Ingredients for Deepening the Securitization Market A Presentation at Conference on the East Asian...
Transcript of Ingredients for Deepening the Securitization Market A Presentation at Conference on the East Asian...
Ingredients for Deepening the Ingredients for Deepening the Securitization MarketSecuritization Market
A Presentation at
Conference on the East Asian Financial Markets: Conference on the East Asian Financial Markets: The Next FrontierThe Next Frontier
Sponsored by
The World BankThe Hong Kong Monetary Authority
June 21-23, 2006
Joseph Hu, Ph. D. China Country Manager
2
Ingredients for Deepening the Ingredients for Deepening the Securitization MarketSecuritization Market
1. Legal Framework
2. Cash Flow Analysis
3. Accounting Treatment
4. Credit Risk Evaluation
5. Investment Banking
6. Government Debt Market
7. Active Secondary Market
8. Diversified Investors
3
1. Legal Framework1. Legal Framework
A SPE has to set up to guard the investor interest in the underlying assets
The SPE is to purchase all the loans that are originated and sold by the lender and to issue security to the investor with the proceeds to pay for the underlying loans
SPE has no other assets other than the loans acquired from the lender, and has no other liabilities other than those associated with the issued security
The law has to protect the investor against any claim on the cash flow of the SPE
Legal arrangement to define the duties and responsibilities of the issuer, the trustee, the custodian of the pool of loans and the servicer of the security
4
2. Cash Flow Analysis2. Cash Flow Analysis
Securitization is to enable the lender to obtain the cash that is equivalent to the present value of the future cash flow of the underlying loans, after netting out necessary costs of securitization
It is critical for the issuer to conduct the cash flow analysis to ensure that the obligation of the SPE can be paid in a full and timely manner
Assumptions of the discount rate for the present value calculation, the future behavior of the cash flow, such as economic scenarios during the life of the underlying loans, borrowers’ propensity to repay the loans, and incidence of default
In-depth analysis of the historical cash flows of a vast amount of underlying loans to insure realistic assumptions
5
3. Accounting Treatment3. Accounting Treatment
Incomes to the SPE has to be legally exempted from taxation
The cash-flow waterfall that clearly spells out how the monthly cash flow is allocated among all the participants of a transaction
Based on this waterfall, the servicer of the security needs to inform the investor about the components of the monthly cash flow and the part of the cash flow that is taxable versus non-taxable
Expenses of securitization and payments to the trustee, the custodian, and the servicer
6
4. Credit Risk Evaluation4. Credit Risk Evaluation
Since the lender is issuing a security that is backed by a pool of consumer or commercial loans it origins, the investor would naturally be concerned with the credit risk of the loans
Depending on the cash flow structure of the security, the credit of the security often needs to be rated by one or several credit rating agencies. In the United States, there are now four credit rating agencies that provide ratings on structured finance securities: Dominion, Fitch, Moody’s, and Standard & Poor’s
The credit rating agencies will assign credit ratings on the various segments of the cash flow of the security
7
5. Investment Banking5. Investment Banking
The underwriting and the distribution of a newly issued security are the responsibilities of the investment banker, the intermediary connecting the issuer and the investor
During the entire process of securitization, the investment banker performs critical functions:• Coordinating and helping with the issuer to deal with the legal,
the accounting, the taxation, and the analytical cash-flow aspects of the security
• Underwriting the newly issued security by setting the price of the security, purchasing the entire issuance of the security, and distributing it to the investor.
• Providing liquidity for the security by “making the market” through actively interaction in buying and selling the security in the secondary market
8
6. Government Debt Market6. Government Debt Market
In order to have a healthy securitization market, it is necessary to have a sound government debt market. Since government securities are free of credit risk, the trading of government debt securities establishes the market level of risk-free yields of various maturities. This credit-risk free relationship between maturities and yields is call “Treasury yield curve”
The government yield curve provides the appropriate benchmarks for the pricing of initial offers and the subsequent secondary-market trading of all other fixed-income securities of various maturities that entail various degrees of credit risk. All non-government fixed-income securities trade at some yield spreads over the Treasury yield curve
9
7. Active Secondary Market7. Active Secondary Market
A successful primary market for the issuance of securities requires the support of an active secondary market
Providing importance pricing information and liquidity The investor can help create an active secondary
market. While the investment banker has the moral responsibility to make markets by actively buying and selling the security in the secondary market, it needs the cooperation of the investor. If the investor simply hoard the security after the primary issuance and not willing to ever trade the security, it would be very difficult for the investment banker alone to maintain an active secondary market
10
8. Diversified Investors8. Diversified Investors
A diversified investor base is important to the development of an active secondary market
Money market funds, corporate treasurers, bond funds, commercial banks, insurance companies, pension funds, etc.
While the investment banker has the moral responsibility to make markets by actively buying and selling the security in the secondary market, it needs the cooperation of the investor. If the investor simply hoard the security after the primary issuance and not willing to ever trade the security, it would be very difficult for the investment banker alone to maintain an active secondary market