RISK MANAGEMENT IN BANKS

What is Risk Management

The four letters RISK indicates that risk is an unexpected event or incident, which needs to be identified, measures monitored and control. R = Rare (Unexpected) I = Incident (Outcome) S = Selection (Identification) K = Knocking (measuring, monitoring, controlling)

Different Types of Risks

The risk can be divided into four main categories. Market Risk: Market Risk can be defined as the risk of losses in and off balance sheet positions arising from adverse movement of market variables. Operation Risk: It is defined as the risk of direct or indirect loss resulting from inadequate or failed internal process , people and system

Different Types of Risks

Country Risk: Country Risk is the possibility that a Country will be unable to service or repay its debts to foreign lenders in a timely manner .Risk relating to dealing with other countries such as sovereign risk, political risk. Credit risk: It is a risk of potential loss arising out of inability or un- willingness of a customer or counter party to meet its commitments in relation to lending.

TOOLS FOR CREDIT RISK MANAGEMENT

Stock Statements Review of account and financial statements Audit and inspections: concurrent audit, annual audit, Stock audit, periodical inspection Discretionary Lending power and Cap Exposure ceiling- Single, Group, and activity exposure. Insurance and Credit rating Credit rating CRISIL ,FITCH,CARE

Risk Based Supervision

The Reserve Bank of India is supervising the banks on CAMELS model which covers Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems & Control. All other Schedule Commercial banks are encouraged to migrate to these approaches under Basel-II in alignment with them RBI has also specified that banks would have to maintain a minimum Tier-I ratio of 6 %, while continuing to maintain CAR of 9 %.

What is BASEL? It is a city in Switzerland

Why Do we Need BASEL norms?

ICICI bank collapse hoax
Back in 2003, Someone started a rumor in Ahmedabad that ICICI bank is going to collapse. Suddenly thousands of panicked account holders lined up at the nearest ICICI branch to take out their money and hence there was such a money-shortage in ICICIs Ahmedabad branches, they had to actually call up trucks loaded with cash from their Mumbai branches. Things settled out after a while and it was confined only to a few cities of Gujarat, but if it was an entirecountrywide hoax, just imagine the fallout!

SBI: Imaginary case

SBI takes deposits from you and me, pays us 7% interest rate, and gives same money as loan to carhome seekers, businessmen etc. at 12% interest rate, thus earning 5% in profit. SBI gave Rs.1500crs as loan to Kingfisher. SBI gave loan of Rs.4500 crores to Telecom players for 2G auction and now the licenses are cancelled. What if those telecom players run away without paying back the loan and Kingfisher goes broke?

SBI: Imaginary case

Adding insult to the injuries, someone starts a systematic campaign on facebook and twitter to spread rumors that SBI itself is going to collapse. Lakhs of middleclass account holders will run to the nearest SBI branch to take out their deposited money (as it happened in ICICI, Ahmedabad in 2003 in real-life). Overnight entire banking sector will collapse and You already know about the sub-prime crisis etc., the aftershocks were felt everywhere in every sector.

Here comes BASEL in picture

The BASEL Norm is kind of a safeguards / backup plan for Banking sector. It provides internationally accepted detailed guidelines about how much money should a bank keep aside, to deal with such financial crisis. Even if loan-takers run away without paying, Bank should have money to give back to deposit holders. More risk the bank takes, more money it has to keep aside in reserve to counter the risk.

What is Tier 1 and Tier 2 Capital?

Capital= Wealth in form of Money, Property, Bonds etc. As we saw earlier, banks need to keep some money aside to deal with crisis. It meant the word capital. If bank keeps aside capital, in form of real-estate investment (say buying 5 farm houses) then during the crisis, it wont be easy to sell away farm-houses and get money within a day or two. So this Capital is not liquid.

Tier 1 and 2
It is way of classifying the capital of a bank. Tier 1 Easily liquid. For example ; Currency notes and coins in the bank value Stocks held by Bank, can be easily sold off in share-market. Tier 2 Not easily Liquid, for example ; the Building or land owned by the bank.

For BASEL norm will be something like this

[technically totally incorrect, just for the purpose of basic understanding] 1.If a Bank loans 1 crore rupee to a company with B Credit Rating, it must keep capital worth 20 lakhs aside for crisis. 2.And out of that 20 lakhs, Rs. 15 lakhs must in form of Tier 1 Capital and 5 lakhs can be in form of Tier 2. 3.If the Company has credit rating of AAA then Capital worth Rs.xyz and so on..

Preventing another Global financial crisis

Governor of RBI signs on this BASEL agreement, comes back home and forces all the Indian banks to follow these norms. Same thing will be done by French, Chinese, Americans etc. and thus banks in every country will function prudently thus preventing another Global financial crisis. Latest is BASEL III accord, came in 2010. It has stringent provisions keeping in mind the subprime crisis.

Criticism of BASEL
1.One shoe doesnt fit all. 2.Just because American Banks were so imprudent in their functioning and ran into trouble, doesnt mean WE the Indian banks need be so overcautious and keep so much of money aside for safety, it could be used for giving loans to needy people. 3.Already existing complex Monetary policies of Central Banks in each country (example RBIs CRR, SLR, Repo etc.) make it difficult to uniformly implement BASEL norms.

Basel III norms

Barring four, all other public sector banks are quite comfortably placed at 8% CAR,which is much above the required 6%, as prescribed by the Reserve Bank under the Basel III norms. The CAR requirement will increase by 50 basis points to 6.50% from March 2014. P Chidambaram had said that all banks with capital adequacy ratio of less than 8% will be given preference for capitalization. Dena Bank has the lowest CAR at 7.26% followed by Bank of Maharashtra (7.57%), IDBI (7.68%) and Indian Overseas Bank(7.80%).

CAPITAL STRUCTURE of SBI

TABLE DF-2 CAPITAL STRUCTURE Quantitative Disclosures (Rs. in crores.) (a) Tier-I Capital 1,07,800 Paid-up Share Capital 671 Reserves 1,02,181 Innovative Instruments 6,778 Other Capital Instruments 0 Amt. deducted from Tier-I Cap including Goodwill and investments 1,830 (b) The total amount of Tier-2 Capital (Net of deductions from Tier II Capital) 43,757

CAPITAL STRUCTURE of SBI

(c) Debt Capital Instruments eligible for inclusion in Upper Tier-2 Capital Total amount outstanding 25,333 Of which raised during Current Year Amount eligible to be reckoned as Capital funds 25,333 (d) Subordinated Debt eligible for inclusion in Lower Tier-2 Capital:
Total amount outstanding 19,857 Of which raised during Current Year 50 Amount eligible to be reckoned as Capital funds (e) Other Deductions from Capital if any 0 (f) Total Eligible Capital 1,51,557

14,517

Credit Risk Mitigation (CRM) Techniques

1. Collateralised Transactions Certain securities are eligible to be considered for Basel-II purpose. The securities may be either prime securities or collateral securities like cash margin, Banks own deposit, NSC, Indira Vikas Patras & Kisan Vikas Patra, LIC policies, Gold, etc. i.e. cash or near cash securities are considered as security for Basel-II purpose. In respect of Standard Assets Basel-II does not recognize land and building, Plant and Machinery as Collateral for risk mitigation purposes.

Credit Risk Mitigation (CRM) Techniques

2. On balance sheet netting - It is confined to loans / advances and deposits, where banks have legally enforceable netting arrangement, involving specific lien with proof documentation. Loans and advances are treated as exposure and deposits as collateral. Exposure may be offset against eligible collateral credit.

Credit Risk Mitigation (CRM) Techniques

3. Guarantees The eligible guarantors are ; Sovereign, sovereign entities, ECGC, PSEs, Banks, primary dealers with a lower risk weight than the counter party (borrower), other entities rated AA or better External Credit

Mitigation Of Risks
1.Credit Concentration Risk Concentration risk may be used in a broader sense to include concentration by sector, Concentration by Industry, geographical location and concentration of risk mitigant measures. 2.Country Risk The exposure to various countries are in terms of rating categories as specified by the ECGC guidelines on Country risk management in terms of percentage to Tier 1 and Tier 2 Capital

Interest Rate Risk

3. Interest Rate Risk in the Banking Book Interest rate risk is taken to be the current or prospective risk to both the earning and capital of the bank arising from adverse movements in interest rates.

Liquidity Risk
Liquidity risk occurs when an institution is unable to fulfill its commitment in time when commitment falls due. The liquidity risk for the bank will be monitored and measured as per the ALM Policy.

Reputation Risk
Reputation risk is the current or prospective indirect risk to earnings and capital from adverse perception of the image of the bank on the part of customers, shareholders and regulator.

Reputation risk may originate in lack of compliance with industry service standards and regulatory standards, failure to deliver on commitments, lack of customer friendly service and fair market practices, a service style that does not harmonize with customer expectation.

Business and Strategic risk

Business risk means current or prospective risk to earnings and capital arising from changes in the business environment and from adverse business decisions.

Off Balance Sheet

Off-balance sheet (OBS), or Incognito (having one's identity concealed, as under an assumed name, especially to avoid notice or formal attentions)Leverage usually means an asset or debt or financing activity that is not on the company's balance sheet.

Off Balance Sheet

Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients. The assets in question (often securities) usually belong to the individual clients directly or in trust, while the company may provide management, depository or other services to the client.

Off Balance Sheet

The company itself has no direct claim to the assets, and usually has some basic fiduciary (trustee)duties with respect to the client. Financial institutions may report off-balance sheet items in their accounting statements formally, and may also refer to "assets under management," a figure that may include on and off-balance sheet items.

Off-balance-sheet financing
Under current accounting rules both in the United States (US GAAP) and internationally (IFRS), operating leases are off-balance-sheet financing. Financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may also be off-balance sheet. Such obligations were part of the accounting fraud at Enron.

Finance & Operating Lease

Finance lease is a lease agreement in which substantially all the risks and rewards incidental to ownership of an asset are transferred to the lessee from the lessor. Where lessee is the person who acquired an asset from lessor for use and lessor is the person who is the owner of the asset and has handed over the asset to lessee to earn rentals. On the other hand operating lease is a lease agreement which is NOT a finance lease. In short, a lease agreement in which risks and rewards associated with the asset are not transferred to the lessee and stays with the owner of the asset i.e. lessor.

Finance & Operating Lease

Even though the lessor is the rightful owner of the asset and most often owners are responsible to bear any loss and obtain economic benefits associated with the asset but sometimes the risks and rewards associated with the assets are transferred to another person by the owner himself without transferring the title of ownership of the asset. Same is the case with the finance lease.

Accounting distinction between on and off-balance sheet items

The formal accounting distinction between on and off-balance sheet items can be quite detailed and will depend to some degree on management judgments, but in general terms, an item should appear on the company's balance sheet if it is an asset or liability that the company owns or is legally responsible for; Uncertain assets or liabilities must also meet tests of being probable, measurable and meaningful..

Potential legal liability

For example, a company that is being sued for damages would not include the potential legal liability on its balance sheet until a legal judgment against it is likely and the amount of the judgment can be estimated; if the amount at risk is small, it may not appear on the company's accounts until a judgment is rendered

Differences between on- and offbalance sheets

Traditionally, banks lend to borrowers under tight lending standards, keep loans on their balance sheets and retain credit riskthe risk that borrowers will default (be unable to repay interest and principal as specified in the loan contract). In contrast, securitization enables banks to remove loans from balance sheets and transfer the credit risk associated with those loans. Therefore, two types of items are of interest: onbalance sheet and off-balance sheet.

Traditional & securitized loans

The former is represented by traditional loans, since banks indicate loans on the asset side of their balance sheets. However, securitized loans are represented off the balance sheet, because securitization involves selling the loans to a third party (the loan originator and the borrower being the first two parties). Banks disclose details of securitized assets only in notes to their financial statements.

The Banking Example

A bank may have substantial sums in off-balance sheet accounts, and the distinction between these accounts may not seem obvious. For example, when a bank has a customer who deposits $1 million in a regular bank deposit account, the bank has a $1 million liability. If the customer chooses to transfer the deposit to a money market mutual fund account sponsored by the same bank, the $1 million would not be a liability of the bank, but an amount held in trust for the client (formally as shares or units in a form of collective fund).

The Banking Example

If the funds are used to purchase stock, the stock is similarly not owned by the bank, and do not appear as an asset or liability of the bank. If the client subsequently sells the stock and deposits the proceeds in a regular bank account, these would now again appear as a liability of the bank.

The Banking Example

As an example UBS has CHF (Swiss Frank)60.31 billion Undrawn irrevocable credit facilities off its balance sheet in 2008 (USD 60.37 billion.) Citibank has USD $960 billion in off-balance sheet assets in 2010, which amounts to 6% of the GDP of the United States

Securitization

Securitization
Securitization is the financial practice of pooling various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations, and selling said consolidated debt as passthrough securities, or collateralized mortgage obligation (CMOs) to various investors.

Securitization
The cash collected from the financial instruments underlying the security is paid to the various investors who had advance money for that right. Securities backed by residential mortgage receivables are called residential-mortgagebacked securities (RMBS), while those backed by other types of receivables are asset-backed securities (ABS).

Securitization
Securitization can provide many advantages, such as lower cost of capital, diversification for investors, enhanced liquidity and others. However, critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the US subprime mortgage crisis.

Securitization
In addition, offbalance sheet treatment of securitizations along with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an underpricing of credit risk. Offbalance sheet securitizations are believed to have played a large role in the high leverage level of US financial institutions before the financial crisis and in the need for bailouts.

Securitization
The granularity of pools of securitized assets mitigates the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structuredependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

Securitization
Securitization has evolved from its tentative beginnings in the late 1970s to an estimated outstanding $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the United States and $652 billion in Europe. Whole-business securitization (WBS) arrangements, in which senior creditors of an insolvent business effectively gain the right to control the company, first appeared in the United Kingdom in the 1990s and became common in various Commonwealth legal systems

Structure
Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company looking to raise capital, restructure debt, or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, a bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the company's credit rating and the associated rise in interest rates.

Pooling and transfer

The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided leases with a nominal value of $10 million and would receive a cash flow from these over the next five years. It cannot demand early repayment on the leases and so cannot get its money back early.

Complex Structure
If it can sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.

Special purpose vehicle (SPV)

A suitably large portfolio of assets is "pooled" and transferred to a special purpose vehicle (SPV): the issuer, a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote," meaning that if the originator goes into bankruptcy, the issuer's assets will not be distributed to the originator's creditors. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.

Qualifying special purpose entity

Accounting standards govern whether such a transfer is a sale, a financing, a partial sale, or part sale and part financing. In a sale, the originator is allowed to remove the transferred assets from its balance sheet; in a financing, the assets remain the property of the originator. Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" (qSPE).

Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.

Issuance
To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities that are issued to provide an external perspective on the liabilities being created and help investors make more informed decisions.

Issuance
In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities, and work with financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent that initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities, and work with financial markets to sell the securities to investors.

Issuance
Some deals may include a third-party guarantor that provides guarantees or partial guarantees for the assets, the principal, and the interest payments, for a fee. The securities can be issued with either a fixed interest rate or a floating rate under a currency pegging system. Fixed-rate ABS set the "coupon" (rate) at the time of issuance, in a fashion similar to corporate bonds and TBills. Floating-rate securities may be backed by both amortizing and non-amortizing assets in the floating market.

Issuance
In contrast to fixed-rate securities, the rates on "floaters" periodically adjust up or down according to a designated index, such as a US Treasury rate or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.

What is securitisation
In traditional methods of corporate finance, a corporation raises equity/obligations to own assets. In securitisation, a corporation creates and securitises assets - that is, transfers assets in form of securities. The claim is on assets, and not on the entity Hence, asset-based funding

Securitisation and traditional funding: the difference

All claims are, eventually, claims on assets: question is one of stacking order: securitisation puts investors on the top of the stacking order by isolation Broader the periphery of assets backing up the claims, more the volatility, risks Asset-backed funding narrows down asset definition and hence reduces volatility Hence, reduces credit enhancement Crux of asset backed funding lies in reducing the equity, and increasing the leverage

Basic process of securitisation

10. Originators residuary profit

Originator
4. Proceeds of sale of receivables

1. Cash flow before securitisation

Obligors
6.Passes over to SPV, less fees

2.Assigns Cash flow

Security trustee

SPV special purpose entity

3. Issues securities/ notes

8. Reinvestment proceeds/liquidity facility

5.Collection and servicing

7. Reinvestment/liquidity buffer

Reinvestment contract
4. Proceeds of issue of securities

9. Payments to investors

Investors

Key features of securitisation

Capital market funding Use of special purpose vehicles as a transformation device Structured finance Meaning of structured financial products: product structured or made-to-needs of the investor Key structuring principles: What are investors rating needs What are investors payback needs/ paydown needs What is investors appetite for interest rate risk, prepayment risk? Securitised instruments reorganise investors rights to suit their needs

Concept of SPVs
Transferor Transferor Special purpose vehicles as owner Security trustee holding charge for investors

Special purpose vehicles as trustee

Investors as beneficial owners

Pass-through form

Investors as debt investors

Pay-through/ CDO/ CLO form

Use of SPVs
Generic use of SPVs - to isolate identifiable assets/risks into a stand alone, self-sustained entity which is no more than such assets/ risks. SPVs are used in securitisation transactions as devices of hiving off assets and converting assets into securities. An SPV is no more and no less than incorporated name for specific assets no more than isolated assets - no other assets or general recourse against the SPV no less than isolated assets - no other claims to affect the investors rights over assets

Operating companies and SPVs: SPVs are not companies in substantive operations; they do not have any business except acting as a legal instrumentality. This feature is necessary to ensure asset-backed securities Nature of interest in SPV: beneficial or proportional, equity-type interest in assets debt-type interest, collateralized by specific assets

Use of structured finance devices

Structured finance devices mean re-distribution of risks/rewards or components of assets into different segments, to churn out securities with different risk/reward profiles. Uses of structured finance:
aligning securities to investor needs - term, credit risk, prepayment risk, interest rate risk, etc credit enhancement arbitrage

Common structuring devices:

tranching subordination support classes:
planned amortisation class and support class floating rate class and inverse floating class fixed income class and leveraged floating class debt class and equity class

Use of repackaging devices

Repackaging implies:
Repackaging various loans or structured products into a new product Repackaging loans into loans of smaller or longer tenure

Repackaging by components:
Structured finance resecuritisations

Repackaging by tenure:
Revolving type structure Refinancing type structures

ABS types based on collateral

Securitisation Existing asset Future asset

Risk

Mortgage backed Asset backed RMBS CMBS Operating revenues Credit risk

Insurance risk

ABS types based on other parameters

Securitisation

Purpose

Nature of asset transfer

Synthetic structures

Term of paper

Balance sheet

Arbitrage

Cash structures

True sale structure

Term paper Secured loan structure

Commercial paper

Life cycle of asset-backed securitisation

Quasi-financial deals
Unrated, Bilateral transfers Full originator backing Purpose: off-balance sheet; exploiting excess spread, etc Transfers through SPV route High degree of credit enhancement/ cash participation by originators Purpose: off balance sheet; better ratings
Credit enhancements dwindle; lower classes take risk Synthetics; arbitrage activity enter the stage Purpose: economic capital; better capital/ risk management
Separation of funding and risk transfers Synthetics answer regulatory concerns more easily In traditional cash structures, transaction models are built around securitisation mechanics; origination/ servicing split

Early-stage securitisation Advanced-stage securitisation Synthetics stage Operating Risk transfers/ Index risk transfers ? (possibly, reinvention stage)

More stress on risk transfers risks of operating businesses: retail credits, performance-oriented businesses are transferred Distinction bet. banking and insurance becomes less clear

Parties to securitisation transaction

Originator Obligors Special purpose vehicle: single/ multiple Trustees Investors Swap counterparties Liquidity provider Credit enhancement provider

Typical originators
Application of securitisation techniques has greatly expanded recently. Typical users of securitisation are:
Mortgage financiers Bank loans Finance companies Credit card companies Hoteliers, rentiers Public utilities Intellectual property holders insurance companies aviation companies exporters of unprocessed materials plantations governments

Typical assets securitised

Financial assets
long-term assets short term assets revolving assets

Physical assets
using transformation devices using secured loan structures

Whole business transactions Future flow transactions Structured investment vehicles:

CDOs of investment products such as hedge funds, private equity funds, etc.

Trustee

A logistic requirement, later made a statutory obligation in public offerings of debt instruments Fiduciary for the investors Holder and administrator of security interests and safeguarding collateral documents Traditional functions:
Acting as registrar and transfer agent for the securities Distribution of principal and interest payments oversight of the conduct of the transaction, particularly payments, comingling, compliance with respective agreements monitoring covenant compliance and reporting - regular loan level and bond level reports monitoring principal and interest payments Enforcement of seller representations and warranties monitoring of triggers and withholding distributions

Timely, decisive action Ability and willingness to act as backup servicer or organise succession

Securitisation investors
Professional investors Institutional investors Fixed income investors Investors driven by concerns of risk diversification

Securitisation and borrowing

Legal nature of the transaction Parties to the transaction Transfer of an asset/ several assets of the originator To allow the pool of receivables to be aggregated and kept intact, a collective investment medium, the SPV is formed. Hence, there are 3 parties to the transaction - the Originator, SPV (issuer) and the investors Transfers claims against debtors/ customers of the originator Either a fractional interest in the pool of receivables held by the SPV, or a debt obligation of the SPV Exercisable against the SPV, or through the SPV against the debtors of the originator Normal monetary obligation o f the originator There are two parties to the transaction - the borrower and the lender. In case of participation of several persons in the loan, there might be an indenture trustee acting as a trustee for the investors. No connection with the debtors of the originator Debt obligation of the originator

Relation with the debtors of the originator Nature of instrument acquired by investors

Legal rights of the investors

Exercisable against the originator

Securitisation and borrowing

Treatment for regulatory purposes Effect on regulatory capital requirement Bankruptcy of the originator Not treated as borrowing from public Normally frees up regulatory capital Investors beneficially own the pool of assets transferred to the SPV Treated as borrowing from public Does not free regulatory capital Investors have a claim against the originator; usual bankruptcy/ distressed company protection available to the originator Investors will not be affected; they have a claim against the originator

Failure of the debtors of the originator

Depends upon recourse features; normally investors will suffer a loss

Introduction to Securitisation by Vinod Kothari

Why securitisation
Lower cost - inherent cost and weighted average cost
The best example of economics of securitisation is an arbitrage CDO

Alternative investor base -institutional and retail Matching of assets and liabilities Issuer rating irrelevant Multiplies asset creation ability Non-conventional source; may allow higher fundingOff-balance sheet financing - removal of accounts Frees up regulatory capital Improves capital structure Higher trading on equity with no increased risk

Why securitisation - 2
Extends credit pool Not regulated as loan Reduces credit concentration Risk management by risk transfers Arbitraging opportunities - repackaging transactions Avoids interest rate risk Improves accounting profits

 Better security as direct claims over assets Tested in several bankruptcies: Japan Leasing, several Thai companies; Philippine Airlines, Turkey cos. Rating resilience - transition studies confirm ABS ratings are more stable than other fixed incomes. High rate of default recovery Structuring features: possibility for better risk-return alignment Rated investment Very few instances of default in 20 years history: In European securitisation, no default to date. Even when underlying obligations default, losses are much lesser: In case of corporate bonds, 47% of the par value lost -Moodys study Better yields in emerging markets Moral responsibility of investment bankers/ rating agencies: case of Ahmsa, Mexican companys default.

Securitisation from Investors viewpoint

Defaults and recoveries in ABS transactions

S&P released a defaulted class recovery study on 4th Sept. 2001 Total defaults only 116 out of 13538 classes - only 0.86% This shows that even after D rating, there are substantial recoveries for ABS investors. 116 defaults till June 2001 - RMBS 83 (out of 6361); CMBS 14 (out of 1984) , ABS 19 (out of 5193 classes) RMBS recovery rate average 61% - 65% in prime and 49% in subprime. 96% in prime AAA, 81% in prime AA, etc. CMBS average recovery 66%. (AA 89%) ABS recovery rate uneven averaging 29%. Of the 19 defaults -12 belonged to a single issuer of credit card transactions which was a fraud. Credit cards and franchise loans took 17 of the defaults. Rating agency Moodys cautions: due to the unique terms of structured finance transactions, there might be a prolonged credit deterioration of a rated tranche before it can be termed a default.

ABS/ MBS default history S&P study of 12th Sept 2002

The first study period had some 15000 classes outstanding, and the second period had additional 3500 classes

Recent default update (April 2004)

Legal structure
Most securitisation transactions are based on true sale structure:
True sale provides isolation:
Isolation makes originator performance irrelevant

True sale provides bankruptcy remoteness

Despite sale of the assets, originator retains significant role relative to the assets:
As servicer As first loss support provider

Therefore, characterising a securitisation transaction as a true sale can be challenging Other option:
Secured loan structure with appropriate security interest creation:
Will work in countries that allow security interest enforcement without bankruptcy court intervention

Cash flow structure

Pooling of assets:
One-time/ continuing transfers

Pay-outs to investors:
Pass-through or pay through

Paydown to investors:
Sequential, proportional or a combination

Structural protection:
Diversion of proportional payments to sequential payments

Credit enhancement structure

Excess spread Over-collateralisation Subordination

Cashflow schematics of securitisation

We will model the cash flow structure of a dummy securitisation transaction And iterate it with respect to:
Simple pass through Reinvestment of principal into passive financial instruments Reinvestment of principal into the original asset

To see the impact on:

Residual returns Weighted average maturity

Cash Flow Scheme of Securitisation

Collect Interest (plus other revenue) Collect Actual Principal (Scheduled) Collect all Prepayment

Deduct all Senior Expenses

No Is Actual Principal < Scheduled Principal? Yes Debit Deliqnent Principal Ledger

Pay Senior Coupon

Excess Spread Is excess spread >delinquent Principal ? Yes Pay Junior Coupon Pay Principal No Transfer to Deliqnent Principal

Principal Waterfall

Understanding the impact of prepayment

Prepones principal, reduces interest Reduces the weighted average maturity of the pool Impacts the quality of the pool Introduces callability risk in asset backed securities

Analysis of the cumulative loss curve

The cumulative loss curve plots the cumulative losses/charge offs to the initial outstanding balance of the pool Relation between prepayment and expected loss:
As obligors prepay, even though the charge off rate rises, the cumulative loss rate slows down In such cases, it is important to examine the hazard rate, that is, the rate of charge off relative to the then-outstanding portfolio balance To smoothen the impact of periodic ups and downs, a 6-monthly moving average may be used

For a typical portfolio, the hazard rate ascends as the portfolio seasons; however, the cumulative loss rate tends to flatten as the impact of ascending hazard rate is reduced by reducing pool size

Prepayment models
Prepayment models try to project the prepayment behavior of mortgage loans over time; useful in predicting cashflows, expected maturity, and callability risk Mortgages in different countries behave differently One of the popularly used prepayment model is PSA model:
Mortgages begin with a prepayment rate of 0.2% (annualised) in Month 1 and linearly go upto 6% in Month 30; then stay constant Prepayment behavior of specific mortgage pools is based on PSA 100 PSA meaning equal to the above rate, 200 PDA would mean twice as much Impact of seasoning

Standard default assumption

Default models try to project the movement of the default rate in relation to time. Standard default assumptions in different countries project default movement over the seasoning of the pool. US Bond Market Associations SDA:
Starts with 0.02% annualised default rate in Month 1, grows linearly upto 0.6% in Month 30, then stays constant for the next 30 months, and then declines to 0.03% to the maturity of the mortgage 100 SDA would mean default rate equivalent to the standard rates; 150 SDA would mean 1 times the same