone Port in Dubai, will serve as a regional distribution hub and cargo consolidation centre in line with the Government's objective of making Port Klang a distribution base and a trade and logistics midpoint.

The transaction, the first of its kind in Malaysia, has been structured by Malaysian International Merchant Bankers (MIMB). To be issued in 11 series, the term of the bonds will range from 4 years to 14 years. The senior bonds are expected to be rated AAA. According to reports, MIMB will also be the initial subscriber to the bonds.

Vinod Kothari adds: The Malaysian ABS market was going through doldrums over the last few months and this deal may help to instil some life in the market. Evidently, Malaysian market is prepared to try out new assets instead of being contented with traditional asset classes such as residential mortgages and auto loans.

Links For more on Malaysia, see our page here.

Training courses in Malaysia Vinod Kothari Consultants with Rating Agency Malaysia regularly hold public and private training courses in Malaysia. For more information, contact us.

Taiwanese real estate securitisation law to push commercial property volumes

Taiwan recently [July 8-10] promulgaged a new law on real estate securitisation that allows either a property owner to put real estate into an authorised trust for the latter to raise funding, or, similar to REITs, for an authorised financial intermediary to raise funding from the capital markets and invest the same in real estate.

This, along with certain other economic laws passed by the Govt recently, are said to have given a positive strength to the current ruling party, as also are expected to push real estate development in the country.

The new law gives important tax benefits to the investment conduits. According to the law, investors will be exempted from paying stock-transaction taxes when buying the certificates, though a 6-percent tax will be levied on other transactions similar to that on financial asset-backed securities. Moreover, investment earnings will not be included in consolidated income or corporate business income taxes of beneficiaries.

According to an evaluation by the Council for Economic Planning and Development, the law will add 0.45 percent to 0.65 percent to economic growth in addition to providing diversified financial products and enlarging capital markets. Furthermore, objectives of securitized ownership, public funding and professional management will be achieved. Market analysts said securitization would be most common for commercial properties that have stable rental or cash incomes such as office buildings, department stores, shopping centers, hotels, exhibition halls and rental apartments.

Links For more on securitisation in Taiwan, see our page here.

Eurpean securitisation continues to try diverse asset classes, as volumes grow in H1, 2003

European securitisation registered impressive growth in first half of 2003, with securitisation spreading to new countries in the continent and strengthening in the traditional strongholds.

A notable feature is the dominating presence of Italy, which has risen from a one-time position of number 3 to number 1. In the first half of 2003, Italy takes more than half of the total issuance. Indications are that Italy will continue being a strong player, with strong activity by both the government (SCIP and INPS programs) and private players.

Europe can easiy be described as the securitisation laboratory of the World: with the most diverse range of asset classes. With death bonds (bonds backed by funeral fees) to wool, champagne and metals, Europe has done more experiments with asset classes than any other part of the World.

This half, legislative developments continued to take place. Greece passed a new law to encourage securitisation.

Links For more on European securitisation, see our page here.

Latin America: activity shifting to domestic flows

Citing Mexico as an example, S&P sees a growing market for domestic flows in Latin America. This is a shift from the usual future-flows dominance in these markets.

A report dated 16th July states that in Mexican market, for example, there are growing inquiries for auto loan ABS transactions and consumer lending securitizations. The market is showing interest for credit card ABS transactions. The report ascribes this to the changing undercurrents in the Latin American market: "An important shift emerging in the Latin American structured market is that domestic markets are gaining strength. This has been especially true in recent years because domestic interest rates in some countries, particularly Mexico, have been declining, which discourages the need for cross-border transactions. Other reasons for the strengthening of domestic markets include the consolidation of institutional investors, resulting in a more sophisticated local investor base. In addition, transaction costs for domestic deals below $100 million are more affordable than cross-border transactions and local securitization reduces currency risk.

Links For more about Latin American markets, see our country pages here.

2003 to be the best year for US RMBS: S&P

Half-way through, rating agency S&P is already in a mood to celebrate the record breaking volume for the US RMBS industry. In a note of 15th July 2003, S&P says that the 2003 volumes will likely have witnessed its most active year in history, with issuance volume surging to as high as $500 billion, up from $373 billion in 2002. Quite obviously, this is due to historically low interest rates, pushing up mortgage origination volumes. The projected mortgage origination volume for 2003 is $3.2 trillion, up from $2.6 trillion in 2002, and $2.1 trillion in 2001.

Apart from interest rates, S&P analysts also spotted other factors such as rising incomes, baby boomers buying second homes at a record pace, and much of the population continuing to shun other financial assets in favor of investing in their homes.

Links For more on RMBS, see our page here.

BBC looking for CMBS funding

The British Broadcasting Corporation (BBC) is looking for funding to the tune of USD 1.33 billion (GBP 800 million) for the redevelopment of its London headquarters, Broadcasting House.The state-owned broadcaster hired Morgan Stanley to manage the issue.

For securing the CMBS funding, BBC will pledge to bondholders the rental payments on its 150-year lease on its art deco building, shaped like a luxury liner, in London's West End. With a legal maturity of 30 years, the expected maturity is likely to be 22.3 years.

The BBC wants to raise fundin at this opportune time when yields on AAA bonds are at their lowest. The AAA rating of the bonds wil be assured by a monoline wrap from Ambac.

The securities will be sold through Juturna (European Loan Conduit No. 16) PLC, a specially-created company.

Links For more on CMBS, see our page here.

Australian deal proposes revolving funding for construction firm

Everything can be securitised: is the buzz these days. A recent Australian structure seems to exhibit this. This structure proposes a revolving line of credit for a property construction firm which can tap the facility to build, sell what it builds, and then re-use the funds until the amortisation begins.

According to reports, Australian property developer Mirvac Group Ltd. has established a A$500 million pre-sold residential development securitization program. Apparently, the pool allows the developer to tap the funds for construction of specified portfolio of properties. Called Multi Option Pre-sale Securitisation, or MOPS, the program offers a rolling facility to Mirvac for selected residential property developments. Mirvac may draw funds for projects in the portfolio based on the off-the-plan value of those projects and once a project is completed and sold, the sale funds can be used to repay investors and finance further projects.

The structure was reportedly developed by Coudert Bros. Initially, 6 property projects will be covered by the funding. The program allows the special purpose vehicle to issue either MTNs or commercial paper.

Links For more on Australian market, see our page here.

Workshops We regularly hold training events in Australia: for calendar of courses in offing, see here

Securitization News and Developments

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August 2004 to March 2005

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Egypt instals mortgage finance companies; mulls securitisation

When it comes to modern financial instruments, Egypt is still living in an age slightly more advanced that that of the Pyramids.

Not to speak of concepts like securitisation or secondary mortgage markets, evey primary mortgage markets are still very undeveloped in the country. A mortgage law was enacted in 2001. Since then, only two mortgage firms have been established in the market, in March and October of last year. The first company, Al-Taamir, has only offered a dozen loans during that period, and the other company, Al-Masriya, has made less than five loans. This should not give the impression that there is no housing finance in the country – as several local banks mix housing finance with personal loans.

That has, however, not stopped the government from exuding extraordinary optimism to call 2005 "the year of mortgage finance".

Experts point out that three major problems dog the way of the evolution of a badly needed mortgage system — the lack of expertise in most of activities related to the system (loan officers, appraisers, monitoring the system, etc), a very complicated and expensive system of real estate registration, and the high cost of finance for both the borrower and the mortgage finance companies. Thus, a modern mortgage finance and refinance system is the absolute need of the hour.

Party for the Egypt Financial Services Project, a USAID $32 million five-year project aims to provide technical assistance to establish a developed mortgage finance system.

Links For securitisation in the rest of Africa, see our page here.

Life insurance companies find embedded value in securitization

The concept of securitisation is finding a new buyer – life insurance companies. Not that life insurance companies are known to securitisation. In the past, securitisation of life insurance policies was based on diverse purposes such as raising funding against endowments or funding reserve requirements. But the latest trend is to securitise the embedded value of life insurance policies in force, to monetize the future profit and where accounting standards permit, also to book the same as income.

Insurance companies now seem to reviving the technique tried several years ago by UK insurer called NPI. Two recent instances where monetisation of a defined book of life policies have been successful are the Gracechurch and Box Hill transactions. Gracechurch, which closed in November 2003, involved the monetisation of the VIF of the entire book of life policies of Barclays Life, providing equity capital of £400m. The VIF was reinsured with a Dublin-based captive insurance company, which used it to back a limited recourse loan from a finance vehicle, which itself used that to back the notes of £400m issued to the capital markets. A similar structure was adopted more recently in Box Hill where the VIF of a defined book of life policies, held by Friends Provident, was monetised to provide capital of £380m. In both cases the notes issued to the markets were wrapped by a monoline to provide an AAA rating.

An article by Jennifer Donohue & Peter Hoye in Legal Weekb says that "opportunities abound for more innovative monetisations involving new business, potentially volatile types of business such as annuities and even with profits business. The reduction or elimination of risk in such books of business, but in a way that retains the principle of equity capital, is the next goal to which the alchemists should turn their attention." 

Link For more on securitization of embedded value in life insurance policies, see our page here. 

Swiss Re takes life insurance policies to capital market

While securitisation of insurance risk is not new in the market, taking traditional insurance products, such as life insurance, by packaging the same into securities is an interesting development.

Swiss Re has successfully completed its` first securitisation of future profits from a portfolio of US life insurance policies. The USD 245 million issue benefits Swiss Re by transferring insurance risk to the capital markets, thereby increasing capital fficiency.

Capital efficiency and capital relief are major drivers for banks to securitise, but here, it is an insurance company trying to further its "strategic objective of accelerating the balance sheet through risk securitisation."

The issue, which closed on 20 January 2005, was issued to a variety of institutional investors. It consists of three separate tranches of securities, paying an average pre-tax coupon of 6.96% with an expected maturity ranging between six and 11 years.
The asset backing the securitisation is the expected future profits from five blocks of life insurance business previously acquired by Swiss Re through Admin Re(SM) transactions. Investors' return is subject to various factors that reflect the risks of the underlying business, including mortality, persistency and investment risks.

A company release claims that by transforming insurance risk into a tradeable security Swiss Re is able to turn intangible assets into cash, which otherwise would only emerge over time. The transfer of risk to the capital markets allows Swiss Re to more effectively use its capital. As a result, shareholders' return on the risks flowing through Swiss Re's balance sheet is improved. Seemingly, the securitisation transaction has also been used for upfronting of estimated gains from the insurance contracts, like what is done in other traditional forms of securitisation.

Links For more on insurance risk securitisation, see our page on alternative risk transfers here. Also, see our page here.

Deutsche structures a USD 2 billion CDO square for Taiwanese insurer

CDOs and CDO squares, which looked like the mindsport of hi-fi investment bankers, are now a regular treasury product in most developed Asian financial centers. Bespoke and specially-structured CDO products are being marketed strongly in Asian markets.

This week, Deutsche gave a big push to CDOs by structuring a $ 2 billion CDO square for Taiwanese insurer Shin Kong Life. It is the bank's first CDO-squared deal in Taiwan, the first managed CDO that Shin Kong has bought and one of the country's biggest CDO deals to date.

A report in Finance Asia says that Taiwanese insurers are becomingly increasingly adventurous with CDO products since they won the go-ahead to invest in them in the middle of 2004. This latest deal for Shin Kong includes a pool of 40 asset-backed securities, in addition to the 250 corporate names included in the CDO pool. The split is 80% CDOs to 20% ABS.

Links For more on CDOs, and CDO squares, see our page on CDOs here. For more on securitisation in Taiwan, see our pagehere.

 AIDS drugs to get securitisation funding

An interesting and innovative use of securitisation funding is to be tried by UK financiers – close to USD 2 billion funding is proposed to be raised by securitisation of the revenues of drugs to be developed.

According to a report in Financial Times says that SecurePharma, the group planning the bond, said a series of bond issues could raise up to $50bn (€38bn, £26bn) over 20 years, to fund the production of medicines for diseases such as AIDS, tuberculosis and malaria that would otherwise be abandoned as uneconomic. The scheme is only in the planning stage, but at least one big pharmaceutical company and a number of biotechnology companies have said they might participate.

Development of drugs is a long-term business – the R&D expenses could be huge and the payback period could be substantially long. Large pharmaceutical companies abandon the development of more drugs than they market, setting a minimum threshold of around $300m of sales a year. Many potential cures for developing world diseases fail to meet this criteria.

HSBC and Deloitte Corporate Finance have appointed as advisors for this interesting securitisation collateral.

Links For more on alternative asset classes in securitisation, see our page here.

Do structured finance ratings reveal all? 
Basel working group seemingly has doubts

Ratings in structured finance have been a very sensitive topic for some time now, but a time when Basle II capital standards rely increasingly on ratings, the paper by a Basle working group suggesting structured finance ratings don't reveal the risk of unexpected losses adequately enough might sound different, if not strange.

A Basle working paper titled "The Role of Ratings in Structured Finance: Issues and Implications" goes into both the reliability or otherwise of the ratings, as also the risks that central banks and regulators need to be concerned about.

The working group, based on a survey of the market participants concludes that the market participants are aware of the limitations of ratings. The reliance on the rating agency's assessment of the pool is inversely proportionate to the sophistication of the investor. "Despite the "value added" by the rating agencies, market participants need to be aware of the limitations of ratings. This applies, in particular, to structured finance and the fact that, due to tranching and the effects of default correlation, the one-dimensional nature of credit ratings based on expected loss or probability of default is not an adequate metric to fully gauge the riskiness of these instruments. As the unexpected loss properties of structured finance products tend to differ significantly from those  of traditional credit portfolios or individual credit exposures, structured finance tranches can be significantly riskier than portfolios with identical weighted average ratings."

Are structured finance products riskier than straight-forward corporate bonds? The working group feels that one of the prime reasons for investors buying them up is for yield pickup, which is essentially a reflection of higher risk. Structured finance instruments may be significantly more leveraged than comparable portfolio investments in traditional corporate credit. As a result, tranched products can have unexpected loss characteristics that differ substantially from those for equally rated bond portfolio exposures.

Links For the full text of the Basle working paper, click here.

Germany's 'true sale initiative' does not find much of initiative

A report in Financial Times says that Germany's true sale initiative still remains largely a "promise" and has not been able to "provide" much tangible results. [Promise and Provide are names of KfW’s programs on securitisation]. The report quotes Commerrzbank data for German securitisation deals which fell from €41.6bn in 2002 to €19.6bn in 2004, although the number of deals done shrank only slightly.

The True Sale Initiative, which is jointly supported by cooperative banks, commercial banks and the savings banks’ group seeks to promote the capital-market segment of true sale securitisation, which is still fairly underdeveloped in Germany. On July 9, 2003, Bayerische Landesbank, Citigroup, Commerzbank, DekaBank, Deutsche Bank, Dresdner Bank, DZ BANK, Eurohypo, HSH Nordbank, HVB Group, KfW Group, Landesbank Hessen-Thüringen and WestLB AG signed the Letter of Intent. This Letter of Intent defined the development and design of a securitisation platform in order to execute true sale securitisation. This was the starting signal for the structuring phase.

In a true sale securitisation claims of one or several banks are pooled in a single portfolio, bought up by a special purpose vehicle and after being divided into tranches with different degrees of risk are sold to investors in the capital market. By taking credits off their books, banks will receive liquid funds, reduce the capital charge on their own funds, and increase scope for making fresh loans. Small and medium-sized companies will benefit from this as well .

Only one securitisation has been completed so far using the special framework created by the TSI. Volkswagen Bank, part of the automobile manufacturer, issued €1.1bn worth of bonds backed by car purchase loans in November.

German banks have been complaining of tax and insolvency law hurdles that need to be crossed before the true sale initiative becomes anymore than a dream.

Links For more on securitisation in Germany, as also on the true sale initiative, see our country page.

Australia grants financial services license exemption to SPVs

The regulators' power to exempt is quite often a mixed blessing – it comes with several restraints, and it takes away more than it gives. Special purpose vehicles, being mere legal myths to provide a legal domicile to a securitisation transaction, are hardly engaged in any business at all to require a license, but Australian regulations required it, and now seek to provide exemption.

The Australian securities regulator, ASIC, recently issued conditions for exempting special purpose vehicles from holding a financial services license. Though the conditions are elaborately stated in order CO 04/1526 of 23rd Dec 2004, the primary condition seems to be that securitisation products are not marketed to retail clients.

The regulation seeks to define a 'securitisation entity" (SPV) and a "securitisation product" (asset backed security). The securitisation product has to be a debt instrument, which in turn is defined as a 'chose in action' or actionable claim. It is to be examined whether pass through instruments, which are beneficial interest certificates, will qualify as chose in action under Australian law – if they do not, then, pass-through type transactions which dominate the RMBS market, might have difficulties.

The debate on licensing of special purpose vehicles has been raging for quite a while. In August last year, the ASIC had issued draft proposals for the same, which apparently were discussed with the industry as also with the banking regulator APRA.

Links For more on Australian market, see our Australia page. For more on SPVs, see our page here.

Taiwan securitisation market to maintain the 2004 growth rate

A report in Taiwan Times says that Taiwan's fledgling securitization business is expected to continue its robust growth this year with a wider range of asset classes to be deployed, as well as a larger average transaction value per deal. The report quotes Moody's.

Moody's expects an issuance exceeding USD 1.88 billion in 2005.  The passage of the Financial Asset Securitization Law  in 2002 and the Real Estate Securitization Statute  in 2003 established a framework to help provide low-cost liquidity to asset owners, as well as diversification and higher returns to investors.

The nation saw securities worth over NT$50 billion issued last year, a significant leap from more than NT$30 billion in 2003, according to Moody's.

.Links: For more on Taiwanese securitisation, see our country page here.

Links: Our new page on Regulation AB – here

Securitisation accounting for failed US bank costs E&Y deer

Accounting for residual interests in securitisation transactions may be both tricky and tormenting – accounting major Ernst and Young (E&Y) would have learnt it the hard way. E&Y has agreed to pay a total of USD 125 million in damages in the matter of failure of Chicago-based Superior Bank.

Superior Bank went down in 2001 amidst allegations of wrong accounting of residual interests in securitisation transactions. Superior's balance sheet included massive amounts of retained interests which were not real. Investigations revealed that Superior 's residual interests represented approximately 100 percent of tier 1 capital on June 30, 1995. By June 30, 2000, residual interest represented 348 percent of tier 1 capital, which, put simply, would mean that that the risk on the asset side was 3 1/2 times the risk on the liability side. After all, the first loss risk retained by the originator in a securitisation transaction is comparable to equity in a corporation.

Holding the accounting firm responsible for the overvaluation of the residual interests, FDIC filed a USD 2 billion claim against E &Y. The claim has been finally been settled for USD 135 million, of which part will be paid to FDIC as damages, and part to thrifts supervisory as restitution claims.

Accounting for securitisation has a contentious, critical item – valuation of residual interests of the originator. Like all valuations, this valuation is also subjective. But the key difference here is that valuation of gains/losses on sale in securitisation transactions is primarily based on the value of this residual interest, which is like an unrealised profit on sale. However, instead of leaving this profit unrealised, accounting standards require this profit to be reported upfront.

Links

European securitisation volumes zoom

Securitisation in Europe is zooming. Data published recently by the European Securitisation Forum reveal that there has been substantial increase in activity in almost every asset class. The volume for the first 3 quarters of the year is likely to reach €179.2
billion which is 33.0 percent higher than the €134.7 billion a year ago. At this pace, it will surpass the record of €217.2 billion set in 2003.

The favorable financial market environment facilitated by the European Central Bank’s decision to maintain a target interest rate of 2.0 percent supports an expectation that issuance this year will set another record, says the Forum.

The increase is spread all across. Issuance in mortgage backed market grew 23.5% over the numbers for the last year. However, the real pick up is in the non-mortgage market, where the growth rate has been 47.4%.

In terms of countries, UK, Italy and Spain remain significant centres of activity.

Links For more on European securitisation, see our page here.

Israel securitisation market suffers early jolt of bankruptcy

Securitisation is not very well known in Israel, but soon after its inception, there has been a bankruptcy of an auto lease securitisation originator.

The originator in question is Car and Go. Strangely enough, the bonds entered into a default on its very first interest payment, though the bonds had been given a AA rating by Maalot rating company.

The company has completely shut down its operations, and the liquidator was appointed mainly to ensure that bondholders and other creditors do not start seizing cars from Car & Go's unprotected lots to protect their interests.

Car & Go, one of the country's smallest leasing firms, issued bonds less than a year ago in order to raise money. Most of the bonds were bought by provident funds and insurance companies: Funds belonging to Israel Discount Bank and Bank Yahav, for instance, bought NIS 20 million worth of bonds apiece

Amidst allegations of breach of duty by the accounting firm Brightman Almagor, the transaction would throw into tizzy the very nascent securitisation market in the country.

Links For more on securitization in Israel, see here. For more on instances of default in securitisation, see our page here.

 

Parmalat administrator launches lawsuit against Citibank

Securitisation is bankruptcy-remote, as long as the originator is not in bankruptcy. Every major bankruptcy hurls some or the other legal trouble to most mega financial deals, and of late, attacking structured finance and other "complex" financial deals is in latest fashion.

Enrico Bondi, the administrator of Parmalat, the fallen Italian dairy giant, is pursuing a two-pronged strategy: to seek billions of dollars in damages from banks on the grounds that they knowingly hid the true state of Parmalat's finances, while using the same charge of insider knowledge to revoke billions of euros in debt.

At the centre of the litigation against Citibank is a securitisation deal where asset-backed commercial paper conduits run by Citibank were buying receivables generated by Parma – these receivables were actually duplicated by false invoicing. The suit filed against Citibank in a New Jersey court seeks damages close of USD 10 billion, on the ground that Citibank officials were hand-in-glove in the securitisation transaction that, among others, was responsible for overleveraging of Parma, finally leading to its collapse. The law suit charges that officers of Citibank knew, from the deal's inception in 1994, that receivables being securitised and sold to investors — through special purpose companies called Eureka and Archimede — were being counted twice. In 1994, Citibank's relationship manager was Alberto Ferraris, who joined Parmalat in 1997, becoming CFO from March to November 2003, just before the collapse. The lawsuit claims Ferraris proposed or was aware of many of the transactions, which expanded rapidly under CFO Fausto Tonna from 2000, and continued through 2003. The lawsuit provides Citibank's due diligence memos, from 1994 and 1995, about how the invoices for the receivables were being counted twice.

Parma's petition claims: "The securitisation programme was intended to, and did, create the false impression that Parmalat was generating nearly twice as much cash flow from its operations."

As Parma's bankruptcy resolution unfolds, there might be some painful lessons for the structured finance industry to learn.

Links Vinod Kothari's lectures on bankruptcy laws are here.

Performing loans securitisation makes its mark in China

Is this an isolated deal, or has the dragon finally arrived? The global securitisation industry looks with tremendous interest at China – where loan originations, lease transactions, auto finance, housing finance, are all on a steep upward curve. But where is securitisation happening? That loan originations should continue to go up but not securitisation is surprising. Particularly so where China prepares to host the next Olympics.

In our comment here some days ago, we asked this question.

Amd the silence has been broken by Industrial and Commercial Bank of China (ICBC) hives off a pool of residential mortgages, something that has never been done before in the country, while Cinda Asset Management plans another non-performing loan (NPL) sale. ICBC's maiden deal is small, marking the caution associated with the maiden entry.

Experts point out tax uncertainties. [See, however, Vinod Kothari's comments in the previous story below]

But more than regulatory issues, the market is worried on more substantive issues. Proper securitisation requires a long credit history to evaluate risk well – which is not the case in China since more credits starting exploding only fairly recently. Does a green unburnt portfolio create more risks? There are reasons to differ, based on empirical experience world over, but then, the fear of dealing with something not known is always understandable.

To resolve the problem of inadequate data, companies have been taking the over-collateralisation route. But that is certainly not an efficient or preferred way to deal with securitisation deals. The other option, used in developed markets, is to have an outside guarantor like MBNA to agree to top up a failing securitisation for a fee.

Clearly, Chinese securitisation has a long way to go, but it seems it will go a long way, if it does not go the wrong way.

Links For more on securitisation in China, see here. For training workshops in China, public or private, do get in touch with us.

Malaysian ABS market picks up

The market for private debt securities, called PDS market in Malaysia, remains dull – with the total issuance estimated at about RM 25 billion for the whole of 2004. However, interest in asset-backed securities continues to be strong.

Malaysian ABS issues so far

Prisma Assets Berhad RM225 mil 
CBO One Berhad RM385mil 
Securita ABS One Berhad RM310 mil 
ABS Real Estate Berhad RM450mil 
Aegis One Berhad RM1bil 
Road Asset Vehicle Berhad RM350 mil 
Auito ABS One Berhad RM510 mil 
Ambang Sentosa Sdn Bhd RM1.049bil 
Soeial Port Vehicle Bhd RM1.310bil 
Astute Assets Bhd RM699mil 
Domayne Asset Corporation Bhd RM100mil 
Synergy Track Berhad RM152 mil 
ABS Land abd Properties Bhd RM109 mil 
Kerisma Bhd RM1bil

Market players state that the total number of issues upto August this year (from the very start) was 14, involving a total size of RM 7.65 billion. Since the number is cumulative, it is not a number to boast of. Of course, the issue size this year is influenced by the first-time entry of housing sector giant Cagamas into the ABS market for the first time. But then, quite likely, Cagamas would like to stay in the securitisation field.

Market players expect further activity in motor vehicle loan receivables, credit card receivables, housing loans and property rental.

Activity in traditional retail loan pools is often associated with interert rate curve. As interest rates start falling, banks and originators typically try to capture the profits of their past glorious years into their current books by selling off pools. But as interest rates rise, players would prefer to wait than to securitise.

Links For more on Malaysia, see our page here.

Will China remain limited to NPL securitisations, even as massive opportunities knock at the door?

A recent report by Standard and Poor's looks at China's securitisation potential, and laments that despite massive opportunities, so far, there has not been any tangible performing assets securitisation deals in China. The so-called NPL securitisations are closer to asset sales or liquidating securitisations, than securitisations in true sense.

First, take a look at the NPL securitisation market. Two domestic NPL securitizations have been completed; these have caught the attention of participants in the Asian securitization market. In June 2003, China Huarong Asset Management Co., one of the four Chinese AMCs, securitized a portfolio of 256 NPLs, raising Chinese renminbi (RMB) 1 billion. In April 2004, Industrial Commercial Bank of China (ICBC) securitized a RMB2.6 billion portfolio of nonperforming and subperforming loans for the ICBC branch in Ningbo. Both NPL securitizations issued senior-rated certificates by a trust created under China's trust laws. In addition, in June 2004, China Construction Bank (CCB) successfully completed a global auction of its real estate holdings with a face value of US$483 million to international buyers, recouping US$171 million. There is promise of more auctions and securitizations to follow.

However, on the performing assets side, despite massive opportunities, transactions have so far been evasive. Possibly, lack of a legal framework is missing, or as quite often happens, people are waiting for a precedent, and so also is the precedent-setter.

There are massive opportunities in Chinese real estate sector. Apart from commercial real estate, there has been double digit growth in the volume of residential mortgage loans. Recent data published by S&P demonstrate the housing loans have grown only in pace with the growth of GDP in the country.

The S&P report gets into what is missing in China. "Presently, not only does China lack a clear-cut set of laws (including tax laws) specifically governing securitization, it is still unclear which regulatory body would oversee securitization transactions." And further, "From a credit analysis perspective, the weak judiciary system and enforcement of creditors' rights mean that it is very difficult to assign recovery values to defaulted assets. This is true for corporate loans, corporate bonds, and consumer loans. It is likely that changes will be accelerated in this area. For instance, the ultimate enactment of a revamped bankruptcy law, which would strengthen creditor's rights under China's legal system, would be a major milestone on the road to reform. The increased activity by foreign investors in the NPL market bodes well as these investors contribute new skills and practices, such as credit underwriting, credit monitoring, work outs and bad loan resolution, and increased efficiency in the judiciary process. This has already been observed in many Asian countries, including Japan, Korea, and Taiwan, which will help rating agencies and investors alike to gauge the likelihood and quantum of recovery."

Vinod Kothari comments: Lawyers talk about two things – law and practice. China has thrived more on practice than on law – strong legal system was never the strong point of China. In fact, in many cases, the absence of clear laws fuelled activity than foiled it. However, on capital-market front, a more systematic approach to risk evaluation, mortgage foreclosure and bankruptcy resolution is required. The S&P report also says that synthetic transactions might precede cash transaction – but that would be highly surprising. In a growing market, what is required is funding or refinancing, which synthetics fail to answer.

Links For more on China, click here. For more on NPL securitisations, click here.

 

S&P lists pre-conditions for secondary mortgage markets

Unarguably, residential mortgage markets where securitisation is the most important – and countries need secondary mortgage markets to promote housing finance. Among all asset classes, RMBS is surely the one that is most significant for macro-economic development.

Rating agency Standard and Poor's (S&P) listed the pre-conditions for RMBS markets. Of these, the most significant condition is the existence of an appropriate legal system. The system must have the following requisite features:

  • Recognition of true sale: This is needed to insulate investors from any insolvency of the mortgage originator.
  • Trust or special-purpose entity: This entity must be bankruptcy remote, with the single purpose of buying assets and issuing the MBS. In Mexico, Argentina, Spain, and France, special funds or trusts had to be created for MBS. In Sweden, trusts were recognized, but because those with assets of less than US$50,000 were subject to taxes, issuing vehicles were set up offshore.
  • Mortgage-registration process: The registration of loans to the new owner should be easy and inexpensive. In some countries this may require the elimination of the requirement to notify the borrower about the loan transfer and the elimination of expensive stamp duties. Before states in Mexico modified their civil codes, stamp duties on the sale or transfer of mortgages were prohibitively expensive for securitization.
  • Set-off risk: Laws need to address the risk that a mortgagor could offset any payments it owes on a loan against money owed to it by the lender (such as a bank account deposit).
  • Consumer privacy laws: These laws may prohibit the sharing of mortgagor information with the trustee and rating agency.
  • Debtor- versus creditor-friendly environment: Some countries have laws that are friendlier to consumers; these can impede a lender's ability to foreclose on a bad loan.
  • National versus state differences: One securitization law may not work for an entire country. For example, in Argentina, the law that was passed in 1995 worked for all provinces, but in Mexico, state-specific laws were needed.

Apart from the legal framework, it is also important to have loan and documentation standardisation. Standardization of underwriting criteria and contracts better provides for homogeneous assets; these ease the analysis of portfolio risk and makes future performance easier to predict.

The rating agency also notes that sometimes, efforts to develop RMBS are also hamstrung by the inability of the originators to churn the required data. Critical information includes historical loan delinquencies, defaults, foreclosures (recovery amounts and related expenses), and prepayments. It has been very difficult to get data on the volatility of house values, especially through different economic cycles. In addition, emerging market lenders have difficulty accessing borrower payment history when national credit bureaus do not exist.

Links We posted a similar article relative to Germany – appropriate legal structure for German securitisation market which makes an interesting reading. For more on RMBS, see here. For more on legal issues, see here. Also see Vinod Kothari's article on legal structure of securitisation.

Single tranche synthetic CDOs make advent in Taiwan

Clearly indicating the growing comfortability of Asian investors with synthetic CDOs, Deutsche Bank recently sold an AA-rated piece of a synthetic CDO to a Taiwanese bank. The ease with which Asian banks are picking up synthetic CDO positions is sure to fuel the explosion of synthetic CDOs in Asia.

According to news report in Finance Asia of 16th Sept., Deutsche Bank structured a synthetic CDO referenced to 100 international names. The notional amount of the CDO portfolio is $2.36 billion and the three-year bullet notes are credit-linked to the AA tranche of the CDO. The notes were placed privately with Jih Sun International Bank, which in turn will sell them to a group of corporate and high-net worth clients.

The deal has been structured as a fixed-rate, three-year static deal to take advantage of this continuing environment of low short-term interest rates, tightening credit spreads and fewer corporate defaults.

A synthetic CDO synthetically assimilates a portfolio of diversified credits. In a single tranche deal, instead of buying protection for all tranches of the synthetic CDO, the CDO merely buys protection at a particular level, like at the AA-level in this case, and thereafter delta-hedges the rest of the portfolio based on its own model of the portfolio's delta.

Securitisation market is growing fast in Taiwan, particularly after the legislations passsed last year. CDOs are a new craze.

Links For more on Taiwan, click here. For more on synthetic CDOs, see our page here. See also our site on credit derivativeshere. 

SPVs in Singapore to qualify for concessional tax regime

In a bid to provide tax neutrality to securitisation transactions, the Singapore government proposes a concessional rate of tax to special purpose vehicles. A Budget 2004 pronouncement proposed a lower rate of tax for securitisation vehicles. The Budget proposal said:

"To provide greater regulatory certainty, MAS issued regulatory guidelines to financial institutions participating in asset-backed securitisation and credit derivative transactions in 2000. As a complement to these measures, a concessionary tax treatment will be conferred on Special Purpose Vehicles (SPVs) engaged in asset securitisation. This concessionary tax treatment will apply to SPVs set up for asset securitisation on or after the date of Budget announcement. It will address and mitigate tax disadvantages that an asset securitisation SPV may face as a result of mismatches in timing between the receipt of income and the payment of expenses."

The Inland Revenue Authority has, however, deferred the notification implementing the lower rate of tax to October 2004. A note posted on IRAS website does not provide any reasons for the deferral, but quite obviously, the delay is due to inconclusive deliberations as to what are the securitisation transactions that should benefit out of this concessional tax, and what are the defining features of a special purpose vehicles.

Special purpose vehicles, easily understandable as a notion, are indeed very difficult to identify in law – the US accounting rule FIN 46 (now FIN 46 R) has to spend lot of energy to identify special purpose entitites.

Links For more on Singapore securitisation, see our page here. For more on taxation issues in securitisation, see here.

Workshops in Singapore : We offer several training events in Singapore round the year – for our latest offerings, see this page.

Indian securitisation: the shine continues in 2004

We reported recently about India having reached position no 2 in ex-Japan Asian securitisation. 2004 is going to be much better.

Nithya Easwaran of Citibank reports that the volumes for the first half of 2003 have already exceeded to the entire year's volume in 2003, and looking at the strong pipeline, it is quite clear that 2004 will be a landmark year.

The volume for the first half of 2004 is Rs. 77.65 billion (Rs 45 = 1 USD). The volume for the entire year 2003 was Rs. 69.31 billion, composed of ABS Rs. 41.01, MBS Rs 5.71, and CLO Rs 22.59, all in billions.

This year so far, the number of deals the number of deals is about half that of the last year but the volume has already exceeded – which obviously indicates appetite for larger deal sizes.

The Reserve Bank of India has recently notified that investment in mortgage backed securities satisfying certain criteria will be regarded as priority sector lending by banks. The criteria themselves are worded like a maze and are literally dificult to achieve. The Securitisation Act in India does lots of things except securitisation – therefore, the market growth is unaffected by regulatory moves.

Links For more on securitisation in India, see our India page. For training courses in India, see our training calendar.

IASB issues exposure draft of new disclosure norms for financial instruments

Accounting Standards on financial instruments, it seems, will never be complete – the standard setters have a tremendous penchant for writing! Even as the ink is yet to dry on IAS 39 (FAS 140/FAS 1115/ FAS 133 in the USA), there is a new exposure draft of an accounting standard that would require further disclosures in case of financial instruments.

Exposure draft 7 (ED 7) is prepartory to issuance of the IFRS series of accounting standards.

ED 7 proposes additional disclosures in case of financial instruments and is specifically aimed at enhanced information about the liquidity, credit and operational risks inherent in financial instruments. This would be a standard that would correspond to the existing IAS 30 and IAS 32 and would be a part of the IFRS series (IAS 30 would be withdrawn and IAS 32 will be amended). The [draft] IFRS requires qualitative and quantitative disclosures about exposure to risks arising from financial instruments. The qualitative disclosures describe management’s objectives, policies and processes for managing those risks. The quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel. Together, these disclosures provide an overview of the entity’s use of financial instruments and the exposures to risks they create.

The proposed IFRS is to apply to all entities including non-financial entities.

Relative to securitisation transactions, ED 7 has certain provisions relating to derecognition – most securitisation transactions result into derecognition of the whole or a part of the asset. In case of derecognisd assets, the entity would disclose the following:

a) the nature of the asset;
(b) the nature of the risks and rewards of ownership to which the entity remains exposed;
(c) when the entity continues to recognise all of the asset, the carrying amounts of the asset and of the associated liability; and
(d) when the entity continues to recognise the asset to the extent of its continuing involvement, the total amount of the asset, the amount of the asset that the entity continues to recognise and the carrying amount of the associated liability.

Comments on ED 7 are due by 22 Oct 2004.

Links For more on accounting for securitisation, see our page here.

 

India at number 2 in ex-Japan Asian securitisation

Startling – India has come to be the second largest securitisation market in ex-Japan Asia. Typically, while analysing Asian volumes, we never include Japan as Japan is a world by itself. But in ex-Japan Asia, Korea is the largest, and India is at number two in 2003, up from nowhere.

India was never talked about in global securitisation scene – as it was a dot in a spectrum. But last year's mega deals have catapulted India to a significant position.

There is a quite a gap between position number 1 – that of Korea, and position number 2. Korean market is about 10 times the size of India, but the potential for India is huge. In fact, the transaction volumes in 2004 have been encouraging though the recent upward move of interest rates is a dampening factor.

An S&P report titled A True Asia-Pacific Securitization Market Emerges says: "Asian securitization volumes from these countries (Taiwan, Hong Kong, South Korea, Thailand, Malaysia, India, and Singapore) now exceed the equivalent of US$46 billion. (This figure includes only public deals, and therefore, likely understates the true volumes, which may include numerous conduits bought by ABS and synthetic CDOs). In the early years, so-called Asian securitization was really a misnomer as deal flows came from only one or two countries. In 2002 and 2003, for instance, the market was mostly limited to Korean credit card securitizations. Recently, securitization platforms have successfully been established in many more Asian countries and at a rapid pace."

Another notable development in the Asian market is the rapidly establishing CMBS market: "Commercial real estate securitization is starting to take hold in several Asian markets. For a long time, aggressive bank lending to real estate restricted CMBS in Singapore and Hong Kong. However, with the influence of market discipline, the REITs market has brought a level of realism to the market, closing the real estate valuation gap and the expectation of funding proceeds based on gearing ratios that reflect the risks of property financing and refinancing."

Links For more on securitisation in India, see our country page here.

Workshops: We regularly hold securitisation training workshops in several Asian locations. For schedule of our forthcoming workshops, click here

 

News on Securitization: Asia-Pacific securitisation reviving, as Singapore registers some securitisation deals

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November 30, 2013

The market for asset-backed securities, which went into hibernation post the 2007-8 crisis, seems to be coming back to life. Hong Kong and Singapore and the two main centers of financial activity : most of investment banks in both the places had shut their stops and disbanded their investment banking teams post the sub-prime crisis. However, there are clear signs of activity resurfacing in both the places.

As regards Singapore – there have been 2 deals towards October-November.

One is a CMBS deal with pre-sales of properties under construction. This type of transaction has been done in Singapore long time back and was not seen over more than 6-7 years in the past. This deal, brought by T G Master, pertains to sale of spaces in Skies Miltonia, a property in Singapore. The progress payments on the property have been securitised, thus providing construction finance. This deal was structured and sold by DBS Singapore.

Another deal, brought by Courts Asia, uses two distinct SPVs – one in Malaysia and one in Singapore – to structure a multi-currency multi-jurisdiction transaction.

Hong Kong teams also seem busy structuring transactions for China.

Down South, Macquarie Leasing’s SMART template continues to have new issuances – this pertains to a portfolio of financial and operating leases.

In short, the Asian securitisation market has shown signs of clear revival in 2013, and 2014 may be holding the portents for a promising start.

Reported by: Vinod Kothari

News on Securitization- Home rental securitization deals opens up vistas to a massive market: Analysis of Invitation Homes REO-to-rental securitization

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November 30, 2013

A recent $ 278.7 million REO-to-rental securitization deal from Invitation Homes, a subsidiary of Blackstone, has set the pheromone levels of securitization structurers high. If this is a template that one could write on, there is substantial scope for similar deals to follow.

REO, or “real estate owned” is a property that  a lender acquires against a defaulted mortgage loan. The lender puts the property to auction typically at a reserve price equal to the outstanding loan – but if the market value is lower than such reserve price, there may not be takers, and the property then becomes a part of the “owned” stock of the lender – thus called “real estate owned”. REO is a part of the non-performing asset portfolio of the lender. Thanks to the crisis, there were tens-of-thousands of such homes on the books of several lenders which REITs have been acquiring since 2008 –which they rent out. This is the so-called “REO-to-rental” market, having an estimated potential of about $ 1 billion.

The deal structure emulates a typical CMBS transaction, though it has elements of an RMBS inbuilt into it. There are 6 classes of notes, with the bottom two unrated. The over-collateralisation at Class A is approximately 41.8%. The transaction has a term of only 5 years, including 3 one-year extensions. Moody’s rating presale report, detailing the transaction is here: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_SF346785

Reported by: Vinod Kothari

News on Securitization: AIFMD exemption for Irish securitisation companies

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November 29, 2013

The Central Bank of Ireland has recently clarified that:

  • securitisation companies that have registered with the Central Bank as “financial vehicle corporations” pursuant to Regulation (EC) No 24/2009 of the European Central Bank[1] (the “FVC Regulation“); and / or
  • securitisation companies funded by way of debt or other non-equity instruments,

are outside the scope of the Alternative Investment Fund Managers Directive (Directive 2011/61/EU)[2] (the AIFMD) and the Commission Delegated Regulation[3] (EU) No 231/2013 as transposed into Irish law under the European Union (Alternative Investment Fund Managers) Regulations, 2013 (the “AIFM Regulations“).Consequently they do not need to seek authorization as, or appoint, an AIFM. The Central Bank of Ireland does not intend to do that at least for so long as ESMA continues its current work on this matter.

Section 110 of the Irish Taxes Consolidation Act 1997[4] creates the legislative framework for securitisation companies in Ireland. Such companies are commonly called “Section 110” companies. Many existing and newly established section 110 companies would be required by the FVC Regulation to register with the Central Bank as “financial vehicle corporations”, by virtue of the fact that they carry out, or intend to carry out, one or more “securitizations” (within the meaning of the FVC Regulation). Following the clarifications, it is now clear that AIFMD and the AIFM Regulations do not apply to such companies.

AIFMD and the AIFM Regulations also do not apply to section 110 companies that are not required to register as FVCs, provided they are not engaged in the activity of issuing shares or units. This would include, section 110 companies that are not FVCs, where they are funded by entering into loans, issuing debt securities, and / or issuing non-debt instruments (such as certificates, warrants and derivative instruments) that do not convert into, and are not convertible into, shares or units giving an ownership interest in the company.