Innovations in Corporate Finance

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Innovations in Corporate Finance
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Innovations in Corporate Finance
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Securitizing future cash flow

• This is the purpose of standard bonds. However,
  they draw upon the general cashflows of a
  company.
• Project financing channels pre-specified subsets
  of a companys cashflows to bondholders.
• More specialized projects like rock-n-roll
  bonds.

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Rock-n-Roll bonds

• David Bowie, issued February 1997, raised 55 m.
  by selling securities.
• Backed solely by expected royalites from future
  sales of his first 25 albums.
• 7.9 coupon, 15 yr maturity, 10 yr. av. maturity.
• Investment banker on the deal was David Pullman
  at Gruntal Co.
• Prudential Insurance Co. is purchaser.
• Bonds guaranteed by EMI Group Plc.

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Rock-n-Roll bonds

• Ethan Penner, in Sept. 1997, set up Nomura
  Capital Entertainment Finance to be sole investor
  in making 1 billion in loans to musicians,
  actors and studio executives.
• Bear Stearns is interested in securitizing the
  expected cash flows of existing and
  soon-to-be-released films.
• Target Insurance companies looking for
  diversification.

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Problems/Questions

• What is the purpose of the loan for the issuer?
• Consumption
• Diversification
• Artists might want to repurchase artistic works
  that they were forced to sell earlier in their
  careers.
• To buy other artists intellectual properties.
• Tax reasons
• What about the issue of Moral hazard?

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Valuation of Rock-n-Roll Bonds

• Actuarial approach is not possible.
  One-of-a-kind.
• The riskiness of cashflows from the asset itself
  as opposed to the issuer (e.g. if Citibank
  securitizes its credit card receivables)
• Collection of cashflows (from the entertainment
  industry) will have to be more scientific and
  specialized.
• How to evaluate cashflows that are projected to
  grow, rather than depreciate? (Lengthens the
  life of the asset.)

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Rock-n-Roll Bonds

• Possible solutions
• Diversification of trust issuing the security.
  This is the Penner strategy.
• Securitize cashflows from known artists and/or
  known works with a history.
• Credit Enhancement

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Corporate Bonds which Securitize Insurance Risks

• Catastrophe or Act-of-God Bonds
• Weather Bonds

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Issues

• Insurance companies can go bankrupt traditional
  insurance requires a very large amount of
  capital.
• Insurance companies are locked into the deal for
  a long time. Investors in capital markets are
  more willing to hold these risks, because they
  can sell them off.

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Catastrophe Bonds

• Oriental Land Company placed two 100 million
  catastrophe bonds with special purpose reinsurers
  to protect against earthquakes.
• First bond has a five-year maturity. Payment
  depends upon magnitude, location and depth of
  earthquake, regardless of actual property damage.
  (Why? Auditing problems?)
• Second provides post-earthquake financing
  Oriental Land will ussue a 100 million 5-yr bond
  to the reinsurer with no interest for the first
  three years. (Put like?)

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Weather Bonds

• In Oct. 1999, Koch Ind., of Wichita and Enron
  Corp, of Houston issued 200 m. of weather bonds.
• The interest on the Koch bonds depends on the
  weather in the 19 cities in which Koch operates.
• If temperatures are similar to historical levels,
  the coupon is 10.5.
• If temps are colder (warmer) by ¼ degree on
  average, the coupon is 10 (11).
• Kochs objective Hedging
• Value for investors Diversification

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Alternatives to Securitization of Insurance Risks

• Catastrophe Insurance
• Catastrophe Derivatives
• Pros and Cons
• Information Costs versus Basis Risk

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Securitization

• The repackaging of receivables in a tradable
  form.
• SEC definition "the creation of securities that
  are primarily serviced by the cashflows of a
  discrete pool of receivables or other assets,
  either fixed or revolving, that by their terms
  convert into cash within a finite time period
  plus any rights or other assets designed to
  assure the servicing or timely distribution of
  proceeds to the security holder

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Securitization Purposes

• The goal is to sever the risk of originator
  insolvency from the risk of asset performance
  the investor can rely on asset risk rather than
  the general corporate credit of the originator.
• Increase the clientele for the companys
  liabilities and thus decrease the cost of
  financing.

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Earliest examplesThe market for home mortgages

• Banks provided loans for the purchase of homes.
• Government agencies, such as the Government
  National Mortgage Association (GNMA), and the
  FHLMC (Freddie Mac) and private corporations,
  such as the Federal National Mortgage Association
  (FNMA) were charged with providing broader and
  more stable sources of capital to the residential
  mortgage market.

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Mortgage Backed Securities

• These agencies started securitizing mortgages by
  purchasing home mortgage loans from local lenders
  and guaranteeing securities backed by pools of
  residential mortgages.
• Result
• Volume of funds available for housing expanded.
• Redistribution of mortgage funds from
  capital-surplus to capital-deficit regions.

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An example GNMA pass-throughs

• GNMA pass-throughs were issued by mortgage
  bankers and were backed by pools of newly issued
  FHA/VA single-family mortgages (i.e. loans
  guaranteed by the Farmers Home Administration or
  the Veterans Administration).
• GNMA guaranteed the timely payment of scheduled
  monthly principal and interest.
• These guarantees represent full faith and credit
  obligations of the US Government.

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Structure of a GNMA Pass-through
Homeowners
Scheduled Principal (Amortization)
Interest
Prepayments
Servicing Fee/ Guarantee Fee
Originator/Servicer
Delinquencies
Defaults
Investors
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Credit Enhancements

• The purpose is to improve the quality of the
  asset
• External Enhancements
• Corporate Guarantee
• Letter of Credit
• Pool Insurance
• Bond Insurance

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Credit Enhancements

• Internal Credit Enhancements
• Reserve Funds
• Cash Reserves
• Excess Servicing Spread Accounts
• Overcollateralization
• Establishing a pool of assets with principal ?
  principal amount of the securities issued.
• Senior/Subordinated Structure
• The subordinated class absorbs all losses on the
  underlying collateral, protecting the senior
  class.
• A Shifting Interest Structure redirects
  prepayments disproportionately from the
  subordinated class to the senior class according
  to a pre-specified schedule.

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Collateralized Mortgage Obligations

• CMOs are bond classes (tranches) created by
  redirecting the cash flows of mortgage-related
  products so as to mitigate prepayment risk.
• Sequential Pay tranches Principal payments are
  directed to the seniormost tranche until it is
  paid off, then to the next senior tranche, etc.
• Accrual bond/tranche The interest for this
  tranche accrues until more senior tranches are
  paid off.

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Automobile ABS

• Traditional Auto ABSs price up to 10 bp wider
  than credit card ABSs because auto deals have
  amortizing tranches that depend on prepayments.
• In Aug. 99, GMAC securitized a pool of amortizing
  auto loans and created bullet maturity structures
  by having all the amortization that occurs
  between bullet payments get absorbed by a
  variable funding certificate.
• This structure matches corporate bonds and makes
  it easier to construct swaps.

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Sport Securitization

• Formula One, the British company that manages the
  international car-racing championship has issued
  1.4 b. in bonds securitized by all assets of
  Formula Ones business, including its TV and
  promotional contracts.
• Shows that intangible assets and intellectual
  property rights can be the basis for
  securitization.

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Standard Lease vs. Purchase
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Synthetic Leases
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Synthetic Lease

• Company can use the depreciation on the asset.
• The lease and the asset do not show up on the
  balance-sheet of the company the lease structure
  allows classification as operating lease.
• The company obtains operating control of the
  asset, unlike in a traditional operating lease.
• Payments to investors can be structured to
  resemble a bullet loan.
• The lenders do not have to bear all the risk of
  the assets end-value, as in a bullet loan,
  because of the final guaranteed payment.

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Catastrophe Bond w/ Synthetic Put

• USAA, in 1998, wanted to cede 400m. of insurance
  risk. It sold a structured note split into two
  classes.
• Tranche A2 of 313m., paying LIBOR5.76 is fully
  at risk if insurance losses go above 1b.
• Tranche A1 of 163m., paying LIBOR 2.73, has
  its principal protected (a portion of the tranche
  is placed in escrow to be paid to A1 investors).
• In effect, USAA does not have to pay 313m. of
  insurance losses, if total losses go above 1b.
  Equivalently, it can put 313m. worth of
  insurance contingent on total losses going above
  1b.

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Synthetic IPO

• Allows issuers to sell shares, but investors
  purchase bonds.
• Issuer raises non-recourse financing, but holds
  on to a 100 shareholding in company.

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Synthetic IPO
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Synthetic IPO

• SLEC is a holding company that owns Formula One
  (FO) Management that owns the assets.
• FO Finance, a SPV, lends money to FO
  Administration, another SPV, to buy FO Management
  shares from SLEC.
• These funds are raised by a loan issue made by FO
  Finance.
• After the share purchase, FO Administration buys
  assets from FO Mgmt.
• SLEC, which owns the SPVs, gets the money from
  the bond issue, and retains control.

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Synthetic IPO

• Ecclestone, the owner of FO does not want to
  issue an IPO currently because it currently has
  stable earnings, which is not attractive to
  investors.
• Ecclestone believes that in the near future, FO
  will have explosive growth. At that time, he
  will want to issue stock. Since investors
  already know FO, the stock issue will be easier
  then.
• FO does not have to provide the disclosure that a
  standard IPO would require.

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J.P. Morgan ARPPS

• Corporate treasurers have to decide how to invest
  short-term funds.
• Preferred Stock is attractive because of the tax
  preference on dividends received. 70 of
  intercorporate dividends are deductible for tax
  purposes.

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Disadvantages for Investing Corporations

• Issues for the Corporate Treasurer
• Safety
• Short-term liquidity

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Floating versus Fixed rate securities

• Fixed Rate securities are riskier for investors
  with a short-term horizon.
• Floating rate securities are less desirable for
  issuers because of
• refinancing risk
• Cost of refinancing

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Compromise ARPPS

• Long-lived security with a floating rate reduce
  refinancing costs.
• Limits on coupon payments reduce refinancing
  risk for issuer.
• Offsetting characteristic The benchmark rate is
  the max of three rates
• T-bill rate
• The 10-year constant maturity rate
• The 20-year constant maturity rate

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Investor Risk

• Reduced risk protection due to collar.
• The floating rate structure reduces price risk.
• The benchmarking of the coupon to the max of
  three rates makes the security more desirable.
• The 4.875 penalty is the premium for the option
  implied by the benchmarking criterion.

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Investor Risk

• Investor not protected against non-parallel term
  structure changes
• If the yield-curve flattens, the investor would
  be getting less value for the 4.875 implied
  option premium.
• If interest rates become less volatile, the fixed
  4.875 option premium would become too high.

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Alternatives to ARPPS

• CAPS Convertible Adjustable Preferred Stock
• These securities were convertible at any time
  into as many common shares as it took to obtain a
  market value equal to the CAPS par value.
• This was supposed to reduce fluctuations in their
  market value, which was a problem with the ARPPS.
• What is the advantage of making the CAPS
  convertible into stock? Why not make it
  puttable?
• Would there be any reason for CAPS not to trade
  at par?

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Alternatives to ARPPS

• PARPS Price Adjusted Rate Preferred Stocks
• The dividend on the PARP stock was inversely
  proportional to the observed trading price of the
  security in a specified two-week period.
• In other words, the sum of the capital gain and
  the cash payout was to be kept as stable as
  possible.
• Can you think of any problems with the price
  stability of PARPS?

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Alternatives to ARPPS

• MMP Money Market Preferred Stocks
• Every 49 days, the yield on the MMP security
  would be reset through a Dutch Auction.
• All winners of the auction would receive the same
  dividend rate in the future 49-day period, equal
  to the highest bid (dividend rate) that cleared
  the market.
• In theory, this would clear the market at a price
  equal to par (since the winning bidder would be
  willing to pay par by definition).
• DARTs was the name given to comparable securities
  issued by Salomon Brothers.

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Alternatives to ARPPS

• Municipalities issued similarly structured debt
  instruments that were also designed to maintain
  their value.
• Since these were munis, they were free of federal
  tax liability.
• At the same time, the municipalities did not need
  the equity classification of the Floating Rate
  Adjustable equity securities discussed above.

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Trust Preferreds

• A recent alternative to ARPPS?
• Similar to ARPPS, these securities are also
  structured to be carry tax advantages to
  investors and desirable balance sheet/tax
  characteristics to issuers.
• Riggs National Corp. of Washington, sold 200
  million of floating-rate trust- preferred
  securities in July 1999.
• The issue has been rated on the borderline
  between investment grade and non-investment grade
  by Moody's Investors Service and Standard
  Poor's Inc.

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Structure of a Trust Preferred
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Trust Preferreds

• Also used as a way to manage reporting
  requirements because they are not treated as debt
  for reporting purposes.
• For financial reporting purposes, the loan from
  the subsidiary to the parent is eliminated,
  leaving only the preferred stock issued to
  outside investors in the balance sheet. This
  need not be shown as debt.
• However, because the trust is structured to
  qualify for tax purposes as a partnership, it
  does not have to be consolidated for tax
  purposes, and the interest paid by the parent is
  tax-deductible.