2. SECURITISATION
What is securitisation?
Accounting for securitisation
Contribution to global financial crisis
Issues for regulators
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3. WHAT IS IT?
A process of changing non-tradable debt into
tradable debt by
combining the non-tradable debt into a portfolio and
issuing tradable debt financial instruments secured by
the portfolio
Frequently used for consumer and small business debt
Home mortgages
Credit cards
Personal loans
Student loans
Small business loans
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4. REASON 1 – AVAILABILITY OF FUNDS
Increase the amount of funds available for these
types of loans be getting funds from debt markets
Pension and superannuation funds
Insurance companies
Corporations with excess cash
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5. REASON 2 – LIQUIDITY
Consumer loans like mortgages are for long terms
25 years in Australia
40 years in USA
Investors reluctant to commit their cash for that long
Securitisation financial instruments are tradable
which makes them liquid
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6. REASON 3 – DIVERSIFICATION
Combining different debt instruments in one
portfolio reduces unsystematic risk
Apartments, small houses, large houses
Different cities (and countries)
Non-mortgage debt
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7. DIVERSIFICATION THEORY – MARKOWITZ
MODEL
n n
p
X j X k j k r jk
j 1 k 1
X = proportion of security
σ = standard deviation
r = correlation coefficient
j, k = security
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p = portfolio
8. DIVERSIFICATION THEORY CONTINUED
As long as rjp < 1
Correlation between existing portfolio and new security
And
σj ≤ σp
Risk of new security less than or equal to risk of existing
portfolio
Adding additional securities will reduce the risk of
the portfolio
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10. VANILLA PROCESS – ARRANGING THE
MORTGAGE
Mortgage originator negotiates loan with consumer
Aussie Home Loans is an example of an originator
Gets a fee for doing so
Promoter creates securitisation entity
Gets a fee for doing so
Securitisation entity provides money to consumer
and receives principal and interest payments over
the life of the loan
Payments may be passed via the originator
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11. VANILLA PROCESS – POOLING
Securitisation entity repeats the process of
providing mortgages
Common to issue 200 – 300 mortgages to create the
portfolio
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12. VANILLA PROCESS - SECURITISATION
Securitisation entity issues debt instruments
(bonds) to financial markets
CMO bonds – collateralised mortgage obligation bond
CDO bonds – collateralised debt obligation bond
ABS – asset backed security
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13. ADD-ON – GUARANTEE
To improve the credit rating of securitisation
debt, the entity can purchase a guarantee
Typically provided by a financial institution
A major part of Fannie Mae’s business was to sell these
guarantees
The originator, the promoter or another entity may be
the guarantor
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14. COST OF DEBT BY RATING
S&P Rating Basis Points over LIBOR
AAA 30
AA+ 45 Ashcraft, A. B., & Schuermann, T. (2008).
Understanding the Securitization of Subprime
Mortgage Credit. SSRN eLibrary. Retrieved
AA 47 April 27, 2009, from
http://papers.ssrn.com/sol3/papers.cfm?abstra
AA- 48 ct_id=1071189.
A+ 53
A 56
A- 69
BBB+ 135
BBB 150
BBB- 308 14
BB+ 375
15. ADD-ON – OVER-COLLATERALISATION
To improve the credit rating, the promoter may put
more assets into the portfolio than needed
The promoter will receive any surplus when the
portfolio is liquidated
The originator or another entity may be the promoter
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16. ADD-ON – TRANCHING
A proportion of the bonds issued (called a tranche)
may be given a higher priority for repayment
High ranking tranches get a better credit rating
(hence, lower interest rate) than low ranking tranches
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17. ACCOUNTING FOR SECURITISATION
Typically, securitisation entities are not consolidated
by:
Originator
Promoter
Guarantor
Use structures to get around consolidation standard
Special purpose entities
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18. GAME PLAYING USING SECURITISATION
Non-consolidation of securitisation entities
encourages game playing
Lowering leverage ratios
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19. REGULATION OF FINANCIAL INSTITUTIONS
Financial institutions must maintain sufficient capital
under national and international regulations
Called capital adequacy
Debt to asset ratio < 92%
This is a simplification
Securitisation entities are not regulated
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20. THE GAME
Sell assets (mortgage assets typically) to a
securitisation entity
Use proceeds to repay debt
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21. EXAMPLE – PART 1
Bank Ltd has $1,000m in assets (receivables on
mortgages and other loans) and $920m in liabilities
Debt to asset ratio 92.0%
Sells $100m in assets to securitisation entity for
$99m and uses proceeds to repay debt
Assets now $900m and liabilities $821m
Debt to asset ratio now 91.2%
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22. EXAMPLE – PART 2
Bank Ltd sells guarantee to securitisation entity for
$1m and uses proceeds to repay debt
Assets now $900m, liabilities $820m
Debt to asset ratio now 91.1%
Better debt to asset ratio means:
Lower marginal cost of debt – maybe
Less chance of breaching government regulations
Capital adequacy
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23. BUT
Has the risk of Bank Ltd changed as a result of
these transactions?
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24. CONTRIBUTION TO GFC
First, the impacts:
On guarantors
On holders of bonds
Then, the contribution
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25. GUARANTORS
The increase in default level on mortgages has
required the guarantors to pay on the guarantee
Some of the largest guarantors were:
AIG
Lehmann Bros
Fannie Mae
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26. HOLDERS OF BONDS
If the bonds were not guaranteed or if the guarantor
is insolvent and
If there have been a large number of defaults on
the mortgages in the portfolio
Then the holders of bonds will not be getting their
principal and/or interest payments
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27. TOXIC ASSETS
Bonds which are not paying interest and/or principal
are one type of “toxic asset”
The secondary market for these bonds has
disappeared so holders cannot sell or liquidate
them
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28. IMPACT ON REPORTS
Most bonds are required by IAS 39 (and equivalent
SFAS and AASB) to be recorded at fair value
With changes in fair value recorded in the income
statement
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29. IMPACT ON CAPITAL ADEQUACY
If the holder of the bonds is a financial institution
The reductions in fair value of the bond assets can
send its debt to asset ratio above 92%
In breach of capital adequacy requirements
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30. IMPACT ON DEBT COVENANTS
Debt contracts often contain restrictions
(covenants) based on leverage ratios
If the permitted leverage is exceeded then
Penalty interest rates apply and/or
The loan must be repaid immediately
Write-downs of bonds can place a company in
breach of its debt covenants
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31. CONTRIBUTION – SECURITISATION
ACCOUNTING
Ability to use securitisation as an OBF vehicle may
have led to excessive securitisation
Inadequate disclosure of exposure to risks from
securitisation may have led to incorrect risk
assessments by shareholders and creditors
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32. CONTRIBUTION – WRITE-DOWN OF CMOS
Write-down of bonds may have put companies in
breach of debt covenants and capital adequacy
rules
Forced companies to repay debts or pay higher interest
when they have insufficient cash
Insolvency or government bail-out
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33. CONTRIBUTION – INDIRECT
One of the immediate impacts of the GFC was to
make companies re-evaluate credit risk
also called counter-party risk
Fear and distrust of accounting reports may have
caused adverse selection problem
led to collapse of inter-bank market which caused
massive contraction in money supply which caused
worst recession in 80 years
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34. ISSUES FOR REGULATORS – SECURITISATION
How to report securitisation?
Options for regulators:
Require consolidation – but by whom?
Originator
Promoter
Guarantor
Require disclosure in notes
Net or gross?
No change
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35. ISSUES FOR REGULATORS – REPORTING
WRITE-DOWNS
When bonds’ values falls
Adjust to fair value and record loss in income statement
Adjust to fair value and record loss in reserves
Do nothing until realised
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36. ISSUES FOR REGULATORS – MARKET
COLLAPSE
The market for bonds has collapsed
No-one is buying
Cannot observe fair value
How should fair value be reported?
At $0
Based on DCF estimating default and risk-adjusted
discount rate (mark to model)
At last observed market price
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