Prof. Ian Giddy New York University Financing with Asset-Backed Securities SIM/NYU The Job of the CFO

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

The technique Legal, tax and accounting issues The economics An application ABS in Asia


Securitization of Assets

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

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

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?

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

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

The structure is legally insulated from management

The SPV issues (usually) high-rated debt.


SPONSORINGCOMPANY

SPECIALPURPOSEVEHICLE

ACCOUNTSRECEIVABLE

ACCOUNTSRECEIVABLE

ISSUESASSET-BACKEDCERTIFICATES

SALE ORASSIGNMENT

Securitization: The Basic Structure


The Process

Key features are: pooling of a group of similar non-traded financial assets transfer of those assets to a special-purpose company

which issues securities risk reduction by systematic risk assessment, by

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

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

example, as a portfolio of loans or receivables) on-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)

Finance company whose growth is constrained

Has pool of automobile receivables Has track record 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

Credit risks Liquidity risk Servicer performance risk Swap counterparty risk Guarantor risk Legal risks Sovereign risk Interest rate and currency risks 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

Mortgage Securitization Non-Mortgage ABS Intangibles Infrastructure and Project Financing


Asset-Backed Securities: Legal and Regulatory Aspects

LegalThe TransferThe Special-Purpose Vehicle

Taxation Accounting Treatment Bank Regulatory Treatment


Legal Aspects

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

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 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.

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

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

LEGAL


What Makes it a Sale?

The form and treatment of the transaction The nature and extent of the benefits

transferred The irrevocability of the transfer The level and timing of the purchase price, Who possesses the documents Notification when the assets are sold

LEGAL


What Makes it Likely to be Consolidated? The difficulty of segregating and ascertaining

individual assets and liabilities The presence or absence of consolidated

financial statements The comingling of assets and business

functions The existence of parent and intercorporate

guarantees and loans The transfer of assets without strict

observance of corporate formalities.

LEGAL


Taxation Aspects

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 of Seller/servicer Trust or special-purpose corporation Investors

TAX


Accounting Treatment

Sale versus financing Consolidation Accounting for loan servicing

ACCOUNTING


FASB Sale Treatment

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

The SPV cannot require the transferor to repurchase the assets except pusuant to certain recourse provisions

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

ACCOUNTING


Consolidation Treatment

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

"Nonhomogeneous operation" exception

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

ACCOUNTING


Fees

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

Commitment fees. These are to be deferred.

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

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

Avoid excessive bank risk-taking Discourage speculative investments Prevent financial market scandals Prevent circumvention of deposit regs Encourage financing of capital investment Discourage financing of consumption 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 within

But what makes them worth more outside?


For Banks: Capital Requirements

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

But if regulatory capital requirements penalize banks for holding such assets, they should: securitize the good assetsprofit from origination and servicing

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 Two-year bank notes vs pass-though rate

1.1

Upfront costs Underwriting SEC filing, legal fees, etc

(2.6)

Ongoing costs Letter-of-credit fee (0.5)

Capital charge 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:

Identify and isolate good assets from a company or financial institution

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

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?

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

sources Needed to continue to fund its car loans Only way to do this was to securitize the

loans “Firms that securitize tend to have

considerably weaker credit quality than other firms.”


Costs Associated with Securitization

Interest cost of the debt Issuance expenses of the debt Also:

Credit enchancement and liquidity support for the assets

Structuring fees payable to bankersLegal, accounting and tax advice feesRating agencies' feesSystems modificationsManagement time


Costs Needed to Measure the Annual Pre-Tax Impact of Securitization The interest on the securitized funding The annual costs of credit enhancement/liquidity lines Any guarantees to enhance the credit rating of any

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

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

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

retention in any guaranteed investment contract (GIC)

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

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

Collateralized debt Securitized loans Non-recourse project debt Basic question: Why should a company

segregate the cash flows from a particular business, and make it self-financing?


Project Financing

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

Structure? Participants? Funding sources? Risks?


Project Financing (Summary)

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

Sponsor's vehicle company structures multi-stake finance

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

Risks: resource quantity, input costs, technical, timing, pre-completion, demand, operating, force majeure, political

Risk sharing and mitigation


Project Financing

Definition 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

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

Security for the loan the revenue generating asset all shares and interests in the

entity real property all contacts, permits authorizations, etc.; and, all other instruments necessary for continuing project

operations

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

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

Risk Sharing and Diversification Accounting Treatment Preserves

Corporate Borrowing Capacity Access to Long Term Financing Tax Benefits Political Risk Mitigation


The Risks

Political Resource & input Technical Construction Legal Economic

Cost overruns Completion delays 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 and Supply 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

Who is the issuer?Ras Laffan LNG Co. Ltd. (Qatar)But Security Trustee (IBJ) plays unusually major

role

What assets does it have?Natural gas reserves; LNG take-or-pay Sale and Purchase Agreement

with Korea Gas; Security Trust Agreement; Project Coordination

Agreement; loan refund agreement, etc.


Ras Laffan

What are the risks, and how are they handled?Qatar/regional interferenceQatar legal systemDefault on AgreementsCompletion/timingOperatingEconomic (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


asiansecuritization.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

Prof. Ian Giddy New York University Financing with Asset-Backed Securities SIM/NYU The Job of the CFO