Islamic Financial Products

Mudaraba Musharaka Ijara with diminishing Musharaka Murabaha Qard Wakala Takaful Istisna’a Sukuk

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?

A to Z of The Securitization in Islamic Countries

Introduction

Major Players Rating Agency’s 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

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

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

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.  

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.

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.

Istisna’a 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.

Issuer Coupon %

Maturity YTM %

Modified Duration (Year)

DV01 $

Par Amount (million)

Full Price (000)

S&P Credit Rate

Treasury 6.5 2/15/10 4.55 6.56 50,109.87 67 76,387 Treasury 5.625 5/15/08 4.64 5.48 54,121.57 92 98,762 Treasury 5 8/15/11 4.57 7.77 203,838.95 84 87,192 Treasury Sector

6.56 172,095.69 262,341

Time Warner Enterprise

8.18 8/15/07 5.47 4.72 44,231.12 82 93,710 BBB+

Texas Utilities

6.375 1/1/08 6.19 5.06 15,523.06 30 30,678 BBB

Rockwell International

6.15 1/15/08 6.04 5.13 26,735.52 52 52,837 A

Transamerica Corporation

9.375 3/1/08 6.34 4.93 8,600.38 15 17,445 AA-

Coastal Corporation

6.5 6/1/08 6.76 5.25 15,830.32 30 30,153 BBB

United Airlines

6.831 9/1/08 5.99 5.51 22,011.89 38 39,949 A-

Burlington Northern Santa Fe

7.34 9/24/08 5.67 5.36 1,817.04 3 3,390 A+

News America Holding

7.375 10/17/08 6.56 5.34 17,243.92 30 32,292 BBB-

Litton Industries

8 10/15/09 6.70 5.81 38,830.55 60 66,834 BBB-

America Standard Inc.

7.625 2/15/10 7.59 6.10 25,212.52 41 41,332 BB+

Caterpillar Inc.

9.375 8/15/11 6.01 6.79 18,759.41 A+

Corporate Sector

5.39 235,137.67 436,248

Portfolio 5.83 402,030.38 698,589

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

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

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.

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

Treasury Inflation Protection Bonds

Inflation Indexed Treasury

  COUPONMATURITY

DATE

CURRENTPRICE/YIELD

PRICE/YIELDCHANGE

TIME

5-Year 0.625 04/15/2013 97-01 / 1.29 -0-00 / .004 11:07

10-Year 1.375 07/15/2018 97-07 / 1.68 0-01 / -.006 11:08

20-Year 1.750 01/15/2028 93-08 / 2.18 -0-07 / .015 11:08

30-Year 3.375 04/15/2032 123-04 / 2.12 -0-07 / .011 11:08

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).

Sharia Principles

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?

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

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)

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).

Islamic Certificate of Deposit (ICD)

Investors have to be compensated:

1. For the loss of purchasing power

2. 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.

Pay off of ICD

Investors will be compensated investing in the ICD in the following two ways:

1. NP(1+Γ*(CPIt /CPIt-1-1)), where CPI is the consumer price index at time t and t-1, NP is the notional principal invested and Γ is set to be equal .80.

2. Max (NP*wt* (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.

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

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.

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.

1. 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= D21,900.00Total return = 9.5 percent over 2-year investment horizon

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.

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.

Securitize or not securitize

Does the firm need cash to grow and expand its existing operation,

To retire maturing debt, or buy back firm’s own stocks?

What are the alternatives cost of funding?

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

Panel A Balance Sheet of Company A as of 01/02/XXXX in (000) Cash 2,000 Short term notes 1,000 Receivables 15,000 Senior notes 29,000 Residential mortgages 25,000 Sub-debts 20,000 Other 18,000 Equity capital 10,000

Panel B Balance Sheet of Company A as of 01/02/XXXX in (000) Cash 27,000 Short term notes 1,000 Receivables 15,000 Senior notes 29,000 Residential mortgages 25,000 Sub-debts 45,000 Other 18,000 Equity capital 10,000

Panel C Balance Sheet of Company A as of 01/02/XXXX in (000) Cash 25,750 Short term notes 1,000 Receivables 15,000 Senior notes 29,000 Investment in mortgages 1,250 Sub-debts 20,000 Other 18,000 Equity capital 10,000

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.

What is Securitization?

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.

Structure of typical securitization

Receivables:

Current or future

Receivables:

Current or

future

Issues ABS backed by the pool of receivables

Sponsor/originator Balance sheet

SPV Balance sheet

Tranche 1: L-risk

Tranche 2: Mezzanine M-risk

Tranche 3: 5% F-loss H-risk

Credit enhanced

Structure of Creating ABS/MBS

Obligor

SPV

Arranger

Underwriter

Investors

Credit enhancer

Liquidity Enhancer

Swap Counterparty

Rating Agency

Clean sale/no recourseProceed

South Korean Bank Securitization

Shinhan Bank Securitization

Shinhan Bank Korea

SPV Issues Asset

backed securities

Senior- Investor 80%

Merrill LynchArranger

Credit Enhancementcollateralization

Sub- 15 %

Senior Class $551.724 million

5 % First Loss

5 % First Loss

KW 800 billion

Proceeds Proceeds

Fixed FloatingKW $

Cross Border Securitization of Consumer Loans in South Korea

Structuring and Pricing CDO

SPV Tranches

Pool

AAA

BBB

BB

B

NR/equity

5%

5%

7%8%

75%Senior

Mezzannine

Junior

Corporate bonds

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.

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…..

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

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.

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.

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

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.

RTC and Real Estate Crisis

The real estate crisis associated with the insolvency of the S&L 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:

1. To manage liquidation of the performing and non-performing residential mortgages originated by S&L.

2. Minimize the impact of real estate crisis on the financial market and the economy

3. To preserve affordable housing These mandates proved to be the catalyst to jump

start securitization in this sector of the U.S. economy.

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.

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).

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.

1. First, less capital is required to be held in support of the securitized loans.

2. Second, securitization reduces other regulatory costs associated with on-balance-sheet assets.

3. Third, the value of the equity in the banks is increased given that the deposit insurance premium remains the same.

Review of Literature

Elul (2005) points out that securitization is driven by the bank’s 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 bank’s 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.

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.

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

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.

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

provider) Swap Counterparty Investors

Major Players

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.

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.

Breakdown of Financial risks

Commercial Investment Treasury Retail Asset

Banking Banking Management Management Management

operational

Credit

Market

Source: Robert Gescke

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:1. Any financial risk other than credit and market risk.2. Risk arising from operation, such as back office

problems, failure in processing transactions and in systems, and technology breakdown,

3. The risk of loss from failed internal processes, people, and systems, or from external events

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

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.

Diagnosis

Analysis

Production

Underwriting

Legal framework

Process

Rating Agency’s 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.

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

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

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.

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

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

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.

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

Benefits to borrowers/consumers

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.

Benefits to arranger/investment bankers

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.

The growth in securitization of RMBS

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.

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?

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.

Indication of over-collateralization levels for traditional

and defeasance mortgage backed bonds (percent of par)

Bond Type of collateral Traditional Defeasance

GNMA pass-through 120-140 110-120 FNMA/FHLMC MBSs 130-145 110-120 US Treasuries 110-130 105-120 Collateralized mortgage obligations 130-150 No standard Whole loans (fixed rate) 155-175 No standard Whole loans (floating rate) 160-190 No standard Corporate bonds (AAA-B) 135-200 No standard Source: Federal Reserve Board.

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.

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.

Example: Shifting Interest Structure

Shifting Interest Structure Months Percentage of

Prepayments Directed to

Senior Class 1-60 70

61-72 60 73-84 40 85-96 20

97-108 12 109 + pro rata

Source: Frank J. Fabozzi, “Bond Markets, Analysis, and Strategies.” Fifth Edition, 2004, Prentice Hall P. 234.

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)

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 originator’s capital/risk-asset ratio.

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.

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

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.

Arranger fee Servicer fee Liquidity fee

Sponsor BankArranger

$12.5 million

Lender A$12.5 million

Lender B$12.5 million

Lender C$12.5 million

Post Novation: Regional bank sells $50 million loans to SPV

SPV

Clean sales/no recourse proceeds

Securitization Through Novation Process

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.

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).

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.

Participation and Sub-Participation

Banks fee Amount of capital funded

Fee income

12 sub-participants

.01 $600 million $6,000,000

10 sub-participants

.01 $300 million $3,000,000

12 sub-participants

.01 $240 million $2,400,000

Arranger .038409 $110 million $4,225,000 total 1.25 % $1.25 billion $15,625,000

The Participation Process

Arranger fee Servicer fee

Sponsor Bank Arranges $1.25 billion Loan

Retains $110 million

12 Sub-participants $50 million each

10 Sub-participants $30 million each

12 Sub-participants $20 million each

Borrower $1.25 billion

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.

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.

Sovereign Creditworthiness Risk Weights

Correlations Between Ratings and Variables

Sovereign Migration

Transfer risk Migration

Malaysia (1998, Asian crisis), South Korea (1998, Asian crisis),

Kuwait (1990, Gulf war) and Russia (1991)

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.

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.

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.

Problems for emerging market economies

1. Country’s 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.

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.

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.

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

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.

The emerging market economies are faced with few problems in securitization, which include:

1. Country’s 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.

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.

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.

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

Rate0.190 4.96 years

WAC of Collatera

l0.2052

WAM of Collateral 102 Months

*** G.A. Homaifar, “The Case for securitization of credit in Iran,” International Economics, Vol. LIX. No 2- May 2006

Four-Tranche Sequential-Pay Structure***

Par amountCoupon

RateMaturity 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 collateralIR850

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

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).

Four-Tranche Sequential-Pay Structure*

  Par amount

Coupon RateMaturity 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 0.19 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

     

Originator

Designated Foreign Obligors

Sells goods & services

Pays for goods by hard currency

Special Purpose Vehicle

Proceeds

INVESTORS

Pay for ABS

Receive coupon and principal

Offshore Trust

Structure of typical corporate future Flow-backed securitization

Offshore

Proceeds & excess spread

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

** Including Sino-Soviet area

Source: National Westminster Bank

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 & Poor’s (1999b), Fitch

(2000b)

Hierarchy in future flow-Backed Transactions

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

Bank in Emerging market

Country

Merchants in Emerging market country

Foreign Business and Tourist

Submit credit card vouchers

Pays for vouchers in local currency

Sells goods & services

Pays for goods by credit cards

Special Purpose Vehicle

Proceeds

Right to collect future receivables

INVESTORS

Pay for ABS

Receive coupon and principal

Offshore Trust

Sell Voucher

Pay Voucher

Structure of typical future Flow securitization

Offshore

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

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 S&P

Source: Basel Committee on Bank Supervision, Bank for International Settlements

Source: Islamic Republic of Iran Central Bank DAY 1381

Source: Islamic Republic of Iran Central Bank DAY 1381

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?

Various types of Risks

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

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 LIBOR+300bps+MV and receives LIBOR + 75 bps.

Bank

Buyer of protection

Hedge Fund

Seller of protection

LIBOR+300 bps+ MV

LIBOR + 75 bps

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