Securitization in Financial Markets Development: An Emerging Market Perspective

1. Securitization in Financial Markets Development: An Emerging Market Perspective Dr. JAY SA-AADU Chester A. Phillips Professor of Finance and Real Estate University of Iowa, U.S.A

2. African Capital Markets: The Next Investment Frontier • Our Financial Field of Dreams • Develop new Financial Instruments • Develop deeper, more liquid , sounder and more resilient capital markets • Raise capital more efficiently • Remember the following two principles • Capital has no Conscience, and it is very more mobile • Prosperity Makes Friends, adversity tries

3. Focus of My Talk • Winds of Positive Change in Emerging Markets • The Financial Innovation of Structured Finance and Securitization • Origin of the Sub-prime Mortgage (SPM) Debacle • Lessons from SPM Related Securitization • Using Securitization to Develop and Deepen Domestic Bond Markets • Necessary Infrastructure Conditions • Areas of Focus and Potential benefits of Securitization for African Capital Markets

4. Winds of Challenge: Perfect Alignment of Capital Market “gods” • Capital Markets are springing up across the continent • Spreads on emerging market bond index at historically low points • Emerging market bonds constitute an important asset class • International Investors starting to purchase local currency bonds • African sovereign bond issues on the go • Critical vote of confidence in future financial and economic stability

5. Appropriate Steps Taken to consolidate & enhance gains • Enhanced macroeconomic performance • Better Monetary and Budget Policies • Currency stabilization and redenomination • Taming Inflation • Building Legal, accounting, regulatory infrastructures to facilitate entry and exit all investors • But much more needed to be done to reach potential • Outstanding emerging bond market only 40% of GDP, compared to 140% for matured markets

6. The Innovation in Securitization: Don’t be Thirsty in the Middle of the River • What is Structured Finance ? • What is Asset Backed Securitization ? • Leveraging on good assets • Raise Capital at better terms • Manage Balance sheet • Risk Diversification • Transparency • Cash flows based solely on credit quality of underlying asset • Credit Enhancement • Transfer asset risk to those best able to shoulder them • The global outstanding ABS now in excess of US $10 trillion

7. Exhibit 1: The Basic structure of ABS The Separation of Two Business: Origination and Funding Sponsoring Company Asset securitization makes sense when the assets are worth more outside the company than within. But what makes them worth more? • Assets Servicing agreement Sale or assignment Special Purpose Vehicle Issues Asset Backed Certificates • Assets

8. Exhibit 2: Overview of Credit Risk Transfer (CRT) Instruments Risk Transfer Instruments Our focus Traditional Products Capital Market Products** Credit Insurance Syndicated Loans Financial Guarantee Securitization Credit Derivatives Other Instruments Asset Backed Securities (ABS) Mortgage-Backed Securities (MBS) Collateralized Debt Obligations (CDO) Credit Default Swaps (CDS) Total Return Swaps Credit Spread Options Loan Sales Bond Trading Asset Swaps Collateralized Loan Obligations (CLO) Collateralized Bond Obligation (CBO) Hybrid Products “Synthetication” “Pool of Pools- Hybrids” Credit-linked Notes (CLN) Synthetic CDOs CDOs of CDOs CDOs of ABSs

9. The Technology has Evolved Through Several Stages Exhibit 3:Stages and Innovations Structured Finance (Securitization) Extensive use of Credit Derivatives Credit Risk transfer (CDS) Without Asset transfer Synthetic CDO Securitization 4th Stage Multiple Class Tradable Derivative Securities Tranching & Subordination Of Cash flows 3rd Stage Innovation What is the Innovation? Conventional CDO Multiple Class of Tradable Derivative Securities (Structured Claims) Structured ABS with Tranching 2nd Stage Innovation What is the innovation? Single Class Tradable Derivative Security 1ST Stage Innovation What is the innovation? Basic Structured Finance (ABS) Primitive Assets/Receivables Illiquid Assets (Primitive Asset) Mortgages, consumer credit (auto loans, credit card), equipment leases commercial loans, student loans, aircraft lease, royalties, future flows, etc

10. Exhibit 4: Structural Characteristics of ABS Transaction 1ST Step: Sales of Assets to SPV 2nD Step: Issuance of Securities on the market Sale of Asset Portfolio Placement Placement Originator (Asset Seller) Special Purpose Vehicle (SPV) Investment Banks Capital Market Investors Purchase Price Purchase Price Asset Cash Flows Purchase Price Purchase Price Placement Credit Enhancement, Liquidity Support Obligors Cash Flow Rating Agency • Debt Account • Collection of • Principal & Interest Servicer Cash Flow • Trustee • Paying office • Administration of • transferred assets • Issued Securities • Single • Multiple • Equity (unrated) Other Key participants Typically Provided by originator

11. Exhibit 5: Economic Risk Transfer to Capital Markets and Economic Capital Reduction Expected Loss Unexpected Loss Default Loss Covered by earned risk premium and loan loss provision Before Securitization Covered by economic capital Retained risk exposure (First Loss Protection) After Securitization transferred risk exposure

12. Origins of Subprime Mortgage Debacle: “Exuberant” Search for High Yields • What are Subprime Mortgages? • Convergence of many factors -- 1997-2005 • Global Liquidity • Low Interest Rates • High Yield Securities -- MBS and CDO • Investment Banks • Growth and Stability • Subprime Mortgage Credit • Asset Price Bubble • Credit squeeze • Bubble started to burst after 2Q 2006 • The Rest is History • Question: Do you think SPM are bad and should be banned?

13. Some Lessons from SPM Related Securitization • Lesson #1: Real Business operations that create the assets and their credit quality are fundamental to financial and investment success of securitization • Lesson #2: The complexity of some securitization structures may conceal the real risk of the new securities • Lesson #3: Securitization may be susceptible to principal-agent problem • Lesson #4: The value chain may only be as strong as its weakest link – systemic dependence or diffused responsibility • Lesson #5: The prospect of the contagion – ability to provide liquidity support may diminish

14. Some More Lessons • Lesson #6: Rating and Rating Agencies matter a lot for the well-functioning of markets for financial assets, especially, asset backed securities (ABS) • Lesson #7: Back to Basic– Cash Flows come real business operation or LHS, not RHS of the balance sheet • These are important lessons, BUT • Do not exaggerate or overreact

15. Mr. Chicken Little, Is the Sky of Securitization Falling? • NO! Stay Calm, the Sky is Not Falling • The genie of financial innovation is already out of the bottle, and is a good genie -- WHY? • Securitization has created dynamic & beneficial relations between individual and business borrowers on one side, and the vast global capital markets that were previously non existent • It has broadened access to credit for individuals and businesses at reasonable terms

16. How Does Securitization Create Value? • Securitization creates value by rearranging the balance sheet to mitigate one or more markets imperfections • Information asymmetries • Incomplete Markets • Economic capital • Regulatory Capital • Taxes • Translation: Capital Structure may not be irrelevant!

17. The Economics of Asset Securitization “The Chicken Theory” $6.99 Whole chicken is worth $6.99 Incomplete market Can you make money by cutting up the chicken? Where did Colonel Saunders get his idea from?

18. The Economics of Asset Securitization: “The Chicken Theory” $2.95 $1.40 $1.98 $1.25 Cut and enhanced chicken $7.58 Whole Chicken 6.99 Economic Value Added $0.59 How? “Go ask the Colonel for his secret recipe or you can homebrew your Own”

19. Should African Capital Markets “Enter the Kingdom of Securitization”? • Emerging Economies of Africa should consider wading in the waters of the innovation of structured finance and securitization -- gradually • Several emerging markets have already embraced the technology • Credit default swap (CDS) now constitute about 20% of face value of emerging market debt • The World Food Program has sold futures on Ethiopian, rains – Now that is EXOTIC • Argentine GDP-linked bonds • Securitization may very well be a form of financial inoculation for African Capital Markets

20. What Should be the Priority Objective? • Development of more inclusive and flexible debt market, characterized by efficient risk transfer , sound risk management , lower cost of capital, with all the necessary shock absorbers • Complete Markets • Well-functioning capital markets will make crucial contribution to growth and stability

21. The Necessary Conditions • Uphold and protect the sanctity of property rights • Improve the legal environment to foster the use of financial innovation • Strong standard for investor protection • Protection and enforcement of creditor rights • Prudent (not excessive) regulation and supervision, by central banks an other regulatory bodies • Subscribe to the maintenance of stable macroeconomic framework -- value proposition

22. The Necessary Conditions • Overall improvement of financial infrastructure • Improve financial architecture • Appropriate governance and transparency • Clear and transparent bankruptcy code • Appropriate yield curves across all maturity spectrum • Effective underwriting and hard-nosed auditing of assets -- Where are the rating agencies? • Most of all financial transparency and honesty

23. What Do African Capital Markets Get for This Tall Order? -- The Benefits • Inclusive and Flexible Capital Markets • Securitization of Future Flows to accelerate economic growth • Access to capital markets for SMEs • Long Term Financing for Housing and Infrastructure • Transparency in risk pricing, mitigation and transfer • Capital Markets Integration • Lower cost of capital • Broader access to capital markets • More efficient capital utilization

24. Concluding Remarks • I WOULD LIKE TO READ THIS