First there was securitisation, then came credit derivatives. Now financial engineers have put the two together, allowing banks to securitise almost any kind of asset. But there are risks as well as opportunities, says Claire Smith.
Securitisation was once a tool for banks to take large pools of assets off their balance sheets and sell to a wide range of investors. But now individual investors with particular requirements are coming to them and asking for tailor-made securitisations. The banks, conscious of the shortfall in supply for certain market segments, in particular, money market funds, are creating structures designed around the needs of that segment. They have become engaged in a rush of creativity as they package up debt obligations into new and inventive forms from which paper can be issued.
These range from commercial paper backed by assets consisting of trade finance, and other receivables, to entirely synthetic structures where the special purpose vehicles used in standard securitisations are simply a means of repackaging portfolios of credit default swaps. There are also short-term notes, based on long-term obligations, issued flexibly via a revolving issuance programme, where the assets of the special purpose vehicle (SPV) are effectively managed as an adjunct to the bank's trading book. Large-scale transactions, formerly driven by a bank's need to reduce regulatory capital, are now prompted more by a desire among investors to obtain a full complement of credit exposure in one tailor-made discrete bundle. In some cases, the investors can have their package within 24 hours.
But with these new innovations come risks. One banker has warned of the dangers of mismatching maturities, which can leave banks exposed if the yield curve inverts or credits are downgraded. Operational risk results from the mushrooming of interlinking derivatives transactions and banking facilities that may be attached to each note issue. Documentation has to be sufficiently detailed to correctly capture the intricacies of each instrument on either side of the SPV. But if banks get the legal and risk management aspects right, they will make considerable profits from these new repackaging tools. Indeed, banks knowledgeable in this market are starting to offer their expertise to less canny counterparties.
Credit derivatives to the fore
Underpinning this new trend in securitisation are credit derivatives. Outstanding credit derivatives contracts exceeded all predictions in 2000, at more than $810bn notional value. The biggest growth was in synthetic securitisations, which now account for 26% of the market. Although vanilla default swaps are the largest segment in total outstandings, the majority of trading volume goes through in synthetic securitisations and credit-linked notes. Counterbalancing the declining importance of single name vanilla swaps is an upsurge in basket default swaps, mostly in large, broadly-based groups of 25-100 names.
Default swaps are the building blocks of the credit derivatives market, with more than $1bn in notional amounts traded daily. The basic default swap can be transformed into a financial guarantee or reinsurance contract, executed in a pre-paid form, embedded in a credit-linked note, or used as the basis for synthetic securitisation. Inclusion of credit default swaps in hybrid collateralised debt obligations (CDOs) first appeared in 1999 and now many deals are wholly synthetic, based on an assortment of default swaps. Yields on structures that use credit default swaps in their construction will generally be higher than on traditional cash instruments of a similar credit quality. The market is skewed because banks, corporate treasurers and hedge funds will pay premiums over the asset swap price to hedge credit exposure.
With lacklustre growth in traditional unsecured commercial paper (CP), asset-backed commercial paper (ABCP) issued by generally rated conduits, is satisfying the burgeoning demand from money market funds. According to Moody's, ABCP makes up 42% of the $1540bn in US commercial paper, and represents on average 24% of a typical US money market fund's assets. Typically, ABCP is sponsored by a bank or other financial institution that pools financial assets and converts them into capital instruments. By transforming otherwise illiquid assets or non-assignable loans into cash, banks increase balance sheet liquidity.
The US conduit business is well established and a E70bn market has developed in Europe, secured on receivables such as Greek lottery receipts and Italian social security payments. Again, there is a yield advantage over traditional paper, of around 5-7 basis points, despite often being secured. As demand builds for these instruments, the arbitrage reduces, although investors will always demand a premium for the additional work involved in analysing an unusual structure or underlying exposure.
One structure (see figure) that combines the off-balance sheet nature of a securitisation with the flexibility of a credit-linked note is where a bank transfers debt obligations into a SPV and issues short-dated securities linked to individual assets within the vehicle. Total return swaps on non-assignable loans, credit default swaps and other synthetic securities can equally be used as the basis for note issues. Any unsold exposures residing within the SPV are covered by a series of repurchases under a master agreement between the bank and the SPV and repayment of notes is guaranteed by a bank liquidity facility.
Tailoring note issues
Within this structure, it is possible to tailor note issues to investor preferences for currency, term, fixed or floating rate on a revolving basis. As notes are sold, or are redeemed, the repo is in a constant state of flux and has to be actively managed as an adjunct to the bank's trading book. Because of the bank's freedom to sell any asset to the SPV, it is unrated. Calls on the liquidity facility and the size of the asset pool covered by the master repo depend on the bank's ability continually to distribute paper based on the SPV's assets.
Mike Connor, head of structured credit derivatives at UBS Warburg, highlights the risks being taken in essentially lending long and funding short, a strategy that brought down the savings and loans sector in the US in the early 1990s. Hedging long-term credit exposures with short-term protection carries the risk of a worsening of the credit position of any name, increasing the cost of the short-term protection to the point where the credit spread curve might ultimately invert. However, he concedes that this risk is mitigated by the quality of the names typically involved in these strategies.
According to Philip Basil, head of securitisation at Royal Bank of Scotland, discrete issues against segregated pools should be transparent enough not to require a rating. Royal Bank of Scotland has four repackaging vehicles, and Mr Basil claims that repackaging transactions can be put together in 24 hours. Antoine Chausson, head of credit derivatives structuring at BNP Paribas, says: "The increasing flexibility provided by derivatives to the securitisation and repackaging market, whereby warehousing or longer-term financing of assets can be effected by ring-fenced transactions out of an unrated vehicle."
Iain Barbour, head of structured finance research at Commerzbank Securities, sees the linking of a single asset (or group of assets) in an SPV into short-term notes as offering value to both originators and investors. "The underlying assets, coupled with appropriate credit enhancement, receive a long-term credit rating, sufficient to support the short-term ratings on the actual notes issued to investors," he says.
At Dresdner Kleinwort Wasserstein (DrKW), some $18bn of assets have been taken into Dresdner-sponsored conduits. DrKW is currently making this conduit technology, previously available only for assets originated by Dresdner Bank, available to clients. Forbes Elworthy, co-head of credit structuring at DrKW, comments: "Dresdner is conscious of the convergence between different sectors of the financial services market. For example, banks are being encouraged by regulators to become service providers rather than just lenders. DrKW is advising a number of banks on setting up conduit vehicles to hold assets. These banks become administrators of the new vehicles and receive fees for these services. One interesting twist we have introduced enables some of these conduits to fund lower grade assets.
"Most conventional conduits can only fund triple-A and double-A assets. One structure developed by DrKW, which we call the CAFE structure, has been used to fund asset pools with an average rating down to triple-B."
Tough US regulations on investor suitability (the Rule 144a-10b5 provision) and a new standard on consolidation and control in Financial Accounting Standard 140 for firms subject to US Generally Accepted Accounting Principles rules, makes this route of greatest benefit to European-based players, with access to a European investor base.
Jason Ekarib, head of repackaging at Goldman Sachs, reveals: "We are working hard to bring our vibrant OTC total return swap business into the securities arena." But exploiting fully the wealth of different assets that resides on banks' balance sheets can be tricky, as some do not lend themselves to the process of securitisation. As Mr Ekarib says: "Using a repo can be problematic, as some of the more exotic loans and mortgages have unpredictable cashflows". The drive towards fully synthesised securitisation programmes is a major trend in sourcing and distributing credit exposure. An example is the BNP Paribas Riviera Finance One, an arbitrage CDO SPV, which issued three tranches of five-year notes of varying degrees of seniority on e1bn notional of credit default swaps on 52 different entities diversified by industry and geography. According to Mr Chausson, insurance companies typically take the most junior paper, for additional yield, whereas banks and finance companies take the more senior tranches.
New entrants
Relatively new entrants into the global credit markets, such as insurers and sovereigns, are buying tailormade portfolios of assets via credit derivatives. JP Morgan's head of structured credit derivatives, Jonathan Laredo, notes as much investor-driven business this year as issuer-driven in 2000, as euro-zone investors switched their attention from equities to credit in the aftermath of the stockmarket downturn. Rather than spend time and effort building portfolios of assets in cash instruments, credit derivatives are a more efficient way of achieving the desired exposure. Typical size in these transactions is e500m to e1bn notional across a portfolio size of 50 to 100 names and some 20 deals of this type are believed to have taken place in the year to date.
The involvement of investors is transforming the credit derivatives market by transferring risk through to the best marginal buyer, says Mr Connor. Balance sheet restructuring trades lead to irregular, lumpy issuance, a particular feature of the European market, which is one-fifth of the size of the US market, where origination and financing of credit risk is less regulatory driven. Investor demand is creating a steadier stream of business and a more stable growth path, with smaller, structured, credit-note deals taking the place of bulky CDOs.
Advanced trading capabilities differentiate market leaders from middle-ranking players, and enable them to structure deals more closely to investor requirements. For example, only a few banks can seamlessly embed subordinated credit risk from a synthetic portfolio within the running coupon on a high-quality credit instrument, to provide the investor with a familiar asset type, secure principal and a high level of current income.
In the ABCP market, a deviation from market convention in the Basel II definition of liquidity facilities is causing banks to reconsider their use of 100% facilities, which attract zero capital if less than 364 days. Jean Dornhofer, European head of ABCP at Moody's, highlights two alternatives to conserve capital usage. Limited purpose investment companies (LIPICs) use the market value of liquid securities to manage the liquidity facility down to 15-20% of notional amount. An alternative, soon to debut on the market, is where the CP issuer simply sells a credit default swap to the holder of a portfolio of debt obligations, obviating the need for a liquidity facility.
Risk concerns
Operational risk looms large when processing revolving securitisations of single names temporarily repackaged into a different currency or rate format. Documentation of unlisted issues out of unrated SPVs will generally take place in-house and personnel may not be professionally qualified or may be unfamiliar with the intricacies of the underlying asset. Each asset type, whether a bond, a total return swap or a credit derivative, creates a different set of circumstances.
Basis risk can arise in both securitised and synthetic deals on any mismatch between documentation on each side of the transaction. The recent lawsuit between Deutsche Bank and UBS highlights the potential for disagreement in even the simplest of credit derivative structures. In March 2001, UBS sued Deutsche Bank when the latter refused to pay on a credit default swap because the name of the company whose credit was referenced under the swap had changed following a transfer of ownership.
Jeanne Bartlett, a partner at law firm Orrick Herrington & Sutcliffe, has worked with a number of banks to set up guidelines for use by transaction processing staff incorporating checklists and flow charts showing what approvals and which form of documentation are necessary for which underlying instrument. A concern of Tariq Rafique, global head of asset securitisation at ABN Amro, is that there may be conflicts between individual creditors of the SPV, commenting, "it is important to establish whether default in one series could cause the entire edifice to collapse, or if an investor in a single series would have a claim over other assets held by the SPV".
There is no disclosure to the investor in these notes about how many series are outstanding or the total size of balance sheet of the SPV, and investors in one note issue depend on the bank to manage properly the remainder of the pool. As the use of SPVs moves from being a loan restructuring vehicle to a tool for trading book risk management, the number will increase.
Jonathan Davies, head of credit derivatives consulting at PricewaterhouseCoopers, questions whether senior officers within a bank really know how many SPVs a bank has and if they are being managed properly, particularly once there is no longer any motivation for setting them up. The reverse can also be problematic, as Mr Davies says: "The more successful an SPV is, the more pressure there is on the systems used to record, monitor and report on transactions. Often these systems rely on the sponsoring bank for support." Any conflict between the bank being both the adviser to the SPV and actively managing the repo line are probably minimised by its need to place paper. Banks have even removed downgraded names from within an SPV to ensure continued investor confidence in the programme. Regulators might begin to question whether the assets were ever really off balance sheet.
Mr Connor highlights the increasing complexity in credit derivatives structures, for instance, where interest rate or foreign exchange swaps knock in or out on default. Here, it is important to counterbalance the binary nature of the structure with a limit on the extent of loss. Being a fundamentally illiquid and developing market adds complexity beyond the classic derivatives risk management proposition. JP Morgan makes conservative assumptions in its risk parameters to account for gapping or market seizure and maintains heavy reserves against book profits on open positions.
Sourcing of paper in the European markets can be a problem, according to Mr Laredo, who cites 300 liquid names for use in basket default swaps. However, default swaps can be structured to transform more readily available dollar credit risk into euro form, without bringing in any residual currency exposure, so overcoming issues with denominational issues, if not domicile. As banks mine the various asset categories to meet the mounting demand for credit exposure, they are finding that credit derivatives as a tool provide access to a rich seam.
Securitisation
Credit default swap - an over-the-counter contract between buyer and seller whereby the seller of protection receives a fee (the default swap spread or premium) quoted in basis points per annum for safeguarding against losses on the default of a reference entity. Following a default event, the seller of protection would be required to either take delivery of the reference entity's bonds, or settle on the cash value of those bonds, to the buyer of protection.
Basket default swap - a default swap where the reference entity is a basket of credits, typically 25 or more, and default on one name will trigger settlement to the value of the proportion of the basket in that one name.
Credit-linked note - a note issued by a bank whose performance either in terms of coupon or capital repayment is linked to the performance of another credit instrument.
Collateralised debt obligations - the notes issued from a special purpose vehicle which holds actual loans or other debt obligations which have been transferred from a bank's balance sheet.
Synthetic securitisation - a structure whereby credit default swaps are used to transfer the credit risk associated with a portfolio into a special purpose vehicle which then issues notes whose performance depends on that of the portfolio of credits.