Global Financial Engineering Institute

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Global Financial Engineering Institute
GFEI
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Islamic Financial Products

• Mudaraba
• Musharaka
• Ijara with diminishing Musharaka
• Murabaha
• Qard
• Wakala
• Takaful
• Istisnaa
• Sukuk

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Transparency in Islamic products?

• Fee based banking, no transparency
• Income provided in the form of gift, an
  inconvenient truth.
• Surely, we can do better
• Tax implication and deductibility as tax shelter.
• WWJD?
• WWMD?

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A to Z of The Securitization in Islamic Countries

• Introduction
• Major Players
• Rating Agencys Function in a Typical
  Securitization
• Credit Enhancement
• External Credit Enhancements
• Internal Credit Enhancements
• Over- collateralization
• Senior/Subordinated Structure
• Dynamics of Underwriting Process
• Requirements for Successful Securitization
• Secondary Market Provider
• Benefits of Securitization
• Cost of Securitization
• Fixed and Variable Costs of Securitization
• Case Study

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Financial Engineering Process

• Characteristics of Assets to Be Securitized
• Structure of the Assets Created in a
  Securitization Process
• Residential Mortgage Backed Islamic Securities
  RMBIS
• Commercial Islamic Mortgage Backed Securities
  CIMBS
• Legal and Structural Issues
• Sale Accounting
• Sales of Loan
• Assignment
• Participation
• Case Study

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Algorithm of Securitization

• Legal Framework
• Macro Economics of Securitization
• Implications
• Construction of Monthly Cash Flow for
  Pass-through Securities
• Multi Class Sequential-Pay Pass-through
• Creating Islamic Floater and Inverse Floater
• Creating Commodity based Accrual Bonds (zero
  coupon)
• Islamic CDs
• Case Study

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Islamic Products

• Ijara Buy and Lease, ownership remains with the
  party who purchased the product.
• Ijara-wa-iktana It is similar to Ijara, except
  the custmer agrees to buy the product at the end
  of lease period.
• Ijara with diminishing Musharaka for home-buying
  purposes, where home owneres equity increases
  over time as payment is made over and above
  preagreed term, and final transfer of tittle to
  the homeowner.
• Mudaraba an investment on behalf of a party by a
  professional . This is an agreement between two
  counterparties where one provides the funds and
  the other who provides the expertise and who
  agree to the division of any profits made in
  advance.  

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Islamic Products

• Murabaha This is a financing arrangement where a
  party usually a bank who purchases the product
  for resale to a counterparty at a margin over the
  price. Installment payment
• Musharaka Partnership, where loss is
  proportional to equity investment.
• Qard Loan free of any profit, to be paid back on
  demand.
• Wakala An agency contract where the creditor
  pays management fee to the bank.

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Islamic products

• Takaful is an Islamic insurance based on the
  principle of Taawun (cooperative assistance of
  many) and Tabarru (voluntary contribution), where
  risk to anyone is shared by individuals.
• Istisnaa is a financing instrument that could be
  used for funding construction projects,
  industrial equipment, and various other heavy
  equipments purchase.
• Contracts in PPP, such as BOT (Build, operate,
  and Transfer) can be categorized as Istisna'a
  transactions.
• Istisna'a has wide applications for the Islamic
  banks to finance the public goods for the greater
  good.

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Example
Treasury Time Warner Texas Utility United Airline Coupon .05625 .0818 .06375 .0631 Yield Maturity .0464 5 .0547 5 .06125 5 .0599 5 Par 125 85 36 69 Price Rate 130.384 -- 98.84 BBB 36.37 BBB 69.93 BBB
Default rate in all 3 bonds is 5 percent with recovery of .48


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Example continued

• Create 2 tranches of floating rate note and
  Inverse floater, with 80/20 allocation from the
  portfolio of 3 corporate bonds rated BBB.
• WAC.0715 WAM 5
• WAC of 2-tranches .07
• Coupon of Floating rate note L 2
• Assume 6-month LIBOR is 3.5 percent.
• Coupon of Inverse floater .27- 4(L)
• Both issues are priced at par initially

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Example continued

• Floater is rated AAA, and has default rate of 1
  percent
• Inverse floater is rated B, and absorbs the first
  loss in the underlying collateral.
• Market value weighted average of default of the
  2-tranches has to be equal that of the
  collateral.
• Tranche floater is less risky, therefore, the
  inverse floater must be more risky, with default
  rate of 21 percent.

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Islamic Financial Instruments

• Islamic CDs
• Preserves purchasing power
• Risk free
• Does not require partnership in the spirit of
  Sukuk
• Provides returns in excess of inflation premium
• It is close cousin to TIPs issued by the U.S.
  Treasury

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Treasury Inflation Protection Bonds
Inflation Indexed Treasury Inflation Indexed Treasury Inflation Indexed Treasury Inflation Indexed Treasury Inflation Indexed Treasury Inflation Indexed Treasury
  COUPON MATURITYDATE CURRENTPRICE/YIELD PRICE/YIELDCHANGE TIME
5-Year 0.625 04/15/2013 97-01 / 1.29 -0-00 / .004 1107
10-Year 1.375 07/15/2018 97-07 / 1.68 0-01 / -.006 1108
20-Year 1.750 01/15/2028 93-08 / 2.18 -0-07 / .015 1108
30-Year 3.375 04/15/2032 123-04 / 2.12 -0-07 / .011 1108
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Sharia Principles

• Over the long run the real return on fixed income
  securities is 2 percent or less, and most of the
  rate of return investors receive is for capital
  preservation and not a real increase in value of
  capital.
• Fiat money has created some problems
  (opportunities) for Muslim scholars. During the
  prophet era financial transactions were conducted
  via gold, silver and commodities. Hence, fiat
  money inflation was not a problem.
• There is a common thread in Islamic trade and
  business transactions that neither party should
  be hurt or penalized (La Darara Wala Derar) due
  to loss of value of fiat money.
• Sharia Law states that if you borrow x Bushels
  you should return x Bushels of the same commodity
  (value-capital preservation), (Al Kailu be Al
  Kail). It never stated that you should pay back
  in dirham (dinar, Reyal, dollar, fiat money).
  

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Challenges and Opportunities

• Are the prevailing property laws in Islamic
  countries conducive for securitization? New Acts
  conducive for securitization need to be enacted.
• Which types of securitization are consistent with
  the existing laws in Islamic countires?
• How to create SPV, to preserve clean break
  criteria as outlined in Basle II Accord and that
  is consistent with the prevailing assignment law
  in the Islamic countries?
• Given high inflation and interest rates in most
  Islamic countries. Can financially engineering
  ABS or MBS attract investors to this type of
  securities in Islamic countries?
• Who will appraise the underlying collateral?
• How the external guarantees are achieved?
• How much over-collateralization is needed to
  insure safety of interest and principal on the
  first generation of MBS?

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Sharia Laws and its implications

• According to Article 14 of the Monetary and
  Banking Law of Iran, the CBI is authorized to set
  RRR within 10 to 30 percent depending on banks
  nature of assets and liabilities composition.
• Banking profit rates - With the implementation of
  Usury-free Banking Law, the profit rate or
  expected rate of return on banking facilities are
  determined by the Money and Credit Council (MCC).
  
• Issuing bonds with fixed interest rate is
  prohibited according to Islamic Sharia however,
  participation certificates and investors
  partnership in economic activities and payment of
  profit is encouraged.
• MCC can intervene in determining rates both for
  investment projects or partnership and for credit
  facilities extended by banks.
• Source http//www.cbi.ir

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• The Sharia encourages the use of profit sharing
  and partnership schemes, and forbids riba
  (interest), maysir (gambling and pure games of
  chance), and gharar (selling something that is
  not owned or that cannot be described in accurate
  detail i.e., in terms of type, size, and amount
  El-Gamal (2000).
• Unlike conventional mutual fund managers, Islamic
  fund managers are not allowed to speculate.
• Source Haddad, Homaifar and Elfakhani (2007)

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• Some Islamic scholars allow partially
  contaminated earning income to be cleansed or
  purified.
• For example, an Islamic Mutual Fund has 8
  percent interest-related income, then 8 percent
  of every dividend payment must be given away to
  purify the fund earnings. Cleansing capital
  gains, however, remains debatable.
• Another form of purification is Zakah. The rate
  of zakah differs with the type of the asset, 2.5
  percent being the rate on most forms of monetary
  wealth and earned income Al-Qaradawi (1999).

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Islamic Certificate of Deposit (ICD)

• Investors have to be compensated
• For the loss of purchasing power
• For the time value of money
• Therefore, in an Islamic setting where interest
  (Reba) is forbidden, conventional CDs can not be
  offered by an Islamic bank.
• Islamic CDs of varying maturities can mitigate
  problems embedded in the conventional CDs.

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Pay off of ICD

• Investors will be compensated investing in the
  ICD in the following two ways
• NP(1G(CPIt /CPIt-1-1)), where CPI is the
  consumer price index at time t and t-1, NP is the
  notional principal invested and G is set to be
  equal .80.
• Max (NPwt (Pt - Pt-1)/Pt-1, 0)
• Where P is the price of a commodity at time t and
  t-1 , i.e., oil price, gold price, stock price.
  and wt is the percentage that is an increasing
  function of time t taking values of up to 100
  percent at the limit.

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Example

• Consider an Islamic investor in SA who invests
  20,000 Dinnar over one year horizon in a 1-year
  ICD. Assume that consumer price index is equal to
  175 at the time of investment and 185.50 after
  one year. Furthermore assume that the SA stock
  index is at 715 at the time of investment and
  786.50 by the end of the year. The pay-off of the
  ISD for our hypothetical investors is as follows
• 20000(1.80(185.5/175-1))D 20,960.00
• 20000.10.10 D 200.00
• Total pay-off D 21,160.00

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Example continued

• Realized return .058
• 80 percent of the loss of purchasing power is
  restored
• 1 percent in the form of appreciation in the
  price of commodity assuming bank passed 10
  percent of the appreciation to the investor in a
  completely riskless transaction.

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2-Year ICD

• Likewise in a 2-year ICD, in the same example
  assuming CPI increased by 4 percent in the second
  year, while stock index retreated to 860 by the
  end of the second year. The pay-off of 2-year ISD
  will be as follows assuming the bank funnels 20
  percent of the increase in the price of the
  commodity to investors.
• Year 1 pay-off D 1260
• D960 for the loss of PP
• D200 for the appreciation of the commodity price
• 2. Year 2 Pay-off D 640 for the loss of PP
• Zero for the decrease in the price of
  commodity
• Plus initial investment of D20,000.
• Total pay of 2-y ICD D21,900.00
• Total return 9.5 percent over 2-year investment
  horizon

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Continued

• Criteria 1 insures that investors purchasing
  power is maintained, consistent with the Islamic
  Sharia (Al-kailabo bel kail),
• Criteria 2 insures that investors pay off is
  either zero or positive in excess of the loss of
  purchasing power.

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Is the firm facing higher funding cost?

• The lender is likely to securitize its loan
  assets when removing assets than when keeping
  them on balance sheet creates more value.
• Firms rated AAA can secure credit in the market
  at a substantially lower cost than their
  counterparts with low ratings and with higher
  funding cost.

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Securitize or not securitize

• Does the firm need cash to grow and expand its
  existing operation,
• To retire maturing debt, or buy back firms own
  stocks?
• What are the alternatives cost of funding?

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Alternative Funding

• First alternative The firm can borrow 25
  million by issuing 7-year unsecured debt at
  all-in-cost of 7.25 percent from its bank.
• Second alternative Secured debt can be issued
  by pledging mortgage loan assets as collateral at
  all-in-cost of 6.75 percent.
• Both funding scenarios are achieved by
  increasing assets and liabilities on balance
  sheet

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What is Securitization?

• The process of transforming relatively homogenous
  illiquid assets into heterogeneous ABS for sale
  to third party investors is known as
  securitization.
• Securitization involves the economic or legal
  transfer of assets to a third party, SPV.
• A bank can only remove the assets from its
  balance sheet using clean break criteria
  according to the new Basle Accord.

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True Sale

• There are three basic principles that ensure that
  an originator has surrendered control of
  financial assets and can legally record a sale of
  the assets
• - Asset isolation,
• - Originator or SPV control,
• - Originator or seller non-control.

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• Structure of typical securitization

Sponsor/originator Balance sheet
Receivables Current or future
Credit enhanced
SPV Balance sheet
Receivables Current or future
Issues ABS backed by the pool of receivables
Tranche 1 L-risk Tranche 2 Mezzanine
M-risk Tranche 3 5 F-loss H-risk
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Structure of Creating ABS/MBS
Obligor
Clean sale/no recourse
Proceed
Credit enhancer
Rating Agency
SPV
Arranger Underwriter
Liquidity Enhancer
Swap Counterparty
Investors
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South Korean Bank Securitization
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Shinhan Bank Securitization
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Structuring and Pricing CDO

• SPV Tranches

Pool
AAA BBB BB B NR/equity
Senior Mezzannine Junior
75
Corporate bonds
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7
5
5
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Example Creating Synthetic CDO

• Consider the underlying collateral is 1.5
  billion worth of corporate debts with 150
  obligors each 10 million with WAM of 10 years,
  WAC of 7.5 percent and weighted average duration
  of 7.2 years.
• Creating MBS, CMOs, CDOs
• SPV issues multiple tranches
• The senior tranche is 1.125 billions
• The mezzanine tranche is 300 millions.
• The equity tranche is 75 millions or 5 of the
  underlying collateral.

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• The equity tranche is not rated. Due to leverage
  and priority rules, the return and risk are very
  high for this tranche.
• The equity tranche is exposed to 5 first loss.
• For example, cumulative loss of 75 millions can
  wipe out equity tranche.
• What ever transformation is executed on the
  collateral, the package of new securities must
  obey basic laws of conservation, namely..

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Pricing Equity Tranche

• Investors for taking first loss, are compensated
  in two ways
• Up-front fees
• Running spread
• Up-front fee usually is quoted at say 40-50
  percent of investment grade CDO.
• Suppose investors in the equity tranche get 30
  up-front for assuming the 5 first loss.
• Investors hedge their exposure to 150 obligors by
  buying say 2 million notional CDS on the same150
  obligors for 2.5.
• 300 x .025 7.5 Millions
• Assume zero recovery in the event of default

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Case Study J.P Morgan/ Enron

• J.P Morgan purchased 2.1billion worth of 5-7
  year gas and oil forward from Enron in 1999.
• J.P Morgan off-load risk to Enron by buying
  surety bonds from 11 insurers.
• Enron collapsed November 2001.

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Historical Perspectives

• The process of securitization in the United
  States has gone through a trial-and-error phase,
  with the changes in legal, accounting,
  regulatory, tax, and other issues occurring.
• The first triple-A rated 30- year pass-through
  security issued by Bank of America in 1977,
  entitled the investor to a pro rata share of the
  cash flows.
• It turned out that the new pass-through
  securities by the blue-sky laws, the States legal
  investment laws, did not qualify as an investment
  vehicle except in fifteen of the fifty States in
  the union.

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• Freddie Mac exemption from the blue-sky laws as a
  federal agency proved to be crucial.
• In this process Freddie Mac purchased seasoned
  mortgage securities and issued MBS by
  guaranteeing interest and principal with
  relatively higher yield .
• The initial 30-year MBS appealed to fewer
  investors in the market.
• As initial 30-year MBS exposed investors to
  prepayment risk

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• The market needed to offer wider array of
  securities.
• The ability to predict average life of the pool
  of mortgages was crucial to sustaining wider
  classes of investors.
• Furthermore, because of the complexities of the
  new MBS, with unknown cash flows, investors
  needed to be educated about these securities.
• The key was to convince investors that new
  securities offered them relatively more yield.
• Therefore, these securities initially issued
  relatively cheap.
• The next phase in securitization came in the
  creation of collateralized mortgage obligations
  (CMOs) that solved many of the earlier problems.

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RTC and Real Estate Crisis

• The real estate crisis associated with the
  insolvency of the SL of the late 1980s, and the
  creation of the Resolution Trust Corporation RTC
  by congress in 1989 are two related such events.
• The RTC had several mandates
• To manage liquidation of the performing and
  non-performing residential mortgages originated
  by SL.
• Minimize the impact of real estate crisis on the
  financial market and the economy
• To preserve affordable housing
• These mandates proved to be the catalyst to jump
  start securitization in this sector of the U.S.
  economy.

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Problems and Lessons

• Securitization was extended to second mortgages
  up until early 1980s as the U.S. economy faced
  double-digit inflation and interest rates.
• Rising interest rates caused market value of
  homes particularly in California to drop
  substantially.
• The real estate scam of the century. Californian,
  having secured a second mortgage in the property
  walked out of their residence by turning over the
  property to the lenders.

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Review of Literature

• Data from (Call Report) by (FFIEC) reveals that
  on average, banks with total assets greater than
  2.5 billions securitize 20 percent of their
  assets quarterly Markose and Dong (2005).
• Securitization lowers mortgage interest rate, and
  eliminates regional variations in mortgage
  interest rates Jaffee and Renaud (1995), Jaffee
  and Rosen (1990), Olson (1990).

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Review of Literature

• Jaffee and Rosen (1990) show that rising
  foreclosure rates, increases in (ARM) securities,
  and reduced federalization in the mortgage market
  adversely affect securitization.
• Calomiris and Mason (2003) investigate the degree
  to which securitization permits banks to obtain
  greater return on capital by avoiding regulatory
  capital requirement.
• Calomiris and Mason point out that the benefits
  of securitization stem from three sources.
• First, less capital is required to be held in
  support of the securitized loans.
• Second, securitization reduces other regulatory
  costs associated with on-balance-sheet assets.
• Third, the value of the equity in the banks is
  increased given that the deposit insurance
  premium remains the same.

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Review of Literature

• Elul (2005) points out that securitization is
  driven by the banks desire to reduce indirect
  bankruptcy costs.
• If the bank retains the mortgages, investors have
  to share the risks. As a result, investors is
  likely to offer low price for these securities.
• Therefore, investors would be willing to pay
  higher price for the window dressed ABS.
  Consequently, the banks indirect costs of
  raising funds is reduced.
• Loutskina (2005) studies the effect of
  securitization on bank lending.
• She suggests that securitization increases banks
  lending and alleviates the effect of restrictions
  in availability of funds on banks loan supply.
• In particular, securitization weakens the link
  from monetary policy to bank lending activity.

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Lessons

• Securitization of mobile homes was also a
  sobering experience for the industry.
• Unlike home mortgages, The underlying asset tends
  to depreciate, rather than appreciate over time.
• Securitization of airplane leases is difficult as
  single airplane crash can be catastrophic for the
  underlying bond issue. The cost of credit
  enhancement for such deal can be extremely
  prohibitive.

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Absence of Prepayment

• Challenges and opportunities
• Implications for ABS to be created
• Creating contraction risk synthetically
• Exposing other classes to extension risk
• Simple Pass-through may not be appealing
• Sequential pay structure offers potential
• Definitely Zero coupon bond has to be created

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Implications

• The longer the maturity of the assets the larger
  is the amount of over-valuation.
• For example, a typical 27 percent auto loan has a
  maturity of three years and an implied rate of
  24.2 percent
• Therefore, this asset class is overvalued in the
  bank balance sheet by approximately three percent
• On the other hand, a ten year mortgage is
  overvalued by approximately 6.5 percent--the
  difference between the rate in the legal loan
  documentation of 27 percent and the rate of 20.52
  percent implied from the installment payments.
• Flawed algorithm conveys faulty information to
  average depositors and borrowers in some Islamic
  countries.

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Major Players

• Loan Originator (Sponsor)
• Third Party Guarantor (Credit enhancer)
• Rating Agency
• Special Purpose Vehicle SPV
• Arranger (underwriter)
• Liquidity Enhancer (secondary market provider)
• Swap Counterparty
• Investors

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Intermediation

• Banks and Savings Loans were largely responsible
  to perform all functions of
• originating,
• servicing,
• credit risk taking and managing it,
• and investing in a typical mortgage loan.

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Disintermediation

• Disintermediation has shuffled various functions
  into different entities that specialized to
  perform. For example, an originator does not need
  to use its own funds to finance a mortgage.
• Rather, using the capital markets to acquire
  funds cheaply has created thousands of mortgage
  companies, thereby
• Increased price and rate competition, and the
  range of available products.
• The volume of securitized instruments speaks
  loudly of the success.

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Breakdown of Financial risks

• Commercial Investment
  Treasury Retail Asset
• Banking Banking
  Management Management Management

operational
Credit
Market
Source Robert Gescke
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Operational Risk

• The Basle Committee on Banking Supervision BCBS
  reported recently that,
• An informal survey highlights the growing
  significance of risks other than credit and
  market risks, such as operational risk, which
  have been at the heart of some important banking
  problems in recent years.
• Few definitions
• Any financial risk other than credit and market
  risk.
• Risk arising from operation, such as back office
  problems, failure in processing transactions and
  in systems, and technology breakdown,
• The risk of loss from failed internal processes,
  people, and systems, or from external events

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Market Risk

• Risk of sudden shock, which could damage the
  financial system that the wider economy would
  suffer is an example of systematic or market
  risk.
• Contagious transmission of the shock due to
  actual or suspected exposure to a failing bank or
  banks. Followed by flight to quality.
• Panicky behavior of depositors or investors or
• Interruption in the payment system

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• Financial Engineering Process
• Securitization is financial engineering in a
  classic sense. The process of financial
  engineering is as follows
• Diagnosis is the firm facing high funding cost?
• Analysis Are the assets suitable for
  securitization?
• Production Repackaging and unbundling the pool
  into marketable securities (underwriting)
• Pricing The structure of securities created from
  the pool. What is the Risk/return profile of new
  securities and types of credit enhancement
  attached to them?
• Customization Tailoring the new product to the
  specific needs of customers
• Legal Framework The law governing securitization
  in the country of issuance.

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Process
Diagnosis
Analysis
Production
Underwriting
Legal framework
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Rating Agencys Functions

• Analyzes individual assets in the pool, compares
  them to the historical performance of assets in
  its data bank, and subjects the pool to stress
  tests based on severe market conditions.
• Looks at the seasoning of the pool, as mortgages
  are more likely to default in the first four
  years.
• Evaluates geographic diversification of the
  loans.
• Projects the amount of credit enhancement needed
  based on the worst-case scenario.
• Secures legal certification that assets
  transferred to the SPV are true sale, and thus
  legally isolated from the reach of originator.

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Internal Credit Enhancements

• These come in several different forms and are
  custom designed to enhance the quality of the
  underlying pool of the collateral. They possibly
  may alter characteristics of the cash flow of the
  securitized products. They can be classified as
  follows
• Over-collateralization
• Senior/subordinate structure
• Reserve funds
• Excess spread

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Shift to Securitization in 1980

• Deterioration of the credit quality of the major
  banks portfolio as a result of less developing
  countries LDC debt crisis of 1982.
• Mushrooming innovative products induced by
  liberalization of regulatory landscape that
  transferred risk from banks other
  intermediaries to ultimate investors.
  
• Return to a more favorable macro-economic
  conditions, i.e., reappearance of positive real
  interest rates and upward sloping yield curves
• Disintermediation of credits induced through
  securitization

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Asset on Balance Sheet

• Illiquid and non-tradable
• Not transparent
• Valued by originator
• Risk assessed by originator
• Originator has high cost of funding
• Have lower ratings
• Concentration risk is high
• Market is local
• Limited in terms, rates, duration, convexity, etc.

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Asset backed securities ABS off-balance sheet

• Highly liquid and tradable
• Transparent
• Value is determined in the market daily
• Risk assessed by rating agencies
• Originator has low cost of funding
• Credit enhanced with higher ratings
• Diversified
• Market is national and global
• Offers investors/borrowers variety of options

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Summary of the basic requirements for
Securitization

• Standardization of contracts
• Standardization of underwriting and appraisal
  process
• Actuarial analysis of risk
• Standardization of governing laws
• Historical data base for estimation of default
  and delinquencies
• Reliable secondary market players
• Reliable supply of third party guarantor
• Reliable management information system

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The keys for the success

• The success of securitization in the United
  States is related to the following phenomena
• Attracting private capital to the housing sector
  by meeting investors needs.
• Providing lower cost financing for home ownership
  through increased price and rate competition
  among various lenders in a securitization
  process.
• Reducing overall riskiness of the pool of
  mortgages through diversification,
• To increase income stability and enhance the
  management of risks inherent in mortgage
  products.

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Benefits to borrowers/consumers

• Access to competitive rates and terms
• Access to cheaper financing
• Availability of array of financing alternatives
• Funding availability for all types of borrowers
• Reduced processing time
• Benefits to originators
• Reduce funding cost
• Improve profit margin on asset and equity
• Removing illiquid assets off-balance sheet
• Improve asset/liability management
• Reduce concentration risk

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Benefits to arranger/investment bankers

• Increased product lines and fees
• Increased opportunities to expand operation
  nationally and globally
• Increased trading volume and profit
• Improved efficiency and specialization
• Benefits to investors
• Attractive yields on rated securities
• Diversification of risk
• Improved liquidity
• Availability of vast array of products that meet
  their desire in terms of duration, convexity,
  etc.

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The growth in securitization of RMBS

• May be attributed to several reasons
• Homogeneity of the residential mortgages in terms
  of underwriting standards encouraged by federal
  government involvement to promote home ownership
  that helps to increase job creation in a labor
  intensive sector of the U.S. economy.
• Mitigation of default risk on the RMBS due to the
  existence of government or private insurers in
  this market.
• Availability of large historical data base
  reflecting performance of the pool of mortgages
  in terms of delinquencies, default rates,
  payments, and prepayments that helped the
  investors to price various risks in determination
  of the fair market value of these asset backed
  derivative instruments.
• Government and quasi government agencies created
  through congress various Acts is to be credited
  for establishing infrastructures i.e., active
  secondary markets (needed for providing
  liquidity), and the legal frameworks that
  encourage securitization.

74

• The need is the mother of all inventions. To
  manage and mitigate imbalance in duration of the
  assets and liabilities of the depository
  institutions, new innovative asset backed
  securities needed to improve asset/liability
  management.
• Passage of the 1986 Tax Reform Act that permitted
  real estate mortgage investment conduits REMICS
  to be tax exempt entities as well as allowing
  REITs to invest in mortgages and their
  derivatives MBS products fueling growth of the
  securitization.
• Last but not least was the profitability of these
  instruments as the proceeds from the sale of the
  pool was greater than the amount the pool paid to
  investors in the ABS credit enhanced by the
  originator or third party guarantor, thereby
  improving ratings beyond the rating of the
  sponsor or originator allowing the new securities
  to be sold to the ultimate investors at a
  premium.

75
Legal and Structural Issues

• Revolving Credits
• Achieving Capital Relief
• Moral Hazard Problem
• Relationship Banking
• Cherry Picking Lemon Selling
• Liquidity Facilities and Large Exposure
• Which Regulator?

76
Over-collateralization

• Establishes more collateral than the underlying
  ABS created from the pool, the amount of which
  depends on
• The coupon rates underlying the collateral
• The rates offered to investors,
• The type of rating sought,
• The psychology of the market at the time of the
  issue, among other things.

77
Indication of over-collateralization levels for
traditional and defeasance mortgage backed bonds
(percent of par)
78
Senior/Subordinated Structure

• This is a self-imposed structure by the issuer by
  prioritizing cash flows of the entire pool of the
  underlying collateral.
• This is also the most widely used internal credit
  enhancement.
• The senior class of bondholders is willing to
  sacrifice yield in securing priority of claims
  over subordinated class.

79
Shifting Interest Structure

• All securitization programs involving
  senior/subordinated structures have incorporated
  a shifting interest structure which allows
  disproportionate redistribution of prepayments
  from subordinate class to senior class.

80
Example Shifting Interest Structure
81
New Basel Risk Weights Securitization Tranches
AAA / A / BBB / BB / B and below
AA A BBB BB or unrated
Tranche 20 50 100 350 1250 (deduction)
82
Types of Assets to be Securitized

• Types of assets chosen for securitization pose a
  serious concern for regulatory authorities.
• It is likely that the originating bank cherry
  picking portfolio of its loans for
  securitization.
• Attempt to securitize good credits leads to the
  deterioration of the remaining assets in the
  portfolio.
• This is likely to increase originators
  capital/risk-asset ratio.

83
Cherry Picking and Lemon Selling

• Lemon selling of the loans for securitization may
  lead to improvement in the bank portfolio.
• Based on the Basle Accord, banks need to lessen
  their exposure to credit risk through
  diversification of their overall portfolios by
• Industry,
• Economic sector,
• Country of the borrower,
• and types of borrower and credit facility.
• Absent of this diversification, minimum capital
  ratio would be greater than eight percent.
• Assets chosen for securitization, therefore need
  to be randomly selected.
• The originating bank must maintain a delicate
  balance between the on and off balance sheet
  without provoking a regulatory backlash.

84
Sales of Loan

• Under the existing common law regarding true
  sales there are three methods by which a loan
  sale by the bank originator can achieve relieve
  of regulatory capital. These methods are
• Novation
• Assignment and
• Participation

85
Novation

• Novation, involves transfer of an asset from the
  originator to the SPV with the consent of the
  obligor (debtor).
• In this tri-party arrangement, the originator and
  obligor jointly agree to transfer the asset(s) to
  third party the SPV.
• Originator unconditional agreement to terminate
  all of his security interest, and SPV assumes all
  rights and obligations.

86
Securitization Through Novation Process
87
Assignment

• Under the Common Law, assets can be assigned
  through legal assignment and equitable
  assignment.
• An assignment is a legal assignment that
  satisfies four criteria of the section 136 of the
  1925 of the Law of Property Act, that the
  assignment is
• (a) an absolute assignment,
• (b) in writing,
• (c) of the full amount of debt,
• and (d) notified in writing.
• In the event any of the four criteria is not
  satisfied, the assignment is termed as an
  equitable assignment.
• The method of assignment in transfer of assets to
  SPV in a securitization is through an equitable
  assignment, as originator is unwilling to inform
  the customers that their assets are being sold.

88
Participation

• This is an agreement where the originating bank
  transfers the right to the investors a pro rata
  share of interest and principal from the
  borrower.
• Participation does not transfer voting rights and
  does not require the consent of the borrower.
• It imposes limits on the ability of the
  originating bank to the changes in interest
  rates, principal, scheduled payments, guarantor,
  and collateral without approval of the buyers
  (investors).

89
Example Participation

• Consider a multinational corporation who wishes
  to borrow a 1.25 billion jumbo loan in the
  Eurodollar market at LIBOR plus 1.25 percent over
  a 7-year period with an up-front fee of 1.25
  percent. The lead arranger bank retains 250
  million in its book and spread the risk and
  reward proportionally among the sub-participants
  as illustrated in figure 1.9. The arranger bank
  books 4.225 million arranger fee of the total
  up-front fee of 15.625 million collected from
  the borrower.

90
Participation and Sub-Participation
91
The Participation Process
92
Syndication

• ATLANTA,   October 1, 2007 (SPC NYSE)
   Spectrum Brands, Inc. announced today that it
  has successfully closed a 225 million
  asset-based revolving credit facility with
  Goldman Sachs Credit Partners L.P. and Wachovia
  Bank, National Association.
• This facility at rate of 225 basis points over
  LIBOR, is available to finance seasonal working
  capital and other general corporate needs.  
• Spectrum Brands generated net sales of 2.5
  billion in fiscal 2006 and has approximately
  7,500 employees worldwide.

93
Transfer Risk

• Transfer risk is analyzed on a qualitative basis,
  using several risk indicators such as economic
  development, the balance of payment situation,
  foreign debt, and the stability and
  predictability of economic policies, political
  and social stability, and other qualitative
  factors.

94
Sovereign Creditworthiness Risk Weights
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Correlations Between Ratings and Variables
97
Sovereign Migration
98
Transfer risk Migration
Malaysia (1998, Asian crisis), South Korea (1998,
Asian crisis), Kuwait (1990, Gulf war) and Russia
(1991)
99
Events and Spread

• Recent work by Kaminsky and Schmukler (2002) who
  conclude not only that rating agencies contribute
  to financial instability and cross-country
  contagion, but also confirm that rating agencies
  act pro-cyclical.
• The rating agencies do not so much lead but lag
  the market and the rating agencies are overall
  slow to adjust their ratings.

100
Cost of Transfer Risk

• The probability of a transfer event happening has
  become lower as governments are perceiving higher
  costs of a transfer event in the form of
  exclusion of foreign borrowing, losses from FDI
  and trade flows.
• Transfer rating and sovereign ratings provide, as
  expected, very similar assessments of country
  risks and based on similar considerations of
  countries fundamentals.

101
Legal Framework

• Common law governs the process of securitization
  in the United States, United Kingdom and
  Australia.
• Civil Law is the governing principle in the most
  other nations in a securitization process.
• Civil law restricts the assignment or transfer of
  assets.
• Also, Insolvency Laws dictate that the obligor is
  to give its express consent.
• Otherwise, the transfer would not constitute a
  true sale.

102
Problems for emerging market economies

• 1. Countrys legal issues as to whether assets
  can be assigned to an SPV,
• 2. Limits imposed by rating agencies (sovereign
  ratings ceilings),
• 3. Local customs, such as direct debits may be
  used for receivables and thereby qualify for
  securitization,
• 4. Lack of availability of currency swaps if
  receivables are denominated in the local currency.

103
Potential Achievements in Securitization

• Improved return on assets and return on equity
• Credit risk is reduced as securitization spreads
  the risk.
• Interest rate risk is mitigated as securitization
  of the assets improves asset/liability
  management,
• Concentration risk to particular obligor(s) and
  or industry is mitigated.
• Strictly speaking, novation represents the
  cleanest form of transfer from legal standpoint.
  However it is rarely used.

104
Contraction Risk

• Contraction risk arises in the event of falling
  interest rates, as prepayments speed up.
• The fall in interest rates makes refinancing
  attractive for mortgagors or individuals
  relocating and selling property.
• The pass-through life therefore shortens and
  subjects investors to contraction risk.

105
Extension Risk

• As rates drop issuer is likely to call the bond
  to reissue at a lower rate.
• As rates increase, the maturity of the issue is
  extended, exposing investors to extension risk.
• The market imperfections of the cartel era
  provided the financial engineers in the Wall
  Street the opportunities

106

• There are three basic principles that ensure that
  an originator has surrendered control of
  financial assets and can legally record a sale of
  the assets
• - Asset isolation,
• - Originator or SPV control,
• - Originator or seller non-control.

107

• The emerging market economies are faced with few
  problems in securitization, which include
• 1. Countrys legal issues as to whether assets
  can be assigned to an SPV,
• 2. Limits imposed by rating agencies (sovereign
  ratings ceilings),
• 3. Local customs, such as whether direct debits
  (automatic/electronic payment of debt servicing
  obligation by a financial institution on behalf
  of an obligor or borrower) may be used for
  receivables and thereby qualify for
  securitization,
• 4. Lack of availability of currency swaps if
  receivables are denominated in the local currency.

108
Case Study

• We will demonstrate construction of monthly cash
  flow for a hypothetical pass-through with
  notional of IR850 billion, assuming the
  underlying mortgages have WAC of 20.52 percent
  and WAM of 102 months and pass-through rate of 19
  percent. Furthermore, we assume the underlying
  mortgagors prepay at an average rate of 3 percent
  per year with seasoning of 18 months.

109
Rules for distribution of cash flows

• 1. Periodic coupon interest Disburse coupon
  interest to all four-tranche based on the
  principal balance at the beginning of the month
  for each tranche at the respective coupon
  interest rate applicable to the tranche.
• 2. Principal Payment Disburse scheduled
  principal payment plus prepayment of the entire
  pool of collateral to tranche A until it is
  completely paid off, followed sequentially to
  tranche B, tranche C, and finally the retirement
  of the tranche D.

110
Four-Tranche Sequential-Pay Structure
Par amount Coupon Rate Maturity in Months Principal Pay-down Window In Months Average Life
Tranche A 21,125,000,000 0.174 36 36 1.625 year
Tranche B 21,125,000,000 0.181 64 29 4.4 years
Tranche C 21,125,000,000 0.190 85 22 6.36 years
Tranche D 21,125,000,000 0.215 102 18 7.84 years
Total collateral IR850 billion
Pass-through Rate 0.190 4.96 years
WAC of Collateral 0.2052
WAM of Collateral 102 Months
G.A. Homaifar, The Case for securitization
of credit in Iran, International Economics, Vol.
LIX. No 2- May 2006
111
Four-Tranche Sequential-Pay Structure
Par amount Coupon Rate Maturity in Months Principal Pay-down Window In Months Average Life In year
Tranche A 21,500,000,000 0.174 24 23 1.04
Tranche B 21,500,000,000 0.181 43 20 2.82
Tranche C 21,500,000,000 0.190 61 18 4.40
Z Bonds 21,500,000,000 0.215
Total collateral IR850 billion
Pass-through Rate 0.190 102 4.96 years
WAC of Collateral 0.2052
WAM of Collateral 102 Months
G.A. Homaifar, The Case for securitization
of credit in Iran, International Economics, Vol.
LIX. No 2- May 2006
112
Future Flow Securitization

• This transaction involves the borrowing entity to
  sell future receivables that would have been
  generated by selling future products directly or
  indirectly to an off-shore facility known as
  special purpose entity (SPE).

113
Four-Tranche Sequential-Pay Structure

  Par amount Coupon Rate Maturity in Months Principal Pay-down Window In Months Average Life
  Par amount Coupon Rate Maturity in Months Principal Pay-down Window In Months In year
Tranche A 21,500,000,000 0.174 24 23 1.04
Tranche B 21,500,000,000 0.181 43 20 2.82
Tranche C 21,500,000,000 0.19 61 18 4.4
Z Bonds 21,500,000,000 0.215      
Total collateral IR850 billion        
Pass-through Rate   0.19 102   4.96 years
WAC of Collateral   0.2052      
WAMof Collateral   102 Months      
114

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International Balance of Payments Current Account

  1978 1979 1980 1981 1982
Total OECD 12.2 -27.7 -69.1 -31 -26.4
Non-OPEC Developing -24 -39 -63 -73 -60
OPEC 4.5 62 115 67 -5
Other Countries -9 -4 -11 -10 3
Major Industrialized Countries Major Industrialized Countries Major Industrialized Countries Major Industrialized Countries
Including Sino-Soviet area Including Sino-Soviet area Including Sino-Soviet area
Source National Westminster Bank Source National Westminster Bank Source National Westminster Bank Source National Westminster Bank
118
Hierarchy in future flow-Backed Transactions

• Heavy crude oil receivables
• Airline ticket receivables, telephone
  receivables, credit card receivables, and
  electronic remittances
• Oil and gas royalties, export receivables
• Paper remittances
• Tax revenue receivables
• Source Standard Poors (1999b), Fitch (2000b)

119
Spreads of Pemex Finance Ltd. Securitized Debt
and UMS Versus US Treasuries

  Rating US million Average life (year) Final life (year) Spread over US Treasuries Coupon Issue date
Pemex Finance A AAA 500 3 5 125 5.72 12/4/1998
Pemex Finance A BBB 350 7 8.5 350 7 12/4/1998
Pemex Finance A AAA 400 10 11.5 175 6.3 12/4/1998
Pemex Finance A BBB 250 18 20 412.5 9.15 12/4/1998
Pemex Sr. Unsecured BB 600   10 462.5 9.375 12/2/1998
UMS BB 1500   10 571 9.875 12/4/1998
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Summary Statistics of Pemex 7-year and 18-year
oil-backed papers and UMS 2026 (Unsecured)

  Pemex 7-years Pemex 18-years UMS 2026
Mean 309 356 372
Range 205 202 324
Standard deviation 63 62 79
123
Future Flow Securitization by Sector

  million Share of total dollar volume No. of transactions
Oil and gas receivables 16,362 45 25
Non-oil export receivables 7,537 20.7 40
Credit card receivables 4,314 11.8 37
Project finance 2,467 6.8 6
Telephone receivables 2,519 6.9 15
Remittances 1,731 4.8 14
Other receivables 1,443 4 11
  36,372 100 148
Source Fitch, Moodys and SP Source Fitch, Moodys and SP Source Fitch, Moodys and SP
124
Source Basel Committee on Bank Supervision, Bank
for International Settlements
125
Source Islamic Republic of Iran Central Bank DAY
1381
126
Source Islamic Republic of Iran Central Bank DAY
1381
127
Various types of Risks

• Various risks Involved in Future Flow
  Securitization are
• Sovereign risk will the originator government
  take steps to disrupt the payment arrangement set
  out in the structured transaction?
• Performance risk will the originator have the
  ability and willingness to produce and deliver
  the product?
• Product risk will there be sufficient demand for
  the product at a stable price and will the buyer
  meet his payment obligation?
• Diversion risk can the product or the receivable
  be diverted to customers other than designated
  customers?

128
Total Return Swaps

• TRS are HLT that motivate the receiver to take on
  the credit risk of an asset it does not own.
• The bank who wishes to layoff the risk to the
  reference asset has high concentration risk.
• The bank motivations may include
• Reducing exposure without selling the asset
• Preserving banking relationship with the client
• Realizing regulatory capital relief
• Managing balance sheet to originate

129
Total Return Swap Example

• A Bank enters into a TRS with a hedge fund on the
  reference credit rated BBB to layoff credit risk,
  with the notional principal of 50 million. The
  bank agrees to pay LIBOR300bps?MV and receives
  LIBOR 75 bps.

130
Motivations of the Receiver of TRS

• The receiver is likely to have a host of reasons
  to enter into this HLT, for example
• Financing huge transaction with limited capital
• Exploiting the leverage as the return/risk can be
  magnified
• Arbitrage profit albeit risky
• Access to capital market not previously available
• Sectoral arbitrage of credit risk in the high
  yield market