by Vinod Kothari


The new face of securitization

Securitization in future will be back on the balance sheet

4 April 2008

See my latest article here, where I argue that the world cannot do without securitization, and what we need to do is to explore methods of balance-sheet securitization. This is what I hag argued soon after collapse of Enron; Treasury Secretary Paulson is talking about the same thing now.

Sentimental Accounting: Time to question mark to market

We need to ask ourselves if MTM is procyclical and helps the market disequilibrium

4 April 2008

See my latest article here, where I produce arguments against MTM accounting – primarily on two grounds. One, it leads to volatile accounting and almost every accounting estimate is liable to question. Two, and more seiously in the current crisis, MTM accounting is procyclical.

The perils of securitisation

The sub-prime crisis focus-lights two "old" risks

24th July 2007

The subprime crisis

The subprime crisis is now littered all over the financial press. Every day, in all parts of the world, financial and non-financial press talk about the perils of the possible contagion effect that the subprime crisis might have. Some indications of a spillover effect are already there – apprehensions are if it might worsen into a larger crisis. Next few months might provide that crucial test.

First risk: originate and sell it all

In the wake of the subprime crisis, securitization and CDOs as a strategy have come under sharp critique. It is nothing new. For example, when Enron collapsed, SPVs came under sharp attack, because Enron had used SPVs. Public’s scrutiny of an evil episode is always like that –there is a mix of superstition in the way people look at things. If I committed an accident driving a particular vehicle, part of the blame is cast upon the vehicle. Securitization was the vehicle used by banks to create and distribute subprime loans, and securitization is being made out as the culprit.

In fact, in a way, the commentators this time are at least partly right. Even the regulators (For example, UK FSA’s latest Financial Stability Report) talks about the risks of an originate-and-distribute strategy. In a securitization model, banks create loan pools and sell off various tranches of such loans in form of securitized bonds. In a traditional securitization model, banks were still retaining a “first loss piece” and providing credit enhancement to the deal, but enter the hedge funds, and banks found it possible to even sell the first loss or equity pieces too. So, it was possible for banks to originate a subprime loan pool at obviously high spreads, skim the spreads in form of an IO strip or otherwise, sell off most pieces of the loan pool, and realise an instant gain. 

Remembering Henry Kaufman:

Post the 1997 Asian crisis, 1998 Russian crisis and the failure of LTCM, Henry Kaufman wrote: “I would be first to argue that, in a deregulated, entrepreneurially based financial system, nobody can ever get rid of financial excesses entirely. Nor should we ever want that kind of world, because it would be one in which market participants would be so leery' of taking on any risks that legitimate credit needs of the economy would not be met. History proves that too little credit creation is as harmful as too much. But in many respects the system that has been evolving during the past couple of decades may represent the worst of all possible worlds, in which credit availability and leveraging lurch from one extreme to another, whipsawing borrowers and lenders alike”. [Protecting Against the Next Financial Crisis: Business Economics, July, 1999]

Kaufman in loud and clear words talked about the risks of securitization: “securitization has opened up literally trillions of dollars worth of assets to the harsh glare of changing market circumstances, and therefore to market risks unimaginable just twenty years ago”.

In the go-go years of securitization, it would have been anachronistic to talk about risks of securitization-driven system, but current developments have exposed those risks.

Second Risk: Leveraged vehicles with automatic deleverage triggers:

In the hours of crisis, what you need from the financial intermediaries is forbearance. While bankers are known to be the people who want back the umbrella when it starts raining, in reality, the banking system has lot more tolerance. Imagine a business that goes through a downturn – sales are dropping, realisations are lacking, and therefore, profits suffer. If at the very same time, the bank triggers the “accelerated repayment”, that is, premature repayment of its funding, the business is sure to get into complete shambles.

Most of the leveraged investment vehicles, which provide much of the funding that has fuelled the financial markets of today, act of automated deleverage trigger. Most of these vehicles are non-discretionary – that is, they are looked after by trustees and managers who do not have a discretion; they are controlled by specified triggers. This is an example of an automatic trigger: a CDO allows the manager to reinvest the capital of the CDO if certain tests are continuously satisfied. These tests importantly have to do with the value of the assets. If the value of the assets fall, the CDO manager must start retiring the liabilities, which means the on-going investments by the CDO are reduced. Most hedge funds also have similar triggers. It is not difficult to understand that if, in situation of a market downturn, most of these vehicles have been hit by automatic triggers, they cannot invest any further and must start downsizing their operations, it would create a liquidity squeeze which comes at a very wrong time.

Among the investment strategies that are reputed to have caused the crash of 1997 is “portfolio insurance”, which is also an example of an automatic deleverage trigger. When the portfolio starts suffering losses, the portfolio manager is required to curtail his investments into risky assets and make more investments in risk-free assets, thereby creating a liquidity squeeze. The liquidity squeeze is self-feeding: the consequence becomes the cause for more, thereby pushing the market into a vicious cycle.

It is not surprising that in the benign market conditions, the “constant proportion portfolio insurance” device had become the buzzword in the CDO business too. There were several CPPI CDOs, or CPDOs that came into the market of late, and rating agencies had warm-heartedly promoted these institutions. CDOs, conduits, hedge funds, structured investment vehicles, private equity funds – almost all of them have such deleverage triggers. Tragedy is that the developments in the market have already stepped on these triggers.


Is it time to re-look at the fundamentals of SPEs?

30th July 2003


In the wake of Enron and the investigations and penalties that followed, two words made most of the buzz: complex structured finance transactions and special purpose entities (SPEs). The securitization industry makes use of SPEs too. "Complex structured finance" is a relative term and complexity is (a) in the eye of the beholder; and (b) is mostly retrospective, as it was in the case of Enron. However, the accounting standard-setters in the USA are busy comprehensively revisiting the approach to SPEs. A new accounting rule FIN 46 was brought in which specifically excluded qualifying SPEs (QSPEs) for securitization transactions. However, the FASB proposes further amendments to the conditions of QSPEs, which, in the opinion of the industry, would render nugatory the whole concept of QSPEs, as no SPEs in practice would so qualify on a strict interpretation of the proposed rules.

While industry bodies such as the American Securitization Forum and The Bond Markets Association have strongly opposed to these changes, they have also asked the FASB to give a serious thought to a brave new approach: forget about off-balance sheet accounting altogether, and move to a new approach called the "matched presentation approach" which is inspired by the UK accounting standard called FRS 5. Under this approach, the assets of the SPE will be on the books of the transferor, but will be netted off by the non-recourse liabilities and external equity of the SPE. Resultingly, SPEs are no more off the balance sheet – they are on the balance sheet, though after netting off (in the sense of the net interest of the transferor being added to the asset value of the transferor -for details, see AFS proposal).

Is it not time to take a fundamental relook at the whole concept of SPEs, and consequently, their accounting? We invite you to share your thoughts on this issue which, you will agree, is not only crucial to the USD 6 trillion strong securitization industry, but also whole lot of synthetic leases, and other off balance sheet items.

The questions below are merely to inspire your thought process. You do not have to be guided by or limited to these questions.

Q. 1: The age old concept of an artificial legal entity is a creature of law that carries on a substantive business activity. Companies or corporations were envisioned centuries ago for carrying on business operations, clothed with an artificial legal personality. In case of special purpose entities, we narrow down the scope of operations of the entity to an extent where it is merely reduced to a bunch of assets: as if the assets are being given an incorporated status. Conceptually this is still fine: you might have a corporation with multiple businesses, or a narrow line of business, which one can squeeze to the present concept of a special purpose entity. Do you agree with this?

Q. 2: If it is an entity that has either a substantive business or substantive assets, it must also have some identifiable owners. After all, a legal entity comes into existence only based on securitised ownership. Do you think the concept of ownership in SPEs is made virtually redundant by grossly inadequate capital, such that the so-called legal capital cannot be the risk-capital of the entity?

Q. 3: Do you think the accounting concept of "equity" as "residual economic interest" in an enterprise, if applied properly, is enough to expand the accounting definition of "equity" to include the risk-capital of SPEs, and therefore, consolidation norms may apply to SPEs based on such risk capital rather than economic capital?

Q 4: Is there any justification in FAS 140 excluding qualifying SPEs from consolidation rules?

Q. 5: Possibly, the securitization industry needs to isolate assets more for the purpose of bankruptcy remoteness than for the purpose of off-balance sheet accounting. That is to say, off balance sheet accounting is more a result than a reason for isolation of assets into SPEs. (Do you agree?) If that is the case, would things be much better if legal systems allowed isolation of assets without the assets being transferred into a separate vehicle? After all, an SPE is nothing but a legal myth and a mere device of isolation. For example, if the corporate laws allowed a company to have a multiple cells within a company, each of which may have their independent assets and liabilities, the need to create artificial separation into SPEs would go away. Bankruptcy remoteness could be achieved on the balance sheet itself. Do you think such a development is needed at this stage? Notably, some countries like Italy have already put in place enabling laws in this regard.

Q. 6; Do you agree with ASF's suggestion of a matched presentation approach to accounting for SPEs?

You may send your comments by e-mail to me

In defense of securitisation

21 Feb 2002: Banc One Capital Markets came out on Feb 19 with a piece titled In Defense of Securitization. It is probably for the first time since the inception of securitisation that someone is having to defend securitisation. We have been covering on our news pages the aftermath of the Enron collapse. Enron's questionable accounting practices, in specific, the use of SPEs for putting liabilities off the balance sheet, has put a broader question mark on off-balance sheet financing in general. At the same time, the occasion was thought appropriate by several law professors to press the point that a pending bankruptcy law reform which seeks to give a safe harbour to securitisation transactions against judicial review may be potentially dangerous.

The controversy on accounting practices continues to thicken. US markets have suffered over the last few days on "balance sheet worries". A general reaction is developing against complex financial instruments, which in public perception, includes securitization as well.

What is happening around is natural. It is the intuitive knee-jerk reaction that is seen everytime a major financial scandal rocks the markets. Barings Bank and LTCM have both resulted into upheavals are rethinking on the role of derivatives. This time, accounting has come into sharper focus.

There are two major issues in the present debate concerning securitisation: one is the bankruptcy protection, and second is the off-balance sheet liabilities.

The views of the secuitisation industry on bankruptcy safe harbour are well represented by the Bond Markets Association letter. The industry argument is primarily based on the need for a certain legal treatment to securitisation investors who invest money at lower costs, leading to more efficient operations, and hence, general economic good. The contrarian view is that there is no reason for not extending judicial review to securitisation as is applicable to all commercial contracts. After all, in the history of securitisation world, there have not been too many instances of recharacterisation, and we can trust the judiciary that it will apply the recharacterisation power only in fit cases.

On balance, the securitisation industry should be agreeable to subject itself to judicial review in proper cases. There was sec 912 of the Bankrutpcy Reform law in the past, and the markets have continued to grow over last 25 years. There is no comparable provision in any other country, and yet the markets have grown everywhere. Neither is sec. 912 a precondition for growth of securitisation, nor is its absence fatal in any way. Courts have established principles for judicial review which are used extremely cautiously. LTV's case questioned true sale, but there was no ruling against true sale anyway.

The other key issue is off-balance sheet liability. Business Week is leading investor sentiment on this issue – it has been coming down sharply on accounting practices ever since Enron collapsed. The 18th Feb issued carried a peace titled Five Ways to avoid more Enrons – and the top way suggested is: bring hidden liabilities back on books.

The investor concern on off balance sheet liability is simple: bring all off balance sheet liabilities on the balance sheet. But to an accountant: the issue is one of the finer distinction between the entity's liability and the liaibility of a spun-off entity which has been separated. If primary credit support for a liaibility is provided by the entity, even if it is a legal liability of someone else, there is no reason why the liability should not be on the balance sheet of the entity.

The FASB has been meeting regularly of late on the complicated issue of consolidation of SPEs. The present interpretation permits an SPE to avoid consolidation if it has, among other conditions, a 3% risk capital support from unconnected entities. This has certainly bred misuse: entities get that 3% from law firms or others who are paid fees in compensation, and the SPE remains unconsolidated. Too much dependance on numerical tests is the key difference between FASB standards and the International Accounting Standards. The latter depends on time-tested but very subjective tests such as substance over form, direct credit support, subordnation of interests, etc. Where the US interpretation can keep an SPE unconsolidated, an IASB SIC 12 will require consolidation.

We need to realise that it is not good for an acccounting standard to leave too much to quantifiable tests. Subjective tests require auditors to use discretion: they can therefore be hauled for not doing so properly. There is a greater sense of responsibility. On the contrary, if I have a 3% risk capital rule, all I need to do is to ensure that I nominally comply with it.

The unfortunate but inevitable result of the present controversy is that securitisation itself has acquired some kind of an antipathy. However, this would be hopefully transient.

archived on 21st Feb 2002

Trends in global securitisation:

The world of securitisation is moving very fast. Volumes, asset classes, investor classes – every way, the acceptance of securitisation as the financial instrument of the new millennium is growing at a very fast pace.

At this stage, the some of the discernible trends are as follows:

1. Blurring distinction between structured finance and corporate finance:

Convergence is the essential rule of development – so, as the markets are developing, there is an increasing convergence between securitisation and corporate borrowing. Several applications of securitisation look closer to secured borrowing than to mainstream securitisation. One noteworthy example is whole business securitisation – where the entire cashflows of an operating company are securitised. A traditional lender also takes exposure on the entire cashflows of an operating company – leading to a very close similarity. Similarly, there are certain single obligor based mortgage securitisations which also amount to an implicit lending to such obligor. These instruments are hybrids between mainstream asset-backed products and corporate finance.

Investors are essentially looking at credit enhancements. For example, in whole business securitisations, investor comfort is the level of cash collateral, cashflow trapping and the inherent disincentives for the operator to default. As long as there are substantial credit enhancements, the instrument appeals to the investor – securitisation or no securitisation.

The key issue is : if credit enhanced borrowing is alright, why do we talk about securitisation at all? The answer lies in originator motivations. If the originator's approach is shaped by his own motivations of off-balance sheet funding, regulatory relief, gain on sale, etc., he will rather go for a full-fledged securitisation. On the other hand, if all he wants is a lower funding cost which is attainable with credit enhancements, collateralised borrowings or instruments with a hybrid character are acceptable.

2. Increasing use of derivatives in securitisations:

An increasing number of securitisations are using the synthetic method – that is, transferring risks using credit derivatives. Later, we undertake a detailed discussion on synthetic securitisation. Essentially, the purpose in a synthetic securitisation might be either funding with transfer of risk, or mere transfer of risk with no funding involved.

In central place of activity in synthetic securitisation is Europe. At the beginning of year 2001, synthetic CDOs were estimated to be occupying more than 50 % of CDO volumes in Europe. The reasons for increased acceptance of synthetic CDOs in Europe are not difficult to find – they do away with the tedious process of asset transfers and yet achieve the significant effects of capital relief, risk transfer and reduced concentration.

Synthetic securitisation is an important development for both securitisation and derivatives. It is an unfunded securitisation and a funded derivative. Going forward, it is clear that the trend towards synthetic securitisation would be gather more strength and result into increasing use of securitisation for pure transfer of risks.

3. Increasing risk securitisations

Five years ago, securitisation of risk appeared to be an innovation – now it is already a buzzword. The market is now seeing even more exciting forms of risk transfers, such as securitisation of hedge funds, or securitisation of private equity funds.

Risk securitisation device was first experimented in the insurance market. To date, insurance risk securitisation has been more talked about than practiced. But interestingly, outside the insurance world, the technique has found a number of interesting applications such as securitisation of weather risk, credit risk, etc.

4. Equity into debt, and debt into equity:

Once again, it is the rule of convergence. A CDO essentially strips a portfolio of debts and converts into several layers of debts, leaving an equity tranche. In other words, it carves out an equity tranche into debt.

Recently, a path-breaking transaction was noted – carving out debt out of equity. This was securitisation of private equity investments, notable as the first such application of securitisation. Prime Edge, a securitised portfolio of investments into private equity funds, made the headlines in innovative finance in June 2001. By securitising private equity investments, the transaction allows bond investors to participate into the venturesome area of private equity investments.

archived on 12th June 2001

Bankruptcy remoteness as a buzzword

Bankruptcy remoteness or isolation is truly a basic premise of securitization, but unfortunately, it seems to be becoming more of a dogma of late. Securitization structures sometimes go to quite some length, building up artificial facades, merely to fight against an imaginary risk of bankruptcy.

It is important to agree on some basic tenets of securitization:


  • As against a traditional debt issuance, securitization is a self-amoritising device; the cashflows or assets dedicated by the originator should automatically retire the investors' security. As the sole source of primary payment for the investors is the assets transferred by the originator, it is necessary that there should be no eventuality whereby the assets so transferred are either clawed back, or made a part of the bankruptcy estate of the originator.
  • This necessitates the following:


    • There must be a true sale, because a true sale would mean the legal interest in the asset has been divested by the originator and vested into the SPV.
    • There is no question, nor any way, of ensuring that having transferred the assets, the originator does not go bankrupt. He may. If he does, and does so within a few months of transfer, there is a clawback rule in most countries which permits a court to recapture assets transferred within 6 months prior to bankruptcy, as fraudulent preferences or transfers in anticipation of bankruptcy. This rule would presumably affect only those transfers which are not bonafide. Securitization transfers are unlikely to be affected by this rule.
    • Irrespective of when does the originator go bankrupt, there is a possibility that the Court may substantively consolidate the originator and the SPV, that is, lift their separate corporate veil and treat them as one entity. This possibility is a product of the judicial practice in the country concerned. US Courts, for example, are more inclined to pass orders for substantive consolidation than their UK counterparts, who still believe in the age-old 1897 ruling in Solomon v Solomon and Company. [Click here for an article on UK practice in lifting of the corporate veil] The rules for consolidation with many precedents in hand sound clear enough: if circumstances exist indicating that the creditors of one company might have relied upon the credit of the other company, and the Court considers it fair in the interest of all creditors that the two companies should be consolidated, a consolidation order will be passed. Some lessons have been learnt from cases such asKingston Squate [See our cases page] .
    • This apart, the structure needs to ensure that the SPV itself does not go bankrupt. This is done by putting in clauses that the SPV will not incur any liabilities, will not get into any other business, and those who deal with the SPV will give it an undertaking not to take the SPV to liquidation.
  • Once again, the extent to which these precautions are to be used depends on the judicial approach in the country concerned.
  • If these precautions are used, the purpose of bankruptcy remoteness is achieved.

However, in some cases, the concept of bankruptcy remoteness has been stretched to extremes. One current example is the insistence of the FASB that single step securitizations in the USA by FDIC-insured entities are not bankruptcy remote as the FDIC has an equitable power of redemption, even though there is no noted history of such power being exercised ever, not to speak of securitization transactions.

In some countries, regulators insist that the originator should not hold any equity capital in the SPV, as if by merely holding the equity, the risk of consolidation is increased. This leads to artificial subterfuges such as spreading the equity capital, or transferring the equity in the name of trusts etc which do not sound business-like.

In my perception, we seem to be over-reacting to an imaginary bankruptcy risk.

Any views?

The true sale question is not dead
Safe harbour to securitizations needed

The bankruptcy of US steel company LTV raised a serious question for the securitization industry: is the sale of receivables made to an SPV a true sale? Needless to say, true sale is one of the most crucial questions in securitization, and the very edifice of securitization, the very distinction it enjoys from traditional forms of funding, rests on this key question. The true sale question is not just limited to legal rights of investors: it is also the fulcrum of the accounting treatment, regulatory treatment, tax treatment, and so on.

To read more about the LTV case, see our news pages here and here.

The LTV case posed a challenge to this fundamental basis for securitization. Guess what might happen to the multi-trillion dollar industry if the Court decides that securitization did not constitute a true sale but was a mere funding arrangement? Investors who thought they would enjoy distinctive undeterred rights over isolated assets of the originator would get relegated to the unsecured creditor status. Off balance sheet accounting would be at stake. Regulatory treatment, in case of banks and financial intermediaries, would not be possible. Tax treatment would be different, and so on. Suffice it to say, the 30-year old securitization industry, making strides all over the World, would come to a sudden demise.

The hearings on the true sale issue in LTV case, scheduled for 7th March, got a reprieve as LTV seems to have tied up some arrangement with its lenders who have agreed to give it an DIP funding of USD 700 million, on the condition that the Court rules that the transaction of securitization was indeed a true sale. The deal is a win for LTV, and a face-saver for the securitization industry, but the given facts of the case would prove to be Achilles heals for the industry in time to come. The grounds on which LTV pleaded for consolidation of the subsidiary with the originator are common in most securitization deals, and therefore, every other originator who having securitized assets and goes into bankruptcy would use the LTV-type threat and arm-twist the entire industry. In other words, the true-sale question might lead to a collective black mail.

Not that such questions have not been raised in the past, e.g., Octagon's case, Towers Healthcare, etc., but LTV case is more representative of the reality in securitization industry and is therefore, crucial.

The Bankruptcy Reform Act 2001 is already on the calendar of the US Congress [see our Securitization laws section – United States for text] and we are told that it is on fast track and would come up for enactment soon. The law, when enacted, will ensure that the truth of securitizations is not disrupted in bankruptcy, in all such securitizations where at least one tranche is rated investment grade by rating agencies. The law also provides that such a safe harbour would be available irrespective of the tax, accounting or regulatory treatment of the transaction. The law applies to present and future financial assets, and to total or partial transfer of such assets.

As the accounting, tax and regulatory treatment is, very largely, dependant on the true sale in bankruptcy, the amendment of bankruptcy laws will go a long way in giving the much needed safe harbour to securitizations.

But that is for the US: how about other countries?

Amicus curae memorandum in LTV case [see our news report linked above for details] said the securitization industry is USD 5.1 trillion strong, including outstanding value of ABCP, MBS and ABS. Assuming the rest of the world adds up to only 0.9 trillion, we are talking about a USD 6 trillion industry, whose fate may be written one day, and that too, in retrospect, by one of the several thousands of bankrupcy judges all over the World. This only highlights the need to have an international securitization lobby that could mobilise a case before Governments of the World to adopt something similar to Sec. 912 of the Bankruptcy Reforms Act. UNCITRAL is doing something in this regard, but that process is painfully slow, and if the pace at which financial leasing laws were adopted in the past is of any indication, very very ineffective. [March 10, 2001]

Dutch tax reforms: When is a subordinated debt not debt for tax purposes?

The Dutch government has recently proposed tax reforms that would treat subordinated tranches of securitisation paper, if they satisfy certain conditions, as equity for tax purposes. Click here to know more of the proposed amendment. The consequence of the subordinated tranche being treated as equity is two-fold -payments are not allowed to be tax deductible as interest; and there might be withholding tax consequences too.

The market is already concerned –read a news on our news board.

What is the essential distinction between equity and debt for tax purposes? As per elementary tax rules, payments on account of equity cannot be tax deductible. It is true that many securitisation structures are so devised that the subordinated tranche serves the purpose of equity for the rest of the structure, and yet it is made to look like a debt instrument. In such cases, will the tax officer treat it as a debt? Or equity?

There have been several tax rulings World-over on this issue. One of the oft-cited rulings is that of the US Court of Appeals (Fifth Circuit) in Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972). In this case, 13 non-exclusive factors were considered for determining whether a source of funding was debt or equity. These are:

1) the name given to the certificate evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments, i.e., whether the recipient of the funds can repay the advance with reasonably anticipated cash-flow or liquid assets; (4) whether the provider of the funds has the right to enforce payment; (5) whether the provider of the advance gains an increased right to participate in management; (6) the status of the contribution in relation to regular creditors; (7) the intent of the parties; (8) whether the recipient of the advance is adequately capitalized; (9) whether there is an identity of interest between the creditor and the shareholder; (10) source of interest payments, i.e., whether the recipient of the funds pays interest from earnings; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the recipient used the advance to buy capital assets; and (13) whether the recipient repaid the funds on the due date.

None of these factors could be decisive, but based on facts, a junior-most layer in a securitisation might be subserving the commercial function of equity. The issue is made more complicated by inserting a further bottom layer by way of residual income notes, which, of course, is treated as equity for tax purposes.

The issue remains interesting, and of course, quite important.

Do you have any views on this matterPlease do write them and we will be very happy to publish them on this site.

Caveat banker: How would revised bank regulatory guidelines affect banks' health?

The US bank regulators recently issued a revised draft of regulatory statement for bank securitizations – see news report on our site. Also click here for an article by Mayer and Brown. The prime thrust of the proposals is to thoroughly re-frame the existing guidelines largely in line with the current thinking of the Bank for International Settlements.

The regulators have proposed to revise, for the third time in a decade, the guidelines under which banks compute the required capital for assets which have been put off the balance sheet. While US accounting standards permit, or rather require, securitized assets to be put off the balance sheet, the regulators have still been treating these assets on-balance-sheet for regulatory capital purposes. The regulatory guidelines distinguished between assets supported by originator recourse (or subordination) and other securitized assets. It is only in the latter case that full regulatory capital relief was available.

The proposed set of guidelines intends to give a homogenous treatment to securitizations with recourse or without, and proposes to weigh the retained assets based on the rating of such assets.

According to the proposals, assets rated AAA or AA will be assigned 20% risk weightage, while assets rated A with 50%, and BBB with 100% risk weighing. Assets below investment grade, that is, below BBB will come for 200% risk weightage.

With some differences on the weightages, the proposals are the same as suggested by the BIS in their June 1999 revised capital adequacy framework.

The new guidelines are expected to have a two-fold impact on the bank CDO market: eliminate much of the malaise associated with imaginary values to retained tranches in securitizations, which are mostly below investment grade. These will require higher capital allocation due to 200% risk weightage and would be therefore costlier for the originating bank, or, for that matter, any one else who buys it.

On the other hand, senior tranches with AAA or AA rating will be favoured by the investors due to a very low capital allocation. What is, however, difficult to predict, is the impact of the guidelines on bankers' tendency to seek regulatory arbitrage by their best assets. The trend has already been noted by several commentators. It is quite likely that the trend towards regulatory arbitrage will only be strengthened by the new guidelines. A bank would obviously find a bevy of takers for AAA rated tranches. It will, therefore, try to parcel out its portfolio of best rated loans, to raise cheaper funds.

In result, it is likely that banks of future are found sitting on the junk assets that could not be securitized.

Do you have anything to contribute about the bank regulatory guidelines? Do feel free to write to me.

If you have any comments on this, post your comments on Discussion Forum – click here.

 Editorial archive

Archived on 1st March, 2000

Tokyo loves securitisation .. and sometimes, securitises love

For several years, Japan remained a dormant market for securitisation. However, the recent spurt of activity in Japanese securitisation market has prompted several dramatic comments. For example, the following story appeared in Financial Times of 15th December:

There's no use denying it. Japan has gone securitisation-mad. In some countries, bonds are just backed by run-of-the-mill things like mortgages and credit card payments. But in Japan they can even be supported by payments on loans to buy outrageously expensive kimonos.

It's hard to borrow from banks, so many Japanese take credit where they can – and where there's lots of debt, someone's often keen to buy it.

Now Daiwa SBM is looking at securitising loans for ordinary household items like bed linen and toiletries. So next time you sleep in a Tokyo bed, beware – an angry bondholder might come to reclaim the sheets.

In a recent securitization summit in Hong Kong, speaker after speaker lamented the slow growth of securitisation in Asia other than Japan, but went gaga about the level of activity in Tokyo. It is also a fact a number of investment bankers have shifted their offices from Hong Kong and Singapore over to Tokyo.

On our news page, we recently carried an estimate that the volume of outstanding securitised instruments in Japan had doubled in 1999 and is expected to double again in year 2000. The issuance in 1999 is estimated at around USD 17.23 billion upto end-Nov 1999. One of the remarkable features of the growth in Japan is that the instruments are being offered not only out of Japan in the USA and Europe, but in Japan itself. This indicates not only the interest of originators, but also investors.

Japan has several advantages that other Asian economies lack. For one, the legal system in Japan was greatly reformed in course of last couple of years to make it understandable to western investors and lawyers. Japanese currency may be volatile, but Japan does not face any of the political risks that other Asian economies have displayed time and again needing external enhancements such as monoline insurance and political risk covers.

Japan's property sector is badly in need or liquidity, and mortgage securitisation may be just the right thing. Several Japanese banks are also looking at securitisation to clean up their balance sheets of non-performing loans. Recent bad loans securitisation by Morgan Stanley (reported on the news page of this site) was successful, and may draw in more originators.

The entire securitisation fraternity is quite bullish about the developments in Japan.

 Archived on 21st Dec., 1999

Some things are going high ..
.. like securitization in Europe

Till last year, securitisation was largely being talked about over Europe, except in UK. This year, in most European markets, securitisation is as much being talked about as done. A recent article in Euromoney (July 1999) remarked: "Of all the growing asset classes in the European capital markets, asset-backed finance has been one of the most hyped."

What is good about the European interest is that the hype is accompanied by lot of action. UK was a traditional strong fort of securitisation – UK has given interesting deals such as Formula One, financing of a pub, and more recently, financing of London Exhibition centre, funding of a soccer club. However, the real action lies in securitisation of bank loans. That is where Italy has taken the real lead – not a week goes without a major loan securitisation by Italian banks. Obviously enough, Italian banks were sitting on piles of non-performing assets, and here is an opportunity to get rid of them.

The heightened interest in European securitization is explained by the advent of euro. This makes it easier for investors to diversify their portfolios outside their own country.

The other major factor is enabling legislation. Till recently, securitization activity in Europe was hamstrung by restrictive laws – either the traditional Roman-Dutch principles came in the way or the bank regulator restriction against securitising any thing other than mortgage receivables. However, recently, most of the significant European markets have removed restrictions, taken steps to put in place permissive laws, and generally give regulatory support. France has enacted a framework for a mortgage funding instrument in June this year. Italian law framed in April this year is already in limelight. The German regulators also removed a number of restrictions on non-mortgage securitization, same in Spain and Switzerland.

Lot of interest is being evinced even in Eastern European markets – transactions have begun to standardize. It is expected that volume for this calendar year may top the last year's volume by at least 50%.

For more on European securitization markets, refer to the country profiles on this page.

Do you know anything specific about European securitization market that you would like to share with the visitors: if so, write to me. Your contribution will be appreciated with gratitude.

  • Archived on 28th Sept., 1999
    Interest rate risk management by securitisation

Securitisation offers some very interesting opportunities for interest rate risk management.

One of the popular instruments in collateralised mortgage obligations (CMO) structures is a floating and inverse floating instrument. These two instruments mutually absorb the risk of interest rate variations. To understand how, let us visualise the crucial issue before the risk manager of any financial firm: how to take care of the interest rate risk if the entity has invested in fixed rate applications. The obvious answer is to go for an interest rate swap. The swap buyer (the financial entity in case) has now passed on the interest rate risk to the swap seller – if rates of interest go up, the swap seller would pay the swap buyer for the rate movements, and vice versa. As for the swap buyer, the rate of return is now a floating rate. If one looks at the swap seller, his rate of return varies inversely with interest rate movements. Any increase in interest rate will bring down his income, as he will have to pay to the buyer. Any downward movement will double his earnings, as he will earn both the swap fees as also the spread on account of reduced interest rates.

The floater and inverse floater structure uses the same concept but instead of involving any swap counterparty, it spreads the interest rate risk between two sections of the investors. Those who buy floating rate notes will have a floating rate of return, and those who buy inverse floaters will have a rate of interest that varies inversely to interest rate movements. For example, if the mortgages originated by the originator pay 10% interest which, net of fees, etc., say, pays 8% return to the investors. Let us assume that this rate to start with is the same for floaters and inverse floaters. Now if the reference rate of interest goes up by 1%, the floaters will get 9% return, and the inverse floaters will get 7% return. If the rate of interest goes down by 1%, the floaters will earn 7% but the inverse floaters will earn 9%.

As one would appreciate, this structure has put the inverse floater investors in the position of an interest swap seller. And this could be an excellent hedging instrument for investors following different strategies. So, an institutional investor who has built up a stock of floating rate investments may like to hedge by buying an amount of inverse floaters that would even out the ups and downs in returns from the floating class.

Securitised instruments offer tremendous hedging opportunities to investment managers.

 Added on 2nd August, 1999:

Be careful in future flows securitisation

Lately, a lot of interest is being evinced in future flows securitisation. The first future flows securitisation was the 1987 issue of telecom receivables-backed bonds from Mexico, and since then, there have been a lot of such issuance particularly from emerging markets. The essential idea these issues, normally involving overseas receivables, is to strip the issue of the sovereign rating and the exchange control risk otherwise attached to the issue, by providing to the investors a claim on income being generated outside the country of origin, normally receivable in foreign currency.

While every securitisation involves pooling of an interest in future cash flows, the typical feature of a future flow securitisation is that there is no existing claim or receivable against identifiable obligors which is capable of a legal transfer. This brings two issues: one, that a future flow securitisation cannot be altogethe free of the originator-risk, and two, that since the receivable being assiged by the originator does not exist as of date, what does not exist cannot be transferred, and so, a future flow securitisation always remains a promissory transfer of receivables.

Legal limitations on assignability of future debt would be a very serious issue in future flows securitisation. A debt that exists, either payable today or in future, can be assigned. Where the debt does not exist, but the source that would give rise to the debt is also a property, and can be assigned. Where neither the source nor the debt exist, there is no assignment; hence, the only legal right of the investor is to enforce a promise on the part of the assignor to assign the debt, as and when it arises.

Legal issues apart, future flows securitisation might easily be nothing but a risk on the originator, no better than a secured loan risk. If the idea is to merely secure a loan by a specific claim on particular receivables, it would be better to document the transaction as a secured loan, rather than as an assignment of non-existing, unforeseen, receivables.

An enthusiast may suggest that anything and everything can be securitised: it is important to ensure that the wonderful idea of securitisation is not pushed to an absurd extent.

  • Added on 31st May, 1999:

The Himalayan success that was Securitisation workshop in Mumbai

With 71 participants representing the top of the country's financial firms, the recent securitisation workshop in Mumbai, India was a tremendous success. It was not a dumb crowd of the curious – it was a unique, rare event where every single word that the speaker spoke or wrote on the screen was watched and debated upon. And, with a crucial cricket match clashing, it was so overwhelming to see about 50 odd people still in the hall till 6.30 pm on the second day.

The workshop was symbolic of the immense interest securitisation activity in India had picked up. At the same time, the fact that the market was only tending towards maturity was abundantly clear as there were a number of gray areas. Practices were still far from precept.

All the 4 guest speakers, Rajesh Mokashi from CARE, Venu Parameshwaran from Citibank, Conrad D'Souza from HDFC and Cyril Shroff from Amarchand Mangaldass and Co. were at their erudite best.

Some of the crucial issues that emerged are as follows:

  • In a maturing market, securitisation may not, for some time, achieve its basic intent, viz., reducing funding costs. The market demands a premium for a product that is new and therefore perceived risky.
  • Accounting rules are flagrantly being violated by Indian players – absence of a stand by the ICAI is helping players write securitised assets off the balance-sheet, while most such deals retain risks with the originator.

High time the RBI wrote a proper code on securitisation.