Company can borrow money by pledging pool of receivables and related cash flows

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1 Conduiitts and SIIVs TTrraaddi itioonnaal l aasssseet t-bbaacckkeedd ccoommeerrcci iaal l-ppaappeerr ccoonndduui itt Background: secured loan using receivables as collateral Company can borrow money by pledging pool of receivables and related cash flows Lender would insist on haircut to account for expected write-offs and time value of money Haircut would need to be set conservatively at some reasonable multiple of recent write-off rate to protect lender Cautious lender might also impose other eligibility restrictions on pool, such as: No receivable past due date No receivable whose enforceability is uncertain No obligors that fail to meet designated criteria that address ability and willingness to pay their obligations Below is example of pool of monthly receivables for electricity company: Pool Size $125 million Number of customers ( obligors ) 1 million Average exposure per obligor $125 Payment terms 30 days Average historical delinquency rate 3% Average historical monthly write-off % 0.5% Largest 3 obligor concentrations 0.25% each Worst historical monthly write-off % 2% Secured loan drawbacks Under secured loan structure, bank would book loan on balance sheet, which would require regulatory capital Bank would also reduce to some degree available credit lines to company, even though it is looking primarily to obligors in receivables pool for repayment Company would report liability which would inflate balance sheet and worsen leverage and debt service ratios Could become problem for company under loan covenants and for other purposes 1

2 Alternative structure to finance pool of receivables Bank establishes SPV owned by independent third party SPV raises short-term funds in CP market SPV purchases pool of receivables instead of lending against it Purchase price includes conservative 4% haircut, so company receives only $120MM Rating agencies typically require haircut to be: higher of 3 times recent write-off experience or sum of 3 largest obligor exposures Following simple diagram summarizes structure: Cash allocation example Assume 30-day CP net proceeds are $120MM, and that CP yields 6% Assume also actual write-off experience 1.6%, i.e. > average but not > worst case Cash allocation would proceed as follows: Aggregate cash collected is $123MM ($125MM * 98.4%) $120.6 MM is used to pay off CP, including 6% interest for 30 days; Remaining $2.4MM is returned to seller, ignoring other costs such as legal and administration fees for SPV, issuing fees for CP, rating agency fees EEnnhhaanncceemeennt tss too t oorri iggi innaal l sst trruucct tuurree Enhancement 1: revolving purchase facility Company often generates new receivables monthly and wishes to continue selling them to conduit. Three major features added to structure: 1. SPV issues new series of CP each time previous series matures, and uses proceeds to pay off interest and principal from previous series 2. Any cash remaining, plus cash collected on receivables from original pool, is remitted back to seller in return for newly-generated pool 3. If pool size is increasing due to seasonal fluctuations in demand, size of new series of CP also increases 2

3 Enhancement 2: multi-seller conduits Conduit often can purchase receivables from variety of sellers in different industries and geographies to increase diversity: Several sellers access same conduit minimize administrative costs SPV issues CP series to match each pool it purchases No cross-collateralization exists, i.e. excess collections from one pool cannot be used to cover write-offs in different pool Enhancement 3: program-wide credit enhancement (PWCE) Stems from sponsor's desire to achieve highest possible rating for CP While possibility exists that one or two pools may experience write-offs in excess of haircuts, highly improbable that all of them could do so PWCE available to absorb excess write-offs if limited number of pools exceed their haircuts PWCE can take various forms: Cash collateral deposited by sponsor in escrow Guarantee or insurance policy from highly-rated third-party Subordination of some investors to CP noteholders End-result is that pool credit risk has been tranched among 3 risk takers, with first loss assumed by sellers, second loss by PWCE provider, and last by CP noteholders Liquidity support in multi-seller conduits Risk exists that CP market undergoes systemic or program-specific shutdown and becomes unwilling to roll over CP of some or all conduits liquidity problem Rating agencies require backstop liquidity lines from well-rated commercial banks, for 100% of CP outstanding Banks stand ready to finance the SPV if it cannot issue more CP, but only against performing receivables Banks charge modest commitment fee for this facility, since loan documentation requires banks to make advances only against receivables that are fully-performing (so very limited credit risk) PWCE and pool haircuts are available to provide credit enhancement; bank lines are supposed to protect only against liquidity shortfalls Conduits and use of hedging instruments Some conduits purchase pools in variety of currencies but issue CP only in USD and EUR So conduit has FX exposure to strengthening USD or EUR, which it hedges by means of FX forwards or cross-currency swaps Some conduits also purchase receivables that pay interest linked to Libor, so are exposed to basis risk between Libor and CP rate. SPV can use Libor/CP basis swap to hedge this risk 3

4 Multi-seller vehicles: final structure Coonndduui itt aaccccoouunnt tinngg aanndd rreegguul laat toorryy ccaappi itaal l trreeaat t tmeennt t Accounting Question 1: how does seller account for transaction on balance sheet: simple sale or secured loan? If latter, seller's leverage ratio and debt service ratio could deteriorate significantly Sale treatment generally permitted given (i) modest amount of haircut applied to cover write-offs and (ii) absence of guarantee from seller to pay CP if haircut proves insufficient Question 2: is SPV consolidated into financials of any principal party, such as seller, sponsor, or liquidity/pwce provider? Consolidation rules extremely complex, and currently under review as consequence of credit crisis Under IFRS, consolidation by sponsor is likely in most instances; US GAAP will likely end with same outcome once potential revisions become effective Test increasingly is not who owns SPV, but who controls it or derives greatest economic benefit from it In some cases seller may need to consolidate SPV Capital requirements under Basel 2 PWCE provider: generally viewed as guarantor of investment-grade risk; so treatment similar to that for ABS investment rated investment-grade subject in worst case to 100% riskweight 4

5 Liquidity providers: some capital typically needed depending on period of commitment, whether facility provides any credit enhancement, and whether liquidity provider ranks paripassu with CP noteholders Sponsor: currently no capital required, even when he consolidates conduit CP noteholders: depends on rating of CP and other factors, but generally very low risk-weight (in 7% - 20% range) because of typically high credit rating SSt trruucct tuurreedd innvveesst i tmeennt t vveehhi iccl leess (SSI ( IVVss) ) Motivation behind SIV creation Bank is attracted to high-grade security but unable to reach minimum hurdle for return on capital due to tightness of spread Bank wishes to book instruments in unconsolidated vehicle but still earn some spread This might diminish capital requirement and enable bank to meet minimum hurdle return on capital SIV (simplified) economics illustrated below: Instrument Notional Yield/cost Assets: 3-year AA floating-rate securities, such as senior CDO tranches/fi paper 100% Libor + 25bps CP Liabilities: mostly short-term 95% Libor flat Capital notes: receive remainder after paying CP; assuming no default, Libor + 500bps 5% Libor + 500bps 500 bps spread typically shared between holders of capital notes and SIV sponsor SIV sponsor normally acts as asset manager that selects assets for purchase and reinvests proceeds from asset sales and redemptions in new assets SIV issues: rating and liquidity Is size of capital notes large enough for rating agencies to grant highest credit rating to CP? Illustration below from Fitch assumes arranger requests CP credit rating in highest possible category: plots capital requirement for each asset based on rating and tenor Credit rating/tenor 1-year 2 years 5 years Triple-A 2% 3% 5% Double-A 3% 4% 7% Single-A 6% 9% 12% Triple-B 10% 15% 18% Double-B 15% 22% 30% 5

6 Liquidity mechanism for SIV needed, given huge tenor gap between assets (~ 3 years) and liabilities (~ 15 days) No guarantee that CP can be refinanced on each maturity date Bank liquidity equal to 100% of CP outstanding erodes transaction economics To generate liquidity required by rating agencies, three features often added 1. SPV issues CP but also MTNs with longer tenor: reduces refinancing risk but also erodes available spread 2. Asset manager must initiate sale of assets promptly if solvency or liquidity of SIV under threat 3. SIV obtains backstop liquidity from banks, but for only ~ 20% of total liabilities SIV structure diagram SIV Manager Derivatives counterparties Assets SIV Senior liabilities CP and MTN investors Liquidity providers Capital Capital note investors SIV revised economics Instrument Notional Annual yield/ cost Assets 100% Libor + 25bps CP 45% Libor flat MTNs 50% Libor + 10bps Backstop liquidity 20% 10 bps Capital notes 5% Libor + 360bps Different SIVs split spread in different ways At least some SIVs give asset manager 50% of excess spread after return on capital notes exceeds L Implies L for noteholder, and 155 for asset manager Regulatory treatment of capital notes Basel 2 sets capital charges for securitized investments based principally on credit ratings, but also requires first loss tranches to be deducted from capital 6

7 Capital notes need to be deducted from capital unless they have solid credit rating Specific rules are complex, but 100% risk-weight may apply if capital notes have investmentgrade rating Often possible to achieve BBB or even A ratings, especially where assets are AA or better Results in 8% capital charge, so return on investor s capital is 2.05%/8% = 25% (before expenses, taxes etc), assuming investor s funding cost is Libor flat SIV asset sale triggers Triggers differ from one SIV to another and have variety of consequences, ranging from obligation to "repair" breach, to cessation of debt issuance, to forced liquidation Forced liquidation is required once capital notes suffer significant erosion, usually defined to mean 50% of initial value Proceeds repay CP and MTNs before it is "too late" and assets have declined further in value To reach 50% erosion on capital notes in example above, spread widening must reach 100bps would have been considered extreme until credit crisis Double-A spread widening 100 bps Spread duration of 3-year floating-rate security 2.5 approx. Price effect of spread widening 250 bps MTM losses on portfolio 2.5% Erosion of Capital Notes 50% To wipe out capital notes, spread widening needs to reach 200bps extremely unlikely especially since SIV is actively selling assets at this stage before further spread widening Explains why CP and MTNs were able to achieve ratings in highest categories Coonndduui itss,, SSI IVVss aanndd ccrreeddi itt ccrri issi iss Early signs of trouble First signs of trouble: some SIVs and MSVs found to have significant subprime exposure In two instances exposure was so high that Capital Notes were wiped out quickly and senior debt holders began suffering losses News alarmed among conduit investors generally, and few had sufficient knowledge to distinguish between MSVs and SIVs, or among different structures across SIVs or different assets owned by each Panic was widespread, and those who could exit did so promptly Liquidation mode Investors understood that even for healthiest SIVs senior noteholders were likely to opt out, forcing SIVs to initiate large asset sales 7

8 With many SIVs holding substantially similar assets, liquidations depressed prices, destroying capital notes entirely Sponsors became concerned also about reputation and franchise, especially since they had marketed senior debt as very low risk investment Many restructuring suggestions were made to reduce pressure on SIVs to liquidate and give hope for capital noteholders Sponsor bailouts Many SIVs were deemed solvent but plagued by market illiquidity Sponsors concerned for their reputation guaranteed rollover risk for senior noteholders in many cases Was done either by providing loan to SIV that repaid entirely senior creditors, or by guaranteeing SIV's liquidity access to encourage senior noteholders to stay put In turn this eliminated need to engage in fire-sale asset disposals Vertical slices Capital noteholders pay off more senior creditors pro rata. In return, they receive equivalent proportion of SIV assets, and can decide whether to sell or hold them Only cash-rich/capital-rich investors considered this alternative Coonnccl luussi ioonn With hindsight, collapse of conduits, and SIVs in particular, was perhaps inevitable Market can set prices at completely irrational levels; especially in difficult market conditions Conduits with 100% liquidity support need not worry about this much; but those relying on asset sales at market prices to generate cash never had a chance once crisis began 8