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:

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 viewsPlease 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