August 2005 No. 5 Executive Summary Securitization: Bringing a Modern Financial Instrument to Israel David Dvir and Yohay Terri Koret-Milken Institute Fellows
About the Koret-Milken Institute Fellows Program The Koret-Milken Institute Fellows Program accelerates Israel s economic growth through innovative, market-based solutions for long-term economic, social, and environmental issues. The program focuses on connecting government, philanthropic, and business resources that are vital to national growth and development. Directed by the Milken Institute Israel Center, the Koret-Milken Institute Fellows Program awards annual fellowships to outstanding graduates of Israeli and international institutes of higher education. Fellows serve yearlong internships at the center of the nation s decision-making the Knesset, government ministries, and other Israeli agencies and aid policymakers by researching and developing solutions for various economic and social challenges. In addition, fellows craft their own policy studies aimed at identifying barriers to economic and employment growth in Israel. The fellows studies, carried out under the guidance of an experienced academic and professional staff, support legislators and regulators who shape the economic reality in Israel. The program offers the ultimate educational exercise, combining real-life work experience with applied research five days a week. Throughout the year, fellows receive intensive training in economic policy, government processes, and research methods. They acquire tools for writing memorandums, presentations, and policy papers, and they develop management, marketing, and communication skills. The fellows participate in a weekly workshop, where they meet senior economic and government professionals, business leaders, and top academics from Israel and abroad. They also participate in an accredited MBA course that awards three graduate-level academic credits that are transferable to other universities in Israel. The course, which focuses on financial and economic innovations, is taught at the Hebrew University of Jerusalem s School of Business Administration by Professor Glenn Yago, Director of the Milken Institute Israel Center and Director of Capital Studies at the Milken Institute in California. Fellows Program alumni can be found in senior positions in the public and private sectors. Some serve as advisers to government ministries while others work at private-sector companies or go on to advanced studies at leading universities in Israel, the United States, and Great Britain. Within the program s framework, more than 80 research papers have been published, catalyzing reforms, reducing barriers, bringing about economic growth, and improving the quality of life for Israeli citizens. The Koret-Milken Institute Fellows Program is nonpolitical and nonpartisan. It is funded by the Koret Foundation, the Milken Institute, and other leading philanthropic organizations and individuals in the United States and Israel. More about the program: www.kmifellows.org Contact us: info@kmifellows.org
Securitization: Bringing a Modern Financial Instrument to Israel David Dvir and Yohay Terri This study recommends: Enacting a comprehensive national securitization law to define the legal norms for the operation of a secondary capital market for the sale of existing credit portfolios; Using philanthropic loan guarantees to facilitate the sale of existing small business loan portfolios, thereby increasing the availability of small business credit, encouraging the use of securitization and developing the secondary credit market. Introduction It is no secret that there is a credit crunch in Israel. Seventy-one percent of the credit in Israel is allocated to less than one percent of the population, and 93 percent of all bonds are government bonds; there is no doubt that the credit market in Israel is failing to adequately function as a means to accelerate economic growth, capital formation and job creation. Financial resources must be accessible to investors and businessmen in order for any economy to grow. The lack of such resources puts many private and public projects in doubt and leads to economic stagnation. In Israel today, this stagnation can be seen in the large number of small businesses unable to get credit, and in the large number of municipalities and local authorities unable to raise funds. One of the ways to increase credit availability is a secondary credit market. This consists of packaging debt, its capital and interest, 1 or a future stream of income based on a business venture, 2 as a new financial instrument. This new instrument is purchased by investors, either by an institutional investor in a private sale or via bonds in a public offering ( securitization ). The original holder of the debt thus obtains new funds, while the investor receives the future income at set dates or rates. Securitization, also known as structured finance, is an important part of any secondary credit market. Securitization developed originally in the U.S. mortgage market and over the past decade has become an important financial tool in use around the world. In addition to the funds or income made available to sellers or investors, securitization brings new players to the capital markets and thus serves to increase liquidity and efficiency. It also enables the funding of infrastructure and public projects, while reducing the interference of governments in the economy [ 1 ]
and increasing the role of the private sector. These features of securitization have caused it to become a major part of financial markets around the world. In 2003, over 3 trillion dollars of asset-backed securities were issued. 3 In Israel, the potential embodied in securitization has not been realized. How It Works Structured finance is based on the separation between the overall credit risk of the original firm (which holds but now sells the debt) and the risk involved in the particular stream of income. The separation of the firm from the specific risk enables an analysis and rating of this income stream and a portfolio based on it. After the risk is determined, the original holder of the debt (known as the originator ) sells the income stream to a newly formed corporation known as a Special Purpose Vehicle (SPV), which can be a company, trust or partnership, and which is usually a separate legal entity. This SPV then sells the package by issuing bonds in a public offering to private or institutional investors. The purpose of selling the assets to an SPV is to separate the sale and its results from the original company, legally and financially, and thus to protect investors from the risks involved in the originator s other business, guaranteeing the stability of the stream of income in the SPV. The originator usually continues to provide the services it always has, such as the actual collection of income, and for this activity it now receives a management fee. Should the originator go out of business, or be unable to provide the collection service, it can be replaced with another service provider that will receive the management fee. In short, securitization is when the original company sells assets (a future income stream) to an SPV, which issues bonds based on this income stream, to be purchased by new investors. The Advantages of Structured Financing Structured financing allows corporations to raise new capital in ways that suit their current needs, while removing assets from their balance sheets for sale to investors in exchange for immediate income. Through securitization, corporations may seek to solve credit problems or spread their debts or payments due over a long, fixed term. 4 Securitization can also be used to reduce a company s dependence on banks, since it is an alternative source of borrowing. Alternative financing creates greater flexibility for entrepreneurs in managing their capital structure and aligning that structure with the timing and levels of capital necessary for executing business growth strategies. In addition, securitization will put more credit at the disposal of small business, if, for instance, small business loan portfolios are securitized. Today, banks offer credit from the funds at their disposal, and they are also forced by banking regulations to maintain a minimum amount of capital in reserve. These conditions limit their [ 2 ]
ability to grant more loans and limit the amount of credit available in an economy, thereby slowing the economy s ability to develop and grow. Creating an opportunity for securitization in Israel would allow local banks to package a portfolio comprised of a large number of existing loans, which they could then resell to investors. This would allow the banks to remove these loans from their balance sheets, freeing the minimum capital they are holding in reserve, and in addition give them immediate income from the sale, all of which can be used to offer more credit. This almost infinite ability to offer loans and resell them to investors would lower credit costs and increase the supply of credit to many sectors and individuals who have until now encountered difficulties in receiving a fair share of the bank s credit. The development of a securitization market will have major impact acr oss the whole structure of the economy. Structured financing holds advantages for investors, creditors and the whole economy. Some of these advantages are: For the Originator (Seller): Reducing financial reliance on the banking system Creating new sources of funding and expanding the base of current and future investors Evaluating the feasibility and effectiveness of raising capital Reducing credit costs in the long term With favorable credit ratings, further lowering the cost of capital Relatively fast access to capital Maximizing the suitability of income dates, credit payments and realization terms, Improvement of balance sheets by realization of assets and by removal of debt from the originator s books Solvency improvement Spreading credit risks For the Investor (Credit Package Purchaser): Increasing the diversity of investments with relative safety and spreading risks Enhancing the information available about investments; securitization can be a tool to compare alternative investments Enhancing market liquidity and the negotiability of securities in the secondary market Obtaining a professional objective evaluation of financial and economic risks Maximizing the suitability of income dates, credit payments and realization terms Enhancing the value of the investments Proven performance For the Government and the Economy: Accelerating development of the capital market Modernizing the local capital market (structure, portfolio management, services and financial systems) [ 3 ]
Assisting banks to maintain minimum capital levels Attracting investors Reducing the interference of the government in the market Promoting specific objectives and removing obstacles to specific sectors (i.e., small businesses, students loans, urban revitalization) Securitization can increase funding for public projects by involving the private sector. Sometimes the government, philanthropic institutions or the private sector itself can offer guarantees and safety nets for projects to be funded and managed by the private sector. State funding and managing of major projects can be reduced, as these projects become efficient and profitable business. Philanthropic organizations can use securitization to leverage their investments and contributions to the community. For instance, by offering guarantees for specific projects or loan pools, they can draw private investment to goals and projects they wish to promote. Despite the numerous advantages of securitization, Israel remains far behind other Western countries in realizing its potential. Securitization in Israel is negligible, and most of the securitization here is not classic securitization: banks, for instance, have made a limited number of sales of portfolios to institutional investors, but without an SPV or a public offering. This deprives companies, investors and the whole economy of the advantages of securitization. The gap in the extent of securitization in Israel s and other countries can be seen in Table 1. Table no. 1 Extent of Securitization in 2003 Country Extent (millions of dollars) USA 3,250 England 67 Spain 33 Italy 30 Sweden 19 Israel 2* Sources: Maalot, Rating Securitization Deals: Structured Finance Theory and Fact (Tel Aviv, December 2004) [Hebrew]; The Interministerial Committee to Examine the Issuance of Property Backed Bonds, Draft Report, p. 16; European Securitization Forum (ESF), European Securitization Data Report (Securitization Issuance Surges to a New Record in 2003), Winter 2004, p. 1, www.europeansecuritization.com/pubs/esfdatarprtwinter04.pdf. (June 28, 2005). All figures are based on average annual rate of exchange (1 euro = 5.1366 shekels, 1 dollar = 4.5442 shekels). * This reflects the extent of all securitization since 1999. The ratio of securitized assets and GDP in the different countries shows that the negligible amount of securitization in Israel cannot be blamed on the size of Israel s economy. Figure 1 shows that Israel s GDP is relatively low, compared to some [ 4 ]
countries, but this is not the reason for the lack of securitization. Among the European countries, Portugal has the highest securitization-gdp ratio. But Portugal has a relatively low GDP, only 1.45 times higher than Israel s. Nevertheless, the rate of securitization is 60 percent of GDP, which is more than 4 times the ratio in Israel. And we must keep in mind that the figure we are using for Israel is the sum of all the securitization accomplished over 4 years! So, Israel is certainly far behind other countries. In the U.S., for instance, securitization is so well developed that it is 2.3 times the GDP. Figure no. 1 The Ratio between the Extent of Securitized Assets and GDP Sources: Maalot, Rating Securitization Deals: Structured Finance Theory and Fact (Tel Aviv, December 2004) [Hebrew]; The Interministerial Committee to Examine the Issuance of Property Backed Bonds, Draft Report p. 16; European Securitization Forum (ESF), European Securitization Data Report (Securitization Issuance Surges to a New Record in 2003), Winter 2004, p.1, www.europeansecuritization.com/pubs/esfdatarprtwinter04.pdf (June 28, 2005); Universal Bank, GDP Table 2003, www.worldbank.org/data/databytopic/gdp.pdf (June 28, 2005). It seems that the main reasons for lack of securitization in Israel are the high costs and the legal complexity involved in conducting the first sales. These costs result from the lack of local legislation authorizing such sales and from the unclear legal and regulatory status of such sales. As a result, the risk involved rises, potential investors refrain from investing, and every securitization sale has to write the rules ab initio. In addition, specific problems with Israel s banking system have stymied the creation of a secondary capital market and securitized debt. The loans and credit process is not standardized, and there is no uniform credit database; these problems make rating loans more difficult, time consuming and expensive. 5 The government has taken some positive steps to promote securitization in Israel, such as offering economic incentives for the first instances of securitization, reducing the amount of government bonds, bringing more players to the capital market and founding a committee to examine obstacles. Inter national experience has shown that decisive legislation will remove the uncertainty about securitization and ease the complex procedure involved in such sales. [ 5 ]
From Theory to Practice: Practical Models There are two feasible models: classic securitization and a straightforward sale. As examples, we will apply these models to securitization in the small business sector. We choose small business because of the ability of small businesses to accelerate the growth of the economy and the funding difficulties they currently encounter, and because of the existence of loan portfolios for small businesses, which have philanthropic or state guarantees. Such external guarantees can facilitate their securitization or sale. A similar model is in advanced planning stages in San Francisco. The Isabella Project is designed to promote the development of the Latino population in the San Francisco Bay area, by increasing the availability of capital to small businesses via securitization. 6 Loans issued to small businesses, backed by philanthropic or governmental guarantees, will be packaged into a loan pool. This will be sold to groups that will securitize and resell them, after dividing them into different layers of debt, in a public of fering to private and institutional investors. It is expected that securitization will improve the funding opportunities for Latino small businesses and thus improve the condition of the entire Latino population in the area. 7 Like the Isabella Project, the two models we present are based on the guarantees of a philanthropic institution and/or the government for a sale or an offering of a small business loan portfolio. From meetings held with the Managing Director of Koret Israel Economic Development Funds (KIEDF), we know philanthropy can be involved by giving guarantees within the framework of small business loan securitization. 8 KIEDF currently guarantees loans offered through Bank Otzar Hachayal to facilitate lending to small businesses lacking suf ficient securities. KIEDF guarantees an average 35 percent of each loan. According to Doron Kalif, Vice President and Manager of the Financial Division of Otzar Hachayal, the bank is interested in facilitating the sale/securitization of KIEDF loans. The bank is already conducting an analysis of the portfolio in order to examine the possibility. 9 The government is also ready to cooperate by adding to the necessary guarantees. 10 The first possible model is classic securitization: Classic Securitization The bank would sell KIEDF s loan portfolio in a verified sale to an SPV, which will be formed for this securitization. The bank would transfer the debtors securities to the authority of the SPV. The current philanthropic guarantees in the portfolio would become guarantees for future payments in case of default, or for purchase of the inferior bonds in order to guarantee investors their income stream. The necessary rate of guarantees would be determined by a rating company. The SPV would issue the bonds in a public offering. [ 6 ]
Figure no. 2 Securitization of Small Business Loans Selling the portfolio and its future cash flow to an SPV would enable the bank to remove the loans from its balance sheets, thereby improving its minimum capital ratio. With the securitization of the KIEDF loans, the bank would be required to allocate the income from the sale of the loan portfolio to new small business loans. The second model is a loan portfolio sale. This is simpler legally and involves lower costs and less time to execute. Considering the relatively short life span of small business loans in the portfolio, reducing the costs and time necessary for the sale would make it much more attractive. 11 The Sale Model The bank would sell the KIEDF loan portfolio to an institutional investor. The philanthropic guarantees would ensure payments of the income stream and interest to the institutional investor, if borrowers payments are not made. The bank would allocate the income from this sale to new loans to small businesses. [ 7 ]
Figure no. 3 Sale Model In contrast to the classic securitization model, such a loan sale is not an innovative tool for the Israeli economy and will not directly assist in developing a securitization market. The Importance of Implementing the Models The cost of conducting classic securitization sales is derived from the number and scope of the sales. The more sales, the lower their marginal cost. However, these sales will not simply happen. International experience shows that external intervention to reduce risks and costs can jump-start the securitization market. The involvement of philanthropy in guaranteeing loans to small businesses would ease their securitization and offer opportunities for developing the capital market. The initial contribution of classic securitization, with gover nment and philanthropic guarantees, would be in opening an investment route for new investors. Bonds backed by loans to small businesses would assist in diversifying investor portfolios in a manner only currently available to local banks. The participation of private investors would add new funding sources for small business loans. The more [ 8 ]
such sales are made, the more the rating skills and databases and the legal and procedural practices in conducting them will be developed. Thus the private sector would use securitization, with all its advantages for the creditors, debtors, investors and the whole economy. With securitization, the state and philanthropic institutions could achieve far greater leverage with their guarantees and contributions by generating a continuous stream of new small business financing while, simultaneously, helping to develop a more sophisticated capital market to fuel expanded credit and investment. Recommendations In addition to our primary recommendation to securitize small business loan portfolios, the following steps are necessary in order to develop a securitization market and improve the capital market in Israel: Legislation of a comprehensive securitization law (as exists in many countries). The law should describe the specific characteristics of securitization sales, such as the status of an SPV, and the transfer of rights, 12 define a verified sale, and so forth. Such a law can be based on the U.S. model. It will reduce uncertainty and regulate the legal and accounting pr ocedures for securitization. Promote synthetic securitization. Synthetic securitization is a for m of classic securitization that raises capital and reduces risks for the originator, but does not entail transferring securities. It can avoid some of the current legal obstacles to classic securitization and reduce costs and can be implemented more swiftly while the legislative and regulatory frameworks are improved. Standardization of business and individual credit ratings is needed. A credit rating system based on uniform standards will enhance the data that businesses and individuals maintain and improve decision making in bank credit allocation. Standardization will facilitate securitization as it will allow an easier assessment of risk. As a side benefit, competition in the banking system will also be enhanced. Establish a database of small business loans. The data in the loan portfolios backed by government and philanthropic guarantees should be turned into a database suitable for the needs of securitization. This data would then be available for analysis or pooling, taking into consideration geographic and professional parameters, as well as the type of securities involved. Consideration should be given as to how to provide an incentive for the banks to use existing data to create such a database. A database of small business loans would ease the securitization of such loans. Financial innovation is a necessity not a luxury. Israel cannot remain so far behind the rest of the world in exploiting such a proven financial instrument and meet its growth objectives. A secondary capital market and securitization would create new [ 9 ]
funding sources other than local banks while facilitating bank access to huge amounts of new capital that can be offered as credit. The local capital markets would be enervated; investors, creditors, borrowers and the entire country would benefit. 1. Secured debt. 2. Structured finance. 3. In 1990 it was less than $50 billion. 4. This often has important ramifications in accounting. 5. Baruch Govi, accountant, interview with authors, Tel Aviv, March 27, 2005; Asher Rabinovich, attorney, interview with authors; Tel Aviv, May 22, 2005; Ronen Baumes, accountant, Adanim Bank, phone interview with authors, June 15, 2005. 6. Marcela Davison Aviles, Richard Ventura, Glenn Yago, Betsy Zeidman, The Isabella Project - Closing the Latino Capital Parity and Procurement Gap (San Francisco: The Latino Community Foundation, Milken Institute, San Francisco Hispanic Chamber of Commerce, 2004) 7. Ibid., pp. 13-16. 8. Carl H. Kaplan, KIEDF Managing Director, interview with authors, Jerusalem, March 10, 2005. 9. Doron Kalif, CFO, Otzar Hachayal Bank, interview with authors, Tel Aviv, March 10, 2005. 10. Ran Alon, Ilanit Verner, Finance Ministry, interviews with authors, Jerusalem, March 15, 2005. 11. Professor Amir Barnea, Interdisciplinary Center, interview with authors, Herzliya, March 10, 2005. 12. This is especially important regarding real estate. [ 10 ]
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