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Asset-Backed Securities (ABS) Class Outline

Asset-Backed Securities (ABS) Class Outline. What is Securitization? Why Securitize? The SPV and Investors’ Risk Basel Capital Rules for ABS Risk Cross-Border ABS: Investors’ Risks, Banks’ Bad Loans The Role of Government in Developing ABS Markets. Securitization.

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Asset-Backed Securities (ABS) Class Outline

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  1. Asset-Backed Securities (ABS)Class Outline • What is Securitization? • Why Securitize? • The SPV and Investors’ Risk • Basel Capital Rules for ABS Risk • Cross-Border ABS: Investors’ Risks, Banks’ Bad Loans • The Role of Government in Developing ABS Markets

  2. Securitization • Pools smaller non-tradable loans to reach a scale that can tap securities markets for funding. • Types: • Mortgage-Backed: loans secured by real property • Asset-Backed: other loans Why treat them differently?

  3. An Example of ABS Step 1. Company A owns receivables (e.g., it made many loans to consumers buying its goods). Its balance sheet: Assets Liabilities Co. A: 100 Receivables 100 Loans from banks Step 2. Company A sells receivables to Special Purpose Vehicle (SPV) and SPV pays Company A for them Co. A: 100 Deposit with bank 100 Loans from banks SPV: 100 Receivables 100 Commercial paper or bonds Company A still collects the loan payments, but passes them to SPV, which owns them now and uses the cash flow from the receivables to service the securities it issued to buy them. Why would Company A do this?

  4. Overview of a Securitization:BHP Players and Financial Flows SECURITIZATION COMPANY (SPV) ISSUER (SPV) UNDER-WRITERS R-M SECUR-ITIZATION LTD. RHEIN MAIN NO. 4 LTD DEUTSCHE BANK, LEHMAN ORIGINATOR BHP AUS-TRALIA GERMAN, MID-EAST DEUTSCHE BANK INVESTORS BHP EM-PLOYEES ARRANGER, MANAGER, AGENT, FX COUNTERPARTY LIQUIDITY* AND CREDIT ENHANCER *Other banks enhance liquidity too DEBTORS

  5. The Role of the SPV • The purpose of the SPV is to: • 1. Take ownership of the assets (the receivables) • True sale • Bankruptcy remote • 2. Issue and service the securities

  6. Types of SPVs Three types: 1. Pass through. SPV sells investors a share or participation representing an undivided pro-rata interest in the pooled assets and a right to a pro-rata share of cash flows. This is like equity. 2. Pay through. SPV sells investors securities that reconfigure the cash flows from the assets, often creating two or more classes of securities (e.g., one for principal, one for interest). 3. Collateralized debt. Originator/issuer sells investors debt giving the right to receive a stated interest and principal, independent of the assets’ cash flow but generated by it and secured by the assets, which stay on the originator’s books. Why would an investor prefer one type over another?

  7. The Two-Tier SPV SECURITIZATION CO. (SPV TIER 1) ISSUER (SPV TIER 2) PAY INT., PRINC.ON C.P.. TRANSFER PRINCIPAL FEES R-M SECUR-ITIZATION LTD. Tier 2 RHEIN MAIN NO. 4 LTD ORIGI-NATOR BHP AUS-TRALIA No.1 No. n SERVICE C.P. PAY PRINCIPAL ON BHP LOANS No.2 No.5 No. 3 GERMAN, MID-EAST BHP EM-PLOYEES INVESTORS Why have a two-tier SPV? DEBTORS

  8. Risk for Banks in ABS Markets:Proposed Basel Capital Adequacy Rules • 1. Banks play many roles in ABS: originate assets, sponsor SPV and deals, enhance credit, give liquidity facility, FX swaps, underwrite securities • 2. Basel proposes two approaches for capital: • a. Standardized: apply risk weights using external ratings • (we will discuss this) • b. Internal ratings based (IRB): only sketched in the proposal • 3. Special rules apply to originators selling assets, enhancing credit, giving liquidity facilities or other help, and investors • a. Operating rules (e.g., a true sale) • b. Special capital rules

  9. Standardized Approach: Operating Rules for Originating Banks Selling Their Assets • Regulators’ concern: Is there a true sale? • Standard Approach: get opinion of lawyer that break is clean – • 1. Assets are beyond reach of transferor and its creditors • 2. SPV can pledge or exchange the assets without direct or indirect control of the transferor • Without this, the assets remain those of the bank. • Bank can enhance credit (to reduce default risk) or give liquidity facility (to smooth flow of funds) Why does a bank originator’s credit enhancement and liquidity facility not undermine the true sale?

  10. Standardized Approach: Operating Rules for Originating Banks Supporting Their Own ABS • Basel imposes operating rules on originating banks that give: • Credit enhancement: reduce risk to investors • Can only give at start of the scheme • Liquidity facilities: ensure uninterrupted flow of payments • Cannot vary from original contract terms; must be very low credit risk and reimbursed with priority over payments due to investors and for credit enhancement (generally) • How easy are these services to distinguish? • Why limit them this way?

  11. Standardized Approach: Capital for Originating Banks Supporting Their Own ABS Capital forOriginating bank must 1. Enhancing credit: Deduct full amount from capital 2. Liquidity facility: Convert at 20% notional amount of the facility, then use a 100% risk weight • Why deduct the credit enhancement from capital? • A liquidity facility now has a 0% conversion factor to the credit equivalent. Why not leave it as it is, for the originating bank?

  12. Standardized Approach: Capital Rules for Banks Investing in ABS • Risk weights by external credit ratings: • 20% AAA to AA- • 50% A+ to A- • 100% BBB+ to BBB- and junior tranche generally • 150% BB+ to BB- • Deduct from B+ and below, and unrated junior tranche held • capital by originator (like credit enhancement) • Look to under- Senior unrated tranche with risk of asset, not of • lying risk weight issuer Why not look through to the underlying risk weights in all cases? Junior tranches: why treat the originator differently?

  13. Cross-Border ABS: Investors’ Risks • Risks associated with cross-border finance generally: • FX risk: use swaps • Country risk: use credit enhancement • Risks peculiar to ABS: The true sale, bankruptcy remote • 1. Applicable law: of the receivable, originator, contract, other? • 2. To establish the sale of intangibles against 3rd parties: Give notice of the assignment (usually by filing) • 3. Future assets: the receivable does not exist when the interest is transferred to the SPV Would #2 or 3 ever be serious problems for cross-border ABS?

  14. Cross-Border ABS: Investors’ Risks • Risks associated with cross-border finance generally: • FX risk: use swaps • Country risk: use credit enhancement • Risks peculiar to ABS: The true sale, bankruptcy remote • 1. Applicable law: of the receivable, originator, contract, other? • 2. To establish the sale of intangibles against 3rd parties: Give notice of the assignment (usually by filing) • 3. Future assets: the receivable does not exist when the interest is transferred to the SPV Would #2 or 3 ever be serious problems for cross-border ABS?

  15. Cross-Border ABS: Banks’ Problem Loans • Banks have serious non-performing loans in many countries of Asia. • Privately owned banks that are parts of financial groups • Japan, Korea, Thailand • State-owned banks dominate: • India How well could international ABS markets help banks in Asia get their problem loans off their books?

  16. The Role of Government in Developing the ABS Market in a Country • Many countries have sought to develop their ABS markets in the last decade or less. • Industrial countries: Europe, Japan • Emerging markets: many helped by multilateral agencies like the International Finance Corporation (IFC) Why would a country want to promote the development of an ABS market? Are there any risks?

  17. ABS Markets Around the World .

  18. Government Role inDeveloping ABS Markets: The Legal Infrastructure • Two countries changed their laws to promote ABS markets: • 1. Germany’s 1997 policy change: Regulator and law define (and protect from bankruptcy) true sale, solve secrecy problems, limit originator’s role, let banks package OECD sovereign loans. • Still unclear: 3rd party loan collection by non-lawyers • 2. Japan: 1998 SPV law, register to notify 3rd parties of assignment, law for non-bank ABS issuers • Still unclear: obligor’s set-off rights, notice to obligor, collection by 3rd party non-lawyers Will this legal change bring ABS markets in Germany and Japan to equal the U.S. market in importance?

  19. Developing ABS Markets: The Legal Infrastructure inEmerging Markets • India wants to develop an ABS market, but law is weak: • Investor base: pass through not a security; weak disclosure; • financial firms lack power to invest in ABS • Regulation: true sale not defined; SPVs treated as NBFIs • Legal system: no securitization law; high fees, stamp tax; • can’t assign partial or future asset; • corporate SPV easily put into bankruptcy; • secrecy laws prevent disclosure (SOE); • weak laws for security interests; • enforcement very slow. What legal changes should India concentrate on?

  20. Direct Government Role Developing ABS Markets • Many countries change their laws to promote ABS markets: • Germany and Japan are two examples • Many others say that they want to promote the markets. • More than legal change is needed. How direct a role should the government play in any country, including the U.S.?

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