Financing with Asset-Backed Securities

1. Financing withAsset-Backed Securities SIM/NYU The Job of the CFO Prof. Ian Giddy New York University

2. Asset-Backed Securities • The technique • Legal, tax and accounting issues • The economics • An application • ABS in Asia

3. Securitization of Assets • Securitization is the transformation of an illiquid asset into a security. • For example, a group of consumer loans can be transformed into a publicly-issued debt security. • A security is tradable, and therefore more liquid than the underlying loan or receivables. Securitization of assets can lower risk, add liquidity, and improve economic efficiency.

4. What is the Technique for Creating Asset-Backed Securities? • A lender originates loans, such as to a homeowner or corporation. • The securitization structure is added. The bank or firm sells or assigns certain assets, such as consumer receivables, to a special purpose vehicle. • The structure is legally insulated from management • The SPV issues (usually) high-rated debt.

5. Securitization: The Basic Structure SPONSORING COMPANY ACCOUNTS RECEIVABLE SALE OR SPECIAL ASSIGNMENT PURPOSE VEHICLE ISSUES ACCOUNTS ASSET-BACKED RECEIVABLE CERTIFICATES

6. The Process Key features are: • pooling of a group of similar non-traded financial assets • transfer of those assets to a special-purpose company which issues securities • risk reduction by systematic risk assessment, by diversification, by partial guarantees, etc. • division of the benefits (and risks) among investors on a pro-rata basis • being offered in the form of a security (rather than, for example, as a portfolio of loans or receivables) • on-going servicing of the underlying assets' cash flows through to the asset-backed security investors. IMPLEMENTATION

7. Finance Company Limited

8. Case Study: The Company(Finance Company Limited) • Finance company whose growth is constrained • Has pool of automobile receivables • Has track record • Plans to use this as an ongoing source of financing

9. Key Decisions Securitize the assets Decisions Form of transfer of asset Form of special purpose vehicle Form of credit enhancement Form of cash flow allocation Form of transformation of cash flows

10. Case Study: Initial Exchanges Finance Co.’s Customers Rating Agency Hire-Purchase Agreement Top Rating Servicing Agreement Finance Co. Ltd (Seller) FCL 1997-A (Special Purpose Co.) Investors Proceeds Proceeds Sale of Assets Asset-Backed Securities Trustee Financial Guarantee Provider (if required) Trust Agreement Guarantee Agreement

11. Case Study: Ongoing Payments Finance Co.’s Customers Hire-Purchase Payments Servicing Fees Monthly HP Payments Monthly ABS Payments Finance Co. Ltd (Seller) FCL 1997-A (Special Purpose Co.) Investors Trustee Financial Guarantee Provider Trustee Responsibilities Guarantee Responsibilities

12. Getting a Rating: The Risks • Credit risks • Liquidity risk • Servicer performance risk • Swap counterparty risk • Guarantor risk • Legal risks • Sovereign risk • Interest rate and currency risks • Prepayment risks

13. Risk-Management Techniques in ABS CREDIT ENHANCEMENT SPONSORING COMPANY ACCOUNTS RECEIVABLE SOVEREIGN PROTECTIONS SALE OR SPECIAL ASSIGNMENT PURPOSE VEHICLE INTEREST RATE/ CURRENCY HEDGES ISSUES ACCOUNTS ASSET-BACKED RECEIVABLE CERTIFICATES CASH FLOW REALLOCATION

14. Rating Agency Credit Enhancement:An Alternative Approach Top Rating Senior Lower Rating Subordinated Finance Co. Ltd (Seller) FCL 1997-A (Special Purpose Co.) Proceeds Sale of Assets No Rating More Subordinated

15. Choose a Structure to Suit the Type of Assets to be Securitized • Mortgage Securitization • Non-Mortgage ABS • Intangibles • Infrastructure and Project Financing

16. Asset-Backed Securities: Legal and Regulatory Aspects • Legal • The Transfer • The Special-Purpose Vehicle • Taxation • Accounting Treatment • Bank Regulatory Treatment

17. Legal Aspects LEGAL • Goal: Credit quality must be solely based on the quality of the assets and the credit enhancement backing the obligation, without any regard to the originator's own creditworthiness • Otherwise, quality of the ABS issue would be dependent on the originator's credit, and the whole rationale of the asset-backed security would be undermined.

18. Three conditions enable the separation of the assets and the originator LEGAL • The transfer must be a true sale, or its legal equivalent. If originator is only pledging the assets to secure a debt, this would be regarded as collaterized financing in which the originator would stay directly indebted to the investor. • The assets must be owned by a special-purpose corporation, whose ownership of the sold assets is likely to survive bankruptcy of the seller. • The special-purpose vehicle that owns the assets must be independent

19. What Makes it a Sale? LEGAL • The form and treatment of the transaction • The nature and extent of the benefits transferred • The irrevocability of the transfer • The level and timing of the purchase price, • Who possesses the documents • Notification when the assets are sold

20. What Makes it Likely to be Consolidated? LEGAL • The difficulty of segregating and ascertaining individual assets and liabilities • The presence or absence of consolidated financial statements • The comingling of assets and business functions • The existence of parent and intercorporate guarantees and loans • The transfer of assets without strict observance of corporate formalities.

21. Taxation Aspects TAX • If the SPV or the transfer is subject to normal corporate, withholding, or individual tax rates, investors or borrowers could in principle be subject to additional or double taxation Must avoid double taxation of • Seller/servicer • Trust or special-purpose corporation • Investors

22. Accounting Treatment ACCOUNTING • Sale versus financing • Consolidation • Accounting for loan servicing

23. FASB Sale Treatment ACCOUNTING • The transferor relinquishes control of the future economic benefits embodied in the assets being transferred • The SPV cannot require the transferor to repurchase the assets except pusuant to certain recourse provisions • The transferor's obligation under any recourse provision are confined and can be reasonably estimated

24. Consolidation Treatment ACCOUNTING • International accounting standards hold that consolidated financial statements are more meaningful than separate ones • "Nonhomogeneous operation" exception • Finance, insurance, real estate and leasing subsidiaries can generally be left apart

25. Fees ACCOUNTING • Loan-origination fees. These are deferred and recognized over the life of the loan as an adjustment of yield. • Commitment fees. These are to be deferred. • Syndication fees. These should be recognized when the syndication is complete unless the originator retains a portion of the syndicated loan.

26. Bank Regulationand Capital Requirements • Goal: Ensure that the substance and not the form of the asset transfer is what governs capital requirements. The regulatory authorities may assess capital or reserve requirements as if the financing was a secured borrowing:

27. Bank Regulation: Issues in Asia • Avoid excessive bank risk-taking • Discourage speculative investments • Prevent financial market scandals • Prevent circumvention of deposit regs • Encourage financing of capital investment • Discourage financing of consumption • Promote development of capital markets

28. Asset Securitization:Cost-Benefit Analysis

29. Separation of Two Businesses: Origination and Lending

30. Separation of Two Businesses: Origination and Lending Asset securitization makes sense when the assets are worth more outside the company than within But what makes them worth more outside?

31. For Banks: Capital Requirements • In a perfect world, adding good assets would require little additional capital, since creditors would not see any increase in the bank's risk • But if regulatory capital requirements penalize banks for holding such assets, they should: • securitize the good assets • profit from origination and servicing • In general, regulatory costs or rigidities create an incentive for banks to shrink their balance sheets by securitizing loans

32. A Bank’s Capital Savings Securitization Cost-Benefit Analysis Gain/cost (for a regulated financial institution) ($ millions) Funding cost savings  Two-year bank notes vs pass- 1.1 though rate Upfront costs  Underwriting (2.6)  SEC filing, legal fees, etc Ongoing costs  Letter-of-credit fee (0.5) Capital charge  Cost of capital at 25% (15% 7.7 after tax) Net benefit 5.7

33. For Corporations: “Pure Play” Argument Separate the credit of the assets from the credit of the originator: • Identify and isolate good assets from a company or financial institution • Use those assets as backing for high-quality securities to appeal to investors. • Such separation makes the quality of the asset-backed security independent of the creditworthiness of the originator.

34. Sears: Asset-Backed Financing? SEARS

35. Why Did Chrysler Use ABS in 1992? • Downgraded to B+ in early 1992 • Lost access to its normal funding sources • Needed to continue to fund its car loans • Only way to do this was to securitize the loans • “Firms that securitize tend to have considerably weaker credit quality than other firms.”

36. Costs Associated with Securitization • Interest cost of the debt • Issuance expenses of the debt • Also: • Credit enchancement and liquidity support for the assets • Structuring fees payable to bankers • Legal, accounting and tax advice fees • Rating agencies' fees • Systems modifications • Management time

37. Costs Needed to Measure the Annual Pre-Tax Impact of Securitization • The interest on the securitized funding • The annual costs of credit enhancement/liquidity lines • Any guarantees to enhance the credit rating of any interest rate or foreign exchange swap counterparty • Amortized front-end fees (debt issuance, credit enhancement, liquidity lines) • Amortized transaction costs (legal, accounting, structuring, rating, etc.) • Opportunity costs relating to any temporary cash retention in any guaranteed investment contract (GIC) • Annual systems/accounting/rating agency costs etc.

38. Sample Cost/Benefit Analysis

39. Corporation or Financial Institution requires additional funds to give customers financing or to finance a future revenue stream. The Decision Process Yes Are funds freely available from banks ? Borrow from banks No No Does the firm/FI have good, self-liquidating assets ? Issue equity or mezzanine capital Yes No Do the assets have a sufficiently high yield to cover servicing and other costs ? Get out of the financing business Yes Would the assets be worth more (have a cheaper all-in funding cost) if they were isolated from the company/FI ? Use assets as collateral for on-balance sheet debt No Yes Securitize the assets

40. Project Financing Asset-Backed Securities Prof. Ian Giddy Stern School of Business New York University

41. Asset-Backed and Project Financing • Collateralized debt • Securitized loans • Non-recourse project debt • Basic question: Why should a company segregate the cash flows from a particular business, and make it self-financing?

42. Project Financing • Stand-alone, non-recourse, multi-stake, "production payment financing" • Structure? • Participants? • Funding sources? • Risks?

43. Project Financing (Summary) • Stand-alone, non-recourse "production payment financing" • Sponsor's vehicle company structures multi-stake finance • Sources: govt development financing, IBRD/IFC, sponsor loans, supplier credits, customer credits, institutional investors, banks, lease financing, equity • Risks: resource quantity, input costs, technical, timing, pre-completion, demand, operating, force majeure, political • Risk sharing and mitigation

44. Project Financing Definition • Lendingto a single purpose entity for the acquisition and /or construction of a revenue-generating asset with limited or no recourse to the sponser • Repaymentof the loan is solely from the revenues generated from operation of the asset owned by the entity • Securityfor the loan • the revenue generating asset • all shares and interests in the entity • real property • all contacts, permits • authorizations, etc.; and, • all other instruments necessary for continuing project operations Steps Project Identification & Resource Allocation Risk Allocation & Project Structuring Bidding & Mandating Contracts Due Diligence & Documentation Execution & Monitoring Construction Monitoring Term Loan Conversion & Ongoing Monitoring

45. Benefits of Project Financing • Limitation of Equity Investment to Project’s Economic Requirement - Enhanced Returns • Risk Sharing and Diversification • Accounting Treatment Preserves Corporate Borrowing Capacity • Access to Long Term Financing • Tax Benefits • Political Risk Mitigation

46. The Risks • Political • Resource & input • Technical • Construction • Legal • Economic • Cost overruns • Completion delays • Mounting interest expenses

47. Eurotunnel: The Risks and the Remedies

48. Sponsors / Shareholders SINGLE PURPOSE PROJECT COMPANY Syndicate Equipment Banks Supplier Feed Stock (e.g., fuel) Supplier Sample Structure Arranging Bank Warranties and Offtake (e.g, power purchase) Agreement Supply Agents Turnkey Contractor Construction Other Project Participants: Currency and Interest Rate Hedge Providers Multilaterals and EDA’s Legal Counsel Technical Consultants Long Term Agreement Purchaser Operator Operations & Maintenance Mgmt

49. Ras Laffan • Who is the issuer? • Ras Laffan LNG Co. Ltd. (Qatar) • But Security Trustee (IBJ) plays unusually major role • What assets does it have? • Natural gas reserves; • LNG take-or-pay Sale and Purchase Agreement with Korea Gas; • Security Trust Agreement; Project Coordination Agreement; loan refund agreement, etc.

50. Ras Laffan • What are the risks, and how are they handled? • Qatar/regional interference • Qatar legal system • Default on Agreements • Completion/timing • Operating • Economic (LNG market)