Asset-Backed Securities ABS: The Hidden Risks Prof. Ian Giddy Stern School of Business New York University
Hidden Risks and Rewards Synthetic CLOs Waterfalls Whole business securitization Future flow ABS ABS: Hidden Risks and Rewards 2
Collateralized Debt Obligations Cash flow backed CLOs and CBOs Market value backed CBOs Synthetic CLOs ABS: Hidden Risks and Rewards 3
Cash Flow Backed CBOs Motivation: Motivation: Cash Cash flow flow arbitrage arbitrage (bonds (bonds have have good good returns returns relative relative to to risk, risk, but but may may be be illiquid) illiquid) BONDS MANAGER SALE SPECIAL PURPOSE VEHICLE BOND PORTFOLIO ISSUES ASSET-BACKED CERTIFICATES ABS: Hidden Risks and Rewards 4
Cash flow Backed CLOs CREDIT ENHANCEMENT Senior-Sub with priorities of cash flows Cash reserve accounts Letters of credit Guarantees LOANS Cash flows SPV ABS flows Investors ABS: Hidden Risks and Rewards 5
Cash Flow Backed CBOs Cash flow CBOs are built around a pool of assets with predictable cash flows. As such, these structures are restricted to investments that meet minimum credit quality, tenor and expected recovery characteristics. The analysis of a cash flow deal and determination of credit enhancement is based on the expected probability of default, severity of loss, and timing of default and recovery of the assets in the pool. The ongoing market price of collateral assets is not important in a cash flow deal. Instead, it is the ability of each asset to pay scheduled principal and interest that makes these deals successful. ABS: Hidden Risks and Rewards 6
Market Value Backed CBOs Motivation: Motivation: Price Price arbitrage arbitrage (bonds (bonds are are underpriced, underpriced, and and tradeable) tradeable) BONDS MANAGER SALE SPECIAL PURPOSE VEHICLE BOND PORTFOLIO ISSUES ASSET-BACKED CERTIFICATES ABS: Hidden Risks and Rewards 7
Market Value CBOs A market value CBO can be generally described as an investment vehicle that capitalizes on the arbitrage opportunities that exist between high yielding investments and the lower cost funds of highly rated debt. The transaction is typically capitalized with multiple classes of rated debt and a layer of unrated equity and invests in a pool of investments that is diverse in obligor, industry, and, frequently, asset class. In order to gauge the performance of the transaction, the asset manager will mark the value of each investment to market on a regular basis, usually weekly or biweekly. ABS: Hidden Risks and Rewards 8
Market Value Backed CBOs MANAGER Trades bonds to meet interest & principal needs BONDS Cash SPV ABS flows Investors flows ABS: Hidden Risks and Rewards 9
Characteristics of Market Value CBOs Market value transactions are often collateralized by leveraged loans, highyield bonds, mezzanine debt, distressed debt, and public and even private equity. Market value transactions are less restrictive with respect to cash flow requirements, credit quality, and maturity of the collateral. The manager can trade the securities. ABS: Hidden Risks and Rewards 10
Rating Agencies Analyze Price Volatility to Determine CE Requirements ABS: Hidden Risks and Rewards 11
Advance rates determine how much rated debt can be issued against the market value of an asset. ABS: Hidden Risks and Rewards 12
The Alternative: Synthetic ABS HVB (Originator) REFERENCE POOL OF LOANS (Stay on balance sheet) CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE TOP QUALITY INVESTMENTS ISSUES ASSET-BACKED CERTIFICATES ABS: Hidden Risks and Rewards 13
Synthetic ABS or Collateralized Loan Notes CLNs are SPV debt backed by the credit of the selling bank (or better) No loans are sold to the SPV But performance is based on the performance of a reference pool of loans If the reference credits perform, full debt service is made on the CLN If the reference credits default, the CLN is deemed defaulted and payment is halted. ABS: Hidden Risks and Rewards 14
Case Study: Global High Yield Bond Trust What is the legal structure of this deal? What are the assets? What is the basis for the ratings? What is the form of credit enhancement? What are the different classes of securities, and their terms? How do the synthetic CLOs work? (Draw a diagram) Should investors buy the subordinated tranche? ABS: Hidden Risks and Rewards 15
Global High Yield Bond Trust ABS: Hidden Risks and Rewards 16
Paydown: Waterfall vs Soft Bullet Structure ABS: Hidden Risks and Rewards 17
Ford Structure: Waterfall Receivables Class A-1 to A6 Class B Class C Class D ABS: Hidden Risks and Rewards 18
Ford Structure: Waterfall
Belenus What is the nature and value of the assets? How strong is the legal structure? Is the collateral sufficient? Would you recommend purchasing the second (B) tranche? What could go wrong with this deal? What could go right? ABS: Hidden Risks and Rewards 21
Belenus Credit Enhancement Class Orig rating Curr rating Orig C/E Curr C/E 12/96 11/98 A AA Paid 62 0 B A AA+ 48 95.5 C BBB AA- 38 75.6 ABS: Hidden Risks and Rewards 22
Implications of Waterfall Upgrades The capital allocated to a well-balanced ABS portfolio should slowly decrease over time, whereas the same cannot be said of a similar corporate loan portfolio. Rating upgrades should be the norm in the ABS world, and downgrades the exception (currently, the situation is exactly the opposite). In the corporate world, we should rather expect downgrades to equal upgrades over long time intervals. An ABS portfolio should be traded much more actively than a corporate loan portfolio to take advantage of its inherent rating volatility. ABS: Hidden Risks and Rewards 23
Thin Air Intangible financings telling rights from wrongs Bowie Bonds, FILMS Future-flow financings locking out the sovereign Hong Kong Card ABS: Hidden Risks and Rewards 24
Bowie Rights What does the SPV really own? Where s the money? What s it worth? ABS: Hidden Risks and Rewards 25
Bowie Rights: Copyrights is Wrong ABS: Hidden Risks and Rewards 26
Bowie Rights: Where s the Money? ABS: Hidden Risks and Rewards 27
Bowie Rights: What s it Worth? ABS: Hidden Risks and Rewards 28
Case Study: FILMS What are the underlying assets, and why do they need to be financed in this manner? What is the legal relationship between the parties to the deal? What are the benefits or risks to the borrower and investors? ABS: Hidden Risks and Rewards 29
Films (Finance for an Italian Library of Movies) ABS: Hidden Risks and Rewards 30
Chase Manhattan Hong Kong: Summary Credit Card Agreement (HK$) Hong Kong Credit Card Obligors Chase 100% Manhattan Card Co.Ltd. (Servicer) Receivables Purchase Agreement (HK$) Pooling & Servicing Agreement (HK$ Payments) Manhattan Card Funding Corp. (Seller/Cayman Island SPV) HK$ Spread Account Excess Spread (HK$) after losses Bankers Trust Trustee Hong Kong Card Master Trust (US Based Issuer) HK$ Swap Payments Chase Manhattan Bank N.A. (Swap Bank/Back-up Servicer) FSA Financial Guaranty Investors US$ Swap Payments US$ Principal/Interest Payments ABS: Hidden Risks and Rewards 31
Summary of Terms Issuer Hong Kong Card Master Trust Amount US$200mm Paydown 4-7 years Calls 5% Clean-up Rate Libor+0.25% Collateral $255mm HK credit card receivables pool Rating AAA/Aaa (FSA guarantee) ABS: Hidden Risks and Rewards 32
Paydown Structure 225 Seller interest 200 June 1999 (princ. Commencement) 10 Clean-up call Nov 1994 Jan 2000 (exp. Final) Nov 2001 (Final) ABS: Hidden Risks and Rewards 33
The Economics Average revenue yield HK$ 25.25% Less charge-offs HK$ -1.50% (2xaverage) Less rate paid US$ -5.31% (Libor+0.25%) Other costs (est.) -2.50% Net revenue (est.) +/-16.00% ABS: Hidden Risks and Rewards 34
Ian H. Giddy Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0332; Fax 630-604-7413 ian.giddy@nyu.edu http://giddy.org ABS: Hidden Risks and Rewards 35