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The Economics Of

Structured Finance

Pratik Killa

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THE ECONOMICS OF

STRUCTURED FINANCE

A PROJECT REPORT

Submitted By

PRATIK KILLA

In partial fulfillment for the award of the Degree

Of

BACHELOR OF COMMERCE

ROLL NO – 31

ROOM NO - 06

ST. XAVIER’S COLLEGE (AUTONOMOUS)

DEEMED UNDER UNIVERSITY OF CALCUTTA

APRIL 2011

THE ECONOMICS OF

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ACKNOWLEDGEMENT

To begin with this project undertaken by me was an extremely rewarding

experience for me in terms of learning and exposure. I have tried to keep the

project as simple as possible so as to impart a better understanding of the content

and to demonstrate exactly what I am trying to bring to the fore through this

project.

I would like to extend my deep gratitude towards the Department of Commerce,

St.Xavier’s College, for designing a curriculum which inculcates research and

project work.

I would like to extend my deepest gratitude to my research guide, Prof. Soummya

Banerjee, Senior lecturer, Dept. of Commerce, who gave his valuable time and

guidance in every step of my project. Sir has always helped me out with valuable

information and has contributed immensely towards the successful completion of

this project .

Apart from the above, I would like to thank all my peers and colleagues for their

contribution in this project of mine. I would also like to thank my family who kept

motivating me and suggested me in the content of my work.

PRATIK KILLA

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TABLE OF CONTENTS

1. INTRODUCTION 06

DEFINITION OF STRUCTURED FINANCE 06

OBLECTIVE OF THE STUDY 09

LITERATURE REVIER 10

METHODOLOGY 12

2. OVERVIEW OF STRUCTURED FINANCE MARKETS & TRENDS 13

A SPECIFIC NOTE ON EMERGING MARKETS 16

INDIAN STRUCTURED FINANCE EVOLUTION 19

CURRENT STATE OF SF IN INDIA 19

FUTURE PROSPECTS FOR INDIA 22

3. RATINGS IN STRUCTURED FINANCE: WHAT WENT WRONG?? 23

ISSUES ASSOCIATED WITH RATING SF TRANSACTIONS 24

THE LESSONS WE LEARNT 28

RECOMMENDATIONS 33

4. CASE STUDY: HOW ENRON HAS AFFECTED THE BOUNDARIES OF SF 35

BACKGROUND 36

EFFECT ON TRADITIONAL PROJECT FINANCE 36

STRUCTURED PROJECT FINANCE 38

SPECIAL PURPOSE ENTITIES 38

SOURCES OF FREE CASH FLOW 39

SECURITY INTERESTS 39

HOW COMPANIES HAVE RESPONDED 40

INCREASED TRANSPERANCY AND DISCLOSURES 41

REGULATORY ISSUES 42

OTHER LESSONS LEARNED 42

5. CONCLUSIONS, LIMITATIONS AND RECOMMENDATIONS 44

6. BIBLIOGRAPHY 48

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ABSTRACT

The financial crisis that began in late July 2007 represented the first test of the new

complex structured finance products, markets, and business models that have

developed over the past decade.1 The crisis has been both deep and protracted:

one-month and three-month interbank interest rates remain elevated despite

coordinated central bank operations and rate cuts; there is significant uncertainty

about the valuations and disclosures of structured instruments; counterparty risk

remains a concern; and the balance sheets of financial institutions have been

weakened. As a result, important questions are being asked about whether

structured finance products provided the intended benefits, the extent to whichthese products increased the risk of a crisis and exacerbated its consequences, and

the need for both the official and private sectors to address systemic weaknesses.

The conclusion of this research project is that, although structured finance can be

beneficial by allowing risks to be diversified, some complex and multi-layered

products added little economic value to the financial system. Further, they likely

exacerbated the depth and duration of the crisis by adding uncertainty relating to

their valuation as the underlying fundamentals deteriorated. The recovery of the

structured market will likely entail more standardized products, at least for sometime to come, and better disclosure both at origination and subsequently.

To this end, policy measures should aim to strengthen design and market

weaknesses and to close the regulatory gaps in structured finance, without

impeding innovation.

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chapter 1

INTRODUCTION

In the wake of the financial crisis, many once-esoteric investment terms have

become a familiar part of our vocabulary. The role of structured finance securities

such as collateralized debt obligations (CDOs), for example, and the part played by

ratings agencies in legitimizing these products, has become all too clear. The

pooling and repackaging of economic assets such as loans, bonds, and mortgages

resulted in enormous yields for many investors — until, one day, they didn't.

DEFINITION OF STRUCTURED FINANCE

There is no universal definition of Structured Finance. It is apparent from the way

that Structured Finance teams are organized in banks that the term covers a wide

range of financial market activity. The following can be viewed as a good working

definition of structured finance:

. . . Techniques employed whenever the requirements of the originator or owner of the asset, be they concerned with funding, liquidity, risk transfer, or other need,

cannot be met by an existing off the shelf product or instrument. Hence, to meet

this requirement, existing products and techniques must be engineered into a tailor

made product or process. Thus structured finance is a flexible financial engineering

tool.

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The following elements can be enumerated as characterizing a structured finance

transaction:

A complex financial transaction that may involve actual or synthetic transfer

of assets or risk exposure, aimed at achieving certain accounting, regulatoryand/or tax objectives;

A transaction ring-fenced in its own special purpose vehicle;

A bond issue that is asset-backed and/or external reference index-linked;

A combination of interest-rate and credit derivatives;

A transaction employed by banks, other financial institutions, and

corporations as a source of funding and/or favorable capital, tax and

accounting treatment; and

Disintermediation between banks and other corporate entities.

As we just noted, there are alternative definitions of structured finance. Some of

them proposed by practitioners and regulators have been identified in the next

section. As will be seen, the working definition above, as well as the elements of

structured finance given above, tie together many of the alternative definitions

identified in the next section.

SF involves tailoring a product to the risk-return profile and maturity requirementsof the borrower. Usually improvised over traditional loan financing products, it

refers to such financing structures wherein the lender does not look at the entity as

a risk but tries to align the financing to specific cash accruals of the borrower. It

encompasses all advanced private and public financial arrangements that

efficiently refinance and hedge any profitable economic activity beyond the scope

of conventional forms of on-balance sheet securities (debt, bonds, equity) in the

effort to lower cost of capital and to mitigate agency costs of market impediments

on liquidity

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Source: Committee on the Global Financial System (2005), “The role of ratings in Structured Finance: issues and Implications”, cited in “Structured Finance: Complexity and Uses of Rating”, BIS Quarterly Review, June 2005

As it is highlighted in this chapter Structured Finance is a term that covers a very

wide range of financial market transactions and products. While a common

definition of it seems to center on securitization, structured financial products also

include complex instruments such as bonds with embedded options and

transactions such as project financing and leveraged leasing. It is thus suggested

that securitization and the employment of SPV entities is a subset of structured

finance, albeit a large subset.

In conclusion, it is probably best to say that there is no one definition of structured

finance, and that the term can be used to describe any financial transaction or

instrument that is not plain vanilla.

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OBJECTIVES OF THE STUDY

1. To have an overview of the structured product market and the trend.

2. To analyze the role of credit rating agencies in the issuance of structured

financial products.

3. To track the evolution of structured finance in the Indian financial market.

4. Analyze the views of how the Enron debacle affected project finance and the

broader realm of structured finance.

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Andrew Silver of Moody’s Investors Service defines Structured Financing asfollows:

Structured Finance is a term that evolved in the 1980s to refer to a widevariety of debt and related securities whose promise to repay investors is

backed by (1) the value of some form of financial asset or (2) the creditsupport from a third party to the transaction. Very often, both types of backing are used to achieve a desired credit rating.

Structured Financings are offshoots of traditional secured debt instruments,whose credit standing is supported by a lien on specific assets, by adefeasance provision or by other forms of enhancement. With conventionalsecured issues, however it s generally the issuers earning power that remainsthe primary source of repayment. With structured financings, by contrast, theburden of repayment on a specific security is shifted away from the issuer to

a pool of assets or to a third party.

Securities supported wholly or mainly by pools of assets are generallyreferred to as either mortgage-backed securities (mortgages were the firsttypes of assets to be widely securitized) or asset-backed securities, whosecollateral backing may include virtually any other asset with a relativelypredictable payment stream, ranging from credit card receivables orinsurance policies to speculative grade bonds or even stock. Outside theUnited States both types of structured financing are often referred to assimply ―Asset-Based Securities.‖

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METHODOLOGY

The project undertaken by me is of Descriptive and Exploratory in nature.

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2OVERVIEW OF STRUCTURED FINANCE

MARKETS AND TRENDS

The easiest way to highlight the development of the structured finance market is to

quantify its new issuance volume. That volume has been steadily climbing all over

the world, with U.S. leading, followed closely by Europe, and Japan and Australia

a distant third and fourth. The rest of the world is now awakening to the

opportunities offered by structured credit products to both issuers and investors

and gearing up for a strong future growth. In that respect, it is worth mentioning

Mexico, which is leading the way in Latin America; South Korea and Republic of

China lead in continental Asia and Turkey in for the Middle East and Eastern

Europe. It is only a matter of time before Central and Eastern Europe and China

and India spring into action, and the Middle East launches its own version of

securitization.

The data shown in Tables 1.1 to 1.4 are based on publicly available information

about deals executed on each market. Such data is believed to seriously understate

the size of the respective markets due to several factors:

The availability of private placement markets in many countries, the data for

which are not widely available;

The execution of numerous transactions executed for a specific client,known as bespoke or custom tailored deals, especially in the area of

synthetic collateralized debt obligations and synthetic risk transfers.

The exclusion from the count of many transactions based on synthetic

indices, such as iTraxx and CDX, ABX, etc, whereby structured products are

created using Tranches from these indices

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That being said, the publicly visible size of the markets and their growth rates are

sufficient to attract investors, issuers and regulators. The structured finance market

growth also stands out against the background of declining bond issuance volumes

by corporates and the rising issuance volumes of covered bonds, which in turn are

increasingly becoming more ―structured‖ in nature.

The markets of United States, Australia, and Europe can be viewed as

international markets, i.e., providing supply to both domestic and foreign investors

on a regular basis and in significant amounts, whereas the other securitization

markets remain predominantly domestic in their focus. The international or

domestic nature of a given market is not only related to where the securities are

sold and who the investors are, but also to the level of disclosure, availability of

information and, subsequently, the level of quantification (as opposed toqualification) of the risks involved, in particular structured finance securities and

underlying pools. If we were to rank the markets by the level of disclosure of

information about the structured finance securities and their related asset pools, we

should consider the U.S. market as the leader by far in terms of breadth, depth,

and quality of the information provided — being the oldest structured finance

market helps, but it is not the only reason: investor sophistication, type of

instruments used (those subject to high convexity risk, for example), bigger share

of lower credit quality securitization pools, higher trading intensity with related

desire to find and explore pricing inefficiencies, etc. are all contributing factors.

Other structured finance markets, however, are making strides in that direction as

well. Some of the reasons are associated with the type of instruments used: say,

convexity-heavy-Japanese mortgages, refinancing-driven UK subprime, default-

and correlation-dependent collateralized debt obligations (CDO) structures, etc.

The existence of repeat issuers with large issuance programs and pools of

information also helps. However, outside the United States, another major change

is quietly driving toward more quantitative work: the need to quantify risks in

structured finance bonds is moving from the esoteric (for many) area of back-

office risk management to front-office investment decision making based on

economic and regulatory capital considerations, under the new regulatory

guidelines of BIS2 (Basel 2 Banking Regulation) and Solvency 2 (Regulation of

Insurance Companies

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TABLE 1.1

US STRUCTURED PRODUCT NEW ISSUANCE VOLUME, 2000-2005

AUTO CRCARDS HEL MH EQUIP STLOANS OTHER OTHER ABS

2000 64.72 50.45 55.73 9.13 9.56 12.42 16.90 38.89

2001 68.96 58.47 71.79 6.27 7.40 9.94 24.14 41.48

2002 93.08 70.04 148.14 4.30 6.54 20.18 12.41 39.14

2003 85.49 66.55 214.99 0.44 10.09 39.96 16.67 66.71

2004 77.02 50.36 320.11 0.50 5.92 44.99 6.73 57.64

2005 99.54 67.51 493.20 NA 7.93 70.36 14.93 93.23

Abbreviations: SF CBO = Structured Finance Collateralized Bond Obligation; HY CLO = High Yield Collateralized Loan

Obligation; TruPS = Trust Preferred Securities; HY CBO = High Yield Collateralized Bond Obligation; IG CBO = Investment

Grade Collateralized Bond Obligation; MV = Market Value Collateralized Debt Obligation.

Source: Merrill Lynch.

TABLE 1. 2

U.S. CDO NEW ISSUANCE BY CDO TYPE, 2000 –

2005

2000 2001 2002 2003 2004 2005

SF CBO 10.3 13.5 25.2 26.2 56.8 69.9

HY CLO 16.8 11.5 14.7 16.7 30.2 50.5

TruPS 0.3 2.2 4.3 6.5 7.5 9.0

HY CBO 17.5 15.2 1.5 0.8 0.6 0.0

IG CBO 13.1 5.2 4.4 0.0 0.0 0.0

Other 10.2 5.4 3.2 4.6 3.9 25.4

MV 0.2 0.0 0.0 0.0 0.9Total 68.5 53.0 53.3 54.9 99.9 154.8

Synthetic 5.5 6.0 11.0 6.2 29.7

Total 68.5 58.5 59.3 65.9 106.1 184.5

Abbreviations: ABS = asset backed securitizations; CDO = collateral debt obligations; CMBS = commercial mortgage

backed securitizations; CORP = Corporate Securitization; RMBS = Residential Mortgage Backed Securitization.

Source: Merrill Lynch.

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Source: JPMorgan SF Research cited in BIS Quarterly Review, June 2005

The United States is the largest, deepest and widest securitization market in the

world.13 Australia has a market size of A$10bn. and is dominated by residential

mortgages and commercial property leases. In Japan, securitization is largely

undeveloped with transactions confined to about US$4.8bn In Asia, assets worth

only US$2bn. has been securitized, half of which were in Hong Kong. India,

Indonesia, and Thailand are the future markets on horizon with a few deals of lowvolume having been concluded in each country. In Latin America, securitization

transactions were up from about US$3.67bn. in 1995 to 10.3bn in 1996. In South

Africa, very few transactions have taken place although the Government has

enacted a special law in 1992.

A SPECIAL NOTE ON EMERGING MARKETS

Emerging Markets have high costs of raising funds and look for alternative sources

for raising funds at cheaper sources. FIs in Asia have large illiquid debt to get rid

off. These countries have the potential to benefit from securitization as soon as the

situation improves in South East Asia. Some of the countries in Emerging Markets

have introduced specific securitization laws. Eastern Europe offers good scope

with the growth of consumer assets; export credit for traditional markets is

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growing in countries like Poland, Czech Republic, Hungary, and Slovakia. After

the success of securitization of credit cards and workers’ remittances in Turkey,

other markets in the region like Israel, Lebanon, and Egypt are ready for consumer

type securitization. Latin America is already on the path of active securitization

and is well ahead of the other EMs.

After having evolved rapidly as a risk transfer and refinancing tool in developed

economies, asset securitization has also assumed a vital role for private sector

financing in Emerging Market countries. Since the end of the 1980s, large and

highly-rated corporates and banks in developing economies have successfully soldreceivables from future claims against obligors. Such ―future flow securitization‖

involves the origination of foreign currency denominated debt secured by future

export receivables (e.g. oil and steel) and financial flows from either credit card

merchant vouchers or other payment rights in a move to vault the low sovereign

ceiling of Emerging Market county ratings and borrow at lesser cost than under

conventional funding methods. In light of the importance of financial liberalization

in improving the efficiency of capital markets, several Emerging Market countries

have developed the legal and financial infrastructure necessary to strengthen theirlocal securitization markets. This has allowed the securitization of existing assets

in local currencies in domestic capital markets or even abroad via cross-border

ABS transactions (CBEAs) (despite the currency mismatch between securities

denominated in foreign currency and underlying assets generated in local

currency).

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Also the public sector in many emerging market countries has embraced

securitization as an expedient means to foster favorable external debt dynamics

(i.e. lower debt service relative to current account receipts), greater fiscal

consolidation (i.e. lower public debt relative to GDP), and a more balanced

amortization profile of public debt. With the development of a strong localinstitutional investor base amid regulatory, tax, and legal reforms, asset

securitization has become an attractive funding solution for the public asset-

liability management. The securitization by sub national authorities is particularly

prominent. Over the recent past, federal, state and local authorities (municipalities

and provinces) as well as government agencies in various emerging market

countries have securitized future revenues to domestic and/or retail investors. In

most cases, public sector agencies have enlisted securitization in order to monetize

tax receivables (federal tax participations), deferred sales tax revenue, oil and gasroyalties, future water receivables, toll road revenues, sovereign lease receivables,

government loans, housing loan receivables, and performing bank assets from state

deposit insurance schemes.

Resource-rich countries, such as Brazil and Venezuela, have recorded

securitization mostly on future oil export receivables sponsored by government-

controlled entities. In Brazil, government controlled Petróleo Brasileiro S/A

(Petrobas) issued future flow ABS on U.S.$1.5bn and €200m (U.S.$257m) of

future oil export receivables by from 2001-2003. In Venezuela, government

controlled Petróleos de Venezuela (PDVSA) raised U.S.$2.5bn and €200m

(U.S.$257m) from future flow ABS on oil export receivables from 1998 to 2001.

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INDIAN STRUCTURED FINANCE EVOLUTION

Securitization is a relatively new concept in India but is gaining ground quite

rapidly. One of the earliest structured financing deals in India was the India

Infrastructure Developer issue on BOLT structure to institutional investors. Global

Telesystems also used the SPV structure to raise capital on its telecom future

receivables. ICICI and DOT did one of the first deals for securitizing receivables.

TELCO did a hire-purchase deal, where the future receivables from truck sales,

along with the ownership of assets, were assigned to investors directly without an

SPV. CRISIL rated the first securitization program in India in 1991 when Citibank

securitized a pool from its auto loan portfolio and placed the paper with GIC

Mutual Fund. While some of the securitization transactions which took place

earlier involved sale of hire purchase or loan receivables of NBFCs arising out of

auto-finance activity, many manufacturing and service companies are now

increasingly looking towards securitizing their deferred receivables and future

flows also.

CURRENT STATE OF SF IN INDIA

In FY2005, the market for SF transactions grew by 121%-y-o-y in value terms.The number of transactions increased only by 41%, pointing to a significant rise inaverage deal size. Within the SF domain, the ABS market showed maximumgrowth. This was largely due to strong increase in retail lending by banks andNBFCs.The SF scenario is largely based on ABS, accounting for 72% of the SF market in

2005, covering a variety of asset classes like cars, commercial vehicles,construction equipment, two-wheelers and personal loans.

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NOTABLE SHIFTS

In ABS:

ABS is the dominant type of instrument in the Indian SF market. The growthof ABS issuances in recent years has been due to a continued increase indisbursements by key retail asset financiers, investors’ familiarity with theunderlying asset class, relatively shorter average tenure of issuances andstability in the performance of a growing number of past pool

FY2005 saw relatively newer asset classes such as loans for financing usedcars, three wheelers and two-wheelers which were securitized in asignificant way.

The average ABS deal size almost doubled y-o-y to Rs. 2.9billion inFY2005, mainly due to large pools securitized by leading vehicle financierslike ICICI Bank and HDFC Bank.

There is a growing preference for floating-rate yields, given the volatileinterest rate conditions.

Time-tranching is increasingly becoming the norm: during FY2005, 64% of ABS issuances involved multiple tranches with different tenures.

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Source: ICRA

In MBS:

The largest ever MBS transaction in India, a RS. 12billion mortgage-backedpool of ICICI Bank happened in FY2005.

MBS has the potential for maximum growth, given the significant expansionin the underlying housing finance business underway. However, the longtenure of MBS papers and the lack of secondary market liquidity still deterinvestors.

In CDO:

Investment decisions influenced by the rating of the underlying corporateexposures in a CDO pool (and not purely the rating of the instrument) haveimpeded the growth of CDO in India.

Corporate loan securitization has been far lower than that in retailsecuritization.

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FUTURE PROSPECTS FOR INDIA

Securitization will grow in future for two significant reasons: (a) securitized paperis rated more creditworthy than the FI itself and (b) strict capital requirements are

imposed on the FIs. Moreover, the opening of the insurance sector for privatization

can create demand for securitized paper.

The extent of securitization in relation to incremental retail loan disbursements

remains low at less than 10% estimated) in India. Going forward, ICRA believes

that there is potential for ABS and RMBS volumes to grow, with Originators

scaling up their lending volumes and with investor confidence returning. Funding

needs together with regulatory prescription — such as priority sector lending

guidelines — are likely to remain the key factors prompting lenders to securitize.

Higher activity may be expected in the second half of the current year (FY2011),

as has been the case in the past, with banks keen to meet their annual PSL

requirements. While the various hindrances to RMBS continue to play their part,

the recently stated intention of the National Housing Bank (NHB) to revive the

market for RMBS appears encouraging.

Convergence with International Financial Reporting Standards (IFRS) is expected

to impact ABS and MBS, as asset de-recognition is a challenge for transactions

wherein the Originator provides credit enhancement. Nevertheless, the deferment

of IFRS implementation to 2013-14 for most banks (and to 2014-15 for most

NBFCs) could provide some relief for the time being.

The final Judgment of the Supreme Court on the issue of trading in loans by banks

can also have a crucial bearing on securitization volumes in India. In the light of

the RBI’s recent draft guidelines on MHP and MRR, the prospects are dim forLSOs. The applicability of these guidelines to securitization (and bilateral loan

pool assignments) by NBFCs will have a crucial bearing on ABS and RMBS

activity in India, going forward.

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3RATING IN STRUCTURED FINANCE:WHAT WENT WRONG???

The problems in Structured Finance markets that emerged in mid-2007 have

revealed weaknesses in risk management. Given the important role of ratings in the

investment and risk management processes, and in regulation, the turmoil has also

raised questions about the effectiveness of Credit Rating Agencies (CRAs’)

assessment of risks in rating complex financial products. This chapter focuses on

the use of rating information on Structured Financial products by different investor

groups, including the ―hard- wiring‖ of ratings in structured investment vehicles

(SIVs) and the role of monolines in providing credit enhancements to Structured

Finance product ratings, and discusses opportunities to broaden the scope,information content and reliability of SF ratings.

One lesson from the recent market turmoil is that investors’ risk management and

stress- testing systems need to be updated to account better for the key differences

in risk characteristics between structured finance and traditional corporate debt

securities. A number of initiatives are already under way to improve the

information content and to explore the usefulness of complementary risk measuresfor Structured Finance ratings by CRAs, in consultation with investors. The

chapter supports these efforts by proposing four ways in which CRAs should

improve the information on SF products:

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First, by enhancing the clarity and accessibility of existing ratinginformation and documentation on SF products.

Second, by improving the information available to investors on the key risk

factors that drive SF ratings, in particular on model risk and the sensitivity of ratings to assumptions about macroeconomic and sectoral developments.

Third, through periodic provision of information on the robustness of aCRA’s ratings criteria for classes of SF instruments to changes in system-wide market developments

Fourth, by expanding the ratings framework for SF products to includeinformation on the risk properties of individual issues and their ratedtranches.

ISSUES ASSOCIATED WITH RATING SF TRANSACTIONS

During the second half of 2007, the deterioration in the performance of subprime

loans in the United States resulted in a broad re-pricing of asset-backed securities

(ABS) and collateralized debt obligations (CDOs), many of which were backed by

subprime mortgages and in a loss of confidence in SF products more generally.

The ongoing re- pricing undercut investors’ confidence in the ratings of existing SF

products backed by subprime mortgages and, to a lesser degree, those backed byother assets. Indeed, rating revisions and frequency of multi-notch rating

downgrades on SF products far exceeded those on corporate securities in 2007

Rating migration characteristics of corporate and SF Securities

Relative stability of SF and corporate debt rating frequency of more than one notch downgrades

100 16

90 12

80 8

2007 structured finance2007 global corporate1978 – 2007 structured finance 70 4 1984 – 2007 corporate

60 0

AAA AA A BBB BB B AAA AA A BBB BB B

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This section highlights the factors that are likely to have contributed to the poor

rating performance of the US subprime mortgages included in pools of residential

mortgage-backed securities (RMBS), and consequently those of SF products

backed by them. In particular, the underlying risks associated with those mortgages

were obscured, and the impact of resulting losses was amplified, through the re-securitization of subprime RMBS in the form of CDOs of ABS. The complexity

and underlying leverage of these instruments may not have been apparent to many

investors who placed undue reliance on the ratings.

1. CRAS UNDERESTIMATED THE SEVERITY OF THE HOUSING

MARKET DOWNTURN:

The accuracy of SF credit ratings depends crucially on the precision of the CRAs’

economic forecast. The pooling of assets reduces idiosyncratic risk, but increases

exposure to systematic risk. Hence, losses in a mortgage pool are driven by

changes in economic conditions, and especially in house prices. In contrast, a

corporate credit rating relies on the CRAs’ assessment of the likelihood that a firm

will default during neutral economic conditions (i.e. full employment at the

national and industry level). If one were to fix the level of economic activity – for

example at full employment and zero home price appreciation (HPA) – the level of

losses in the RMBS pool is determined and, according to the model, the probability

of default is either zero or one. It follows that the credit rating on an RMBS trancheis the agency’s assessment that economic conditions will deteriorate to the point

where losses on the underlying mortgage pool exceed the tranche’s credit

enhancement. However, the failure of CRAs to spot early enough a deterioration in

underwriting standard led to a significant underestimation of both the level and the

correlation of defaults. As a result, it does not appear that the agencies fully

anticipated the severity of the housing market downturn.

Economic projections remain an important factor in subprime RMBS surveillance,

and the CRAs have changed their outlook for the housing market dramatically over

the last year. Broadly speaking, whereas in January 2007 they expected zero

nationwide HPA during the housing market downturn, by July they had revised

their expectation to price in declines of about 10% and by January 2008 to falls of

20%.

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2. LIMITED HISTORICAL DATA ADDED TO RATING MODELRISK:

RMBS ratings rely more heavily on quantitative models while corporate debt

ratings are more dependent on analyst judgment but a long historical record. In

particular, corporate credit ratings require the separation of a firm’s long-run

condition and competitiveness from the business cycle, the evaluation of whether

or not an industry downturn is cyclical or permanent, and an assessment about

whether or not a firm could actually survive a prolonged transitory downturn. In

contrast, RMBS credit ratings rely crucially on the ability of the rating agency to

predict how the level of losses for a particular loan pool will respond to a number

of different economic scenarios. Errors in the CRAs’ model of the relationshipbetween losses and economic conditions create an additional source of uncertainty

in the performance of RMBS credit ratings.

The lack of comprehensive historical data is likely to have added to model risk

during the current turmoil. Historical data on US subprime loans are largely

confined to a relatively benign economic environment, with very little data on

periods of significant declines in house prices. Given the importance of refinancing

to the performance of subprime loans, and the inherent non-linearities in the payoff of the refinancing option, this could be an important source of model error as the

limited historical data will provide inadequate information on the underlying risks.

Fitch has recently noted that the increased ―willingness of borrowers to simply

walk away from mortgage debt has contributed to extraordinary levels of early

default. The lack of historical data arguably added to difficulties in correctly

assessing correlations, and the degree of diversification achieved through a pooling

of subprime loans. In particular, the assumption that geographical diversification

exists turned out to be incorrect.

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3. CRAS UNDERESTIMATED THE ORIGINATOR RISK FACTOR:

While there is typically diversification across borrowers within a mortgage pool,

there is not similar diversification across originators, issuers or servicers. This

leaves SF investors vulnerable to correlated risk, introducing additional risk factors

which need to be addressed. In the case of RMBS, the performance of mortgage

loans depends in part on the state of refinancing conditions. The level of interest

rates, credit spreads, and the general level of underwriting standards each have

important effects on the performance of mortgage loans.

Since all of the loans in a pool are serviced by the same firm, and are originated by

at most a few firms, there is correlated risk across the loans related to servicer

and/or originator quality. The CRAs have noted that servicer quality has a dramaticimpact on the loss distribution, and publish servicer quality ratings in order to

minimize this source of uncertainty. However, the CRAs do not deal with

differences in originator quality with the same amount of analytical rigour.

The July 2007 subprime RMBS downgrades were concentrated in the issues of

four firms, suggesting that there were important unobserved differences in

underwriting standards across originators. Some weakly capitalized originators

may have taken advantage of transparent rating agency criteria, enabling borrowersto misrepresent occupancy, income, down payment source and/or property

appraisals. A recent report by Fitch observes that, for a significant fraction of early

payment defaults, there were clear signs of fraud in the loan files that were ignored

in the underwriting process. To deal with this problem, Moody’s changed its

surveillance criteria in October 2007, splitting originators into three tiers, with loss

expectations increasing significantly from the highest to the lowest tier.

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THE LESSONS WE LEARNT!!

1. Credit rating information should support, not replace, investor duediligence :

Recent events have shown that many investors failed to incorporate adequately the

risk characteristics of SF securities into their portfolio allocation and risk

management systems. Several factors probably contributed to this failure,

including a ―search for yield‖ in an environment where credit spreads were being

progressively squeezed, combined with a lack of experience with, and

understanding of, the risk characteristics of structured credit products.

That said, credit ratings on SF products have played an important role in portfolio

allocation and risk management processes. Some investors whose investment

mandates and asset preferences are significantly governed by minimum external

rating requirements have been attracted to highly rated SF securities. In part, this

has happened because such securities, given their apparently well diversified

collateral and perceived low default risk, appeared to offer better value than highly

rated corporate or sovereign bonds, or non-structured, pass-through securitizations

Investors with relatively long holding periods were also attracted by high spreads,

which they may have assessed as reflecting liquidity rather than credit risk given

the high CRA ratings attached to the securities. And many investors have probably

read far more into ratings than the CRAs have ever claimed for them.

The responsibility of investors for risk assessment and stress testing of any

investment product must be strengthened going forward. In particular, trustees of

investment funds and investment managers should review their internal procedures

and guidelines concerning how ratings information on SF products is used in theirinvestment mandates and decisions. At the same time, rating information is likely

to remain a key input to asset allocation and risk management processes.

Moreover, credit ratings also serve as an input for determining banks’ regulatory

capital under the Basel II framework, as well in other areas of non-bank financial

regulation. In fact, many of the investors with exposures to structured finance

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securities have been supervised institutions, and some of the largest losses have

been sustained by firms active in the design and marketing of these structures.

Against this background, we expect the CRAs to continue to play an important role

by conveying rating information in a way that supports risk analysis and investordue diligence. It is apparent from the responses of the CRAs to recent criticism that

they recognize that more should have been done to alert users to the limitations of

their rating models and their own scrutiny of the quality of underlying asset pools,

as well as the sensitivity of their ratings to any divergence from the key central

assumptions upon which their analysis rested. Against this backdrop, while it is

important for public authorities to identify clearly areas where improvement is

needed and to suggest alternatives as to how such improvement could be achieved,

the group believes that it is the responsibility of CRAs and users of ratings tocollaborate on developing specific solutions. The consultation processes initiated

by various CRAs and industry organizations serve this purpose.

2. CRAS SHOULD ENHANCE THE INFORMATION UNDERLYINGSF RATINGS:

CRAs do already provide a large amount of information on SF products. Currently

CRAs provide a view on an SF transaction, in the form of a ―pre-sale‖ report

which includes indicative tranche ratings. The models on which their ratings arebased are available to investors, along with defaults and transition studies. Once a

deal has been completed, CRAs process information from the trustee report in

standardized format (like other private vendors) and show the remaining level of

the credit enhancement. However, such post-deal monitoring, including the

processing of trustee reports, has not always been timely.

Information provided by CRAs should be presented in a way that facilitates

comparisons of risk within and across classes of different SF products. For

instance, standardization of pre-sale and post-sale performance reports would

support monitoring. This would apply particularly to re-securitization products,

where relatively little performance information is currently provided. Information

should be provided on the timing and completion of post-issuance reviews by

CRAs, and whether an existing rating has been reassessed in the light of changes to

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modeling assumptions. Finally, more user-friendly access to CRA SF models and

their documentation should be provided.

The Group recognizes that responsibility for improving the transparency of SF

markets does not, of course, rest solely with the CRAs. At present, the initialinformation provided by issuers is often regulated, as it supports the sale of the

products. Public data on collateral pool asset performance are very fragmented

among a large number of commercial data vendors who specialize in different

asset classes, and none is able to provide market-wide data. Competitiveness

concerns are usually the reason put forward by sponsors to explain these

shortcomings. However, in the changed market conditions this reticence may

disappear.

3. BETTER INFORMATION ON KEY RISK FACTORS OF SFRATINGS IS NEEDED:

The massive rating downgrades in 2007 dramatically illustrated the risk properties

of SF instruments that arise from the tranching of claims against an underlying

portfolio of collateral assets. These differences manifest themselves in the stability

characteristics of ratings. Over a long period and at an aggregate level, highly rated

SF securities have shown greater ratings stability than corporate bonds. This long-

run historical experience is reflected in the lower risk to highly rated SF securitiesof a single-notch downgrade, but this disguises the higher risk of multi-notch

downgrades that can follow a more pessimistic reappraisal of the prospective

performance of the underlying collateral. Usually this risk will be small, but where

projected losses on the pool are subject to a significant adverse and correlated

change, sharp downgrades can ensue.

CRAs should provide more information about their assumptions on the key risk

factors that influence ratings of SF securities. These include:

Model risk: CRAs should document the sensitivity of SF tranche ratings to

changes in their central assumptions regarding default rates, recovery rates

and correlations. Limitations to the historical data on underlying pools, for

instance if they cover only a short time period, apply only to similar rather

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than identical contracts, or where the characteristics of underlying assets

have changed significantly, should be clearly disclosed as a risk to the

rating, as should any adjustment made to mitigate this risk. CRAs should

give greater emphasis to stress tests by providing such analysis in their

publications or by facilitating ―what if?‖ scenario analysis by users.

Macroeconomic forecast error . CRAs should clearly and regularly disclose

to investors their economic assumptions underlying the rating of SF

products, and document how they expect each rated tranche of a structured

finance transaction to perform under different economic scenarios. CRAs

should document the type of scenario that would lead to a severe impairment

of a tranche. Related to the above, CRAs could indicate the extent to which

ratings based on historical default experience have been modified by their

assumptions about the macroeconomic outlook.

Other risk factors. The rating agencies should take effective steps to ensure

that information from issuers and originators is trustworthy, and monitor

more intensively the performance of the various agents in the securitization

process. One key practical proposal would be that the agencies should rate

mortgage originators, as they do servicers. The rating would focus on

reducing uncertainty created by the originator risk factor. Hence, it might

look at factors such as underwriting standards rather than the originator’sdebt.

4. CRAS SHOULD TAKE SYSTEM-WIDE RISK INTO ACCOUNT:

CRAs should periodically consider the wider systemic implications of a rapid

growth of similar instruments or vehicles, or of new business undertaken by

existing vehicles, for the continued robustness of their original ratings criteria.

Such growth may lead to a concentration of market and other risks that may not

have been anticipated at the time the CRA’s minimum requirements were

formulated. As illustrated by the recent experience of SIVs, the consequences of

exposure to a common shock can be amplified when several vehicles sharing

common ratings rules are simultaneously affected. This is particularly the case

when market-based triggers are incorporated in the rating.

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Such a review, perhaps conducted on an annual basis (and made available to

investors), may lead to a tightening of ratings criteria and possibly to downgrades

if existing structures are unable to adapt quickly. Moreover, anticipatory

adjustments, if carried out in calmer times, are likely to be less disruptive to

financial markets.

Among other issues, this raises the question of the potential system-wide

implications of rating structured products and vehicles, whose ratings themselves

are sensitive to market value changes and/or to the ratings of their collateral assets.

Similar effects may arise from ratings being embedded in financial regulation.

5. SF RATINGS SHOULD MORE CLEARLY BE DIFFERENTIATEDFROM SINGLE-NAME CREDIT RATINGS:

Considering ways to distinguish clearly between the rating information on

structured and other securities appears important for certain groups of investors. In

the course of rating SF instruments, CRAs collect and process large amounts of

information, much of which might be useful to investors who devote substantial

resources to risk assessment and management. These users may well communicate

with CRAs on their own initiative to solicit additional information. However,

ratings are extensively used, and will continue to be used, as rough standalonemeasures of overall credit risk by a number of participants: investors who have

limited access to analytical resources; private ―principals‖ (such as pension fund

trustees) that wish to provide straightforward and easily verifiable risk guidelines

to managers to whom they have delegated investment decisions; and public

regulators.

Several options are available for incorporating different risk characteristics into the

ratings framework, which can be broadly classified under one-, two- or multi-

dimensional measures of risk. For example, lower ratings can be assigned tostructures with high model uncertainty, a practice referred to as notching, than

might otherwise be warranted by the central (but highly uncertain) estimates of key

parameters such as correlation, default probabilities and recovery rates.

Alternatively, different loss characteristics of SF instruments could also be

conveyed using a separate rating scale.

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RECOMMENDATIONS

1.

Investment fund trustees and managers should review their internalprocedures and guidelines concerning how ratings information on SF

products is used in their investment mandates and decisions.

2. Rating reports should be presented in a way that facilitates comparisons of

risk within and across classes of different SF products. For instance, pre-

sale and post-sale performance reports should be standardized. This

would particularly be important for re-securitization products, where

relatively little performance information is currently provided.

3. Rating agencies should provide clearer information on the frequency of

rating updates. For instance, CRAs should disclose the timing and

completion of post-issuance reviews by CRAs, and disclose whether an

existing rating has been reassessed in the light of changes to modeling

assumptions.

4. More user-friendly access to CRA SF models and their documentation

should be provided . Rating models made available by CRAs should

facilitate the conducting of “what if?” analysis or stress tests by users on key model parameters.

5. CRAs should document the sensitivity of SF tranche ratings to changes in

their central assumptions regarding default rates, recovery rates and

correlations. For instance, how would ratings of different tranches change if

the recovery rate assumption were altered?

6. CRAs should clearly and regularly disclose to investors their economic

assumptions underlying the rating of SF products. This includes

documenting how they expect each rated tranche of an SF transaction to

perform under different economic scenarios, as well as the type of scenario

that would lead to severe impairment of a tranche. CRAs could also indicate

the extent to which ratings based on historical default experience have been

modified by their assumptions about the macroeconomic outlook.

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7. Limited historical data on underlying asset pools should be clearly

disclosed as adding to model risk, as should any adjustment made to

mitigate this risk. For instance, CRAs should state in reports that they

cannot attach the same degree of confidence to the quality and stability of

the product’s rating as would be the case with more established products.

8. CRAs should monitor more intensively the performance of the various

agents involved in the securitization process, particularly where potential

incentive misalignments and poor quality data inputs can undermine the

presumed quality of the underlying assets. One key practical proposal would

be that the agencies should assign ratings to mortgage originators’ loan

approval processes and controls.

9. CRAs should periodically consider the wider systemic implications of a rapid growth of similar instruments or vehicles, or of new business

undertaken by existing vehicles, for the continued robustness of their

original ratings criteria.

10. CRAs should consider how to incorporate additional information on the

risk properties of SF products into the rating framework. CRAs should, in

the next few months, explore with market participants and regulators ways

to indicate rating risk for SF instruments in a summary form. For instance,

could a simple rating risk suffix, stating rating volatility or uncertainty,

increase investor risk awareness without further increasing reliance on

ratings? CRAs should provide an analysis of the reliability with which risk

suffixes could be calculated. Regulators will also need to consider how

additional dimensions of rating risk could be taken into account in

determining regulatory capital.

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CHAPTER

4CASE STUDY: HOW ENRON HAS AFFECTED THE

BOUNDARIES OF SF

In the spring of 2002, the Journal of Structured and Project Finance surveyed

nine frequent contributor and leading experts to hear their views of how the Enron

debacle affected project finance and the broader realm of structured finance. Their

general view is that the Enron bankruptcy and related events have changed neither

the nature nor the usefulness of traditional project finance but they have led to a

slowing down of some of the more innovative forms of structured and project

finance. Among the other direct and indirect effects of Enron have been increased

caution among lenders and investors toward the energy and power sectors;

increased scrutiny of off balance-sheet transactions; increased emphasis on

counterparty credit risk, particularly with regard to companies involved in

merchant power and trading; and deeper analysis of how companies generate

recurring free cash flow. There is increased emphasis on transparency and

disclosure, even though disclosure in traditional project finance has been more

robust than in most types of corporate finance. In the recent market environment,

for reasons that extend beyond Enron, some power companies have been canceling

projects and selling assets to reduce leverage and resorting to on-balance-sheet

financing to fortify liquidity.

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BACKGROUND

The immediate cause of the Enron bankruptcy was a loss of confidence among

investors caused by that company’s restatement of earnings and inadequate,

misleading disclosure of off-balance-sheet entities and related debt. There were

also secondary causes related more to conditions in the energy and power business

than to structured finance, including (1) the California power crisis in 2001; (2) the

related Pacific Gas & Electric bankruptcy; (3) falling spot power prices, caused

largely by recent over-building of power plants; (4) increasing perception by

investors, lenders, and rating agencies of the risk related to independent power

producers; and (5) increasing skepticism of the energy trading business, includingsuspicion that some parties were manipulating their earnings through the marking

to market of power contracts and off-balance-sheet vehicles.

EFFECT ON TRADITIONAL PROJECT FINANCE

Traditional project finance is cash-flow-based, asset-based finance that has little incommon with Enron’s heavily criticized off -balance-sheet partnerships. According

to Roger Feldman, Partner of Bingham McCutchen, the historic elements of project

finance are firmness of cash flow, counterparty creditworthiness, and ability to deal

over a long timeframe, and confidence in the legal system. Barry Gold, Managing

Director of The Carlyle Group, points out that project finance is a method for

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monetizing cash flows, providing security, and sharing or transferring risks. The

Enron transactions had none of these characteristics. They were an attempt to

arbitrage accounting, taxes, and disclosure.

Traditional project finance is based on transparency, as opposed to the Enronpartnerships, where outside investors did not have the opportunity to do the due

diligence upon which any competent project finance investor or lender would have

insisted. Those parties are interested in all the details that give rise to cash flows.

As a result, there is a lot more disclosure in project finance than there is in most

corporate deals.

In traditional project finance, analysts and rating agencies do not have a problem

with current disclosure standards; it is not hidden and it never has been. First, theyknow project financing is either with or without recourse and either on or off the

balance sheet. For example, in the case of a joint venture where a company owns

50% of a project or less, the equity method of accounting is used. On the

company’s income statement, the company’s share of earnings from the project are

included below the line in the equity investment in unconsolidated subsidiaries

and, on the balance sheet, its investment is included in equity investment in

unconsolidated subsidiaries. The point to remember is that whether a project is

financed on or off the balance sheet, analysts know where to look.

Off-balance-sheet treatment may not be the principal reason for most project

financing. It usually is motivated more by considerations such as risk transfer or

providing a way for parties with different credit ratings to jointly finance a

project — whereas if all of those parties provided the financing on their own

balance sheets, they would be providing unequal amounts of capital by virtue of

their different borrowing costs. None of these considerations have anything to do

with the Enron partnerships, where a 3% equity participation from a financial

player with nothing at risk was used as a gimmick to get assets and related debt off

the balance sheet.

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STRUCTURED PROJECT FINANCE

Even though pure project finance has not been affected very much by Enron, some

slowing of activity in the more innovative types of structured finance such assynthetic leasing, structured partnerships, and equity share trusts can be seen.

Synthetic leases are a mature product, understood by rating agencies andaccountants, in which billions of dollars of deals have been done. But the problemis ―headline risk.‖ Since the Enron debacle, numerous other companies have haddisclosure issues. Even though synthetic leases are transparent and well understoodby financial experts, they have an off-balance-sheet element that is not understoodby everyone in the market at large.

But Christopher Dymond of Greengate LLC cautions that the investor market hasoverreacted to anything that sounds ―like Enron.‖ Structured and project financialtechniques have been developed for sound risk management reasons and, in hisopinion, must be defended vigorously on those grounds. He believes a prejudiceagainst ―complexity‖ in financial structures could have a real economic andfinancial cost. Most sponsors and investors are sophisticated enough to make thesedistinctions. However, if sponsors fear that the wider market will punish them forusing complex structures, they will stop using them. After the Enron crisis, several

companies made public vows not to use any off-balance-sheet structures. But,rather than pandering to uninformed sentiment, Dymond believes that companiesshould make greater efforts to clearly delineate the difference between legitimatenonrecourse debt and the Enron structures.

SPECIAL PURPOSE ENTITIES

By using corporate stock as collateral and by creating conflicts of interest, Feldman

of Bingham McCutchen believes that Enron undermined the pristine nature of thespecial purpose, nonrecourse entity and caused all such structures to look suspectin some people’s eyes. He stresses that in traditional project finance, a specialpurpose, nonrecourse entity must be clean and fully focused on the transactionconcerned. In the aftermath of the Enron bankruptcy, project sponsors and thebankers and lawyers who support them have had to make special efforts to explain the legitimate business reasons for these entities.

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SOURCES OF FREE CASH FLOW

William Chew, Managing Director of Standard & Poor’s recalls that immediately

after Enron filed for bankruptcy protection, some questioned whether project andstructured finance would survive in their current form. And indeed, somecorporations with large amounts of off-balance-sheet financing and inadequatedisclosure were subjected to increased scrutiny and sharply reduced valuations forboth their equity and their debt. In response, a number of those companiesexpanded their liquidity and reduced their debt to the extent possible. But Chewbelieves that, as time progresses, that the main fallout from Enron and the otherrecent market shocks may be not so much a turning away from project finance butrather a greater stress on bottom-up evaluation of how companies generate

recurring free cash flow and what might affect it over time. In this process, Chewbelieves that project finance and other types of structured finance probably willcontinue to play an important role. The change, in his view, is that the focus will beon not only the project structures, but also on how they may affect corporate- levelcash flow and credit profiles — for example, through springing guarantees andpotential debt acceleration, through contingent indemnification and performanceguarantees, through negative pledges and their limits at both the project and thecorporate holding company level, and through the potential for joint-venture andpartnership dissolutions to create sudden changes in cash flows. Standard & Poor’sreminds us in its project as well as its corporate credit analysis that there can be a

big difference between generally accepted accounting principles (GAAP) and cashflow analysis.

SECURITY INTERESTS

The power business, in part, has shifted from a contract business to a trading, cash

flow kind of business where the counterparty becomes critical to the viability of a

transaction. The security in the transaction is less the asset itself and more what thetrading counterparty does with the asset. That asset has an option value in the

hands of counterparty, but a far different value if a bank has to foreclose on it — a

value you would rather not find out.

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Enron’s alleged tendency to set its own rules for marking gas, electricity, and

various other newer, thinly traded derivative contracts to market raises some

interesting questions about collateral and security. Historically, the security in a

power plant financing has consisted of contracts, counterparty arrangements, and

assets. But if a lender’s security depends on marking certain contracts to market,and there is some question as to the objectivity of the counterparty that is marking

them to market, that raises additional questions as to what is an adequate sale, what

is adequate collateral, how a lender takes an adequate security interest, how a

lender monitors the value of its security interest, and what a lender needs to do to

establish a sufficient prior lien in the cash flow associated with the transaction. In

the case of a structured finance transaction, the key question remains just as it

always has been: whether the security is real and whether you can get your hands

on it.

HOW COMPANIES HAVE RESPONDED

The affected companies have responded to the post-Enron market environment

rapidly and decisively to strengthen their liquidity through issuing new equity,

canceling projects, selling assets, either unwinding structured finance deals or

putting them on the balance sheet, and increased transparency and disclosure. Even

though traditional project finance has little to do with the off-balance-sheet entities

that brought Enron down, Dino Barajas of Paul, Hastings, Janovsky, and Walker,

LLP fears a backlash that could affect project finance in the event of a credit

crunch. If that happens, one possible solution could be, simply, to finance more

projects on the corporate balance sheet. Some power companies have set up

massive credit facilities for doing so based on their overall corporate cash flow and

creditworthiness.

Another option for a company is to borrow against a basket of power projects,

allowing the lenders to diversify their risks, although such a facility is still largely

based on the credit fundamentals of the corporation. But project financing on an

individual plant basis can be preferable to either of these approaches for both

project sponsors and lenders. For example, say a company is financing 10 projects

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and three run into trouble. The company can make a rational economic decision as

to which of those projects are salvageable and which ones do not merit throwing in

good money after bad. It might let one go into foreclosure and be restructured and

sold. But if a company is financing ten projects together, its management may feel

compelled to artificially bolster some of its projects so that the failure of one

project does not bring the entire credit facility down. Making such an uneconomic

decision for the near term would not be in the company’s long-term interests.

INCREASED TRANSPARENCY AND DISCLOSURE

It was observed that after Enron major players started to release much more

information than before about their businesses and financing arrangements.

Similarly an overriding aura of conservatism was seen in disclosures, for example,

in conference room discussions while drafting prospectuses for project finance

deals. Bankers were making extra efforts to confirm that deals are being disclosed

and explained the right way.

Going forward, strong management actions are needed to restore belief in honesty

of numbers. A company’s management needs to demonstrate the same passion for

integrity as it had for growth in the past. It needs to get rid of gimmicks and

consistently communicate and execute a simple, clear strategic vision. This

involves cleaning up the balance sheet. Transactions that have significant recourse

to the sponsor should be put back on the balance sheet. Only true nonrecourse

deals should be left off the balance sheet. To convey an accurate, fair picture of the

business, companies need to communicate — to the point of obsession — information and assumptions about how earnings are recognized, including mark-

to-market transactions. Managing earnings is out and managing cash flow is in —

and, as Chew of Standard & Poor’s noted earlier, that is what the rating agencies

are looking at anyway.

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REGULATORY ISSUES

One of the reasons Enron was left to its own devices in valuing gas, electricity, and

other types of contracts was that it became, in effect, the largest unregulated bank

in the world. It was able to avoid regulation of its trading activities by the

Commodity Futures Trading Commission (CFTC), partly as a result of its own

lobbying efforts, and the Federal Energy Regulatory Commission (FERC) declined

to get involved as well. Therefore, it was able to duck some of the scrutiny that

regulators have directed toward commercial and investment banks dealing in

derivatives. Of course, securities analysis had long complained about Enron’s

opaque financial reporting, only to be told in return that they just did not

understand the business.

OTHER LESSONS LEARNED

Some general lessons from Enron in the field of Structured Finance:

The transfer of assets, intangible and otherwise, into non consolidating

vehicles controlled by a sponsor may mislead investors as to the extent of

nonrecurring earnings or deferred losses, even in the absence of fraud.

There is a risk of low recovery rates on structured transactions secured by

intangible assets (investments, contracts, company stock) or by tangible

assets whose values are not established on an arms-length basis.

Having been badly burned by the Enron bankruptcy, banks and investors

involved in structured and project financings, and in the energy sector

generally, will be especially conservative, and this will limit credit and

capital access for many clients in the sector, creating a general liquidity issue

for these customers.

An effort must be made by all in the project finance industry (and investor

relations) to underscore the distinction between true nonrecourse structures

and Enron’s activities.

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The terms nonrecourse and off-balance-sheet should remain synonyms.

Liabilities that truly have no recourse to a company’s shareholders can justly

be treated as off-balance-sheet. Enron appears to have violated this principle

since the undisclosed liabilities in the off-balance sheet partnerships actually

had significant recourse to Enron shareholders through share remarketingmechanisms

Many project finance structures are ―limited‖ recourse rather than ―non‖

recourse, and thus there is a potential gray area in which accounting rules

allow off-balance sheet treatment but there is nonetheless some contingent

liability to the parent company’s shareholders. Full (footnote) disclosure of

any potential shareholder recourse was advisable pre-Enron, and is

absolutely necessary now.

To conclude, project finance today is alive and well as a form of structured

finance. We may just need to remind some people of its basic fundamentals.

Neither project finance nor sensible innovations in structured finance with sound,

well explained business reasons have been shaken by Enron. The principal lessons

learned from the Enron debacle have to do with transparency and disclosure. When

some of our businesses or our financing structures become hard to explain, we may

begin to question whether they make sense in the first place.

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5CONCLUSIONS, LIMITATIONS

& RECOMMENDATIONS

The financial turmoil of 2007-2008 has revealed substantial transparency and

information shortcomings due to the increasing opaqueness and complexity of the

global financial system. This has in particular been evidenced by uncertainty on the

size and distribution of the losses resulting from the subprime crisis and on the

valuation and related ratings of structured finance products. The aim of this paper

has been to present an overview of the fundamental characteristics of the main

instruments of structured finance and their role in the financial turmoil.

Against the background of rising regulatory unease about the evolution of

derivative markets, it is argued that a clear-cut definition of structured finance

helps substantiate more viable debate about the resilience of credit risk transfer to

financial shocks. Structured finance encompasses all advanced private and public

financial arrangements that serve to efficiently refinance and hedge any profitable

economic activity beyond the scope of conventional forms of on-balance sheet

securities (debt, bonds and equity) in the effort to lower cost of capital and to

mitigate agency costs of market impediments on liquidity. Especially, the

distinction of the various methods of credit risk transfer through credit derivatives

in a wider and narrower sense as well as securitization transactions illustrates the

need for more comprehensive and creative regulatory considerations that take on

board the heterogeneity of institutions, markets, and infrastructure.

CHAPTER

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From an investor perspective, structured finance has allowed for a more widely

diversified population of investment alternatives from which to choose, with

varying degrees of credit, interest rate, or prepayment risks from which to choose.

In short, when properly structured, these are legitimate transactions meeting

important business and economic needs. The Enron transactions were secular,unusual transactions designed to take risk rather than ameliorate it, entirely unlike

the vast majority of legitimate structured finance solutions.

The structured finance market can be complicated. Investors need to be aware that

there are multiple layers of risk, including the unique risks for each segment of the

market, risk of the underlying assets in the pool, structural risk, and risks

associated with the servicer and issuer of the transaction. Much of the market is

subject to interest rate and prepayment risk. Potential investors will want toconsider investment managers with a long track record in the asset class. Since

detailed due diligence needs to be performed at each level, a robust research

organization should also support the investment management process. Similar to

the corporate credit market, fundamental and quantitative analysis must focus on

early detection of credit deterioration. Rotation among the various segments of the

market is critical, so managers with broad access to the market, the ability to

source new deals, and research capabilities to uncover potential credit problems

and perform relative value analysis should be given extra consideration.

The structured finance market in the U.S. continues to evolve. The developments

of the subordinated sector and the ABCDS market have increased the opportunity

set for investors in the market. The asset class has historically shown rating

stability and good relative value when compared to other sectors in the fixed

income market. The single-A to triple-B or subordinated component of the market

represented about 0.6% of the LB Aggregate Bond Index as of December 31, 2005.

We believe investors largely overlook this component of the market, but with

prudent investment management it has the potential to provide excess returns to an

investor’s fixed income allocation. Based on this, investors searching for alpha

might want to take a deeper look at the structured finance market.

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LIMITATIONS OF THE STUDY

The calculations for the industry wide data for various factors taken into

consideration are based on all the players’ aggregate data. As we are

aware that as of now only few players have significant market share. So

the data for the insignificant issuing companies will act as outliers thus

skewing the result and hence the conclusions as well.

The collection of primary data was not possible given the time

constraints and the volume of data associated with the same. Thus the

accuracy of the data is contingent.

Proxy variables are used for some of the factors for calculation purpose.

The conclusion depends on the correctness of the assumptions made

about the proxy variables.

Not all data were readily available and hence certain assumptions were

made about the data used for calculations. The accuracy of the

conclusions depends on the assumptions made about the data used

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RECOMMENDATION

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6BIBLIOGRAPHY

BOOKS

Structured Finance: Techniques, Products and Markets; Edited by Caselli, Stefano

and Gatti, Stefano; 2005; Springer Berlin – Heidelberg; Germany

A Primer on Securitization; Edited by Kendall, Leon T. and Fishman, Michael, J.;

1998; Massachusetts Institute of Technology Press; Cambridge, USA

Kat, Harry M.; Structured Equity Derivatives: The Definitive Guide to Exotic

Options and Structured Notes; 2001; John Wiley & Sons, Ltd; West Sussex;

England

Davidson, Andrew; Sanders, Anthony; Wolff, Lan-ling; Ching, Anne;

Securitization: Structuring and Investment Analysis; 2003; John Wiley & Sons,

Inc.; New Jersey; USA

JOURNALS

Welsher, Ellen and Penrose, James; Securitization of “New Asset Classes”: A

rating approach; The Journal of Structured Finance, Summer 2004, Vol. 10, No. 2,pp. 20-23

Belmontes R., Manuela; Using the Cayman Islands and other offshore

jurisdictions for securitization transactions, The Journal of Structured Finance,

Summer 2004, Vol. 10, No. 2, pp. 36-41

CHAPTER

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Erturk, Erkan and Gillis, Thomas G.; Default behavior of global structured finance

securities; The Journal of structured finance, Fall 2004, Vol. 10, No. 3, pp. 48-55

Humphreys, Peter; Structured Finance Challenges for New Issuers and New Assets: an overview, The Journal of structured finance, Fall 2004, Vol. 10, No. 3,

pp. 56-61

Kavanagh, Barbara T.; The Uses and Abuses of Structured Finance; Policy

Analysis, No. 479; 31st

July, 2003; Cato Institute

Lipton, Joshua; The Silent Scream; The American Lawyer; July 2006

Booth, Laurence; Aivazian, Varouj; Demirguc-Kunt, Asli; Maksimovic, Vojislav;

Capital Structure in Developing Countries; The Journal of Finance; Vol.56, No.1,

pp. 87-130; Feb 2001

Frankel, Tamar; Cross-Border Securitization: Without Law, But Not Lawless;

Duke Journal of Comparative & International Law; Vol. 8:255, pp. 255-282; 16th

Dec 1998; 12:26 pm

Baker, Malcolm; Wurgler, Jeffrey; Market Timing and Capital Structure; The

Journal of Finance; Vol. 57, No.1, pp. 1-32; Feb 2002

Strassberg, Richard M., Esq.; Falvey, John J., Jr., Esq.; Farley, John O., Esq.; The

Pendulum Swings Back; White-Collar Crime, Vol. 20, Issue 8; May 2006;

Thomson West

PAPER, PRESENTATIONS & REPORTS

Gada, Kalpesh; Inamdar, Rohit; Update on Indian Structured Finance Market ;

ICRA Rating Feature; July 2005

Report of the In-house Working Group on Asset Securitisation; Dec 1999, Reserve

Bank of India, Mumbai

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Kamesam, Vepa; Deputy Governor, Reserve Bank of India; Indian Banking of

Tomorrow

Cowan, Cameron L.; Hearing on Protecting Homeowners: Preventing Abusive

Lending While Preserving Access to Credit ; 5th

Nov, 2003; American

Securitization Forum; Orrick, Herrington, and Sutcliffe, LLP

Skarabot, Jure; Asset Securitization and Optimal Asset Structure of the Firm; 21st

Mar, 2001

Kohn, Meir; The Capital Market Before 1600; Working Paper 99-06; Feb 1999;

Department of Economics; Dartmouth College

Horsewood, Rachael; BIS Stress Tests Structured Finance; International

Securitisation Report; 1st

Mar, 2005; from

http://www.tavakolistructuredfinance.com/isr1.html

Giddy, Ian; Presentation on Structured Finance; NYU Stern School of Business,

2006

Subramanyam, Pratap G.; Presentation on Structured Financing and Advisory

Services

Jobst, Andrea A.; What is Structured Finance?; Working paper; Sep 2005

WEBSITES

Wayman, Rick; Off-Balance-Sheet Entities: The Good, The Bad and The Ugly; 20th

Feb, 2002 from

http://www.investopedia.com/printable.asp?a=/articles/analyst/022002.asp

Securitization; Wikipedia, the free encyclopedia; from

http://en.wikipedia.org/wiki/Securitization



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