Financing with Asset -Backed Securities - NYUpages.stern.nyu.edu/~igiddy/corpfin/Singapore/simabs.pdf · lAvoid excessive bank risk -taking lDiscourage speculative investments lPrevent

Giddy/SIM Asset Securitization/1

Prof. Ian GiddyNew York University

Financing withAsset-Backed Securities

SIM/NYUThe Job of the CFO

Copyright ©2001 Ian H. Giddy Asset Securitization 2giddy.org

Asset-Backed Securities

l The technique

l Legal, tax and accounting issuesl The economics

l An application

l ABS in Asia



Securitization of Assets

l Securitization is the transformation of an illiquid asset into a security.

l For example, a group of consumer loans can be transformed into a publicly-issued debt security.

l A security is tradable, and therefore more liquid than the underlying loan or receivables. Securitization of assets can lower risk, add liquidity, and improve economic efficiency.


What is the Technique for Creating Asset-Backed Securities?

l A lender originates loans, such as to a homeowner or corporation.

l The securitization structure is added. The bank or firm sells or assigns certain assets, such as consumer receivables, to a special purpose vehicle.

l The structure is legally insulated from management

l The SPV issues (usually) high-rated debt.



SPONSORINGCOMPANY

SPECIALPURPOSEVEHICLE

ACCOUNTSRECEIVABLE

ACCOUNTSRECEIVABLE

ISSUESASSET-BACKEDCERTIFICATES

SALE ORASSIGNMENT

Securitization: The Basic Structure


The Process

Key features are:upooling of a group of similar non-traded financial

assetsu transfer of those assets to a special-purpose company

which issues securitiesu risk reduction by systematic risk assessment, by

diversification, by partial guarantees, etc.udivision of the benefits (and risks) among investors on

a pro-rata basisubeing offered in the form of a security (rather than, for

example, as a portfolio of loans or receivables)uon-going servicing of the underlying assets' cash flows

through to the asset-backed security investors.

IMPLEMENTATION


Finance Company LimitedFinance Company Limited


Case Study: The Company(Finance Company Limited)

l Finance company whose growth is constrained

l Has pool of automobile receivables

l Has track record

l Plans to use this as an ongoing source of financing



Securitize the assets

Form of transferof asset

Form of creditenhancement

Form oftransformation of

cash flows

Form of cash flowallocation

Decisions

Form of specialpurpose vehicle

Key Decisions


Finance Co. Ltd(Seller)

FCL 1997-A(Special Purpose Co.)

Investors

Financial GuaranteeProvider

(if required)

Servicing Agreement

Proceeds

Sale of Assets

Proceeds

Asset-BackedSecurities

GuaranteeAgreement

Rating Agency

Top Rating

TrusteeTrust

Agreement

Finance Co.’sCustomers

Hire-PurchaseAgreement

Case Study: Initial Exchanges





Investors

Financial GuaranteeProvider

Monthly HPPayments

GuaranteeResponsibilities

TrusteeTrustee

Responsibilities

Monthly ABSPayments

Servicing Fees

Finance Co.’sCustomers

Hire-PurchasePayments

Case Study: Ongoing Payments


Getting a Rating: The Risks

l Credit risks

l Liquidity risk

l Servicer performance risk

l Swap counterparty risk

l Guarantor risk

l Legal risks

l Sovereign risk

l Interest rate and currency risks

l Prepayment risks



SPONSORINGCOMPANY


ACCOUNTSRECEIVABLE

ACCOUNTSRECEIVABLE


SALE ORASSIGNMENT

CREDITENHANCEMENT

CREDITENHANCEMENT

SOVEREIGNPROTECTIONS

SOVEREIGNPROTECTIONS

INTEREST RATE/CURRENCY

HEDGES

INTEREST RATE/CURRENCY

HEDGES

CASH FLOWREALLOCATION

CASH FLOWREALLOCATION

Risk-Management Techniques in ABS




Senior

Proceeds

Sale of Assets

Rating Agency

Top Rating

Credit Enhancement:An Alternative Approach

Subordinated

More Subordinated

Lower Rating

No Rating



Choose a Structure to Suit the Type of Assets to be Securitized

l Mortgage Securitization

l Non-Mortgage ABSl Intangibles

l Infrastructure and Project Financing


Asset-Backed Securities: Legal and Regulatory Aspects

l LegaluThe Transfer

uThe Special-Purpose Vehicle

l Taxation

l Accounting Treatmentl Bank Regulatory Treatment



Legal Aspects

l Goal: Credit quality must be solely based on the quality of the assets and the credit enhancement backing the obligation, without any regard to the originator's own creditworthiness

l Otherwise, quality of the ABS issue would be dependent on the originator's credit, and the whole rationale of the asset-backed security would be undermined.

LEGAL


Three conditions enable the separation of the assets and the originator

l The transfer must be a true sale, or its legal equivalent. If originator is only pledging the assets to secure a debt, this would be regarded as collaterized financing in which the originator would stay directly indebted to the investor.

l The assets must be owned by a special-purpose corporation, whose ownership of the sold assets is likely to survive bankruptcy of the seller.

l The special-purpose vehicle that owns the assets must be independent

LEGAL



What Makes it a Sale?

l The form and treatment of the transaction

l The nature and extent of the benefits transferred

l The irrevocability of the transfer

l The level and timing of the purchase price,

l Who possesses the documents

l Notification when the assets are sold

LEGAL


What Makes it Likely to be Consolidated?

l The difficulty of segregating and ascertaining individual assets and liabilities

l The presence or absence of consolidated financial statements

l The comingling of assets and business functions

l The existence of parent and intercorporateguarantees and loans

l The transfer of assets without strict observance of corporate formalities.

LEGAL



Taxation Aspects

l If the SPV or the transfer is subject to normal corporate, withholding, or individual tax rates, investors or borrowers could in principle be subject to additional or double taxation

Must avoid double taxation ofl Seller/servicerl Trust or special-purpose corporationl Investors

TAX


Accounting Treatment

l Sale versus financing

l Consolidationl Accounting for loan servicing

ACCOUNTING



FASB Sale Treatment

l The transferor relinquishes control of the future economic benefits embodied in the assets being transferred

l The SPV cannot require the transferor to repurchase the assets exceptpusuant to certain recourse provisions

l The transferor's obligation under any recourse provision are confined and can be reasonably estimated

ACCOUNTING


Consolidation Treatment

l International accounting standards hold that consolidated financial statements are more meaningful than separate ones

l "Nonhomogeneous operation" exception

l Finance, insurance, real estate and leasing subsidiaries can generally be left apart

ACCOUNTING



Fees

l Loan-origination fees. These are deferred and recognized over the life of the loan as an adjustment of yield.

l Commitment fees. These are to be deferred.

l Syndication fees. These should be recognized when the syndication is complete unless the originator retains a portion of the syndicated loan.

ACCOUNTING


Bank Regulationand Capital Requirements

l Goal: Ensure that the substance and not the form of the asset transfer is what governs capital requirements.

The regulatory authorities may assess capital or reserve requirements as if the financing was a secured borrowing:



Bank Regulation: Issues in Asia

l Avoid excessive bank risk-taking

l Discourage speculative investments

l Prevent financial market scandals

l Prevent circumvention of deposit regs

l Encourage financing of capital investment

l Discourage financing of consumption

l Promote development of capital markets

Asset Securitization:Cost-Benefit Analysis



Separation of Two Businesses: Origination and Lending

SPONSORINGCOMPANY


ACCOUNTSRECEIVABLE

ACCOUNTSRECEIVABLE


SALE ORASSIGNMENT


Separation of Two Businesses: Origination and Lending

SPONSORINGCOMPANY


ACCOUNTSRECEIVABLE

ACCOUNTSRECEIVABLE


SALE ORASSIGNMENT

Asset securitization makes sense when

the assets are worth more outside the

company than withinBut what makes them

worth more outside?



For Banks: Capital Requirements

l In a perfect world, adding good assets would require little additional capital, since creditors would not see any increase in the bank's risk

l But if regulatory capital requirements penalize banks for holding such assets, they should:

usecuritize the good assets

uprofit from origination and servicing

l In general, regulatory costs or rigidities create an incentive for banks to shrink their balance sheets by securitizing loans


A Bank’s Capital Savings

Securitization Cost-Benefit Analysis(for a regulated financial institution)

Gain/cost($ millions)

Funding cost savings C Two-year bank notes vs pass-though rate

1.1

Upfront costs C UnderwritingC SEC filing, legal fees, etc

(2.6)

Ongoing costs C Letter-of-credit fee (0.5)

Capital charge C Cost of capital at 25% (15%after tax)

7.7

Net benefit 5.7



For Corporations: “Pure Play” Argument

Separate the credit of the assets from the credit of the originator:

l Identify and isolate good assets from a company or financial institution

l Use those assets as backing for high-quality securities to appeal to investors.

l Such separation makes the quality of the asset-backed security independent of the creditworthiness of the originator.


Sears: Asset-Backed Financing?

SEARS



Why Did Chrysler Use ABS in 1992?

l Downgraded to B+ in early 1992l Lost access to its normal funding

sourcesl Needed to continue to fund its car loansl Only way to do this was to securitize the

loansl “Firms that securitize tend to have

considerably weaker credit quality than other firms.”


Costs Associated with Securitization

l Interest cost of the debtl Issuance expenses of the debtl Also:uCredit enchancement and liquidity support

for the assetsuStructuring fees payable to bankersuLegal, accounting and tax advice feesuRating agencies' feesuSystems modificationsuManagement time



Costs Needed to Measure the Annual Pre-Tax Impact of Securitization

l The interest on the securitized fundingl The annual costs of credit enhancement/liquidity linesl Any guarantees to enhance the credit rating of any

interest rate or foreign exchange swap counterpartyl Amortized front-end fees (debt issuance, credit

enhancement, liquidity lines)l Amortized transaction costs (legal, accounting,

structuring, rating, etc.)l Opportunity costs relating to any temporary cash

retention in any guaranteed investment contract (GIC)

l Annual systems/accounting/rating agency costs etc.


Sample Cost/Benefit Analysis

With securitization Without securitizationPortfolio yield 18.50% 18.50%Funding cost -7.22% -9.00%Default rate -5.00% -5.50%Amortized upfront issuance costs -0.10% -0.05%Amortized upfront securitization costs -0.20%Annual costs of guarantees and credit lines -0.25%Annual additional costs (systems, reporting, trustee fees, etc) -0.25%Effect on sponsor's marginal cost of capital 0.00%

Profits 5.48% 3.95%

Net savings from securitization 1.53% per annum



Corporation or Financial Institution requires additional funds to givecustomers financing or to finance a future revenue stream.

Are funds freely available from banks ?

Does the firm/FI have good, self-liquidatingassets ?

Do the assets have a sufficiently high yieldto cover servicing and other costs ?

Would the assets be worth more (have a cheaper all-in funding cost) if they were

isolated from the company/FI ?

Securitize the assets

Borrow frombanks

Issue equity ormezzanine capital

Get out of thefinancingbusiness

Use assets as collateral foron-balancesheet debt

No

Yes

Yes

Yes

Yes

No

No

No

The Decision Process

Project Financing

Prof. Ian GiddyStern School of Business

New York University

Asset-Backed Securities



Asset-Backed and Project Financing

l Collateralized debt

l Securitized loansl Non-recourse project debt

l Basic question: Why should a company segregate the cash flows from a particular business, and make it self-financing?


Project Financing

l Stand-alone, non-recourse, multi-stake, "production payment financing"

l Structure?

l Participants?

l Funding sources?

l Risks?



Project Financing (Summary)

l Stand-alone, non-recourse "production payment financing"

l Sponsor's vehicle company structures multi-stake finance

l Sources: govt development financing, IBRD/IFC, sponsor loans, supplier credits, customer credits, institutional investors, banks, lease financing, equity

l Risks: resource quantity, input costs, technical, timing, pre-completion, demand, operating, forcemajeure, political

l Risk sharing and mitigation


Project Financing

Definitionl Lending to a single purpose entity

for the acquisition and /or construction of a revenue-generating asset with limited or no recourse to the sponser

l Repayment of the loan is solely from the revenues generated from operation of the asset owned by the entity

l Security for the loanu the revenue generating assetu all shares and interests in the

entityu real propertyu all contacts, permitsu authorizations, etc.; and,u all other instruments necessary

for continuing projectoperations

StepsProject Identification

& Resource Allocation

Risk Allocation & Project Structuring

Bidding & Mandating Contracts

Due Diligence & Documentation

Execution & Monitoring

Construction Monitoring

Term Loan Conversion & Ongoing Monitoring



Benefits of Project Financing

l Limitation of Equity Investment to Project’s Economic Requirement -Enhanced Returns

l Risk Sharing and Diversificationl Accounting Treatment Preserves

Corporate Borrowing Capacityl Access to Long Term Financingl Tax Benefitsl Political Risk Mitigation


The Risks

l Political

l Resource & inputl Technical

l Construction

l Legal

l Economicn Cost overrunsn Completion delaysn Mounting

interest expenses



Eurotunnel: The Risks and the Remedies

Category Nature Remedy

Political NationalizationGovt interferenceTaxes & the like

LegalTreaty ratified

Technical ProcessEffect on completionRepairability

Use existing technology

Construction DelaysOverrunsRepairability

Use top expertsPerformance bonds

Legal Access to control in defaultFire, injury, etc liability

Security interestsDefault defn

Economic Price competitionRail links

Market studies


Sample Structure

Sponsors /Shareholders

SINGLE PURPOSEPROJECT COMPANY

EquipmentSupplier

Contractor

Feed Stock(e.g., fuel)Supplier

Warranties andSupply Agents

Operator

TurnkeyConstruction

Long TermAgreement

Operations &Maintenance Mgmt

Purchaser

SyndicateBanks

Other Project Participants:

Currency and Interest Rate Hedge Providers

Multilaterals and EDA’s

Legal Counsel

Technical Consultants

Offtake (e.g, power purchase) Agreement

Arranging Bank



Ras Laffan

l Who is the issuer?uRas Laffan LNG Co. Ltd. (Qatar)uBut Security Trustee (IBJ) plays unusually major

role

l What assets does it have?uNatural gas reserves; uLNG take-or-pay Sale and Purchase Agreement

with Korea Gas; uSecurity Trust Agreement; Project Coordination

Agreement; loan refund agreement, etc.


Ras Laffan

l What are the risks, and how are they handled?uQatar/regional interference

uQatar legal system

uDefault on Agreements

uCompletion/timing

uOperating

uEconomic (LNG market)



Ras Laffan: Natural Gas Project Finance

Ras LaffanLiquified Natural Gas

Korea Gas

Security Trustee

LNG

LNGpayments

Debt servicepayments

Ras LaffanLiquified Natural Gas

Korea Gas

Security Trustee(New York)

Bondholders

Mobil QM(Mobil Corp.)

Qatargas(State of Qatar)

Joint venture agreement

30% 70%

ContractorsContractors

Contractors

LNG

LNGpayments

Debt servicepayments

Residualpayments

Contractpayments

BanksExport Credit

Agencies

Debt servicepaymentsRas Laffan



nasiansecuritization.com


Ian H. Giddy

Stern School of Business

New York University

44 West 4th Street, New York, NY 10012, USA

Tel 212-998-0332

Fax 917-463-7629

[email protected]

http://giddy.org

Documents

Financing with Asset -Backed Securities - NYUpages.stern.nyu.edu/~igiddy/corpfin/Singapore/simabs.pdf · lAvoid excessive bank risk -taking lDiscourage speculative investments lPrevent