THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS OF BANKS

THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS OF BANKS Wilhelm Pieter Campe Smith Dissertation submitted in fulfillment of the requirements for the degree Magister Commercii in Economics in the Faculty of Economic Science at the University Of Johannesburg JOHANNESBURG September 2007 Supervisor: Dr. R. Hattingh Co-supervisor: Dr. C. Schoeman 1

ACKNOWLEDGEMENTS The author wishes to express his gratitude to Dr. Hattingh and Dr. Schoeman for their advice and guidance. 2

SYNOPSIS The securitisation industry started in the early 1970s in the United States when securities, backed by pools of home loans, were issued for the first time. During the 1980s, securities supported by other types of financial assets such as auto loans and credit card receivables were issued. Since then, securitisation has expanded rapidly into many countries, including South Africa. The first securitisation transaction in South Africa was a securitisation of home loans in 1989, but very few securitisations came to the market after that. In December 2001 the South African Reserve Bank amended the securitisation regulations, which had been in existence since 1992. This created greater certainty for arrangers and investors, and from 2002, the South African securitisation market has grown quickly, driven by frequent securitisation issues by banks. Securitisation is attractive for banks, because it is an additional funding source and allows for the matching of the maturity of a bank s assets and liabilities. Another reason for the attractiveness of securitisation for banks is that it is a mechanism for managing the regulatory capital that a bank is required to hold. In a securitisation transaction, a loan originator such as a bank sells loans on its balance sheet to an independent company, which issues asset-backed securities to fund the acquisition of loans. Provided the transaction complies with the securitisation regulations, the transaction will result in the bank having to hold less regulatory capital compared to a situation where it had not securitised the loans. This regulatory capital arbitrage has been a major factor in banks securitising loans. Regulatory capital arbitrage is possible because of the relatively simplistic manner in which the Basel I capital adequacy guidelines calculate the regulatory capital a bank is required to hold. Given the worldwide growth of the securitisation industry, regulators have become increasingly concerned that banks may not be holding adequate capital as a buffer for the economic risks to which banks are exposed. The Bank for International Settlements, through its Basel Committee on Banking Supervision, has therefore devised a new set of capital adequacy guidelines to replace the Basel I guidelines. The aim of the new Basel II framework is to achieve a greater alignment of regulatory capital with economic risks and to improve risk management practices in banks. Although the Basel Committee cannot enforce its recommendations, it is expected that most regulators throughout the world will adopt the Basel II framework. It is generally expected that the implementation of Basel II will have a substantial impact on banks securitisation activities, especially to the extent that securitisation has been used for regulatory capital arbitrage purposes. 3

LIST OF DIAGRAMS Diagram 2.1: Generic securitisation structure Diagram 2.2: Commercial mortgage-backed securitisation structure Diagram 2.3: Credit-tenant lease structure Diagram 2.4: Covered bond structure Diagram 2.5: Registering SPV structure Diagram 2.6: SUBI structure Diagram 2.7: Future flow securitisation structure Diagram 2.8: Inventory pledge structure Diagram 2.9: Inventory sale structure Diagram 2.10: Whole business securitisation structure Diagram 2.11: Intellectual property secured loan structure Diagram 2.12: Intellectual property true sale structure Diagram 2.13: Single-seller ABCP conduit structure Diagram 2.14: Multi-seller ABCP conduit structure Diagram 3.1: Total return swap Diagram 3.2: Credit default swap Diagram 3.3: Credit spread option Diagram 3.4: Credit-linked note Diagram 3.5: CLN issued by an SPV Diagram 3.6: Different generations of synthetic CDOs Diagram 3.7: Unfunded synthetic portfolio CDO Diagram 3.8: Unfunded synthetic CDO with an SPV Diagram 3.9: Funded synthetic portfolio CDO Diagram 3.10: Partially funded synthetic portfolio CDO Diagram 3.11: Synthetic portfolio CDO with protection buyer as super-senior counterparty Diagram 3.12: Synthetic CSO (collateralised swap obligation) transactions Diagram 3.13: Hybrid synthetic transaction Diagram 3.14: Single-tranche synthetic structure Diagram 3.15: Synthetic CDOs of CDOs Diagram 3.16: Standard tranches of credit default swap indices Diagram 3.17: Arbitrage synthetic CDO Diagram 4.1: The securitisation rating process Diagram 5.1: Structure of the Basel II Accord 4

Diagram A1.1: South African security structure Diagram A1.2: Mortgage guarantee trust structure Diagram A1.3: Assignment of mortgage guarantees Diagram A4.1: Reference entity successor test Diagram A4.2: Replicating credit default swap exposure 5

LIST OF TABLES Table 2.1: Thekwini floating rate notes Table 2.2: Rating multipliers Table 2.3: Characteristics of various CDO types Table 5.1: Causes of banking problems Table 5.2: Capital management options Table 5.3: Comparing default rates with confidence intervals Table 5.4: Comparing measures of capital Table 5.5: Risk weights per asset category Table 5.6: Credit conversion factors per asset category Table 5.7: Add-on amounts for derivative transactions Table 5.8: Reasons for Basel II Table 5.9: Risk weights in the Standardised approach for banking book risk Table 5.10: Asset classes in the IRB approach Table 5.11: Retail correlation factors Table 5.12: Eligible collateral under the Standardised and IRB approaches Table 5.13: Comparing the Standardised and IRB approaches Table 5.14: Standardised risk weights for securitisation exposures Table 5.15: Different risk weights for investing and originating banks Table 5.16: RBA risk weights for long-term rated securitisation exposures Table 5.17: RBA risk weights for short-term rated securitisation exposures Table 5.18: Comparing risk weights under the Standardised approach and the RBA Table 5.19: Comparing the Standardised and IRB approaches Table 6.1: Comparing return on regulatory capital Table A4.1: Using credit spreads to price a credit default swap Table A4.2: Default probability table for pricing credit default swaps Table A5.1: Comparing rating symbols Table A5.2: Comparing rating definitions Table A5.3: Comparing annual cumulative default rates Table A6.1: Basel II adjustment factors Table A6.2: Claims on sovereigns Table A6.3: Risk weighting of banks under option 1 Table A6.4: Risk weighting of banks under option 2 Table A6.5: Claims on corporates Table A6.6: Short-term risk weights 6

Table A6.7: Standard supervisory haircuts Table A6.8: Minimum holding periods Table A6.9: Risk weight categories for specialised lending Table A6.10: Mapping supervisory categories to external ratings Table A6.11: Supervisory categories for high-volatility commercial real estate Table A6.12: Determining effective LGD Table A6.13: Supervisory risk weights for specialised lending Table A6.14: Supervisory risk weights for high-volatility commercial real estate Table A6.15: Supervisory risk weights for long-term securitisation exposures Table A6.16: Supervisory risk weights for short-term securitisation exposures Table A6.17: Credit conversion factors for credit lines with controlled early amortisation Table A6.18: Credit conversion factors for credit lines with non-controlled early amortisation Table A6.19: Long-term risk weights under the RBA Table A6.20: Short-term risk weights under the RBA 7

LIST OF CHARTS Chart 4.1: Vintages of loans Chart 4.2: Static default data for one vintage Chart 4.3: Static default data for different vintages Chart 4.4: Loss probability distribution Chart 4.5: Variations in probability distributions Chart 5.1: Value at risk for different rating categories Chart 5.2: Distribution of losses Chart 5.3: Confidence level for potential losses Chart 6.1: Multiple of the SF capital requirements to RBA capital requirements Chart 6.2: Difference between SF and RBA varies across securitisation tranches Chart 6.3: Disparity between SF and RBA evident across all asset classes Chart 6.4: Multiple of unsecuritised to securitised capital requirements Chart 6.5: Comparing unsecuritised and securitised assets under Basel II Chart 6.6: Comparing risk weights for Standardised and RBA rating categories Chart 6.7: The impact of Basel II on the securitisation of different asset classes 8

LIST OF ABBREVIATIONS ABCP: Asset-Backed Commercial Paper ABS: Asset-Backed Security AMA: Advanced Measurement Approach BATS: Bond Automated Trading System CBO: Collateralised Bond Obligation CCF: Credit Conversion Factor CDO: Collateralised Debt Obligation CDS: Credit Default Swap CLN: Credit Linked Note CLO: Collateralised Loan Obligation CMBS: Commercial Mortgage-Backed Security CMO: Collateralised Mortgage Obligation CP: Commercial Paper CPR: Conditional Prepayment Rate CRM: Credit Risk Mitigation CSO: Collateralised Swap Obligation CTL: Credit Tenant Lease DSCR: Debt Service Coverage Ratio EAD: Exposure at Default ECAI: External Credit Assessment Institution ECN: Extendible Commercial Note EL: Expected Loss FHLMC: Federal Home Loan Mortgage Corporation FNMA: Federal National Mortgage Association FRN: Floating Rate Note GIC: Guaranteed Investment Contract GNMA: Government National Mortgage Association HVCRE: High-Volatility Commercial Real Estate IAA: Internal Assessment Approach IMF: International Monetary Fund IO: Interest Only IPRE: Income Producing Real Estate IRB: Internal Ratings-Based ISDA: International Swaps and Derivatives Association 9

JIBAR: Johannesburg Interbank Agreed Rate LIBOR: London Interbank Offered Rate LGD: Loss-Given-Default LTV: Loan-to-Value MBS: Mortgage-Backed Security MDB: Multilateral Development Bank MTM: Mark-to-Market MTN: Medium-Term Note NIF: Note Issuance Facility NPL: Non-Performing Loan OTC: Over the Counter PAC: Planned Amortisation Class PC: Participation Certificate PD: Probability of Default PO: Principal Only PSA: Public Securities Association PSE: Public Sector Entity RBA: Ratings-Based Approach RMBS: Residential Mortgage-Backed Security RUF: Revolving Underwriting Facility RWA: Risk-Weighted Asset SDA: Standard Default Assumption SF: Supervisory Formula SLN: Secured Liquid Note SMM: Single-Monthly Mortality SIV: Structured Investment Vehicle SPV: Special Purpose Vehicle STRIP: Separately Traded Registered Interest and Principal SUBI: Special Unit of Beneficial Interest TAC: Targeted Amortisation Class UL: Unexpected Loss VADM: Very Accurately Determined Maturity VaR: Value at Risk WAC: Weighted-Average Coupon WAM: Weighted-Average Maturity 10

TABLE OF CONTENTS PAGE 1. INTRODUCTION AND FRAMEWORK 1. INTRODUCTION 13 2. FRAMEWORK OF THE STUDY 24 2. AN OVERVIEW OF CASH FLOW SECURITISATION 1. INTRODUCTION 26 2. HISTORY AND DEVELOPMENT OF SECURITISATION 27 3. MOTIVATION FOR SECURITISATION 29 4. GENERIC SECURITISATION STRUCTURE AND MECHANICS 32 5. KEY SECURITISATION PARTIES AND THEIR ROLES 39 6. KEY FEATURES OF SECURITISATION 43 7. SECURITISATION ASSET CLASSES 57 8. CONCLUSION 110 3. AN OVERVIEW OF CREDIT DERIVATIVES AND SYNTHETIC SECURITISATION 1. INTRODUCTION 113 2. THE DEVELOPMENT OF CREDIT DERIVATIVES 115 3. THE DEVELOPMENT OF SYNTHETIC COLLATERALISED DEBT OBLIGATIONS 129 4. CONCLUSION 153 4. THE ROLE OF RATING AGENCIES IN SECURITISATION 1. INTRODUCTION 156 2. THE SECURITISATION RATING PROCESS 158 3. RISK ANALYSIS IN RATING SECURITISATION TRANSACTIONS 162 4. DATA EVALUATION IN SECURITISATION TRANSACTIONS 172 5. COMBINING QUANTITATIVE AND QUALITATIVE MODELS 182 6. CONCLUSION 188 5. AN OVERVIEW OF CAPITAL ADEQUACY REGULATIONS 1. INTRODUCTION 190 2. BANKING RISKS AND THE CAUSES OF BANKING CRISES 192 3. BANK CAPITAL MANAGEMENT 197 4. THE DEVELOPMENT OF BANKING REGULATIONS AND THE BASEL I ACCORD 208 11

5. THE DEVELOPMENT AND USE OF REGULATORY ARBITRAGE BY BANKS 221 6. BACKGROUND AND MOTIVATION FOR THE BASEL II ACCORD 228 7. THE OVERALL STRUCTURE OF THE BASEL II ACCORD 232 8. CONCLUSION 266 6. THE IMPACT OF BASEL II ON BANKS SECURITISATION ACTIVITIES 1. INTRODUCTION 269 2. THE IMPACT OF BASEL II ON SECURITISATION MARKETS 270 3. CONCLUSION 285 7. CONCLUSION AND RECOMMENDATIONS 1. INTRODUCTION 287 2. MAJOR FINDINGS 293 3. RECOMMENDATIONS 295 APPENDIX 1 - LEGAL CONSIDERATIONS IN SECURITISATION 296 APPENDIX 2 - ACCOUNTING CONSIDERATIONS IN SECURITISATION 305 APPENDIX 3 - TAX CONSIDERATIONS IN SECURITISATION 310 APPENDIX 4 - FEATURES OF CREDIT DEFAULT SWAPS 317 APPENDIX 5 - CREDIT RATING SYMBOLS AND DEFINITIONS 345 APPENDIX 6 - SUMMARY OF THE MINIMUM CAPITAL REQUIREMENTS IN TERMS OF THE BASEL II FRAMEWORK 360 APPENDIX 7 - BASEL II CAPITAL REQUIREMENTS ON SAMPLE PORFOLIOS 428 REFERENCES 436 12

CHAPTER ONE INTRODUCTION AND FRAMEWORK 1. INTRODUCTION The object of this dissertation is to examine critically the implications of the new Basel II capital adequacy framework 1 on the regulatory capital arbitrage deriving from banks participation in securitisation transactions. In primitive societies people made use of barter to satisfy their needs. Given the difficulty of finding a double coincidence of wants between two people, societies have, over the ages, adopted common measures of value such as gold or silver. Later on paper notes backed by these precious metals, or specie, started replacing gold and silver coins as stores of value and mediums of exchange. Later cheques, i.e. orders by depositors to the goldsmiths and bankers to make payments on their behalf to someone else, became widely accepted as a means of payment. In this way claims on deposits and orders to make transfers between deposits came to dominate specie itself as a means of payment. Yet another important development was when bankers realised that they need not hold specie fully equal to their liabilities in the form of banknotes and deposits in order to be able to meet their promise to pay on demand. This was because few depositors wanted to be repaid their deposits at one and the same time. Banks began to lend out money in greater amounts than the specie kept in their custody, and earned interest on these loans. This process constituted the origin of the fractional reserve banking system, for whenever a banker granted a loan without receiving full specie in exchange, money was created. In this way the rigid link that existed between specie and the money supply was broken and banks as institutions that accept deposits and extend loans came into being. Legal definitions of what constitutes a bank vary from country to country, but it has become widely accepted that the activity that makes banks special is the taking in of deposits, since deposits, specifically demand deposits, constitute funds on call that can be used as a means of payment and settling debts with third parties. Consequently, banks find themselves at the centre of the payments system, the efficiency of which is very important for a country s economy, and the whole financial system. 1 Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, Bank for International Settlements, June 2004. An updated version was published in 2005. 13

A country s financial system comprises the arrangements embracing the lending out of funds by savers to borrowers, either between savers and borrowers contracting directly with each other, or through the intervention of financial intermediaries. The financial system s primary function is to mobilise savings and allocate those funds among competing borrowers on the basis of expected riskreturn. This process can be carried out in two competing ways: either through financial intermediation or through financial disintermediation. Financial intermediation refers to the process whereby financial intermediaries such as commercial banks take in deposits from savers with the aim of on-lending to borrowers. Depositors and borrowers risk appetite, term preferences, savings availability and borrowing requirements, however, are seldom matched. Depositors tend to save smaller amounts for shorter periods than the amounts and periods required by borrowers. Depositors are also risk averse and do not have the resources available to assess the risks that borrowers might not repay their loans. Banks bridge this divide by means of maturity transformation and by risk diversification. Maturity transformation refers to the process whereby banks take in generally short-term deposits from savers, and lend the funds so procured out to borrowers for generally longer periods. In doing so the banks expose themselves to liquidity risk, credit risk and price or market risk. Liquidity risk refers to the inability of a bank to meet its commitments on time, specifically the commitment to repay depositors their deposits when they require these, which is an inherent risk of maturity transformation. Credit risk refers to the potential inability of a borrower to repay its loan in full. Market risk refers to the risk of unexpected movements in, for example, interest rates and the impact thereof on the bank. For taking on these risks they charge an interest rate spread, which is the margin between the interest rate paid on deposits and the interest rate charged on loans to borrowers. Banks attempt to ameliorate these risks by diversification of their loans across different borrowers, and across different market sectors, something that would be very difficult for an individual saver to do. Despite the difficulties of savers and borrowers matching their different requirements, and therefore using financial intermediaries such as banks to do this, the process of financial disintermediation has grown rapidly. Disintermediation is the process whereby financial intermediaries are bypassed and savers contract directly with borrowers. The markets that bring savers or investors directly together are the money markets and the capital markets. The money market deals in short-term financial instruments usually with a maturity of less than one year, whereas the capital market deals in longerterm instruments. Investors in the money and capital markets are institutional investors such as insurance companies, pension funds and asset managers, while borrowers tend to be large corporates. The credit risk is borne by the investors, who are assisted in the risk assessment and risk monitoring 14

by credit rating agencies such as Standard & Poor s, Moody s Investors Service and Fitch Ratings. Liquidity, e.g. the ability for an investor to liquidate its investment is provided by the secondary market, which is the market for trading financial instruments after they have been issued originally in what is termed the primary or new issue market. Both the money market and the capital market have a primary and secondary market. Typically, the financial instruments issued and traded in the money market are negotiable certificates of deposit, promissory notes and commercial paper, which are all certificates of indebtedness with maturities ranging from a few days to 364 days. Instruments with maturities in excess of 364 days that are issued and traded in the capital market are fixed coupon bonds, zero coupon bonds and floating rate notes. The different money market instruments are technically very much the same, whereas the various capital market instruments are distinguished by their different interest rate profiles. On a fixed rate bond the investor receives a fixed interest payment, called the coupon. A zero coupon bond does not pay a coupon over its lifetime, but is issued at a discount and redeemed at its nominal or face value. The difference between the issue price the investor pays for the zero coupon bond, and the redemption amount reflects the investor s return on the instrument. Floating rate notes are bonds that pay a variable rate coupon, which is linked to a specified reference interest rate. Traditional financial intermediation is an inherently costly process because the intermediary requires, and is required by, the regulators to hold sufficient capital to protect itself against default risk, which adds a layer of cost to the process. It comes as no surprise that financial intermediaries such as banks have been steadily losing market share to the process of disintermediation. Disintermediation as such is not a new phenomenon, as financial markets have been trading equities and bonds for over a century. The greater acceptance by investors of credit ratings provided by rating agencies, as well as more liquid secondary markets, has greatly encouraged the growth of disintermediation during recent times. Disintermediation has gained additional impetus from the development of the securitisation market over the last 25 years. Until the development of securitisation, disintermediation only really applied to the issue by large creditworthy corporates of relatively large amounts of debt into the money and capital markets. Securitisation however allows much smaller amounts of consumer and business debt to be funded through the money and capital markets. Through securitisation, which is a more elaborate process of disintermediation than the issuance of corporate bonds or commercial paper, illiquid consumer loans such as residential mortgages, vehicle finance and credit card receivables can be repackaged into liquid financial instruments. A typical securitisation transaction is structured around a number of basic building blocks: 15

Origination, which is the process carried out by the financial institution that extended the loans and comprises the acquisition and credit appraisal of loans. Structuring, which entails the creation of a special legal entity known as a special purpose vehicle (SPV) for the sole purpose of purchasing loans from the originating institution, using the assets so purchased as collateral for asset-backed securities issued into the capital market to fund the purchase. True sale, the principle whereby assets are legally sold to the SPV and the SPV has no recourse to the originator if some of the assets default, nor do the originator s creditors have any claim against the assets if the originator becomes insolvent. Bankruptcy remoteness, whereby the SPV is limited by its constitutive documents to engage only in the purchase of specified assets and the issue of asset-backed securities to finance the purchase. Credit enhancement, which is the technique whereby the credit quality of the asset pool is improved to such an extent that the asset-backed securities that are issued on the strength of the collateral plus the credit enhancement are of a sufficiently high credit rating assigned by a rating agency to make them attractive to investors. Often the originator provides credit enhancement through a subordinated loan to the SPV. Otherwise, external credit enhancement can be procured from an insurer that provides a guarantee, or internal credit enhancement can be used by way of creating an internal reserve. Underwriting and placing, whereby the asset-backed securities are placed with investors. Hedging, the process whereby all interest rate and currency risk is hedged out through financial derivatives in order to protect investors. Servicing, being the process of collecting interest and principal debt from the borrowers and paying it over to the SPV for disbursement to investors. Servicing is usually performed by the originator. The securitisation market had its beginnings in the early 1970s with the sale of pooled mortgage loans guaranteed by United States government agencies, namely the Government National Mortgage 16

Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). In the United States a lender can extend a conventional mortgage loan based on the credit of the borrower and on the mortgage collateral. The lender may also take out mortgage insurance from these government agencies to provide a guarantee for the fulfilment of the borrower s obligations. Because the United States government guarantees the loans, these guaranteed mortgage loans are of a high quality and became obvious candidates for securitisation. In 1985 the first securitisation transaction backed by assets other than mortgage loans, in this instance computer leases, was launched in the United States. Later in that same year the first auto loan-backed securities were issued, followed by the first credit card-backed securities in 1987. Since then the securitisation market has expanded, as has the range of assets that have been repackaged into securities. While the United States market still accounts for the largest share of the global securitisation market, securitisation has become increasingly popular in Europe and Asia as well as emerging markets. The flexibility and applicability of the securitisation concept itself means that virtually any asset is a candidate for transformation into securities. Generally speaking, the securitisation market is composed of mortgage-backed securities (MBS), where the underlying assets that are being securitised are mortgages, and the asset-backed securities (ABS) market, which includes all other asset classes except mortgages. Each type can be further subdivided, for example, the MBS market can be subdivided into residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). As a rule of thumb, the nature of the underlying assets determines what the securities are called. The original mortgage securitisations were structured as pass-through transactions, in which case the regular repayments by borrowers (being payment of interest and capital) and pre-payments, are directly passed through to investors. The investor s return is equal to the underlying cash flow from the asset, minus a servicing fee paid to the originator, and other transaction fees. Subsequently, paythrough structures were developed whereby the cash flows emanating from the underlying assets are not passed through to investors as the cash flows are received, but captured in the SPV and allocated to investors according to certain rules. These pay-through structures allow for different classes, called tranches, of MBS and ABS to be issued, each tranche having a different cash flow and risk profile. A securitisation SPV could for instance issue three tranches rated AAA, AA and BBB by a credit rating agency. The repayment method can be sequential, which means that all the cash flows are first used to retire the AAA debt, then the AA debt, and only finally the BBB rated securities. Because the AAA securities are retired first, they are the least exposed to any losses on the underlying assets, which is why they carry the highest rating reflecting the lowest risk. On the other hand, the BBB securities have the highest risk exposure, since they stand last in line for payment and are liable to 17

sustain most of any losses. If, for instance, 5% of the total securities issued by the SPV is rated BBB and eventual losses on the underlying assets amount to 5%, then BBB investors will lose all of their investment, whereas AAA and AA investors will be repaid in full. If losses exceed 5% then the AA investors will be the next in line to suffer losses. This tranching of securities and the so-called waterfall of payments, where the higher rated securities are paid first from the available cash flow is a common feature of pay-through securitisation structures. Investors in securitisation transactions rely considerably on the credit ratings provided by a credit rating agency. The rating agency conducts a due diligence on the pool of assets, and rates the securitisation structure, including the adequacy of the cash flows, credit enhancement and administrative competence of the originator as service provider. Based on these factors, it gives a rating to the asset-backed securities. During the life of the securitisation transaction the rating agency monitors the transaction every month and provides a quarterly surveillance report. Securitisation transactions, where the assets are physically sold by the originator to the SPV, are called cash transactions. Another form of securitisation that has become popular is what is called synthetic securitisation. In a synthetic transaction the originator does not sell the assets to the SPV, but only the credit risk of the assets is transferred to the SPV. This is done through the use of credit derivative instruments. Financial derivatives, of which credit derivatives represent but one type, have grown exponentially since their inception 30 years ago, around the same time as when the concept of securitisation started. The origin of the derivatives industry can be traced back to 1975 when Fischer Black and Myron Scholes published their now famous Black-Scholes option pricing methodology in the Journal of Political Economy. This led to the birth of today s huge financial derivatives industry and the concept of financial engineering, whereby mathematical techniques are used to manipulate financial flows. In the June 2004 Quarterly Review of the Bank for International Settlements the aggregate turnover of exchange traded financial derivatives contracts amounted to US $272 trillion during the first quarter of 2004. The amount of outstanding over-the-counter (OTC meaning that counterparties deal with each other directly outside of a derivatives exchange) derivatives stood at US $197 trillion at the end of 2003. A derivative contract assumes its value from the price of an underlying item such as a commodity, financial asset or an index. The underlying item could be a physical good such as wheat, copper or frozen pork bellies or a financial instrument such as equities, bonds or currencies, where a derivative s 18

price is affected by expectations about future supply and demand factors. Generally a financial derivative contract derives a future price for a specific asset on the basis of that asset s current price (the spot price) and interest rates (the time value of money). In the case of financial derivatives the underlying assets are typically based on interest rates or currency exchange rates. A relatively recent derivative instrument is the credit derivative of which the credit-default swap is the preferred instrument of use in synthetic securitisation transactions. A credit default swap (CDS) is a credit derivative in which a bank that owns a portfolio of assets purchases credit protection on the portfolio from a protection seller, usually another financial institution. To the extent that any defaults occur on the portfolio, the protection seller will make good the losses to the protection buyer. In return for taking on the risk of the asset portfolio the protection seller receives a regular payment, the premium, from the protection buyer. Synthetic securitisation is a combination of securitisation and credit derivative techniques. In a synthetic securitisation there is no true sale of bank assets (reference assets); however, asset risk is transferred through a credit derivative, usually a credit default swap from the bank to the securitisation SPV. Because the reference assets are not removed from the bank s balance sheet, synthetic securitisations are easier to execute than cash-funded structures. This is particularly so in the case of bank loans, which may require borrower notification and consent, or have other restrictions on loan sales. Synthetic securitisation transactions are typically used by banks to achieve a reduction in the regulatory capital they are required to hold against the loans on their balance sheets. Securitisation is particularly attractive to banks because of the regulatory arbitrage opportunities it offers. Regulatory arbitrage is the process whereby banks restructure their asset categories so as to attract a lower regulatory capital adequacy charge. It must be borne in mind that governments heavily regulate banks and the rules on capital adequacy are the most prominent of these regulations. This prominence results from the central role banks play in financial intermediation and the payments system in an economy; the systemic risks posed to the economy if a bank fails; the importance of sufficient bank capital for bank soundness; and the efforts of the international community to adopt common capital adequacy standards. Capital, of course, carries a cost. Bank shareholders would prefer the minimum amount of capital consistent with the risks the bank takes, so as to have the highest possible return-on-equity. Regulators, on the other hand, are mostly concerned with the safety and soundness of banks and would therefore prefer more rather than less capital. Countries such as the United States had first 19

begun to lay down minimum capital standards for banks in the early 1980s. Many other countries had prudential approaches, but without specified minimum capital adequacy standards. Capital as a percentage of assets had seen a long-term decline throughout banking systems across the world and there was a concern that there would be a further erosion of bank capital thus making the banking system more risky. Capital adequacy regulations also differed across countries thereby giving banks in some countries a competitive advantage, forcing banks operating in a more restrictive environment to lower their pricing in order to compete, thus potentially weakening their capital base. When banking systems in a number of industrial countries weakened in the late 1980s, pressure developed for a harmonisation of bank regulations among these industrial countries. The harmonisation was driven by the need to prevent banking failures in one country from spreading to another, and also levelling the playing fields, so that banks in different countries would not gain a competitive advantage through different regulatory requirements. In order to address the situation, the central banks and bank regulators of the so-called Group of Ten (G10) countries, in effect the major industrial countries of the world, agreed on a common approach to bank capital regulations. The design of the new international regulatory regime was delegated to the Basel Committee on Banking Supervision (Basel Committee) based at the Bank for International Settlements in Basel, Switzerland. The Basel Committee completed the accord on capital adequacy regulations, called the Basel Accord or Basel I, in 1988 for implementation by member G10 countries by the beginning of 1993. Over time the benefits of standardised capital adequacy regulations were realised by other countries, including emerging economies, and by 1999 Basel I had been adopted by around 100 countries worldwide. The major contribution of Basel I was to lay down minimum capital guidelines for banks and a standard methodology for the assessment of a bank s capital adequacy. Since the beginning of 1993 banks incorporated in G10 countries have been obliged to comply with a minimum capital to riskweighted assets ratio of 8% 2, also known as the Cooke ratio. The ratio is defined as capital as a percentage of the total of risk-weighted on-balance sheet assets plus the risk-weighted credit equivalent for off-balance sheet exposures. Basel I divided assets into four risk buckets, namely: for a bank s exposure to sovereign governments (0%); exposures to other banks (20%); exposures to residential mortgages (50%); and lastly all claims on the non-bank sector, irrespective of the credit quality of the exposure (100%). It is especially this last one size fits all calculation that opened the door for regulatory arbitrage. For example, a bank loan to a corporate with a good credit rating carries, under Basel I, exactly the same risk weight (and therefore capital allocated) as a loan to a risky 2 In South Africa, the South African Reserve Bank increased the minimum capital requirement to 10%. 20

start-up company. Because of the higher risk, the bank would charge a higher interest rate on the start-up loan, thus achieving a higher return on the capital that the bank is required to hold. Basel I therefore provided the incentive for banks to shift towards more risky asset portfolios for which they could command higher interest rates, while having to hold the same amount of capital, as the bank would have to hold against low-risk assets. These activities that allow the bank to assume greater risk without any increase in its regulatory capital requirements are the oldest form of regulatory capital arbitrage. Securitisation is a newer form of arbitrage that achieves the same result. When a bank sells assets to a securitisation SPV, it normally retains most of the risk of the assets sold because of the credit enhancement the bank provides to the transaction. In terms of Basel I, a bank must hold regulatory capital against the full amount of credit enhancement provided to the transaction, if the bank previously owned the assets. It follows that, if the credit enhancement amounts to less than 8% of the asset portfolio that has been securitised, the bank has reduced its regulatory capital requirement despite being exposed to essentially the same risk it faced before the securitisation. Initially, Basel I was a significant success and global average levels of bank capital increased. However, over time the shortcomings of specifying the same risk-weight for corporate loans irrespective of the risk thereof became apparent. The consequences of this were that banks migrated to higher-margin higher-risk lending; pricing in corporate lending continued to be undifferentiated by risk; activities that carried no explicit risk-weight such as asset management and custodial services were seen to be risk-free; and regulatory arbitrage became widespread, primarily through the use of securitisation, whereby high-quality low-margin lending is removed from a bank s regulatory balance sheet without a commensurate reduction in economic risk. The end result is that the current Basel I Accord has encouraged a reduction in overall bank solvency standards, rather than the increase that was originally envisaged. The shortcomings of Basel I led the Basel Committee to devise improved international capital adequacy regulations starting in 1999 with the development of what was to become the Basel II framework. The overall objective of Basel II is to increase the soundness of the international banking system by establishing regulatory capital requirements that more accurately reflect the true economic risks that banks face. This means more capital will be required for more risky activities and less where there is less risk, thus departing from the one size fits all approach of the Basel I Accord. The final Basel II document was published in June 2004 (followed by an updated version in 2005), with implementation to commence as of year-end 2006 in countries that plan to fully implement Basel II. Banks in these countries will have three years, from 2007 to 2009, to make the transition to compliance. In South Africa, full implementation of Basel II is planned for January 2008. The new 21

framework proposes a system based on three mutually reinforcing pillars, which are briefly discussed below. Pillar 1 specifies minimum capital requirements for banks exposures to credit risk (substantially revised and enhanced from Basel I), market risk (unchanged from the 1997 Amendment to Basel I), and operational risk (new in Basel II). The rules contained in Pillar 1 set out the minimum ratio of capital to risk-weighted assets. The current definition of capital and the 8% minimum capital requirement remained unchanged; however, risk weights will become more risk sensitive. In terms of credit risk, Pillar 1 of Basel II draws a distinction between non-securitised assets on the bank s balance sheet, and the treatment of a bank s exposure to securitisation transactions as originator and investor. For the credit risk of bank assets Basel II advances three approaches, namely the Standardised approach, and the Internal Ratings-Based Foundation and Advanced approaches. The Standardised approach is a relatively simple method conceptually in line with the existing approach under Basel I, but with more risk weight categories. Instead of only one risk weight category for corporate lending (100%), there will be four categories (20%, 50%, 100%, and 150%). Banks will slot assets into weighting categories to be referenced to a credit rating provided by an approved rating agency. The Internal Ratings-Based (IRB) Foundation approach allows banks to categorise exposures based on the banks internal risk assessments. If a bank has had in place a system, recognised by its supervisor, for internally rating borrowers for at least three years, it will be able to use its own ratings to slot loans into probability-of-default (PD) bands. The bank will be able to choose as many bands as it wishes, with the capital requirement for each band set according to a formula. A set loss-givendefault (LGD) factor is applied to produce the actual capital charge, reflecting the likelihood of recoveries, given the type of collateral. The IRB Advanced approach will allow banks to recognise any form of collateral and will allow banks to set their own LGD factors. For the credit risk of a bank s securitisation exposures Basel II advances two approaches, being the Standardised approach and the IRB approach. Banks that apply the Standardised approach to credit risk for the type of underlying assets that will be securitised must use the Standardised approach under the securitisation framework. The capital treatment of positions retained by originators, liquidity facilities, credit risk mitigants, and 22

securitisation of revolving exposures are identified separately. The risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the position by the appropriate risk weight determined in accordance with specified tables. Banks that have received regulatory approval to use the IRB approach for the type of underlying exposures securitised must use the IRB approach for securitisation. Conversely, banks may not use the IRB approach to securitisation unless they have received approval from their national supervisor to use the IRB approach for the underlying assets. Under the IRB approach for securitisation, a hierarchy of approaches is proposed, depending on whether assets are rated or not. The Ratings- Based Approach (RBA) must be applied to securitisation exposures that are rated, or where a rating can be inferred. Under the RBA, the risk-weighted assets are determined by multiplying the exposure by a specified risk weight that depends on the external rating grade, the diversification (granularity) of the underlying asset pool, and the seniority of the exposure. Where an external or inferred rating is not available, either the Supervisory Formula (SF) or the Internal Assessment Approach (IAA) must be used. The IAA is only available to exposures that banks extend to asset-backed commercial paper (ABCP) programmes. Under the SF, the capital charge for a securitisation tranche depends on five bank-supplied inputs: the IRB capital charge had the underlying assets not been securitised; the tranche s credit enhancement level and thickness; the asset pool s number of exposures, and the pool s exposure-weighted average loss-given-default. A bank may use its internal assessments of the credit quality of the securitisation exposures the bank extends to ABCP programmes, only if the bank s internal assessment process meets the approval of the bank s national supervisor. The internal assessment of exposures must be mapped to equivalent external ratings of a rating agency. In terms of Pillar 1, there is no change in the calculation of market risk from the current Accord. For operational risk there are three possible approaches: the Basic approach, Standardised approach, and the Advanced Measurement approach. It is not foreseen that this risk element will influence banks involvement in securitisation, since securitisation is mainly used as a regulatory capital management tool and as a source of funding. The second Pillar provides for the supervisory review of banks capital adequacy and their internal assessment processes. National supervisors will be responsible for evaluating and ensuring that banks have sound internal processes in place to assess the adequacy of their capital, and may intervene to prevent a bank s capital from falling below the level required by the bank s specific risk requirements. 23

Pillar 3 will promote market discipline through enhanced disclosure requirements for banks. This increased transparency should give market participants a better idea of a bank s risk profile and its capital buffer. Basel II is expected to have an even more profound impact on the banking industry than its predecessor. It will have an equally important impact on the securitisation industry. The objective of Basel II is, inter alia, to achieve a much greater congruence between regulatory and economic capital and reduce the regulatory arbitrage that is currently achievable through securitisation transactions. The new regulatory capital treatment of bank assets and banks securitised exposures will therefore have a major impact on banks participation in securitisation transactions, and it is expected that Basel II will lead to significant shifts in the securitisation market. It will be the aim of this study to investigate to what extent and in what manner the new Basel II regulations will impact on securitisation. More specifically, the aim will be to investigate to what extent the economically more realistic treatment of securitisation under Basel II will influence the use of securitisation by banks to manage their regulatory capital. 2. FRAMEWORK OF THE STUDY The investigation will attempt to trace the development of securitisation with reference to banks in particular and the importance of banking regulations with respect to securitisation, and to analyse the new Basel II framework and its potential impact on securitisation, to the extent that banks use securitisation as a regulatory arbitrage tool. The research methodology proposed is a literature study. This method is proposed since a field study will not be helpful, as Basel II will only be implemented from 2008 onwards in South Africa. A literature study is feasible and would fit the chosen objective. It is proposed that only the potential impact of Basel II on banks participation in securitisation, in so far as it is used as a regulatory arbitrage technique, be covered in the research. The use of securitisation by banks for purposes other than regulatory arbitrage, e.g. for funding, will therefore not form part of this study. The aspects of Basel II that would influence the use of securitisation by banks the most profoundly are the new regulations regarding credit risk. The effects of other parts of Pillar I, e.g. market risk and operational risk, will not be investigated. Likewise, Pillars II and III are 24

not regarded as having a major impact on banks decisions whether, or not, to participate in securitisation transactions. These restrictions should not influence the validity of the research. The study will be divided into the chapters set out below. Chapter 2 will provide an overview of cash flow securitisation. Chapter 3 will present an overview of synthetic securitisation. Chapter 4 will investigate the role of the credit rating agencies. Chapter 5 will offer an overview of capital adequacy and the Basel regulations. Chapter 6 will investigate the implications of Basel II in regard to the use of securitisation by banks for purposes of regulatory arbitrage. Chapter 7 will conclude the study. 25

CHAPTER TWO AN OVERVIEW OF CASH FLOW SECURITISATION 1. INTRODUCTION The purpose of this chapter is to examine the history and development of securitisation and its use in the financial markets. The parties to a securitisation, the reasons for securitisation, the key features of a securitisation transaction, the various securitisation structures and different asset classes are described. Securitisation is a financing tool for selling assets in the form of receivables. Assets in this context can be defined as rights or access to future economic benefits controlled by an entity as a result of transactions concluded in the past. Through the process of securitisation, assets from corporates or banks are pooled, repackaged and sold as asset-backed securities. These asset-backed securities are collateralised or backed by the pooled assets, and are therefore not considered as obligations of the sellers. Investors only consider the cash flows from these assets as repayment of their investments in the securities. Securitisation has become established as an important method of finance, whereby an investor effectively agrees to evaluate only the credit risk of the relevant pool of assets, thus divorcing the credit risk from the original owner of the assets. Asset securitisation differs from collateralised debt or traditional asset-based lending, in the sense that the assets, such as loans or other financial claims, are assigned or sold to a third party, typically a special purpose vehicle (SPV) constituted as a company or trust. This third party, in turn, issues asset-backed securities to fund the purchase of the assets. Securitisation can thus be seen to have evolved from the process of factoring, where a corporate sells short-term assets, such as trade receivables at a discounted price to a third party such as a collection agency. In the factoring process, the seller retains no interest in the receivables (which are usually sold at a significant discount), and no longer controls the collection of the cash flows. In a securitisation transaction however, the seller (also referred to as the originator) of the assets continues to administer and collect the cash flows from the assets. The originator also retains a substantial part of the profit generated by the underlying assets by extracting this profit from the SPV. The SPV is established with the strictly limited purpose of only purchasing specified assets and funding them only in the capital markets. This structure effectively isolates the underlying assets from 26

the originator, which makes the asset-backed securities attractive to investors, thereby allowing relatively low cost funding, unlike factoring, which is a relatively expensive source of funding. Over the past three decades, the use of securitisation as a financing tool has grown rapidly, not only in the United States where securitisation can be said to have started, but also globally. It has become an important source of funding for corporates, but especially for banks and other financial institutions. Securitisation transactions vary in complexity depending on specific structural, accounting, tax and legal considerations as well as on the type of asset that is being securitised. The development of the securitisation market over the last few decades has had a number of beneficial effects on capital markets. The introduction of a new class of debt instruments has broadened the capital markets. Securitisation allows investors to invest in assets, which they otherwise could not have accessed, and greatly contributes to the availability of highly-rated bonds to investors. 2. HISTORY AND DEVELOPMENT OF SECURITISATION Securitisation is a widely used financial methodology applied by banks and corporates to raise funding and also used by banks to manage their risks. In normal market parlance, the term securitisation 3 has had two primary meanings. Initially, the term was applied to the process of disintermediation, or the substitution of securities issued for bank lending. More recently, the term has been used to refer to structured finance, the process whereby relatively homogeneous, but illiquid, assets are pooled and repackaged, with claims to the incoming cash flows and other economic benefits generated by the asset pool sold to investors as financial securities (Lumpkin, 1999:25). In its simplest form, securitisation is a method of funding receivables such as mortgage debts, leases, loans, or credit card balances by the creation of freely tradable securities backed by these assets (Pulido, 2004:1). Andrews et al., (2004:2) describe securitisation as the process of setting up a credit-enhanced asset-holding structure, which is legally remote from the bankruptcy of the original owner of those assets. Typically a company or a bank that originates assets such as receivables or loans sells these assets to an SPV 4, which issues tradable securities to investors to fund the purchase. Cash flows collected from the assets are used by the SPV to make repayments of principal and interest to the investors. 3 Also called securitization. 4 The terms Special Purpose Entity (SPE), Single Purpose Company (SPC), or Special Purpose Institution (SPI) are also used. 27

The earliest securitisation transactions date back to the early 1970s in the form of pooled mortgage loans sold by the Government National Mortgage Association (GNMA or Ginnie Mae) in the United States (Gangwani, 1998:1). These transactions were followed by transactions from the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae) in the early 1980s. The first non-mortgage asset-backed securities transaction was originated by Sperry Lease Corporation of the United States in a computer lease transaction in 1985 (Henderson, 1997:3). The United States market is the largest, most liquid, most innovative and most sophisticated debt market. Securitisation has grown concurrently with other developments affecting banks and savings and loans institutions, which include: increased competition following financial deregulation; regional imbalances in capital flows in the United States; the search for fee rather than margin income as margins have deteriorated; the imposition of capital adequacy standards; and increased emphasis on return on capital rather than returns on asset. As securitisation techniques matured, United States corporate borrowers started disintermediating the bank sector by directly accessing the public money and capital markets. From the mid-1980s, receivables-backed financing became a mainstream source of corporate finance. Until 1995 the United States was the main source of securitisation transactions. Since 1996 there has been rapid growth in Europe, and since 1997, also in Japan and Australia (De Paauw and Ross, 2000:4). By 2004 the total outstanding issuance of securitisation securities worldwide has reached a level of approximately seven trillion dollars (Pulido, 2004:1). In South Africa R7.5 billion of new securitisation issues came to the market during 2004, increasing total issuance volume to R29.5 billion (Bate and Leegerstee, 2005:1). Henderson (1997:4) identifies three irreversible trends in debt financial markets that have promoted the growth of securitisation. Firstly, whether it would ever be traded or not, debt is increasingly presented in tradable format, and a network of dealers, market makers and clearing houses have already created a liquid market for debt securities. Secondly, securitisation participates in the wider trend towards outsourcing and functional specialisation. It treats each part of the process of originating, administering and funding of an asset portfolio as separate elements. Such a division of labour and appreciation of constituent risks is made possible by the third trend, which is the application of computer technology to capture and manipulate large databases, and to model outcomes under assumed scenarios. Recent trends include a blurring of the distinction between structured finance and corporate finance, increased use of derivatives and securitisation in the same transaction, and the securitisation of new 28

asset classes. In some countries (in Eastern Europe for example) the basic legal, regulatory, tax and accounting infrastructure for securitisation has been implemented for the first time, while in others such as South Africa certain refinements have been introduced to existing securitisation legislation. 5 3. MOTIVATIONS FOR SECURITISATION The motivation for securitisation in terms of its benefits for a number of participants such as corporates, banks, regulators and investors is set out below (European Securitisation Forum, 2002:13). 3.1 Motivation for Securitisation for Corporates Cheaper Funding: Securitisation is an attractive financing alternative. By segregating the underlying assets from the credit risk of the corporate, the corporate can reduce the corporate credit risk premium and can therefore fund itself more cheaply irrespective of its own credit-worthiness on a stand-alone basis. Alternative Funding: Securitisation broadens the range of funding alternatives available to a corporate. Without disturbing the existing relationships with lenders, securitisation extends the pool of available funding sources by bringing in a new class of investors such as insurance companies, asset managers and pension funds that may not have been available other than through a securitisation (Kothari, 2003:113). For smaller and unrated corporates that are not sufficiently large to issue debt in their own name, securitisation is an ideal way to access the capital markets. In addition, in a time of financial stress or during a cyclical downturn, the asset-backed market may be relatively more open than the unsecured debt market (Moody s, 2003a:3). Higher Funding: Banks lend money to corporates for working capital purposes, taking a cession of assets such as trade receivables as security. Typically a bank will only lend an amount that is a fraction of the assets on the balance sheet of a borrower. Securitisation investors consider future cash flows rather than assets on the balance sheet only. A corporate may thus acquire a higher amount of funding through securitisation than by conventional funding methods (Kothari, 2003:114). 5 The South African securitisation regulations were last modified by Government Notice R. 681 dated 4 June 2004. 29

3.2 Motivation for Securitisation for Banks Capital Management: A bank can reduce its risk-based capital requirements, thereby freeing up capital to generate more assets or to reallocate capital to other business lines, thereby improving the return on risk-weighted assets. Securitisation thus allows a bank to increase the leverage of its capital base. Credit Management: Securitisation allows a bank to improve the management of its exposure to particular economic sectors or business lines. Funding Diversification: Securitisation can diversify the bank s funding sources. Additional Funding: Securitisation is a source of additional funding and can supplement the bank s core deposit base. Asset-Liability Management: A bank can reduce its asset-liability mismatches (funding mismatches) by using long-term securitisation funding to match long-term bank loans, thereby replacing the shortterm deposit-based funding of long-term bank loans. Client Relationships: Securitisation allows the bank to manage credit concentrations while maintaining critical client relationships. It allows continuation of the client relationship while capping or reducing credit exposure to the client. Risk Transfer: Securitisation allows the bank to transfer catastrophic credit risk to credit enhancement providers and investors. Catastrophic credit risk is the risk of loss above and beyond the amount expected (Merrit, Stroker and Weinstein, 1999:4). In a securitisation, credit risk retained by the originating bank is in effect capped at a residual amount, generally the excess spread and the retained first-loss portion. In the event of a decline in the asset pool s performance, excess spread is used to absorb the losses, thereby reducing profit extraction back to the bank. Should excess spread become depleted, the first-loss portion held by the bank is used to absorb the risk, followed by the remaining default risk (catastrophic risk), which is then transferred to credit enhancement providers and investors. Additional Products: With securitisation as a low cost alternative financing technique, the bank can provide a different product to clients. 30

Additional Income: The bank can generate fee income by providing advisory services and from credit enhancement, liquidity facilities, and placement of the securities to securitisation transactions. 3.3 Motivation for Securitisation for Regulators Regulators recognise securitisation as a financing technique that can assist banks by improving the management of banks exposure to particular economic sectors or business lines; introducing transparency through third party review and market discipline to asset origination and servicing processes; and encouraging asset-liability matching and the diversification of funding away from the short-term interbank market. 3.4 Motivation for Securitisation for Investors Secure Investment: The investors have a direct claim over a portfolio of diversified and credit-enhanced assets. Because of the isolation of the underlying asset pool from the insolvency of the originator, investors are not affected by any of the risks that may beset the originator. The securities are supported by the cash flows from the isolated assets, and are divorced from corporate credit risk. Asset-backed securities are largely immune from event risk, the risk of a rating downgrade of a single borrower resulting from takeovers, restructurings and other events that effectively alter the credit status of senior unsecured corporate debt (Giddy, 2000:20). Investors can also take comfort from the highest level of structural and legal review in a securitisation transaction. Investing in asset-backed securities is therefore safer than investing directly in the debt or the equity of the corporate. In Europe, for example, there has been no instance of default of securitisation issuance in almost a decade (Kothari, 2003:119). Diversification: Investing in asset-backed securities allows diversification into new asset classes and along the credit spectrum. Since securitisation transactions are typically backed by diversified pools of assets, investors can diversify their portfolios by purchasing asset-backed securities that are, by definition, diversified. Investors can also reduce their direct exposure to corporates, while retaining exposure to the sectors in which such corporates operate. Flexibility: Asset-backed securities tend to be issued in a number of tranches with different risk-return characteristics and maturities. These give investors greater flexibility in matching their investment objectives. 31

Rating Resilience: Rating resilience means the stability of the rating of a security after issuance i.e. what the likelihood is of it being downgraded over time. The likelihood of downgrades is mirrored by past history of downgrades collectively called ratings migration. For securitisation issuance the rating agencies have published rating migration studies, which indicate that securitisation investments are considerably safer than investments in corporate debt (Kothari, 2003:119). Transparency: The quality of information available from a securitisation transaction, with regard to the assets generating the cash flows, is specific and transparent. There is also ongoing monitoring by the rating agency of rated assets. 4. GENERIC SECURITISATION STRUCTURE AND MECHANICS Through securitisation, financial assets are pooled together and their cash flows redirected to support payments on related securities, referred to as asset-backed securities (ABS) 6, which are then sold to investors. The basic concept of securitisation may be applied to virtually any asset that has a reasonably ascertainable value, or that generates a reasonably predictable future income stream. Although the list of potentially securitisable assets is almost endless, the fundamentals of securitisation are relatively basic and are common to nearly all types of transactions. As a result, the process of securitisation, including the structures that are used, and the roles and functions of the key transaction participants, will be similar to a meaningful degree wherever the securitisation concept is applied. These similarities are present even in various countries under different legal and regulatory regimes. At the most basic level, the intended goal and effect of securitisation transactions is to isolate the financial assets that support payments on the related ABS (European Securitisation Forum, 1999:1). This isolation ensures that payments on the securities are derived exclusively from the performance of a segregated pool of financial assets (and any related credit and liquidity enhancements that are part of the transaction), rather than from the entity that originated or held the assets. In this sense securitisation may be distinguished from traditional forms of debt and equity financing, in which case returns to investors are derived from the profit-making potential of an ongoing business enterprise. Both the science and art of securitisation transactions lie in the structure. In the context of securitisation, structure is a generic term embracing a wide range of considerations, from the very general to the very detailed. Complex structural features such as accounting, tax, legal and regulatory 6 When the underlying assets are mortgage loans, the securities issued are referred to as mortgage-backed securities (MBS). 32

considerations, the selection of appropriate liquidity facilities and credit enhancement facilities, and profit extraction techniques will often depend on the particular asset class to be securitised. The requirements of the originator and investors may give rise to transaction-specific structural issues. Although the asset types in a securitisation transaction may differ in nature, and thus the dynamics of the cash flows to be securitised, there are several components common to all securitisation transactions. The originator is the original owner of the assets that are sold to the special purpose vehicle, referred to as the issuer SPV or just SPV. In order to pay for the purchase of the assets the SPV issues ABS into the money and capital markets. After the sale, the debtors, or obligors, make repayments on their debt directly to the SPV. The originator will, however, continue to provide the debt administration and collection function to the obligors in accordance with its existing credit and administration procedures. This function is referred to as servicing, and the originator, in carrying out this function, is referred to as the servicer. Depending on the nature of the transaction and the assets, the structure may have to be supported by a variety of liquidity facilities, credit enhancement facilities and hedging facilities in order to achieve the desired risk profile for the debt securities being issued. The transaction is invariably rated by one or more credit rating agencies 7 so that investors can ascertain the risks of the securities issued. Where the securities are to be listed on a recognised financial exchange, it will be important to ensure compliance with the relevant listing rules. 7 The most important international credit rating agencies are Fitch Ratings, Moody s Investors Service, and Standard & Poors. All three have representative offices in South Africa. 33

4.1 Typical Securitisation Structure Diagram 2.1 depicts the cash flows and the major participants in a typical South African securitisation structure 8. Liquidity Facility Provider Originator 1 Obligors Credit Enhancement Facility Provider 2 4 Issuer SPV Owner Trust 5 Issuer SPV 100% 9 Hedge Facility Provider 6 3 8 7 Security SPV 100% Administrator Investors Security SPV Owner Trust Diagram 2.1: Generic securitisation structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships). 4.2 Securitisation Transaction Steps 1. The originator extends financing to the obligors. 2. On the issue date the Issuer SPV, which is 100% owned by the Issuer SPV Owner Trust, purchases the assets from the originator for a cash consideration. 3. The Issuer SPV funds the purchase of assets by the issuance of securities to investors, and makes interest and principal repayments to investors at regular intervals. 8 Adapted from the rating report on Fintech Receivables 1 (Proprietary) Limited, a South African lease receivables securitisation rated by Moody s, dated 2 December 2002. 34

4. Subsequent to the sale of the assets, the obligors make their payments directly to the Issuer SPV. The originator will perform the role of servicer in terms of which it will manage the collection and payment by the obligors. 5. The Issuer SPV enters into liquidity, credit enhancement and hedging agreements with various counterparties. 6. The Issuer SPV outsources its day-to-day operations to an administrator. 7. The Security SPV, which is 100% owned by the Security SPV Owner Trust, guarantees the Issuer SPV s obligations to the secured creditors, including investors, subject to the priority of payments. 8. The Issuer SPV indemnifies the Security SPV in respect of claims made under the Security SPV guarantee. The Issuer SPV s obligations under the indemnity are secured by a cession in securitatem debiti of its assets in favour of the Security SPV. 9. The Issuer SPV Owner Trust binds itself as surety to the Security SPV of the Issuer SPV s obligations under the indemnity. The surety is secured by a pledge of the ordinary shares of the Issuer SPV in favour of the Security SPV. 4.3 Structural Variations in Securitisation Transactions A number of different securitisation structures can be identified in terms of their cash flow allocation, and these are set out below. 4.3.1 Pass-Through Structure A pass-through structure, whereby direct participations in the underlying pool of assets are sold to investors, is the simplest form of securitisation. A pass-through certificate represents an ownership interest in the underlying assets and thus in the resulting cash flows (International Finance Corporation, 2004:7). In the pass-through structure the cash flows received from the underlying assets are passed directly through to investors to pay down the securities (De Paauw and Ross, 2000:25). Pass-through securities are fully amortising, meaning that principal is returned to investors throughout the life of the transaction. 35

Bank originators generally allow borrowers to prepay their car loans and mortgage loans. If these are fixed-rate loans, borrowers have the incentive to refinance their loans if interest rates decline, i.e. repay the current loan by taking out a new loan at the lower prevailing interest rate. When such loans that have been securitised are prepaid, it means that investors in pass-through securities receive back their principal invested earlier than expected. If the securities are fixed rate, and this has happened while interest rates are falling, the investor is exposed to reinvestment risk in that the proceeds have to be invested at a lower interest rate. Hence a key element in pricing a fixed-rate pass-through security properly is to determine the prepayment profile of the underlying assets by determining the constant prepayment rate (CPR). The CPR states the average length of time at which an investor should expect to receive its investment (International Finance Corporation, 2004:7). The CPR is established as an average over a certain time horizon, based on historical information. 4.3.2 Pay-Through Structure The pay-through structure was developed to address the pre-payment risk inherent in pass-through structures. In a pay-through structure the SPV issues debt collateralised by the assets. Investors in a pay-through security are not direct owners of the underlying assets; they have simply invested in a security backed by the assets (International Finance Corporation, 2004:7). In a pay-through structure, the SPV can, instead of merely passing the cash flows it receives through to investors, reconfigure the cash flows into separate payment streams thereby creating securities with characteristics different from the underlying assets. The structure cannot eliminate prepayment risks, but it can divide the various forms of this risk between different tranches with varying risk-return characteristics that may be more suitable to the needs of investors (Fabozzi, 1996:260). The payments from the SPV to investors are distributed according to a priority of payments, or waterfall. Payments can be structured sequentially or pro-rata, or a combination thereof. 4.3.2.1 Sequential Pay Structure A sequential pay securitisation creates multiple tranches with varying seniority and/or maturities. All scheduled and unscheduled principal prepayments are directed to the investors in the most senior tranche, or shortest average life tranche, until it is repaid in full. Investors in subordinated tranches do not receive any principal payments until the most senior tranche has been retired. This sequential pay down continues until the last tranche the most subordinated security, or the security having the longest maturity has been retired. 36

4.3.2.2 Non-Sequential Pay Structures Transactions with a non-sequential or pro rata principal waterfall allocate, subject to certain tests and conditions, a portion of principal receipts to the subordinated tranches prior to the full liquidation of the most senior tranche (Chacon and Liloia, 2002:1). In a non-sequential structure, the cash flows are therefore allocated on a pro rata basis to the different tranches. The waterfall may also be structured so that payments shift from sequential to pro rata, or from pro rata to sequential upon the occurrence of certain credit events (Telpner, 2003:3). Chacon and Liloia (2002:8) identify three categories of non-sequential pay structures: pure pro-rata, modified sequential and modified pro-rata. Transactions with pure pro-rata principal distributions allow each tranche to receive its proportionate share of scheduled and unscheduled principal payments. Modified sequential structures call for principal payments to be made on a sequential basis until specified target levels of credit enhancement 9 are reached for each tranche. Once the credit enhancement target level has been attained for a tranche, principal payments flow to the next most senior tranche until that tranche reaches its target level. Modified pro-rata structures allow for the senior class to receive more than its pro-rata share of principal, but less than the full principal payment, with the remainder allocated to the subordinated classes. 4.3.2.3 Fast-Pay Structure A fast-pay structure provides for excess spread (the SPV income minus costs) to be distributed as an additional payment of principal on the securities. This structure serves two purposes. It helps to pay down the balance of certain tranches quickly, and it builds up credit enhancement through overcollateralisation (Metz and Mistretta, 1995:603 cited in Fabozzi et al., 1995). 4.3.3 Revolving Structure The revolving structure is generally used when a pool of short-term assets, e.g. credit cards or trade receivables which have a life of between 60 to 120 days, is used to back a long-term security. Generally, revolving structures incorporate two periods, the first period being the revolving period, followed by an accumulation period. During the revolving period the cash flows received are used, after paying interest on the securities, to purchase new receivables. Investors only receive interest during the revolving period. At the end of the revolving period, typically 12 months prior to the 9 As a tranche is repaid in order of seniority, the subordinated tranches as a percentage of the total amount of securities in issue increase, thereby increasing the level of subordination and credit enhancement to that tranche. 37

scheduled redemption date, the accumulation period starts whereby cash flows will be accumulated monthly in a reserve account in order to have sufficient funds available at maturity to repay the securities. Alternatively, instead of accumulating cash in a reserve account, it can be paid to investors in regular instalments, which is referred to as controlled amortisation (De Paauw and Ross, 2000:25). The revolving period is thus followed by a controlled amortisation period. A key feature of revolving structures is early amortisation events or triggers. When such specified triggers are breached, the purchase of new receivables will cease and all cash flows from the underlying assets will be applied to pay down the securities. A number of developments may cause an early amortisation e.g. insufficient excess spread, an increase in the default rate of the underlying assets, or insolvency of the originator. Early amortisation events can occur at any time during the revolving period, accumulation period or controlled amortisation period. Once early amortisation has been triggered, it cannot be rescinded or reversed. The accelerated repayment is a rating agency requirement and serves as protection for investors (European Securitisation Forum, 1999:10). 4.3.4 Amortisation Structure Fully amortising structures such as pass-throughs are intended to track closely the repayment of the underlying loans, such as mortgage loans or car loans that amortise through scheduled principal and interest payments. As a result, the structure faces greater prepayment risk if the underlying loans are prepaid sooner than expected (Telpner, 2003:2). 4.3.5 Bullet Structure Bullet structures, which are also used with revolving assets, are designed to return the principal amount to investors in a single payment. Cash received from normal amortisation of the principal amount, as well as any prepayments, are trapped in a reserve account and paid to investors at maturity. The most common bullet structure is the soft bullet, so called because the bullet payment is not guaranteed on the expected maturity date. A hard bullet structure, conversely, ensures that the principal amount is paid off on the scheduled maturity date. This is accomplished by providing for a longer accumulation period, a third-party guarantee, or both (European Securitisation Forum, 1999:10). 38

5. KEY SECURITISATION PARTIES AND THEIR ROLES A securitisation transaction tends to involve a large number of parties, each having different roles and functions in a securitisation transaction (Lumpkin, 1999:29). Obligors: The assets that underlie the securitisation transaction are first created when an entity makes a loan or otherwise extends financing to a borrower. Obligors is generally the term used for borrowers (whether an individual consumer or a corporate) making payments on the underlying assets being securitised. These payments are the source of cash flows which service the securitisation transaction and from which investors are repaid. The assets should generate predictable and stable future cash flows. They should not only be clearly defined, but also legally transferable. Originator: The originator is the seller of the assets to be securitised. It is the entity that has extended finance to borrowers, or has bought the asset portfolio from a third party. An originator is typically any entity, which has well defined assets on its balance sheet. Examples of originators are: banks and other financial institutions, business enterprises, governments and municipalities. Servicer: The servicer, usually the originator, provides the debtor collections on behalf of the issuer. This role is crucial because investors rely on the cash generated from the assets for their repayment, as there is no recourse to the originator of those assets. Standby Servicer: The standby servicer, also referred to as the back-up servicer, assumes the duties of the servicer in the event that the servicer is unable to fulfil its duties, or if the appointment of the servicer is terminated for whatever reason (for instance as a result of the insolvency of the servicer). The speed with which receivables can be transferred depends on the back-up servicer s level of involvement before a servicer default occurs. Third-party arrangements are typically described in terms of temperatures, which increase with the back-up servicer s level of involvement (Chisholm and Speaks, 1997:4). A back-up servicer that duplicates an initial servicer s processes provides a hot back-up, meaning that personnel and systems are able to assume full management of the assets almost immediately. Warm back-up servicing reflects varying levels of preparation including regular portfolio monitoring and coordination of servicing systems. A back-up servicer that is not actually involved until after a servicer default is called a cold back-up servicer. Issuer: The issuer is an entity specially created for the purposes of the securitisation transaction. The issuer, also referred to as the purchaser, is an SPV that purchases the assets to be securitised. It is 39

incorporated as a company whose only business activity is to acquire and hold the assets, and to issue securities backed by the assets to fund the purchase price. The issuer is not meant to have any other obligations or incur other debt. It has no employees, and uses third parties acting as agents that perform the issuer s day-to-day functions. Issuer Owner Trust: As beneficial shareholder, the trust owns all the shares in the issuer and stands surety to the Security SPV for the performance of the issuer (its obligations to secured creditors). The trust pledges its shares in the issuer as security for the suretyship. Security SPV: A Security SPV is a company incorporated to hold and realise security, subject to the priority of payments, for the benefit of secured creditors, including investors. Security SPV Owner Trust: This type of trust is established solely to own, as beneficial shareholder, all the shares in the capital of the Security SPV. Trustee: The trustee acts on behalf of the holders of securities and other creditors of the issuer. The trustee s primary duties are to ensure the orderly payment of interest and the final payment of principal to investors, other creditors as required, and to notify rating agencies and investors of events of default and covenant breaches. The trustee on behalf of the Security SPV must have a priority interest in the assets supporting the securitisation; have an ability to oversee the performance of the other parties involved in the transaction including the servicer; review periodic information on the status of the asset pool; superintend the distribution of cash flows to investors; and, if necessary, declare the transaction in default and take legal action to protect investors interest. The trustee acts as an intermediary between the issuer and its creditors in the event of default by the issuer. The trustee appoints directors to the Issuer Owner Trust and the Security SPV. Liquidity Provider: A liquidity provider, typically a bank, provides a liquidity facility which is the funding source to a securitisation transaction to meet timely payments of interest and principal to the extent that there is a temporary shortfall in revenue available from the assets. The liquidity provider may only provide for short-term cash flow mismatches, and not for cash shortfalls due to losses in the pool. Unlike credit enhancement, any drawings under the facility will become a senior obligation of the SPV, ranking at least pari passu with the securities. 40

Credit Enhancement Provider: Depending on the structure, a highly rated party may provide credit support to the transaction. As one of the credit enhancement techniques used in securitisation, a financial guarantee may be required to achieve the desired rating for the asset-backed securities. Hedge Facility Provider: A hedge facility provider hedges any currency or interest rate exposure the issuer may have. Since the hedge counterparty enters into a transaction with an SPV, it has no recourse of any value in the event of a cancellation of the hedge beyond the assets securing the securities. Administrator: Also referred to as the manager, the administrator provides a number of services to the issuer: banking and cash administration; maintaining books of account and preparing management accounts; submitting tax and other statutory returns; keeping records and documents; preparing reports for rating agencies and investors; calculating the interest payable on the securities; and generally performing all such other administration services as may be necessary to ensure the efficient and effective management of the issuer. The arranger of the securitisation transaction is often the administrator. The originator can, in addition to its role of servicer, also be the administrator. Arranger: Also called the sponsor or structurer, the arranger is normally an investment bank that arranges and structures the transaction. The arranging bank is responsible for co-ordinating the whole transaction with respect to the originator, lawyers, rating agencies and other third parties. It will design the securitisation structure, taking into account the accounting, legal and tax issues relating to securitisation transactions, and will build a cash flow model of the transaction. The arranger will obtain statistical information on the asset pool from the originator and will provide the information to the rating agency rating the transaction. The arranger is responsible for obtaining all regulatory approvals that may be required, and preparing a programme memorandum for the benefit of investors. Lead Manager: The lead manager is usually an investment bank in its role as the structuring bank that arranges the transaction and liaises with other parties involved in the transaction. Where the transaction involves a public issuance of securities, that role will also include managing the issuance of securities. The lead manager is responsible for advising on the pricing, the underwriting and the allocation of securities to investors, and accepting responsibilities for the compliance of the issuance with the relevant securities law and regulations. 41

Placement Agent: The placement agent is the primary distributor of the securities issued. The placement agent works closely with the lead manager to determine the amount, maturities, interest or discount rates, and denomination of securities issued. The lead manager can be the placement agent. Underwriter: The underwriter commits to the issuer an amount and price against which the securitisation transaction will be sold. This gives the issuer certainty over the placement and proceeds of the securitisation issue by transferring market risk to the underwriter, for which the underwriter charges a fee. The lead manager is often also the underwriter. Rating Agencies: Rating agencies may be the single most important players in the securitisation process (Telpner, 2003:4). Most securitisations will contain multiple classes of securities that will be rated by one or more rating agency. The role of the rating agency is to provide investors with an independent opinion on the creditworthiness of a debt instrument. This opinion is expressed through a standard matrix of rating levels identified by way of symbols. The rating will address the likelihood that a debt instrument will pay timely interest and repay principal in full according to its terms and conditions. A rating agency will conduct its own independent review of the entire transaction covering asset, legal and credit risk related issues. The rating agency establishes the credit enhancement levels, i.e. the cushion that investors receive to protect them against losses, according to the desired rating levels. On a periodic basis, the rating agency will undertake surveillance of a completed transaction during the lifetime of such a transaction. Auditors: Auditors are often required to conduct an asset due diligence. Audit opinions may also be required for regulatory purposes. Custodian, Paying and Settlement Agent: The paying and settlement agent is responsible for the payment and settlement pertaining to the issuance and repayment of the securities to investors. Payment is usually made via a clearing system. In South Africa that will be through the Bond Automated Trading System (BATS). The custodian is responsible for holding the securities in safe custody and maintaining a record thereof. Often the roles of the paying and settlement agent and custodian are assumed by the same third party, acting under a single agreement. Account Bank: This is the bank at which the issuer s bank account is held. 42

Investors: These are also called noteholders. Examples of investors in securitisations are: pension funds, banks, unit trusts, hedge funds, insurance companies, and other business enterprises. For public issues, a programme memorandum discloses all material risks for investors. 6. KEY FEATURES OF SECURITISATION Securitisation structures vary according to the objectives of the originator, the assets involved, and the requirements of the targeted investors, but in general they tend to share a number of common features as described below. Assets: The asset in a securitisation is the right to receive payment of interest and principal in terms of a loan agreement or payment of amounts due as a result of a trade. The SPV can purchase the assets at a premium above face value, at face value, or at a discount against face value. In the latter instance the face value of the assets will be greater than the face value of securities issued to fund the purchase, thereby effecting what is called overcollateralisation. Assets that can be securitised should have the following attributes (Kothari, 2003: 75): Stable Cash Flows: The assets in question should give rise to steady and easily identifiable cash flows over time. Periodically paying assets are more conducive to securitisation due to their smooth cash flows. Quality of the Receivables: The assets should generally be of a high quality, evidenced by regular past payment history. Lower quality assets can also be securitised, but require a higher degree of credit enhancement. Diversification of the Portfolio: The degree of diversification of a portfolio is an important rating factor. The greater the diversification, the less likely it is that the default of a few assets will affect the portfolio. No individual asset should have a significant value relative to the total portfolio. Homogeneity of the Assets: The advantage of homogeneous assets is that the pooling, and the analysis of the pool, will be easier since historical data can be applied to projecting the future risks in the portfolio. No Executory Clauses: Executory contracts refer to contracts where the originator has certain obligations, e.g. to maintain an asset subject to a rental agreement. In a securitisation, the 43

underlying contracts must not be influenced by the insolvency of the originator. To be securitisable, the underlying contract should therefore not contain an obligation by the originator. Capacity to Assign: Securitisation involves the transfer of a right to receive, that is, the transfer of a right against a third party to the assignee. The law of the land or the contract between the parties should not prohibit the right to assign the right to receive. Independence from the Originator: The on-going performance of the assets should be independent from the existence of the originator, and should not depend on the originator being a going concern. However, certain securitisation transactions e.g. future flow securitisations, depend on the continuing existence of the originator. The suitability of assets for securitisation lies not so much in what they are, but in whether the assets are amenable to rigorous credit and statistical analysis (Giddy, 2000:3). Normally, at least three years of data are required on the composition of the assets, ageing, defaults, losses and dilution. It is also important that the assets show stable and consistent trends. Securities: The asset-backed financial securities or notes are issued in the form of bonds by the SPV to fund the acquisition of assets. A bond is defined as a debt issuance that pays a specific amount on redemption and, usually, an amount at regular periods through its life (Place, 2000:51). The most common types of bonds, reflecting different investor requirements, are described below. Conventional or Fixed-Rate Bonds: A conventional bond is one that has a series of fixed coupons and a redemption payment at maturity. Coupons can be paid annually, semi-annually, or quarterly. Since the coupons are fixed, the price of a fixed-rate bond changes in a direction opposite to that of interest rates. As rates rise, the price of a bond will fall, and vice versa. Floating-Rate Bonds or Floating-Rate Notes (FRNs): A floating-rate bond has a variable coupon linked to some short-term reference rate, e.g. LIBOR. 10 It is usually issued at a margin (or spread) above this reference rate. For these bonds, coupon rates are reset periodically according to changes in the reference rate. Coupons are normally paid quarterly or semi-annually. Since the coupons are variable, the price of an FRN does not change as interest rates change; however, the price will change if the credit spread changes. 10 London Interbank Offered Rate; the South African equivalent is the Johannesburg Interbank Agreed Rate (JIBAR). 44

Zero-Coupon Bonds: A zero-coupon bond has only one redemption payment and is sold at a discount to its principal or face value. In pricing the bond it will be discounted at the spot rate, i.e. the discount rate specific to that maturity. The yield is the difference between the issue price and the principal redemption amount. Strips: A strip is a zero-coupon bond derived from separating a standard coupon-bearing bond into its constituent interest and principal payments that can be separately held or traded as zero-coupon bonds. Stripping refers to the act of separating a coupon-bearing bond into its individual cash flows. A strip is one of these separate cash flows. A five-year bond with an annual coupon could, for example, be separated into six zero-coupon bonds, five representing the cash flows arising from the coupons and one relating to the principal repayment. When strips were first introduced in the United States, STRIP was an acronym for Separately Traded Registered Interest and Principal, but the term strip is now used (Place, 2000:32). Stripped mortgage-backed securities are created by paying the entire principal to one bond class and all the interest to another bond class. A zero-coupon mortgage-backed security is referred to as a principal-only (PO). These securities are created by stripping the interest from a securitised pool of mortgage loans to create the PO and its associated interest-only (IO) security (Carron, 1995:567, cited in Fabozzi et al., 1995). The PO only represents the principal in the pool of mortgages. They are sold at a large discount to face value and pay no periodic interest coupon. Principal is returned in the form of scheduled amortisation and prepayments until the entire face amount of the PO is repaid to the investor. The IO security only represents the interest from the asset pool and the investor receives only periodic interest coupons during its life with no principal redemption at maturity. An IO has no par or face value and is sold at a discount to its notional 11 value. PO and IO securities are especially sensitive to prepayments. With a PO, higher prepayments lead to a more rapid return of principal and a higher yield, which in turn leads to an increase in the value of the PO. PO securities thus increase in value when prepayments increase, and vice versa. In contrast to a PO investor, an IO investor will prefer slow prepayments. Prepayments cause the outstanding principal to decline, and the notional amount on which interest is calculated to reduce correspondingly. In fact, if prepayments are made too rapidly, the IO investor may not recover the amount paid for the IO (Fabozzi, 1996:284). IO securities thus decline in value when prepayments increase, and vice versa. 11 A notional amount is the principal balance used as a reference to calculate the amount of interest due. 45

Medium-Term Notes: A medium-term note (MTN) is a debt instrument with the unique characteristic of being offered continuously to investors by the issuer (Fabozzi, 1996:153). An MTN 12 programme is a programme under which an issuer can issue many bonds without having to issue the same documentation in each instance again. This has the advantage of reducing the time to issuance. The notes can be issued as fixed-coupon notes, zero-coupon notes or floatingrate notes. Commercial Paper: Commercial paper (CP) refers to short-term unsecured promissory notes issued in the open market as an obligation of the issuing entity (Fabozzi, 1995:186, cited in Fabozzi et al., 1995). In the securitisation market Asset-Backed Commercial Paper (ABCP) conduits are large issuers of CP. SPV: Central to the securitisation process is the creation of an SPV, which may be established under either trust or company law. The originator sells assets to the SPV, transferring ownership of the relevant pool of loans and receivables and any collateral rights. The SPV pays for the assets by issuing securities backed by the asset pool. The SPV is a shell company, also called an orphan company, which holds the assets for the benefit of the investors (De Paauw and Ross, 2000:13). Cash flow from the underlying assets is used to meet the SPV s debt servicing obligations, other ongoing costs such as trustee, management and custodian costs, and to repay principal, as the securities mature or are retired. In this way the SPV serves as the mechanism by which risk is transferred from the originator to investors. Investors must absorb any bad debts that emanate from the asset pool as well as any other events that may reduce the adequacy of the underlying cash flows to service the issued securities (to the extent that losses exceed the credit enhancement in the structure). The SPV thus operates as a barrier; it acts to separate investors from the credit risk of the originator and the originator from any subsequent deterioration of the performance of the transferred assets (Eastwood and Liaw, 2000:5). Bankruptcy-Remoteness 13 - A securitisation SPV is structured to ensure that its assets are isolated from the bankruptcy risk of the originator. Typical requirements that have to be met to achieve bankruptcy remoteness are set out below (Telpner, 2003:5). 12 Also called a DMTN or Domestic Medium Term Note; the term MTN is misleading in that it describes the continuing issuance of notes and not the maturity of the notes. 13 This does not mean the SPV is bankruptcy proof. 46

The SPV must neither be owned nor controlled by the originator. An independent third party such as a charitable institution or trust should be the owner of the SPV. The SPV must have its own board with independent directors. The organisational documents of the SPV must restrict its ability to declare itself bankrupt without approval by a requisite number of independent directors. The business activities of the SPV must be strictly limited to those necessary to carry out the securitisation. The SPV must maintain assets, bank accounts and record keeping separate from the originator. The SPV must pay its own expenses out of its own funds. The originator must disclose to its creditors that the assets of the SPV are separate and not available to satisfy their claims. All dealings between the originator and the SPV should be at an arm s length basis. True Sale: One of the main goals of securitisation is the separation of the credit risk of the asset pool that is being securitised from the credit risk of the originator (Moody s, 2003a:5). Simply structuring the SPV to be bankruptcy-remote does not ensure that its assets will be separated from those of the originator in the event that the originator becomes subject to a bankruptcy proceeding. The transfer of the underlying assets must be an absolute assignment, or true sale, of those assets (Telpner, 2003:5). Through a true sale or absolute transfer of an asset pool to an SPV, the assets are legally separated from those of the originator. A true sale refers to the concept that once the sale and transfer of the assets to the SPV have been effected, these cannot be challenged, voided or otherwise reversed in the bankruptcy of the originator or otherwise (International Finance Corporation, 2004:2). This means that, if the originator were to file for bankruptcy protection, the unsecured creditors of the originator would not have any claim against the asset pool and its related cash flows. Conversely, investors in the securitisation transaction would not have any claim against the originator s estate in the event of the originator s bankruptcy. The investor can depend only on the cash flows generated 47

from the asset pool and credit support built into the transaction for repayment of the securities legally the investor has no recourse to the originator. An originator could be presumed not to have executed a true sale if there is, inter alia, (BIS, 1992:8): any obligation to repurchase or exchange any of the assets sold; any kind of legal recourse through which any risk of loss from the assets sold could be retained or returned to the originator; or any obligation to any party for the payment of interest and principal with regard to the assets sold (other than those arising from services provided). Commingling Risk: After the sale of the assets to the SPV, the SPV is the new beneficiary of the obligors interest and principal payments. However, other parties to the transaction, such as servicers or account banks, which collect and hold the funds for the SPV, may go into default, causing a commingling of funds belonging to the SPV with the defaulted parties bankrupt estates (Bund, Mezzanotte et al, 2004:2). Credit Enhancement: Credit enhancement is a key feature of securitisation structures. Its purpose is to protect investors by absorbing credit losses, thereby improving the credit rating and thus marketability of the securities issued by the SPV. An asset-backed security is said to be credit enhanced if there is some feature present in the transaction that makes it more likely that the holder of the security will receive payments when these are due. Credit enhancement accomplishes two goals (Telpner, 2003:5). It provides a source of funds to supplement payments on the underlying assets in the event that the collections on the assets are insufficient to pay scheduled interest and principal. It allows different tranches of securities to achieve desired ratings, even where the assets themselves cannot support such a rating. The credit enhancement is sized, normally by the rating agency, to reflect an expected loss level determined in relation to a series of adverse scenarios that could affect the asset pool during the pool s life (De Paauw and Ross, 2000:16). Usually, this results in an enhancement that covers, by a 48

multiple of several times, the historical default rates of the underlying assets. The appropriate degree of credit enhancement can either be built in structurally or obtained externally (Eastwood and Liaw, 2000:5). In the earlier stages of the development of the securitisation market, external credit enhancement prevailed (De Paauw and Ross, 2000:17). External credit enhancement typically involves letters of credit, insurance, or guarantees provided by a third party. The credit enhancement is called upon if an asset in the pool defaults, with the credit enhancer purchasing the asset at face value, or otherwise restoring value to the SPV. In evaluating a given securitisation transaction, the rating agency assumes that the credit quality of the structure cannot be higher than the weakest link in the credit enhancement provided. Thus, with external credit enhancement, the rating of the most senior securities issued by the SPV is capped at the rating level of the third-party guarantor, irrespective of the quality of the asset pool. Downgrades in the credit ratings of external credit enhancers have thus led many securitisation sponsors to opt for internal forms of credit enhancement (Lumpkin, 1999:38). Structural, or internal, credit enhancement does not rely on an injection of outside resources to replace losses. Instead, it reallocates losses among the participants in the structure. Internal credit enhancement can take many different forms (Moody s, 2003:5) and these are discussed below. Subordination: Typically a securitisation transaction carves up the cash flows generated from the asset pool into various classes or tranches of differing seniority. A senior tranche has the first claim on the cash flows, while a subordinated or junior tranche has a lower claim. As long as losses do not exceed the face value of the subordinated tranches, the senior tranches will be paid in full. The subordinated tranches thus provide credit enhancement by absorbing losses on the asset pool before more senior tranches have to. Credit risk is therefore concentrated in the junior or lower-rated tranches. The most junior (usually unrated) tranche, also called the equity piece or first-loss piece, carries a disproportionately large share of the credit risk and is normally retained by the originator. Excess Spread: Excess spread is the difference between the return on the underlying asset pool and the debt service and other expenses of the SPV. Excess spread is typically the first line of defence for absorbing losses and is tapped into before any other form of credit enhancement is used. If excess spread is unused, it is returned to the originator as profit extraction, or trapped in a reserve account. 49

Cash Reserve Account: The originator may pre-fund a certain amount of cash in a reserve account of the SPV to absorb potential losses. Alternatively, the structure may be such that the SPV captures excess spread until a cash reserve account is built up to a specified level. If losses occur and the reserve account is depleted, any excess spread would normally first be used to replenish the reserve account to a certain level before it is released to the originator. The structure may also have performance-related triggers, which require additional cash flows to be trapped if the quality of the underlying assets deteriorates. Overcollateralisation: This is the term used when the value of the assets sold to the SPV exceeds the value of the securities issued, i.e. the assets are sold at a discount to their face value. The cash flow generated by the additional collateral is thus available to absorb potential losses. Trigger Events: Trigger events are occurrences of specified events such as the insolvency of the originator, a deterioration in pool credit quality as expressed in the delinquency or loss levels, a decrease in excess spread, or a decrease in the minimum required debt service coverage ratio (DSCR). The minimum DSCR is the requirement that the cash flows generated by the assets must exceed the debt service by a predetermined factor, thus allowing for monitoring the performance of the underlying asset pool. A breach of the trigger events will prompt certain actions e.g. trapping excess spread in the reserve account, or an early repayment of the securities in the securitisation transaction. Early Repayment: This is also called early amortisation. Early repayment clauses are common to revolving securitisations. They are designed to force a wind-down of the transaction and rapid repayment of principal to investors if specified triggers are breached. In an early repayment event no more revolving is permitted and all obligor repayments are used to pay down the securities. The aggregate amount of credit enhancement appears to support only a fraction of the total value of the securities in issue. In reality, however, it reflects highly condensed credit risk (Bank for International Settlements, 1992:4). Prepayment Risk: Prepayments are payments made in excess of the scheduled principal payments (Giddy, 2000:7). Prepayments are more common and applicable in longer term, prepayable and high volume assets such as mortgage loans (Pulido, 2004:5). A common feature of mortgage loans is that they allow the borrower to prepay some or the entire principal loan, without penalty, at any time before the stated maturity of the loan. Because of the right granted to the homeowner to prepay, an 50

investor in a mortgage pass-through security or an amortising mortgage-backed security cannot be certain of the timing of the cash flows. This uncertainty regarding the amount and timing of cash flows is known as prepayment risk (Standard Corporate and Merchant Bank:17). Prepayments occur for several reasons, the most important of which are selling and refinancing (Hayre, 1999:21). Refinancing is typically a feature of fixed interest rate high-value loans when interest rates decline sufficiently, it becomes worthwhile for a borrower to repay the current loan and take out a new loan at the lower rate. In contrast, borrowers with floating-rate loans have little incentive to refinance if interest rates decline. Likewise, the incentive to refinance on low-value loans is less because, on a small loan, the net benefit in monetary terms of a refinancing is relatively low and smaller loans are thus not as sensitive to changes in interest rates. Profit Extraction: Profit extraction is the payment of a return to the originator on the assets transferred to the SPV (Henderson, 1997:45). Usually in a securitisation transaction the credit enhancement is either provided by the originator, as in the case of a pre-funded cash reserve account, or retained by the originator, as in the case of the most junior tranche. Most of the risks are thus retained by the originator. Most of the benefits of the transaction are also retained because, if the transaction performs as anticipated and the credit enhancement is not used, all the excess cash flow is released to the originator. The profit can be extracted in many ways e.g. as interest on the junior tranche or cash reserve account, origination fees, deferred consideration, swap payments, or fee income from any administrative services. Liquidity Support: Liquidity facilities may be required to assure investors of the timely receipt of interest and principal i.e. to cover mismatches or delays in the SPV s receipt of scheduled funds from the asset pool and the SPV s obligation to make scheduled payments to investors. Liquidity facilities may also be needed to guard investors against market disruptions e.g. if maturing short-term securities are regularly rolled over to fund longer-term assets (Eastwood and Liaw, 2000:6). Hedging Facilities: One of the principles of securitisation is that investors should not be exposed to currency and interest rate risk, and therefore these risks have to be mitigated by the SPV entering into hedging facilities. By entering into a currency swap an entity can switch an asset or liability from one currency to another (Andersen, 1993:265). The swap transaction can be done on the same interest rate basis (that is, fixed into fixed rate or floating into floating rate), or the swap can switch from a fixed interest basis to a floating rate basis in another currency, or from a floating rate basis into a fixed rate basis in 51

another currency. The currencies are swapped initially through a normal spot foreign exchange transaction so that each of the counterparties has complete access to the currencies they are seeking. Throughout the life of the two obligations, each of the counterparties pays the counterparty s interest obligations in accordance with the swap agreement. At maturity, the currencies are swapped back to the original currencies through a forward foreign-exchange transaction, which is arranged at the inception of the transaction. Interest-rate swaps are the hedging instrument most frequently used to convert the interest basis of the underlying collateral in a securitisation transaction into the same interest basis as that of the debt that funds the transaction (Henderson, 1997:49). By entering into an interest-rate swap agreement, an entity can switch an asset or liability from a fixed-rate basis to a floating-rate basis, or vice versa, in the same currency (Andersen, 1993:261). Interest rate swaps are private agreements between two entities to exchange future cash flows according to a previously agreed upon formula. The most common type of interest rate swap is the plain vanilla swap (Hull, 1997:111). In the case of a vanilla swap, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a notional principal for a specified period. At the same time, party A agrees to pay party B cash flows equal to interest at a floating rate on the same notional principal for the same period. The currencies of the two sets of cash flows are the same. If the legs of the swap refer to a fixed-rate reference on the one side and a floating-rate reference on the other, the swap is also described as a fixed-floating (interest rate) swap. If both legs of the swap refer to a floating-rate reference, the instrument is called a basis swap (Bund, Gatfield et al., 2004:2). A basis swap is a contract in which both counterparties make payments linked to floating rates, but with different indices for each counterparty (Parekh, 1995:11). Securitised assets in South Africa are often linked to the South African prime interest rate, while asset-backed securities are typically linked to the Johannesburg Interbank Agreed Rate (JIBAR) (Kearns et al., 2004:1). A basis swap is then used to hedge the potential change in spread between the two different interest rate indices. Events of Default: Events of default are the events that will lead to the unwinding of the securitisation transaction. Typical events of default are when the SPV (issuer): fails to pay any amount in respect of the securities; fails to perform or fulfil any obligation binding on it under the securities; 52

is insolvent, wound-up or liquidated; is deemed to be unable to pay its debts; attempts to compromise with its creditors, or attempts to defer payment of debt owing by it to its creditors; alienates or encumbers any of its assets; or ceases to carry on its business in a normal manner, or it becoming unlawful for the SPV to perform any of its obligations. Upon the occurrence of an event of default, the Security SPV will deliver a written notice, an enforcement notice, to the SPV declaring the securities and any other obligations by the SPV to be forthwith repaid to the extent permitted by, and in accordance with, the post-enforcement priority of payments (Private Mortgages, 2002:47). Priority of Payments: A key feature of securitisation structures is that the payments by the SPV to investors and other creditors are made in a strict sequence in accordance with a priority of payments (also known as a payment waterfall ), which means that certain parties are paid before others (International Finance Corporation, 2004:2). The investors in the highest-ranking tranches are the first to have their claims for payment of capital and interest honoured, and subsequently all subordinate securities are paid in succeeding order. Payments are thus distributed from the highestranking to the lowest-ranking securities, while losses are allocated from the lowest-ranking to the highest-ranking securities. The rate of return increases in line with the greater risk that the lowestranking securities are exposed to, and investors can choose between different risk and return combinations. Prior to the delivery of an enforcement notice, the pre-enforcement priority of payments will be applied. Upon the delivery of an enforcement notice, the post-enforcement priority of payments will be applied. A typical priority of payments, as adapted from a securitisation programme memorandum (Equipment Rental Securitisation, 2003:44), has the following sequence as directly quoted below. 53

Pre-Enforcement Priority of Payments: The payments to be made on each payment date from the transaction bank account. First, to pay all statutory expenses. Where amounts have accrued but are not yet payable, the amounts shall be transferred to the provisioning account. Second, to pay pari passu and pro rata - The remuneration payable to the Security SPV 14 on the relevant payment date and any fees, costs, charges, liabilities and expenses incurred by the Security SPV required to be paid on such payment date; the remuneration payable to the trustee of the Issuer Owner Trust on the relevant payment date and any fees, costs, charges, liabilities and expenses incurred by such trustee required to be paid on such payment date; and the remuneration payable to the trustee of the Security SPV Owner Trust on the relevant payment date and any fees, costs, charges, liabilities and expenses incurred by such trustee required to be paid on such payment date. Third, to pay pari passu and pro rata - The remuneration payable to the issuer administrator on such payment date and any fees, costs, charges, liabilities and expenses incurred by the issuer administrator required to be paid on such payment date; the minimum servicing fee payable to the servicer on such payment date together with costs and expenses which are payable to the servicer on such payment date; and the standby servicing fee payable to the back-up servicer on such payment date together with costs and expenses which are payable to the back-up servicer on such payment date. Fourth, to pay pari passu and pro rata all sundry expenses subject to the sundry expense limit. Fifth, to pay pari passu and pro rata any payments due under the hedge agreements. Sixth, on any payment date other than an interest payment date, to pay into the interest provision set aside in the provisioning account, interest payments payable in respect of the Class A notes on the following interest payment date and accrued up to the relevant payment date; and on interest payment dates, to pay interest payments payable in respect of the Class A notes on such interest payment date. 14 Inclusive of VAT, if any. 54

Seventh, on any payment date other than an interest payment date, to pay into the interest provision set aside in the provisioning account, interest payments payable in respect of the Class B notes on the following interest payment date and accrued up to the relevant payment date; and on interest payment dates, to pay interest payments payable in respect of the Class B notes on such interest payment date. Eighth, on any payment date other than an interest payment date, to pay into the interest provision set aside in the provisioning account, interest payments payable in respect of the Class C notes on the following interest payment date and accrued up to the relevant payment date; and on interest payment dates, to pay interest payments payable in respect of the Class C notes on such interest payment date. Ninth, to pay into the reserve account the amount required to ensure the balance standing to the credit of the reserve fund equals the reserve fund required amount. Tenth, to fund, specifically and only during the revolving period, the acquisition of additional receivables, up to an amount equal to the lower of the principal redemption amount and cash available at this point after the payment of all higher ranking items. If there are no or insufficient eligible receivables offered to the Issuer for purchase by the Seller or any conditions to purchase are not satisfied, such amount or the balance of such amount, as the case may be, shall be transferred into the top-up provision set aside in the provisioning account. Eleventh, to pay any amounts payable in excess of the sundry expense limit. Twelfth, to pay any amounts pursuant to any unwinding of any hedge agreement. Thirteenth, to pay any interest on the start-up loan. Fourteenth, to pay ordinary share dividends, if any, to the shareholders of the issuer. Post-Enforcement Priority of Payments: The payments to be made on each payment date from the transaction bank account. First, to pay all expenses relating to the liquidation of the issuer, should there be any. 55

Second to Tenth (inclusive) as per first to ninth of the pre-enforcement priority of payments. Eleventh, to pay all remaining amounts to the Class A noteholders until the outstanding principal amount on all of the Class A notes has been reduced to zero. Twelfth, to pay all remaining amounts to the Class B noteholders until the outstanding principal amount on all of the Class B notes has been reduced to zero. Thirteenth, to pay all remaining amounts to the Class C noteholders until the outstanding principal amount on all of the Class C notes has been reduced to zero. Fourteenth, to pay any amounts due and payable in excess of the sundry expense limit on such payment date. Fifteenth, to pay any amounts in respect of the hedge agreements pursuant to the unwinding of any hedge agreements. Sixteenth, to pay any interest on the start-up loan, due and payable on such payment date. Seventeenth, to pay all remaining amounts to the provider of the start-up loan until the outstanding principal amount on the start-up loan has been reduced to zero. Eighteenth, to pay any additional Servicer fees payable on such payment date. Nineteenth, to pay ordinary share dividends, if any, to the ordinary shareholders of the issuer. Twentieth, to repurchase the ordinary shares. Clean-Up Call: Clean-up calls are common features in many securitisation transactions. A clean-up call is an option that permits the asset-backed securities to be called (bought back) before the underlying assets have been repaid (Basel Committee, 2004a:114). This is a method of protecting the SPV from enduring unnecessary and excessive costs associated with maintaining a securitisation transaction with small underlying asset balances (Bhattacharya and Fabozzi, 1996:301). A clean-up call is usually achieved when the originator buys back the underlying assets from the SPV once the pool balance or 56

outstanding securities have fallen below a specified level. The SPV uses the proceeds to call (repurchase) the outstanding securities. The clean-up call should not be mandatory nor be a form of credit enhancement, and should only be exercisable when 10% or less of the original underlying asset pool, or securities issued, remain (Basel Committee, 2004a:117). 7. SECURITISATION ASSET CLASSES Theoretically, any asset that has a revenue stream can be transformed through securitisation into a marketable debt security. In practice, the majority of asset-backed securities are collateralised by loans and other financial assets. 7.1 Residential Mortgage-Backed Securities Residential mortgage loans were the first application of securitisation, and the volume of residential mortgage-backed securities (RMBS) far exceed the total value of any other securitisation application (Kothari, 2003:269). Residential mortgage loans are globally considered to be one of the safest financial claims, as the funding of such claims is backed by a claim over the house in which the borrower resides 15. Investors in residential mortgage-backed securities are investing in a widely diversified pool of loans backed by residential property, hence making it a safe investment. The basic mortgage-backed security structure is the pass-through, which means that the monthly principal and interest payments (less a servicing fee) from a pool of mortgage loans are passedthrough to the holders of the security. Thus investors in a pass-through security structure are, in effect, buying shares of the cash flows from the underlying loans. On the other hand, structured mortgage-backed securities, such as collateralised mortgage obligations and stripped mortgage securities, carve up mortgage cash flows in a variety of ways to create securities with given prepayment and maturity profiles (Hayre, 1999:9). 7.1.1 Pass-Through Securities A mortgage pass-through security is created when one or more mortgage loan originators or holders form a pool of mortgage loans and sell shares or participation certificates in the pool (Fabozzi, 1996:232). The cash flows from a pass-through depend on the cash flows from the underlying mortgages and consist of interest, scheduled repayment of principal, and prepayments of principal. Generally, cash is passed through to security holders each month as it is received. The amounts 15 A borrower does not necessarily have to reside in a property to make it feasible for securitisation. 57

passed through, however, are not identical to the amounts received. The pass-through coupon rate is less than the mortgage rate on the underlying pool of mortgage loans by an amount equal to the servicing and guaranteeing fees (Fabozzi, 1996:233). Not all the underlying mortgage loans have the same mortgage rate and the same maturity, and when describing a pass-through, a weighted-average coupon rate (WAC) and a weighted-average maturity (WAM) have to be determined. The WAC is determined by weighting the mortgage rate of each mortgage loan by the amount of the mortgage loan outstanding, while the WAM is calculated by weighting the remaining number of months to maturity for each mortgage loan by the amount of the mortgage loan outstanding (ibid.). A pass-through is essentially an American product. Fabozzi (1996:233 to 253) describes the three types of pass-throughs, called agency pass-throughs, which are guaranteed by three different agencies, namely the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae). An agency can provide one of two types of guarantees. One is to guarantee the timely payment of both interest and principal, even if some mortgagors fail to make their monthly mortgage payments. Pass-throughs with this type of guarantee are referred to as fully modified pass-throughs. The second type, called modified pass-throughs, also guarantees both interest and principal payments, but only the timely payment of interest is guaranteed. The scheduled principal is passed through as it is collected, with a guarantee that the scheduled payment will be made no later than a specified date. Ginnie Mae pass-throughs are guaranteed by the full faith and credit of the US government and for this reason, are viewed as risk-free just like Treasury securities. Only mortgage loans insured or guaranteed by the Federal Housing Administration, the Veterans Administration, or the Farmers Home Administration can be included in a mortgage pool guaranteed by Ginnie Mae. Ginnie Mae pass-throughs are all fully modified pass-throughs and are called mortgage-backed securities (MBS). The second largest type of agency pass-through is the participation certificate (PC) issued by Freddie Mac. Freddie Mac purchases mortgage loans from mortgage originators, and issues PCs backed by these mortgage loans. Although a guarantee by Freddie Mac is not a guarantee by the US government, most market participants view Freddie Mac PCs as similar, though not identical, to Ginnie Mae pass-throughs. Freddie Mac offers both modified pass-throughs and fully modified passthroughs. 58

Fannie Mae pass-throughs are similar to Ginnie Mae pass-throughs called MBS, but like a Freddie Mac PC a Ginnie Mae MBS is not an obligation of the US federal government. All Fannie Mae MBSs are fully modified pass-throughs. Private-label pass-through securities are issued by commercial banks, thrifts 16 and private conduits. Private conduits purchase non-conforming mortgage loans, pool them and use them as backing for pass-throughs sold by the conduits. These private-label pass-throughs are similar to agency passthroughs, but without any guarantees, explicit or implicit, from the US government. The passthroughs are rated by credit rating agencies. Since these pass-throughs carry no government guarantees, credit enhancement techniques have been key to the success of these securities. External credit enhancement are in the form of third-party guarantees, usually from insurance companies, that provide for first-loss protection against losses up to a specified level, e.g. 10%. A security with external credit enhancement is subject to the credit risk of the third-party guarantor. Should the third-party guarantor be downgraded, the pass-through securities could be subject to downgrade even if the structure is performing as expected. Internal credit enhancements come in the form of excess spread accounts, senior and subordinated structures, and reserve funds. To value an agency pass-through security it is necessary to project its future cash flow, which may be difficult to predict because of prepayments of principal. Two widely used conventions for projecting prepayments are the Conditional Prepayment Rate (CPR), and the Public Securities Association (PSA) benchmark. The CPR, which is the annual prepayment rate assumed for a pool of mortgage loans, assumes that some fraction of the remaining principal in the pool is prepaid each month for the remaining term of the mortgage loans. It is based on historical prepayment experience and is conditional on the remaining loan balance. To estimate monthly prepayments, it must be converted to a single-monthly mortality rate (SMM), which is determined by a specific formula 17 for a given CPR. The PSA prepayment benchmark is a market convention of prepayment behaviour, and is expressed as a monthly series of annual prepayment rates. It assumes that prepayment rates are low for newly originated mortgage loans and speeds up as loans become seasoned. The PSA benchmark assumes the following CPRs for 30-year mortgage loans: a CPR of 0.2% for the first month, increased by 0.2% 16 Thrifts are savings and loans institutions, and are similar to building societies in other countries. 17 SMM = 1 (1 CPR) 1/12 Prepayment for month t = SMM x (beginning mortgage balance for month t - scheduled principal payment for month t) 59

per month for the next 30 months until it reaches 6% per year, and then a 6% CPR for the remaining years. This benchmark, which is referred to as 100% PSA or simply 100 PSA, can be expressed as follows: If t 30: If t > 30: CPR = 6 %(t/30) CPR = 6%, where t is the number of months since the loan was originated. Slower or faster speeds are then referred to as some percentage of PSA, e.g. 50 PSA means half the CPR of the PSA benchmark prepayment rate, 300 is three times the CPR of the benchmark prepayment rate, and 0 PSA means that no prepayments are assumed. The CPR is converted to a monthly prepayment rate using the SMM formula 18. Using the WAC, WAM and SMM, assuming a certain PSA, a monthly cash flow can be constructed. In agency pass-through securities, the cash flow is not affected by defaults and delinquencies. For private label pass-throughs, however, the effect of defaults and delinquencies must be considered. The PSA Standard Default Assumption (SDA) benchmark gives the annual default rate for a mortgage loan pool as a function of the seasoning of the loans. The PSA SDA benchmark, or 100 SDA, specifies the conditions set out below. The default rate in month one is 0.02% and increases by 0.02% per month up to 0.60% in month 30. From month 30 to month 60 the default rate remains at 0.60%. From month 61 to month 120 the default rate declines from 0.60% to 0.03%. 18 Example: Assuming a 165 PSA, the SMMs for month 5 and months 31 360 are calculated as follows: Month 5: CPR = 6%(5/30) = 1% = 0.01 = 1.65(0.01) = 0.0165 SMM = 1 (1 0.0165) 1/12 = 0.001386 Month 31-360: CPR = 6% = 0.06 = 1.65(0.06) = 0.099 SMM = 1 (1 0.099) 1/12 = 0.007828 60

From month 121 on the default rate remains constant at 0.03%. As with the PSA prepayment benchmark, multiples of the benchmark are determined by multiplying the default rate by the assumed multiple. A 0 SDA means that no defaults are assumed. Mortgage pass-through securities backed by fixed-rate loans are vulnerable to prepayment risk. Suppose an investor buys a 10% fixed coupon Ginnie Mae pass-through at a time when interest rates are 10%. If interest rates now decline to 6% there will be two adverse consequences. Firstly, when interest rates decline, the price of a fixed-rate option-free bond will rise. However, in the case of a pass-through security, the rise in price will not be as considerable as that of a normal bond because a fall in interest rates increases a borrower s incentive to prepay the mortgage loan and refinance the debt at a lower interest rate. The upside price potential of a pass-through is thus limited because of prepayments, a characteristic that is referred to as negative convexity. The second adverse consequence is that the investor must now reinvest the prepayment cash flow at a lower interest rate. These two adverse consequences are referred to as contraction risk. On the other hand, if interest rates rise, the price of a pass-through will decline like any other bond. However, a pass-through will decline more than a normal bond because the higher interest rates will slow down prepayments, in effect increasing the amount the investor has invested at the coupon rate, which is now lower than the market interest rate. Prepayments will slow down because homeowners will not refinance or prepay their mortgage loans when interest rates are higher than their contract interest rate of 10%. This is, however, just the time that investors want prepayments to speed up so that they can reinvest the prepayments at the higher market interest rates. The adverse consequence of rising interest rates is called extension risk. Prepayment risk thus encompasses contraction risk and extension risk, which make pass-through securities unattractive for some institutional investors. 7.1.2 Collateralised Mortgage Obligations Collateralised mortgage obligations (CMOs) are bond classes created by redirecting the cash flows from mortgage-related instruments so as to mitigate pre-payment risk. CMOs do not eliminate prepayment risk, but transfer the various forms of prepayment risk to different classes of instruments with varying risk-return characteristics, thereby broadening their appeal. A CMO is a security backed by a pool of pass-throughs or mortgage loans, and is so structured that there are several classes, commonly referred to as tranches, of bonds with varying stated maturities (Fabozzi, 1996:260). The principal payments from the underlying collateral are used to retire the tranches according to the priority of payments specified in the structure. CMOs issued by Ginnie Mae, Freddie Mac and 61

Fannie Mae are referred to as agency CMOs. A private entity that issues a CMO where the underlying collateral consists of a pool of pass-throughs guaranteed by an agency is called a privatelabel CMO. If the collateral for the CMO is a pool of unsecuritised mortgage loans, it is called a whole-loan CMO. The various types of CMOs as described by Fabozzi (1996: 260 to 285) are listed below. 7.1.2.1 Sequential-Pay CMOs The first CMO was created in 1983 and was so structured that each bond tranche would be retired sequentially. The result is that the tranches have average lives that are different from that of the collateral; the senior tranches that are paid off first have shorter average lives, and the junior tranches have longer average lives. By prioritising the distribution of principal to the senior short-term tranche, a CMO is protected from extension risk. The protection comes from the longer-term junior tranches. At the same time the short-term tranche protects the longer-term tranches against contraction risk. 7.1.2.2 Accrual Bonds In many sequential-pay CMO structures, at least one tranche does not receive current interest. Instead, the interest for that tranche would accrue and be added to the principal balance of that tranche. Such a tranche is called an accrual tranche or Z bond because it is similar to a zero-coupon bond. The interest that would have been paid on the accrual tranche is then used to speed up the repayment of the principal balance on the other tranches higher up in the payment waterfall. Thus the inclusion of a Z bond in the structure creates shorter-term tranches and a longer-term tranche, the Z bond itself. Since in a Z bond there are no coupons to reinvest, reinvestment risk is eliminated until the other tranches are paid off, and accrual bonds are therefore attractive to investors who are concerned with reinvestment risk. 7.1.2.3 Planned Amortisation Class Bonds Investors requirements for CMOs with the characteristics of a corporate bond, namely either a bullet maturity or a sinking fund type schedule of principal repayment, have led to the development of planned amortisation class (PAC) bonds. In a PAC bond the cash flow pattern is known, provided prepayments are within a specified range of PSA speeds. The greater predictability of cash flows from PAC bonds occurs because PAC bondholders have priority over all other classes in receiving 62

principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-pac classes, called support or companion bonds, which absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection. 7.1.2.4 Targeted Amortisation Class Bonds A targeted amortisation (TAC) class bond resembles a PAC bond in that it also has a schedule of principal repayment. The difference between a PAC bond and a TAC bond, however, is that the PAC bond has a wide PSA range over which repayment of principal is protected against contraction risk and extension risk. A TAC bond, by contrast, has a single PSA rate from which principal repayment is protected, and as a result the prepayment protection afforded to a TAC bond is less than that for a PAC bond. The creation of a bond with a schedule of principal repayments based on a single PSA rate results in protection against contraction risk, but not extension risk. Thus, while PAC bonds have two-sided prepayment protection, TAC bonds only have one-sided prepayment protection. TAC bonds are therefore acceptable to investors who are more concerned about contraction risk than extension risk. Conversely, some investors are more concerned with extension risk and are willing to take contraction risk. Reverse TAC bonds have been created to provide such protection instead. 7.1.2.5 Very Accurately Determined Maturity Bonds Guaranteed final maturity or very accurately determined maturity (VADM) bonds use accrual or Z bonds as their support. They are created by using the interest accruing on the companion Z bond to pay interest and principal on the VADM bond. This effectively provides protection against extension risk even if prepayments slow down, since the interest accruing on the Z bond will be sufficient to make scheduled interest and principal repayments on the VADM bond. The maximum final maturity of the VADM bond can therefore be determined with a high degree of certainty. However, if prepayments are high, resulting in the supporting Z bond tranche being paid off faster, a VADM bond s term can shorten. 7.1.2.6 Support Bonds Support bonds are the bonds that provide prepayment protection for the PAC tranches, and consequently are exposed to the greatest level of prepayment risk. A support bond can be structured 63

as a sequential-pay bond, an accrual bond, or even portioned into a PAC bond with its own support bond. In a structure with a PAC bond and a support bond with a PAC schedule of principal repayments, the former is called a PAC I bond and the latter a PAC II bond. 7.1.2.7 Notional Interest-Only Bonds In earlier CMO transactions, all of the excess interest between the interest received on the underlying collateral and the coupon interest on the bond tranches was paid to an equity class referred to as the CMO residual. However, this is no longer the practice, and instead, a tranche is created that receives the excess interest, called a notional interest-only (IO) tranche. An IO tranche has no par amount. Its notional amount is the amount on which the interest payments are calculated, not the amount that will be paid out to the holder of the bond. Mathematically, the notional amount is found in terms of a formula 19. 7.1.2.8 Stripped Mortgage-Backed Securities Stripped mortgage-backed securities were introduced by Fannie Mae in 1986. Unlike a pass-through that divides the cash flow from the underlying pool of mortgages on a pro rata basis across bondholders, a stripped mortgage-backed security has an unequal distribution of principal and interest. The three types of stripped mortgage-backed securities (synthetic-coupon pass-throughs, interest-only strips and principal-only strips) are described in the section below. 7.1.2.8.1 Synthetic-Coupon Pass-Throughs The first generation of stripped mortgage-backed securities was called synthetic-coupon passthroughs because of the unequal distribution of coupon and principal results in a synthetic coupon rate that is different from the interest on the underlying collateral. 19 Assume a tranche B of R194 million and a coupon rate of 6%. The interest on the underlying loans is 7.5% so that the excess interest is 1.5%. An IO with an interest coupon of 1.5% and a notional amount of R194 million can thus be created, which is equivalent to an IO with a 7.5% coupon and a notional amount of R38,8 million. Notional amount for r % IO = (tranche s par value x excess interest)/r %. In this example an IO tranche with a 10% coupon would result in: Notional amount for 10% IO = (194,000,000 x 1,5%)/10% = R29,100,000 64

7.1.2.8.2 Interest-Only/Principal-Only Strips In the case of these securities all the interest is allocated to the interest-only (IO) class, which has no par value, and all principal to the principal-only (PO) class, which has no interest coupon. The PO bond is purchased at a substantial discount to par value. The yield a bondholder will realise depends on the speed at which prepayments are made. The more frequent the prepayments, the higher the yield the bondholder will realise 20. Since pre-payments are determined by changes in the market interest rate, the price of a PO will change as interest rates change. When interest rates decline, prepayments speed up, accelerating principal repayments to the PO holder. This cash flow will be discounted at the now lower market interest rate. The result is that the price of a PO will increase when interest rates decline. On the other hand, if interest rates increase, prepayments will slow down and it will take longer to recover principal repayments. Coupled with a now higher discount rate, the price of a PO will fall when interest rates rise. IO securities behave differently. In contrast to a PO investor, the IO investor wants prepayments to be slow. The reason for this is that the IO investor only receives interest on the principal amount outstanding. As prepayments are made, the outstanding principal declines and less interest is received. Thus, if interest rates decline, prepayments will speed up, reducing the expected cash flow from the IO bond. Although the cash flow will be discounted at a lower rate, the net effect is typically a decline in the price of the IO. On the other hand, if interest rates increase, the expected cash flow increases, but will be discounted at a higher rate. The net effect may be either a rise or fall in the price of the IO. An IO s price, therefore, tends to move in the same direction as the change in interest rates. This effect occurs when market interest rates fall below the coupon rate, and for a certain range of interest rates above the coupon rate. A CMO structure can be divided into PO and IO classes, which are referred to as CMO strips. 7.1.2.9 CMO Floating-Rate Tranches All the CMOs discussed thus far offer a fixed coupon rate on all tranches. Floating-rate tranches can be created from fixed-rate tranches by creating a floater and an inverse floater. Assume a fixed-rate 20 Assume a 30-year mortgage pool of R400 million and that investors can purchase POs backed by this collateral for R175 million, resulting in a return of R225 million. How quickly the return is recovered by investors determines the yield on the investment. At one extreme case all homeowners will prepay immediately, and investors will realise the R225 million immediately. At the other extreme no homeowners prepay, and the R225 million is spread out over 30 years, resulting in a lower yield. 65

tranche with a par value of R100 million. A floater and inverse floater with a combined par value of R100 million can be created, in any combination, from this tranche. Assume the floater is set at 75% and the inverse floater at 25% of the par value. Unlike a floating-rate note in the bond market, whose principal remains unchanged over the life of the instrument, the floater s principal balance declines over time as principal payments are made. The principal payments to the floater are determined by the principal payments from the tranche from which the floater is created. As in the case of the floater, the principal paydown on the inverse floater will be a proportionate amount of the principal paydown of the fixed-rate tranche. Assuming that one-month LIBOR is the reference rate, the coupon rates on the floater and inverse floater can be calculated in terms of a formula 21. The higher the coupon leverage, the more the inverse floater s coupon rate changes for a given change in the reference rate. A coupon leverage of 3.0 means that, for every 100 basis point change in the reference rate, the coupon rate will change by 300 basis points, whereas a coupon leverage of 0.7 would lead to a 70 basis points change for every 100 basis points change in the reference rate. The coupon rate on the fixed-rate tranche supports the total interest paid to the floater and inverse floater. Suppose the coupon rate on the fixed-rate tranche is 7.5%. Assume that the coupon rate for the floater is set at one-month LIBOR + 0.50. For the inverse floater the coupon rate is 28.50% 3 x (one-month LIBOR). If the one-month LIBOR is 3.75%, then the coupon rates would be as follows: Floater = 3.75% + 0.5% = 4.25% Inverse floater = 28.50 3(3.75%) = 17.25% Since the floater is 75% and the inverse floater 25% of the fixed-rate tranche s par value, the weighted-average coupon (WAC) rate can be calculated in terms of a formula 22. If the one-month LIBOR is 9%, then: Floater = 9.0% + 0.5% = 9.5% 21 Floater coupon rate = One-month LIBOR + spread Inverse floater coupon rate = K L x (one-month LIBOR), where K is the cap or maximum coupon rate and L is the coupon leverage for the inverse floater. If one-month LIBOR is 3.75%, K is set at 28.50% and L at 3, the coupon rate for the inverse floater would be: 28.50% - 3(3.75%) = 17.25% 22 WAC rate = 0.75(floater coupon rate) + 0.25(inverse floater coupon rate) = 0.75(4.25%) + 0.25(17.25%) = 3.1875% + 4.3125% = 7.5%. 66

Inverse floater = 28.50 3(9.0%) = 1.5% and WAC calculated in terms of the formula 23. The weighted average coupon rate is 7.5%, regardless of the level of LIBOR. Consequently the 7.5% coupon rate on the fixed-rate tranche from which these two classes were created can support the aggregate interest payments that must be made to them. Because LIBOR is always positive, the coupon rate paid to the floater cannot be negative. The coupon rate of the inverse floater, however, can be negative unless restrictions are placed on the coupon rate. To prevent this, a floor or minimum, can be imposed on the coupon rate. In many cases, the floor is set at zero. Once a floor is set for an inverse floater, a cap is imposed on the floater. If in the example a floor of zero is set for the inverse floater, the floor results in a cap for the floater of 10%. This is found by substituting zero for the coupon rate of the inverse floater in the formula for the weighted-average coupon rate, and then setting the formula equal to 7.5%. The cap for the floater and inverse floater, the floor for the inverse floater, the coupon leverage, and the margin spread are not determined independently. Given four of these variables, the fifth will be determined. 7.1.3 Floating-Rate Note RMBS Although residential mortgage loans can be fixed-rate or floating-rate loans, residential mortgage loans in South Africa are almost exclusively of the floating-rate type, referencing either the Prime rate or JIBAR (Standard Corporate and Merchant Bank:7). To eliminate basis risk, South African RMBS transactions thus issue the majority of the securities as floating-rate notes (FRNs). A typical example of a South African RMBS transaction is The Thekwini Fund 5 (Proprietary) Limited (Bate, 2005:2), which issued RMBS backed by home loans originated by SA Home Loans (Proprietary) Limited. Class Rating Amount (R million) % of total notes outstanding Legal final maturity Coupon step-up date Interest rate type Initial margin Step-up margin A1 Aaa.za 1,795 59.84% 21/2/2030 21/2/2010 Floating 0.36% 0.75% A2 Aaa.za 787 26.23% 21/2/2030 21/2/2010 Floating 0.36% 0.75% A3 Aaa.za 253 8.43% 21/2/2030 21/2/2010 Fixed 8.17% 0.75% B A1.za 105 3.50% 21/2/2030 21/2/2010 Floating 0.95% 1.50% C Baa2.za 60 2.00% 21/2/2030 21/2/2010 Floating 2.00% 2.50% 3,000 100.00% Table 2.1: Thekwini floating rate notes 23 WAC rate = 0.75(floater coupon rate) + 0.25(inverse floater coupon rate) = 0.75(9.5%) + 0.25(1.5%) = 7.125% + 0.375% = 7.5%. 67

Since the notes are FRNs, there is no basis risk, as the mortgage loans and the notes are based on three-month JIBAR and are resetting at the same time. An interest rate hedge provider swaps a portion of the floating interest income into fixed rate to provide for the A3 class of fixed rate notes that comprises 8.43% of the total issuance amount. 7.2 Commercial Mortgage-Backed Securities Commercial mortgage-backed securities (CMBS) are debt instruments collateralised by commercial property, as opposed to RMBS that are collateralised by residential property (Kothari, 2003:308). Commercial property means property let out or managed for economic benefit and includes properties such as apartments, retail centres, office buildings, factories, hotels, hospitals and warehouses. In the case of a commercial mortgage-backed securitisation, the underlying collateral takes the form of commercial mortgage loans on commercial property. Sanders (2001: 662 to 669, cited in Fabozzi, 2001) describes CMBS risks. There are two sources of risk relating to a commercial mortgage loan portfolio underlying a commercial mortgage-backed securitisation, namely prepayment risk and default risk. Unlike residential mortgage loans, commercial mortgage loans have some form of prepayment penalty that reduces prepayment risk. Typical call protection features are discussed below. Prepayment Lockout: Prepayment lock-out occurs when the borrower is contractually prohibited from prepaying the loan during the lockout period. Prepayment lockout is the most stringent form of call protection since it removes the option for the borrower to prepay before the end of the lockout period. Yield Maintenance: In the case of yield maintenance the borrower is required to pay a make whole penalty to the lender if the loan is prepaid. The penalty is calculated as the difference between the present value of the loan s remaining cash flows at the time of prepayment and the principal prepayment. Defeasance: Defeasance is calculated in the same manner as yield maintenance. However, instead of passing the loan repayment and penalty through to the lender, the borrower invests the cash in government bonds to fulfil the remaining cash flow structure of the loan. 68

Prepayment Penalties: In the case of prepayment penalties, the borrower must pay a fixed percentage of the unpaid balance of the loan as a prepayment penalty if the borrower wishes to prepay. The penalty usually declines as the loan ages, e.g. starting with 5% of the outstanding principal in the first year, 4% in the second year, and so on. The reduction of prepayment risk in a commercial mortgage loan portfolio is counterbalanced by the increase in default risk. Unlike residential mortgage loans that are fully amortised over a long period, which can be up to 30 years, commercial mortgage loans are often balloon loans that require a substantial principal payment on the final maturity date, although the loan is fully amortised over a longer period of time. For example, a commercial loan may fully amortise over 30 years, but may require a full repayment of the principal amount outstanding in year 10. The purpose of a balloon loan is to keep the periodic payment of interest and principal on the loan as low as possible. Balloon loans pose potential problems for borrowers due to the large, lump-sum payment that must be refinanced. If there is a decline in the commercial property market, there is a danger that the borrower may not be able to refinance the loan, which can result in the borrower defaulting on the loan. In order to prevent this type of loan failure at the balloon date from occurring, there are two types of loan provisions. Internal Tail Provision: This type of provision requires the borrower to provide proof that an application is being made to refinance the loan at least one year before the balloon date, and proof of a re-financing commitment not later than six months prior to the balloon date. External Tail Provision: In the case of an external tail, the maturity date of the securities issued under the commercial mortgage-backed securitisation transaction is set to be longer than the maturity date of the underlying commercial mortgage loans. This allows the borrower more time to arrange refinancing while avoiding default on its obligations. An important factor in analysing the risk of a commercial mortgage-backed securitisation is the spatial diversification of the underlying loans over properties in different regions of the country. Rather than having the loan pool subject to an idiosyncratic risk factor in one part of the country, the risk should be spread across the country. In addition to spatial diversification, the loans underlying a commercial mortgage-backed transaction should also be diversified across property types, since a pool that is diversified across property types will be likely to avoid the potential of a property price downturn in one of the sectors. 69

Diversification of the underlying collateral is one way of reducing default risk. Another way to reduce default risk is to use cross-collateralisation, which means that the properties that serve as collateral for the individual loans are pledged against all the other loans in the portfolio as well. Thus, the cash flows on several properties can be used to make loan payments on a property that has insufficient funds to make a loan payment. This pooling mechanism reduces the risk of default. To add some additional enforcement penalties to the cross-collateralisation mechanism, the lender can use crossdefault, which allows the lender to call all the loans within the pool when any one of the borrowers defaults. Unlike other types of securitised assets, commercial mortgages are not homogeneous. As a result, it is not possible to rely on statistical analysis of historical performance data to estimate the credit risk of a pool of commercial mortgage loans. The credit risk of a commercial mortgage loan will depend primarily on the: characteristics of the underlying properties securing the loan (cash flow, quality, type of property, tenants, and diversity), and loan structure (leverage, amortisation profile, interest rate, reserves, cross-collateralisation, seasoning, and delinquency history). The credit risk of the commercial mortgage pool will depend on the credit risk of each loan individually, as well as the overall portfolio diversification. The interaction between these two factors may be reflected to a large extent in the debt-service-coverage ratio (DSCR) and the loan-to-value ratio (LTV) associated with the commercial mortgage loan. Both the DSCR and the LTV are considered to be good proxies for the credit risk on a commercial mortgage loan, with the DSCR being the main driver of loss frequency, while the LTV is the key determining factor for the expected loss severity (Pfister, 2001:2). Rating agencies play a critical role in the commercial mortgage-backed securitisation market. They examine important characteristics of the underlying pool of loans such as the DSCR and the LTV to provide an opinion on the amount of credit enhancement required. The credit enhancement required can be calculated on the following basis (Kendra and Vrchota, 2001:2) as set out below: Default probability x loss severity Base subordination + pool composition factors = Base credit enhancement = Final credit enhancement. 70

The DSCR and the LTV ratios are commonly used to quantify the probability of default and the loss severity. However, some collateral and structural characteristics of a loan are not adequately addressed by solely analysing the DSCR and LTV, and qualitative features of the underlying loans and property collateral have to be reviewed to adjust the base probability of default and loss severity. Loan pools with the same weighted average DSCR and LTV may require different levels of credit enhancement based on these qualitative pool composition factors (Kendra and Vrchota, 2001:3). Typical pool composition features to be analysed are loan size diversity, geographic diversity, and maturity year diversity. Loan diversity refers to the number of loans and the relative size of each loan in the pool. A pool with greater diversity requires less credit enhancement, as will a pool with greater geographic diversity. A pool with a large percentage of loans maturing in any given 12-month period poses increased balloon risk (the risk that the borrower may not be able to refinance the balloon payment because of the uncertain future economic and interest rate environment). A pool with evenly distributed maturity dates, therefore, requires less credit enhancement (Kendra and Vrchota, 2001:6). A commercial mortgage-backed securitisation generally involves the sale of a single commercial mortgage loan or a pool of commercial mortgage loans to an SPV. Whilst payments on the loans service the SPV s note interest obligations, final repayment of the principal is usually supported by a refinancing exercise by the borrower. If the refinancing exercise fails and the borrower defaults on the mortgage loan, the SPV will enforce the security and the proceeds recovered will be used to repay the principal on the notes (Ming and Tun, 2002:6). Originator (Bank) Purchases loan SPV Funding Investors Mortgage bond Repays loan Property Owns property Obligor (Borrower) Diagram 2.2: Commercial mortgage-backed securitisation structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 71

A credit-tenant lease (CTL) transaction involves a sale and leaseback whereby the borrower sells one or more properties to the SPV, which in turn leases the property back to the borrower. The sale and leaseback arrangement is underpinned by the stream of lease payments made to service the SPV s debt obligations, and is a function of the strength of the tenant (Ming and Tun, 2002:7). Lease payments Obligor (Borrower) Purchases property SPV Funding Investors Rent payments Owns property Tenants Property Diagram 2.3: Credit-tenant lease structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) A typical credit-tenant lease financing will unconditionally oblige the lessee (borrower) to make lease payments to the SPV in an amount sufficient to make timely payment of debt service and fully amortise the notes issued, as well as to pay all costs associated with occupying, operating, and maintaining the property (Nayar, 1998:3). 7.3 Structured Covered Bonds A covered bond can be defined as a full recourse debt instrument that is secured by a pool of mortgage assets and/or public sector claims (Poulain and Verbeek, 2003:1). They are securities issued under a specific legal framework where specifically authorised financial institutions, e.g. mortgage banks, are able to issue securities secured on a dynamic pool of assets such as residential mortgage loans, commercial mortgage loans, and public sector loans (Albers et al., 2004:1). Investors have the benefit of security provided by a pool of assets. A law, referred to as a covered bond law, explicitly defines the security interest and eligible assets. Several European countries have their own covered bond law, including Germany, (Hypotheken and Offentliche Pfandbriefe), Denmark (Realkreditobligationer), France (Obligations Foncieres), Spain (Cedulas Hipotecarias), and 72

Luxembourg (Lettres de Gages). Other countries with covered bond laws are Austria, Finland, Hungary, Ireland, and Latvia. Some European countries currently considering the establishment of covered bond laws currently are Belgium, Portugal and Sweden (Poulain and Verbeek, 2003:2). A structured covered bond is defined (Poulain and Verbeek, 2003:1) as either: a covered bond where securitisation techniques have been used to enhance the rating of the covered bonds; or a secured bond issued against a pool of assets in a jurisdiction where no specific covered bond law has been established. In a typical structured covered bond programme, an issuer that has mortgage loans on its books sells these loans to a limited-purpose subsidiary, where the loans are separate from the other assets of the issuer. The issuer provides an intercompany loan to the subsidiary to enable it to purchase the mortgage loans. The issuer then issues bonds in the capital market, secured by a guarantee from the subsidiary holding the mortgage loans (adapted from Lindstrom and Macedo, 2004:4). Transfers mortgage loans Issuer Grants intercompany loan Purchases mortgage loans Subsidiary (Covered bond guarantor) Funding Investors Covered bond guarantee Diagram 2.4: Covered bond structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 73

Structured covered bonds, like covered bonds, are full recourse instruments to the issuer, but investors also benefit from a security interest over a cover pool of assets. Nevertheless, even with the structural provisions borrowed from the securitisation market, structured covered bonds differ quite considerably from securitisation transactions. In pure securitisation transactions only the cash flows from the assets serve to repay the securitisation bonds. However, investors in structured covered bonds continue to have direct or indirect recourse to the originator, while only upon default of the originator is the collateral used to repay the structured covered bonds (Poulain and Verbeek, 2003:2). Structured covered bond issuers are exposed to cash flow mismatches that arise because asset pools are mainly composed of amortising mortgage loans, while the bonds have bullet maturities, i.e. no principal is amortised over the life of the bond and the full principal amount is payable at maturity of the bond. The cash flow mismatch exposes issuers to re-investment risk, which may impair their ability to repay investors. This risk is somewhat mitigated by the flexibility allowed in most structures to have substitution assets that can be included in the cover pool. However, adding new loans to the asset pool exposes investors to a change in asset pool characteristics and hence risk characteristics. Overcollateralisation, i.e. an excess of eligible assets over liabilities, as credit enhancement is thus commonly used to provide protection against losses that may exceed the net interest margin on the pool, which is the first layer of protection (Poulain and Verbeek, 2003:5). 7.4 Credit Card Securitisation Credit cards and auto loans form the two pillars of the asset-backed securities market (Kothari, 2003:330). The first credit card asset-backed securities were issued in 1987 to diversify sources of bank funding and to free up regulatory capital (Dean and Murphy, 2001:3). Credit card securitisation is also the primary funding source for specialised credit card banks and allows these banks to raise funds more cheaply than what would otherwise have been possible. Although credit card receivables are short-term assets, the receivables are revolved into the creation of fresh receivables on a steady basis, resulting in a steady stream of cash flows, thereby making these receivables ideal assets for securitisation. Credit card companies earn high interest from credit cards, and constantly monitor the conduct of cardholders. A credit card company can immediately block a card in case of delinquencies. Relative to any other type of consumer lender, the credit card lender has a better understanding of a borrower s creditworthiness and greater flexibility in responding to changes in cardholder behaviour as they occur (Deutsche Bank, 2001, cited in Kothari, 2003:331). 74

A credit card pool, unlike an amortising asset pool such as auto loans, is a revolving pool of assets. Repayments by cardholders may be replaced by new charges and the credit limit may continually be utilised to the maximum limit. A credit card securitisation mirrors the revolving nature of the underlying asset pool (DiMartino and Kane, 2001:33). As with the securitisation of other assets, the goal in credit card securitisation is to transfer the receivables generated from the credit card accounts to a bankruptcy-remote SPV that functions as the issuer of the credit card asset-backed securities. The originator remains the owner of the credit card accounts, but initially transfers the outstanding receivables to the SPV and pledges to transfer any future receivables generated by the accounts, which the SPV typically purchases at par (Dean and Murphy, 2001:3). The SPV acquires a beneficial interest in the receivables, but the relevant credit card accounts are not assigned to the SPV (Kerschkamp, 2002:3). Each month, receivables are repaid and repayments are replaced by new receivables, enabling the issuer SPV in the securitisation transaction to maintain a level pool balance, assuming active utilisation of the accounts in the receivables pool (DiMartino and Kane, 2001:33). Usage of a revolving structure gives the originator medium-term to long-term financing and provides investors with a predictable schedule of interest and principal payments. A typical credit card securitisation structure has three different cash flow periods revolving, amortisation, and early amortisation. Each period performs a distinct function and allocates cash flows differently (Dean and Murphy, 2001:6). All collections on the receivables are split into finance charge income and principal repayments. Each of the three periods treats finance charge income in the same manner. Monthly finance charges are used to pay servicing fees, cover receivables defaults, pay the interest coupon to investors, and release any excess spread to the originator as profit extraction. Principal collections, however, are allocated differently during each of the periods as discussed below. Revolving Period: During the revolving period, monthly principal collections are used to purchase new receivables generated by the designated credit card accounts. The revolving period continues for a predetermined period, which can range from two to 15 years. Investors only receive interest payments during this period. Amortisation Period: At the end of the revolving period, the principal amortisation period begins. Three different amortisation structures have been used in credit card securitisations: a passthrough structure, a controlled amortisation structure, and a bullet payment structure (Fabozzi, 1996:317). 75

In the pass-through structure, the principal cash flows from the credit card accounts are paid to investors on a pro rata basis. In the case of controlled amortisation structure, which typically runs for 12 months, principal collections are no longer reinvested in receivables, but are paid to investors in 12 equal instalments. The payments will be sized at exactly one-twelfth of the invested amount so investors can be repaid on a predetermined schedule. Under a bullet payment or controlled accumulation structure, the monthly principal repayments are deposited into an interest-bearing trust account where it is held until the maturity date of the asset-backed securities. Because interest earned would likely be less than the bond coupon, a reserve account funded from excess spread prior to the commencement of the accumulation period is used to cater for the interest shortfall. At the end of the accumulation period investors are repaid their principal in a single payment on the maturity date. Early Amortisation: Severe asset deterioration, problems with the originator or servicer, or certain legal troubles can trigger early or rapid amortisation at any point in the transaction, whether it is revolving or amortising. In such a case, the transaction begins to repay investors immediately with all principal repayments directed to senior investors first. Principal distributions will be made to subordinate investors only after senior investors have been fully repaid. A credit card securitisation structure may also make use of a liquidity facility, which will provide liquidity in the event that the outstanding balances in the accounts increase significantly above historically observed levels, such as during the Christmas season (Kerschkamp, 2002:4). 7.5 Auto Loan Securitisation Auto loans were one of the earliest products in the securitisation market. In 1985, Chrysler Financial issued the first public securitisation of its auto loan portfolio (DiMartino and Kane, 2001:4). Many investors originally supported auto loans as a result of the security interest in hard collateral, in contrast to unsecured obligations such as credit cards, and collateral remains a positive aspect of this asset class. The nature of the obligation is also a positive attribute. A vehicle ranks highly in the consumer hierarchy of needs, and many people will make their monthly vehicle loan payment a priority, as consumers need vehicles to get to work and for basic transportation. Further benefits of 76

auto loans include large and diversified pools, a stable track record with low losses, and stable and consistent prepayment speeds with little volatility (DiMartino and Kane, 2001:11). An auto loan securitisation is straightforward. An originator of a pool of auto loans sells the receivables, consisting of the rights to receive proceeds and the rights to retain possession of the vehicles, into a bankruptcy-remote SPV. An auto loan can be a simple interest loan payable over a predetermined time frame, or a balloon loan. A balloon loan poses substantial risk at maturity (Mrazek and Neiliwocki, 2002:5). This tail-end risk results from the borrower s option to return the related vehicle to the originator rather than purchase it for the lump sum balloon amount. The vehicle then has to be sold in the used vehicle market to realise the balloon amount. Any shortfall in proceeds is passed through to the securitisation structure as a loss. Most transactions have, as credit enhancement, a cash reserve account that is either pre-funded by the originator or funded from excess spread until the required level is reached. Auto loans typically pay monthly over a period of 36 to 60 months. Investors are paid by way of a pass-through structure or a pay-through structure. In the pass-through structure, the cash flows mirror the cash flows of the underlying loans and are paid pro rata to all classes of securities. In the pay-through structure, the cash flows are time-tranched and reallocated amongst senior and subordinated investors. This structure has a series of classes in staggered maturity (DiMartino and Kane, 2001:14). There is typically a short-term money market class, and a one-year, a two-year, etc. class. Investors are repaid sequentially in the order of maturity and seniority. Auto leases are different from auto loans. In a typical consumer auto lease transaction, the lessor purchases a vehicle from a manufacturer or dealer and leases it to the consumer. The lessee pays the lessor for the right to use the vehicle during the term of the lease. Leases usually incorporate a residual value, which is determined at the inception of the lease contract and represents an estimate of the leased vehicle s resale value at the end of the lease. At the maturity of the lease, the lessee effectively has a call option to purchase the vehicle for the stated residual value. Otherwise, the lessee will return the vehicle and the lessor takes possession and assumes responsibility for disposing of the vehicle and the residual value realisation (Chou et al., 2000:3). Leasing is an important part of the vehicle finance market, but the securitisation of auto leases has been somewhat limited. Historically, three issues have hampered the securitisation of auto leases, namely vehicle ownership, residual value risk, and conflicting tax and accounting goals of originators (Chou et al., 2000:4). 77

Vehicle Ownership: The largest hurdle in securitising auto leases relates to the difficulty in effecting a true sale of the assets to be securitised. In the securitisation of auto loans, which are considered to be financial assets, transfer of the ownership of the loans is achieved by selling them to the SPV issuing the asset-backed securities. The SPV then has ownership of the loans resulting in the isolation of the loans from the bankruptcy estate of the originator. However, in the case of auto lease securitisations, both the vehicle and the lease contract constitute the asset sold to the SPV. Thus the asset is not considered financial, and the vehicle must be registered in the name of the owner. Without formal legal transfer of ownership of the vehicle from the lessor to the SPV through re-registering, the risk that such a transfer does not constitute a true sale remains high. To overcome vehicle ownership problems, the origination, or registering SPV, structure was developed. In this structure the registering SPV, not the lessor, purchases the lease contracts and leased vehicles directly from the supplier. The registering SPV, instead of the lessor, is listed on the title certificate. The registering SPV then transfers to the lessor a beneficial interest, also referred to as an undivided trust interest (UTI), in all the vehicles and leases owned by the registering SPV. The holder of the beneficial interest, namely the lessor, obtains the economic value for tax purposes and can therefore depreciate the assets, but does not obtain the ownership of the assets of the registering SPV from an accounting perspective. Lessor Funding Registering SPV Purchase assets Supplier Lease payments UTI Contracts and titles Lessees Vehicles and leases Diagram 2.5: Registering SPV structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) The assets underlying the beneficial interest can be carved up and segregated into a certificate of beneficial interest, frequently referred to as a special unit of beneficial interest (SUBI). Upon the accumulation of a sufficient number of leases in the registering SPV to complete a securitisation, the registering SPV transfers the certificate of beneficial interest in a true sale to an issuing SPV, which 78

obtains a perfected security interest in both the certificate of beneficial interest and the cash flows from the lease (Chou et al., 2000:5). Lessor Registering SPV Vehicles and leases Repay funding Lessees SUBI and UTI Issuing SPVs Purchase SUBI and UTI Interest coupon Investors Lease payments Funding Diagram 2.6: SUBI structure (The solid lines in the diagram depict cash flows with the broken lines indicate legal contractual relationships.) The use of a registering SPV structure thus removes most of the costs and burden of re-registering vehicles, transfers economic ownership of the leases and vehicles to a third party, and maintain a true sale of assets from the lessor. Residual Value Risk: Another hurdle to securitisation of auto leases is residual value risk. One of three things can occur to a leased vehicle at the maturity of the contract (ibid.). The lessee can purchase the vehicle for the stated residual value. The lessee can return the vehicle to the dealer, who can subsequently purchase it. Once the lessee has returned the vehicle, the dealer can choose not to purchase it, in which case the vehicle must be disposed of at an auction or in the used car market by the lessor. This scenario results in the greatest residual value risk. Residual value risk is the risk that the full residual value is not realised upon disposal of the vehicle. As residual values represent on average 65% - 70% of a vehicle s cost, they represent the primary risk in auto lease securitisations (Chou et al., 2000:6). The most common method of mitigating residual value risk is through the purchase of a residual value insurance policy. A typical residual value insurance policy covers the difference between the stated residual value of a vehicle and the realised 79

proceeds upon disposition for those lease contracts that reach full maturity. The residual values of leases that default or prepay are not covered by the policy (Chou et al., 2000:7). Conflicting Accounting and Tax Goals of the Originator: Another roadblock in securitising auto leases is the conflicting goal of obtaining a true sale opinion for legal and bankruptcy purposes while retaining enough ownership to receive the tax benefits of depreciation (Chou et al., 2000:8). Once the lease has been sold to the securitisation SPV, the SPV becomes the lessor and can claim the depreciation allowance on the asset. The originator is not the lessor anymore and loses this tax benefit. 7.6 Equipment Lease Securitisation Equipment leases are similar to auto leases, but largely without the issue of re-registering, because the equipment is, unlike vehicles, not registered in the name of the user. Equipment leases can be structured as operating or finance leases. In both instances, the lessor purchases the equipment and leases it under a contract to a lessee, obligating the lessee to a set of scheduled payments (Bella et al., 2005:5).The difference between the two types of leases are described below. Finance Leases: Finance leases are structured so that the net present value of the lease payments cover at least 90% of the original equipment cost for new equipment, or the fair market value for used equipment. At the end of the lease term the lessee is entitled to purchase the equipment at a nominal price, generally either the remaining fair market value of the equipment or 10% of the original equipment cost. Finance leases can also terminate with a nominal R1 buy-out purchase option. The lessee is essentially purchasing the equipment on a regular payment plan, because the lease term covers at least 75% of the useful life of the equipment. Operating Leases: Payments on operating leases cover less than 90% of the equipment cost, with the remaining portion being the residual value. At the end of the lease term, the lessee can either purchase the equipment for the residual value, or obtain an extension of the lease. Alternatively, the lessee can return the asset to the lessor and the lessor can sell the equipment in the secondary market or re-lease the equipment to a different lessee. The distinction between operating and finance leases is important. The primary characteristic of an operating, or true, lease is that ownership of the equipment remains with the originator/lessor. While there may be a purchase option in favour of the lessee, it is exercisable only at the fair market value of the equipment and is not compulsory. In a true lease, the lease payments by the lessee do not count 80

as part of the purchase price. Conversely, if the arrangement between the lessor and the lessee is structured as a finance lease, the lease payments can be viewed as instalment sale payments. In a finance lease, the agreement usually stipulates that ownership of the equipment remains with the lessor during the lease term, with ownership vesting in the lessee upon receipt of the final instalment payment. In a finance lease, payments by the lessee count toward the purchase price of the equipment, and the lessee builds up equity in the equipment (Standard & Poor s, 1999:37). Lease agreements may allow for early termination by the lessee, often to upgrade equipment. The required prepayment amount typically comprises the present value of all payments due, including the residual value, on the lease from the time of prepayment until the end of the lease term, and possibly a prepayment penalty (Bella et al., 2005:6). In an equipment lease securitisation the originator, i.e. the lessor, sells the leases to a bankruptcyremote SPV, which issues asset-backed securities to fund the purchase. When the leases are operating, or true leases, the lessor should sell the leases themselves, namely all their rights and obligations, to the SPV. The SPV becomes the new lessor, while the original lessor, now the SPV s agent, continues to act as servicer. However, if the leases are finance leases, which are documented as leases, but are treated as instalment sales of the underlying equipment, the lessor may sell only the receivables due in terms of the leases, rather than the leases themselves (Bella et al., 2001:9). Equipment lease securitisations are often structured with a revolving period of nine to 24 months. During the revolving period, investors only receive interest payments, with all principal payment collections used to originate new equipment lease receivables. An amortisation period follows in which all lease collections pay interest and principal to investors. Leases added during the revolving period are typically subject to eligibility criteria in order to maintain certain collateral characteristics and concentration limits. In addition, early amortisation triggers tied to the performance of the asset portfolio are structured to maintain the integrity of the portfolio s original characteristics and protect investors (Bella et al., 2005:7). 7.7 Future Flow Securitisation In a traditional asset-backed securitisation, existing receivables i.e. amounts owed for products already sold and delivered or services already performed, are transferred to an SPV, and securities backed by, and payable from, the receivables are issued out of the SPV. Because all actions necessary to generate the receivables have been completed, the receivables are isolated from the ongoing business and 81

credit risks of the originator once the receivables have been transferred to the SPV. Consequently, the credit ratings of the asset-backed securities issued by the SPV and backed by the receivables will depend almost entirely on the credit quality of the receivables and the transaction structure (credit enhancement, etc.), and may therefore exceed the credit rating of the originator. In a securitisation transaction backed by future receivables (future flow securitisation), however, the receivables that are intended to generate the cash flows from which the financing will be repaid do not exist at the time the securities are issued. Even after the right to the future receivables payments has been transferred to an SPV, investors remain dependent for repayment on the originator s continuing ability to generate the receivables (Coen et al., 1998:1). In a future flow securitisation, an SPV issues a debt instrument whose repayment of principal and interest to investors is secured by payments on future receivables that the originator expects to generate in the normal course of its operations. The cash flow typically derives from a specific line of business in which the originator has a history of participation and that is expected to continue for the foreseeable future. Unlike a traditional securitisation where a higher credit rating can be achieved through the isolation of the quality of the assets from the credit quality of the originator, the rating of a future flow securitisation is thus invariably linked to the credit quality of the originator. Originators face performance risk in future flow securitisations because they must deliver a product or service before the creation of the actual receivable, and they must also continue to generate receivables even through periods of economic or political turmoil. (Dadina et al., 1999:3). Since the cash flows do not exist at the time of the debt issuance, technically, these transactions are considered to be structured finance rather than asset-backed securitisations (Albers et al., 2000:1). An additional complication for investors in emerging markets is that future flow transactions also contain a sovereign risk element. Existing and potential political and macro-economic conditions in the country where the originator is located have to be considered. It is possible, nonetheless, for a properly structured cross-border future flow securitisation transaction to achieve a rating that exceeds both the credit rating of the receivables originator and the foreign currency debt rating, i.e. the sovereign ceiling, of the country in which the originator is located. To achieve that, the factors listed below should be present in the transaction (Coen et al., 1998:2). The originator should have a consistent operating history over a number of years. The product that generates the export receivable should be exported to an identifiable market and not easily replaced. 82

It should be highly probable that the originator would be able to continue to generate export receivables during periods of political and economic turmoil in its home country. The transaction should be so structured that the SPV has a clear, enforceable interest in the export receivables, irrespective of any possible insolvency or reorganisation of the exporter. Importers must make payments directly into an offshore bank account that is controlled by an independent, third-party trustee that is subject to the laws of a highly-rated jurisdiction. The typical future-flow originator of receivables has been an operationally strong company domiciled in an emerging-market country (Dadina et al., 1999:1). The first international future flow transaction appeared in 1987 with the securitisation of telephone receivables due to the Mexican telephone company, Telmex. International future flow securitisations are broadly defined as structured debt offerings in one country sponsored by a foreign originator and secured by receivables due from designated international obligors (Dadina et al., 1999:2). The originator sells future foreign currency receivables to a foreign domiciled SPV, which, in order to finance the purchase, issues securities backed by the receivables to foreign investors. Foreign obligors are directed to make payments directly to the SPV s collections account managed by an independent trustee in the foreign country where the SPV is domiciled. The trustee applies amounts collected from the receivables first to pay investors and associated transaction costs, and then to release excess amounts to the originator. Since the foreign obligors payments on the receivables do not enter the originator s home country, the structure mitigates, although does not necessarily eliminate, the risk that the originator s sovereign government will enact restrictions on the transfer or convertibility of foreign currency. 83

Purchase price Funding Exporter (Originator) Foreign SPV Foreign investors Goods Sale of receivables Coupon Security Importer (Obligor) Payment Security trustee Payment Collections bank account controlled by trustee Importer s bank in foreign country Payment Exporter s bank in foreign country Diagram 2.7: Future flow securitisation structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) Diagram 2.7 depicts a typical export receivables transaction (Dresdner Kleinwort Wasserstein, 2004:15). The exporter trade as normal with importers who make payments via their bankers to the exporter s designated correspondent bank, which directs all payments to the foreign domiciled SPV s bank account under control of the security trustee. Usually the structure is revolving and once investors interest is paid, the SPV purchases new receivables from the exporter. Towards the end of the transaction, payments are accumulated so as to repay the note principal. Other types of international future flow receivables transactions include the securitisation of airline ticket receivables, international telephone settlement receivables, and financial future flows. A financial future flow securitisation is backed future cash flows to financial institutions, such as credit card receivables, trade payment rights, electronic transfers, cheque remittances, and workers remittances. Generally, financial institutions securitise the cash flows and arrange and facilitate these types of transactions (Albers et al., 2000:1). 7.8 Trade Receivables Securitisation Trade receivables are obligations generated when one business sells goods or services to another business. They are unsecured claims on obligors, and, unlike an auto loan or equipment lease, there is no underlying hard asset that can be repossessed in the event of non-payment. Since there are seldom finance charges, there is a reduced incentive for obligors to pay on time, and therefore 84

delinquencies can be quite high. As trade receivables are generally unsecured obligations of obligors, a 100% loss severity often results if an obligor defaults (Dornhofer and Pilcer, 2002:3). The legal structure used in trade receivable securitisations is comparable to that of other asset securitisation transactions. The receivables are sold to a bankruptcy-remote SPV, which issues assetbacked securities to fund the purchase. Like any securitisation, the structure of the transaction should be able to withstand the bankruptcy of the originator, servicer or any debtor. There are, however, certain key structural issues that are particularly relevant to trade receivable transactions (Agarwala et al., 2001:2-4). Short-Term Nature: The maturity of a trade receivable is a combination of the credit term given by the originator and the additional time taken by the debtor to pay the account. Due to the shortterm nature of trade receivables, the securitisation thereof is revolving, with collections being used to purchase newly created receivables on a frequent basis. Seasonality: Typically, trade receivables will follow a recognisable seasonal trend. As a result, the securitisation will follow one of two patterns to cope with these fluctuations: the originator will sell all receivables generated, and receive a fluctuating amount of proceeds throughout the year; or the originator will segregate a pre-determined core level of receivables and receive a level amount of funding throughout the year. Fluctuating Asset Balances: If the originator chooses to sell all receivables generated, the trade receivables pool purchased by the SPV will vary in size throughout the year. The transaction structure will therefore have to take into account whether collections are sufficient to purchase new levels of receivables. Conversely, when collections are high but new receivables generated are at a low level, the structure must have the flexibility to return collections to the originator, while maintaining sufficient reserves to avoid reinvestment losses on the unutilised cash. Revolving Sales: Since trade receivable securitisations are structured as revolving transactions, given that receivables are generated on a daily or weekly basis, the transfer of the receivables to the SPV must be valid at each sale date. The governing law of the trade receivable is important in 85

determining how that transfer takes place and whether the receivable must be specifically identifiable in law. Non-Interest Bearing: Because trade receivables are non-interest bearing, there is no excess spread available to credit enhance the securitisation transaction. The SPV therefore purchases trade receivables from the originator at a discount to provide the required yield, and also credit enhancement through overcollateralisation (Dornhofer and Pilcer, 2002:4). When determining the credit enhancement, usually via a reserve fund, that is required for a receivables transaction, it is necessary to undertake a trend analysis of how the receivables have performed historically, typically looking at monthly data for the previous three to five years. A default analysis and a dilution analysis of the portfolio to determine the credit enhancement that would be required for the transaction are also needed (Agarwala et al., 2001:3): Default Analysis: A technical default date is selected, after which the receivable is deemed to be in default. This typically may be set at 60 to 90 days past the original due date of the receivable. A historic analysis is conducted whereby the amount of receivables becoming defaulted in any month is compared to the sales levels in the month when the receivables were generated, and a loss ratio is determined. Dilution Analysis: Dilution occurs when a credit note is issued to a debtor to compensate for an incorrectly billed receivable or faulty goods. Once a credit note is issued, the value of the related trade receivable is reduced to zero. If that receivable has been sold to the securitisation SPV, there is a direct deduction in the expected cash flow. The levels of dilution experienced in a particular pool of receivables during the previous three to five years must therefore be analysed, and credit enhancement provided to cater for the dilution risk. A critical element associated with the development of trade receivables as a securitisation asset class has been the use of a dynamic reserve mechanism, which is a formula-driven form of credit enhancement that constantly adjusts the amount held in the reserve fund in response to changes in the pool s performance. From both the investors and the issuer s perspective, the dynamic reserve is preferable to a static reserve. From the investors perspective, a dynamic reserve results in credit enhancement that automatically adjusts based on the performance of the underlying assets, taking into account changes in pool characteristics and protecting against rapid deterioration of the pool. From the issuer s perspective, a dynamic reserve results in an enhancement formula that is more cost 86

effective than a static one. Agarwala et al., (2001:7) explain how the dynamic reserve, which may be subject to a minimum required reserve floor, is calculated. Dynamic reserve = Loss reserve + dilution reserve + carrying cost reserve, where the: Loss reserve = (A x B x C x D) + E, with: A B C D E = Rating multiplier = Default ratio = Default horizon stress = Payment terms factor = Default volatility factor Rating multiplier: The rating multiplier is used to add a multiple of stress commensurate with the transaction s rating level, to the other loss reserve components; for example: Required rating Multiplier AAA 2.5 AA 2.25 A 2.0 Table 2.2: Rating multipliers Default ratio: The default ratio is the highest three-month rolling average of the receivables default percentage. Default horizon stress: The default horizon stress is calculated as the sum of the weighted-average payment terms and the number of days delinquent used to approximate losses (e.g. 90 days past due date). Payment terms factor: The payment terms factor is determined by the current weighted-average payment terms divided by the original weighted-average payment terms. Default volatility factor: The default volatility factor is the 12-month sample standard deviation of the monthly default percentage multiplied by the Z value. A Z value of 1.96, therefore, suggests a confidence interval of 95% for all rating categories. 87

Dilution reserve = [(A x B) + E] x C x D, which is calculated on the same basis as the loss reserve by substituting dilutions for defaults in the terms of the equation: A B C D E = Rating multiplier = Dilution ratio = Dilution horizon stress = Payment terms factor = Dilution volatility factor Carrying cost reserve: This is the reserve designed to cover interest and expenses during an amortisation period. 7.9 Inventory Securitisation Inventory securitisation originated in Europe in the year 2000 with the securitisation of inventories of luxury goods, specifically champagne and diamonds (Yomtov, 2002:1). Both have characteristics that maintain or increase in value over time, elements that can also be found in other asset classes that have a regulated market with generally high barriers to entry, liquidity and tradability of the inventory, and which constitute durable goods. These characteristics are not specific to luxury goods and could apply to other assets such as commodities. Perishable goods, however, are not suitable for inventory securitisation. The inventory could be either finished or semi-finished products. Inventory securitisation can be implemented through a secured loan structure or a true sale structure: 7.9.1 Secured Loan Structure In terms of a secured loan structure a bank initially grants a loan secured by a pledge 24 over the inventory to an originator. The bank sells the secured loan, together with the pledge as security, to a bankruptcy-remote SPV. The SPV issues notes to fund the purchase of the secured loan. Interest and principal repayments on the loan fund the note coupon and note amortisation. The SPV pledges all its assets, being the secured loan and the pledge over the inventory, to a security trustee who provides a guarantee to the investors. 24 A gage avec depossession, which is a security under French law. 88

Secured loan Originator SPV Liquidity facility provider Pledge of inventory Funding Pledge of assets Inventory Investors Security trustee Guarantee Diagram 2.8: Inventory pledge structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 7.9.2 True Sale Structure In the case of a true sale structure an originator sells its inventory on a revolving basis directly to the SPV, which issues notes to fund the acquisition of the inventory (Yomtov, 2002:6). Purchase of inventory Originator SPV Liquidity facility provider Transfer of inventory Funding Pledge of inventory Inventory Investors Security trustee Guarantee Diagram 2.9: Inventory sale structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In contrast to the secured loan structure, the notes are directly backed by the inventory. Although the inventory is the property of the SPV, the latter will place the inventory on consignment with the originator. Once the originator has found a buyer it will purchase the inventory back from the SPV before selling it to the buyer (Heberlein, 2001:4). The SPV first uses the proceeds from the sale of 89

inventory to settle its expenses and refinance its costs, and the remainder is applied to again purchase inventory from the originator so as to maintain an ongoing revolving inventory. Since the inventory itself does not generate interest, the transaction must be structured in such a way as to provide a source of cash flow to pay interest on the notes issued (Yomtov, 2002:6). This is achieved by the SPV purchasing the inventory at a discount sized to cover the cost of funding the notes. In cases where a credit rating agency is asked to rate the SPV s ability to pay interest in a timely manner, a cash reserve or liquidity facility is required to cover the time needed to liquidate the inventory. The inventory is pledged to a security trustee who provides security to investors. Redemption of the notes at maturity is achieved by stopping the revolving purchase of inventory, and using the proceeds from the sale of inventory to redeem the notes. In an inventory securitisation, irrespective of whether a secured loan or true sale structure is used, the funding through the issuance of notes is directly linked to the volume and composition of the inventory by a borrowing base formula. According to Yomtov (2002:1to 6), the borrowing base can be calculated as a fixed amount per unit of inventory, or a percentage of the current value of a unit of inventory. For example, if a single unit of inventory is priced at R100, then, under a fixed amount calculation, R70 of notes could be issued per inventory unit, whereas, under the fixed percentage method, the note issuance would be 70 percent of the price of an inventory unit. This borrowing base mechanism provides the overcollateralisation between the value of the inventory and the note amount issued, thereby providing the credit enhancement required by investors. There are two types of borrowing base calculations discussed below. Fixed Amount Borrowing Base: In terms of the fixed-amount borrowing base, the overcollateralisation is variable since the value of the inventory may vary over time, whereas the value of notes in issuance remains constant. Investors are thus exposed to a sharp decline in inventory prices. This risk can be mitigated by including performance triggers to track inventory price declines, which if breached, would lead to an adjustment of the borrowing base or an early amortisation event. Fixed Percentage Borrowing Base: In the case of the fixed-percentage borrowing base, the overcollateralisation remains constant, since the amount of notes in issuance is adjusted to the inventory price variation. In the case of an increase in inventory value, new notes will be issued that will rank pari passu with the existing notes. In the case of a decline in inventory values, notes will be partially repaid so as to keep the value of notes as a percentage of inventory value constant. The partial repayment of notes in such an instance will be made by the originator. Investors risk exposure after an early amortisation event is therefore limited to the liquidation period, which is 90

the time it takes to sell the inventory and repay investors. The borrowing base should take into account the potential decrease in inventory value and the amount of interest on the notes that would have to be paid over the liquidation period. Variations in the borrowing base formula that combine both the fixed amount and fixed percentage calculations are possible. The borrowing base may be set as a fixed amount per unit of inventory at the inception of the transaction, but may be changed to a percentage of a unit of inventory if the price drops below a set floor. Alternatively, at inception the borrowing base may be a percentage of the inventory value, but capped at a fixed amount when an upper price limit is breached. An inventory securitisation structure usually includes early amortisation events, which will be triggered by a breach of the borrowing base, a trigger indicating a decrease in the value of the inventory, or default events related to the originator (Yomtov, 2002:4). An early amortisation event stops the revolving purchase of inventory in a true sale structure, and causes the repayment of the secured loan in the secured loan structure, resulting in the liquidation of the transaction and repayment of the notes. In an early amortisation event, investors rank first in the allocation of cash flows generated by the sale of the inventory or a refinancing by the originator. During the liquidation period, which can take up to 18 months, the liquidity facility that has been made available for a specified amount and period will be used to fund the payment of interest on the notes. An early amortisation event may be cured by the originator providing a subordinated advance to the SPV (Heberlein, 2001:5). 7.10 Whole Business Securitisation Whole business securitisation emerged in the mid-1990s in the United Kingdom with the securitisation of cash flows generated by a nursing homes company. Several transactions followed, involving assets as diverse as hotels, pubs, theme parks and airports (Pfister, 2000:1). While a standard securitisation structure isolates certain specific assets, e.g. mortgage loans, from an originator and uses the pre-contracted cash flows derived from those assets to service the debt, a whole business securitisation relies on future, and less predictable, cash flows derived from the entire business of an operating company. According to Pfister (2000:1), whole business securitisations are, from a structural perspective, midway between standard securitisations and corporate debt. Similar to secured corporate debt, the debt issued in a whole business securitisation is a direct liability of the operating company. Ownership of the assets remains with the operating company, and bondholders are only granted a charge over those assets. As with a typical bond, bondholders are exposed to the 91

risks consistent with the credit rating of that company. However, as in the case of a securitisation, the assets that secure the debt are isolated from the insolvency of the operating company. This is achieved by creditors ability in the United Kingdom, specifically, to replace the insolvent operating company by a third party who will then manage the assets solely for the benefit of the creditors. Secured loan Operating company SPV Liquidity facility provider Pledge of assets Funding Pledge of assets Guarantee Administrative receiver Investors Guarantee Security trustee Diagram 2.10: Whole business securitisation structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In this typical United Kingdom whole business securitisation, the legal structure is based on that of a secured loan rather than a sale of assets, since the revenues of the entire business are securitised (Pfister, 2000:2). An SPV is set up to raise debt, which the SPV on-lends to the operating company (borrower). The borrower repays the loan out of the cash flows generated from its business. The loan is secured by all of the assets of the borrower, including a security interest over any properties, investments and accounts, and the assignment of the borrower s rights under any contracts, licences or agreements. In addition, the borrower grants a floating charge over all of its assets. The security is held by a security trustee for the benefit of investors and other secured creditors such as the liquidity facility provider. In order to protect the cash flows from the insolvency of the borrower, the United Kingdom legal structure relies on the Insolvency Act of 1986 25. This Act permits the holder of a charge over all of a company s assets to control the insolvency proceedings of that company through an administrative receiver. If the borrower becomes insolvent, the security trustee, as holder of the fixed and floating charge over all the assets of the borrower, will be able to stop the appointment of an administrator by 25 UK law has recently been amended to make it more debtor friendly. However, due to the importance of whole business securitisation, a special exemption has been included which is designed to maintain secured creditor control of the insolvency of a company that has raised finance through a whole business securitisation. 92

the Court, and appoint an administrative receiver of its choice. The administrative receiver will take control of the borrower s assets and will manage those assets for the sole interest of the creditors until the debt is repaid in full. Alternatively the administrative receiver can choose to liquidate the assets and repay the debt early if it judges this to be a more appropriate course of action. Upon liquidation, investors as holders of a fixed charge will have priority over any other creditors of the borrower. Delays may arise in the process of taking control of the assets and cash flows of the borrower during insolvency proceedings. A liquidity facility, typically covering 18 to 24 months of debt service, is accordingly required to avoid any disruption of debt servicing. The ability to replace the management of the borrower by a substitute manager, the administrative receiver, in an insolvency proceeding is somewhat comparable to the concept of a back-up servicer in a standard securitisation. The expediency of appointing an administrative receiver, as opposed to protracted proceedings in some other countries, and the existence of a liquidity facility should preclude a default under the securitised debt (Pfister, 2000:3). The administrative receiver is expected to manage the assets of the borrower actively on a day-to-day basis until the secured loan is fully repaid or the portfolio liquidated. Consequently the structure relies upon the critical assumption that another operating company or third-party servicer can be found who would be willing to take over and manage the assets once the borrower becomes insolvent. This in turn assumes that, despite the insolvency of the borrower, its assets and the industry in which it operates will be viable in the long run (Pfister, 2000:4). The intrinsic value of the borrower s business will be greater if the borrower is not insolvent. It is in the interests of bondholders to recognise early signs of severe problems, which is usually achieved through financial covenants, which if not complied with by the borrower, will lead to a default under the secured loan agreement, the enforcement of the security and the appointment of an administrative receiver. One of the most efficient and often used financial covenants is based on a minimum debt service coverage ratio (DSCR) test, defined as adjusted EBITDA 26 over debt service. The EBITDA figure is adjusted for non-cash and exceptional items to reflect the free cash flow of the borrower. The DSCR is normally set at well above one times the debt service, so that an alarm sounds before the borrower is no longer able to generate sufficient cash flows to pay capital expenditure, tax and debt service (Pfister, 2000:5). Whole business securitisation is best applied to companies within stable or essential industries benefiting from high barriers to entry and limited existing competition, which generate predictable 26 EBITDA = Earnings before interest, tax, depreciation and amortisation. 93

cash flows from a portfolio of diverse long-term sustainable assets with substantial alternative use value (Pfister, 2000:9). 7.11 Intellectual Property Securitisation Intellectual property-backed securitisation transactions are a form of future flow securitisations. However, one characteristic that differentiates intellectual property 27 transactions from other types of future flow securitisations is that they are profoundly dependent on popular tastes, adding a layer of complexity and risk to the structure (Eisbruck, 1999:1). Intellectual property transactions to date have largely been backed by future payments generated by music royalty rights. The first music royalty securitisation was completed in 1997, involving the future revenues generated by the music catalogue of pop artist David Bowie, and commonly referred to as Bowie Bonds (Eisbruck, 1999:2). As is the case with other types of future flow transactions, the receivables in a music royaltybacked transaction do not exist at the inception of the transaction, but instead are to be generated during the life of the transaction. Intellectual property-backed transactions can be implemented through a secured loan structure or a true sale structure (Lester, 2002:9-13). 7.11.1 Secured Loan Structure In terms of the secured loan structure, the issuing SPV issues notes to provide a secured loan to an intellectual property SPV, which is created specifically to purchase and isolate the originator s intellectual property rights. The underling obligors from that point on make their royalty payments directly to the intellectual property SPV, which uses the cash flows to repay the secured loan. The intellectual property SPV cedes the intellectual property rights and related contracts as security for the loan to the issuing SPV, which pledge all its assets to the security trustee for the benefit of investors. 27 Intellectual property can be defined as the ownership and control over the tangible or virtual representation of ideas. 94

Secured loan Funding Intellectual property SPV Issuing SPV Investors Pledge of rights Royalties & license fees Purchase rights Pledge of assets Guarantee Underlying obligors Originator Security trustee Contracts Diagram 2.11: Intellectual property secured loan structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 7.11.2 True Sale Structure In the case of the true sale structure, as depicted in Diagram 2.12, the issuing SPV purchases the intellectual property rights from the intellectual property SPV, which gives the issuing SPV exclusive licence of the intellectual property rights, and the right to receive the future cash flows from the underlying obligors. Purchase rights Funding Intellectual property SPV Issuing SPV Investors Sale of rights Purchase rights Royalties & licence fees Pledge of assets Guarantee Originator Underlying obligors Security trustee Contracts Diagram 2.12: Intellectual property true sale structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 7.12 Securitisation of Non-Performing Loans The broadest definition of a non-performing loan (NPL) is any debt obligation for which the original contract repayment plan has not been honoured (Cataldo et al., 2003:1). Non-performing loans can 95

be classified into secured and unsecured non-performing loans. Secured non-performing loans are debt obligations, such as mortgage loans, which are secured by a high-ranking economic lien with a voluntary judicial mortgage. Unsecured non-performing loans are debt obligations on which there is no collateral or good quality security package available (Cataldo et al., 2003:2). The securitisation of non-performing loans enables a bank to lower its non-performing asset ratio, obtain regulatory capital relief, avoid potentially catastrophic losses, and permit management to focus on new business. A bank may have already written down the value of the distressed loans being sold, and the loans must be purchased by the SPV at the current (written down) market values. Securitisation transactions backed by non-performing loans have unique credit risk profiles as a result of the cash flows being derived purely from the expected recovery of this distressed loans and the timing of this recovery. Recovery assumptions are the most important determinant of overall credit enhancement levels for a non-performing loan portfolio. As a general rule, the total debt issued by the securitisation SPV must be less than the total purchase price or fair market value of the nonperforming loan portfolio (Bonelli and Howard, 2001:2). Credit enhancement is high compared to other asset classes, and is calculated as the difference between 100% and the ratio between the total amount of notes issued and the portfolio gross book value (Cataldo et al., 2003:12). Cataldo et al., (2003:3) classify non-performing loan securitisation structures into three main types. Standard Structure with Pure Liquidity Line: In a standard structure, the risk for investors is directly linked to the expected collections and timing on the non-performing loan portfolio. No external guarantees are provided to support potential inflow shortfalls. A liquidity line is provided solely to pay interest on the notes for a limited time in case of a severe cash flow shortfall. Similar to a traditional pure liquidity line in a normal securitisation transaction, it may not provide credit enhancement to the transaction. Mixed Structure with Advance Facility: An advance facility is a form of credit facility made available by servicers in the case of a collections shortfall. With this type of structure, the risk taken by investors is linked to both the non-performing loan portfolio inflows and the advance facility provider s ability to provide credit enhancement. Whenever collections from the portfolio fall below a certain specified threshold, the SPV is allowed to draw the shortfall amount out of the available advance facility. 96

Mixed Structure with Collateral: In this structure the risk to investors is linked to the collections from the non-performing loan portfolio and to the quality and availability of collateral, which is made available through a limited recourse loan to the SPV. Since the performance of a non-performing loan portfolio is largely based on the ability to resolve defaulted loans actively, servicers play a crucial role in such transactions. Almost all cash flows pertaining to a non-performing loan securitisation stem from active servicing or are a direct result of actions taken by the servicer. This is significantly different from the case of performing asset securitisations, where most debtors make regular payments pursuant to their loan agreements. Servicers are essentially broken down into primary servicers and secondary servicers. Typically, a primary servicer is also the originating bank of the debt obligations, but has also become the servicer of the securitised non-performing loan portfolio. A special servicer is a servicing company specialising in the resolution of distressed debt, and may or may not be part of the originating banking group (Cataldo et al., 2003:11). 7.13 Life Insurance Securitisation The embedded value is often a material part of the balance sheet and capitalisation of life insurers. The embedded value for a life insurer is stated as follows (Harris, 2002:3): Embedded value PVIF = Adjusted net asset value + PVIF, where: = Present value of future policies. The adjusted net asset value generally reflects the tangible equity within the business that is attributable to shareholders. The PVIF is largely a result of the mismatch between statutory reserve requirements for life insurance policies and the cash flow profile of those policies. Regulators, in safeguarding policyholder security, require that prudent reserves are established at the outset, thereby front-loading capital requirements. However, cash flows and profits from such policies tend to be end-loaded, as a result of the insurer paying initial commission expenses and the term nature of premiums. In capital terms this has two effects. Writing new policies invokes a capital strain as reserves established exceed available cash flows for a specific policy. 97

Such policies also lead over time to profit emergence as prudent statutory reserve margins are released and as cash flow profiles turn positive. Whereas profits from current business are realised over an extended period of time, a life insurance company may suddenly need liquidity. The securitisation of embedded values appeals to life insurers in several ways as suggested below: the immediate crystallisation of excess assets on a statutory basis; redeployment of capital from one business area to another; and immediate liquidity gains. A securitisation transaction thus provides for capital market financing with the repayment of principal and interest secured by future profit on the underlying book of business. 7.14 Asset-Backed Commercial Paper Conduits Asset-backed commercial paper (ABCP) programmes first appeared in the mid-1980s. As of September 2004, there were approximately 280 active ABCP programmes in the United States, with more than US $717 billion in outstanding commercial paper (Fitch Ratings, 2004c:1). An ABCP programme is composed of a bankruptcy-remote SPV, called a conduit, that issues commercial paper (CP) and uses the proceeds of such issuance to obtain interests in various types of assets, either through asset purchase or secured lending transactions (Fitch Ratings, 2004c:1). Some common assets financed through ABCP conduits include trade receivables, consumer debt receivables, and auto and equipment loans and leases. Often transactions entered into by a conduit represent the revolving purchase of assets. Conduits may also invest in asset-backed securities, corporate bonds and government bonds. Traditionally, commercial paper is short-term debt, generally limited to a period of 364 days and issued on either an interest-bearing or discount basis. Most commercial paper is issued at a discount to face value, with a fixed rate of interest expressed on a 365-day basis. The only payment is the face value at maturity. The issuer has no right to prepay nor does the investor have a right to put the commercial paper back to the issuer prior to its maturity date. The only difference between commercial paper and asset-backed commercial paper is that the former is a senior unsecured 98

obligation of a corporate, while the latter is issued by an SPV and is secured and repaid by a pool of assets. The term of most commercial paper issued by conduits is usually much less than the permitted maximum because investors and issuers are reluctant to hold or issue fixed rate notes with longer maturities. One solution has been for conduits to issue floating rate commercial paper (Bate et al., 2003:52). The repayment of commercial paper depends on the cash collections received from the conduit s asset portfolio and the conduit s ability to issue new commercial paper. Typically, the conduit applies the proceeds of new commercial paper issuance to repay maturing commercial paper, a process called rolling commercial paper (Bate et al, 2003:11). This permits the conduit to fund even long-term assets on a continuing basis. Additionally, in the event new commercial paper cannot be issued and to guarantee funding to the seller/borrower, conduits can draw on liquidity facilities to repay maturing commercial paper. However, new commercial paper issuance and liquidity support are conditioned upon the satisfactory performance of the assets financed by means of the original commercial paper issuance (Fitch Ratings, 2004c:2). ABCP conduits issue commercial paper as their main liability. However, some conduits have diversified their funding sources to include extendible commercial paper and medium-term notes (Bate et al., 2003:5). Extendible commercial paper, also called extendible commercial notes (ECNs) or secured liquidity notes (SLNs), allows the conduit to extend the scheduled maturity of the commercial paper to a later, final maturity date if it cannot roll, i.e. re-issue new commercial paper. If extended, the commercial paper switches to a variable rate that resets monthly. Once extended, the note has a call feature permitting prepayment by the issuer as funds become available. The conduit s option to extend is embedded in the note so that investor s consent is not required to extend the maturity. Investors in effect provide liquidity to the conduit and are compensated by receiving a higher interest rate during the extension period (Bate et al., 2003:44). Medium-term notes (MTNs) have maturities ranging from 180 days to 30 years. By locking in long-term funding, MTNs are a powerful tool for managing liquidity needs (Bate et al., 2003:54). While ABCP programmes share certain features with term securitisations, conduits differ in many ways (Fitch Ratings, 2004c:2). Conduits investment in assets can be revolving and fluctuating in size, whereas in a term securitisation the asset pool remains constant or amortises. Conduits may invest in various types of assets, thereby creating diversified portfolios, whereas in a term securitisation the transaction is limited to one asset class. 99

Conduits fund long-term assets by issuing short-term liabilities, relying on liquidity support for potential repayment shortfalls caused by asset and liability timing mismatches. In the case of a term securitisation, the term of the assets and liabilities match. In conduits there is no scheduled amortisation of assets and liabilities, since the additional issuance of commercial paper is used to maintain the conduit s investment in assets. In the case of a term securitisation, the assets amortise. ABCP conduits rely heavily on credit enhancement and liquidity facilities, which are discussed below. Credit Enhancement: ABCP programmes are structured with credit enhancement to protect against losses on the programmes underlying asset portfolio. Credit enhancement may either be transaction-specific or programme-wide, or a combination of both. It comes in various forms and can be provided on either an internal or external basis. For credit enhancement provided by an external party, the rating of the credit enhancement provider must be at least equivalent to that of the commercial paper. Transaction specific credit enhancement provides loss protection for a particular transaction only, and cannot be used to cover losses stemming from other transactions in the conduit s asset portfolio. Transaction-specific credit enhancement is sized and structured to address the unique characteristics and credit risk of the underlying assets. Typically, revolving pools have dynamic credit enhancement, whereby the size of the credit enhancement fluctuates, based on the performance of the underlying asset pool (Fitch Ratings, 2004c:8). Programme-wide credit enhancement is designed to cover losses stemming from any asset in the portfolio. Programme-wide credit enhancement may be fixed or fluctuate in size based on the configuration of the asset portfolio. For multi-seller programmes, in which each transaction is structured on a stand-alone basis to a level commensurate with the rating of the commercial paper, the required level of programme-wide credit enhancement is typically a fixed percentage. In such circumstances, programme-wide credit enhancement provides an additional layer of loss protection that addresses pooling risk, which is the increased risk to the portfolio associated with the inclusion of additional assets. In contrast with multi-seller programmes, programme-wide credit enhancement for securities-backed programmes is generally dynamic, and fluctuates in size based on the rating distribution of the asset portfolio. Highly rated securities are usually excluded from the calculation of the required minimum amount of programme-wide credit enhancement, because their credit quality meets, or exceeds the requisite level necessary to be consistent with the rating of the commercial paper issued. If a programme is structured with both transaction-specific 100

and programme-wide credit enhancement, transaction-specific enhancement serves as a first layer of loss protection, while the programme-wide facility serves as a second layer of loss protection, absorbing losses in excess of the transaction-specific credit enhancement (ibid.). ABCP programmes can be further classified as fully supported or partially supported based on the level of external credit enhancement provided to the program. Fully supported programmes are backed by 100% credit enhancement, while partially supported programmes are backed by less than 100% credit enhancement. The credit quality of the assets purchased by fully supported programmes is inconsequential to the rating of the commercial paper, since the ultimate repayment of commercial paper relies on the third-party credit enhancement provider (Fitch Ratings, 2004c:4). Risk-based capital standards require credit enhancement providers for fully supported programmes to hold regulatory capital for the full face value of the commercial paper outstanding, because the facility is regarded as a direct credit substitute. These costs motivated banks to create partially supported ABCP programmes, which are eligible for more advantageous regulatory capital treatment. The primary distinguishing feature of partially supported ABCP programmes is that the credit enhancement facilities are not intended to fully insulate investors from the credit risk associated with the asset portfolio of the conduit, and investors will have to bear a portion of the credit risk (Bate et al., 2003:19). Often a partially supported conduit funds one or more fully supported transactions, although the majority of transactions are only partially supported. Sometimes a conduit sponsor wishes to close a transaction quickly. Since the credit analysis of a fully supported transaction is focused on a structural review rather than an asset review, a fully supported transaction can be closed more quickly than a partially supported one. The transaction can subsequently be restructured as partially supported at a later date. Sometimes individual transactions are fully supported because the credit quality of the assets is such that full support is the only way that conduit funding is possible. For the fully supported transaction, though not for the entire conduit, investors are exposed to the risk of the credit enhancement provider, and not the credit quality of the underlying assets (Bate et al., 2003:20). Liquidity Support: Liquidity support refers to the internal and external sources of funds available to the conduit to enable it to repay maturing commercial paper on a timely basis. Because internal sources of liquidity, or collections on assets, may be insufficient to repay maturing commercial paper, most ABCP programmes are structured with at least 100% external liquidity support. External liquidity support is provided by financial institutions and usually takes the form of loan 101

facilities or asset purchase facilities. These facilities provide alternative sources of funds for a conduit to repay maturing commercial paper when it is unable to issue new commercial paper due to a market disruption, or it is experiencing cash flow mismatches, or it cannot liquidate assets in a timely manner. These facilities may also provide alternative funding sources for conduits to meet funding or purchase commitments when they cannot issue new commercial paper. Liquidity facilities do not cover cash shortages caused by asset defaults, and are not allowed to provide credit enhancement to the asset portfolio. Liquidity facilities can either be transaction-specific or programme-wide, and can be in the form of a liquidity loan agreement, or an asset purchase agreement. Under the liquidity loan agreement, the liquidity provider agrees to lend funds on a committed basis to the conduit when requested. Under the asset purchase agreement, the liquidity provider agrees to purchase an asset on a committed basis from the conduit when requested (Fitch Ratings, 2004c:9). Liquidity facilities usually have a term of 364 days and are renewable at the option of the provider. The term and structure of liquidity facilities must ensure that they provide a liquidity backstop for the entire term of the commercial paper issued by the conduit. This can be accomplished by employing an issuance test that ensures that all commercial paper issued is backed by a liquidity facility with a remaining term greater than that of the related commercial paper. Alternatively, liquidity facilities may be structured with a non-extension draw provision that allows the conduit to draw on the liquidity facility if the liquidity provider does not agree to an extension of its liquidity facility. The proceeds from such a liquidity draw are then retained in a segregated account and made available for liquidity purposes only, until the non-extending liquidity provider has been replaced (ibid.). Under exceptional circumstances, internal liquidity support can reduce the necessity for 100% external liquidity support. One such circumstance is when commercial paper maturities are match funded to the maturities of the assets in the portfolio. In this case, the assets must have maturities that either match or precede the maturities of the commercial paper issued in connection with the financing of such assets. In the absence of a default of the assets, the matching of asset and liability maturities ensures the full and timely repayment of the commercial paper. Another event that may reduce the need for 100% external liquidity support is when marketable securities or a pool of highly liquid assets with a predictable cash flow are combined with strict management of commercial paper maturities (ibid.). 102

ABCP programmes are generally sponsored by banks or large corporates and are established to finance the sponsor s own assets, or, if the sponsor is a bank, to provide financing alternatives to the bank s clients (Fitch Ratings, 2004c:3). Initially, ABCP conduits were primarily sponsored by banks as a means of providing low cost trade receivable financing to their corporate clients who could not otherwise directly borrow in the commercial paper market (Bate et al., 2003:5). ABCP programme structures are differentiated by the sponsor s role in referring the assets to be financed through the programme and the purpose of the financing (Fitch Ratings, 2004c:3). Bate et al., (2003:7) identifies six principal types of ABCP programmes: Single-seller General purpose multi-seller Credit arbitrage Structured investment vehicle Loan-backed Hybrid Serialised. The classification by fully or partially supported cuts across all of these programme types, that is each type can be of a fully supported or partially supported nature. 7.14.1 Single-Seller ABCP Single-seller ABCP conduits provide financing for assets originated by only one company, or related to one company s business operations, and the company uses the conduit as an alternative source of funding for its own business activities. The company whose assets will be financed usually sponsors single-seller conduits. If the company is highly rated, then the sponsoring company may provide both liquidity support and credit enhancement to the conduit. Otherwise the conduit will use liquidity and credit enhancement facilities provided by a bank or syndicate of banks. 103

Sponsor Obligors Funding Liquidity support provider Conduit SPV Security cession Credit enhancement provider Funding Hedging facility provider CP investors Guarantee Security SPV Diagram 2.13: Single-seller ABCP conduit structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) Companies establish their own ABCP programmes if they desire to have more control over the issuance of commercial paper. Frequent issuers of term asset-backed securities also actively use single-seller conduits for warehousing transactions. A single-seller warehouse conduit finances assets for a period of time until the amount of the assets accumulated and market conditions permit the assets to be sold to a term securitisation SPV and efficiently securitised in the term securitisation market (Bate et al., 2003:79). The funding amount of a single-seller warehouse increases during the accumulation phase, but is then quickly reduced when the assets are packaged into term asset-backed securities. These warehousing transactions are common in respect of auto loans, auto leases, residential mortgages and other mortgage-related assets (Bate et al., 2003:15). 7.14.2 Multi-Seller ABCP In a multi-seller structure, the sponsor is usually a bank seeking to provide financing alternatives to its clients. The multi-seller structure provides the flexibility to purchase a variety of assets from many different sellers and provide finance across a wide variety of industries and asset types, thereby offering ABCP investors a well-diversified pool of supporting assets. 104

Obligors Obligors Obligors Seller Seller Seller Funding Funding Funding Asset-purchasing SPV Asset-purchasing SPV Asset-purchasing SPV Funding Liquidity support provider Conduit SPV Security cession Credit enhancement provider Funding Hedging facility provider CP investors Guarantee Security SPV Diagram 2.14: Multi-seller ABCP conduit structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 7.14.3 Credit Arbitrage ABCP In a credit arbitrage programme the sponsor is usually a bank seeking arbitrage opportunities. Credit arbitrage conduits invest in rated asset-backed securities, corporate bonds and government bonds. These conduits use the proceeds of low-cost ABCP to fund the purchase of higher yielding, longerterm securities. The resulting spread is passed on to the sponsor. 7.14.4 Structured Investment Vehicles Structured investment vehicles (SIVs) are another form of credit arbitrage programme. SIVs issue not only ABCP, but also MTNs that provide half to two-thirds of the SIV s funding. The proceeds are then invested in highly rated securities. SIVs operate on a market-value basis in that they must 105

maintain a dynamic overcollateralisation ratio determined by an analysis of the potential price volatility in the portfolio. SIVs are monitored on a daily basis, ensuring strict liquidity, capitalisation, leverage and concentration guidelines (Bate et al., 2003:8). 7.14.5 Loan-Backed ABCP A variation of the multi-seller structure is a loan-backed programme that makes short-term, unsecured loans direct to the bank s corporate clients. 7.14.6 Hybrid ABCP Hybrid conduits feature characteristics of more than one type of ABCP programme. They typically combine multi-seller, credit arbitrage and loan-backed structures, thus giving the sponsor the flexibility to serve its own needs and those of its clients. While hybrid programmes offer great flexibility, they suffer from the disadvantages of agglomeration. Many investors prefer single-purpose conduits that are easier to understand and allow investors to choose a particular type of conduit exposure (Bate et al., 2003:24). 7.14.7 Serialised ABCP In most conduits, all of the outstanding liabilities are equally secured by all the assets. To cater for investors who dislike hybrid programmes, a conduit may issue serialised commercial paper. In a serialised ABCP programme, the conduit issues different series of commercial paper. A specific, identifiable asset portfolio, with its own credit enhancement and liquidity support backs each series. The credit enhancement and liquidity facilities for one asset pool are not available to repay commercial paper issued in respect of another asset pool (Bate et al., 2003:54). In South Africa there were, at the end of 2005, six ABCP conduits, of which two were serialised conduits, three were hybrids, and one a single-seller mortgage warehousing conduit. Total outstanding commercial paper issued by the conduits increased by 65% year on year from R10.7 billion to R17.7 billion at the end of 2004 (Bate and Leegerstee, 2005:1). 106

7.15 Collateralised Debt Obligations Collateralised debt obligations (CDOs) are asset-backed securities where the underlying asset portfolio can include either various types of debt obligations or focus solely on one class of debt (Fitch Ratings, 2004b:2). CDO structures typically involve an SPV acquiring pools of either loans or bonds, or a combination of these, and funding the acquisition by issuing notes to investors. Investors assume the financial losses of any obligor in the pool unwilling or unable to meet the terms of its debt obligations, and the investors return is therefore directly linked to the performance of the pool (Howladar, 2005:1). CDOs can be categorised using three criteria: asset type, motivation and form of risk transfer. The specific combination of these criteria will dictate a CDO transaction s name, although despite the variety of transaction types, all CDOs have one thing in common, which is to securitise the credit risk of debt obligations (Fitch Ratings, 2004b:2). CDOs can be classified in a number of ways. These are set out below. Classification by Asset Class: CDOs encompass collateralised loan obligations (CLOs), in which the assets being securitised are loans, or collateralised bond obligations (CBOs), in which the securitised portfolio is made up of bonds. Both transaction types are often just classified as CDOs, which is also the term used for portfolios combining both loans and bonds, portfolios of structured finance products such as asset-backed securities or other CDOs, and for transactions where the underlying portfolio does not reference specific debt obligations, but rather entities e.g. corporates or financial institutions. Classification by Motivation: Depending on the motivation behind a CDO transaction, it can be split into balance sheet and arbitrage CDOs. Balance sheet CDOs are used by banks to transfer credit risk into the capital markets to manage their credit exposures and/or improve their returns on economic or regulatory capital. The motivation for an arbitrage CDO is to realise a profit on the margin between the weighted average return received on a portfolio of debt obligations and the cost of the CDOs issued in the capital markets. Classification by Risk Transfer: A third criterion in differentiating between CDOs is the way that credit risk is transferred into the capital markets, e.g. by means of a true sale securitisation whereby the SPV purchases the debt obligations and becomes the legal owner, or by means of a synthetic securitisation using credit derivatives 28 (Fitch Ratings, 2004b:2). 28 Synthetic securitisation is discussed in Chapter 3. 107

Characteristics of Various CDO Types Criteria Characteristics CDO Type Asset Type Bonds Collateralised Bond Obligation (CBO) Loans Collateralised Loan Obligation (CLO) Entities and mixed portfolios Collateralised Debt Obligation (CDO) Structured finance securities CDO of ABS and CDO of CDOs Motivation Arbitrage Arbitrage CDO Risk management Balance sheet CDO Funding Cash flow CDO Risk Transfer True sale Cash flow CDO Synthetic Synthetic CDO Table 2.3: Characteristics of various CDO types CDOs can also be classified as either a cash flow or a market value CDOs. Cash flow CDOs are structured vehicles that issue different tranches of liabilities and use the proceeds to purchase, through a true sale, a pool of assets with predictable cash flows. The cash flows generated by these assets are used to repay investors. As such, these structures are restricted to investments that meet minimum credit quality, term and expected recovery characteristics. The 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. What is important in a cash flow CDO is not the ongoing market price of the collateral, but the ability of each asset to pay scheduled principal and interest (Howard et al., 1999:2). Market value CDOs are similar to cash flow CDOs, but the SPV does not issue debt based on the par value of the assets, but rather issues debt based on an advance rate associated with each type of asset purchased. Market value CDOs are designed around a pool of assets with predictable market price movements. The assets are classified into broadly defined investment categories, which have similar observed price volatility and liquidity characteristics. Advance rates are calculated for each investment category based on the historically observed volatility and relative liquidity of the assets. The advance rates determine how much rated debt can be issued against the market value of an asset. Rated debt backed by assets with lower assumed volatility will be advanced at higher advance rates than rated debt backed by assets with greater volatility (Howard et al., 1999:3). The portion of the assets not funded by rated debt is then funded by a combination of subordinated debt and equity. Unlike cash flow CDOs where the payment of liabilities is strongly dependent on the credit risk of the underlying assets, the performance of market value CDOs is based upon the market pricing and returns on assets (Standard & Poor s, 2002a:5). The determination of credit enhancement is based on the composition of assets, the ability of the structure to withstand significant asset price declines within a limited period of time, and the ability to liquidate assets in a timely manner. The structure is limited to the amount of debt that can be outstanding as a percentage of the current market value of 108

the assets. The collateral pool is mark-to-market (MTM) on a periodic basis, and in the event that the value of the assets decline below acceptable levels, the asset manager will be required to take corrective action in order to cure the situation. If this is not possible, the assets will be liquidated and the proceeds used to repay investors (Howard et al., 1999:2). CDOs can also be classified between static and actively managed transactions. In a static transaction the payments cannot be reinvested or securities substituted. In an actively managed CDO the asset selection and substitution decisions are made by a collateral manager. The manager is responsible for the ongoing trading activities during a reinvestment period to realise gains and minimise losses. As a result of the latitude afforded the manager in actively adjusting the composition of the collateral pool, the manager s expertise is paramount to the success of a CDO transaction (Standard & Poor s, 2002a:6). Like asset-backed securities, CDOs contain various mechanisms and covenants that dictate all aspects of a transaction, such as the types of, and limits, to assets owned by the SPV, responsibility of each of the participants, priority of payments and allocation of losses to each class of liabilities, overcollateralisation and interest coverage requirements, and note redemption mechanisms. Certain features, however, distinguish CDOs from traditional asset-backed securities (Standard & Poor s, 2002a:12). Most CDOs are managed vehicles. The structure contains a reinvestment period during which the collateral manager can actively trade assets within clearly defined covenants. This trading activity could cause the composition of the asset portfolio to change significantly throughout the life of the transaction. CDOs often include an initial ramp-up period, typically three to six months, during which time the collateral manager acquires additional assets with remaining issuance proceeds. This ramp-up period allows CDO transactions to close without fully acquiring all the collateral in the portfolio, thereby shortening the warehousing period. CDO asset pools are not as homogeneous as traditional asset-backed securities. In general, arbitrage CDOs have 70 to 90 obligors, with the collateral being quite lumpy. Cash flow CDOs have larger pools, typically in the 200 to 300 range, but still have fewer obligors than diversified asset-backed securities pools. Some CDOs are even more concentrated with only 20 to 30 109

obligors. Because of this, the traditional actuarial loss methods used for asset-backed securities cannot be applied to CDO pools. CDO transactions have potentially greater ratings volatility relative to traditional asset-backed securities, because their performance is susceptible to more variables. CDO performance is affected by factors such as the ratings migration of the underlying collateral, the trading activity of the collateral manager, the timing and magnitude of the defaults in the collateral pool, and the recoveries realised on the defaulted assets. A CDO transaction may be downgraded even if it has not suffered any defaults, but purely due to the ratings migration of the underlying assets. The portfolio collateralising CDOs can include multiple types of assets. Besides corporate loans and bonds across industries and credit ratings, the collateral may also include various asset-backed securities, other CDOs, and synthetic securities. These mixed pools allow greater diversity that potentially results in lower default correlation across asset types. To date there have only been three CDOs issued in the South African market, these being Kiwane, launched in January 2000 and de-listed in 2003, and Fresco and Procul, two synthetic CDOs launched in 2003 (Bate and Leegerstee, 2005:4). 8. CONCLUSION In recent years securitisation has become one of the most important financing methods internationally. Securitisation is used by companies to raise cheaper funding and by banks to manage their regulatory capital more efficiently. For both it is also a way to tap additional sources of funding and to diversify their funding. The process of securitisation starts with a company or a bank, the originator, identifying the assets it wants to securitise. These assets typically represent rights to payments at future dates. After identifying the assets to be used in the securitisation, the originator transfers the assets to a newlyformed company referred to as a Special Purpose Vehicle (SPV). The transfer is intended to separate the assets from risks associated with the originator. For this reason the transfer must constitute a true sale, that is, a sale that is sufficient under a bankruptcy or similar law to allow for the removal of the assets from the originator s bankrupt estate. 110

To raise funds to purchase these assets, the SPV issues asset-backed securities in the capital markets. The SPV must be structured as a bankruptcy-remote entity to gain acceptance as an issuer of capital market securities. Bankruptcy-remote in this context means that the SPV is unlikely to be adversely affected by a bankruptcy of the originator. To achieve bankruptcy remoteness, the SPV s organisational structure strictly limits its permitted business activities, the goal being to prevent creditors, other than the holders of the asset-backed securities, from having claims against the SPV that might force the SPV into bankruptcy. The SPV uses the cash flows from the assets it has purchased to repay investors in the future. Consequently investors are concerned only with the cash flows coming due on these assets. Also of importance to investors, is the credit rating that the asset-backed securities receive from independent rating agencies such as Fitch Ratings, Moody s and Standard & Poor s. Given that most investors have neither the time nor the resources to investigate fully the financial condition of the asset-backed securities, these ratings are significant. The ratings of the asset-backed securities are largely determined by the quality of the assets, and are further improved by various credit enhancement techniques. Typical forms of credit enhancement are: the build-up of a reserve account from excess spread as a buffer against defaulted assets; a senior/subordinated structure whereby the securities are divided into different classes according to seniority, with the most subordinated class first absorbing asset defaults; and external credit enhancement through a guarantee by a highly-rated third party. A securitisation transaction usually also benefits from liquidity support from a highlyrated third party to cover any timing mismatches between the receipt of cash flows by the SPV and the repayment of securities. In a securitisation transaction the originator receives the excess spread as profit extraction from the SPV. The originator normally also buys the most subordinated, or first-loss, class of securities. This means that the originator essentially faces all the benefits and risks associated with the assets that have been securitised. The result of this is that the originator will have to consolidate the SPV with its group accounts according to accounting regulations. Securitisation thus does not offer off-balance sheet treatment. However, it does reduce the cost of funds of an originating corporate, since the securities are backed by an isolated pool of assets and are therefore protected from any corporate credit and event risk. The asset-backed securities can thus attain a higher credit rating by the rating agency than the rating that the corporate would have received had it issued debt securities. A higher rating means less risk which translates into a lower cost of funding. 111

Securitisation does not normally reduce a bank s cost of funding, however it is a source of liquidity and diversifies the funding base. Securitisation is also an effective asset-liability management tool for a bank. Banks, in the normal course of their business fund long-term loans with short-term liabilities (deposits). Asset-backed securities are medium to long-term debt instruments and through securitisation, a bank can match the term of its funding with that of its loans. The greatest benefit for a bank however, is the ability to manage its regulatory capital requirements more efficiently through the use of securitisation. Although the bank has to consolidate the SPV under accounting rules, it does not consolidate the SPV on its regulatory balance sheet, which means the bank can reduce the regulatory capital it is required to hold. This allows the bank to hold more loans on its balance sheet with the same amount of capital, thereby improving its return on capital. It is this regulatory arbitrage that has been the prime motivating factor for the use of securitisation by banks. Although almost any type of cash flow can be securitised, the majority of securitisation transactions are backed by loans. The predominant asset class is mortgage-backed securities, divided into residential mortgage-backed securities and commercial mortgage-backed securities. The securitisation of financial assets such as auto loans, equipment leases, trade receivables and credit cards falls into the asset-backed securities category, while the securitisation of bank loans and corporate bonds is classified as collateralised debt obligations. Included in the asset-backed securities asset class is also the securitisation of less well-known assets such as inventory, intellectual property, life insurance premiums and non-performing loans. Whole-business securitisation is a separate asset class that combines securitisation techniques with secured lending. Another asset class is future flow securitisation, which has some similarities with whole-business securitisation in that the transaction also depends on the ongoing financial viability of the originator of the assets. Asset-backed commercial paper is an asset class which, strictly speaking, is more of a securitisation technique than an asset class itself. Almost all types of financial assets can be securitised under assetbacked commercial paper programmes, which fund the acquisition of financial assets and rated securities through the issuance of short-term commercial paper. These programmes rely on liquidity support to cover the difference in term between long-term assets and short-term liabilities. 112

CHAPTER THREE AN OVERVIEW OF CREDIT DERIVATIVES AND SYNTHETIC SECURITISATION 1. INTRODUCTION The purpose of this chapter is to trace the development of the synthetic securitisation market and to investigate the various synthetic securitisation structures. Securitisation can be divided into cash flow securitisation, also called traditional securitisation, and synthetic securitisation. Chapter 2 described the process of cash flow securitisation and in this chapter the development of the synthetic securitisation market is traced. Credit derivatives are the building blocks for the process of synthetic securitisation and an understanding of these instruments is a prerequisite for understanding synthetic securitisation. The different credit derivative structures are examined, with the emphasis on the features of the most common credit derivative structure, which is the credit default swap. It is important to realise that the use of credit derivatives in synthetic securitisation is only a part of their function. The most widespread use of credit derivatives is as instruments to reallocate credit risk between different counterparties, and credit derivatives are typically constructed as over-the-counter derivatives, meaning that credit derivatives are entered into directly between counterparties instead of being traded on an organised exchange. Credit derivatives are part of the larger market of financial derivatives and their development is a logical extension of the ever-growing number of different types of derivatives. In common with other financial derivatives, credit derivatives comprise contracts that transfer the volatility in price or performance of a reference contract or asset. Credit derivatives comprise a variety of financial contracts and techniques designed to desegregate and transfer credit risk from underlying financial instruments such as bonds and loans. Credit derivatives were derived from banks need to manage their illiquid credit concentrations. Banks are efficient originators of loans because of their superior access to corporates. Yet, banks are not the best holders of these loans because credit risk increases exponentially with credit concentration. Banks suffer from a credit paradox. This reflects the situation where a bank concentrates its loan origination and credit granting in the areas where it has expertise in order to minimise the credit risk of its asset portfolio. This, however, increases the bank s concentration risk, which reduces the overall quality of its asset portfolio. Credit derivatives provide a solution to this dilemma. They allow 113

a bank to continue lending in its areas of expertise without increasing its credit concentration risk. As credit derivatives do not require interaction with the original borrower, these instruments enable banks to diversify credit risk while leaving customer relationships intact. A credit derivative is a financial instrument by which credit risk is transferred, at a cost, to another party without disturbing the underlying relationship with the client. Generally the value of a credit derivative is determined by reference to the credit performance of an underlying debt instrument such as a bond or loan, which is called the reference asset or reference obligation. For the most part, credit performance is measured by reference to credit or default status, or yield and price sensitive benchmarks. Credit derivatives also permit the trading of credit risk without actual ownership of the reference asset. Credit derivatives were originally developed by the banking industry for self use only, and the majority of the turnover is generated through the interbank market. Non-bank firms and investors are increasingly active in the market, since credit derivatives as tools for credit risk reduction and diversification can be widely and industry-independently used. The creation of synthetic investments, the arbitrage of market inefficiencies, and the possibility to implement spread expectations have created opportunities for asset managers, pension funds, insurance companies and other investors. A synthetic securitisation is not a type of credit derivative, but rather a form of securitisation. The term synthetic is used to distinguish it from traditional cash securitisation and to describe the process whereby the risks and rewards of an underlying asset are transferred synthetically without actually transferring the asset itself as is the case in a cash securitisation. Synthetic securitisation structures rely heavily on credit derivative instruments. The credit derivative instruments used in synthetic securitisations to transfer risks and rewards are credit default swaps and total return swaps, and the instrument offered to investors is a credit-linked note. Synthetic securitisation developed as a combination of traditional cash flow securitisation and credit derivative techniques. In a synthetic securitisation, instead of a true sale of the assets from the originator s balance sheet, there is only a transfer of the credit risk of a reference asset portfolio through the use of credit derivatives. Since there is no physical or legal transfer of the assets, synthetic securitisation is particularly beneficial for bank loans, which usually have restrictions such as borrower notification and consent on loan sales. Synthetic securitisation is also less administratively burdensome, and is attractive due to its ability to transfer portions of credit exposures and contingent exposures. The greater flexibility even allows for structures tailored around the needs of a single 114

investor. Generally, there is no interest rate mismatch or maturity mismatch between the assets and liabilities in a synthetic transaction. Given these advantages, the synthetic securitisation market has grown rapidly, and new highly innovative structures are being developed aimed at continuously driving market growth. The typical synthetic securitisation structure is in the form of a collateralised debt obligation (CDO). The difference between a cash CDO and a synthetic CDO, however, is that cash CDOs are cash instruments with a physical transfer of assets into the structure, whereas in the case of synthetic CDOs, only the credit risk is transferred and there is no physical transfer of assets. 2. THE DEVELOPMENT OF CREDIT DERIVATIVES Credit risk 29 is arguably the most significant form of risk that capital market participants face (Finnerty:3). Credit derivatives 30 emerged in the early 1990s as useful risk management tools. They enable market participants to separate credit risk from other types of risk such as currency risk or interest rate risk and to manage their credit risk exposures by selectively transferring unwanted credit risks to others. This uncoupling of credit risk from other types of risk created new opportunities for both hedging and investing. Credit derivatives are over-the-counter (OTC) 31 derivative contracts the value of which derives, at least in part, from the credit performance of a reference asset 32 (Herring, 1998:11). The reference assets could include bonds, bank loans or some other credit instrument. In essence, credit derivatives allow market participants to trade the credit risk embedded in reference assets and to construct synthetic investments with specific term and risk profiles. Credit derivatives are new, although options that pay in the event of default have existed for many years, dating back to the introduction of bond insurance in 1971 (Finnerty:3). Letters of credit and guarantees, which pay in the event of default, have been around even longer. In their simplest form credit derivatives are very similar to letters of credit and guarantees (Watzinger, 1998:23). The difference is that letters of credit and guarantees are typically assigned to a specific transaction and 29 Credit risk refers to the risk that an asset such as a bond will lose value because of a reduction in the issuer s capacity to make payments of interest and principal. Default risk refers to the likelihood that the issuer will actually fail to make timely payments of interest and principal. 30 A derivative contract, or derivative for short, is a bilateral contract whose value derives from the value of some underlying asset or index. 31 Meaning direct between counterparties or privately negotiated contract. 32 The terms reference asset and reference obligation is used interchangeably. A bank loan to a borrower (reference entity) is an asset from the bank s perspective and an obligation from the borrower s perspective. 115

cease to exist without it, whereas credit derivatives can transfer risk irrespective of an underlying exposure. With a credit derivative the reference entity, or borrower, whose risk is being transferred need neither be a party to, nor be aware, of a credit derivative transaction. This confidentiality enables users of credit derivatives such as banks to manage their credit risk discreetly without interfering with customer relationships. Since the borrower is not involved, the terms of the credit derivative transaction can be customised to meet the needs of the buyer and seller of risk, rather than the needs of the borrower. Moreover, because credit derivatives isolate credit risk from the relationship, credit derivatives introduce discipline to pricing decisions. Credit derivatives provide an objective market pricing benchmark representing the true opportunity cost of a transaction (JP Morgan:4). The use of credit derivatives continues to expand and participants in this market include banks, corporates, hedge funds, insurance companies, asset managers, pension funds and structured finance vehicles. In the latest global survey by Fitch Ratings, the credit derivatives market grew from US $1.8 trillion in 2003 to US $3 trillion in 2004 (2004a:1). The growth to date, especially the rapid growth from 1998 onwards, has been driven by several factors. Banks, which are under increasing pressure to improve their financial performance, have turned to credit derivatives in order to manage the concentration and correlation risks in their loan portfolios more actively as well as managing the economic 33 and regulatory capital required to support their operations. It was in the period following the Russian default in 1998 however, that the credit derivatives market seemed to come of age (Bowler and Tierney, 1999:3). Although the Russian crisis highlighted a number of documentation and administration problems, in most respects the credit derivatives market worked the way it was supposed to and illustrated how credit risk can be transferred between counterparties. Another key factor that spurred the growth of credit derivatives was the standardised credit derivative definitions introduced in 1999 by the International Swaps and Derivatives Association (ISDA). These common set of definitions eliminated the documentation and legal risk that had existed up to that time due to a lack of standard terms and definitions. In 2003 ISDA published its new credit derivative definitions and master agreement (Cunningham et al., 2003:1). 33 Economic capital is the capital banks set aside as a buffer against potential losses inherent in any business activity e.g. corporate lending or currency trading. 116

There are three basic ways to structure a credit derivative (Finnerty:4). The first is by linking a stream of payments to the total return on a specified reference asset. The total return receiver is exposed to the credit risk of the reference asset because this risk is embedded in the total return payment stream. A total return swap is an example of such a structure. The second is by basing the payoff on a specified credit event, such as a loan default or bond rating downgrade. The payer serves as an insurer and bears the credit risk associated with the credit event. A credit default swap is an example of such a structure. The third is by tying the payoff to the credit spread 34 on a specified bank loan or bond. The seller of a credit spread put option serves as an insurer and bears the risk that the credit quality of the reference asset might deteriorate causing the credit spread on the reference asset to widen. A credit spread option is an example of such a structure. The reference asset is frequently a credit obligation e.g. a loan or bond, although it may also be a portfolio or market index (Bowler and Tierney, 1999:19). Neither the buyer of protection nor the seller of protection needs to own obligations of the reference entity, although, if the contract is to be settled in the form of bonds or loans 35, the protection buyer should be sure of being able to obtain them in the market and having the legal right to transfer them. The protection buyer sheds the risk of the reference entity, but bears the risk that the counterparty, the protection seller, will not perform either because of its inability to do so due to e.g. its insolvency, or because of legal disputes regarding the terms of the contract. The protection seller acquires the risk of the reference entity with the associated earnings, without having to service the client relationship. Conversely, the protection buyer retains the client relationship without retaining the credit risk (Azarchs, 2003:12). 2.1 Total Return Swaps A total return swap is a derivative contract whereby one party, the total return receiver or rate payer, makes periodic fixed or floating rate payments to another, the total return payer, and receives from 34 The credit spread is the difference between the yield on the borrower s debt, i.e. the reference asset, and the yield on a risk-free security of the same maturity. Since a risk-free security such as a government bond is free of any default risk, the credit spread provides a measure of the extra yield investors require to compensate for default risk. 35 Called physical settlement, it is discussed in the section dealing with credit default swaps. 117

the total return payer the total return, that is the interest payments plus or minus price changes, of a reference asset for the period of the contract (Herring, 1998:14). Pays interest from reference asset plus market value appreciation Total return payer Total return receiver (Rate payer) Pays JIBAR plus financing spread and market value depreciation Return on asset Reference asset Diagram 3.1: Total return swap On a regular basis, e.g. quarterly or semi-annually, the total return payer, which is the protection buyer, pays the total return receiver, which is the protection seller, the interest received on the reference asset plus any price appreciation during the period of the contract. The total return receiver makes a regular payment to the total return payer, based on an agreed interest rate benchmark plus a spread, plus any price depreciation on the reference asset during the period of the contract. Thus, total return swaps represent the economic equivalent of buying or selling a reference asset (Azarchs, 2003:13). Total return swaps can replicate and trade the total performance of most credits and are especially well suited to the synthetic trading of bank loans (Herring, 1998:14). A total return payer such as a bank can hedge all credit risk on a loan that it has originated while the total return receiver can gain access to the risk and return of the loan without the cost of originating and administering it. In effect the total return receiver takes a long position in the reference asset without physically owning and funding it 36. Should the value of the reference asset decline by more than the amount of the interest received on the reference asset, the total return receiver must pay to the total return payer the negative total return in addition to its regular payment based on the interest rate benchmark plus a spread. If the value of the reference asset falls to zero due to default, the total return receiver must compensate the total return payer for the loss. The total return receiver is 36 Assume an investor seeks exposure to a loan yielding JIBAR plus 175 basis points that a bank has made to a corporate. The investor enters into a total return swap with the bank whereby it pays JIBAR plus 75 basis points and receives JIBAR plus 175 basis points, plus or minus any change in the market price of the loan. If the value of the loan value remains unchanged over the life of the contract, the investor earns 100 basis points on the transaction. 118

exposed to negative price movements arising from both a deterioration in credit quality and a general decline in market prices (of fixed-rate bonds) due to a rise in interest rates (Bowler and Tierney, 1999:19). Total return swaps thus pass on the entire market risk, in addition to the default risk, of owning a reference asset to the total return receiver. Early repayment risk is also borne by the total return receiver (Herring, 1998:15). 2.2 Credit Default Swaps A credit default swap (CDS) is a derivative contract whereby one party, the protection seller, receives fixed periodic payments from another, the protection buyer, in return for making a single contingent payment covering losses on a reference asset following a credit event such as a loan default or borrower bankruptcy (Herring, 1998:15). Marketable bonds are the most popular form of reference asset because of their price transparency. While bank loans have the potential to become the dominant form of reference asset because of their sheer quantity, this is impeded by the fact that loans are more heterogeneous and illiquid than bonds (Kiff and Morrow, 2000:4). Pays spread over JIBAR multiplied by the notional amount of the contract Protection buyer Protection seller Exposure to asset risk Payment covering losses if credit event occurs Reference asset Diagram 3.2: Credit default swap (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 2.2.1 Single-Name Credit Default Swap A single-name credit default swap transfers the credit risk of a single reference asset from the protection buyer to the protection seller. The term and the notional amount of the credit default swap do not have to correspond to the term or notional amount of the reference asset (Bowler and Tierney, 1999:12). The main purpose of the reference asset is to specify exactly the capital structure seniority of the debt that is covered. It is common to specify a reference asset with a longer maturity 119

than the credit default swap (O Kane, 2001:26). The notional amount of the swap is the maximum monetary amount of exposure under the contract (Adelson and Whetten, 2004a:5). The protection buyer pays the protection seller a spread over an interest rate benchmark representing the risk premium appropriate for the reference entity, multiplied by the notional amount of the contract. Generally the premium payment, which is specified at the beginning of the transaction, is made periodically, usually quarterly (Francis et al., 2003:11), although it may be paid as an upfront fee for short-dated transactions (Bowler and Tierney, 1999:9). The swap s contingent credit event payment is normally calculated as the fall in price below par of the reference asset. If the agreedupon credit event occurs, the protection seller must either accept delivery and pay the par value for the now-depreciated reference asset, or compensate the protection buyer in cash (Azarchs, 2003:12). The protection buyer stops paying the regular premium following the credit event. A credit default swap can thus be viewed as a mechanism to strip off an asset s default risk and trade it separately. Through the use of credit default swaps the protection seller earns income with no funding costs, while the protection buyer hedges the credit risk of the reference asset 37. 2.2.2 Multi-Name Credit Default Swap In the case of a multi-name credit default swap the credit event is tied to a portfolio or basket of reference assets (Finnerty:23). There are two types of multi-name credit default swaps, namely firstto-default basket swaps and second-to-default basket swaps. 37 Assume a bank has just extended a five-year R250 million loan to a corporate. The bank does not require a full hedge against this credit risk, and purchases protection on a R100 million notional amount for a period of two-years, and agrees to pay 100 basis points per annum to the protection seller. The bank will therefore pay R1 million per annum (R250,000 per quarter) to the protection seller until a credit event occurs, or until the agreement expires after two years. If a credit event occurs within the two-year period, the bank will deliver R100 million in face value, though likely worth less due to the credit event, of the corporate s debt to the protection seller for a consideration of R100 million. Alternatively, the contract can specify cash settlement following a credit event, which requires that the seller makes a payment to the buyer equal to the difference between the initial price, usually par, and the current price of the debt based on the valuation procedure indicated in the contract. In this example, if the recovery value of the defaulted debt is determined to be R60 million, then the protection seller will pay the bank par minus recovery, which is R40 million. 120

2.2.2.1 First-to-Default Basket Swap In a first-to-default basket swap the seller assumes the default risk on a basket of reference assets by agreeing to compensate losses on the first asset in the basket to default (Herring, 1998:15). The basket would consist of several equally-rated reference assets, each having the same notional amount and largely similar credit features. The swap terminates when the first credit event occurs and the contingent payment is made. From the viewpoint of the protection buyer of a first-to-default basket swap, this implies that the buyer has protection for all the assets in the basket during the tenure of the contract, however the actual compensation will be limited to only one asset. The buyer is banking on the probability that if one of these assets defaults, the probability of any other asset also defaulting is minimal. This necessitates that the basket consists of mutually uncorrelated or lowly-correlated assets since a joint default in the basket would render unfructuous the very purpose of the basket trade (Kothari, 2002:112). From the protection buyer s view the basket swap is a lower cost method of hedging multiple assets, in effect providing an equity cushion to the asset portfolio. However, since the seller is exposed to the notional amount of only one asset, (the first-to-default), the buyer retains the residual risk of multiple defaults, which represents the imperfect hedge for the buyer. The potential cost of managing the hedge will determine the price the buyer is prepared to pay for protection (Francis et al., 2003:86). The protection seller is motivated primarily by the leverage provided by the structure. Providing protection for a first-to-default asset in a basket is similar to supporting the portfolio with equity. Equity bears the risk of the entire portfolio, but is exposed to losses not exceeding the amount of equity (Kothari, 2002:112). For example, in a basket of five reference assets the seller is exposed to the credit risk of five assets, and the seller receives a premium that is higher than any individual swap to reflect the higher risk. However, in the event of a default of an asset, the seller s maximum loss is limited to the notional amount of only one of the assets. The seller has effectively sold five different swaps, but, after the first credit event, the remaining swaps are knocked out (Francis et al., 2003:85). A basket credit default swap takes the form of a portfolio of put options, which are contingent upon one another because once one of the options pays off, the others automatically expire (Finnerty:23). 2.2.2.2 Second-to-Default Basket Swaps In a basket trade another option is to opt for second-to-default protection. This implies that the first loss in the basket will be borne by the protection buyer, and the protection seller will be exposed to the risk of the second asset defaulting. The risk transferred to the seller is thus much less and would 121

depend on the extent of asset correlation in the basket. A second-to-default swap allows the buyer to cap its losses (Kothari, 2002:113). Basket premiums in multi-name credit default swaps are driven by several factors including the quality of the assets, default correlations and number of assets in the basket. The greater the correlation, the greater the probability of multiple defaults and the lower the value of protection to the buyer, and hence a lower premium. A basket that is based on reference assets with a low likelihood of multiple defaults i.e. low correlation would provide the seller with the highest leverage and the buyer with the most effective hedge. Assuming constant correlation, an increase in the number of assets increases the basket premium. As more assets are added to the basket, the risk of the first-to-default event increases and the seller requires a greater level of compensation (Francis et al., 2003:90). 2.2.3 Portfolio Credit Default Swap A portfolio credit default swap is one where each of the reference assets in the portfolio triggers a protection payment. Unlike a single asset credit default swap, the swap is not terminated on a credit event of any of the assets, and continues for its full tenure (Kothari, 2002:112). The risk can be tranched in using a series of loss thresholds, with the protection seller making loss settlement payments once the cumulative losses in the reference portfolio have exceeded the relevant loss threshold (Fitch Ratings, 2002:3). Portfolio credit default swaps differ from basket default swaps in two ways: first that the size of the underlying portfolio is much larger, consisting of 40 100 reference assets, and second, when the risk is tranched, the redistribution of the risk is specified in terms of the percentage of the portfolio loss rather than the number of reference assets 38 (O Kane, 2001:53). 2.2.4 Index Credit Default Swaps Index credit default swaps, which are credit default swaps on publicly disclosed indices of corporate credits, have become increasingly popular (Standard & Poor s, 2004:1). There are two broad index families the TRAC-X indices, which are administered by Dow Jones, and the CDX indices, 38 Assume a portfolio of 50 names, each name with a notional amount of R50 million, in total R2.5 billion, which has been tranched into a 10% first-loss tranche and a 90% second-loss tranche. The investor (protection seller) in the firstloss piece is therefore exposed to whatever number of defaults that would reduce the portfolio notional by 10% or R250 million. 122

administered by iboxx, as well as other index classes for different market and geographical segments. The indices typically comprise 50 to 150 names in the credit default swap market. The main selling point of all of the indices is that they seek to represent a particular market. The reference assets in the indices are generally highly liquid, well known, and diverse within the limits of the index (ibid.). Indices are constructed to closely represent the market as a whole, which means that indices are powerful tools to manage MTM risk. A seller of protection under a credit default swap seeking to offset spread volatility could purchase protection on an index. In such a case, rising spreads in the market would lead to an MTM loss on the sold protection leg of this hedge and an MTM gain on the bought protection leg. Also, an investor who wants exposure to the entire market and thus sold protection on an index, but does not like certain industries such as telecoms, can buy protection through the CDX telecoms index, thus neutralising this part of its exposure. Terminology: A potential source of confusion is the terminology used to describe what is being bought and sold in a credit default swap. The buyer of protection can also be seen as selling risk, analogous to a holder of a bond selling the bond, thereby eliminating credit risk exposure to that bond. Likewise the seller of protection is buying risk in the same way as an investor who purchases a bond and assumes credit risk. The credit default swap market has, however, moved decisively in the direction of treating credit default swap transactions as purchases and sales of protection, rather than sales and purchases of risk (Bowler and Tierney, 1999:10). Another point of confusion is that credit default swaps are sometimes referred to as credit default options (Bowler and Tierney, 1999:11). This may have come about because the contract involves payment of a fee or premium by the protection buyer in return for a payoff should a credit event occur, thus exhibiting characteristics similar to an option contract. Indeed the earliest credit default swaps were referred to as default puts because a credit default swap can be viewed as a put option whose payoff is tied to a particular credit event (Finnerty:15). However, a key characteristic of options is their asymmetrical payoff and price performance when the price of the underlying asset changes. By contrast, in the case of credit default swaps, the price of the swap varies directly with changes in the price or credit spread of the reference asset, in much the same way that the price of an interest rate swap varies directly with changes in the underlying interest rate. The use of the word swap however, can also be misleading, with contract perhaps a better way of describing the arrangement between buyer and seller of protection. According to a report in 2001 by Bank of America Securities (cited in Watts, 2003:10), the product name reflects its genesis within traditional interest rate swap groups and the use of traditional swap documents also to document credit default swaps. A credit default swap is not really a swap in the sense of continuing exchange of payments since there is only a swap when a credit 123

event triggers a compensating payment. Nonetheless, the term credit default swap has become widespread. A credit default swap is similar in economic substance to a guarantee or credit insurance policy to the extent that the protection seller receives a fee ex ante for agreeing to compensate the protection buyer ex post, but without providing funding. Guarantees and credit insurance are designed to compensate a particular protection buyer for its losses if a credit event occurs. They are state-dependent, i.e. whether a credit event has occurred or not, and outcome-dependent, i.e. whether the buyer has suffered a loss or not. A credit default swap, by contrast, is state-dependent, but outcomeindependent. Payment by the protection seller under the contract is triggered by defined credit events regardless of the exposures or actions of the protection buyer. The single-name credit default swap market allows a protection buyer to strip out the credit risk of a variety of exposures e.g. bonds, loans and trade credit to corporates or governments that it has, and transfers it using a standardised financial instrument. Equally, market participants can buy or sell protection for reasons of speculation, arbitrage or hedging, even if they have no direct exposure to the reference entity (Rule, 2001:118). A credit default swap is both an asset and a contingent liability. Selling protection through a credit default swap creates exposure to the credit risk of the underlying asset, but also to counterparty risk, as the protection buyer has to make periodic premium payments. Buying protection through the swap creates exposure to the protection seller, which has to make the contingent payment after the occurrence of a credit event (Standard & Poor s, 2003:section 1:4). Unless the protection seller has a very high credit rating, the protection buyer generally will require the protection seller to post collateral as security for its obligation to pay if a credit event occurs. However, the amount of collateral that the protection seller would have to provide would normally be substantially less than the full notional amount of the credit default swap (Adelson and Whetten, 2004a:5). Although buying protection is similar to selling (shorting) a cash instrument, and selling protection is similar to be buying (going long) a cash instrument, credit default swaps and cash instruments are not identical investments. Direct investment in fixed-rate corporate debt contains interest-rate and funding risk. Nevertheless, interest-rate risk in a credit default swap is eliminated because there is no initial cash outlay, and there is no funding risk because there is no need to borrow. The unfunded nature of a credit default swap thus creates a pure credit risk position (Bakalar and Prince, 2003:7). 124

2.3 Credit Spread Options A credit spread option is an option on a particular borrower s credit spread (Finnerty:27). Credit spread option contracts isolate and capture devaluations in a reference asset that are independent of shifts in the general yield curve. Essentially they are credit default swaps that stipulate spread widening as a credit event. The spread is usually calculated as the yield differential between the reference asset, typically a bond, and an interest rate swap of the same maturity. 39 Unlike credit default swaps, a credit event does not have to be defined. The payout by the protection seller occurs regardless of the reasons for the spread movement (Kiff and Morrow, 2000:4). Pays option premium Protection buyer (Option buyer) Protection seller (Option seller) Exposure to asset risk If reference asset spread > specified credit spread, then: Pay-out = Notional amount (Final spread strike spread) Reference asset Diagram 3.3: Credit spread option (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In the case of a credit spread option, a reference asset is selected and a specific threshold, the strike spread, and exercise date is set. The protection buyer pays an option premium, usually in advance, but in some cases a series of payments, in return for the protection seller agreeing to make a lump sum payment should the reference asset s credit spread be higher than the strike spread. The payoff is based on whether the actual spot spread at the exercise date is over or under the spread of the reference asset. If the reference asset s spot spread remains below the strike spread at the exercise date, then the option expires worthless. For example, a bond investor may want to protect itself against the risk that the bond s credit rating will be downgraded, in which case the credit spread of the bond will widen and the bond s price will fall. Buying a credit spread option would provide the 39 Yield spreads are often calculated against government bonds, but such spreads implicitly measure a combination of credit risk and liquidity preference. Measuring the spread against the swap curve more effectively identifies changes in the perception of credit risk. 125

desired protection since the protection seller will pay out the difference between the now higher final spread and the strike spread agreed when the option was bought. By separating credit spread risk from market risk and interest rate risk, credit spread options allow investors to hedge credit spread risks fully and protect them from market developments such as ratings downgrades. The higher the strike spread is above the current spread of the reference asset, the more the credit spread option resembles a credit default swap whereby the investor pays a small fee to buy protection against a massive downward shift in the price of the reference asset 40 (Herring, 1998:19). As with standard options, details which must be specified are: whether the option is a call or a put; the expiry date of the option; the strike price or strike spread; and whether the option exercise is European (single exercise date), American (continuous exercise period), or Bermudan style (multiple exercise dates). A put option on the credit spread is equivalent to a call option on the bond price, and a call option on the credit spread is equal to a put option on the bond price (O Kane, 2001:39). 2.4 Credit-Linked Notes Credit-linked notes (CLNs) can be thought of as being structured notes 41 with embedded credit default swaps (Bowler and Tierney, 1999:15), or alternatively as collateralised credit default swaps. The issuer of a credit-linked note receives from the investor cash in advance in the amount of the par value of the note. At maturity of the note, principal is only returned in full to the investor if no credit event has occurred with regard to the reference asset. The credit event in a credit-linked note can be linked to a variety of reference assets. If a credit event occurs, the note matures and the investor sustains a loss based on the reference asset s loss. In effect, the investor sells protection on the reference asset and receives a premium in the form of an attractive yield spread. The issuer of the note, on the other hand, is purchasing default protection on the reference asset. The issuer, as protection buyer, pays the investor, as protection seller, interest payments representing the risk premium appropriate to the issuer s own obligations plus the risk premium appropriate for the reference asset. The benefit of this type of structure to the protection buyer is that it holds cash as 40 Assume an investor sells for 15 basis points a one-year credit spread option with a strike spread of 220 basis points to a bondholder which holds a bond currently yielding 200 basis points above JIBAR and wishes to protect its market price against any credit spread increase over 220 basis points. If the bond s credit spread remains below 220 basis points at the end of the transaction, then the option expires worthless and the investor has earned a premium of the notional multiplied by 15 basis points. If the bond s spread has risen above 220 basis points at the expiry of the contract then the bondholder can exercise its option to sell the bond at the strike spread and the investor buys the bond at 220 basis points. Alternatively the investor can settle the trade by paying the bondholder the notional amount multiplied by the difference in basis points between the final spread and the strike spread. 41 A structured note is a package consisting of a conventional fixed-rate or floating-rate note and a derivative instrument embedded in it. In a credit-linked note the derivative instrument is a credit default swap. 126

collateral that effectively eliminates the counterparty risk of the protection seller. The cash also represents funding for the buyer (Azarchs, 2003:12). Interest plus default premium Reference asset Exposure to asset risk Protection buyer (Note issuer) Note proceeds Protection seller (Note purchaser) At maturity, par less depreciation in reference asset due to any credit events Credit protection Diagram 3.4: Credit-linked note (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) CLNs can be structured to provide for a full return of the principal amount. In such a principalprotected note, if a credit event occurs, the note remains outstanding until its maturity date but ceases to pay interest. Principal-protected notes pay less interest than conventional CLNs, but at maturity the investor is repaid the principal amount (Bowler and Tierney, 1999:16). Alternatively it can be structured with coupon protection instead. Other variations include linking a CLN to credit spreads rather than credit events as such, or referencing it to a credit index. CLNs allow investors and non-bank lenders to participate in the corporate bank loan market while still investing in securities. If the CLN pays interest on the same basis as the corporate loan, the investor has essentially all the risks and rewards of the bank loan without having to take ownership of the loan 42 (Finnerty:40). The performance of the CLNs is directly linked to the performance of the reference pool, and the notes are direct obligations of the issuing institution. As a result, the highest rating assigned to the notes typically is capped at the senior rating of the issuer, in the absence of some structural mechanism. However, with a CLN structure, it is also possible to achieve a rating above the issuer s long-term rating. For this to occur, the issuer purchases collateral rated higher than the rating of the 42 An investor seeks synthetic exposure to a corporate to which a bank has made a loan. The investor purchases a creditlinked note referencing the loan. The note pays an above-market coupon as compensation for the risk the investor takes. If the loan s value remains unchanged over the life of the contract, the investor redeems the note on its expiry at par. If the corporate defaults on its loan and the bank recovers, for example, 30 cents in the Rand, the transaction expires and the note is called. The investor redeems the note for the notional amount multiplied by the 30% recovery rate of the reference asset. 127

issuer and pledges this collateral to a trustee in favour of investors to protect their claims under the CLNs. While the investors still have a claim against the issuer, the rating of the CLNs is no longer directly linked to the issuer s debt rating (Bund et al., 2001:3). CLNs may also be issued from a collateralised SPV, which allows investors who cannot trade derivatives, or do not have an ISDA master agreement, access to the credit derivative market (The Treasurer, 2002:1). Premium Jibar plus premium Protection buyer SPV (Protection seller) CLN investor Credit protection Note proceeds Jibar Note proceeds Reference portfolio Collateral Diagram 3.5: CLN issued by an SPV (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In the typical structure, the protection buyer sets up an SPV to serve as counterparty to the credit default swap, making the SPV the provider of protection. The SPV is funded with the proceeds of notes issued to investors, and the proceeds are invested in highly rated securities in such a way that the ratings of the notes can be de-linked from the protection buyer. As the collateral eliminates the counterparty exposure between the protection buyer and the CLN investor, it broadens the range of investors who can participate in the credit derivatives markets (O Kane, 2001:36). The collateral will be used to make credit events payments if required, and to return any remaining principal to investors at the transaction s maturity (Tolk, 2001:3). If a credit event occurs, the CLN investor, as the ultimate protection seller, will suffer a loss equivalent to the amount of collateral used by the SPV to make a credit event payment to the protection buyer. The investor s return for taking on this risk comprises the interest on the collateral, plus the credit protection premium received from the protection buyer. 128

3. THE DEVELOPMENT OF SYNTHETIC COLLATERALISED DEBT OBLIGATIONS Synthetic CDOs developed from cash CDOs. The first synthetic CDO transactions ( synthetics ) were done by banks in 1997 43 (Goodman, 2002, cited in Gibson, 2004:2). Since then the market has grown dramatically. By 2002 the total European CDO market volume had reached US $183 billion, which represented a 42% year-on-year growth in volume, and an increase of roughly US $54 billion, compared to 2001. Approximately 96% of the deal volume in 2002 was issued in synthetic form (Frey, 2003:1). Cash CDOs typically involve an SPV acquiring bonds or loans, or a combination of both, and funding the acquisition by the issuance of notes to investors, which are exposed to the credit risks of the underlying asset portfolio. In a synthetic CDO the investor s exposure to the credit risks is created synthetically. Instead of the SPV purchasing the assets directly, the SPV enters into a portfolio credit default swap, or a series of single-name credit default swaps, with the protection buyer e.g. a bank (which would have been the seller of the assets under a cash CDO). The aim of this structure is to synthesise the credit risks of buying a referenced pool of assets by using a credit derivative. The CDO investors effectively act as the sellers of credit protection on a pool of reference assets to a single counterparty or multiple counterparties. This is analogous to a pure CLN, but with the two key differences listed below (Frey, 2003:2). The notes risk and return are linked to a pool of assets i.e. there is a portfolio effect. The notes are tranched to give investors different, leveraged credit risk exposures to the pool. This tranching of credit risk is a defining feature of both cash and synthetic CDOs. Losses will first affect the equity or first-loss tranche, next the mezzanine tranche, and finally the senior and super-senior tranches (Gibson, 2004:1). An early driver for the use of synthetics was that problems were experienced with the transfer of loans from an originating bank to an SPV in a cash structure, since loans were not created to be tradable and borrowers often restricted the bank s right to sell the loan. Cash CDOs therefore require much more legal due diligence to ensure adherence to all contractual terms or legal definitions. Synthetic CDOs sidestep this problem altogether because there is no physical transfer of assets. This saves both time and money. Synthetic structures can also facilitate exposure to assets 43 According to Goodman, the first synthetic CDOs in 1997 were structured by Swiss Bank Corporation ( Glacier Finance ) and J.P. Morgan ( BISTRO ). 129

that may be relatively scarce and difficult to acquire via the cash market. Contingent exposures, including undrawn revolving facilities and counterparty credit exposures, can also be accommodated with relative ease (Gerity et al., 2001:2). Another motivation is the flexibility provided by credit derivatives, which can be tailored to meet the specific needs of the originator and provide customised risk-return profiles to investors, and this factor has become the key driver in today s market (Frey, 2003:3). Cousseran and Rahmouni (2005:51) identify four generations of CDOs, from when cash flow CDOs first appeared at the end of the 1980s in the United States, to the latest types of synthetic CDOs. Cash flow CDOs Synthetic balance sheet CDOs Synthetic arbitrage CDOs Synthetic CDOs of ABS Synthetic CDOs of CDOs (CDO^2) Single-tranche synthetic CDOs CDOs of standard tranches of credit default swap indices Diagram 3.6: Different generations of synthetic CDOs The fast growth of the credit derivatives market as of the late 1990s was conducive to the expansion of the synthetic CDO market. Issuance of synthetic CDOs rapidly gained ground as the use of credit derivatives gradually extended to several hundred underlying names. This growth was particularly marked in Europe, due to persistent legal and market obstacles in some countries to securitisation transactions involving a true sale of underlying assets. By using a synthetic arbitrage structure it is possible to generate a substantial yield spread between the underlying asset portfolio and the liability tranches issued, and the proportion of synthetic arbitrage CDOs in total issuance increased substantially. The trend was fuelled by banks declining interest in balance sheet CDOs as they started to show a preference for managing the risk of loan portfolios through individual credit default swaps rather than through synthetic CDOs. The broadening of the range of underlying assets was also largely associated with the rapid and pronounced narrowing of credit spreads as of late 2002. As spreads narrowed, fewer assets offered sufficiently high yield to be worth securitising in arbitrage transactions, forcing CDO sponsors to use more specific underlying instruments that provided additional yield due to their complexity or lack of liquidity. This gave rise to the securitisation of existing structured finance products (CDOs of ABS, etc.). Similarly, issuance of CDOs of CDOs (CDO^2) emerged. As investors became increasingly familiar with the CDO market, they started to target either tailored or standard products. The demand for tailored products resulted in the creation of synthetic single-tranche CDOs. Conversely some market participants showed increasing interest in standard CDO tranches in order to maintain sufficiently liquid buy or sell positions for their active 130

portfolio management strategies. To meet this requirement synthetic CDOs based on standard tranches of indices representing credit default swap portfolios such as the Dow Jones itraxx index were created (Cousseran and Rahmouni, 2005:52). Within the realm of synthetic CDOs there are many variations among structures (Bakalar and Prince, 2003:6-9; Standard & Poor s, 2003:4-10, and 56-62; and Yoshizawa, 2003a:2-5). They differ by asset management (static vs managed), liability distribution (unfunded vs funded), liability structure (whole capital structure vs single-tranche), reference asset type (loans/bonds vs structured finance assets), and underlying motivation (balance sheet vs arbitrage). The common thread among all of these structures is the synthetic nature of the credit risk exposure. 3.1 Static Synthetic CDO In a static transaction, the initial reference portfolio is selected at the outset and does not change over the life of the transaction. All parties are cognisant of the specific reference obligations included in the portfolio. Often the protection seller (investor) has significant input into which names are included. There is no risk that during the life of the transaction certain obligations can be switched for lower quality obligations (Adams et al., 2004:2). 3.2 Managed Synthetic CDO In a managed transaction, changes can be made to the reference portfolio by a third-party manager, the investor, or the dealer who is arranging the transaction. The transaction can thus benefit from the ability to switch obligations for the sake of maintaining or improving the performance or risk profile of the underlying portfolio (Adams et al., 2004:2). The investment manager actively manages the portfolio within specified guidelines. In a managed transaction, the SPV enters into credit default swaps through a single basket credit default swap to one counterparty, selling protection on a portfolio of reference assets, or through multiple single name credit default swaps with a number of swap counterparties. The latter arrangement is more common and is referred to as a multiple dealer CDO (Choudhry, 2003b:39). A percentage of the reference portfolio will be identified at the inception of the transaction, with the remainder being selected during the ramp-up period ahead of closing. Thereafter the investment manager can trade out of its exposure in the following ways: 131

by buying credit protection from another credit default swap counterparty on the same reference entity; this will offset the existing exposure but there may be residual risk exposure unless the maturity dates of the swaps are matched exactly, or if there is a default in both the reference entity and the swap counterparty; by unwinding or terminating the credit default swap with the counterparty; and by buying credit protection on an asset outside the reference portfolio. Fitch Ratings (2003:2) identified a number of factors that has led to a shift towards managed synthetic transactions. Critics argue that static CDOs are not well diversified and are therefore vulnerable to both underlying entity-specific risk and market risk. Another criticism is the inability of static transactions to take losses early where credit deterioration and eventual default are considered inevitable. Some investors believe they have not been adequately compensated for the underlying risk associated with static portfolios where underlying credits are clearly deteriorating. Investors who own static CDOs are locked into portfolios often containing deteriorating credits, with little or no flexibility to transfer reference assets out of the portfolio to limit or prevent losses. Investors who own managed synthetic CDOs have a portfolio manager who has the flexibility to manage credit risk, and a good manager could improve portfolio performance. 3.3 Unfunded Synthetic Portfolio CDO In its most basic form a synthetic CDO is structured as an unfunded credit default swap between two parties whereby the protection seller makes payments as losses occur in the reference pool. Since the transaction is entirely unfunded, no cash is exchanged at the outset and if no credit event occurs, the only cash that would be transferred throughout the course of the transaction would be the premium paid by the protection buyer. The transaction can be layered to allow protection sellers to participate at different risk levels. 132

Premium Senior swap counterparty Reference portfolio Protection buyer Second-loss swap counterparty Credit protection First-loss swap counterparty Diagram 3.7: Unfunded synthetic portfolio CDO (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In unfunded transactions the protection buyer must rely on the protection seller s ability to make the required loss payment when a credit event occurs with respect to the reference portfolio, and therefore protection sellers may be required to post collateral with the protection buyer. Collateral posting are not generally one-for-one, but are rather based on the credit quality of the protection seller (Bakalar and Prince, 2003:7). Often an SPV is interposed between the protection buyer and the investors. The protection buyer enters into a credit default swap with an SPV, which in turn enters into credit default swaps with the individual investors. A periodic swap premium is paid by the protection buyer and passed through to investors on a priority basis, i.e. the senior-most investors receive their promised spread first, then the next most senior investors, and so on. As losses occur on the reference portfolio, the investors make protection payments in reverse priority order (Yoshizawa, 2003a:4). Premium Premium Senior swap counterparty Protection buyer SPV Second-loss swap counterparty Credit protection Credit protection First-loss swap counterparty Reference portfolio Diagram 3.8: Unfunded synthetic CDO with an SPV (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 133

3.4 Funded Synthetic Portfolio CDO Many investors are unable to sell protection in unfunded form. In order to meet the appetite of these investors for credit risk, transactions can be structured in a funded form. A funded synthetic CDO is a more complex structure than an unfunded one. It still involves a credit default swap where the buyer of protection transfers the risk of a portfolio of assets to the seller of protection. To expand the investor base and remove counterparty credit risk, the structure incorporates CLNs, which are funded instruments. The CLNs can be issued by a newly created SPV, an existing multi-issuing SPV, or a bank under an existing MTN programme. Senior CLN investor Premium JIBAR + premium Protection buyer SPV (Protection seller) Mezzanine CLN investor Credit protection JIBAR Note proceeds Note proceeds First-loss CLN investor Reference portfolio Highly rated collateral Diagram 3.9: Funded synthetic portfolio CDO (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) More often than not, funded synthetic CDOs incorporate an SPV, which issues CLNs to investors and uses the proceeds to invest in collateral (Bunja, 2003:2). Under this format the SPV is used to provide a bankruptcy-remote depository for the collateral. The collateral is used to secure the SPV s obligations under both the credit default swap and the notes. Usually the collateral consists of high quality, highly liquid AAA -rated government obligations, cash, GIC 44 (Guaranteed Investment Contract) accounts, or securities typically acquired via a reverse repurchase agreement or put agreement. The SPV will periodically need to pay interest to noteholders and fees to various parties involved. The source of these payments is a combination of the premium payments received from the protection buyer and income received from the collateral. 44 A GIC is a deposit account that pays a specified fixed interest rate, or a specified spread in relation to a benchmark interest rate, during its term. 134

When a credit event occurs with regard to a reference entity in the reference pool, collateral is liquidated in an amount equal to the loss incurred on the reference entity, and the SPV as protection seller pays the proceeds to the protection buyer. The SPV will typically use the cash, sell the collateral, or return the collateral in return for cash in the event that a reverse repurchase agreement or put agreement is used. If the collateral matures on the same day as the maturity of the notes, there would be no need to sell the collateral as the cash will be available. However, if collateral securities need to be sold, the market risk needs to be analysed. Reverse repurchases and put options can be used to reduce the market value risk i.e. potential changes in the market value of the collateral. The SPV may enter into a repurchase agreement wherein the repurchase counterparty will agree to repurchase the collateral based on the initial market value. Alternatively, the SPV can purchase a put option from a derivatives counterparty whereby the SPV may put the collateral to the counterparty at the strike price, which would usually be at par (Bunja, 2003:4). With a reverse repurchase agreement or put agreement the counterparty risk needs to be analysed. Losses are applied to the CLN investors in reverse order of priority by writing down the notes according to the amount of the loss, though sometimes the realisation of the loss is postponed until the maturity of the transaction, allowing noteholders to earn interest on the entire outstanding amount of their investment (Bakalar and Prince, 2003:8). At maturity the remaining collateral is liquidated and the resulting funds are used to repay principal to the noteholders on a priority basis. 3.5 Partially Funded Synthetic Portfolio CDO Most current synthetic CDO transactions are actually a combination of the unfunded and funded structures. In a partially funded, or leveraged, transaction risk transfer is accomplished by issuing various tranches of funded notes whose total value is substantially smaller than the reference portfolio, and the balance of the reference portfolio is hedged through an unfunded senior tranche. A single, highly rated investor, typically an insurance company, will invest in the most senior tranche in unfunded form i.e. it will enter into a credit default swap whereby it sells protection to the protection buyer, whereas the rest of the liability structure is purchased by investors in funded i.e. CLN form. The unfunded senior-most tranche is known as the super-senior swap (the last loss position), to reflect its position above the AAA -rated tranche (Bakalar and Prince, 2003:8). 135

Super-senior counterparty (Implied AAA) Supersenior premium Credit protection Premium JIBAR + premium Senior CLN investor (AAA) Protection buyer SPV Mezzanine CLN investor Credit protection Note proceeds First-loss CLN investor JIBAR Note proceeds Reference portfolio Highly rated collateral Diagram 3.10: Partially funded synthetic portfolio CDO (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) The super-senior swap paved the way for the broad scale application of synthetic CDO technology. Banks have been eager to shed many of their investment grade loans because these loans were often extended for relationship reasons and generated low returns, while carrying a full regulatory capital charge. Early synthetic CDOs permitted banks to reap the benefits of regulatory capital relief but they had to bear the cost of transactions that, under traditional tranching, i.e. without the super-senior swap, were not economically attractive. Senior to the AAA -rated (funded) tranche, the super-senior swap usually accounts for 85% or more of the capital structure, assuming an investment-grade pool of assets, and carries a much lower spread than the spreads of AAA tranches, thereby reducing the weighted average cost considerably. The super-senior swap dramatically improves the economics of the transaction and allows more efficient regulatory capital relief. The reason that the super-senior swap is senior to the highest rated AAA note is because the chance that the super-senior swap will experience a loss is close to zero. Scenarios that will lead to a loss on the super-senior piece are located far out in the tail of the loss distribution of the underlying reference pool. In order for the super-senior swap provider to suffer a loss, the economy has to turn down so heavily that it is very likely that problems will have reached a level where the loss is just the tip of a profound global financial crisis (Bluhm, 2003:6). 136

Variations on the partially funded CDO are common. The super-senior swap provider can be a counterparty to the SPV, and the entire protection premium is paid by the protection buyer to the SPV where it is then partitioned. Instead of using an outside super-senior swap counterparty, the protection buyer may retain the super-senior piece (Yoshizawa, 2003a:3). The protection buyer may also take a first-loss equity stake in the SPV. A portion of the SPV s riskier liabilities may be sold through a subordinated unfunded credit default swap, in addition to the funded CLNs. Protection buyer is the super-senior counterparty Equity piece (First-loss) Super-senior premium Super-senior counterparty Credit protection Protection buyer Premium Credit protection SPV JIBAR + premium Note proceeds Class A CLN investor (AAA) Class B CLN investor (AA) CDS counterparty SPV pays premium for protection JIBAR Note proceeds Reference portfolio Highly rated collateral Diagram 3.11: Synthetic portfolio CDO with protection buyer as super-senior counterparty (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 3.6 Synthetic Collateralised Swap Obligation Transactions In synthetic collateralised swap obligation (CSO) transactions the underlying portfolio are credit default swaps. Therefore, both an asset and a contingent liability are acquired. At closing or over the life of the transaction, the SPV will enter into a series of swaps each referencing a single asset, either as protection seller or protection buyer. In the case where the SPV sells protection, it receives a 137

premium, but has to make payments upon the occurrence of a credit event. In the case where the SPV buys protection, it has to make premium payments, but will receive funds upon the occurrence of a credit event. No funds are needed to enter into the swaps. However, bivariate risk is introduced as credit default swaps expose the SPV not only to the risk of the underlying reference asset, but also to the risk of the swap counterparty, which either has to pay the premium if the SPV sells protection or make a contingent payment if the SPV buys protection. Premium Credit default swap counterparty Credit protection Super-senior counterparty (Implied AAA) Sell credit protection SPV JIBAR + premium Senior CLN investor (AAA) Buy credit protection Note proceeds Mezzanine CLN investor Credit default swap counterparty JIBAR Note proceeds First-loss CLN investor Highly rated collateral Diagram 3.12: Synthetic CSO (Collateralised Swap Obligation) transactions (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In the majority of cases, the portfolio of credit default swaps is actively managed by a portfolio manager and the trading profits and losses are bone by the SPV. The manager can trade out of a credit default swap by terminating the swap or by entering into another credit default swap to buy protection, thereby offsetting the swap in which the manager had sold protection. Trading limits and covenants must curb the power of the manager to trade. Buying protection is referred to as having a short position in the credit default swap and selling protection as having a long position. 45 The primary use of short positions is to buy protection to cover an existing credit exposure. The existing exposure can be a credit exposure via cash assets or a 45 This sounds counter-intuitive, however buying protection means selling, or shorting risk, whereas selling protection means buying risk, thus being long risk. 138

long swap position. Short positions against long positions are referred to as offsetting positions, and could be assumed to render the position flat from a credit perspective. The profit or loss will be the difference between the two spreads. The secondary use of short credit default swap positions is to buy protection on a reference entity without having exposure to that entity, and is referred to as naked shorts (Standard & Poor s, 2003:58). A naked short exposes the SPV to the risk that, if a credit event occurs on the reference asset and when a transaction specifies physical settlement, it may have to buy a reference asset e.g. a bond in the market for delivery to the protection seller. The SPV faces three types of risk with respect to short positions. First, the SPV must have sufficient funds to make the premium payments. The structure will therefore have to include a forward-looking spread test. Second, the SPV must rely on credit protection payments from the counterparty in the event of a credit event. The transaction will therefore have to include strict counterparty rating requirements. Third, if the SPV relies on a short position to offset a long position written on the same reference obligation, it is necessary to ensure that the credit risk of the reference obligation is completely removed. 3.7 Hybrid Synthetic Transactions The main difference between a hybrid transaction and a CSO transaction is that the reference portfolio of a hybrid transaction contains both cash assets and synthetic assets (credit default swaps), whereas the assets of CSO transactions are only synthetic assets (credit default swaps). The liability side of a hybrid usually combines an unfunded portion through a super-senior swap and a funded portion through CLNs. The proceeds of the notes are used to buy the cash assets; simultaneously, the SPV will enter into credit default swaps for which no funds are needed. As the proceeds of the notes are invested in cash assets, another source of funds needs to be available to make payments after the occurrence of a credit event at maturity and upon early termination. This is typically provided by a liquidity facility. Alternatively, the transaction can also use only part of the proceeds to purchase cash assets, in which case the remainder of these funds can be used to make contingent and principal payments. 139

Credit default swap counterparties Premium Premium Super-senior counterparty (Implied AAA) Cash assets Credit protection SPV Credit protection JIBAR + premium Class A CLN investor (AAA) SPV invests in cash assets and receives a return Note proceeds Class B CLN investor (AA) JIBAR Highly rated collateral Note proceeds First-loss CLN investor Diagram 3.13: Hybrid synthetic transaction (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) A hybrid transaction typically includes the ability to buy and sell cash assets; trade and hedge protection sold; buy protection subject to counterparty risk being addressed; and to buy and sell protection referencing the same entity. The transaction is managed by a portfolio manager, and eligibility criteria and trading limits should be in place (Standard & Poor s, 2003:59). 3.8 Single-Tranche Synthetic Structures A synthetic securitisation may involve the transfer of most levels of credit risk to various investors, or the transfer of only a specific level, a single-tranche, of the portfolio credit risk to an investor. One difficulty for arrangers of traditional full-structure synthetic CDOs is that all tranches across the entire capital structure must be sold to investors in order for the transaction to be completed (Gibson, 2004:19). Because it is sometimes difficult to find equity, mezzanine and senior investors at the same time, single-tranche synthetic CDOs have evolved. Single-tranche synthetic CDOs were first created in 2003, and according to Standard and Poor s accounted for around 90% of synthetic CDOs issued in 2003 and 2004 (cited in Cousseran and Rahmouni, 2005:48). A single-tranche synthetic CDO, often called a bespoke 46 synthetic CDO, is a popular secondgeneration product, which unlike traditional synthetic CDOs, is created on a stand-alone basis and does not involve distribution of the entire capital structure (Adelson and Whetten, 2004b:1). As in 46 Meaning custom-made. 140

full-structure synthetic CDOs, credit risk is transferred through a number of credit default swaps. The main difference is that only a specific portion of the portfolio s risk, rather than the entire portfolio risk, is transferred to the investor. A single-tranche CDO can therefore be tailor-made to an investor s particular risk appetite, and customised with regard to portfolio composition, term, credit rating, tranche size and subordination. Since only one tranche is structured and sold, it can be put together in a relatively short time. As with other synthetics, the underlying portfolio can be static or actively managed. The transaction can be unfunded in the form of credit default swap directly between the protection seller and protection buyer, or alternatively it can be a funded transaction in the form of a CLN issued by an SPV (Adelson and Whetten, 2004b:3). Detachment point Tranche thicknes Reference assets Specified loss level Premium SPV JIBAR + premium Single-tranche CLN investor Credit protection Note proceeds Attachment point JIBAR Note proceeds Highly rated collateral Diagram 3.14: Single-tranche synthetic structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In a traditional, multiple-tranche synthetic CDO, a tranche also represents a portion of the underlying portfolio s risk. Losses are first distributed to the equity or first-loss tranche. Once the equity tranche has been wiped out, losses are absorbed sequentially by the mezzanine tranches and finally the senior tranches. However, in a single-tranche synthetic CDO only one tranche is created and sold to an investor. A tranche s attachment point defines the level of losses in the reference portfolio where losses begin to accrue, i.e. it defines the tranche s subordination level. A tranche s detachment point defines the maximum amount of losses in the reference portfolio that can be absorbed by the 141

tranche. The tranche s thickness, i.e. the difference between the tranche s attachment and detachment points defines its notional amount 47 (Adelson and Whetten, 2004b:2). The loss behaviour can be mathematically described in the following manner (Adams et al., 2004:13). If credit enhancement i.e. the attachment point on a particular tranche is represented by A t, the detachment point by D t, and the actual losses on the aggregate portfolio represented by L, then losses on the tranche L can be characterised as follows: L t = MIN{MAX[(L A t ), 0], (D t A t )} where the MIN and MAX functions return the lowest and highest value arguments respectively. In the case that L A t, no losses are realised for the tranche, and L t = 0. Where A t < L D t, losses to the tranche would equal the difference between the aggregate pool loss and the attachment point for the tranche, thus L t = L A t. When pool losses exceed the detachment point of the tranche, losses to the tranche are capped by the thickness of the tranche, thus L t = D t A t, resulting in a 100% loss for the tranche. Unlike a traditional, whole-structure synthetic CDO, it is possible to create two overlapping single tranches e.g. a 5.5% - 7.5% tranche and a 4.5% - 6.5% tranche that reference the same portfolio (Adelson and Whetten, 2004b:3). Many single-tranche transactions are rated by rating agencies. If necessary, the tranche s attachment point, i.e. subordination, is adjusted in order to achieve the desired rating. In this case the tranche with a 4.5% subordination will start to absorb losses before the tranche with 5.5% subordination. The 4.5% tranche will therefore be riskier, resulting in a lower credit rating and to compensate for that will have to pay a higher spread. Although only a portion of the risk is transferred under a single-tranche synthetic CDO, sponsors are willing to accept this risk as they have developed dynamic hedging techniques, referred to as delta hedging (Standard & Poor s, 2003:60). Adelson and Whetten (2004b:4) describes how a CDO tranche can be delta hedged using an overall credit default swap index. This approach focuses on a general market spread movement, rather than a change in a particular obligation s credit default swap spread. As overall credit spreads widen, the credit risk of the portfolio increases and the tranche value declines. However, a long position in the tranche (selling protection) can be hedged with an 47 Assume an R1 billion reference portfolio. A 3% - 7% single-tranche synthetic CDO, with an attachment point of 3% and a detachment point of 7%, would start to absorb losses after portfolio losses exceed R30 million, and the tranche would be wiped out after portfolio losses exceed R70 million. The size of the tranche and the potential loss the investor is exposed to is R40 million. 142

appropriate amount of short position (buying protection) in an index such as the Dow Jones CDX index. If the hedge is successful, the decline in the tranche value is offset by the increase in the value of the CDX index position. In order to delta hedge a tranche with a credit default swap index, the tranche s delta needs to be calculated. The delta is a hedge ratio, and determines the size of the hedge required. The delta for a tranche is calculated as the ratio of a tranche s MTM change to that of a credit default swap index position, given a one basis point movement in the average of all credit default swap spreads in the reference portfolio. Tranche delta = -[change in tranche value]/[change in the index value] A tranche s delta is the ratio of the change in the value of a tranche caused by a one basis point widening in the average credit, to the change in the value of the index caused by a one basis point widening in the average credit. The underlying credit default swap portfolio has a delta of one. If a tranche is riskier than the underlying credit default swap portfolio, the tranche delta will be greater than one, implying that the hedger has to buy or sell protection for a larger notional amount than the tranche to be hedged 48. An equity tranche, i.e. a single tranche with a 0% attachment point, is more sensitive to movements in credit spreads than senior tranches. Since the equity tranche is most exposed to credit risk, its delta will be much higher than that for more senior tranches (Rule, 2001:27). 3.9 Synthetic Resecuritisation Structures Synthetic resecuritisations, also known as synthetic structured finance CDOs (Cunningham et al., 2004:1) or synthetic CDOs of ABS (Standard & Poor s, 2003:56), are CDOs that synthetically reference pools of structured finance securities such as residential and commercial mortgage-backed securities and other types of asset-backed securities, instead of corporate entities (Yoshizawa, 2003b:1). A synthetic resecuritisation is similar to a corporate synthetic structure in that investors provide credit protection on a portfolio of reference entities via one portfolio credit default swap or a 48 Assume a long position (sold protection) in a single-tranche synthetic CDO. A tranche delta of seven implies that a one basis point increase in the average spread of credit default swaps in the credit default swap index would cause a change in the value of the tranche that is seven times as large as that of the index. In that case an investor that wants to hedge its position needs to sell the index (buy protection) for a notional amount of R70 million to hedge a tranche position of R10 million. The combined position should neutralise MTM changes caused by a one basis point change in the average spread. 143

number of individual credit default swaps. While corporate synthetic CDOs reference corporate names, a synthetic resecuritisation references specific tranches of notes within a structured finance transaction. Synthetic resecuritisations may be static or managed, funded or unfunded, single-tranche or whole capital structure. Two issues pose unique challenges in synthetic resecuritisations, namely credit event definitions and settlement mechanisms (Yoshizawa, 2003b:2). Synthetic CDOs and stand-alone credit derivatives that reference corporate entities rely on the definitions of credit events set out by ISDA. These definitions were not drafted with structured finance securities in mind, but were meant to address possible default events on corporate names only. Due to the unique characteristics of structured finance securities, credit events defined for such securities do not generally conform to the standard ISDA definitions. Unlike corporate synthetic CDOs, where failure to pay can occur on any obligation of a reference entity, the failure to pay in a synthetic resecuritisation is on the specific tranche listed as the reference obligation, e.g. if only the subordinated tranche in a structured finance transaction experiences a failure to pay, the protection buyer on the senior tranche will not receive a protection payment. Another difference is that bankruptcy will not be an appropriate credit event for synthetic resecuritisations. The SPVs that issues structured finance notes are specifically designed to be bankruptcy-remote, and are therefore unlikely to become insolvent. Restructuring as a soft credit event is normally not very relevant since structured finance securities are almost never restructured. It poses moral hazard risk in instances where a subordinated noteholder may be an involved party to a transaction e.g. as sponsor, and may have reason to take a loss in order to protect its reputation. Such a loss is not a valid reason for a CLN investor to have to make a reimbursement under a credit default swap (Yoshizawa, 2003b:8). Credit event language should therefore provide an exact alignment of potential synthetic resecuritisation losses with the actual losses experienced on the underlying structured finance securities in order to mitigate soft credit event risk fully. As a result credit event language in synthetic resecuritisations tends to be different from ISDA s templates and documentation for these transactions has tended to be highly customised on a transaction-by-transaction basis (Cunningham et al., 2004:4). For corporate synthetic CDOs, credit events are closely aligned with default events for the corporate entities in the reference pool. In synthetic resecuritisations, credit events do not necessarily result in an event of default for the entire structured finance transaction, but result merely in an immediate loss to a specific tranche of that transaction. Synthetic resecuritisation transactions typically use cash settlement following a credit event. If a write-down occurs on a structured finance tranche, the protection seller will pay the protection buyer the full amount of the write-down subject to the 144

notional amount of the trade. If more of a tranche were to be written down in the future, the additional loss would be paid at that time. This partial settlement mechanism is used only in synthetic resecuritisations because of the potential for structured finance assets to have part of their principal written down (Yoshizawa, 2003b:3). 3.10 Synthetic CDOs of CDOs Synthetic CDOs that reference portfolios of single tranche CDOs of investment-grade corporate risk ( inner CDOs ) represent the latest innovation in the synthetic CDO market, and are referred to as synthetic CDOs of CDOs, or CDO squared (Neugebauer, 2004:1). The underlying assets in a synthetic CDO squared transaction can also be a mixture of synthetic CDO tranches and other assetbacked securities (Drexler and Gilkes, 2003:1). CDO squared transactions, which first appeared in 2003, have become very popular and represented more than half of all synthetic CDOs issued during 2004 in the EMEA 49 market (Frey, 2005:1). 49 Europe, Middle East, and Africa. 145

Credit protection Singletranche CDO Master synthetic CDO Singletranche CDO JIBAR + premium JIBAR + premium Reference assets Singletranche CDO Singletranche CDO Note proceeds SPV Note proceeds CDO^2 tranche Singletranche CDO ABS tranche ABS tranche Investment in ABS Diagram 3.15: Synthetic CDOs of CDOs (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) In a CDO squared, there are two levels of CDOs. There are also structures with more layers e.g. a CDO cubed, which consists of three layers of synthetic CDOs (Adams et al., 2004:15). A typical synthetic CDO squared transaction references a portfolio, called a master or outer CDO, consisting of other synthetic CDO tranches, the inner CDOs. Each inner CDO is a single-tranche synthetic CDO that references corporate obligations and is structured with subordination levels (attachment points) depending on the rating of the tranche. The inner CDO tranches may have similar size and subordination, referencing similar portfolios. In most synthetic CDO squared transactions, the underlying CDO tranches are created for the sole purpose of being included in the CDO squared. Because of its synthetic nature, these underlying CDOs are simply conceptual and are used to calculate cash flows and values of the CDO squared, and a synthetic CDO squared structure can be viewed as a complex derivative instrument (Adelson and Whetten, 2005:2). The master CDO may also benefit from subordination and may be sold to investors in a single-tranche format with its own attachment and detachment points. 146

Any losses associated with the underlying single-tranche synthetic CDOs will only start to impact the overlying synthetic CDO structure when they exceed the subordination levels of the underlying CDOs. If losses in the underlying reference portfolio exceed an inner CDO s attachment point, the tranche notional will be written down by the amount of the losses. Losses incurred by the CDO tranches are passed through to the overlying CDO, which will cause a credit event in the overlying CDO. Write-down is the only credit event in respect of the inner CDOs, leaving little or no ambiguity with respect to credit event language (Neugebauer, 2004:1). Losses on each of the inner CDOs are capped at the detachment point, also called the exhaustion point (Drexler and Gilkes, 2003:2). Investors in a CDO squared transaction will not be required to make payments for losses on an underlying CDO tranche that exceed the detachment point. The maximum loss that can therefore be passed on to an investor is equal to the tranche thickness. While the attachment point determines the probability of default of the CDO tranche, the thickness of a tranche determines the degree of loss that the tranche and ultimately the CDO squared transaction will suffer. The amount of losses in a CDO squared structure depends on not only how many defaults occur but also where they occur i.e. the location of default in underlying CDOs (Adelson and Whetten, 2005:4). If defaults are evenly spread amongst the underlying CDOs in amounts below the individual attachment points of the single-tranches, there will be no losses suffered by the underlying singletranches. However, if all defaults are concentrated in one underlying CDO, it may wipe out that CDO s single-tranche, and the losses will flow through to the master CDO squared. Adams et al., (2004:15) describe the loss behaviour mathematically. If credit enhancement on underlying CDO i is A i, actual losses on underlying CDO i are L i, and the sum of all i is equal to the total number of underlying single-tranche synthetic CDOs, then losses on the overlying structure are realised when L i > A i. If L i A i, then no losses are realised. Hence, the simplified aggregate impact on the overlying structure can be described as the sum of all realised losses on each of the underlying structures: n L o = MAX i= 1 [(L i A i ), 0] In multi-level synthetic CDOs there often exists name, i.e. reference entity, overlap between the underlying CDOs, whereby a number of CDO tranches can reference the same name. Name overlap exacerbates defaults and credit migration. The extent of this effect is directly related to the number of times the name appears in the overall structure. Assume there are ten single-tranche synthetic 147

CDOs in the structure. If a name appears in all ten CDOs, then any credit event in that one name will affect all ten CDOs. On the other hand, if all names appear only once, then each underlying CDO would be entirely independent. Therefore, as the name overlap increases, the underlying CDOs become increasingly correlated. In general, the lower the name overlap, the less correlated the pool, resulting in a structure with lower potential volatility (Adams et al., 2004:18). A recent innovation is that of cross-subordinated CDO squared transactions where the subordination of the underlying single-tranche synthetic CDOs is shared (Neugebauer, 2004:3). The individual tranche losses on each of the inner CDOs are determined in the same way as for standard CDO squared transactions. Any remaining subordination on any of the inner CDOs is used as protection for the overlying CDO. Whereas in a standard CDO squared transaction, losses on any of the inner CDOs are passed through to the overlying CDO, in a cross-subordination CDO squared only the losses that exceed the remaining subordination of all the inner CDOs are passed through to the overlying CDO. The effect of cross-subordination depends on the amount of remaining subordination. Generally, cross-subordination provides better protection to protection sellers if losses are concentrated in a few of the inner CDOs, which in a standard CDO squared would have been passed through to overlying level. Evenly allocated losses across all inner CDOs reduce the remaining subordination and diminish the effect of cross-subordination (ibid.). 3.11 Standard Tranches of Credit Default Swap Indices In June 2004, the Dow Jones itraxx Europe index was created from the merger of two existing credit default swap indices. At the same time, standard tranches of synthetic CDOs based on the itraxx were issued. These tranches replicate the behaviour of unfunded synthetic CDO tranches whose reference portfolio comprises the 125 most liquid names of the European credit default swap market in the index (Cousseran and Rahmouni, 2005:56). Diagram 3.16 represents an investment bank s trading screen data showing the subordination, price and delta of five tranches of the itraxx index. From the bottom to the top there is an equity tranche, two mezzanine tranches, a senior tranche, a first super senior tranche, and finally a second super senior tranche. Official ratings do not exist for itraxx tranches, and the ratings are implied ratings supplied by Fitch (ibid.). 148

itraxx tranches 2 nd super senior 22% - 100% Unrated Unquoted 1 st super senior 12% - 22% Unrated Bid/offer spread 12/14 basis points Delta 0.7x Reference portfolio Dow Jones itraxx Europe (125 names) Senior 9% - 12% AAA Bid/offer spread 25/29 basis points Delta 1.3x Mezzanine 6% - 9% AA+ Bid/offer spread 42/47 basis points Delta 2.4x Mezzanine 3% - 6% BBB+ Bid/offer spread 137/143 basis points Delta 6.3x Equity 0% - 3% Rated Variable yield Delta 18.1x Diagram 3.16: Standard tranches of credit default swap indices If a client of the bank buys protection on, for example the first (3% - 6%) mezzanine tranche, it pays the bank the offer (ask) premium of 143 basis points per year. If the proportion of losses on the itraxx exceeds 3%, the client will be compensated, limited to the size of the tranche, which is 3% (6% minus 3%) of the notional amount of the transaction. The equity and mezzanine tranches are leveraged as their sensitivity to changes in the credit spreads of the underlying index, i.e. their delta, is much higher than one. For example, a one basis point rise in the itraxx results in a 18.1 basis point widening in the spread of the equity tranche that has a delta of 18.1. Cousseran and Rahmouni (2005:56) state that these standard tranches have greatly contributed to the maturity of the synthetic CDO market and have resulted in: greater transparency as tranche prices are continuously quoted; 149

a significant increase in market liquidity 50, allowing protection to be bought and sold at a lower cost, with bid/offer spreads of at most five basis points; an improvement in the management of market participants risk, as they now have access to daily valuations from which they can, by using models, obtain levels of implied correlation. In view of their liquidity, itraxx tranches, or the itraxx index itself, can also be used by arrangers for dynamic delta hedging of single-tranche CDOs; and a broadening of the investor base to new market participants such as hedge funds, which use these instruments for their correlation trading. 3.12 Balance Sheet Synthetic CDOs If the purpose of the transaction is to achieve capital relief from assets that are held on the sponsor s balance sheet, the CDO is classified as a balance sheet transaction. In a typical balance sheet structure there is a sponsoring bank, the buyer of credit protection, which uses a synthetic CDO to remove credit exposures from its balance sheet while retaining ownership of the assets. The credit risk from the reference pool is tranched and sold to investors, with the bank retaining the equity tranche. In this way the bank is able to manage its credit risk more efficiently and obtain regulatory capital relief while maintaining its relationship with its clients, the reference entities. Balance sheet CDOs are typically static or lightly 51 managed vehicles (Yoshizawa, 2003a:2). Since the main motivation is regulatory and economic capital management rather than funding, they generally are partially funded structures (Gerity et al., 2001:5). 3.13 Arbitrage Synthetic CDOs If the purpose is to achieve a gain from a selected reference portfolio that is not already owned by the sponsor, the CDO is classified as an arbitrage transaction. An arbitrage synthetic CDO replicates a leveraged exposure to a reference portfolio of assets, most frequently syndicated loans and bonds (Gerity et al., 2001:3). Arbitrage synthetics, which developed a little later than balance sheet synthetics and tended to be structurally more complicated, take advantage of the difference between the spread received from selling protection on individual reference entities and the spread paid to 50 US $90 billion in 2004 according to Creditflux, as cited in Cousseran and Rahmouni. 51 Lightly managed structures generally allow a limited number of substitutions, or allow for the deletion of reference entities for credit risk purposes. 150

investors to buy protection on a pooled basis (Yoshizawa, 2003a:3). This excess spread may be trapped to offset previous losses, used to enter into additional trades or hedges, or treated as returns to the arranger of the transaction. Arbitrage CDOs are used by asset managers, insurance companies and investment boutiques with the intent of exploiting the yield mismatch between the yield on the underlying assets and the lower cost of servicing the credit-linked notes (Gerity et al., 2001:1). They usually allow for active management of the reference pool, and an investment manager is engaged to make substitution and hedging decisions within the guidelines of the structure s governing documents (Yoshizawa, 2003a:3). In some of theses transactions there may be multiple swap agreements with multiple buyers of credit protection, and there may be provisions that allow the manager to buy protection for hedging or arbitrage purposes. The capital structures of arbitrage CDOs and balance sheet CDOs are similar in that there is tranching of credit exposure. In arbitrage synthetic CDOs, however, the first-loss position is sometimes sold in its entirety to third party investors. Alternatively, the equity is not placed at all and is created internally through the transaction s mechanisms for allocating excess spread to absorb losses up to a certain threshold (ibid.). As is the case with a typical funded synthetic CDO, an SPV is established that issues a combination of notes and equity to investors and invests the proceeds in highly rated collateral. The SPV then sells credit protection to counterparties such as banks with underlying reference portfolios. The credit protection references a much larger portfolio of reference obligations, which are selected by the investment manager, typically six times the amount of issued securities. This amount of leverage is often required for the transaction to make economic sense (Gerity and Koo, 2003:1). 151

Reference assets Bank Liquidity facility Reference assets Bank Premium JIBAR + premium CLN investors SPV Reference assets Bank Credit protection JIBAR Note proceeds Equity investor (sponsor) Reference assets Bank Highly rated collateral R3 billion R500 million Diagram 3.17: Arbitrage synthetic CDO (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) Throughout the reinvestment period the investment manager can select and delete reference obligations, as long as compliance with eligibility criteria is maintained and no tests are breached. The investment manager is usually paid a senior management fee near the top of the priority of payments and also receives a fee at the bottom of the priority of payments. In addition the manager may participate with the equity holders in any residual cash flows. In the event that there is not enough income to cover expenses due to higher than expected losses, some structures allow the liquidation of the SPV s collateral to pay expenses as far down as the note coupon to keep the notes current. Otherwise the notes may capitalise interest. In either case, the shortfall is recouped to the extent that the funds become available in the future (Gerity and Koo, 2003:2). A typical test is for the sponsoring bank to MTM the reference portfolio at regular intervals. This test then compares the current value of the assets belonging to the SPV, including any excess spread trapped within the structure, net of credit losses and market value erosion of the reference assets, to the purchase price of reference portfolio, expressed as a percentage. If this percentage drops below a 152

certain point, due either to excessive credit losses or market value decline, a test is breached 52 (Gerity and Koo, 2003:3). Another unique structural feature not found in traditional synthetics is the existence of a liquidity facility that allows the structure to maintain the maximum amount of leverage. In all synthetics, there is a certain amount of loss that the transaction must be able to withstand to achieve a specific rating. These losses are absorbed by a combination of excess spread and subordination. In contrast, synthetically created arbitrage CDOs rely primarily on excess spread (ibid.). To help achieve this, the structure allows the manager to reinvest recoveries on defaulted and sold assets and use the liquidity facility to reinvest the amount of any losses 53. 3. CONCLUSION Credit derivatives appeared in the early 1990s largely as a market response to increasing credit-related concerns, primarily from banks. They are financial instruments that isolate and transfer the credit risk in lending transactions. The basic structure of a credit derivative is a transaction between a credit protection buyer, which is interested in transferring credit risk, and a credit protection seller, which is willing to accept that risk. If a pre-defined credit event occurs with regard to the obligations of a reference entity to which the protection buyer has credit exposure, the protection seller covers the loss suffered by the protection buyer. For taking this risk the protection seller receives regular premium payments from the protection buyer. Typical credit events are bankruptcy of nongovernment borrowers, or moratorium by governments, failure to pay after a grace period, materially adverse (for the creditor) restructuring of debt, obligation acceleration i.e. the reference debt becomes due early, or repudiation, that is the refusal of public authorities to acknowledge or pay debt. If a credit event occurs the transaction can be settled in two ways. Under a cash settlement the protection seller makes a cash settlement payment to the protection seller. The amount of the cash settlement is determined as the difference between the notional principal and the reduced recovery value of the reference obligation, after the credit event. In physical settlement, the reference obligation is delivered by the protection buyer to the protection seller against payment of the obligation s par value by the protection seller. 52 Assume a R3 billion aggregate reference portfolio and R500 million collateral, thus the collateral comprises 16.67% of the asset portfolio. If this ratio were to decrease below that threshold, then all cash flows in the priority of payments below payments to noteholders would be trapped until the test was back in compliance. 53 If an asset in the reference portfolio defaults the manager may decide that the best course of action is, after having paid the protection amount and taking delivery, to sell the asset at 75% thereby locking in a loss of 25%. The manager can then reinvest the 75% recovery on the sale of the defaulted asset and then draw on the liquidity facility, reinvesting the 25% in additional assets. While the SPV would have to pay interest on the amount drawn under the liquidity facility, it would still be less than the amount earned on the additional investment. 153

There are several types of credit derivative instruments. A total return swap is where the protection buyer pays out to the protection seller the total return of an asset, including any interest payments and capital appreciation, in return for receiving a regular floating-rate payment linked to an interest rate index e.g. JIBAR. At maturity of the contract the seller will make good to the buyer any depreciation in the underlying asset. In a credit default swap contract the buyer pays the seller a premium to protect itself against the occurrence of a contractually-defined credit event on a specific underlying risk of a reference entity. Credit default swaps can be structured as single-name or portfolio transactions. A single-name swap transfers the credit risk of a single reference entity s obligations from the buyer to the seller, whereas a portfolio swap covers the credit risk of a basket of reference entities or obligations. Credit default swaps have become the dominant credit derivative product. In the case of a credit spread option the buyer pays the seller a premium to protect itself against adverse spread movements on an obligation such as a bond issued by the reference entity. Credit spread options are difficult to hedge and complicated to price, and most investors can achieve their objectives with cheaper credit default swaps. Credit-linked notes are synthetic securities with embedded credit default swaps. The redemption of note principal depends on the loss, if any, suffered on the reference assets. If a credit event occurs, the note issuer s repayment obligation decreases by an amount sufficient to offset the loss on the reference assets. The performance of the credit-linked note can be tied to a single reference asset or a basket of reference assets. The payment structure of credit derivatives is similar to that of credit insurance contracts. Unlike credit insurance, credit derivatives are tradable and there exist an active secondary market for them. Because they are tradable, credit derivatives appeal to a larger group of investors than does credit insurance. The ability to trade credit risk separately breaks the link between lending of funds and assuming credit risk, without disturbing the relationship between the lender and the borrower. The rapid growth of the credit derivatives market has been supported by the development of standardised credit derivative contract terms and definitions. The development of standardised documentation has been greatly facilitated by the International Swaps and Derivatives Association (ISDA) through its issuance of the 1999 credit derivative definitions and the updated version of that in 2003. In attempting to standardise documentation for credit derivatives, ISDA has faced the task of reconciling the interests of protection sellers who want the narrowest possible interpretation of credit events, and protection buyers who want the broadest definition. The combination of credit derivatives technology with traditional cash flow securitisation techniques gave rise to unfunded or synthetic securitisation. In a synthetic securitisation the credit risk of a pool 154

of assets is transferred from an originator to investors, but the assets themselves are not sold and remain on the originator s balance sheet. Synthetic transactions have become popular in jurisdictions where it is difficult to undertake a cash transaction due to legal, regulatory or cross-border restrictions. It is generally also quicker and easier to implement a synthetic securitisation since there is no requirement to sell the assets physically, as risk transfer takes place through the use of credit derivatives. Since the inception of the first synthetic transactions, the market has evolved, with continuing development of newer structures to meet differing originator and investor requirements. Originally synthetic CDOs were driven by banks seeking to gain capital relief on assets already on their balance sheet. As the market has developed and became more liquid, banks, asset managers and hedge funds are increasingly using synthetic CDOs for arbitrage rather than balance sheet purposes. 155

CHAPTER FOUR THE ROLE OF RATING AGENCIES IN SECURITISATION 1. INTRODUCTION The purpose of this chapter is to provide an overview of the role of rating agencies in securitisation transactions. Their role is reviewed with respect to rating symbols and their definitions, the securitisation rating process and risk and data analyses. Securitisation is the process of converting financial assets into marketable securities. For the assetbacked securities to be marketable, it requires a wide and diverse investor base. To assess default risk accurately, investors must analyse an issuer s ability to service debt under adverse economic conditions. Such an analysis can be quite costly and time consuming. The relative complexity of securitisation transactions makes it difficult for investors to conduct their own credit analysis and due diligence. A rating is therefore almost indispensable in the process of securitisation in order to have a liquid market for the asset-backed securities. A rating reflects an assessment of the relative risk of a given debt issuer s ability and willingness to make full and timely payments of principal and interest over the life of the rated instrument. In a securitisation transaction the issuer is a bankruptcy-remote SPV, which typically issues different classes of asset-backed securities with different credit ratings. The ratings of asset-backed securities indicate the probability of default and expected loss of the specific class of securities and not the relative risk of the issuer SPV. Any securitisation transaction has the potential to issue securities with a given rating, because the ratings depend not only on the quality of the underlying asset pool, but also on the level of credit enhancement in the structure. All major international rating agencies are engaged in rating securitisation transactions. The major rating agencies, Standard & Poor s, Moody s Investors Service, and Fitch Ratings, have developed frameworks for rating all kinds of debt obligations. In such a framework, gradations of credit risk are indicated by rating symbols, with each symbol representing a group in which the credit characteristics are broadly the same. Debt obligations with the same rating are accordingly broadly similar in creditworthiness, but not exactly the same, since the relatively few rating classes cannot fully reflect all the variations in risk. Likewise, although the rating symbols and definitions of the different 156

rating agencies are comparable, they do not mean exactly the same thing, since the agencies all use different rating methodologies. As ratings are designed exclusively for the purpose of grading obligations according to their credit quality, they have no value in forecasting the future direction of an obligation s market price, since market price movements are influenced not only by credit quality, but also by other factors such as interest rates. When a rating agency assigns a rating, however, it does not look solely at the past and the present status, but considers the worst possibilities in the foreseeable future. In rating a securitisation transaction the rating agency will follow a process that starts with a review of the originator to assess its overall strategy, its reasons for securitising assets, and its competence in managing the proposed transaction. An important part of the originator review is an evaluation of the credit policies and procedures by which assets are originated and serviced. Also important is that the originator has a suitable management information system in key operational areas. The rating agency will look for the originator to demonstrate an ability to service the assets concerned and an ability to continue to originate the assets in the case of future flow or revolving transactions. The rating agency will also analyse the asset pool to be securitised with respect to its historical performance and will make an assessment of the likely future performance of the pool. The pool analysis involves the use of statistical models to determine the way in which the structure will behave under different stress scenarios. The models are designed to calculate the anticipated credit losses for different levels of credit rating for the asset-backed securities, which will eventually also determine the levels of credit enhancement required for each class of securities. The rating agency will, in addition to the analysis of the asset portfolio, also conduct a due diligence on the transaction structure. This involves a review of the originator s solvency at the time of the transaction. Bankruptcy laws generally rule against transfers made by an insolvent, or potentially insolvent, entity. A thorough review will also be conducted on legal issues such as the bankruptcyremoteness of the SPV, the true sale nature of asset transfer, whether obligors have to be notified of the transfer of assets and the enforceability of security by noteholders. The potential impact of taxation as well as regulatory requirements will also be considered. Once the rating agency has completed the rating process, it publishes the ratings assigned to the asset-backed securities. An important facet of the rating process is the ongoing monitoring of a transaction subsequent to its implementation. The rating agency requires regular performance reports 157

from the originator, pursuant to the originator s role as servicer of the transaction, which the rating agency analyses and uses to prepare surveillance reports for investors. If adverse trends in the performance of the underlying portfolio are detected, the rating agency will discuss these with the originator with a view to correcting the situation, failing which, the issue may be downgraded. 2. THE SECURITISATION RATING PROCESS Securitisation is information intensive and requires an originator to be able to communicate clearly the nature of its assets and quantify asset performance in very specific ways. Information used in the rating process may differ from an originator s normal practises, causing internal constraints that may impede the rating process and make securitisation a more time-consuming and costly financing tool for the originator (Dommisse et al., 2004:1). While assigning ratings is only one part of securitisation, understanding the process may help originators and arrangers to identify and address internal challenges to a successful issuance. The securitisation rating process can be expressed diagrammatically as follows (Dommisse et al., 2004:2): Collateral analysis Initial contact Feasibility analysis Originator /Servicer review Collateral cash flow analysis Financial structure Industry review Sovereign risk evaluation Credit enhancement Legal structure/ documentation review Continued documentation review Transaction closing Preliminary rating committee Presale report Final legal review Final rating committee Issuance of final rating Performance analytics Diagram 4.1: The securitisation rating process 158

At initial contact between the originator and the rating agency, the originator should provide a brief outline of the proposed transaction and the asset to be securitised, as well as background information on the originator. Based on this information the rating agency will undertake a brief feasibility analysis and industry review in order to provide a realistic assessment of the proposed transaction and potential challenges, allowing the originator time to address them. If the originator decides to proceed with the transaction, a more detailed review is initiated, which includes four key components. These are discussed below. 2.1 Collateral Analysis The purpose of the collateral analysis is to understand the characteristics and behaviour of the assets concerned under given stress scenarios. Data on the pool of assets likely to be securitised is provided to the rating agency, which reviews the historical performance in terms of dilution 54, delinquencies 55, defaults 56, recoveries and prepayments. Pool characteristics such as obligor diversification and obligor concentration are also evaluated. The provision of this data may be an impediment to rating the transaction, because the data required for a securitisation is often different to that normally used for the management of the asset pool. Securitisation may call for data not previously captured by an originator s systems, while recreating historical data for existing assets using new parameters may be time-consuming. Originators that bring their information systems in line with the data requirements of securitisation will find that ongoing securitisations become more efficient. 2.2 Originator Review This entails a review of the originator s policies and procedures by which the assets to be securitised are originated and serviced to ensure on-going credit quality. Especially important are clearly documented and implemented credit granting policies and procedures and delegated authorities. Also important are the monitoring and collection of non-performing assets, and uniform provisioning and write-off policies. The rating agency reviews internal and external audit policies, control procedures and anti-fraud measures. Comprehensive reporting systems of distributing management information 54 Dilution results from an obligors unwillingness to pay because of returns of sold goods, disputes, offsets, credits, rebates or warranty claims. 55 Delinquency is defined as the failure by an obligor to make a payment against a debt obligation by the specified payment date. 56 From a securitisation perspective, an asset is in default when the cash flow from a delinquent asset is no longer considered available to meet payment obligations to investors. 159

on a timely basis is very important, as are established and tested disaster recovery and contingency planning. The rating agency also considers the availability of a back-up servicer (a replacement servicer that can take over the originator s servicing function if it is terminated, for whatever reason). This function is important in securitisation as it provides a degree of protection for investors when an originator is no longer able to service a securitisation transaction. Standardisation of credit origination procedures is important, as experience suggests that it tends to produce the types of homogeneous pools of assets that facilitate securitisation. The rating agencies believe that historical asset performance, along with the originator s originating and servicing capacity provide an indication of future performance. A track record of asset performance is more meaningful when there has been a uniform application of origination and servicing policies and procedures. Having consistent credit granting standards in place over an extended period of time improves the rating agency s ability to analyse the potential future performance of the asset portfolio to be securitised. 2.3 Legal Structure and Documentation Review The purpose of this review is to assess the credit and legal implications of the transaction structure. Issues considered include: the legal ability to transfer assets and attached security to a third party through a true sale; the notification to underlying obligors of the transfer of assets and to receive confirmation from the obligor; the bankruptcy-remoteness of the SPV; the security interest over the assets; the taxation issues including value-added tax; the regulatory aspects; and 160

set-off 57 risk. 2.4 Sovereign Risk Evaluation The evaluation of sovereign risk on a securitisation transaction results in a sovereign rating. A sovereign rating provides the rating cap, referred to as the sovereign ceiling, for the transaction. The use of a national rating scale specific to a country removes the need to evaluate sovereign risk. A national scale rating of an issuer is not based on default histories and probabilities, but rather indicates the relative creditworthiness of a specific issuer in relation to the best credit within the country, which would typically be the sovereign (i.e. the government). The sovereign is normally rated AAA on the national scale. National ratings are unique to the country in which they apply and cross-country comparisons are not possible. 2.5 Assigning a Rating The results of these four components feed into the collateral cash flow analysis. The cash flow analysis considers the financial structure and determines credit enhancement guidelines. From this is derived a base case asset portfolio performance expectation, which represents the anticipated performance of a portfolio under a non-stressed economic scenario. This base case is then run through stress scenarios at each desired rating category. The rating agency also considers, for the purposes of credit enhancement, aspects such as liquidity, priority of payments, commingling of assets, negative carry risk 58, interest rate risk, and asset amortisation. While the rating process is consistent across asset classes, the rating methodologies vary. Specific rating methodologies are used for pools of corporate and commercial loans, bonds, residential mortgages, commercial mortgages, future flows, credit card receivables, auto loans and leases, equipment leases, and trade receivables. The transaction is then discussed by a rating committee and ratings assigned. Once assigned the ratings are published in the form of a presale report and new issue report and made available to the market via the rating agency s website 59. After the transaction s finalisation the rating agency 57 Set-off risk refers to the right to offset a payable against a receivable. In the context of securitisation, it refers to the right of the obligor to deduct an amount that the originator owes from the amount owed to the originator. Normally the receivables sale agreement would contain a warranty that there is not a right of set-off with the obligor. 58 The risk that interest earned on securitised assets or reinvestment accounts is less than that owed to investors. 59 The websites of the major agencies are: www.standardandpoors.com; www.moodys.com; www.fitchratings.com 161

continues to monitor the transaction throughout its life and provides regular reports to investors on the performance of the transaction. 3. RISK ANALYSIS IN RATING SECURITISATION TRANSACTIONS Dominion Bond Rating Service (www.dbrs.com) describes the risk analyses conducted in rating securitisation transactions. The approach requires three inputs: originator inputs (inputs established by the character of the originator and the underlying assets to be securitised); dynamic elements (those factors that can be changed to provide different levels of credit enhancement or change certain aspects of the transaction); and rating agency inputs (the parameters established during the rating process). 3.1 Evaluating the Originator Securitisations are executed, amongst other reasons, to separate the credit risk of the assets from that of the originator, which makes it possible for the asset-backed securities to attain a higher rating than that of the originator. Despite this separation of risk, the financial health of the originator cannot be completely ignored. The ongoing viability of the originator is critical when revolving assets such as trade receivables or credit card receivables are securitised. In these transactions, new assets are purchased as old assets are repaid. Because of the continual replacement of assets, an element of risk is introduced. If the originator s viability is diminished, the ability to generate new assets can be impaired. If a fixed value of asset-backed securities have been issued, there may be insufficient new assets generated to fully invest such funding, necessitating the investment of surplus cash in permitted investments that would most likely yield less than the cost of the securities. The resultant negative carry would diminish the excess spread and thus the transaction s credit enhancement. Alternatively, the surplus cash could be used to make an early payout to investors. In the latter case, investors may be exposed to reinvestment risk if interest rates have declined and the proceeds from the early redemption of securities have had to be invested at lower interest rates. In a revolving structure, reliance is placed on the originator to maintain credit granting standards, legal safeguards and sound collection procedures. When the financial health of the originator 162

deteriorates, there may be an incentive to loosen these standards or even to generate non-existent assets fraudulently. Fraud is the most worrisome and least controllable risk, and the potential for fraud could be expected to increase as the originator s financial health decreases. Credit granting standards, independent of the historical performance of the assets, have a profound impact on the rating agency s assessment of the quality of the assets. Historical performance is a good indicator of credit granting standards, but not exclusively so. During periods of economic prosperity, the level of losses may generally be quite low. However, when the economy slows, the magnitude and volatility of losses for conservative originators should be less than that of more aggressive originators. The extent that a suitably documented approach to credit granting or asset generation is in place, will increase the likelihood that assets of a consistent quality will be generated. Consistency gives the rating agency more confidence in setting credit enhancement levels, amortisation triggers and other numerical parameters required by a transaction. Also, with a formalised approach, any changes in credit granting standards are approved and documented, which provides the rating agency with a better understanding of the future impact of such changes. Many originators that grant retail credit, e.g. credit card debt, make use of credit scoring systems. Such systems allocate a credit score, i.e. a measure of credit risk based upon demographic and behavioural criteria to an obligor. The use of credit scoring systems is viewed positively because these systems are based on objective criteria that remain relatively constant through time. The level of subjectivity is diminished and a higher level of deliberation is often involved in the setting of credit standards. While it is difficult to capture an accurate assessment of the quality of management, an informal assessment of the capabilities of the originator s management is important. Management is expected to be able to initiate and manage a securitisation transaction adequately, and to operate the business successfully with respect to asset generation, financial health and overall stability of operations. A review of the competitive environment of the originator provides a background for the assessment of the future financial health and growth of the originator. 163

3.2 Evaluating the Assets to be Securitised Valuation of an asset pool encompasses two elements: the value of the specific assets over time and the expected losses associated with such assets. The accounting or notional value of an asset pool is irrelevant because the rating agency must be satisfied that the fair market value of such assets is sufficient to repay any outstanding debt. The liquidity of assets has an important implication in a situation where the transaction enters an early amortisation stage. If the performance of the securitisation transaction is below expectations and early amortisation triggers are breached, the transaction will go into early amortisation. In such a situation, the more quickly and more efficiently assets can be disposed of, the less likely it is that an investor will be subject to a loss. To the extent that assets require a period of time to liquidate in an orderly fashion, the rating agency will conduct stress tests to calculate the associated carrying cost. The volatility of asset values, prepayments and losses can have a profound impact on the level of credit enhancement required for the transaction. Volatility implies uncertainty, which would lead to higher credit enhancement levels. Volatility is incorporated into stress test models in one of two methods. The first method uses either a multiple of a variable, for example losses, or determines a statistically significant confidence level (the number of standard deviations being dependent on the required rating. For example, a AAA rating requires a higher confidence level than a BBB rating, which is then used in the stress scenario. The second method is to incorporate the parameters (mean and standard deviation) of the variable directly into the model and to run the model a number of times to produce a number of results. This distribution should be representative of the expected outcomes associated with the transaction. Credit enhancement is then set at an appropriate level to eliminate a certain percentage of observations 60. 60 In the distribution of losses produced by the model, an AAA rating corresponds, for example, with no more than a 0.2% chance of loss, which is equal to one observation in 500. Assume the largest loss in the results is R500, occurring only once, with the next largest loss being R460, also only occurring once. Therefore, credit enhancement needs to be set so that the R460 loss would be covered, but not covering the one in 500 chance of a R500 loss. Credit enhancement would thus be set at a minimum of R460. 164

For revolving structures, in particular, eligibility criteria act as a filter for assets not satisfying particular criteria. Setting appropriate criteria, e.g. assets should not currently be in arrears or in default, ensures some consistency in the quality and performance of assets. Associated with the eligibility criteria are a representation and warranty from the originator that the transfer satisfies the eligibility criteria. If by error, or fraud, an asset is subsequently determined to be ineligible, the originator would typically substitute it with an eligible asset and reimburse any associated costs. Having adequate assets for the protection of investors in asset-backed securities is insufficient, if legal protection is inadequate. Security is only effective if, firstly, security holders have a legal right to enforce that security and, secondly, the security interest represents a first charge that will not be compromised in any meaningful fashion. The first claim to the security must be legally registered to ensure that other creditors are not favoured by registering a senior claim and to ensure that, if the security has to be realised, it may be realised without undue legal delays or challenges. When registering security, it is necessary to ensure that there are no prior or competing claims against the same assets. Failure to ensure a clean asset may result in a compromised ability to recover on such assets. For a once-off purchase of assets by the SPV, e.g. the purchase of a home loan pool, it is possible to conduct a title deed search and register all security agreements as necessary. However, for revolving assets reliance must be placed on the process the originator uses to register and search title. To the extent that losses occur due to faulty registration, the SPV would have recourse against the originator under the legal covenants. Where there are legal considerations in the transaction that are new or unique, the rating agency relies on its council to have an adequate understanding of the potential benefits and pitfalls of various legal avenues or structures. Only after the rating agency has considered the risks associated with the legal issues, does it indicate whether they are appropriate for the transaction. 3.3 Servicing of the Assets Typically, the originator is also the servicer of the portfolio of securitised assets. In its role as servicer, it will be responsible for the collections of the cash flows emanating from the asset pool. Assets are only regarded as such if the contractual cash flows that should be generated are actually collected, and the value of the assets is directly dependent on the extent of collections. Collection 165

procedures, including repossession and sale of collateral, are an important element of the servicing function, as it is ultimately the collections that repay the outstanding asset-backed securities. While ongoing servicing is a consideration, it is the efficiency and effectiveness of the collection of nonperforming accounts that are particularly important. It is during the deterioration of portfolio quality that the collections effort becomes one of the key determinants of loss levels. It is usually a rating agency s policy to require that a standby backup servicer be appointed for securitisation transactions involving a non-investment grade originator, unless it can be demonstrated that a suitable servicer can be obtained on short notice with little disruption in the servicing function (i.e., it must be demonstrated that the cost of appointing a standby servicer at the time of the transaction outweighs the potential benefits of such appointment). The backup servicer must be able to demonstrate that the delay in collections due to the transition will be minimised. This extends to records transfer and systems compatibility. The rating agency reviews the originator s management information systems as it relates to the servicing function. The rating agency reviews the computer and manual systems to ensure that, should disaster strike, the company has the ability to recreate records and restart systems on a timely basis. Only once the rating agency is satisfied with the feasibility of the disaster recovery plan will the originator s servicing role be approved. 3.4 Evaluating the Securitisation Structure The structural elements of a securitisation transaction are the variable elements that are combined in various permutations to achieve the desired accounting, legal, regulatory and economic effect. Certain structural elements and risks can be identified and these are considered below. 3.4.1 Credit Enhancement The level of credit enhancement is perhaps the most important focus of attention in securitisation transactions. There is an implicit cost associated with credit enhancement in whatever form it is used and an originator has a desire to reduce these costs. However, this is contrary to the interests of investors. The rating agency ensures that the desire of the originator to reduce credit enhancement levels does not compromise the level of protection afforded to investors. Of the various forms of credit enhancement, rating agencies typically prefer cash reserve accounts because cash is liquid, has a known value, is not subject to legal ambiguity and has no associated credit risk. The cost, however, 166

of providing credit enhancement in the form of cash is generally higher than any other form of credit enhancement. Cash reserve accounts are therefore usually limited to a small percentage of securitisation transactions, and are used when liquidity requirements are paramount. Liquidity requirements for term securitisation transactions are lower at inception and more important towards the end of the transaction. Cash reserve accounts are normally set as a percentage of the asset pool, but with a minimum floor amount. This allows the reserve account to decline as the pool amortises, limited by the floor amount, effectively increasing liquidity at the end of the transaction when it is most needed. 3.4.2 Revolving versus Amortising Structures In the case of an amortising pool, the composition of assets is fixed and subject only to the collection of contractual cash flows. In the case of a revolving pool, there is the added complexity of dealing with new assets, which can have serious implications for the performance of the pool, either due to changing origination standards or to different characteristics of the new assets. In revolving pools, the potential for fraud is higher because there is no explicit check on the assets with each purchase. Amortising pools do have an explicit check on the assets when they are purchased. 3.4.3 Commingling Cash Flows The originator usually collects cash on behalf of the securitisation SPV. This cash is often paid into the originator s collections account before being transferred to the SPV s transaction account. During the period that the cash is in the originator s account, it is commingled with other collections of the originator outside of the securitisation transaction. The main concern with commingling is the possibility that cash belonging to the SPV may end up in curatorship upon the bankruptcy of the originator. Such a situation may entail either a prolonged period before the return of such funds or such cash being used to satisfy other creditors and potentially being wholly or partially unrecoverable. Commingling risk is thus a real concern with non-investment grade originators, and in such cases either all funds are deposited in a trust account, or obligors send their funds directly to the SPV. Cash not belonging to the SPV is then released to the originator. 3.4.4 Set-Off Set-off risk is the potential for non-payment by an obligor as the result of the obligor having a competing claim. For example, an obligor may attempt to set-off a deposit with a bank as payment 167

for a loan granted by the bank to the obligor. If the set-off is successful, the obligor s debt is discharged. If the loan has been securitised, the securitisation SPV will have no recourse to the obligor. To mitigate set-off risk, securitisation transactions usually preclude any opportunity for an obligor to set-off. 3.4.5 Liquidity For asset-backed commercial paper conduits the rating agency requires that liquidity lines be provided covering at least 100% of outstanding commercial paper. Generally the term of liquidity lines is 364 days, which corresponds to the longest period for which commercial paper can be issued. The rating agency would insist that all commercial paper be covered by existing liquidity lines, by either limiting the maximum term of the commercial paper, or by having a covenant determining that commercial paper cannot be issued beyond the expiry date of the existing liquidity lines. 3.4.6 Concentration Risk The securitisation of assets relies on a homogeneous pool of a large number of assets so that historical performance is statistically meaningful in predicting future results. However, if there are a few large obligors that represent a significant portion of the pool, the performance of the pool is more directly related to the performance of these few large obligors. As such, the credit risk profile of the pool would be similar to the credit risk profile of these large obligors. Therefore, to ensure that the pool is diversified sufficiently, the rating agency imposes concentration limits on the pool. The concentration limits are tailored to the individual circumstances associated with each transaction. 3.4.7 Material Adverse Change Clauses The material adverse change (MAC) clause is included in the termination events of the transaction documents, and gives the trustee the power to terminate the securitisation transaction if there has been a material adverse change in the affairs of the originator that may affect the performance of the purchased assets. This clause is valuable in that it gives discretion in the determination of events that will terminate the transaction. The rating agency usually requires a material adverse clause for every transaction involving a non-investment grade originator. For investment grade originators, the financial strength of the originator, and also the characteristics of the underlying asset pool are evaluated to determine the need for a material adverse clause. 168

3.4.8 Amortisation Events Amortisation events are triggers incorporated into the transaction that will terminate the purchases of new assets from the originator. Amortisation triggers are particularly critical for revolving asset pools and pay-through structures where cash is accumulated within the SPV during the intervals between payments to investors. For some structures, such as term securitisations, amortisation triggers are irrelevant because no commitment is made to purchase new assets, or because cash payments are paid to investors upon receipt, as is the case with pass-through structures. Amortisation events are designed to be triggered prior to any investor loss. The rating agency desires triggers that have a sufficiently high threshold to prevent unnecessary termination of transactions, which will lead to the reinvestment risk being borne by the investors and potentially significant refinancing costs to the originator. At the same time, the triggers should not be set so high that the triggers are too late to act as a warning to prevent losses to investors. Amortisation triggers can be tied to loss levels, delinquency levels, prepayment rates, the originator s credit rating, the level of remaining credit enhancement and originator bankruptcy. The triggers can be spot or average ratios, and can be fixed or dynamic. Historical performance of the assets is monitored and stress testing incorporated in setting trigger levels 61. 3.4.9 Bankruptcy-Remote Opinions Because of the pivotal role of bankruptcy-remoteness of the SPV in a securitisation, the rating agency s council reviews all legal documentation with respect to true sale and bankruptcy-remote opinions. 3.4.10 Evaluating Basis Risk Basis risk entails potential exposure as a result of differences in the pricing of assets and liabilities. A typical example would be the case where the assets yield a floating interest rate, whereas the liabilities pay a fixed interest rate. Generally, basis risk entails a fixed-floating exposure, but can also be an 61 Assume the results from stress testing indicate that loss levels of four times the historical loss rate can be absorbed on a sustained basis before losses materialise. Setting an amortisation trigger at, for example, two times the historical loss rate may be a good solution because, since it is twice the historic rate, the chances of an inadvertent trigger is low, and since it is only 50% of the rate that would cause losses to investors, there is only a slight possibility that investors would suffer a loss once the trigger had been breached. 169

exposure to different floating rate indices, foreign exchange exposure, or exposure to different repricing sensitivities of derivative instruments. Rating agencies generally do not allow basis risk in securitisation transactions, and therefore require that the SPV enters into hedging arrangements with hedge providers. In some instances non-market hedging arrangements are made with the sponsoring institution when either the feasibility of hedging risk in the marketplace or the cost associated with such hedging arrangements is prohibitive. Customised swapping of cash flows can be accommodated in such situations. In other cases, hedging is not entered into, but collateral or additional reserves are provided, which would be sufficient in the opinion of the rating agency to reduce the risk to a level appropriate for the rating. The counterparties to any hedging arrangements must be of a sufficiently high credit quality as determined by the rating agency. Lower rated parties will only be considered if appropriate collateral or security is provided. 3.4.11 Evaluating Cash Flow Mismatch Risk Cash flow mismatch risk is the risk that the cash flows associated with the underlying assets, while adequate to repay fully the principal and interest of the asset-backed securities to investors, would not be available to repay at the time required. Mismatch risk is not relevant for pass-through structures because they only distribute cash when it is available. The rating agency uses financial models incorporating prepayment and reinvestment parameters, in addition to the normal delinquency and loss considerations, to stress test the cash flows to ensure sufficient cash is available to repay securities as and when they mature. 3.4.12 Due Diligence The credit risk of asset-backed securities is directly tied to the quality of the assets backing the securities and the structure of the transaction. With revolving structures, in particular, it is impossible to review additions to the asset pool, as the former are being added on a continuous basis. The rating agency accordingly does a due diligence that reviews and analyses the asset generation process. 170

Computer systems provide the backbone of the asset origination and management process. Given the level of reliance placed on systems, the rating agency looks for a well-managed systems environment. Collection processes, methods, staffing levels and support systems represent particular focus areas for the rating agency s due diligence. Part of the requirements for adequate completion of a securitisation is the ability to report on the ongoing performance of the asset portfolio. The rating agency reviews the capabilities of the seller to track the performance of the portfolio that was sold separately from the assets retained and produce adequate reports as required. The rating agency reviews the experience and capabilities of management, which is an important qualitative consideration in the overall assessment of an originator s operations. A culture and philosophy that emphasises credit quality would provide more comfort than a volume or market share-orientated culture. The whole process of how assets are generated is important in determining the future consistency of asset quality. The rating agency reviews a number of elements, the most important being credit policies, approval authority levels, exceptions management, credit sources used, credit scoring, the use of standardised contracts, and the ongoing evaluation of existing credits. Well planned and documented procedures are of little use, unless there is an appropriate level of supervision and verification of compliance. The rating agency places much emphasis on fully fledged internal and external audits being regularly performed to ensure that compliance is maintained. 3.4.13 Credit Evaluation of the Originator While securitisation involves the separation of asset risk from the credit risk of the originator, it is nonetheless important to evaluate the credit quality of the originator. An evaluation of the credit risk of the originator is important because some structural elements are tied to the credit quality of the originator. For example, cash commingling becomes an issue when an originator defaults. An originator of high credit quality is less likely to default. Other structural elements are contingent on the maintenance of a certain level of credit quality. For example, a backup servicer generally need not be appointed unless the originator is regarded as being of a non-investment grade. An existing rating 171

is a significant indicator of credit quality. If a rating is not available, a shadow rating may be done by the rating agency. 3.4.14 Stress Testing the Securitisation Structure Stress testing is a process of evaluating an asset-backed securities issuance by using a mathematical model that represents the major characteristics of the financial structure and associated cash flows. The model includes operating characteristics such as delinquencies, losses, prepayments and amortisation triggers. It is also necessary to consider the circumstances that would potentially contribute to such losses. For example, in evaluating the credit risk of a credit card pool, stress scenarios include a concurrent increase in losses with lower payment rates and reduced spread. Just using a multiple of historic loss rates would be insufficient, since losses to investors could occur as a result of spread compression, which means less excess spread is available to provide a cushion against losses, as well as slower payment rates, which means less cash is available to make contractual payments. 3.4.15 On-Going Monitoring of the Securitisation Transaction The rating agency requires that periodic servicer reports be provided on a monthly basis. The reports must include statistics on delinquencies, defaults and prepayments. The rating agency uses the servicer report for a performance review. If any worsening trends are noted, the rating agency discusses these with the originator, with a view of taking corrective action. A continued poor performance of the securitised asset pool may lead to a downgrade of the asset-backed securities. The rating agency also uses the performance review to provide investors with summarised performance information on the transaction. 4. DATA EVALUATION IN SECURITISATION TRANSACTIONS It would be an omission not to stress too heavily the importance of reliable and standardised data in the rating process. For most assets, the most easily securitisable portfolio consists of a homogeneous pool 62, ideally with a large obligor and collateral base that generates a stable and predictable cash flow. Dommisse et al., (2004:6-8) describe the rating agency data requirements with respect to portfolio characteristics and portfolio performance. 62 Homogeneous pools are groups of receivables that are similar both in contractual terms and interest rates as well as in terms of prepayments, delinquencies, defaults and recoveries. 172

4.1 Portfolio Characteristics The rating agency requires a set of data that provides an understanding of the underlying pool of assets. The dataset varies depending on the asset class to be securitised, but generally needs to provide information on the following areas: the characteristics of individual obligors, including geographical location and creditworthiness as defined by internal or external risk rating systems; the structure of receivables, including original amount and term, interest rate, outstanding balance and remaining term; the characteristics of the underlying collateral, e.g. in the case of auto loans this would include information on the make, model and age of vehicles; and the obligor concentrations, e.g. the cash flow from a pool of residential mortgages with high concentrations in a specific area could be negatively impacted by an economic downturn in that area. 4.2 Asset Portfolio Performance The rating agency also requires data to understand the asset pool s historical performance, including delinquencies, defaults, recoveries and prepayments. Rating agencies believe a securitisation is impacted by the performance of an asset portfolio more directly than an originator would be when the assets have not been securitised. For example, a bank has access to a range of cash inflows and is therefore able to meet its liquidity needs even if expected loan payments are not received. By contrast, when the same loan pool is securitised, the cash flows from the specific loan pool are the only funds available to meet the repayment obligations to investors. Delinquencies and defaults increase the cost of securitisation to originators, as liquidity facilities and credit enhancement have to be provided for the transaction to cover potential cash shortfalls. For this reason, the trends in delinquencies and defaults have to be clearly understood. Data provided to the rating agency should follow common definitions. Securitisation relies on international standards for the calculation of delinquency whereby, when a borrower is late on a payment, the entire outstanding principal exposure is classified as delinquent. This definition is used 173

as delinquencies are analysed as a leading indicator of potential defaults. A common understanding should also be achieved between originators and the rating agency on the definition of default and realised loss before recoveries. The rating agency looks for a set date beyond which a delinquent asset is classified as defaulted. This differs from the practice of many originators whereby write-offs are considered on a case-by-case basis. For example, originators may have outstanding delinquent receivables to government agencies, which, while frequently slow payers, generally do ultimately pay. Many originators, therefore, do not classify such debt as in default regardless of the length of time it has been classified as delinquent. The rating agency, however, views a portfolio in terms of its ability to make timely payments to investors in a securitisation. To size credit enhancement appropriately, the rating agency should be able to project accurately what percentage of cash flows from a portfolio may not be available, due to extended non-payment, to meet repayment obligations to investors. Definitions aside, the format in which performance data is required for a securitisation transaction often differs from an originator s normal reporting. Originators often track the performance of their asset portfolios based on dynamic analysis, e.g. current month delinquencies are measured as a percentage of current month total outstanding portfolio balance. Trends in these performance measurements are then tracked across time. However, the securitisation process requires static pool analysis, whereby an originator s asset pool that is to be securitised is broken into static pools. A static pool, or vintage, is a group of assets originated during a specific calendar period, typically a month, quarter or year. Cumulative gross losses and recoveries for each pool are then tracked independently over the remaining life of the assets. Static data analysis allows the rating agency to move beyond an understanding of fluctuations in levels of credit losses over time towards a further understanding of the timing of losses within an asset s life cycle and how the performance of assets may be changing. By analysing different vintages, the rating agency gains insight into how losses build up over the life of the assets and how the loss profile may have altered over time. The rating agency should also be able to quantify the magnitude of ultimate losses in a portfolio caused by defaults. This necessitates static data on amounts and timing of recoveries. The rating agency needs to estimate, based on historical data, how long it takes for the originator to recover funds from defaulted assets. It uses this information to model the level and timing of cash flows a securitisation transaction can realistically expect to receive from defaulted assets to meet its obligations to investors. Some asset classes such as residential mortgages are affected by prepayments and it is important for the rating agency to be provided with this information. 174

A rating agency typically expects a minimum of three to five years of historical data before it can draw meaningful default, recovery and prepayment assumptions. The goal of the data is to create a base case model of performance that can be used to forecast performance. The less data available, the more conservative the rating agency s default probability and realised loss assumptions become, which will result in increased credit enhancement levels for the transaction. 4.3 Dynamic versus Static Analysis A typical business relies on the cash flows from a revolving base of receivables to pay its debts. As long as the business is able to continue to generate new receivables, the corresponding cash flows can be used to cover losses caused by customers who defaulted on their obligations. A revolving pool of assets is referred to as a dynamic portfolio, and the performance of such a portfolio is tracked through dynamic analysis, whereby one current portfolio measurement is compared with another current portfolio measurement, e.g. current month defaults against current month total portfolio balance. Trends in these dynamic performance measurements are then tracked across time. However, dynamic data frequently masks certain trends owing to shifts in portfolio seasoning 63 and overall size. For originators with growing portfolios, dynamic data is particularly problematic, as it tends to make the performance of an asset portfolio look better than it actually is. This because newly originated assets tend to perform better until they become more seasoned and delinquency and default trends develop (Dommisse et al., 2005:3). By contrast, during the amortisation period of a securitisation transaction, when investors are repaid, the transaction relies on the cash flows from a static pool of assets, since no new assets are added to the pool. To size credit enhancement for the transaction appropriately, the rating agency must be able to accurately project what percentage of cash flows from a static pool of assets will be unavailable to the transaction s repayment obligations. The risk in a securitisation transaction is the performance of a static portfolio of assets rather than that of a dynamic portfolio. A review of the originator s assets by static vintages provides important insights into the potential performance of a securitised pool. When preparing for a securitisation the originator s total loan pool is divided into vintages based on the calendar period, typically a quarter, in which each loan was originated. A common understanding must be achieved between the originator and the rating agency on the definition of default. It is necessary to set a date beyond which a delinquent asset is classified as defaulted, for example, all loans 63 The time that has elapsed from an asset s origination date. 175

more than 150 days delinquent are classified as in default. The data reviewed should reflect this definition. Defaults are then tracked by vintage and the number of quarters after origination in which the defaults were recorded. The rating agency uses the static data relating to the historical performance of the asset pool to estimate base case levels of gross defaults and the projected timing of the defaults and recoveries (Dommisse et al., 2005:2). An originator s consumer loan pool can be divided into vintages based upon the calendar period in which each loan was originated. For example, as illustrated by Chart 4.1 below, the originator s loan book is divided into 10 vintages reflecting the assets originated in each quarter, starting in the third quarter of 2001 through to the fourth quarter of 2003. The quarters in which the loans were originated are labelled consecutively as vintage A to vintage J. Vintage A thus reflects all the loans that were originated in the third quarter of 2001, being R612 000, vintage B all the loans that were originated in the fourth quarter of 2001 (R673 400), and so on till the last vintage J, during which quarter R1 569 557 in loans were originated. Chart 4.1: Vintages of loans The originator then tracks defaults by vintage and the number of quarters after origination in which the defaults were recorded. For example, consider a loan that was originated in the third quarter of 176

2001 and was classified as defaulted in the third quarter of 2002. Such a default would be recorded in vintage A in the fourth quarter after origination. Chart 4.2 below illustrates how, in terms of static data analysis, the originator would track gross defaults on the loans originated in vintage A. The originator records the value of gross defaults in each quarter (column A), keeps a running calculation of the cumulative gross defaults for the vintage (column B), and calculates the cumulative gross defaults as a percentage of the total amount originated in the vintage (column C). It completes this process for all vintages for which data is available. Chart 4.2: Static default data for one vintage The example shows that for all the loans originated in vintage A, that is R612 000 in the third quarter of 2001, there were no defaults in the fourth quarter of 2001, which is the first quarter since origination. Defaults to the amount of R1 224 occurred in the first quarter of 2002, which was the second quarter since origination, R1 836 in the second quarter of 2002, which was the third quarter since origination, and so on till the first quarter of 2004, which was the tenth quarter since origination, and in which no defaults were recorded. Total defaults since origination amount to R10 159, which represents 1.7% of the R612 000 originated in vintage A. 177

The data reflects the cumulative percentage of the original amount of the vintage that has defaulted since origination. The cumulative amount of gross defaults for the vintage can be plotted as a percentage of the original origination amount to show the cumulative gross default curve for the vintage. Plotting the cumulative gross default curve for vintage A shows that the largest value of defaults, that is R4 284, was recorded in the third quarter of 2002, which was the fourth quarter since origination. Thereafter defaults levelled off, with R1 836 recorded quarter 5, R306 in quarters 6, 7 and 8, R61 in quarter 9, and no defaults were recorded in the tenth quarter after origination. This process differs substantially from the way in which defaults are usually tracked in terms of dynamic analysis. Information management systems are often unable to report static default data automatically, and require alterations that may delay a transaction. Assets that have been classified as defaulted may still generate some additional cash flows to the transaction through recoveries. Static analysis considers gross defaults and recoveries separately, whereas originators usually monitor net losses or track total recoveries during a given period as a proportion of total defaults, a process which is dynamic analysis. Tracking defaults and recoveries separately as static pools is important, because securitisations are sensitive to the timing of defaults and the time it takes to recover losses. Although static recovery analysis also uses vintages, they are not the same vintages as used in the static gross default analysis. In static recovery data, the vintage should reflect the point at which the asset defaults, rather than when it was originated (Dommisse et al., 2005:4). For example, a loan that was originated in vintage A and was classified as in default in the third quarter of 2002, would in terms of recovery analysis be included in the vintage for the third quarter of 2002 (vintage E). The value of recoveries in each successive quarter is recorded and the cumulative recoveries for the vintage are then tracked. The data is plotted as a percentage of the cumulative gross default for the vintage to show the cumulative recovery curve for each vintage. Evaluating the cumulative gross default curves of all the vintages enables the rating agency to understand the timing of defaults within a vintage, and how vintages performed over the reported period. In Chart 4.3 below, the data represents the cumulative loss curves for different vintages of a portfolio of auto loans originated from the first quarter of 1999 to the first quarter of 2000. 178

Chart 4.3: Static default data for different vintages The static data analysis shows that the performance of the vintages deteriorated over the reporting period, with higher and more rapid growth of defaults in the assets originated in later periods. This may be due to relaxed credit granting standards by the originator, or may reflect the impact of adverse economic conditions on borrowers. When defaults start to occur earlier in a vintage, it may indicate a relaxation in credit standards, while later defaults may represent a change in economic conditions (Dommisse et al., 2005:3). Dynamic analysis frequently masks these types of trends, which is why static data is important to the securitisation process. 4.4 Binomial Expansion Technique A number of methods can be used to estimate the expected loss for asset-backed securities, ranging from Monte Carlo simulation techniques, which are fairly accurate but cumbersome to implement, to rather simple single-event models, which are easy to implement, but much less accurate. Cifuentes and O Connor (1996:1 to 4) describe an alternative to simulation or single-event models, which is the binomial expansion technique (BET) that combines the best of both worlds: a high degree of accuracy coupled with computational friendliness and is well suited to the rating of collateralised debt obligations. 179

The binomial expansion technique is based on the diversity score concept. The idea is to use the diversity score to build a hypothetical pool of uncorrelated and homogeneous assets that will mimic the default behaviour of the original pool. Let D be the diversity score of the collateral pool. Then the behaviour of the collateral pool can be modelled using a fictitious portfolio consisting of D bonds, each of which has the same par value (total collateral par value divided by D). It is also assumed that all these bonds have the same probability of default, determined by the weighted average probability of default of the collateral pool. Then, as far as defaults are concerned, the behaviour of this homogeneous pool of D assets can be fully described in terms of D possible scenarios: one default, two defaults up to D defaults. The probability Pj that scenario j (j defaults) could happen can be computed using the binomial formula: Pj = D! j!( D j)! p j D j (1-p) In the formula p presents the weighted average probability of default of the collateral pool (stressed by the appropriate factor). Let Ej be the loss for the note to be rated under scenario j. The loss, expressed as a percentage, can be computed by taking the present value of the cash flows received by the note holder, assuming there are j defaults, and using the note coupon as the discount factor. The total expected loss, considering all possible default scenarios, is then calculated as follows: Expected loss = PjEj D j= 1 Additional modelling complexities arise in real situations, which must address issues such as amortisation and reinvestment rates. Non-homogeneous portfolios, such as those where a few bonds account for a large portion of the portfolio, may require some modification of the binomial expansion method. 180

4.5 Calculation of Credit Enhancement The rating agency uses the results from the static data analysis of defaults and recoveries to formulate a base case 64 assumption for portfolio losses. The base case loss assumption is then stressed by applying a target rating multiplier to it which is appropriate for the stress experienced at a target rating. From this is deducted the base case recovery rate in order to find the credit enhancement level for each target rating. Example: Typical rating agency 65 multipliers for each target rating level are as follows: AAA 5x AA 4x A 3x BBB 2x BB 1.5x B 1x Assuming a base case loss projection of 2.5%, and a 40% recovery rate, the following credit enhancement levels would be required for each target rating: AAA 5 x 2.5% x (1-0.4) = 7.5% AA 4 x 2.5% x (1-0.4) = 6.0% A 3 x 2.5% x (1-0.4) = 4.5% BBB 2 x 2.5% x (1-0.4) = 3.0% BB 1.5 x 2.5% x (1-0.4) = 2.25% B 1 x 2.5% x (1-0.4) = 1.5% One of the significant features of securitisation as a structured finance device is that the rating is a target, not a fait accompli. Every securitisation transaction has the potential to result in a given rating. For example, if an AAA rating is targeted in a loan pool originated by an A-rated originator, all that is required, is to work out the level of credit enhancement or subordinated interest (Kothari, 2003:259). 64 Expected performance under a non-stressed economic scenario. 65 Fitch Ratings. 181

5. COMBINING QUANTITATIVE AND QUALITATIVE MODELS 5.1 Limitations of Statistical Models Statistical models have revolutionised risk management by providing the credit analysis process with efficiency, speed, accuracy and consistency, and by maximising the quantification of risk. However, statistical models have limitations. Some of these limitations relate to the quality and exact meaning of the data, whereas other factors simply cannot be quantified. Ernst (2001:2-6) describes the limitations of statistical models as expressed below. 5.1.1 Unreliable or Erroneous data The output of statistical models can only be as good as their underlying data. All models are driven by numbers that represent a translation of certain forms of data, for example historic default rates and recovery rates. This data is generated by human and potentially unreliable sources or processes. In addition to errors occurring once the data has been originated, any later conversion or manipulation of the information can result in erroneous input. Accordingly, it is important to understand the data s sources, how it was calculated and what it means. 5.1.2 Not Random, Limited or too Small Sample If historic performance data, on the basis of which future performance is projected, derive from a selected sample, or from the performance of only one type of loan or loans originated in only in one region, the projected performance will only be accurate with respect to that narrow sample. Similarly, loan-by-loan models, whose projected default rate is based on an historical correlation among loan characteristics such as loan-to-value or debt-to-income ratios, will not be statistically accurate if the data sample on which the historic correlation is based was too small, or was not selected at random. 5.1.3 Historic Data not Always a Good Proxy for Future Performance Statistical models rely on past data. However, past data is insufficient because it represents a sequence rather than a set of independent observations as demanded by the laws of probability. It is natural to expect a sequence of historic events to repeat or maintain itself in the future. However, wild events are bound to happen at some point, the only question is when. An example of such an unexpected event was the New York stock market crash of 1987. On 19 October 1987, also known 182

as Black Monday, the Dow Jones industrial index collapsed by 22.6%, nearly double the percentage drop of the index on 29 October 1929. From the close of trading on 13 October 1987 to the close of trading on 19 October 1987, the Dow fell by almost a third, resulting in a loss in value of shares of approximately one trillion dollars. Some market observers calculated that the 19 October crash was a 27 standard deviation event, which should only occur with the probability of 10 to the 160 th power, a virtual impossibility. 5.1.4 The Tail Loss Probability Distribution is Crucial, but Difficult to Quantify Arguably the most important role of models in the context of securitisation rating is an assessment of the loss probability distribution on the issued securities. Based on the input of asset pool characteristics, historic performance data and other relevant assumptions, the model suggests a certain probability for each loss scenario, with respect to each of the rated classes. Chart 4.4 below gives a basic illustration of the loss probability distribution, with loss scenarios in the middle of the spectrum having the highest probability, with a gradual reduction in probability as the loss scenarios are approaching the extreme ends of the spectrum (very low or very high losses). Normal Distribution of Loss Probability Probability Source: M oody's Loss Chart 4.4: Loss probability distribution However, whereas statistical models are quite good at estimating the mean, or the expected case of loss, it is much more difficult to quantify the tail of the probability distribution, that is, to assign probabilities to the extreme cases of loss scenarios that are several standard deviations away from the mean. It appears that the probability of these extreme cases is much more sensitive to economic changes, the originator s credit culture, the servicing quality and other factors that are difficult to quantify. 183

The tail of the loss distribution is nearly all that matters when it comes to assigning credit enhancement levels to the highly rated classes, because a high rating means that the security can sustain a greater level of stress without suffering losses, and is accordingly associated with extreme cases. Therefore, it may well be the case that a model is sufficiently accurate with respect to the speculative-grade classes, which are closer to the mean, but is erroneous with respect to the credit enhancement of the investment-grade classes due to inaccuracies in the pool data, unreported credit changes, origination strategy changes, and other non-quantified factors. Chart 4.5 demonstrates how the expected loss probability of extreme cases, the distribution tail, can vary, although the distribution mean remains the same. Assuming that the model presents these two possible distributions of loss for a given asset-backed security, one would need to evaluate which distribution is the more realistic in order to determine what credit enhancement levels are needed. Probability of the Distribution's Tail Probability A X B Source: Moody's Loss Chart 4.5: Variations in probability distributions If X represents the level of credit enhancement that was assigned to the AAA class of securities, it is most likely due to the assessment that curve A is the most representative of the expected loss distribution, since this would be the only one of the two loss distributions that would not be expected to experience material losses with this level of credit enhancement. If, however, distribution B were to be the one occurring in reality, the X level of credit enhancement might not be sufficient to protect the AAA noteholders against losses. 5.1.5 Models Cannot Capture Nuances Arising from Different Standards in Collecting and Processing Data Even when the data used is technically correct, models cannot capture certain nuances associated with the underlying information. Different lenders use different standards when they generate the 184

data that are fed into the model. For example, using the loan-to-value (LTV) ratio in a model assumes that the appraisal of the underlying property was correct. However, a model cannot distinguish between originators who use stringent external appraisals to evaluate property values and originators who merely rely on an estimation of property prices based on property databases. 5.1.6 Different Timeframes can Yield Varying Credit Ratings The length of the timeframe within which historic data has been obtained has important implications for the outcome. This is particularly relevant when it comes to analysing historical performance data. For example, the data available may relate to a period of benign economic conditions, which would not be an accurate proxy for potential adverse economic conditions in the future. 5.1.7 Operational Changes can lead to Inconsistencies in Data Any statistical prediction with respect to the future performance of assets assumes a certain level of consistency between the credit quality of the sampled historic receivables and the quality of receivables to be originated in the future. However, if the originator goes through some operational changes, e.g. a merger or change in management, which resulted in different credit policies or a different customer base, the performance of future receivables is unlikely to be consistent with their past performance. 5.1.8 Economic Changes Economic changes will have an impact on the performance of financial instruments. While certain assessments are made with respect to relevant economic indicators, these predictions cannot be precise due to the numerous factors driving these changes. 5.1.9 Realistic Expectations It should be recognised that any statistical model has an inherent margin of error, even while assuming that the underlying data is 100% accurate and virtually all of the relevant factors were taken into account. Accordingly any model s output should be viewed through a prism of realistic expectations as to what the data means and what extent of precision it can support. 185

5.2 Importance of Qualitative Analysis Due to the limitations of statistical analysis, a comprehensive approach should include a blend of both quantitative techniques and qualitative judgement. In the context of securitisation, qualitative analysis provides an essential supplement to the qualitative analysis by (Ernst, 2001:1): validating or modifying the underlying data of the model; adding other important components, such as an assessment of the structure and legal elements, an analysis of the expected economic and industry trends, and an evaluation of the quality of origination, credit standards and servicing procedures; and questioning how reasonable the results of the quantitative analysis are by comparing them with similar transactions. Rating agencies thus use a combination of quantitative and qualitative methods when conducting its rating analysis of securitisation transactions. The qualitative review not only verifies that the underlying data is correct, but also adds non-quantitative factors to the analysis and ensures that the final result is reasonable. The asset pool analysis is split between the two methods. To evaluate the credit quality of the assets, the rating agency conducts an operational review of the relevant parties to examine the origination process, the quality of credit appraisal and the efficiency of servicing. On the quantitative side it involves the use of relevant statistical models to simulate various scenarios of frequency of default and severity of loss. At the structural analysis stage, the strength and sustainability of the transaction structure is examined from various quantitative and qualitative angles. These include an evaluation of the financial structure, the cash flow waterfall, the legal issues and tax considerations. Simultaneously, quantitative modelling is being constructed to account for the transaction s structural elements, such as excess spread, subordination of junior security classes, performance triggers, cash reserves and amortisation. Based on all of these elements, the analysis will reveal the level of expected loss with respect to each of the rated security classes. The final stage of the rating process is the rating committee during which the various pieces of the rating process are put together (Ernst, 2001:6 to 7). The rating committee is the final step in the securitisation transaction s rating process. The lead analyst s role is to present the transaction to the committee members and explain the rating methodology. The following issues are typically addressed by the rating committee (Ernst, 2001:8): 186

an overview of the transaction; underlying assets: positive and negative characteristics; originator: strategy, market position, origination process and underwriting practises; servicer (originator): collection and servicing methods, staff, information systems, backup systems; historic performance of assets: delinquency, default and recovery rates; transaction structure: parties and cash flow; cash waterfall: priorities and triggers; hedging mechanisms: interest rate and currency risk mitigation; liquidity facility; modelling: verification of the underlying data, assumptions, type of model, stress scenarios and results; legal issues: true sale, bankruptcy-remoteness of the SPV, security interest, enforceability of documents, tax considerations; preparing a list of follow-up questions; consideration of the credit enhancement levels and the rating of each class of securities; and final voting on ratings and credit enhancement levels. An extensive discussion is held concerning the transaction s structure, the relevant parties, the credit quality of the underlying receivables and the relevant legal issues, following which a vote is conducted with respect to the ultimate credit enhancement levels. An important objective of the committee is to 187

assess the soundness of the quantitative analysis, and this includes a rigid scrutiny of the models used by the analysts. The committee will typically evaluate the quality of the models underlying data, the models assumptions, the overall method and the stress scenarios that were tested. If any of this needs to be modified or re-verified, the committee s vote will either be postponed or become subject to the new results. 6. CONCLUSION Credit ratings play a very important role in securitisation transactions and the issuance of asset-backed securities. The structure of the transactions is generally complex, which makes the task of assessing the credit risk difficult for investors. Credit ratings provide a simple and objective assessment of default risk in the form of a symbol that is easy to comprehend. The framework used for assessing the risk of default in asset-backed securities involves three types of risk credit risk, structural risk and legal risk. Credit risk is the risk of default by the borrowers in the underlying loan pool backing the securities issued. Structural risk refers to the manner in which the transaction is structured to direct the cash flows from the underlying assets (loans) to the investors in the securitisation. Legal risk refers to the compliance with various laws and regulations, and issues relating to a true sale of the assets, the bankruptcy-remoteness of the issuer (SPV), and the legal enforceability of security. The rating process involves an evaluation of the originator, the collateral (underlying assets) backing the securities issued, and the structure of the securitisation transaction. Such evaluation by the rating agency is performed through due diligence, stress testing and credit evaluation, which is followed by an appropriate legal review that provides confidence in the legal opinions relating to true sale of assets, enforceability of security, bankruptcy-remoteness and tax neutrality. Securitisation involves the separation of the credit risk of the underlying assets from the credit risk of the originator. An evaluation of the originator is nevertheless important because of the potential impact on the ability of the originator to continue generating asset of an acceptable quality, which is especially important in revolving transactions. The quality of the underlying assets is an important factor in the level of credit risk absorbed by investors and consequently reflected in the ratings assigned to the asset-backed securities. The most important structural element of a transaction is the level of credit enhancement that is provided, which is another element that allows the credit rating of the asset-backed securities to exceed that of the originator. 188

In order for the rating agency to maintain its rating of the securities, it requires ongoing performance data on the transaction from the originator in the latter s role as servicer. The servicer must also inform the rating agency of events and circumstances that may have an impact on the transaction. If worrisome trends are noted, corrective action needs to be taken to prevent the securities being downgraded. The rating agency uses the performance reports that it receives to prepare surveillance reports for the investors in the asset-backed securities. 189

CHAPTER FIVE AN OVERVIEW OF CAPITAL ADEQUACY REGULATIONS 1. INTRODUCTION The purpose of the chapter is to examine: the risks banks are exposed to; bank capital management; the reasons for banking regulations; how the regulatory environment developed; and to discuss the features of the new Basel II framework as they pertain to the banking industry. Banks play a fundamental role in any country s economy. They accept deposits and act as custodians of much of the public s money; they provide a payments system that makes it unnecessary to make payments in hard cash; they advance loans to clients; they trade in various types of assets; and they provide specialised services to the public such as the purchase or sale of foreign currency. The banking environment is, however, constantly changing. Competition, globalisation, technological innovation and financial engineering have changed the world of traditional banking. Banks have always been in the business of accepting deposits from the public, using the proceeds to make loans to businesses. More recently banks have started to make extensive use of financial engineering techniques, specifically securitisation, to manage in particular their regulatory capital. Banks are exposed to a variety of risks such as credit, liquidity, interest rate and currency risk. Another important risk is capital risk, which is the risk that a bank s capital may be eroded by losses and the bank becoming insolvent, resulting in depositors losing their savings. Capital is one of the most important requirements for starting a bank and to continue operations, the bank s capital has to be efficiently managed. In the management of their capital, banks make a distinction between economic capital, which is the capital that a bank has to set aside as a buffer against potential losses 190

arising from its business, and regulatory capital. Regulatory capital is the capital that banking supervisors require a bank to hold. In order to protect depositors, and because of the important role that banks play in a country s economy, they have always been regulated by national supervisors. The need for regulation also stems from the inherent instability of banks due to their high financial leverage. Banks are considered to be more fragile than non-banks, thus more subject to failure. Regulators have imposed strict capital adequacy requirements on banks to reduce, although not completely eliminate, the likelihood that banks will fail. Banking supervisors seek to ensure that banks are financially sound and have been continuously developing the regulatory environment under which banks operate. The most important international regulatory initiatives have been the Basel Concordat of 1975, which deals with the supervision of banks foreign operations, and the Basel Accord of 1988 that deals with the issue of banks solvency by stipulating specific minimum capital adequacy ratios. Although the Basel Committee s recommendations possess no legal force, most countries in the world have adopted these guidelines, in many cases, as in South Africa, instituting even stringer capital adequacy requirements. As the financial environment has become more complex, banks have responded to these challenges by developing internal risk management systems to measure accurately the risk they are exposed to and allocate economic capital accordingly. This development has resulted in a divergence between the economic capital that banks allocate to particular classes of assets, and the regulatory capital that they are required to hold against these categories of assets. Under the provisions of the Basel I Accord a bank must hold at least 8% capital, irrespective of the credit risk rating the bank may allocate to the client. The bank, however, may in terms of its internal credit grading allocate much more or much less economic capital to the exposure than 8%. This discrepancy has opened the way for what is called regulatory arbitrage, which is the process whereby a bank restructures its assets, or at least some of its assets, in such a manner as to attract a lower regulatory capital charge, though not necessarily a lower actual economic risk charge. Typically a bank might sell its lowest risk assets that yield the lowest margin because of the low risk, and keep the higher-risk but higher-yielding assets on its balance sheet, since the regulatory capital it has to hold against the high-risk assets is the same as that which it has to hold against the low-risk assets. The main driving force behind the development of the new Basel II framework, which is to replace the Basel I Accord, is to align banks regulatory and economic capital better, thereby reducing the regulatory arbitrage activities of banks. Another important motivation for the Basel II framework is to foster efficient risk management practises in the banking industry. The Basel II framework was published in 2004 and is expected to be 191

implemented by the European banks and the largest United States banks by 2007. Final implementation in South Africa is scheduled for 2008. 2. BANKING RISKS AND THE CAUSES OF BANKING CRISES Banks have to manage a variety of risks, which generally can be summarised under six main headings (Meek, 1982, cited in Falkena et al., 1989:4). 2.1 Credit Risk Credit risk refers to the risk that a borrower may not be able to repay its loans. Credit risk is inherent in the process of financial disintermediation as lenders and borrowers meet on different terms. A primary function of a bank is to evaluate the risk of loans made to individuals, companies and government institutions. As the business performance of the debtor falls outside the control of the bank, credit risk cannot be easily manipulated once credit has been granted. The major part of credit risk assessment is related to the initial assessment. Banks cannot avoid losses altogether but can reduce these through the actuarial principle of risk diversification. The aim is to spread the risk over a wide spectrum of customers groups, industry sectors, geographical areas, products, purposes, and achieve a balance between short-term and long-term lending. Part of the credit risk is absorbed by the price of credit. The higher the perceived risk of a borrower, the higher the interest rate charged. 2.2 Liquidity Risk Liquidity risk is the risk of not being able to generate sufficient cash to meet financial commitments. It refers particularly to the risk of a bank not being able to repay its maturing deposits. Liquidity risk is one of the primary risks to which banks are exposed. Banks as financial intermediaries place themselves between depositors and borrowers in order to bridge the different requirements of these parties. Typically borrowers want loans for longer periods than the periods that depositors are prepared to invest their funds at the banks. Banks bridge this maturity gap by borrowing short-term from depositors and lending long-term to borrowers in what is termed maturity transformation (Kelly, 1993:319). By doing so the banks absorb the inherent liquidity risk, for which they are compensated by earning higher interest on long-term loans than the amount they pay for short-term deposits (assuming a normal upward sloping yield curve). Banks must find a balance between longterm loans funded by short-term deposits. Too much liquidity means a loss in potential revenue, while too little can force a bank into insolvency. In essence liquidity risk is due to a faulty bank 192

balance sheet structure, which has no cushion of resources to provide the cash to cope with unexpected events (Revell, 1975, cited in Falkena et al., 1989:78). Active cash flow management is therefore crucial to liquidity risk management. A major problem in this regard has always been the fluctuations in the business cycle and the corresponding changes in the liquidity preferences of bank clients. 2.3 Interest Rate Risk Interest rate risk arises from banks practice of borrowing short from depositors and lending long to borrowers, and the risk of short-term interest rates increasing, thereby eroding the interest rate spread between short-term and long-term interest rates. Interest rate risk is closely linked to liquidity risk. If interest rates on long-term investments are higher than interest rates on short-term investments, the yield curve is said to be normal or positively sloped. In order to maximise profits a bank will borrow funds short-term and grant long-term loans. In doing so the bank will increase its profitability (if its interest rate view proves to be correct), but at the expense of increased liquidity risk as well as increased interest rate risk (if short-term interest rates were to rise above long-term interest rates). This conflict is referred to as the tension between profitability and liquidity (Falkena et al., 1989:40). If, on the other hand, the returns on short-term investments are higher than the return on long-term investments, the yield curve is said to be inverse or negatively sloped. In this case a bank would borrow long-term and lend out short-term to maximise profits. In the process it would also have improved its liquidity position. Unfortunately, inverse yield curves do not exist for long, as the yield curve always returns to its normal slope. Once this happens the bank will sit with long-term deposits it can only invest short-term at a low yield, thereby losing its positive interest spread. The bank would still be liquid, but at the expense of profitability. 2.4 Currency Risk Currency risk entails the risk of currency exchange rates changing to the detriment of the bank. Currency risk can be divided into transaction risk, economic risk, and translation risk. Transaction risk represents the price impact of an exchange rate change on foreign receivables and payables. Economic risk relates to the impact of exchange rates on the competitiveness of economic units, and is of a macro-economic nature. Translation risks arise from the periodic consolidation of the financial statements of a parent and its foreign affiliates, and are essentially book entries. The relevant risk that a bank is thus exposed to is transaction risk. 193

2.5 Investment or Market Risk Investment or market risk is the risk of a decline in the market value of a bank s holdings of marketable financial instruments due to changes in interest rates (ibid.). Market risk can also be defined as the sensitivity of the value of a financial instrument or portfolio to changes in market parameters (Goldman Sachs and SBC Warburg Dillon Read, 1998:33). Financial instruments are loosely qualified as spot, forward or option instruments. A financial instrument can be owned: outright (a spot instrument); will be owned at some point in the future (a forward instrument); or may be owned in the future (an option instrument). Market risk can be broadly categorised in terms of the asset flow that underlies the instrument as being interest rate, foreign exchange, equity or commodity related. An interest rate instrument can for instance comprise a spot instrument (fixed rate bond), a forward (interest rate future), or an option (interest rate option). With respect to instrument types, the risks increase going from spot to forward to option. For spot instruments the major risk is a change in the spot price of the instrument itself. Forward instruments are influenced by the spot risks connected with to the underlying instrument as well as changes in yield curves. These risks, which govern the relationship between the spot price and the forward price on the same asset, are termed basis risks. Options are exposed to both spot and basis risk. In addition, options are exposed to the probabilities of various outcomes. This is volatility risk. Options are also sensitive to changes in volatility risk itself, and this is termed curvature risk. 2.6 Capital or Solvency Risk Capital or solvency risk refers to the risk of a bank s capital being eroded by operating losses or losses on investments. Capital in an economic sense can be defined as the basic source of funds that would be used first in the event of asset shrinkage on the balance sheet of a bank due to losses. To fulfil its role, capital should have two principal characteristics: it should be explicitly subordinated to the claims of depositors, and should be of a permanent nature. The three items on a bank s balance sheet that satisfy these requirements are equity, reserves, and subordinated debt. There are, apart from the regulatory capital directives that banks have to adhere to, several economic incentives for banks to have adequate capital. Capital can absorb losses that may arise from the bank taking onto its balance sheet high-yielding high-risk assets. Capital adequacy also determines the capacity of a bank to attract additional capital from the equity and capital markets when required. The creditors of a wellcapitalised bank, the bulk of which are its depositors, enjoy greater protection should the bank fail. Banks have to maintain adequate capital to protect depositors from not being repaid. Being well capitalised inspires confidence in depositors and serves to attract deposits. 194

In addition to the six traditional risks that banks are exposed to by virtue of their deposit taking and loan granting functions, operational risk has become an important risk factor. Operational risk is the risk of the malfunctioning of information systems, reporting systems, and internal risk monitoring rules of a bank (Bessis, 1998:12). Operational risks appear at two different levels in a bank, namely the technical level, relating to information systems and risk measures, and the organisational level, relating to the reporting and monitoring of risks, and all related rules and policies. Technical risks cover a number of specific risks such as errors in the recording process of transactions, deficiencies in the information system, and the absence of adequate tools for measuring risks. Even when the information systems and risk measurement tools are well developed, the organisation of the reporting and monitoring function deserves much attention. The fundamental principle in this regard is to separate the risk takers from the risk controllers, i.e. the commercial business units that generate risks should be distinct from the credit or risk departments whose function it is to supervise and limit risks. Financial crises are not unique to current financial systems; history is replete with banking and exchange rate crises (Bordo and Schwartz, 1996, and Kindleberger, 1978, cited in the International Monetary Fund (IMF), 1998:74). The IMF (1998:74) identifies the broad types of financial crises. A currency crisis occurs when a speculative attack on a currency results in a devaluation or sharp depreciation in the currency exchange rate, or forces the authorities to defend the currency by expending large amounts of foreign currency reserves or sharply raise interest rates. A foreign debt crisis is a situation in which a country cannot service its private or sovereign foreign debt. A banking crisis refers to a situation in which bank failures induce banks to suspend the internal convertibility of their liabilities, or which compels the authorities to intervene by extending large-scale assistance to the banks. A banking crisis may be so extensive as to assume systemic proportions. Systemic financial crises are severe disruptions of financial markets that, by impairing the markets ability to function effectively, can have considerable adverse effects on a country s economy. Financial crises of all types often have common origins such as the build-up of unsustainable economic imbalances, misalignments in asset prices or exchange rates, and sudden loss of confidence in the currency or banking system. Below, Latter (1997:21) describes the variety of reasons that may explain banking crises. 2.7 Macroeconomic Circumstances Macroeconomic instability is often cited as the principal cause of banking instability. The trigger may be a collapse of asset prices, especially property prices that may have reached unsustainable levels; a 195

sharp increase in interest rates; a fall in the exchange rate; the onset of recession; or an abrupt slowdown in inflation. 2.8 Microeconomic Policies In some cases a bank failure may be ascribed to supervisory failure, but that can never be the sole cause because there must first have been some shortcoming in the failed bank, which escaped the regulator. If supervision were to be too restrictive in order too eliminate bank failures altogether, banking would be a repressive and uncompetitive industry and thus fail in its financial intermediary role for the economy. The regulatory and supervisory system should therefore allow banks sometimes to fail for reasons of economic efficiency and to contain moral hazard. Deregulation in the banking sector has occasionally encouraged rash behaviour leading to subsequent problems. Government interference in the industry such as directives to lend (uneconomically) to certain sectors of the economy, or to fund the government deficit at below-market rates, may result in a liquidity or solvency crisis. Moral hazard is an ever-present factor: if there is a general expectation that no bank will be allowed to fail, banks may be tempted into risky lending. Shortcomings in accounting and auditing procedures may lead to bank failures. A lack of transparency may allow problems to develop to an extent which otherwise might not have been possible. 2.9 Banking Strategies and Operations Banking crises generally stem from the deterioration in the asset side of banks balance sheets. In many instances the problems of a bank have been brought about by its own strategic or operational mistakes. Typical reasons for failure are too rapid growth; expansion into new product or geographical areas; or operational failures. The most common operational failure is weak risk management. Banks often concentrate on growing the balance sheet and on maintaining market share and rigorous credit assessment is neglected. Overconcentration of lending in certain sectors, whether by design or for historical reasons, has been shown in the past to be a source of problems. Senior management may imperfectly understand the risks involved in activities such as derivatives trading, with potentially disastrous results. Unauthorised trading associated with a failure of internal controls can cause a bank to suffer considerable losses. Insufficient hedging of interest rate and exchange rate exposures is another serious operational failure. 196

2.10 Fraud and Corruption Fraud by one or a few employees can have severe consequences for a bank. There have also been instances of major frauds perpetrated by management rather than being the work of one employee. As regards the causes of banking problems, a Bank of England study in 1996 (Jackson, 1996, cited in Latter, 1997:39) identified 22 cases of banks that failed or encountered severe difficulties since 1984 for reasons listed below in Table 5.1. Type of problem Number of banks that have encountered each problem Number of banks that have encountered each problem Poor asset quality 16 - Over-concentration of lending 5 - Over-specialisation by sector or region 10 - Incorrect pricing of risk 13 Mismanagement 18 - Poor strategy 11 - Poor systems and controls 17 Dealing losses 2 Contagion 4 Illiquidity 9 Fraud 7 Table 5.1: Causes of banking problems Some banks suffered from more than one type of problem; for example, of the 18 banks that experienced mismanagement, 17 had poor systems and controls, and 11 of the 18 also suffered from poor strategy. Clearly poor asset quality and mismanagement were the major problems identified, followed by liquidity problems and fraud. Contagion has not had a significant impact, leading one to conclude that most bank problems are internally generated. 3. BANK CAPITAL MANAGEMENT Capital is the foremost financial requirement for starting a bank. Equally important is that a sufficient amount of capital must be present on a bank s balance sheet in order for the bank to continue ongoing operations. The amount of a bank s capital puts a limit on the losses it can bear. To determine how much capital is appropriate for an individual bank, three primary factors have to be taken into consideration, namely the functions of bank capital, the advantage of leverage to shareholders, and the capital adequacy as measured by the banking regulators (Hempel and Simonson, 1999:322). 197

3.1 Functions of Bank Capital The primary function of bank capital is to support or absorb risk. From the viewpoint of a bank s depositors and other creditors capital protects them from loss. Banks that operate at a higher level of risk, for example those that conduct aggressive lending should have more capital than low-risk banks. If risk-averse creditors perceive that a bank has insufficient capital for the risks that it takes, they will avoid lending to the bank. To remain creditworthy banks must thus assure that their capital at least matches the risks they take. 3.2 Advantage of Leverage The average return on assets for banks is low compared to non-banks. In order to attract and keep shareholders banks must have the financial leverage resulting from low levels of equity in relation to their assets. From the shareholders point of view the appropriate amount of equity capital is an amount that is small enough to produce an adequate return on equity and yet have enough to absorb risk. There are factors however that discourages shareholders from using excessive financial leverage. Market constraints keep creditors from lending excessive amounts to banks in relation to the funds provided by shareholders. Excessive leverage may also be inconsistent with the goal of maximising the bank s share price. The additional leverage may well increase the bank s return on actual equity, but if the price-earnings ratio declines because investors perceive the bank to be more risky, the share price may not increase but rather decline, reducing the bank s stock market value. Lastly, regulatory capital rules force banks to keep amounts of capital deemed adequate to protect depositors and the banking system as a whole. 3.3 Capital Adequacy Regulations Bank regulators are responsible for protecting depositors funds and the safety of the banking system. Although factors such as liquidity management and interest rate risk management are important in achieving those objectives, capital adequacy has always been the primary concern for regulators. The issue of bank capital adequacy has long pitted bank regulators against bank management (Koch, 1995). Regulators, concerned primarily with the safety of banks, prefer more capital, whereas bankers generally prefer to have less capital, since higher financial leverage improves a bank s return on equity. Banks must adhere to the regulatory capital adequacy standards, but regulatory adherence is only the beginning of bank capital management. Capital is the bank s ultimate scarce resource and it is 198

management s responsibility to use it as effectively as possible. Broadly speaking there are three definitions of capital to consider when analysing banks, namely book capital, regulatory capital, and economic capital (Mercer Oliver Wyman, 2003:12). 3.3.1 Book Capital Book capital is the capital actually held by the bank. Below are the questions that bank management needs to consider in managing a bank s actual capital (Hempel and Simonson, 1999:332). Which activities are viable? Which activities need correction or improvement? Which activities deserve greater emphasis and material support in the future? Which activities should be eliminated? To make these decisions banks assign their capital to absorb the risk in each of these activities. An accounting system must determine how to allocate capital to each type of activity. Capital is then assigned to cover expected losses and unexpected losses of each activity or line of business. Expected losses can be reasonably accurately established from historical experience and known characteristics of the assets in the particular line of business and loan loss reserves are assigned accordingly. Dealing with unexpected losses is more abstract because management must draw on perceptions of risk that they may never have experienced. One way of quantifying such risk is to set a probability limit on disaster scenarios and assign capital accordingly. If banks believe they have a capital shortage, or on the other hand, excess capital they can take several types of management actions as set out in Table 5.2 (Hempel and Simonson, 1999:336). 199

Bank has capital shortage Bank has excess capital Slow growth of assets and liabilities Increase growth of assets and liabilities a) Sell fixed assets a) Internal opportunities b) Sell or securitise loans b) Acquisitions Decrease risk mix of assets Increase risk mix of assets Increase internal capital generation Decrease internal capital generation a) Increase net income a) Decrease net income b) Decrease dividend payout b) Increase dividend payout Raise capital externally Reduce external capital a) Issue new shares a) Repurchase shares b) Sell debentures b) Redeem debentures Table 5.2: Capital management options 3.3.1.1 Sustainable Growth Rate If retained earnings are sufficient to fill the bank s capital needs they are usually the best form of bank equity capital to use. A general rule is that if a bank can finance all of its capital needs internally it should do so. The variables that determine to what extent a bank can finance its growth internally depend on the amount of capital required (as determined by management, the market or the regulator), the bank s earnings, and the proportion of earnings retained. The relationship between the proportion of capital that is deemed to be adequate and how much growth can be financed internally can be calculated. The annual growth rate in assets that can be supported by internally generated equity capital is called the sustainable growth rate, which can be determined by any one of four equations 66 which appear below. 66 ( PM )( AY )(1 D) a) SG = EC / TA ( PM )( AY )(1 D) ( PM )( AY )( LM )(1 D) b) SG = 1 ( PM )( AY )( LM )(1 D) ( ROA)(1 D) c) SG = EC / TA ( ROA)(1 D) ( ROE)(1 D) d) SG = 1 ( ROE)(1 D) SG = Sustainable growth rate, or the annual rate of increase in average total assets that can be supported by internally generated equity capital PM = Profit margin, or net income after taxes divided by total operating income AY = Asset yield, or total operating income divided by average total assets D = Percentage of after tax net income paid in cash dividends EC = Average equity capital TA = Average total assets LM = Leverage multiplier, or average total assets divided by average equity capital ROA = Return on average total assets, or net income after taxes divided by average total assets 200

Example: Average total assets R500 000 000 Average equity capital 34 000 000 Expected net profit margin 8.50% Expected annual growth rate of average total assets 12.00% Expected return on average total assets 1.02% Leverage multiplier (capital-asset-ratio of 6.8%) 14.71X Expected return on average equity capital 15.00% Cash dividend payout percentage 40.00% 3.3.1.2 The ROA Should Support the Expected Annual Growth Rate of Average Total Assets If the expected annual growth rate of average total assets is 12% for this bank, the ROA required to support that growth is: ROA = ( EC / TA)( SG) (1 + SG)(1 D) = (0.068)(0.12) (1.12)(1 0.40) = 1.21%. 3.3.1.3 The Cash Dividend Payout Percentage Should Support the Expected Annual Growth Rate of Average Total Assets For this bank, with a desired ratio of equity capital to total assets of 6.8%, an expected ROA of 1.02%, and a 12% expected annual growth rate of average total assets, the cash dividend payout percentage is: D = 1 - ( EC / TA)( SG) ( ROA)(1 + SG) = 1 - (0.068)(0.12) (0.0102)(1.12) ROE = Return on average equity capital, or net income after taxes divided by average equity capital 201

= 28.57 percent. 3.3.1.4 The Equity Capital ratio (EC/TA) Should Sustain the Expected Annual Growth Rate of Average Total Assets To sustain an annual growth rate of 12% in average total assets, with an ROA of 1.02% and a cash dividend payout of 40%, the bank s equity capital ratio will decline to: EC/TA = ( ROA )(1 D) SG + (ROA)(1 - D) = ( 0.0102)(1 0.40) 0.12 + (0.0102)(1-0.40) = 5.71%. 3.3.2 Regulatory Capital Three basic categories of capital can serve the purpose of regulatory capital, namely equity capital, debt capital and hybrid capital, the last combining features of the first two types of capital. The minimum share capital and unimpaired reserve funds capital that South African banks have to hold is set out in The Banks Act (1990). An abbreviated summary is listed below (The Banks Act, 1990:64). 3.3.2.1 Primary Share Capital Primary share capital means capital obtained through the issue of ordinary shares or non-redeemable non-cumulative preference shares, excluding ordinary or non-redeemable non-cumulative preference shares issued in pursuance of the capitalisation of reserves resulting from a revaluation of assets. 3.3.2.2 Primary Unimpaired Reserve Funds Primary unimpaired reserve funds mean funds obtained from actual earnings or by way of recoveries, premiums on the issue of ordinary shares or non-redeemable non-cumulative preference shares or a surplus on the realisation of capital assets, and which have been set aside as a general or special 202

reserve, and are disclosed as such a reserve in the financial statements of the bank concerned and are available for the purpose of meeting the liabilities of, or losses suffered by, the bank. 3.3.2.3 Secondary Share Capital Secondary share capital means a prescribed percentage of capital obtained through the issue, approved by the Registrar, of: cumulative preference shares; ordinary shares, or preference shares other than cumulative preference shares, issued in pursuance of the capitalisation of reserves resulting from a revaluation of assets; and prescribed categories of debt instruments. 3.3.2.4 Secondary Unimpaired Reserve Funds Secondary unimpaired reserve funds mean: such funds, obtained from actual earnings or by way of recoveries, as may be prescribed and which have been set aside but which are not disclosed as a general or special reserve in the financial statements of the bank concerned; a prescribed percentage of the amount of any surplus resulting from the revaluation of assets and determined as prescribed; general provisions held against unidentified and unforeseen losses; and funds obtained by way of premiums on the issue of cumulative preference shares or debt instruments issued in accordance with the prescribed conditions, whether or not such funds are disclosed as a general or special reserve in the financial statements of the bank concerned. The capital, the sum of a bank s primary and secondary capital and a bank s primary and secondary unimpaired reserve fund, that a bank in South Africa must hold may not be less than the greater of R250 million, or an amount which represents a prescribed percentage of the bank s risk-weighted 203

assets. The prescribed capital adequacy percentage is currently 10%, which is higher than the Basel I requirement of 8%. 3.3.3 Economic Capital Economic capital is the capital banks set aside as a buffer against potential losses inherent in any business activity, for example, corporate lending or currency trading (KPMG, 2003:1). The Basel Committee defines economic capital as a measure of the amount of capital that a firm believes is needed to support its business activities or set of risks (Basel Committee, 2003:5). Economic capital methodologies seek to aggregate multiple risks such as credit risk, market risk and operational risk, into a single amount of capital needed to support a given set of risks. They are often based on statistical methods, for example the amount of capital needed to absorb losses up to a specified probability (e.g. 99.9%) over a specified time horizon (e.g. one year). The concept of economic capital is a relatively recent phenomenon that evolved in the 1990s from the needs of capital management and risk management, and has become increasingly central to banks decision making. In essence it is a way of quantifying the risks faced by a bank and making sure there is enough capital to cover unexpected losses, and that all expected losses are factored into pricing. The idea is not only to avoid insolvency resulting from a series of disasters, but also to determine whether the bank is deploying its capital in the best possible way. The idea emerged with individual business units in banks as they tried to assess which loans gave the best returns, taking into account the risk of default, and trading departments began using similar ideas to work out the market risk of each asset or liability and determine the expected returns accordingly. Subsequently, some of the biggest banks have realised that if they combine all these various risk assessments, they can determine the risks and capital requirements across the whole group too. That would help to guide strategy because they could compare the economic profit of each business unit more fairly. Economic capital allows banks to take into account the cost of risk when planning their future strategies, by making it clearer which ventures create the most value. It enables them to reassess their investment strategies and to make better operational decisions in areas such as pricing and capital allocation. Until recently the complexity of economic capital systems deterred smaller banks from introducing them. That is now changing and economic capital models are gradually filtering down to smaller banks. The biggest impetus towards the adoption of economic capital comes from the pressure for higher returns in an environment of increasing volatility and competition within many financial markets. The result is that all banks, even small ones, are under increasing pressure to improve their internal risk assessment systems (Price Waterhouse Coopers, 2002:7). 204

Regulators are also seeking to link improved risk management to regulatory capital relief. New banking regulations will reward banks for calculating more accurately the level of their risks and the capital they need to set against them. The shift towards a degree of self-regulation is designed to take advantage of banks greater understanding of the risks they are taking and greater ability to quantify these risks. The Basel Committee has long recognised that its existing capital requirements are increasingly out of kilter with banks real risks. Basel II would enable banks to place more reliance on their internal risk assessments as a basis for determining a more appropriate level of minimum regulatory capital. Banks use economic capital for the following main reasons (Price Waterhouse Coopers, 2002:8): too ensure a safe level of capital to guard against disasters and meet regulatory requirements; to ensure that risks are being managed appropriately and to assess whether risk controls are cost effective; to ensure the bank is correctly capitalised for the risks it assumes; and to ensure that capital is being used efficiently to produce the best returns, and to assess strategy and to support decision-making. Linking risk to capital requires the identification of all material risks and the measurement of these risks, the aggregation of all risks for business lines and for the bank as a whole, and the specification of the risk taking capacity and the tolerance for risk (i.e. definition of target rating and the amount of equity required as economic capital) (KPMG, 2003:5). The actual process of establishing an economic capital system is far from easy, however. Banks need to collect data on three main types of risk namely credit risk, market risk and operational risk. They also need to establish a number of scenarios to cover the full range of possible outcomes, which can be particularly hard in areas such as retail credit or operational risk. To calculate economic capital, a bank needs to quantify the risks it faces over a time period that is relevant to management by analysing what the potential losses could be as well as the probability of a loss of that size. While economic capital can be measured in a variety of ways the most common methodology involves the development of a statistical distribution of potential losses associated with a given set of risks. The distribution can be used to produce an estimate of the probability that a particular loss threshold will be exceeded for a predetermined percentage of the time (called the tolerance level, or also the confidence level). There are several basic 205

ways in which a statistical distribution of potential losses can be generated (Basel Committee, 2003:28) and these are: the analytical method where historical data are fitted to a mathematical distribution formula; the historical data method where actual outcomes are ordered by size and a desired percentile of the result is selected; and the simulation method where a large number of simulations are performed, the results are rank ordered and a percentile of the result is utilised. Risk refers to the probability of loss loss being the adverse variability of returns or the adverse deviation from an expected return (Kelly, 1993:29). There are three types of loss, these being expected loss, unexpected loss, and exceptional loss (Bessis, 1998:68). The expected loss, or EL, is a statistical estimate of average losses. The average loss is often calculated for credit risk because it represents the statistical mean of losses across a portfolio and over all possible outcomes. The unexpected loss, or UL, is the maximum loss that will be exceeded only in a specified fraction of all cases, the fraction being the confidence level. Exceptional or catastrophic losses are those that occur beyond the specified maximum unexpected loss. Their likelihood of occurrence is normally very low and in practice difficult to value. In statistical terms, expected losses, EL, are represented by the amount of loss equal to the mean of the loss distribution (Fitch, 2004:3). Unexpected losses, UL, are represented by the difference between this mean loss and the potential loss represented by the specified confidence interval. Unexpected losses thus represent the economic loss a bank is exposed to, and that should be covered by capital. The expected loss is the loss that a bank can reasonably expect will occur, and the bank would typically cover this exposure through pricing for risk and by creating loan loss reserves. Expected loss for credit risk can be quantified as set out below. Expected Loss (EL) = Probability of Default (PD) x Loss Given Default (LGD) x Exposure at Default (EAD) Definition: The likelihood of a borrower The fraction of exposure at default The exposure at risk in the case being unable to repay. that is lost in the case of default. of a default. Economic capital focuses on unexpected losses, which generally arise through lower than expected returns from assets. The unexpected loss, or maximum loss at a given confidence level, is also called the Value at Risk (VaR). The confidence level is the probability that the loss will exceed this 206

maximum value. The concept of VaR is that unexpected losses over a given time horizon will exceed allocated capital only with a pre-defined probability. VaR thus measures the maximum possible loss to a given probability (confidence level, for example 99%) over a given time horizon (holding period, for example one year). A one-year VaR of R100 at a 99.9% confidence level means there is only a 0.1% probability that unexpected losses will exceed a R100 over a one-year period, or alternatively a 99.9% chance that unexpected losses will not exceed R100 over the one-year period. The VaR methodology can also be used to define risk-based capital and it then becomes Capital at Risk (CaR), which is the economic capital required to absorb potential losses at a given confidence level, the confidence level being the default probability of the bank. The choice of the two key parameters confidence level and time horizon depends on the intended use of the economic capital that are to be calculated. There are two methods for selecting these parameters (KPMG, 2003:18) as discussed below. 3.3.3.1 Economic Capital and the Current Probability of Sustainable Survival This method selects the parameters of time horizon and confidence level such that the confidence level shows what probability of survival the bank has currently, given its reaction times and management mechanisms. To this end the time horizons are chosen for each product and risk in such a way that they reflect the reaction times needed to reduce the risk position. This reaction time includes: the time required to reveal unexpected losses (such as reporting intervals); the decisionmaking time required on whether to adjust the risk position; the time needed to liquidate the risk position, which is dependent on market conditions; and the time required to improve processes. Choosing the time horizon in this way ensures that the calculated economic capital based on this holding period fully captures, within the prescribed confidence level, all the potential losses that may arise if the bank is forced to close its risk position. The confidence level should be chosen in such a manner that the bank s calculated economic capital equals exactly the bank s current book capital. The confidence level would then fully capture the bank s current probability of sustainable survival. 3.3.3.2 Economic Capital and the Probability of Surviving for One Year In terms of the second method, which has been widely adopted, the parameters are chosen in such a way that the confidence level exactly expresses the bank s probability of survival for one year. A universal time horizon of one year is thus selected for all product and risk categories. An actual confidence level can be chosen so that the calculated economic capital that is required to cover the bank s overall risk position is exactly equal to the amount of actual book capital the bank has 207

available. This calculation therefore gives the probability of survival for one year given the bank s current actual capital. Otherwise a target confidence level can be chosen as the desired probability of the bank surviving for one year. The calculated economic capital is then the amount required to enable the bank to survive for one year within a prescribed probability. The one-year confidence level can be compared with the historic one-year default rates of the credit rating agencies. Standard & Poor s Rating One-year default rate One-year confidence level AAA 0.01% 99.9% AA 0.03% 99.97% A 0.07% 99.93% BBB 0.22% 99.78% Table 5.3: Comparing default rates with confidence intervals Thus, if a bank sets its economic capital required for a one-year period as being equal to its book capital, the resultant calculated confidence level, i.e. its probability of survival for one year, may well be 99.80% which is only slightly better than a BBB credit rating. If the bank wants an AA rating it must set a target confidence level of 99.97% and then calculate the resultant economic capital required to achieve the desired rating. The various measures of capital can be summarised in the following manner (Mercer Oliver Wyman, 2003:12). Actual Capital Regulatory Capital Economic Capital Definition Net asset value. Amount of capital required per regulatory definition of capital. Purpose To ensure solvency. Designed to protect depositors and creditors. Acts as a floor, which triggers action by the regulators. Measurement From balance sheet. Based on undifferentiated rules of thumb that do not reflect the real economic risks of the Amount of capital required to protect the bank against economic insolvency over a one-year period. To ensure solvency. Reflects real risks taken and the confidence interval bank management wishes to tolerate. bank. Capital you have Capital you are told to have Capital you actually need given your risk profile and target rating Table 5.4: Comparing measures of capital 4. THE DEVELOPMENT OF BANKING REGULATIONS AND THE BASEL I ACCORD Banks are the oldest type of financial institution and have been regulated by their governments almost from the beginning. Banks are undoubtedly one of the most regulated industries in the world, and rules on bank capital are one of the most prominent aspects of such regulation. The prominence 208

results from the central role banks play in financial intermediation, the importance of bank capital for bank soundness and the efforts of the international community to adopt common bank capital standards (Santos, 2000:1). The need for regulation also arises from the inherent instability of the business of banking. In comparison with non-bank firms, banks have very high financial leverage, therefore, any loss can have a profound effect on a bank s viability. In addition a bank s assets have a longer maturity than the maturity of its liabilities, and a bank s solvency depends on both its ability to retain the confidence of its depositors and the financial markets on which it relies for funding (Ware, 1996:7). The history of bank capital regulation is long and arduous. For the most part banking regulators vacillated between imposing rigidly defined accounting measures and applying liberal standards that measured capital adequacy uniquely for different banks depending on its circumstances. However, starting in the mid-1980s, regulators became concerned with at least three conditions (Hempel and Simonson, 1999:328). Firstly, the capital-to-assets ratios used did not differentiate between banks with high-risk assets and banks with low-risk assets. The capital ratios in use encouraged banks to take higher risks because capital requirements were, for example, the same for low-risk Treasury Bills as they were for high-risk consumer loans. Secondly, banks began to use off-balance sheet assets (derivative instruments, commitments, letters of credit, etc.) to improve the return on assets without impacting on capital-to-assets ratios. Capital adequacy standards only measured on-balance sheet items ignoring off-balance sheet risks. Thirdly, capital adequacy regulations were not standardised internationally, giving banks in some countries a competitive advantage. In 1987 these and similar concerns caused the United States regulators, in conjunction with the Bank of England, to release for public comment a proposed risk-based capital adequacy framework. On the basis of this the Basel I Capital Accord was adopted in 1988. To understand the web of regulations that surrounds banks, White (1999:4) proposes the classification scheme described below. 4.1 Economic Regulation This category of regulation involves governmental controls regarding limits on interest rates that can be charged on loans or paid on deposits; limits on fees for other financial services provided by banks; limits to the fields of activities banks may enter; and requirements that banks provide services to specific economic sectors or geographic areas. 209

4.2 Information Regulation This form of regulation involves the requirements that specific types of information be provided, often in standardised format, with the financial services delivered. Examples are standardised information on loan and deposit interest rates. 4.3 Safety and Soundness Regulation This type of regulation is primarily aimed at preventing the insolvency of banks. The instruments of this regulation includes minimum capital requirements, so as to provide a buffer against potential insolvency; limitations on banks activities so as to limit the risks of the activities of banks; and the monitoring of the competence and honesty of banks management so as to avoid the potential insolvency that may follow from incompetent and dishonest management. Banks are regulated because of the perceived benefits of regulation (Hall and Kaufman, 2002:2). 4.4 Protection of Depositors The most basic reason for banking regulation is depositor protection. Pressure for such regulation arose as the public began making financial transactions through banks, and began holding a significant portion of their funds in banks. Banking poses a number of unique problems for depositors. Depositors are the creditors of a bank and become linked with the fortunes of the bank where they keep their deposits. Under the fractional reserve banking system deposits are only partially backed by the reserves banks hold in cash and balances maintained with the country s central bank. Depositor safety is therefore dependent on many factors including the capital adequacy of a bank and the quality of its asset portfolio. A thorough investigation of all these factors would be too complex and costly for the vast majority of depositors most of whom have accounts too small to justify the scrutiny that might be given to large deposits. Even if depositors could accurately evaluate the soundness of a bank, this could change quickly as economic conditions change or the bank alters its portfolio of assets. In addition, much of the information required for a proper evaluation may be confidential and unavailable to the public. Governments often provide a safety net in the form of explicit deposit insurance and implicit guarantees to assist banks in difficulty, to protect depositors and to prevent banks from becoming insolvent. The safety net is important because a banking system collapse has a devastating effect on economic activity, as witnessed in the United States during the Great Depression, and more recently 210

in the East Asian financial crisis in the late 1990 s. Conscious of this economic impact, and also the social and political repercussions, governments choose to rescue banks rather than accept widespread insolvency. Ironically this safety net provides incentives for banks to take on additional risk since risky loans will yield a high return if the borrowers do not default, while the government will shoulder the burden if the borrowers default on their loans. Governments cannot eliminate the safety net because of the potentially dire economic and social consequences if it does. It can, however, regulate banks in order to limit their risk exposure. Regulators thus impose capital standards on banks intended to ensure that banks hold sufficient capital in proportion to the risk of their loan portfolios. By matching capital requirements to the level of asset risk, regulators intend to discourage high-risk portfolios and to ensure that banks have sufficient capital to cover losses from risky portfolios. Hence, regulating banks capital is a solution to the problems created by the prior decision to extend a safety net to the banking system (Oatley:36). The existence of explicit or implicit deposit insurance is an important reason for the prudential regulation of banks, because it exposes the government to losses from bank failure either directly or indirectly. In addition, because it weakens depositor and market discipline imposed on the banks, deposit insurance requires an offsetting increase in government regulation to maintain the same degree of overall discipline in the banking system (Hall and Kaufman, 2002:10). 4.5 Government Benefit Governments in the past have viewed banks as ready sources for cheap finance, especially in periods of war. In return for that banks were granted monopolistic powers by requiring them to obtain special charters (permission) from the authorities, limiting the parties to whom these charters were granted. Some governments also viewed banks as a ready source of tax revenue. In the United States before 1860 when effectively all banks were chartered by the individual states, a number of states received more than a quarter of their annual revenues from banks to whom they had granted monopoly powers. Government regulation is also used to influence the behaviour of banks for policy reasons. Once again taking the United States as an example, the federal government from the 1930s through to the 1980s encouraged the privately owned Savings and Loan associations to channel funds into the residential mortgage market. Often governments also encourage banks through regulations, such as the Community Reinvestment Act in the United States, to direct credit to low income groups. Many of these regulations effectively have banks conducting government activities, without the costs being borne by the government. 211

4.6 Bank Competition Bank regulation is sometimes justified as a means of maintaining competition, at other times to foster monopolies, either for the government s benefit, or in response to banks requesting less competition. Competition is a driving force in keeping banks innovative in their operations and designing new services for their customers. Competition depends on the number of banks operating in a market, the freedom for other banks to enter and compete, and the ability of banks to achieve an appropriate size to be able to operate efficiently. 4.7 Payment System In most countries, banks provide the retail and wholesale payment system through the clearing of cheques, debit and credit cards, and electronic money transfers. A modern economy requires an efficient payment system, and a breakdown in the payment system will negatively affect the country s economy. 4.8 Consumer Protection There is often the fear that banks may exploit less knowledgeable customers and force them into contracts that would not be entered into by equals. Regulation to protect consumers tends to focus on education, simplification of terms, and protection against fraud and misrepresentation. 4.9 Conflicts of Interest One of the major motivations for the separation of commercial banking and investment banking concerns the potential for conflicts of interest (Kroszner, 1998:4). The public could be harmed by commercial banks engaging in investment banking, because the banks may abuse the trust of their customers and take advantage of them by selling to them low quality securities without fully revealing the risks. The potential for taking advantage of investors arises from the fact that the long-term relationship between a bank and a client firm may make a bank better informed than a public investor about the firm s soundness and prospects. A commercial bank may also have the incentive to use its privileged information to its advantage. Consider the situation where the bank may be aware of problems in a client firm, which borrowed from the bank, before it becomes public information. The bank would want the now-risky loan to be repaid. To facilitate this, the bank may underwrite public securities (shares or debentures) offering of the firm without adequately disclosing the firm s true 212

financial position, and have the firm use the proceeds to repay the loan to the bank. Barth et al., (2002:6) expand on the reasons for restricting the degree to which banks can engage in securities and insurance activities, or own non-financial firms. To the extent that moral hazard encourages riskier behaviour by banks, they will have more opportunities to increase risk if allowed to engage in a broader range of activities (Boyd et al., cited in Barth et al., 2002:6). Broad financial activities and the mixing of banking and commerce may lead to the formation of extremely large and complex entities that are difficult to monitor. These large institutions may become so politically and economically powerful that they become too big to discipline. Finally, large financial conglomerates may reduce competition and hence efficiency in the financial sector. 4.10 Safety and Soundness Banks are considered to be more fragile than non-bank firms, and therefore more subject to failure. Given the central role that banks play in an economy, bank failures are considered to be more seriously damaging than the failure of other firms. The failure of one bank is perceived as spreading easily and quickly to other banks, as banks tend to be closely interconnected through interbank deposits and loans, and the process may lead to a general run on banks and a breakdown of the banking system. Bank safety is thus a major public policy concern. The greater fragility of banks in comparison to non-bank firms arises from their high proportion of demand deposits to total deposits, low ratio of cash to assets, and low ratio of capital to assets. The likelihood of failure results from the interplay of these factors. The proportionally high level of demand deposits gives depositors the right to withdraw the bulk of their deposits at short notice. They may do so if they perceive the bank to be in financial trouble and this can lead to a run on the bank. Because banks hold relatively little cash on hand in terms of the fractional banking system, they will not be able to refund depositors from cash on hand when a run on the bank occurs, and will have to sell assets quickly, resulting in fire-sale losses. When these losses are large, this could drive the bank into insolvency. Because the owners (shareholders) of a bank have a limited liability equal to their shareholding, it creates moral hazard behaviour incentives for owners, or bank management on their behalf, to engage in excessively risky lending. The owners, and management, will capture the positive outcomes from engaging in risky ventures, but their losses from potential negative outcomes are limited to their equity stake. If depositors were information specialists who could readily assess the risks of their bank s activities they could monitor their bank and protect themselves, much in the same way that a 213

bank protects itself in its role as lender. However, depositors are not information specialists, and the potential for moral hazard behaviour by banks is ever present. The safety and soundness regulation of banks can thus be seen as the public sector equivalent, on behalf of depositors, of the restrictions that banks, bond holders and other lenders impose in the form of agreements and covenants on a borrower so as to reassure themselves of repayment. The insistence on the maintenance of a minimum level of capital provides a financial buffer against unexpected declines in the quality of a bank s asset portfolio. A required minimum level of capital also has the indirect benefit: the larger the owners equity stake in a bank, the greater the loss owners will incur in insolvency and the less inclined owners will be to take risks in the first place (White, 1999:14). The need to protect depositors and prevent the undesirable systemic effects that bank failures may provoke is advanced by regulators as justification for the imposition of capital requirements. Bank safety regulation concentrates on the level of bank capital so as to minimise the risk of individual bank failure. According to Jackson et al., (2002:11) the prevalent view among regulators is that the role of capital requirements is to reduce, although not completely eliminate, the likelihood that banks will fail. In a dynamic banking system regulation cannot prevent all banking failures, at least not at an acceptable cost. Even if failures could be prevented the result would be to sacrifice some of the main objectives of regulation. If, for example, poorly managed banks were protected from competition and the disciplines of the marketplace, it would give them further incentives to take excessive risks and avoid corrective actions. Regulatory aid might serve only to protect those responsible for the bank s poor performance its management. Such protection might also leave the customers of these banks with overpriced low-quality services (Spong, 2000:11). Banking regulations come at a cost. Benston (1999, as cited in Hall and Kaufman, 2002:11) distinguishes between intended and unintended cost. Regulations are imposed to change the economic behaviour of targeted units. This gives rise to two intended potential costs: (1) administrative costs to the regulators for drafting, monitoring, supervising and enforcing the regulations; and (2) costs to individual sectors of the economy resulting from the targeted change in behaviour. Unintended consequences and costs of regulation occur when policy-makers cannot foresee all the responses to a particular regulation or because the regulations may not be mutually consistent and attainable concurrently. For example, encouraging banks to lend to sectors favoured by the government, or for socially desirable reasons to sectors perceived to be previously disadvantaged, may endanger the safety and soundness of the banks, especially if loans are granted at below market rates and in excessive quantities. Unintended costs are difficult to quantify, but casual observation suggests they are high. Examples include the Savings and Loans crisis in the United 214

States during the 1980s, which was a direct consequence of government intervention previously to channel funds into the residential mortgage market. Likewise, the costly collapse of banks in Japan and other East Asian countries in the 1990s was a result of government intervention to channel credit to favoured economic sectors by effectively guaranteeing the funding so that depositors were not concerned with the banks risky lending. As their objectives, banking supervisors seek to ensure that banks are financially sound, well managed, and not posing a threat to the interests of their depositors (Ware, 1996:8). In pursuing these objectives supervisors evaluates how much risk each bank is taking, what resources (tangible such as amount of capital or intangible such as quality of management) are available to manage that risk, and whether the level of resources is sufficient to balance the risk. It is not the supervisors role to make the commercial decisions that are the prerogative of bank management. The supervisors monitor and evaluate the overall strategies, policies and performance of the bank, with reference to specific prudential criteria, and reach a view as to the soundness of the bank and the competence of management (Ware, 1996:9). For example, the United States regulators use the CAMEL system, referring to Capital adequacy, Asset quality, Management quality, Earnings quality, and Liquidity. The regulators assign ratings from 1 (best) to 5 (worst) to each category, and an overall rating for all features combined (Koch, 1995:40). When banking systems in a number of industrial countries weakened in the late 1980s, pressure developed for harmonising bank regulation among industrial countries, at least for large internationally-active banks in these countries (Hall and Kaufman, 2002:14). The harmonisation was intended to both enhance safety by reducing the likelihood of a bank failure in one country spreading to another country, and levelling the playing fields, so that banks in different countries would not gain a competitive advantage through differing regulatory regimes. The call for transnational regulation reflected the limited market discipline in many countries because of government guarantees, and the difficulty in monitoring banks in non-home jurisdictions by private stakeholders and regulators, especially if regulations differ significantly across countries. In the 1980 s many of the largest United States banks became imperilled by the Latin American debt crisis. The nine largest banks lent 140% of their capital to three countries, Argentina, Brazil and Mexico, all of which subsequently became unable to service their loans. United States policymakers previously tried to address this problem through the International Monetary Fund (IMF), which was to provide Latin American debtor governments with new credits that could be used to service their loans. To meet this obligation the IMF needed to increase its resources by 47%. The United States 215

was to provide US $8.4 billion as part of the required increase. The United States Congress agreed to provide the funding, provided that domestic banking legislation in the United States was tightened to prevent a recurrence of an over-extension of credit. An increase in banks' capital requirements was also demanded. The American commercial banks were very much against stricter regulation and higher capital requirements, since they were exposed to fierce competition from foreign, especially Japanese commercial banks. They claimed that different international banking regulations put them at a disadvantage and contributed directly to their worsening competitive position, and that further regulation would increase that competitive disadvantage. To accommodate these objections, the United States Congress linked higher capital requirements for domestic banks to a successful completion of an international agreement on capital standards (Oatley:37). At the time countries were developing rather different approaches to prudential supervision. The United Kingdom had gone down the route of broad risk weights. The United States had first begun to establish minimum regulatory capital ratios in 1981, and by 1985 had developed a minimum leverage ratio approach. Under that approach the minimum required ratio of primary capital (equity and loan loss reserves) to total on-balance sheet and total off-balance sheet assets was 5.5%, and a minimum ratio of total capital (primary capital and subordinated debt) to total assets of 6%. In Japan the leverage ratio for all banks was 4% (Jackson:3). Many countries had prudential approaches but without fixed minimum capital ratios. At the same time competition between the large international banks had grown substantially with the development of the syndicated loans market. The high level of competition drove margins down and there was concern that banks which held less capital were prepared to price their loans more finely, forcing other banks to reduce their pricing or lose market share. Equity as a percentage of assets held by banks had been declining across many banking systems since the 19 th century and the concern was that the intense competition in some markets would lead to further erosion (Jackson:3). One factor behind the development of an international floor for capital adequacy was a desire to place a peg in the ground and effectively prevent further erosion of capital requirements. There was a concern that, without an international agreement on a minimum level of bank capital, regulators would come under intense pressure to relax domestic standards. The design of the transnational banking regulations was delegated to the Basel Committee on Banking Supervision, based at the Bank for International Settlements (BIS) in Basel, Switzerland. The Basel Committee was established as the Committee on Banking Regulations and Supervisory Practices by the central bank governors of the Group of Ten (G10) countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets, notably the failure of Bankhaus Herstatt in Germany (Basel Committee, 2004b:1). The Committee provides a 216

forum for regular cooperation between its member countries on banking supervisory matters. Its wider objective has been to improve the quality of banking supervision worldwide. The Committee seeks to do this by exchanging information on national supervisory arrangements, by improving supervisory techniques internationally, and by setting minimum supervisory standards in areas where these are considered desirable. The Committee does not have any formal supranational supervisory authority and its recommendations do not have any legal force. It only formulates broad supervisory standards and guidelines in the expectation that individual country regulators will implement them in a manner best suited to each country. In this manner the Committee encourages convergence towards common standards without attempting a detailed harmonisation across countries. One important objective of the Committee s work has been the pursuit of two basic principles: that no foreign bank should escape supervision, and that supervision should be adequate. In 1975 the Committee settled on the Basel Concordat, which laid down the division of responsibilities among national authorities to try and ensure that there were no gaps in the supervisory net caused by the foreign operations of banks. It established that the home country supervisor of the parent bank was responsible for the prudential supervision of branches of the foreign banks but the local or host supervisor was responsible for the subsidiaries. This agreement was amended in 1983 to ensure that where host supervision of subsidiaries was not adequate, the home supervisor should extend their supervision or discouraging the bank from retaining the subsidiary. The principle of consolidated supervision was thus established for the first time. Host country supervisors were responsible for the foreign establishments operating in their countries (financial soundness of foreign branches and solvency for the subsidiaries), but the home country supervisors would monitor the risk exposure for the whole banking group as well as the total capital adequacy for the group (Jackson:21). The issue of capital adequacy has been a very important one for the Committee. During the early 1980s the Committee became concerned that the capital ratios of the main international banks were deteriorating at the same time as international risks were growing, especially with regard to heavily indebted countries. The Committee, backed by its member countries, resolved to halt the erosion of capital adequacy standards and to work towards greater convergence in the measurement of capital adequacy. There was a great recognition of the need for a multinational accord to strengthen the stability of the international banking system and to discourage competitive inequalities arising from differences in national capital requirements. The accord on capital adequacy regulations, called the Basel Capital Accord or the 1988 Accord (Basel I), was completed in 1988 and implemented by member countries by end 1992. Its major contribution was to focus on the capital adequacy of banks, as measured by their capital relative to the risk exposure, as measured by risk-weighted assets, and to 217

encourage higher capital ratios. Over time the desirability of standardised capital regulations was accepted by other countries including emerging economies, which adopted some or all of the Accord in their countries and achieved representation on the Basel Committee. By 1999, Basel I had been adopted by about 100 countries world-wide (Jackson, 1999:1). The major contribution of Basel I was the development of the rules of the game (Hall and Kaufman, 2002:15) for the capital adequacy assessment of internationally active banks. The developed countries represented in the G10 67 ratified the Committee s proposals in 1988 for adoption by the G10 countries by the end of 1992. Prior to the implementation of Basel I, regulation consisted only of uniform minimum capital standards that were applied to banks, regardless of their risk profiles, and ignoring off-balance sheet positions. For the first time, Basel I established international minimum capital guidelines that linked banks capital requirements to their credit exposures (Crouhy et al., 1998:1). Basel I established a framework that was intended to make regulatory capital more sensitive to differences in risk profiles among banks, to take off-balance sheet exposures explicitly into account in assessing capital adequacy, and to decrease the disincentives to holding liquid low risk assets. The Accord was subsequently amended in 1996, for implementation by the beginning of 1998, to include market risk alongside credit risk. Since January 1, 1993, internationally active banks incorporated in G10 countries have been obliged to comply with a minimum capital to risk-weighted asset ratio requirement of 8% (Hall and Kaufman, 2002:16). The risk-asset ratio is calculated as follows (Hempel and Simonson, 1999:328): Risk-asset ratio = Qualified capital/risk-weighted Assets. This 8% is also known as the Cooke ratio, and is defined as the ratio of capital to risk-weighted onbalance sheet assets plus the risk-weighted credit equivalent for off-balance sheet exposures, where the weights are assigned on the basis of counterparty credit risk (Crouhy et al., 1998:3). Risk-weighted assets are defined as a weighted sum of different assets held by a bank and a bank s on-balance sheet exposures are risk-weighted according to these risk categories (Jackson et al., 2002:35) as set out in Table 5.5. 67 The Basel Committee comprises representatives from the central banks and supervisory authorities of the G10 countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, and United States) and Luxembourg. 218

Risk Weight Asset Category 0% Exposures to OECD member sovereigns and local currency exposures to other sovereigns. Zero weights also apply to cash and gold bullion. 20% Exposures to banks located in OECD countries. For claims on banks incorporated outside the OECD there is a 20% risk weight for less than one-year exposure and 100% for over one year. 50% Residential mortgage exposures. 100% All claims on the non-bank sector, irrespective of the credit quality of the exposure. Table 5.5: Risk weights per asset category Transactions that are fully collateralised by cash and securities such as government bonds or other securities attract the risk weight associated with these assets. In calculating a bank s off-balance sheet non-derivative exposures, conversion factors applies, because the notional amount of these exposures is not always representative of the true credit risk being assumed (Crouhy et al., 1998:4). The exposure is multiplied by its related credit conversion factor (CCF) and the resulting credit equivalent treated as on-balance sheet exposures. The following credit conversion factors appearing in Table 5.6 apply for non-derivative off-balance sheet exposures. Risk Weight Asset Category 0% Commitments with an original maturity of one year or less. 20% Short-term self-liquidating trade related contingencies like letters of credit. 50% Transaction-related contingencies like performance bonds, revolving underwriting facilities and note-issuance facilities. 100% Direct credit substitutes, bankers acceptances, standby letters of credit, sale and repurchase agreements, and forward purchase of assets. Table 5.6: Credit conversion factors per asset category Basel I recognises that the credit risk exposure of long dated financial derivatives fluctuates in value, and estimates the exposure both in terms of the current MTM value, plus a simple measure of the projected future risk exposure (Crouhy et al., 1998:5). Calculation of the risk-weighted amount for derivatives proceeds in two steps: first computing a credit equivalent amount, and secondly multiplying the credit equivalent amount by specified counterparty risk-weighting factors to find the required regulatory capital related to the credit risk exposure. The credit equivalent amount is the sum of the current replacement cost when it is positive (and zero otherwise), and an add-on amount that approximates future replacement costs. The current replacement value of a derivative is its MTM value or liquidation value, only if it is positive, because then the bank may lose money if the counterparty defaults. When the replacement value is negative, the bank potentially owes money to the counterparty and is therefore not exposed to counterparty default risk, and the replacement value is set to zero. 219

The add-on amount is computed by multiplying the notional amount of the transaction by the Basel I required add-on factors for contracts on interest rates, exchange rates and gold, equity, precious metals except gold, and other commodities, as specified in Table 5.7 (ibid.). Residual Maturity Interest Rate (%) Exchange Rate and Gold (%) Equity (%) Precious Metals Except Gold (%) Other Commodities (%) One year or less 0.0 1.0 6.0 7.0 10.0 Between one and 0.5 5.0 8.0 7.0 12.0 five years Over five years 1.5 7.5 10.0 8.0 15.0 Table 5.7: Add-on amounts for derivative transactions Interest rate contracts include single currency interest rate swaps, basis swaps, forward rate agreements and products with similar characteristics, interest rate futures, and interest rate options purchased. Exchange rate contracts include gold contracts that are treated the same way as exchange rate contracts, cross-currency swaps, cross-currency interest rate swaps, outright forward foreign exchange contracts, and currency options purchased. Equity contracts include contracts based on individual shares as well as equity indices; contracts on precious metals (except gold); and contracts on other commodities include forwards, swaps and purchased options on the underlying assets. Restatement of the calculation of the risk-weighted amount is presented below. Step 1: Current replacement cost + add-on amount = credit equivalent. Step 2: Credit equivalent x counterparty risk weighting = risk-weighted amount. In 1995 the Accord was modified to allow banks to reduce their credit equivalent when bilateral netting agreements are in place. The formula for add-ons has been modified as follows: Add-on amount = notional x add-on factor x (40% + 60% x NPR). The add-on factors are the same as in the table above. NPR denotes the net replacement ratio, which is the net replacement cost when positive, or zero otherwise, divided by the gross replacement cost calculated as before, without taking netting into account, i.e. the sum of the positive replacement cost for the transactions covered by the netting agreement (Crouhy et al., 1998:6). 220

Basel I requires internationally active banks regulated in G10 countries to hold Tier 1 capital of 4% plus Tier 2 capital of 4%, in total 8% of their risk weighted assets. The 8% was chosen on the basis that this was the minimum level of capital observed among banks that were perceived to be following best industry practice. Tier 1 capital is defined as shareholders equity plus disclosed reserves, and non-cumulative preferred shares. Tier 2, or supplementary capital, comprises undisclosed and revaluation reserves, general provisions up to 1.25% of total risk-weighted assets, and hybrid and subordinated debt with an original average maturity of at least five years. Goodwill and equity investment in certain unconsolidated subsidiaries are deducted from capital. In the 1996 amendment to Basel I, a third tier of capital was added only to meet market risk requirements. Tier 3, or subsupplementary capital, consists of short-term subordinated debt with an original maturity of at least two years. It must be unsecured and fully paid up. It is also subject to lock-in clauses that prevent the bank from repaying the debt before maturity, or at maturity should the bank s capital ratio drop below 8% after repayment. Data on the capital ratios of G10 banks indicates that the introduction of Basel I was followed by an increase in risk-weighted capital ratios in a number of countries. The average ratio of capital to riskweighted assets of major banks in the G10 rose from 9.3% in 1988 to 11.2% in 1996 (Jackson, 1999:2). This could reflect the direct impact of Basel I, or alternatively the effects of greater market discipline, since the introduction of consistent standards for bank capital increased transparency. 5. THE DEVELOPMENT AND USE OF REGULATORY CAPITAL ARBITRAGE BY BANKS The usefulness of Basel I relies on the risk-weighted categories as reliable implicit measures of a bank s risk-taking. Yet, even at the Accord s inception, it was clearly understood that the methodology of risk-weighted assets was not a reliable measure of risk (Jones, 1999:103). By attempting to apply a one size fits all policy, Basel I encouraged substantial arbitrage between risk classes, which weakened the effectiveness of the regulations (Hall and Kaufman, 2002:14). Corporate loans, for instance, receive the same risk weighting irrespective of the credit quality of the borrower. Faced with this simple risk classification scheme, banks started altering their lending behaviour in ways that the regulators did not expect. The fact that the regulations assign the same risk weight and capital cost to all loans within a given asset category, provides the incentive for banks to shift towards more risky assets for which they can demand a higher interest rate. A loan to a highly rated corporate carries the same risk weight and capital requirement as a loan to a risky start-up company, however, for the latter loan the bank can charge a higher interest rate. The limited risk classifications under 221

Basel I thus provided incentives for banks to hold riskier loan portfolios than they would otherwise have held (Oatley:38). The risk classification scheme also offers incentives to banks to engage in regulatory capital arbitrage, the aim of which is to reduce the regulatory capital a bank has to hold, without reducing the actual risk to which the bank is exposed. It is argued that the heightened scope of large banks risk-taking activities, along with the expanding scope of regulatory arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading (Greenspan, 1998:1). Jones (1999:103) defines regulatory capital arbitrage as activities that permit a bank to assume greater risk with no increase in its minimum regulatory capital requirement, while at the same time showing no change, or possibly an increase, in its reported capital ratios. Capital arbitrage exploits the difference between the true economic risk and Basel I s measure of risk of a bank s asset portfolio. Regulatory arbitrage reflects banks efforts to keep their funding costs, inclusive of equity, as low as possible. Since the cost of equity is generally greater than the cost of debt, when banks are required to hold equity in excess of what they would normally hold, they view capital standards as a form of regulatory taxation. As with other forms of taxation, regulatory taxes encourage banks to develop methods that avoid or minimise these taxes. Securitisation is an important technique for undertaking such capital arbitrage (Jackson, 1999:21). The decision about whether to engage in capital arbitrage, and on what scale, depends on a cost-benefit analysis in which the securitisation structuring costs are weighed against the reduction in the bank s cost of funds (Jackson, 1999:22). Four types of regulatory capital arbitrage predominate (Jones, 1999:103) and are reviewed below. 5.1 Cherry-Picking This is the oldest form of capital arbitrage. It is the practice of changing the asset portfolio towards higher risk assets, which yields a better return than low risk assets. The bank s risk-weighted assets and regulatory capital ratios remain unchanged, although the overall riskiness of the portfolio has increased. 5.2 Securitisation with Partial Recourse Securitisation involves the sale of bank assets to an SPV, which finances the purchase through the issuance of asset-backed securities to private investors. In most instances the bank retains most of the 222

underlying risk of the assets sold through the credit enhancement that the bank provides to the transaction. In terms of Basel I, the credit enhancement to assets that were previously owned by the bank is treated as recourse, which incurs a 1250% risk weighting, resulting in a 100% (1250% x 8%) regulatory capital requirement, i.e. the bank must hold regulatory capital against the full amount of the credit enhancement provided. It follows that, if the credit enhancement amounts to less than 8% of the securitised portfolio, the bank has reduced its regulatory capital requirement despite being exposed to essentially the same risk it faced before the securitisation. In substance, securitisation with partial recourse is nothing more than sophisticated cherry-picking whereby a bank sells off its higher quality assets. The impact of securitisation on a bank s balance sheet can be substantial. In the securitisation of consumer and higher-quality commercial loans, retained recourse amounting to less than 4% of the underlying loan pool is usually sufficient to achieve investment-grade ratings on the asset-backed securities sold to investors. Such a securitisation can therefore reduce a bank s regulatory capital by half relative to its capital requirement were the assets to remain on its balance sheet 68. Since a bank s remaining on-balance sheet assets may display greater loss volatility and less diversification than the loans it has securitised, the reported capital ratios for a bank that is heavily engaged in securitisation may be a misleading indicator of its true financial position (Jackson, 1999:24). 5.3 Remote Origination Banks often structure their securitisations in such a manner that the credit enhancement provided by the bank is treated as a direct credit substitute, which incurs a 100% risk weighting, therefore requiring 8% regulatory capital rather than a complete write-off as with recourse. This is achieved through what is termed remote origination, in that an SPV instead of the bank originates the assets so that the bank never formally owns the assets. Even though the bank is exposed to the same risk as in a normal securitisation, it holds less regulatory capital against the credit enhancement. Remote origination is commonly associated with ABCP programmes (ibid.). 5.4 Indirect Credit Enhancements Securitisation transactions can be structured with indirect credit enhancement such as reserve accounts and early amortisation provisions that reduces the amount of credit enhancement required 68 The distinction between an accounting balance sheet and a regulatory balance sheet is important. From a regulatory perspective, assets that are sold by way of a cash flow securitisation, or where the asset risk have been transferred through a synthetic securitisation, are treated as off-balance sheet. From an accounting perspective, in terms of AC412, the assets sold are consolidated and thus remain on the bank s accounting balance sheet. 223

from the sponsoring bank, thereby further reducing the regulatory capital that the bank is required to hold against the securitised assets. The examples set out below adapted from Jackson (1999:45) illustrate how regulatory arbitrage through securitisation can be achieved. Benchmark scenario - On-balance sheet loans Bank balance sheet Loans 200 Deposits 184 Equity 14 Loss reserves 2 Total 200 200 Total risk-weighted assets = R200 Tier 1 capital (risk-based capital ratio) = R14 (7%) Total capital (risk-based capital ratio) = R16 (8%) Tier 1 risk-based capital required = R8 (4%) Total risk-based capital required = R16 (8%) In the benchmark scenario, the credit risk portfolio is assumed to consist of R200 in gross loans, which are funded with R184 in deposits, R14 in equity capital and a loan loss reserve of R2. The loan loss reserve is assumed to equal the asset portfolio s expected credit loss. Ignoring tax effects, the bank s Tier 1 and regulatory capital ratios would be 7% and 8% respectively. Required regulatory capital would be 4% and 8% respectively. The bank s income would be the excess spread on the R200 loans on its balance sheet. Securitisation without retained risks The bank securitises R40 of loans by selling the loans at par to an SPV, which funds the asset purchase by issuing R40 of asset-backed securities. 224

Loans ABS Bank SPV Investors R40 cash R40 cash It is assumed that the proceeds from the sale of the loans are used to reduce the bank s outstanding deposit liabilities. For simplicity sake, assume no change in loan loss reserves at either the bank or SPV. SPV balance sheet Loans 40 ABS 40 Total 40 40 Bank balance sheet Loans 160 Deposits 144 Equity 14 Loss reserves 2 Total 160 160 Total risk-weighted assets = R160 Tier 1 capital (risk-based capital ratio) = R14 (8.8%) Total capital (risk-based capital ratio) = R16 (10.0%) Tier 1 risk-based capital required = R6.4 (4%) Total risk-based capital required = R12.8 (8%) Relative to the benchmark scenario, the securitisation without retained risks results in the bank transferring all the credit risk of the securitised loans to the investors, whilst retaining the excess spread on the loans through profit extraction from the SPV. Commensurate with this risk reduction, the bank s total risk-weighted assets are reduced, increasing its Tier 1 and total regulatory capital ratios to 8.8% and 10% respectively. The excess capital can be returned to shareholders or can be used to back new loans. Instead of repaying deposits, the bank can use the R40 proceeds from the sale of loans to invest in new loans, bringing its loan balance back to R200. Its total income would include the excess spread on the R200 loans on its balance sheet, as well as the excess spread on the R40 loans securitised. 225

Securitisation of term loans with retained risks In this case the bank securitises R41 of loans, which is supported by the issuance of R40 in assetbacked securities by the SPV. Unlike the preceding example, the bank seeks to improve the credit rating of the asset-backed securities by providing credit enhancement to investors in the form of an R1 subordinated loan to the SPV. The net cash receipt for the bank amounts to R40. Subordinated loan R1 Loans ABS Bank SPV Investors R41 cash R40 cash For regulatory capital purposes, the bank s subordinated loan to the SPV would be treated as recourse and subject to a 1250% risk weighting. SPV balance sheet Loans 41 ABS 40 Subordinated loan 1 Total 41 41 Bank balance sheet Loans 159 Deposits 144 Subordinated loan 1 Equity 14 Loss reserves 2 Total 160 160 Total risk-weighted assets 69 = R171.5 Tier 1 capital (risk-based capital ratio) = R14 (8.2%) Total capital (risk-based capital ratio) = R16 (9.3%) Tier 1 risk-based capital required = R6.9 (4%) Total risk-based capital required = R13.7 (8%) 69 The total risk-weighted assets amount to [R159 + (R1 x 1250% = R12.5)] = R171.5. 226

The bank s total calculated risk-weighted assets are greater in comparison with the previous example of securitisation without recourse, thereby reducing its Tier 1 and total regulatory capital ratios to 8.2% and 9.3% respectively in comparison with 8.8% and 10% respectively. Securitisation with recourse thus requires more regulatory capital than securitisation without recourse, but still less than when compared to the benchmark scenario. This will hold true as long as the retained risk amounts to less than 8% of the loans securitised 70. Application of excess regulatory capital The excess regulatory capital can be returned to shareholders or can be used to back new loans. In this example, the bank can, of the R40 proceeds from the sale of loans, use R28.5 to invest in new loans resulting in total loans of R187.5 (R159 + R28.5) and calculated risk-weighted assets of R200 (R171.5 as calculated above + R28.5). The balance of R11.5 (R40 R28.5) can be used to repay deposits, resulting in total deposits of R172.5 (R184 of the benchmark scenario R11.5). Its total income would include the excess spread on the R187.5 loans on its balance sheet as well as the excess spread on the R41 loans securitised. SPV balance sheet Loans 41 ABS 40 Subordinated loan 1 Total 41 41 Bank balance sheet Old loans 159.0 Deposits 172.5 New loans 28.5 Equity 14.0 Subordinated loan 1.0 Loss reserves 2.0 Total 188.5 188.5 Total risk-weighted assets = R200 Tier 1 capital (risk-based capital ratio) = R14 (7%) Total capital (risk-based capital ratio) = R16 (8%) 70 If the retained risk is 8% (R3.48), the total risk-weighted assets would be [R156.52 + (R3.48 x 1250%=R43.50)] = R200 and the required total capital R200 x 8% = R16, which is the same amount of capital as when the assets are not securitised. 227

Tier 1 risk-based capital required = R8 (4%) Total risk-based capital required = R16 (8%) In empirical work presented by Ambrose et al., (2004:19) it was concluded that lenders do indeed retain higher risk loans for their portfolios while securitising lower risk loans. Their analysis supports the view that regulatory capital arbitrage is the main driver for securitisation by banks. The problems created by regulatory capital arbitrage pertain less to the assets that have been securitised and more to the assets that remain on the balance sheet. As only high quality assets can be securitised at an acceptable cost, securitisation causes the average credit quality of a bank's assets to deteriorate, since the better quality assets are being sold off leaving only lower quality assets in the bank. Against this lower-quality balance sheet, Basel I's minimum capital requirement may be insufficient and the bank's capital ratio may provide a misleading measure of a bank's true financial condition. Also, since the bank is still exposed because of credit enhancement to the securitised assets, its effective regulatory capital levels may be well below Basel I s nominal 8% standard, resulting in insufficient capital in relation to the true economic risk to which the bank is exposed. Because market participants use capital ratios to determine the health of banks, the weakened quality of information may harm market discipline. Given these unintended consequences, Basel I may have made banks less, rather than more, secure (Oatley:138). It should be emphasised that regulatory arbitrage is not necessarily undesirable. In many cases, regulatory arbitrage acts as a safety valve for reducing the adverse effects of those regulatory capital requirements that are well in excess of the levels warranted by a specific activity s underlying economic risk. In the absence of such arbitrage, a regulatory capital requirement that is inappropriately high for the economic risk of a particular activity could cause a bank to exit that relatively low-risk business by preventing the bank from earning an acceptable rate of return on its capital. Therefore, arbitrage may appropriately lower the effective capital requirements against some safe activities that banks would otherwise be forced to drop because of the effects of regulation (Greenspan, 1998:3). 6. BACKGROUND AND MOTIVATION FOR THE BASEL II ACCORD Basel I was implemented against a background of concerns about a decline in capital held by banks that was exacerbated by the expansion of off-balance sheet activity and worries that banks from some jurisdictions were seeking a short-term competitive advantage in some markets by maintaining too 228

low levels of capital (Jackson, 2001:55). The introduction of Basel I has led to some rebuilding of capital by the banks in the G10, but over time the broad nature of the risk categories 71 created strains. The broad categories reflected the state of systems in banks at that time. However, during the 1990s, banks started to develop more sophisticated systems to differentiate between the risks of various parts of their asset portfolios to improve pricing and the allocation of economic capital. Chart 5.1 below sets out the value at risk over a one-year period for exposures in different rating categories (Jackson, 2001:58). 99.7% VaRs on Portfolios of Exposures 30% 25% 24.01% 20% 15% 10.83% 11.52% 10% Basel 8% 5% 2.95% 0.13% 0.43% 1.08% 0% AAA AA A BBB BB B CCC Source: Bank of England Chart 5.1: Value at risk for different rating categories This chart shows that investment grade loans ( BBB and better rated) require less economic capital than the minimum regulatory capital required by Basel I, whereas non-investment grade loans would require more economic capital than the regulatory capital a bank has to hold against these loans. This discrepancy between economic capital and required regulatory capital created an incentive for banks to sell their investment grade loans and retain the higher-risk loans. The ability of banks to choose how much risk they wished to carry against a particular amount of regulatory capital threatened to undermine the objective of an international capital floor. Dissatisfaction with the broad-brush approach of Basel I to credit risk, where the capital requirement of credits of widely differing quality remains the same, have grown. This is particularly so since in the decade after the introduction of Basel I, the nature of banks business and the risks which banks undertake changed dramatically and risk management practises, supervisory approaches and financial markets underwent significant transformations. The Basel Committee has also grown concerned 71 Basel I differentiates between exposures using general categories based on the type of loan exposures to sovereigns (split into OECD and non-oecd), exposures to banks (split into OECD and non-oecd and into less than one year and more than one year), retail mortgages, and other private sector exposures. Assets are classified into four buckets (zero %, 20%, 50% and 100%) according to these debtor categories. Basel I has been supplemented since 1988 to incorporate a measure of market risk, but it remains essentially a single option measure of appropriate capital levels and is not risk sensitive. 229

about the increase in regulatory capital arbitrage, this being the avoidance of minimum capital charges through the securitisation of bank assets for which the capital requirement that the market imposes is less than the current regulatory capital charge. In the opinion of the Basel Committee, the use of securitisation for such purposes could lead to a shift in banks portfolios to lower quality assets, for which the regulatory capital charge is too low (Fan, 2003:15). As the Basel Committee stated in 1999: The current risk weighting of assets results, at best, in a crude measure of economic risk, primarily because degrees of credit risk exposure are not sufficiently calibrated as to adequately differentiate between borrower s differing default risks. Another related and increasing problem with the existing Basel I Accord is the ability of banks to arbitrage their regulatory capital requirement and exploit differences between true economic risk and risk measured under the Basel I Accord. Regulatory capital arbitrage can occur in several ways, for example, through some forms of securitisation, and can lead to a shift in banks portfolio concentrations to lower quality assets (Benink and Wihlborg, 2001:2). Another concern about Basel I was that the limited recognition of risk reduction through collateral or credit derivatives would discourage banks from taking advantage of these techniques. This led to pressure on the Committee to try to align the regulatory capital requirements with the risks of different exposures, recognising credit risk mitigation (Jackson, 2001:58). The first proposal for a new capital adequacy framework (Basel II) to replace Basel I was issued by the Basel Committee in June, 1999. The overriding goal of Basel II is to promote safety and soundness in the international financial system through a new and comprehensive capital adequacy framework which requires more qualitative national supervisory regimes and the introduction of sophisticated risk management techniques and systems by industry participants in place of the current largely formulaic one-size-fits-all capital adequacy requirements (Fan, 2003:15). The Basel Committee describes the rationale for Basel II as the need for more flexibility and risk sensitivity as summarised in Table 5.8 below (Basel Committee, 2001:1). Basel I Focus on a single risk measure One size fits all Broad brush structure Basel II More emphasis on banks own internal methodologies, supervisory review, and market discipline Flexibility, menu of approaches, incentives for better risk management More risk sensitivity Table 5.8: Reasons for Basel II 230

In June 2004 the agreed text of the new Basel II framework was published. This was followed in November 2005 by an updated version incorporating the additional guidance provided by the Basel Committee in a paper published in July 2005 72. In July 2006, the Basel Committee issued a comprehensive version of the Basel II framework. This comprehensive document was published for the convenience of readers and contained no new information. It is a compilation of the June 2004 Basel II framework, the elements of Basel I that were not revised during the Basel II process, the 1996 amendment to Basel I to incorporate market risk and the 2005 paper on the application of Basel II to trading activities and the treatment of double default effects. Basel II provides a spectrum of approaches from simple to advanced methodologies for the measurement of risks in determining capital levels that are more in line with the underlying risks that banks face. It provides a flexible structure in which banks, subject to supervisory review, can adopt approaches that best fit their level of sophistication and risk profile. The framework deliberately builds in rewards for stronger and more accurate risk measurement. Basel II is more comprehensive and more sensitive to risks than Basel I, while maintaining the overall level of regulatory capital in the international banking system. The key objective of Basel II is to promote better risk management in the global banking industry and the clear supervisory thrust of Basel II is to encourage banks to adopt the approaches that require a bank to have modern risk management systems, policies and procedures, and robust data on losses and recoveries. Under Basel II, regulatory priorities will shift towards validating the integrity of databases, appropriateness of bank risk models, meaningful use of internal credit ratings, measurement of collateral values, operational risk management policies and procedures, and other similar systems and policy-orientated aspects of banking (Bugie, 2004:2). It is essential to emphasise that Basel II is a set of guidelines that have no binding authority until these are inscribed into national banking law and regulatory policy. The central banks and banking supervisors of the 13 countries represented on the Committee have endorsed the Basel II Framework. In the European Union, Basel II will be implemented through a capital adequacy directive (CAD) that will update the existing legislation. In the United States, banking regulators will only require the 10 largest banking groups to adopt Basel II and will use only its advanced approaches (Bugie, 2004:1). In South Africa, a common implementation date 1 January 2008 for all the available approaches under Basel II will apply and, as from that date, Basel I will no longer be available to any 72 Basel Committee on Banking Supervision, The Application of Basel II to Trading Activities and the Treatment of Double Default Effects, Bank for International Settlements, July 2005. 231

bank. All banks, branches of foreign banks and mutual banks will be required to perform parallel calculations during 2007 (South African Reserve Bank, 2004:1). 7. THE OVERALL STRUCTURE OF THE BASEL II ACCORD Basel II applies to consolidated banking groups including the bank holding company. It covers the consolidation of all financial subsidiaries, with the exception of insurance subsidiaries, which are treated separately 73. In terms of Basel II, the following investments have to be deducted from the regulatory capital of a bank (Bugie, 2004:2): non-consolidated investments in financial subsidiaries; cross-holdings between banks; and significant investments in commercial (non-financial) entities. Basel II consists of three mutually reinforcing pillars, which together should contribute to safety and soundness in the financial system. The first pillar deals with minimum capital requirements, the second pillar with the supervisory review process and the third pillar with market discipline. The Basel Committee stresses the need for rigorous application of all three pillars and plans to work actively with fellow supervisors to achieve the effective implementation of all aspects of Basel II (Basel Committee, 2001:2). 7.1 First Pillar The first pillar sets out minimum capital requirements. The new framework maintains both the current definition of capital and the minimum requirement of 8% capital to risk-weighted assets. To ensure that risks within an entire banking group are considered, Basel II will be extended on a consolidated basis to holding companies of banking groups. The revision focuses on improvements in the measurement of risks, i.e. the calculation of the denominator of the capital ratio. 73 Basel II partially addresses the issue of insurance subsidiaries, implying that insurance regulators have primary responsibility for supervision. The Basel II treatment is to remove insurance subsidiaries from the consolidated financial group balance sheet. This means deducting the investment in insurance subsidiaries on the basis of 50% from Tier 1 capital and 50% from Tier 2 capital of the banking group. 232

Total capital (unchanged)/(credit risk + Market risk + Operational risk) 74 ( 8%). = Bank s capital ratio The credit risk measurement methods are more elaborate than those in Basel I. The new framework for the first time includes a measure for operational risk, while the market risk measure remains unchanged from Basel I. For each risk category there is a menu of approaches from which a bank can choose from. 7.1.1 Credit Risk Below is the menu of approaches to measure credit risk (applying to banking book and securitisation exposures): Standardised Approach (a modified version the existing Basel I approach); Foundation Internal Ratings Based Approach (Foundation IRB); and Advanced Internal Ratings Based Approach (Advanced IRB). 7.1.2 Market Risk The menu of approaches to measure market risk is: Standardised Approach; and Internal Models Approach. 7.1.3 Operational Risk The menu of approaches to measure operational risk is: Basic Indicator Approach; 74 The credit, market and operational risk are expressed as risk-weighted assets. 233

Standardised Approach; and Advanced Measurement Approach (AMA). 7.2 Second Pillar The second pillar sets out the supervisory review process, which requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks. The new framework stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank s particular risk profile and control environment. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. The internal processes would be subject to supervisory review and intervention where appropriate. 7.3 Third Pillar The third pillar of the new framework aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks risk profiles and the adequacy of their capital positions. The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. The core set of disclosure recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, risk mitigation techniques and asset securitisation. 234

The structure of the Basel II Accord can be diagrammatically depicted as set out in Diagram 5.1 (Basel Committee, 2004a:6). Basel II First Pillar Minimum Capital Requirements Second Pillar Supervisory Review Process Third Pillar Market Discipline Credit Risk Standardised Approach Operational Risk Market Risk (Trading Book) Credit Risk Internal Ratings Based Approach Credit Risk Securitisation Framework Diagram 5.1: Structure of the Basel II Accord The first pillar represents the greatest departure from Basel I. It aims at a greater and more economic differentiation of credit risk, better recognition of the types of exposures and more appropriate consideration of collateral and credit derivatives. It is expected that neither the provisions of the second pillar and third pillar, nor the operational risk and trading book sections of the first pillar, will have any effect on the use of securitisation by banks as a capital management tool. Therefore, for the purpose of investigating the impact of Basel II on banks regulatory arbitrage activities, it is the credit risk approaches under the first pillar that are important. An overview of the credit risk approaches is provided below, with a more comprehensive summary of the credit risk approaches under the first pillar of Basel II provided in Annexure 6. 235

7.4. Definition of Regulatory Capital In terms of Basel II, regulatory capital retains the same definition as under Basel I, with the important exception that the inclusion of loan loss provisions in the calculation of the bank s required capital is limited to certain maximum percentages (Basel Committee, 2005:12). 7.5 Definition of Risk-Weighted Assets Basel II retains a single measure for risk-weighted assets that serves as the denominator for the calculation of a single regulatory capital ratio. Total risk-weighted assets (RWA) are the sum of RWA for credit risk, market risk and operational risk (ibid.). The calculation of RWA for market and operational risk is done by multiplying the regulatory capital requirement for each by 12.5, which is the reciprocal of the minimum capital ratio of 8% 75. Quantitative capital requirements, which are the product of procedures of varying complexity for measuring credit risks, are at the heart of the Basel II framework (Deutsche Bundesbank, 2004:74). Credit risk can be calculated by means of three increasingly sophisticated and risk-sensitive options: the Standardised, Foundation IRB and Advanced IRB approaches towards banking book and securitisation exposures. 7.6 Standardised Approach to Banking Book Credit Risk The measurement of credit risk under the Standardised approach under the new framework is conceptually the same as for the 1988 Basel Accord, but with a higher level of risk sensitivity (European Central Bank, 2005:52). The main changes are the move away from a flat 8% capital charge for corporate risks to a system with greater differentiation of risk, and making greater use of external credit ratings to differentiate credit risk. It includes 13 separate asset classes, and several of the classes have differentiated weightings. The Standardised approach also prescribes risk-weighting adjustments for high-risk categories and for maturity of the exposures, and includes extensive rules for credit risk mitigation (Bugie, 2004:4). In the Standardised approach for measuring credit risk, the risk weights applied to claims on sovereigns, banks and corporates depend on the ratings provided by external credit assessment institutions (ECAIs) recognised by supervisors (Basel Committee, 2005:15). The Standardised 75 The minimum capital ratio in terms of Basel II is 8%. In South Africa, the minimum capital requirement is 10%. 236

approach groups different external ratings into broad categories or buckets. Claims in the higherrated buckets benefit from lower capital charges than claims in the lower-rated buckets (Fitch Ratings, 2005:4). Depending on the external risk score, rated claims are given risk weights of 0%, 20%, 50%, 100% or 150%. Unrated claims are given a 100% risk weight. In terms of the Standardised approach, claims on sovereigns and banks have generally lower risk weights than claims on corporates with the same credit rating. In the case of claims on banks, there are two options for banks to take. The risk weight can be determined based on the bank s external rating, or the bank s risk weight can be derived from the external rating of the sovereign where the bank is incorporated. In such a case the rating of the bank will be rated one level lower than the rating of the sovereign. This option is particularly attractive for small and medium-sized banks, as their low credit rating could otherwise have a negative impact on their refinancing activities (Deutsche Bundesbank, 2004:75). The various risk weights are set out in the Table 5.9 below (Basel Committee, 2005:15-19). Rating Sovereigns Banks: Option 1 Risk weights in the Standardised approach (%) Banks: Corporates Option 2 Commercial real estate Residential real estate AAA to AA- 0 20 20 20 100 35 75 A+ to A- 20 50 50 50 100 35 75 BBB+ to 50 100 50 100 100 35 75 BBB- BB+ to BB- 100 100 100 100 100 35 75 B+ to B- 100 100 100 150 100 35 75 Below B- 150 150 150 150 100 35 75 Unrated 100 100 50 100 100 35 75 Personal loans and SMEs Table 5.9: Risk weights in the Standardised approach towards banking book risk Claims on individuals and small business attract a 75% risk-weighting. To qualify for the 75% risk weighting, loans should comply with the following requirements (Bugie, 2004:4). It must be loans to individuals or small business. It must be revolving credit and lines of credit, including credit cards and overdrafts. It must be term loans and leases to individuals. The loan portfolio must be sufficiently diversified in that no aggregate exposure to one counterpart can exceed 0.2% of the total overall portfolio. 237

Single-party exposure must be limited, with a recommended limit of 1 million. Residential mortgage loans secured by property occupied or rented by borrowers will be riskweighted 35%, while commercial real estate will be risk-weighted 100% (Basel Committee, 2005:20). Depending on the level of provisioning, a 100% or 150% risk weight is applied to the unsecured portion of any loan (other than a qualifying residential mortgage loan) that is past due for more than 90 days (Basel Committee, 2005:21). 7.6.1 Calculation of Capital Requirements under the Standardised Approach to Credit Risk Under the Standardised approach, the calculation of the capital ratio is expressed as described below (Fitch Ratings, 2005:4). Capital/(Credit risk-weighted assets + Operational risk charge x 12.5 76 + Market risk charge x 12.5) > 8%. Loan loss provisions can be included in Tier 2 capital up to 1.25% of risk-weighted assets. 7.6.2 Credit Risk Mitigation Techniques under the Standardised Approach to Credit Risk The Standardised approach recognises a broad range of collateral and other credit risk mitigation (CRM) techniques designed to reduce credit risk. The major areas covered by the CRM framework are collateral, third-party guarantees, credit derivatives and netting. Basel II expands the range of collateral significantly, introduces a wider range of guarantors to include corporates (including insurance companies), rated A- or better as well as securities firms, and for the first time recognises credit derivatives as being economically similar to guarantees. The types of financial collateral banks can recognise are expanded to include sovereign debt rated BB- and above, all other debt rated BBB- and above, listed equities, mutual funds and gold (Fitch Ratings, 2005:9). Banks using the Standardised approach are generally not permitted to recognise physical collateral. In general the Basel II framework requires the use of a substitution approach whereby the risk weighting of the collateral replaces that of the counterparty for the collateralised portion of the 76 The reciprocal of the minimum capital ratio of 8%, i.e. 100/8 = 12.5. Operational risk and market risk are converted into risk-weighted assets. 238

exposure (Basel Committee, 2005:28). Credit derivatives are risk-weighted by assigning, in terms of the substitution approach, the risk weight of the guarantor to the secured part of the loan. Collateral and warranties will be recognised, even if there is a maturity mismatch between the underlying exposure and the collateral instrument. The extent of the risk mitigation will depend on the ratio of the hedge s residual maturity to the exposure s residual maturity. The hedge must have an original maturity of at least one year and a residual maturity of at least three months (Deutsche Bundesbank, 2004:82). The broader CRM approach reflects the sustained development of CRM techniques since the inception of Basel I and the advantages these techniques bring to the management of credit risk. Banks must meet minimum standards for legal documentation and internal information systems in order to qualify for using CRM to obtain capital relief. Documents and standards for all types of CRM techniques must be binding and legally enforceable (Basel Committee, 2005:27). In terms of the CRM framework, the exposure, after risk mitigation has been applied, is multiplied by the risk weight of the underlying counterparty in order to obtain the risk-weighted asset amount. The Basel II framework recognises that price volatility in a collateral instrument pays an important role in the level of risk protection provided. The more volatile the collateral, the more likely that its value will drop, thus reducing the protection provided. Therefore, under both the Standardised and IRB approaches, the treatment of collateral requires that banks apply a haircut to the collateral to reflect the market volatility of the instrument (Fitch Ratings, 2005:9). These haircuts depend on factors such as the type of collateral, the assumed holding period of the underlying transaction and the frequency of revaluation. Banks may use their own estimates of haircuts, provided certain minimum qualitative and quantitative requirements are met, or may use the supervisory haircuts (Deutsche Bundesbank, 2004:81). There are two approaches under the Standardised approach to credit risk that banks may use to determine the risk weight for financial collateral: the simple and comprehensive approach (Bugie, 2004:4). 7.6.2.1 Simple Approach to Credit Risk Mitigation In terms of the simple approach, a borrower s risk weight is replaced by the risk weight of the collateral for the secured part of the exposure, subject to a floor of 20%, with some exceptions to go 239

under the floor (Basel Committee, 2005:40). The simple approach does not allow mismatches in maturity between the collateral and the underlying exposure. 7.6.2.2 Comprehensive Approach to Credit Risk Mitigation The comprehensive approach allows for the measurement of the market value of collateral subject to a haircut that reflects possible future price fluctuations (Basel Committee, 2005:29). A bank using the comprehensive approach can choose between standard supervisory haircuts or haircuts based on internal estimates of the market value volatility of collateral. Higher risk instruments face higher haircuts, e.g. up to 25% for certain types of equities and low risk assets such as cash, subject to a 0% haircut 77. The right of banks to use their internal estimates of price volatility for haircuts is subject to a supervisory validation process that includes several qualitative and quantitative criteria covering confidence intervals, liquidity, observation period, internal control policies and proof of use (Basel Committee, 2005:30). The comprehensive approach allows for partial recognition of maturity mismatches between the collateral and the underlying exposure, unless the original maturity of the CRM contract is less than one year. For repurchase transactions falling under bilateral netting agreements with counterparties, banks will be allowed to make their own estimates of Value at Risk (VaR) in place of the comprehensive approach, subject to supervisory approval (ibid.). 7.7 Internal Ratings-Based (IRB) Approach to Banking Book Credit Risk The internal ratings-based approach (IRB) to credit risk is one of the most innovative elements in Basel II. The IRB approach is based on measures of unexpected losses (UL) and expected losses (EL) (Basel Committee, 2005:48). The IRB risk-weight functions produce capital requirements for the UL portion. 77 Assume a B- rated borrower provides a 10-year sovereign bond rated BBB- as security for a R100 loan. The bond would be assigned a 6% haircut to reflect the volatility of an instrument with these risk characteristics. Applying the 6% haircut means that R94 of the bond can be recognised as collateral, and the lender would have to hold capital against the R6 unsecured exposure. Thus, the risk on the portion of the loan covered by the collateral, after reduction by the relevant haircut, is deemed to be fully eliminated by the presence of the collateral. 240

In terms of the IRB approach, the required minimum capital is based on the distribution of losses due to default in a portfolio of loans or similar instruments 78 (European Central Bank, 2005:52). In contrast to the Standardised approach, the IRB approaches represent a fundamental shift to a regulatory capital system based on a bank s own internal assessments of its risks. It allows banks to quantify certain key elements needed to calculate their capital requirements (Basel Committee, 2005:48). Hence risk weights, and thus capital charges, are determined through a combination of quantitative inputs, provided either by banks or by supervisory authorities, and risk weights specified in terms of the IRB approach, adjusted by the use of CRM techniques. The IRB framework is calibrated to cover a bank s potential economic losses by distinguishing between EL and UL losses (Fitch Ratings, 2005:4). The former is EL, which is the mean or average loss a bank can reasonably expect to incur on the assets it holds and which loss has to be covered by the bank s loan loss reserves (LLR). Eligible LLR are defined as specific provisions, partial write-offs, portfolio-specific general provisions, and discounts on defaulted assets (Bugie, 2004:8). The other is UL, which is the loss that exceeds the bank s expectations and which is estimated based on a statistical distribution of potential loss on a credit portfolio, using a 99.9% confidence level, meaning there would be a one in a thousand chance that the bank s losses over the next year would exceed the minimum capital charge. In statistical terms, the EL is represented by the amount of loss equal to the mean of the distribution, while the UL can be thought of as the difference between this mean loss and the potential loss represented by the assumed confidence interval of 99.9%. The credit risk of an asset reflected both in the EL and UL increases as the default probability increases. Likewise, the level of credit risk also increases with higher loss severities, longer maturities, and larger exposures at default. Additionally, the EL contributes a relatively small portion of the capital charge for a high-quality borrower and an 78 The Basel II approach to credit risk measurement represents a significant step forward in banking regulation because it combines practical applicability with a solid theoretical basis. Given that the new methodology is suitable for implementation by banks of different sizes, business structures and risk profiles, a common approach to modelling credit risk across all types of bank is available for regulatory purposes for the first time. The IRB approach is closely linked to key results of modern asset pricing theory. Its methodology is based on a model which establishes the likelihood of a borrowing company being unable to repay its debt, as determined by the difference between the value of its assets and the nominal value of its debt. The value of the firm s assets is modelled as a variable which changes over time, in part as a result of the impact of random shocks. Default is assumed to occur when a firm s assets are insufficient to cover its debt. The corresponding measure of credit risk within a certain time frame, commonly set at one year, is the probability of default (for more details on this theoretical model, see M. Gordy, A risk-factor model foundation for ratings-based bank capital rules, Journal of Financial Intermediation, Volume 12, 2003: 199 232) (European Central Bank, 2005:53). 241

increasingly greater proportion as an asset moves down the credit quality spectrum. For example, for a loan to a high-quality borrower, the bank anticipates that the loan will perform well and is unlikely to experience credit-related problems. Therefore, any severe credit deterioration or loss that might occur on the loan would differ from the bank s expectation and would thus be primarily explained by the UL. By contrast, for a loan to a weaker borrower, the probability of some credit loss is much greater, enabling the bank to build this expectation of loss into its pricing and its reserving strategies. Therefore, at the lower end of the credit quality spectrum, the EL is a larger component of the credit risk facing the bank than at the higher end of the quality spectrum (Hansen and Olsen, 2004:3). The Basel Committee, in an explanatory note to the IRB risk weight functions, sets out the economic foundations of the risk-weight formulas through which the capital charge for an asset is calculated (Basel Committee, 2004c:1 to 4). In the credit business, losses of interest and principal occur all the time there are always some borrowers who default on their obligations. The losses that are actually experienced in a particular year vary from year to year, depending on the number and severity of default, even if it is assumed the quality of the portfolio is consistent over time. Chart 5.2 below (Basel Committee, 2004c:2) illustrates how variation in realised losses over time leads to a distribution of losses for a bank. While it is never possible to know in advance what losses a bank will suffer in a particular year, the bank can forecast the average level of the credit losses it can reasonably expect to experience. This EL is shown in Chart 5.2 as the dashed line. Banks view EL as a cost of doing business and manage it by the pricing of credit exposures and provisioning. Chart 5.2: Distribution of losses One of the functions of bank capital is to provide a buffer to protect a bank s debt holders against peak losses that exceed expected levels. Such peaks are illustrated by the spikes above the dashed line above. Peak losses do not occur every year, but when they occur, they can potentially be very large. Banks know that these UL will occur now and then, but they cannot know in advance their timing or severity. Interest rates charged on credit exposures may absorb some of the UL, but the market will 242

not support interest margins sufficient to cover all UL. Capital is needed to cover the risks of such peak losses and therefore has a loss absorbing function. In determining how much capital a bank should hold, the IRB approach adopted for Basel II focuses on the frequency of bank insolvencies arising from credit losses that supervisors are willing to accept. By means of a stochastic credit portfolio model, it is possible to estimate the amount of loss that will be exceeded with a small, predefined probability, which can be considered the probability of bank insolvency. Capital is then set at such a level that there is only a small probability that UL will exceed this level of capital, as shown in Chart 5.3 below (Basel Committee, 2004c:3). Chart 5.3: Confidence level for potential losses The curve in the figure above describes the likelihood of losses of a certain magnitude. The area under the curve is equal to 100%, i.e. it is the graph of a probability density and it shows that small losses around the EL occur more frequently than large losses. The likelihood that losses will exceed the sum of El and UL, i.e. the likelihood that the bank will not meet its obligations out of its profits and capital, is equal to the shaded area under the right-hand side of the curve. The difference between 100% and this likelihood is the confidence level and the corresponding threshold is the value at risk (VaR) at this confidence level. If capital is set according to the gap between EL and VaR, and assuming EL is covered by the LLR, then the likelihood that the bank will remain solvent over a oneyear horizon is equal to this confidence level, which under Basel II is set as 99.9%. 243

7.7.1 Calculation of Capital Requirements under the IRB Approach The calculation of the capital ratio in terms of the IRB approaches is expressed as follows (Fitch Ratings, 2005:5): Capital + (LLR Credit risk EL)/(Credit risk UL x 12.5 79 + Operational risk charge x 12.5 + Market risk charge x 12.5) > 8%. As indicated above, the IRB capital requirements cover only UL, i.e. losses not covered by the LLR. Under the IRB approach, banks must calculate EL for their sovereign, bank, corporate and retail exposures not in default. For exposures in default, banks should use their best estimate of default and reflect the possibility that additional losses could be incurred. In terms of the IRB approach, banks will be expected to set up sufficient LLR to cover their EL exposures, while the minimum IRB capital charges are designed to cover the bank s UL exposures fully. Any shortfall in LLR, below the level of EL, must be deducted equally from Tier 1 and Tier 2 capital of the bank. Any excess LLR over and above the amount of EL can be added only to Tier 2 capital, subject to a limit of 0.6% of risk-weighted assets. The calculation of capital requirements for an asset s default risk in terms of the IRB approach relies on six key inputs, which are translated into a capital charge for each asset through a predetermined supervisory risk-weight formula (European Central Bank, 2005:54). Probability of Default (PD): This is the likelihood that the borrower defaults over a specified time horizon, e.g. one year. Loss Given Default (LGD): This is the loss on a loan following a default on the part of the borrower. It is the inverse of the recovery rate and is expressed as a percentage of the debt s original value. Exposure at Default (EAD): This is the nominal value of the borrower s debt. It also reflects the forecast amount that a borrower will draw on a commitment or other type of credit facility. 79 Credit risk UL*12.5 = Credit risk-weighted assets. 244

Remaining maturity of the loan (M): This reflects the fact that longer term corporate exposures carry higher credit risk. Correlation to systematic risk: This is the estimate of the link between the joint default of two separate borrowers. The IRB model relies on a single-factor asset value model to describe the comovement of defaults in a portfolio. The unobservable common factor can be interpreted as a variable which represents the state of the economic cycle. IRB correlations to the single systematic risk factor are a function of the firm s size and credit quality in accordance with the IRB framework 80. Risk-weight function: This is the function relating the loss forecast to minimum capital requirements. The risk weights are specified under the IRB framework. The UL calibration in the IRB approach entails two major consequences (Deutsche Bundesbank, 2004:78). Banks will have to show that they have actually set aside sufficient provisions to cover EL. Insufficient coverage of EL will lead to a deduction of capital equal to the amount of the shortfall. If banks set aside more provisions than necessary, based on their EL calculations, the surpluses may be recognised as additional capital up to a certain level. 80 A critical element of the IRB framework and a key driver of the capital charges are the assumptions around correlation and the correlation values used in the formulas. Basel II does not permit banks to generate their own internal estimates of correlation, but captures correlation through a single systematic risk factor. Since correlation is a key driver in the amount of regulatory capital generated by each of the different asset categories under the IRB approach, different correlations are therefore assumed for different asset classes, e.g. 15% for home loans, 4% for credit cards, 12% to 24% for corporate loans. Low correlation implies that borrowers largely experience credit problems independently of each other due to unique problems that the particular borrower may be facing. A high correlation suggests that credit problems occur simultaneously among borrowers in response to a systematic risk factor, such as deterioration in general economic conditions. In terms of the IRB approach, the degree to which an asset is correlated to broader market events depends on the underlying credit quality of the borrower. Based on empirical studies conducted by the Basel Committee, the performance of higher quality assets tends to be more sensitive to and more correlated with market events. These findings are consistent with the financial theory that a larger proportion of economic loss on high-quality exposures is driven by systematic risk. By contrast, the economic loss on lower quality exposures is driven mainly by idiosyncratic, or borrower-specific, factors and less so by systematic risk. This reasoning suggests that the performance of lower-quality assets tends to be less correlated with market events and therefore the biggest driver of credit risk is the lower intrinsic credit quality (high PD value) of the borrower. By not allowing banks to internally estimate portfolio correlation, e.g. pair-wise correlation among individual borrowers and across asset categories, the IRB ratios are not sensitive to variations in concentration risk. For example, in cases where a significant proportion of a bank s credit exposures is concentrated in a particular geographic area, the underlying correlation between these assets is likely to be higher than the correlation values provided under the IRB approach. Therefore, in such a case, the underlying risk of the bank s portfolio would not be fully reflected in the IRB charges. 245

The UL calibration means that capital no longer has to be maintained in reserve for defaulted loans. The reason for this lies in the IRB risk model in which LGD is entered as a risk-free constant. In reality, however, defaulted loans are fraught with risk since the actual recoverable amounts are uncertain. Defaulted loans should therefore be given capital backing which also maps, in particular, adverse economic influences on the recovery rate. The solution to this is that banks must no longer orientate their internal LGD estimates to historical default-weighted average LGDs, but to conservative scenarios of the business cycle. Banks are to estimate a downturn LGD containing probable losses during an economic downturn. For defaulted loans there will be a capital charge consisting of the difference between the conservative downturn LGD 81 and the provision conditioned by the current economic situation. 81 In principle, regulatory capital charges are intended to cover unexpected losses (UL). Expected loss (EL) is a calculable cost component of credit business and that is supposed to be covered by interest margins and provisions. EL is defined as the product of the probability of default (PD) and loss-given-default (LGD). The Basel II risk weight functions determine the regulatory capital requirement to cover the 99.9% quintile of the portfolio loss distribution function, less the EL. From a theoretical perspective, the LGD parameter can be understood as an average or expected, i.e. default-weighted, loss ratio that is not orientated to a specific economic scenario. The UL risk weight, by contrast, describes the loss that occurs if a systematic risk becomes significant, e.g. owing to adverse economic conditions. To take account of this systematic risk, the input PD is converted into a stress PD by applying the appropriately adjusted UL risk weight function prescribed by supervisors. For the LGD parameter, by contrast, the downturn scenario must already be included in the estimated value as it is entered into the UL risk-weight function without being transformed. The mean LGD is accordingly a lower limit for the downturn LGD. This downturn LGD can be calculated from, e.g. LGDs in time periods characterised by large credit losses. For credit exposures where the LGD is independent of cyclical movements, mean LGD and downturn LGD could be identical. In the Basel II framework, the downturn LGD is applied to non-defaulted loans both when determining UL and when determining EL. This simplification allows banks to use only a single estimated value of LGD to determine the regulatory capital requirements. The estimated value is calculated for each individual category of assets and collateral. In the case of defaulted exposures, the LGD parameter is calculated individually for each exposure. A distinction is made here between mean LGD and downturn LGD. When calculating EL, an expected LGD value that takes into account the current economic environment and the current value of the collateral are estimated. The difference between downturn LGD and expected LGD is a UL risk weight for latent, systematic risk in the part of a defaulted exposure for which no specific provision or write-offs have yet been made. The UL calibration means that, in the IRB approach, banks must compare calculated expected losses with provisions set aside. Insufficient coverage of EL will lead to a deduction in equal parts from the bank s core capital and additional capital. Surpluses of provisions can be recognised as additional capital up to 0.6% of the risk-weighted assets for credit risk. If the amount of provisioning exceeds EL, this does not necessarily mean that the bank has set aside too much in provisions. Rather, deviations between EL and provisions can be due to differences in their calculation methodology. For example, regulatory EL is based on a one-year time horizon, where external accounting standards usually count the entire time to maturity of the exposure. In individual cases, this may lead to overcoverage of EL. The inclusion of overcoverage of EL in additional capital is intended to promote the building of provisions. At the same time, competitive equality between banks is to be maintained by setting an upper limit for the inclusion of provisions (Deutsche Bundesbank, 2004, 91-94). 246

7.7.1.1 Calculation of EL The credit risk EL of a portfolio is assumed to be equal to the proportion of obligors that might default within a given time frame (one year in the IRB approach), i.e. the PD, multiplied by the EAD, and multiplied by the LGD 82. 7.7.1.2 Calculation of UL Basel II will give banks the option of two internal methods, the Foundation IRB approach and Advanced IRB approach, to calculate regulatory capital requirements for UL (Basel Committee, 2005:55). The main difference between the two IRB approaches lies in the definition of the input variables. 7.7.1.3 Foundation IRB Approach In terms of this approach, banks will use their own data to calculate the PD on their corporate assets (ibid.). Banks using the Foundation IRB approach may not, however, provide own estimates for the other inputs in the IRB formula and must use the fixed values specified under the IRB framework as follows: LGD: 45% for unsecured loans; EAD: 75% conversion factor for committed credit lines; and Maturity: 2.5 years. 7.7.1.4 Advanced IRB Approach In terms of the Advanced IRB approach, banks are permitted to calculate their capital requirements using their own internal estimates of PD, LGD, EAD and M derived from both historical data and specific information about each asset (Hansen and Olsen, 2004:3). 82 In currency amounts: EL = PD*EAD*LGD and in percentage terms: EL = PD*LGD. 247

7.7.1.5 Asset Classes under the IRB Approach The IRB framework recognises the importance of asset type in explaining the risk profile of instruments subject to default risk, and therefore defines, as in the Standardised approach, different asset classes for regulatory purposes (Deutsche Bundesbank, 2004:76). The model assumes very low concentration in the loan portfolio and that an individual borrower s default risk does not depend on the composition of the entire portfolio. This characteristic of the IRB approach considerably reduces the complexity of the approach and also allows smaller, less sophisticated banks to apply a modern risk management concept (European Central Bank, 2005:54). In terms of the IRB approach, banking book credit risk assets are divided into five principal asset classes: sovereign, bank, corporate, retail and equity exposures (Basel Committee, 2005:48). The corporate asset class has five sub-classes of Specialised Lending (SL), which are subject to a distinct risk-weighting approach. Retail exposures are subdivided into three subclasses. Sovereign exposures Bank exposures Corporate exposures Retail exposures Equity holdings Asset classes in the IRB approach Corporate entities Project finance Specialised lending Object finance Commodities finance Income-producing real estate High-volatility commercial real estate Residential mortgage loans Revolving credits Other retail exposures and loans to small and medium-sized entities Table 5.10: Asset classes in the IRB approach 7.7.1.6 Rules for the Calculation of UL Capital Requirements for Sovereign, Bank and Corporate Exposures Specified formulas (Basel Committee, 2005:59) are used to calculate the UL capital requirements for sovereign, bank and corporate exposures not in default 83. The UL capital requirements for these 83 Corporate, sovereign and bank risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K): = [LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD] x (1 1.5 x b)^- 1 x (1 +(M -2.5) x b) where correlation (R) = 0.12 x (1 EXP(-50 x PD))/(1 EXP(-50)) + 0.24 x [1 (1 EXP(-50 x PD))/(1 EXP(-50))] with maturity adjustment (b) = (0.11852 0.05478 x ln(pd))^2. N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with a mean zero and variance of one is less than or equal to x). G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N(x) = z). The normal cumulative distribution function and the inverse of the normal cumulative distribution function are available in Excel as the functions NORMDIST and NORMSINV. Ln denotes the natural logarithm. 248

exposures are basically the same with respect to the PD. With respect to corporate exposures, the IRB approach differentiates credit risk based on the LGD experience of the lending bank, with adjustments for the size of the borrower. The size adjustment for small and medium-sized enterprises (SMEs) with less than 50 million in annual turnover reduces capital requirements by about 23% for a given PD and LGD assumption compared with large corporates (Bugie, 2004:6). For IRB banks, Basel II differentiates between two different types of commercial real estate (CRE) lending (Fitch Ratings, 2005:8): Income Producing Real Estate (IPRE), which comprises stable commercial real estate lending with predictable loss pattern; and High Volatility Commercial Real Estate (HVCRE), which comprises commercial real estate lending such as acquisition, development and construction lending with less predictable loss patterns. HVCRE is deemed to be higher risk than IPRE and thus subject to higher capital charges. This is achieved through higher correlation values. Banks can use the Foundation IRB approach if they can estimate the PD or they can use the Advanced IRB approach if they have comprehensive recovery data, i.e. LGD, as well. If IRB banks cannot generate their own loss and recovery estimates, and hence are not able to use the IRB formulas, they must use the Supervisory Slotting approach, which means that the banks will determine their risk levels by classifying their CRE exposures into broad categories. These categories, e.g. strong, good, satisfactory, are based on criteria laid down in terms of Basel II and are roughly designed to correspond to rating agency categories. For instance, the strong category broadly corresponds to the BBB- category and above (Fitch Ratings, 2005:9). 7.7.1.7 Rules for the Calculation of UL Capital Requirements for Retail Exposures As for corporate exposures, the IRB approach for retail exposures estimates the credit risk based on the LGD experience of the lending bank. The types of loans that qualify as retail exposures are residential mortgages for housing units that are owner-occupied, revolving lines of credit, credit cards, overdrafts, personal loans and leases, instalment loans, auto loans and leases, educational loans, and small business loans under 1 million that are treated like personal loans (Bugie, 2004:7). The IRB categories can be sub-divided into the following three categories (Fitch Ratings, 2005:7): 249

residential mortgages, which is geared towards owner-occupied residential property, however regulators are permitted some flexibility in extending it to rental properties in buildings containing only a small number of rental units; qualifying revolving credit, which includes drawn exposures as well as undrawn credit lines; qualifying revolving retail exposures must be classified into three categories: personal loans, qualifying revolving lines (uncommitted lines of under 100,000 to low-risk borrowers), and other consumer loans; and other retail lending that includes auto loans, student loans and small business loans under 1 million. Specified formulas (Basel Committee, 2005:73) are used to calculate the UL capital requirements for these categories of residential mortgage exposures 84, qualifying revolving retail exposures 85 and other retail exposures 86 that are not in default. The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD and the bank s best estimate of expected loss. The major difference in calculating the capital requirement for the different retail categories lies in the different correlation factors used, as depicted in Table 5.11 below. Type of Lending Correlation Factor Residential mortgages 15% Revolving credit lines 4% Other retail lending Between 3% and 16% depending on the PD of the borrower Table 5.11: Retail correlation factors 84 Residential mortgages risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K) = LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD. Correlation (R) = 0.15 85 Qualifying revolving retail risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K) = LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD. Correlation (R) = 0.04 86 Other retail risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K) = LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD. Correlation (R) = 0.03 x (1 EXP(-35 x PD))/(1 EXP(-35)) + 0.16 x [1 (1 EXP(-35 x PD))/(1 EXP(-35))] 250

The risk weights for retail exposures are lower than for corporates with the same PD and LGD, which reflects the fact that capital requirements are calibrated to cover a one-year PD and are not adjusted upward for longer maturities. It also reflects the view that losses on retail exposures are more predictable and are more likely to be covered by lending margins (Bugie, 2004:7). For retail exposures there is no distinction between the Foundation and Advanced IRB approaches. All IRB banks will be expected to use the Advanced IRB approach and calculate the PD, LGD and EAD on their retail portfolios. There is no explicit maturity adjustment, as the differences in tenor of retail assets is reflected in part in the differing correlation values, e.g. residential mortgages are subject to a higher correlation assumption than other types of retail lending (Fitch Ratings, 2005:7). 7.7.2 Credit Risk Mitigation under the IRB Approaches to Banking Book Credit Risk Banks using the IRB approach may only use the comprehensive approach to collateral in terms of the Standardised approach. The simplified approach to collateral under the Standardised approach is not available to banks using the IRB approach (Deutsche Bundesbank, 2004:80). IRB banks are allowed to recognise the credit risk mitigation provided by physical collateral. In the Foundation IRB approach, collateral is recognised by reducing the LGD. For eligible financial collateral, the LGD for the secured part of the exposure is reduced to 0%. For other collateral, the LGD is reduced to 35% for receivables and real estate collateral, or 40% for other collateral. The portion of the loan not covered would receive the standard LGD for unsecured lending, i.e. 45%. Advanced IRB banks are not subject to these limitations and are permitted to recognise the impact of collateral directly in their LGD estimates, based on historical recovery experience for different types of collateral. 251

7.7.3 Summary of Eligible Collateral under the Standardised and IRB Approaches to Banking Book Credit Risk Standardised approach Eligible financial collateral: Cash, Certificates of deposits, Gold, Debt securities, Equities and Transferable securities in mutual funds. On-balance sheet netting. Guarantees and credit derivatives. Summary of eligible collateral under the different approaches to credit risk Internal Ratings-Based approach Foundation IRB Advanced IRB Same as in Standardised approach. Receivables. Commercial and residential real estate. Other collateral allowed by supervisors. Table 5.12: Eligible collateral under the Standardised and IRB approaches Banks may use their own internal estimates of LGD, subject to certain minimum requirements. 7.7.4 Summary of Differences between the Standardised and IRB Approaches to Banking Book Credit Risk Table 5.13 below summarises the major difference between the various approaches to the calculation of credit risk (Hashagen, 2003:20). Criteria Standardised approach Internal Ratings-Based approach Foundation IRB Advanced IRB Rating External Internal Internal Risk weight. Calibrated on the basis of external ratings by the Basel Committee. Function provided by the Basel Committee. Probability of Default (PD): The likelihood that a borrower will default over a given time period. Exposure at Default (EAD): For loans, the amount of the facility that is likely to be drawn if a default occurs. Loss-Given-Default (LGD): The proportion of the exposure that will be lost if a default occurs. Maturity: The remaining economic maturity of the exposure. Credit Risk Mitigation Techniques. Implicitly provided by the Basel Committee; tied to risk weights based on external ratings. Supervisory values set by the Basel Committee. Implicitly provided by the Basel Committee; tied to risk weights based on external ratings. Implicitly provided by the Basel Committee; tied to risk weights based on external ratings. Defined by the supervisor; includes financial collateral, guarantees, credit derivatives and on an off balance sheet netting. Provided by banks based on own estimates. Supervisory values set by the Basel Committee. Supervisory values set by the Basel Committee. Supervisory values set by the Basel Committee. All collateral from the Standardised approach; receivables from goods and services; other real estate and other physical securities if certain criteria are met. Function provided by the Basel Committee. Provided by banks based on own estimates. Provided by bank based on own estimates. Provided by bank based on own estimates; extensive process and internal control requirements. Provided by bank based on own estimates. All types of credit risk mitigation techniques if banks can prove such technique by internal estimation. Table 5.13: Comparing the Standardised and IRB approaches 252

7.8 Credit Risk under the Securitisation Framework Securitisation has received considerable attention because it is one of the areas where the Basel I approach has become clearly outdated. The new Basel II framework will, for the first time, create an internationally harmonised standard for the supervisory treatment of these transactions. This should significantly reduce the incentive for regulatory capital arbitrage, which has been a key motive for securitisation, and risk management and refinancing aspects will assume a more prominent role (ibid.). For a bank that as originator securitises its own assets, capital relief is contingent on an effective and significant risk transfer. The intent of Basel II is to consider the economic substance rather than the legal form when assessing regulatory capital requirements. Thus, in securitisation transactions where the originating bank transfers assets but retains most of the economic risk in junior tranches, the capital requirement is assessed based on the retained economic risk. If certain conditions with respect to risk transfer are met, the securitised assets are excluded from risk-weighted assets (Bugie, 2004:9). The operational requirements for the supervisory recognition of risk transfer are identical for securitisation exposures in the Standardised and IRB approaches. A distinction is made with regard to the capital charge on securitisation exposures held by originators or investors, in order to take due account of the different degrees of knowledge and experience of risk management at the individual institutions. The securitisation framework of Basel II contains detailed rules for the treatment of securitised assets (Basel Committee, 2005:116 to 139). The approach covers assets securitised by a bank, where the bank retains an interest, and also securitised assets where the bank is the investor. Banks must use the securitisation framework to determine regulatory capital requirements for traditional and synthetic securitisation, or structures that combine techniques. In terms of Basel II, the capital treatment of securitisations has to be determined on the basis of its economic substance rather than its legal form. Basel II defines a traditional securitisation as a structure where the cash flows from an underlying pool of exposures are used to service two or more different stratified risk tranches reflecting different degrees of credit risk. Payments to investors depend on the performance of the underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The tranched structures of securitisations differ from ordinary senior/subordinated debt structures in that junior securitisation tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation. 253

A synthetic securitisation is defined as a structure with two or more different stratified risk tranches that reflect different degrees of credit risk of an underlying pool of exposures, where such risk is transferred, in whole or in part, through funded credit derivatives, e.g. credit-linked notes, or unfunded credit derivatives, e.g. credit default swaps. The investors risk is a function of the performance of the underlying pool of exposures. Banks are required to hold regulatory capital against all of their securitisation exposures, including those arising from the provision of credit risk mitigants to a securitisation transaction, investments in asset-backed securities, retention of subordinated tranches, and provision of liquidity and credit enhancement facilities. Where a bank is required to deduct a securitisation exposure from regulatory capital, the deduction must be taken 50% from Tier 1 capital and 50% from Tier 2 capital. Credit enhancing interest-only strips (IOs) are deducted 50% from Tier 1 capital and 50% from Tier 2 capital. Deductions from capital may be calculated net of any specific provisions taken against the relevant securitisation exposures. The securitisation framework of Basel II distinguishes between the Standardised and IRB approach for securitisation exposures. Both the Standardised and IRB approaches to the calculation of securitisation exposures use risk weights which are linked to external ratings by ECAIs. Better rated positions benefit from lower Basel II capital requirements. Banks using the Standardised approach for credit risk are granted only one method for determining the capital requirement for their securitisation exposures, which links the capital requirement to the credit rating of the securitisation position held. The securitisation capital requirements for banks using the IRB approach depend on whether the securitisation position held has a credit rating from a recognised ECAI. For securitisation positions with a credit rating, the bank must use the Ratings-Based Approach (RBA), which links the capital requirement to the credit rating of the securitisation position held. For unrated securitisation exposures, IRB banks must use the Supervisory Formula (SF) that generates a capital charge based on various attributes of the structure and the riskiness of the underlying assets. 254

A bank holding both rated and unrated securitisation positions within the same securitisation structure would apply the RBA to the rated tranches and the SF to the unrated tranches. 7.8.1 Standardised Approach for Securitisation Exposures The Standardised approach for securitisation exposures is generally modelled on the system used in the general Standardised approach for credit risk. However, for tranches with an external rating less than BBB-, higher risk weights are applied. For unrated positions, a deduction of capital, evenly split between Tier 1 core capital and Tier 2 additional capital, is required. This approach takes into account the high concentration of risk in subordinated securitisation exposures and avoids creating the incentive to explicitly forgo an external rating for tranches with poorer credit ratings. Banks that apply the Standardised approach to credit risk for the underlying exposures securitised must use the Standardised approach under the securitisation framework. Under this approach the risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the position by the appropriate risk weight as specified in Table 5.14 (Basel Committee, 2004a:120). Long-term rating category External credit AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ and below or unrated assessment Risk weight 20% 50% 100% 350% Deduction Short-term rating category External credit A-1/P-1 A-2/P-2 A-3/P-3 All other ratings or unrated assessment Risk weight 20% 50% 100% Deduction Table 5.14: Standardised risk weights for securitisation exposures Basel II distinguishes between long-term risk weights for investing and originating banks, as shown in Table 5.15 below. Standardised Approach for Securitisation Investing versus Originating Banks Investing Bank Originating Bank AAA to AA- 20% 20% A+ to A- 50% 50% BBB+ to BBB- 100% 100% BB+ to BB- 350% Deduction B+ and below or unrated Deduction Deduction Table 5.15: Different risk weights for investing and originating banks 255

The risk weights for investing and originating banks are the same for investment grade securitisation exposures, but for speculative grade BB+ to BB- investing banks will have to apply a 350% risk weighting, whereas originating banks must treat such securitisation exposures as a deduction from regulatory capital. 7.8.1.1 Unrated Securitisation Exposures Unrated securitisation exposures must be deducted from capital, with the exceptions listed below. The first is when it is the most senior exposure in a securitisation. A bank that holds or guarantees such an unrated senior position may apply the look-through approach whereby the unrated most senior position will receive the average risk weight of the underlying exposures. Where the bank is unable to determine risk weights assigned to the underlying exposures, the unrated senior securitisation exposure must be deducted. The second is exposures that are in a second-loss position or better in an ABCP programme and that meet certain Basel II guidelines. In terms of the guidelines, a sponsoring bank to an ABCP programme does not have to deduct the exposure if (1) the exposure is economically in a secondloss position and benefits from a first-loss position that provides significant credit protection to the second-loss position; (2) the associated credit risk is the equivalent of investment grade or better; and (3) the bank holding the unrated second-loss position does not also hold the first-loss position. The third exception is eligible liquidity facilities. For eligible liquidity facilities where the conditions for external credit assessments are not met, the risk weight applied to the exposure s credit equivalent amount is equal to the highest risk weight assigned to any of the underlying individual exposures covered by the facility. 7.8.1.2 Credit risk Mitigation for Securitisation Exposures Credit risk mitigants for securitisation exposures include guarantees, credit derivatives, collateral and on-balance sheet netting. Collateral in this context means the collateral used to hedge the credit risk of a securitisation exposure rather than the underlying exposures of the securitisation transaction. Eligible collateral is limited to that recognised under the Standardised approach for credit risk mitigation. Collateral pledged by SPVs may be recognised. 256

Credit protection provided by entities listed in the Standardised approach may be recognised. SPVs cannot be recognised as eligible guarantors. Banks can take account of guarantees or credit derivatives that fulfil the minimum requirements under the Standardised Approach in calculating capital requirements for securitisation exposures. When a bank other than the originator provides credit protection to a securitisation exposure, it must calculate a capital requirement on the covered exposure as if it were an investor in that securitisation. If a bank provides protection to an unrated credit enhancement, it must treat the credit protection provided as if it were directly holding the unrated credit enhancement. The capital requirement for maturity mismatches will be determined in terms of the Standardised approach. When the exposures being hedged have different maturities, the longest maturity must be used. 7.8.2 IRB Approach for Securitisation Exposures The IRB approach for securitisation exposures deviates from the general risk backing rules in the general IRB approach since no internal estimates of tranche-specific PDs and LGDs are taken into account. Accordingly, no distinction is made between a Foundation and an Advanced IRB approach for securitisation exposures. There are three ways to calculate the capital requirements for securitisation exposures: the external Ratings-Based Approach (RBA), the Supervisory Formula (SF) and the Internal Assessment Approach (IAA), which is permitted for only a limited scope of applications. Banks that have received approval to use the IRB approach for the underlying exposures to a securitisation must use the IRB approach for securitisation. Banks that have not received approval from the supervisors to use the IRB approach may not use it. Where there is no specific IRB treatment for the underlying exposure, originating banks that use the IRB approach must calculate the capital charge on these exposures by using the Standardised approach of the Securitisation framework. Investing banks that use the IRB approach must apply the RBA. Risk-weighted assets are calculated by multiplying the capital charge generated through the use of the IRB approaches by the factor 12.5. 257

The RBA must be applied to all securitisation exposures of IRB banks that are rated, or where a rating can be inferred 87. A certain risk weight is assigned to each rating category. However, in contrast to the Standardised approach, the RBA segments rating classes more finely and has a greater range of risk weights, which also takes into account the seniority of the tranche and the granularity of the underlying pool of exposures. Moreover, the RBA does not distinguish between originators (directly or indirectly the original holders of the exposure) and investors. Where an external or inferred rating is not available, either the SF or the IAA must be applied. The IAA is only available to exposures such as credit enhancement and liquidity facilities that banks, including third-party banks, extend to ABCP programmes. Securitisation exposures, to which none of these approaches can be applied, must be deducted. For a bank using the IRB approach to securitisation, the maximum capital requirement for the securitisation exposure it holds is given by the IRB capital requirement that would have been assessed against the underlying exposures if they had not been securitised. In addition, banks must deduct the entire amount of any gain-on-sale and credit enhancing IOs arising from the securitisation transaction. 7.8.2.1 Liquidity Facilities Liquidity facilities are treated as any other securitisation exposure and receive a CCF of 100%, unless specified differently. If the facility is externally rated, the bank may rely on the external rating under the RBA. If the facility is not externally rated, and an inferred rating is not available, the bank must apply the SF, unless the IAA can be applied. 7.8.2.2 Credit Risk Mitigation When applying the RBA or SF approaches, banks can use the credit risk mitigation techniques allowed under the Foundation IRB approach. A bank may reduce the capital charge proportionally when the credit risk mitigant covers first losses or losses on a proportional basis. For all other cases, the bank must assume that the credit risk mitigant covers the most senior portion of the securitisation exposure, i.e. that the most junior portion of the securitisation exposure is uncovered. 87 There are several operational requirements that require a bank to attribute an inferred rating to an unrated securitisation position. These requirements are intended to ensure that the unrated position is senior in all respects to an externally rated securitisation exposure termed the reference securitisation exposure. 258

7.8.2.3 Ratings-Based Approach In terms of the RBA, the risk-weighted assets are determined by multiplying the amount of the exposure by the appropriate Basel II risk weights. The risk weights depend on: the external rating grade or inferred rating; whether the external or inferred credit rating represents a long-term or a short-term credit rating; the granularity of the underlying pool; and the seniority of the position. For the purposes of the RBA, a securitisation exposure is treated as a senior tranche if it is effectively backed or secured by a first claim on the entire amount of the assets in the underlying securitised pool. While this is generally the case for only the most senior position within a securitisation transaction, in some instances there may be some other claim that, in a technical sense, may be more senior in the securitisation waterfall structure, e.g. a swap claim. However, these claims may be disregarded for the purpose of determining which positions are considered senior tranches under the RBA approach. In Table 5.16 (Basel Committee, 2004a:128) the applicable risk weights are presented for the case where the external assessment represents a long-term credit rating, or when an inferred rating based on a long-term rating is available. Banks may apply the risk weights for senior positions if the effective number of underlying exposures, N, is 6 or more and it is a senior position. When N is less than 6, the risk weights for tranches backed by non-granular pools apply. In all other cases the base risk weights apply. 259

RBA risk weights when the external assessment is a long-term rating or long-term inferred rating External rating Risk weights for senior Base risk weights (Illustrative) positions AAA 7% 12% 20% AA 8% 15% 25% A+ 10% 18% A 12% 20% A- 20% 35% BBB+ 35% 50% BBB 60% 75% BBB- 100% BB+ 250% BB 425% BB- 650% Below BB- and unrated Deduction Risk weights for tranches backed by non-granular pools 35% Table 5.16: RBA risk weights for long-term rated securitisation exposures The risk weights in Table 5.17 below (Basel Committee, 2004a:129) apply when the external assessment or inferred rating represents a short-term credit rating. RBA risk weights when the external assessment is a short-term rating or short-term inferred rating External rating (Illustrative) Risk weights for senior positions Base risk weights A-1/P-1 7% 12% 20% A-2/P-2 12% 20% 35% Risk weights for tranches backed by non-granular pools A-3/P-3 60% 75% 75% All other ratings/unrated Deduction Table 5.17: RBA risk weights for short-term rated securitisation exposures 7.8.2.4 Supervisory Formula In terms of the SF, the regulatory capital requirement for a securitisation tranche depends on five bank-supplied inputs: K IRB : the IRB capital charge for the pool of exposures if the pool had not been securitised; L: the tranche s credit enhancement level; T: the tranche s thickness; N: the pool s effective number of exposures; and LGD: the pool s exposure-weighted average loss-given-default. 260

7.8.2.4.1 Definition of K IRB K IRB is the ratio of (a) the IRB capital requirement including the expected loss (EL) portion of the underlying exposures in the pool to (b) the total exposure amount of the pool and is expressed in decimal form. The quantity in (a) above must be calculated in accordance with the IRB approach as if the exposures in the pool were held directly by the bank, irrespective whether it is an originator bank or a non-originator bank. This calculation should reflect the effects of any credit risk mitigant that is applied to the underlying exposures, either individually or to the entire pool, and hence benefits all of the securitisation exposures. In a typical securitisation structure that incorporates an SPV, all the assets of the SPV that are related to the securitisation have to be treated as exposures in the pool, including assets in which the SPV may have invested a reserve account, such as cash collateral. 7.8.2.4.2 Definition of L L is measured, in decimal form, as the ratio of (a) the amount of all securitisation exposures subordinate to the tranche in question to (b) the amount of exposures in the pool. Banks will be required to determine L before considering the effects of any tranche-specific credit enhancements, such as third-party guarantees that benefit only a single tranche. Any gain-on-sale and/or credit enhancing IOs associated with the securitisation are not to be included in the measurement of L. The size of the interest rate or currency swaps that are more junior than the tranche in question may be measured at their current values, without their potential future exposures, in calculating the enhancement level. If the current value of the instrument cannot be accurately measured, the instrument should be ignored in the calculation of L. 7.8.2.4.3 Definition of T T is measured as the ratio of (a) the nominal size of the respective tranche to (b) the notional amount of the exposures in the pool. In the case of an exposure arising from an interest rate or currency swap, the bank must incorporate potential future exposures (in contrast to the procedure of determining L). If the current value of the instrument is non-negative, the exposure size should be measured by the current value plus the add-on as in the 1988 Accord. If the current value is negative, the exposure should be measured by using the potential future exposure only. 261

7.8.2.4.4 Definition of N The effective number of exposures is calculated by a formula 88. Multiple exposures to the same obligor must be consolidated, i.e. treated as a single instrument. In the case of re-securitisation, i.e. the securitisation of securitisation exposures, the formula applies to the number of securitisation exposures in the pool, and not the number of underlying exposures in the original pools. If the portfolio share associated with the largest exposure, C i, is available, the bank may compute N alternatively as 1/ C i. 7.8.2.4.5 Definition of Exposure-Weighted Average LGD The exposure-weighted LGD is also formula-driven 89. In the case of re-securitisation, an LGD of 100% must be assumed for the underlying securitisation exposures. In terms of the SF, a tranche s IRB capital charge = the value of the exposures that have been securitised times the greater of (a) 0.0056*T, or (b) (S[L + T] S[L]), where the SF is defined by the function S[.] 90. 88 The effective number of exposures is calculated as: 2 ( EADi ) i N = 2 where EAD EAD i represents the exposure-at-default associated with the i th instrument in the pool. i i 89 The exposure-weighted average LGD is calculated as: LGD i.eadi i LGD = where LGD EAD i represents the, in itself exposure-weighted, average LGD associated with all the i i exposures to the i th obligor. 90 The Supervisory Formula (SF) is defined as follows: S[L]= L when L K IRB S[L]= ω (KIRB L K IRB + K[L] K[K IRB ] + (d. K IRB /ω)(1 - e / K IRB ) when K IRB < L Where h = (1 - K IRB /LGD) N c = K IRB /(1 h) ( LGD K ) K + 0.25(1 LGD K IRB v = N v+ K 2 IRB f = [ 1 h ( 1 c)c IRB ) (1 K ) K - c 2 IRB ] + (1 h) τ g = f - 1 a = g.c b = g.(1 c) d = 1 (1 h).(1 Beta[K IRB ; a, b]) K[L] = (1 h).((1 Beta[L; a, b])l + Beta[L; a +1, b]c) Where Beta[L; a, b] refers to the cumulative beta distribution with parameters a and b evaluated at L. The supervisory-determined parameters are τ = 1,000 and ω = 20. IRB IRB v 262

7.8.2.4.6 Simplified Method for Computing N and LGD For securitisations of retail exposures, subject to supervisory review, the SF may be implemented using the simplifications: h = 0 and v = 0. Under the conditions below, banks may employ a simplified method for calculating the effective number of exposures and the exposure-weighted average LGD. Let C m in the simplified calculation denote the share of the pool corresponding to the sum of the largest m exposures. The level of m is set by each bank. If the portfolio share associated with the largest exposure, C 1, is no more than 3% of the underlying pool, then for the purposes of the SF, the bank may set the LGD = 0.50 and N equal to a specified formula 91. Alternatively, if only C 1 is available and this amount is no more than 3%, then the bank may use the combination of LGD = 0.50 and N = 1/ C 1. 7.8.2.5 Internal Assessment Approach A bank may use its internal assessments of the credit quality of all securitisation exposures, e.g. liquidity and credit enhancement facilities that the bank extends to ABCP programmes, provided that the bank s internal assessment process meets several operational requirements. Internal assessments of exposures extended to ABCP programmes must be mapped to equivalent external ratings of an ECAI. Those rating equivalents are used to determine the appropriate risk weights under the RBA for purposes of assigning the notional amounts of the exposures. 91 C1 N = [C 1 C m + ( ) C m max{1 - mc 1,0}] m 1 1 263

7.8.3 Comparison between Risk Weights for the Standardised Approach and RBA for Securitisation Exposures Table 5.18 below summarises the different risk weights for the Standardised approach and the base and senior risk weight positions under the RBA. Basel II Risk Weights for Securitisation Exposures: Standardised approach vs. RBA External Rating Standardised Approach Senior RBA Base RBA AAA 20% 7% 12% AA 20% 8% 15% A+ 50% 10% 18% A 50% 12% 20% A- 50% 20% 35% BBB+ 100% 35% 50% BBB 100% 60% 75% BBB- 100% 100% 100% BB+ 350% 250% 250% BB 350% 425% 425% BB- 350% 650% 650% B Deduction Deduction Deduction CCC+ Deduction Deduction Deduction Table 5.18: Comparing risk weights under the Standardised approach and the RBA Interestingly, in almost all rating categories the Standardised approach specifies higher risk weights than the RBA, apart from the BB and BB- categories, where the RBA specifies a higher risk weight (425% for BB and 650% for BB- under the RBA against 350% for both categories under the Standardised approach). 264

7.8.4 Comparing the Standardised and IRB Approaches to Banking Book and Securitisation Credit Risk The differences between the Standardised and IRB approaches are summarised in Table 5.19 below. Standardised Banks versus IRB Banks Asset Standardised Banks IRB Banks Bank balance sheet assets. Use external ratings and Basel-provided risk weights for these ratings to calculate risk-weighted assets. Securitisation assets. Securitisation exposures use Baselprovided risk weights, which are linked to external credit ratings. Use internal measures of risk: PD (probability of default) LGD (loss-given-default) EAD (exposure at default) M (maturity) These measures of risk are used as formula inputs to the Basel-provided formulas (which varies by asset category) to calculate risk-weighted assets when these assets are held on the bank s balance sheet. For rated securitisation exposures, the Ratings-Based Approach (RBA) is used, which links Basel-provided risk weights to external credit ratings. For unrated securitisation exposures, the Supervisory Formula (SF) is used, whereby the regulatory capital requirement for a securitisation tranche depends on five bank-supplied inputs: K IRB : the IRB capital charge for the pool of exposures if the pool had not been securitised. L: the tranche s credit enhancement level. T: the tranche s thickness N: the pool s effective number of exposures; and LGD: the pool s exposure-weighted average loss-given-default. For securitisation exposures such as liquidity and credit enhancement facilities that a bank extends to ABCP programmes, the bank must use the Internal Assessment Approach (IAA). The IAA allows a bank to use its internal assessments of the credit quality of the facilities extended. These internal assessments must be mapped to equivalent external credit ratings. Table 5.19: Comparing the Standardised and IRB approaches 265

8. CONCLUSION Banks are exposed to a number of risks such as credit risk, interest rate risk, market risk, operational risk, and solvency or capital risk. When a bank does not manage these risks efficiently it runs the risk of failure. Banks are more easily exposed to collapse than a normal commercial enterprise because of the high balance sheet gearing, and the risk of a run on deposits when depositors lose confidence in a bank. Such a loss of confidence in a bank, which usually leads to severe liquidity problems for the particular bank, often derives from a deep-seated problem in the bank, for example poor credit risk management that results in loan losses that have become public knowledge. Banking history is replete with examples of financial crises and bank failures. Given the important role that banks play in a country s economy, bank failures may cause much damage to a country s economy, especially when banks collapse one after the other because of a loss of confidence in the banking system. The authorities, usually the country s central bank, have thus always regulated banks. Banking regulation and supervision is primarily geared towards protecting depositors from suffering losses and preventing systemic risk from arising in the banking system. With the growth of international trade and investment, banks have also expanded internationally and have established branch offices and subsidiaries abroad. Regulators became concerned these overseas outposts of banks might fall between the regulatory cracks. To this end the Basel Committee on Banking Supervision was established at the end of 1974 following the collapse of Bankhaus Herstatt in Germany, and other financial market disruptions. The Basel Committee is made up of representatives of the so-called G10 countries i.e. the major industrial countries, plus Switzerland and Luxembourg (Spain joined in 2001). Each country represented has a representative from the central bank and, if separate, from the agency responsible for banking supervision. The Basel Committee reached agreements that the members have said they would abide by, but these agreements do not have legal force. Initially the Basel Committee promoted international co-operation to close regulatory gaps and to improve the quality of banking supervision worldwide. Since the 1980s it has however became increasingly concerned about the level of banks capital adequacy and the discrepancy in capital adequacy regulations in different countries. To strengthen the international financial system the Basel Capital Accord (Basel I) was completed in 1988, which was implemented by its member countries by 1992. Non-member countries followed and by 1999 around 100 countries worldwide had adopted Basel I. Basel I was initially successful in halting the decline in bank capital internationally, and led to some rebuilding of capital by banks. However, from its inception it was recognised that Basel I had 266

deficiencies. The capital ratio standards are for the most part arbitrary, because they do not flow from any particular insolvency probability standard. All corporate loans, for example, are put into the 8% bucket irrespective of the credit quality. The capital standards, moreover do not take account of hedging, diversification and portfolio management techniques. Since 1988 the nature of banks business and the risks that banks undertake have also changed. By the late 1990s, banks had become much more sophisticated in their operations and risk management and were increasingly able to find ways to reduce their risk-weighted assets. Most large banks have developed internal risk models that they use to quantify the risks that they are exposed to by estimating loss distribution probabilities for various risks. Enough economic, as distinct from regulatory, capital is then allocated to each risk so as to satisfy the bank s own risk management requirements. Thus, in the case where a group of loans attracts an internal capital charge that is lower than the regulatory capital requirement, the bank has a strong incentive to engage in regulatory arbitrage, which reflects the activities that allow a bank to reclassify some of its assets into a lower regulatory risk category. The one-size-fits-all nature of capital adequacy under Basel I encouraged the growth of regulatory arbitrage by banks, and regulators became increasingly concerned that banks were not holding sufficient regulatory capital for the risks to which they were exposed. Dissatisfaction with Basel I led to the development by the Basel Committee of the new Basel II framework. The aim of Basel II is to achieve a better alignment of the minimum regulatory capital required with the economic risks that banks face. The Basel II framework consists of three mutually reinforcing pillars. The first pillar deals with minimum capital requirements, the second pillar with the supervisory review process and the third pillar with market discipline. Collectively, they go well beyond the mechanistic calculation of minimum capital levels set by Basel I, allowing banks to use their own models to calculate their regulatory capital requirements. The first pillar distinguishes between credit risk, market risk and operational risk. It is especially the calculation of credit risk and the capital adequacy charges that are expected to have the greatest impact on the regulatory arbitrage activities of banks. Three credit risk approaches of increasing levels of sophistication will allow banks to choose the method of calculating regulatory capital that suits them best. In addition, for the first time, there are now specific regulations for the calculating capital charges of securitisation transactions. 267

The Standardised approach follows Basel I by grouping exposures into a series of risk categories. However, whereas under Basel I each risk category carried a fixed risk weighting, under Basel II three of the categories (loans to sovereigns, banks and corporates) have risk weights determined by the external credit ratings assigned to the borrower. Amongst the other categories that continue to have fixed risk weights applied by Basel II, residential mortgage loans will carry a risk weight of 35% (as opposed to 50% under Basel I). This lower weighting is a recognition of the historically low rate of losses typically incurred on residential mortgage portfolios. In terms of the Internal Ratings-Based (IRB) approach, the regulatory capital requirements are determined by Basel II-supplied risk weight formulas that make use of probabilities of default (PD), loss-given-default (LGD), exposure-at-default (EAD) and maturity of the loan (M). In terms of the Foundation IRB approach, banks will be able to estimate their own PDs on their loan portfolios, whilst using set values for the other parameters, and input these into the Basel II risk weight formulas to provide a risk-weighting for each type of exposure. Banks using the Advanced IRB approach may estimate all these parameters themselves. 268

CHAPTER SIX THE IMPACT OF BASEL II ON BANKS SECURITISATION ACTIVITIES 1. INTRODUCTION The purpose of this chapter is to investigate the potential impact of Basel II on the use of securitisation by banks to reduce their regulatory capital. As described in the previous chapter, the major objective of Basel II has been to align banks regulatory capital requirements more closely with economic capital. The Basel I Accord of 1988 provided fertile ground for regulatory arbitrage because of its flat 8% capital charge on all corporate assets and a 4% charge on residential mortgage loans, irrespective of the underlying credit quality of the borrower. On high-quality assets, the amount of capital that banks are required to hold under Basel I exceeds the level of capital required to cover the economic risk of the assets. Basel I thus presented banks with an incentive to reduce their regulatory capital requirements by securitising these assets, often keeping the riskiest first-loss position to support the transaction. The Basel II framework is designed to curb banks regulatory arbitrage activities. To calculate their regulatory capital requirements for their banking book credit exposures, banks can make use of the Standardised approach, which is a more refined version of the Basel I approach, or the Internal Ratings-Based (IRB) approach, which measures a bank s regulatory capital based upon the default risk, as measured by the probability of default (PD), and loss severity, as measured by the loss-givendefault (LGD). Banks using the IRB approach (IRB banks) will have to make their own estimates of the PD of each of their assets. To determine the loss severity of their corporate exposures and commercial real estate exposures, banks using the Foundation IRB approach will have to use a fixed 45% LGD factor as specified under Basel II if not secured by recognised collateral. Banks using the Advanced IRB approach will be able to use their own estimates for LGD. For retail assets such as residential mortgage loans and credit card exposures, Basel II does not distinguish between the Foundation and Advanced IRB approaches and all IRB banks will have to provide their own PD and LGD estimates. IRB banks must then input these PD and LGD factors into mathematical formulas provided under Basel II to calculate the regulatory capital requirements for their banking book exposures. 269

To determine the regulatory capital requirements for their securitisation exposures, Basel II allows banks to make use of either the Standardised approach or the IRB approach. Under the Standardised approach the regulatory capital requirements are determined by the external credit rating of the exposure by a recognised credit rating agency. For IRB banks, Basel II makes no distinction between a Foundation and Advanced approach to securitisation exposures. Under the IRB approach to securitisation exposures, there are two approaches depending on whether the securitisation exposure is rated or not. For all securitisation exposures with a rating from a recognised credit rating agency, IRB banks must use the Ratings-Based Approach (RBA), which links the regulatory capital requirements to the external credit rating of the securitisation exposure. This RBA is similar to the Standardised approach, but regulatory capital requirements under the RBA are generally lower and there is greater differentiation in requirements. For unrated securitisation exposures, IRB banks must use the Supervisory Formula (SF) or Internal Assessment Approach (IAA) specified in Basel II. In terms of the SF, the regulatory capital requirements are calculated based upon attributes such as the regulatory capital required if the asset pool had not been securitised, credit enhancement supporting the securitisation exposure, relative size of the securitisation exposure and the number of underlying assets in the pool. A bank that holds both a rated and an unrated exposure in a securitisation structure, would apply the RBA to the rated tranches and the SF to the unrated tranches. The interplay between the Basel II regulatory capital requirements for banking book credit risk exposures and securitisation exposures will determine the impact on the use of securitisation by banks for regulatory arbitrage purposes. 2. THE IMPACT OF BASEL II ON SECURITISATION MARKETS Basel II is intended to curb the incentives for regulatory arbitrage by banks in two ways as discussed below. First, Basel II aligns regulatory capital on banking book assets much more closely with the underlying economic risks of those assets, thereby reducing the incentive for regulatory arbitrage. 270

Secondly, Basel II applies stringent regulatory capital charges on the junior securitisation tranches that banks normally retain as credit enhancement to their securitisation transactions. Basel II will not eliminate all regulatory arbitrage opportunities, but will reduce the scope of capital release for many assets if the originating bank retains the residual risks (Reardon, 2006:2). 2.1 Comparing the Capital Requirements for Banking Book Assets versus Securitisation Assets Hansen (2005) has investigated the impact of Basel II on the securitisation market. The methodology used was to calculate the capital charges for sample portfolios 92 of assets as if they were on a bank s balance sheet, and then to calculate the capital charges if the same portfolios had been securitised. The analysis covered a range of portfolios representing different underlying assets and risk levels. Specifically, credit card ABS, CMBS, RMBS and CDOs of corporate debt were evaluated. Hansen s research reveals how the advent of Basel II will potentially affect the securitisation markets. 2.1.1 Lower Capital Requirements on Rated vs Unrated Securitisation Tranches Generally, IRB banks will have to hold less regulatory capital against rated securitisation tranches (exposures) for which the capital requirements have been calculated in accordance with the RBA than on unrated tranches for which the capital requirements have been calculated using the SF. The RBA generates much lower capital requirements than the SF on the same securitisation position, which may provide an incentive for IRB banks to target the rated portion of the securitisation market. 2.1.2 Different Capital Requirements across Different Securitisation Asset Classes The differences in capital requirements between the RBA and SF are most pronounced for credit card ABS and CMBS transactions, as depicted in Chart 6.1 (Hansen, 2005:5). In these asset classes, the SF requires approximately three to four times as much capital as the RBA. By comparison, for CDO and RMBS transactions, the capital requirements calculated under the SF and RBA are more closely aligned. Generally, the SF requires about 1.5 times as much capital as the RBA in these asset classes. 92 The calculations of capital requirements on the sample portfolios are set out in Appendix 7. 271

Chart 6.1: Multiple of the SF capital requirements to RBA capital requirements 2.1.3 Different Capital Requirements across Different Securitisation Tranches The results of the study indicate that the degree of difference between the RBA and SF varies across securitisation tranches, as shown in Chart 6.2 (Hansen, 2005:6). Capital requirements calculated under the RBA and SF are closely aligned in the most senior tranches. Likewise, at the lowest end of the credit spectrum, highly subordinated tranches, e.g. first-loss positions, face stringent capital requirements under both the RBA and SF. This alignment between the RBA and the SF at the high and low ends of the credit spectrum reflects the cap and floor that Basel II applies to the SF, which bounds the resulting capital requirements. For tranches that fall in the middle of the credit spectrum, the RBA generates significantly less regulatory capital than the SF. For example, on tranches rated 272

BBB, the capital requirement calculated under the SF is about 10 to 15 times more than the capital requirement calculated under the RBA. This disparity between the SF and RBA at the BBB rating level is evident across each of the product categories, as depicted in Chart 6.3 (ibid). Thus, IRB banks generally will have to allocate less capital against rated securitisation tranches than against unrated tranches, and this apparent Basel II incentive to obtain a credit rating on securitised positions is strongest for tranches that fall in the middle of the credit spectrum of a securitisation structure. Chart 6.2: Difference between SF and RBA vary across securitisation tranches 273

Chart 6.3: Disparity between SF and RBA evident across all asset classes 2.1.4 Different Capital Requirements between Unsecuritised Asset Portfolios and Rated Securitised Asset Portfolios By fundamentally changing the allocation of regulatory capital, the IRB Approach creates new incentives affecting how banks manage their investment strategy. A critical area investigated by Hansen is how Basel II might affect a bank s investment decisions. For example, a bank that seeks exposure to a certain asset class, e.g. corporate debt, can either extend loans to corporates or purchase corporate bonds, or alternatively, invest in a securitisation of corporate loans or bonds. The analysis investigates the regulatory capital that an IRB bank would have to hold against a portfolio of unsecuritised assets, i.e. banking book assets, as compared to an investment in the rated securitisation notes backed by the same pool of assets. When comparing the regulatory capital requirements on unsecuritised versus securitised assets, it is assumed that the bank purchases all the notes issued by the securitisation structure. Hansen s analysis found that, in some cases, IRB banks will face lower capital requirements by investing in the securitisation of an asset portfolio rather than directly holding the underlying assets. The results are shown in Chart 6.4 (Hansen, 2005:7). Credit card ABS and CMBS become attractive investments for IRB banks, since the capital requirements for unsecuritised credit card and 274

commercial property exposures are several multiples higher than the capital requirements for investing in the securitisation notes. Thus, an IRB bank seeking exposure to the credit card and commercial property loan markets will be better off from a regulatory capital perspective if it invests in a rated securitisation of these assets instead of holding an equivalent pool of unsecuritised assets. For RMBS, there is also a moderate Basel II benefit to investing in the securitised notes of a rated securitisation structure rather than holding the underlying pool of residential mortgage loans, although the disparity between the securitised and unsecuritised capital requirements are not nearly as pronounced as in the case of credit card ABS and CMBS. In contrast to the abovementioned asset classes, for CDOs, there appears to be little difference between the securitised and unsecuritised capital requirements, and IRB banks might be indifferent to the choice between investing in rated CDOs versus holding the underlying pool of corporate debt instruments directly. Therefore, with respect to CDOs, Basel II achieves a close alignment between the IRB capital requirements for holding corporate assets and the RBA capital requirements for investing in securitised notes backed by these assets. Apart from CDOs, banks would generally be better off holding the securitisation notes rather than the underlying assets themselves. This finding is premised on the basis that the notes have an external credit rating, and hence the capital requirements on the notes are calculated in terms of the RBA. 275

Chart 6.4: Multiple of unsecuritised to securitised capital requirements 2.1.5 Different Capital Requirements between Unsecuritised Asset Portfolios and Unrated Securitised Asset Portfolios When an IRB bank invests in unrated securitisation notes, it has to use the SF instead of the RBA. In comparing the regulatory capital that an IRB bank would have to hold against a portfolio of unsecuritised assets, as compared to an investment in unrated securitisation notes backed by the same pool of assets, the analysis found that the investment in unrated securitisation notes requires higher capital requirements than holding the underlying assets. The use of the SF for the calculation of capital requirements on unrated securitisation notes thus provides the incentive for IRB banks rather to hold the underlying assets instead of investing in unrated securitisation notes. 276

2.1.6 Comparing Different Capital Requirements between Unsecuritised, Unrated and Rated Securitised Asset Portfolios The two main findings of the analysis are that in general, Basel II provides the regulatory capital incentive for IRB banks to: invest in rated securitisation notes rather than holding the underlying unsecuritised assets; and hold the underlying assets instead of investing in unrated securitisation notes. The findings are depicted in Chart 6.5 (Hansen, 2005:9). Chart 6.5: Comparing unsecuritised and securitised assets under Basel II The Basel II incentives for banks to invest in rated instead of unrated securitisation exposures are especially pronounced in the case of credit card ABS (Hansen, 2005:8). The marked difference in capital requirements between unrated versus rated credit card securitisation exposures can partly be explained by the role that excess spread plays in credit enhancing the most junior tranches in these structures. Basel II does not explicitly recognise excess spread as credit enhancement under the SF, meaning that enhancement levels used as an input to the SF calculation of regulatory capital on an unrated securitisation tranche only reflect positions or reserve accounts that are junior to the tranche in question. 277

Basel II does not recognise excess spread as credit enhancement under the RBA either. However, risk weights under the RBA are linked to external credit ratings and since credit ratings take excess spread into account in the rating process, the RBA in effect provides indirect recognition of excess spread. The design of the RBA capital requirements means that a securitisation transaction whose most junior tranche is rated BBB would require relatively low levels of regulatory capital, since no part of the structure would face the high Basel II capital requirements on tranches rated below investmentgrade. Thus, for credit card securitisation notes, even the limited recognition of excess spread within the credit ratings process can contribute to important differences in capital between the RBA and the SF and serves as a strong incentive for banks using the RBA to hold the securitisation notes, rather than the underlying pool of credit card receivables. 2.1.7 Different Capital Requirements between Investment-Grade and Sub-Investment-Grade rated Securitisation Notes Basel II introduces a steep cliff in capital requirements between investment-grade and subinvestment-grade rated securitisation tranches. Securitisation structures with a large proportion of notes rated below investment-grade face considerably higher regulatory capital charges. For example, in terms of the RBA, a BB+ tranche (20% capital requirement) will require 2.5 times more capital than a BBB- tranche (8% capital requirement). The impact of this cliff effect is particularly evident in the case of CDOs. The pool of corporate debt instruments underlying CDOs tends to be riskier than retail assets. The higher risk of the assets underlying CDOs means that larger credit enhancement, i.e. a greater proportion of lower-rated tranches, is generally needed to support the more senior tranches. Basel II thus gives banks a regulatory capital incentive to reduce the size of the lower-rated tranches that are used to absorb first losses on the securitised asset pool, and to find other forms of credit enhancement. Banks could try to mitigate their exposures on positions that consume large amounts of capital by the greater use of credit derivatives. Banks could also seek to sell these positions to nonbank investors not subject to Basel II, such as hedge funds. 278

2.1.8 Different Capital Requirements between Standardised Banks and IRB Banks When comparing 93 the Standardised and RBA capital requirements for securitisation exposures, it appears that: IRB banks will face lower capital requirements than Standardised banks on all investment-grade (i.e. BBB- ) or better rated tranches and will have a relative capital advantage over Standardised banks on these exposures; and Standardised banks will face lower capital requirements than IRB banks on investments in subinvestment-grade tranches (i.e. BB or BB- ) and will have a relative capital advantage over IRB banks on these exposures. Basel II could thus lead to double-sided erosion whereby Standardised banks only invest in the riskiest lower-grade securitisation tranches and do not diversify their holdings by investing in the higher-quality tranches. 2.2 Evaluating the Impact of Basel II from an Investor s Perspective Both the Standardised approach and RBA under the IRB approach rely exclusively on external ratings from credit rating agencies to determine the risk weight for securitisation tranches. Basel II will reduce the regulatory capital requirement for most investment-grade securitisation tranches, with the most significant reduction for the AAA tranches. For investment-grade tranches, IRB banks will benefit from base case RBA risk weights that are approximately 60% lower than those applied to Standardised banks for similarly rated securitisation tranches. IRB banks have a greater incentive to hold highly-rated securitisation tranches (7% risk weight for senior position AAA tranches), compared to Standardised banks (20% risk weight for AAA tranches). However, Standardised banks will be more efficient holders of BB and BB- tranches in respect of which Standardised banks will have to apply a 350% risk weight relative to IRB banks that will have to apply 425% and 650% respectively to these tranches (Reardon, 2006:3). Reardon (2006) is of the opinion that Basel II will change the way that portfolios of highly-rated ABS and CDO tranches will be financed in future. Currently, highly-rated securitisation tranches are purchased by a wide range of investors, including ABCP conduits, Structured Investment Vehicles (SIVs), banks, corporate treasuries, securities lenders 93 Refer to Table 5.18 in Chapter 5. 279

and asset managers. The following sections describe the anticipated impact that Basel II will have on the funding strategies for different asset portfolios. 2.2.1 The Impact of Basel II on Banks Purchasing Rated Senior Securitisation Tranches Given the dramatic reduction in risk weights for securitisation tranches, banks will in future be able to use very high leverage to purchase senior securitisation tranches. For banks using the IRB approach to rated senior securitisation positions, the 7% risk weight for a AAA tranche translates into a 56 basis points 94 regulatory capital requirement. This 56 basis point capital translates into a potential leverage of a bank s capital of 179 times 95. The combination of high leverage and low bank senior funding costs will result in high Tier 1 capital returns for a bank and the investment in senior securitisation tranches will therefore become an attractive option for banks. Table 6.1 below set out the potential returns from funding 96 a securitisation portfolio, comparing the return on Tier 1 capital between Basel II and Basel I (Reardon, 2006:5). 94 Regulatory capital requirement: 7% risk weight x 8% minimum regulatory capital requirement = 56 basis points. 95 Leverage: 1.00/0.0056 = 179 96 Assumptions: Asset spread = Jibar + 25 bps Senior funding cost = Jibar + 15 bps Tier 2 capital cost = Jibar + 35 bps Minimum capital = 8%, divided equally between Tier 1 and Tier 2 280

Return on Tier 1 Capital for an Investment in Senior Securitisation Positions Basel II IRB (RBA) Basel II - Standardised Basel I AAA risk weights 7% 20% 100% Assets AAA securitisation portfolio 1,000,000,000 1,000,000,000 1,000,000,000 Funding Senior funding 994,400,000 984,000,000 920,000,000 Tier 1 capital required (50%) 2,800,000 97 8,000,000 98 40,000,000 99 Tier 2 capital required (50%) 2,800,000 8,000,000 40,000,000 Total funding 1,000,000,000 1,000,000,000 1,000,000,000 Return Income spread 2,500,000 2,500,000 2,500,000 Funding cost spread (1,491,600) 100 (1,476,000) 101 (1,380,000) 102 Tier 2 capital cost spread (9,800) 103 (28,000) 104 (140,000) 105 Excess spread 998,600 996,000 980,000 Return on Tier 1 capital 35.66% 12.45% 2.45% Table 6.1: Comparing return on regulatory capital The analysis shows that, whereas the investment in AAA securitisation tranches has been uneconomical under Basel I, such investment will now become attractive under Basel II, especially for IRB banks. 2.2.2 The Impact of Basel II on ABCP Conduits Purchasing Rated Senior Securitisation Tranches Securities arbitrage conduits are major investors in rated senior securitisation tranches. However, once Basel II has been implemented, it can be expected that they will become a less competitive source of funding senior securitisation portfolios. In terms of Basel I, liquidity facilities attracted no regulatory capital as they are less than 365 day facilities. In terms of Basel II, these liquidity facilities will attract a regulatory capital requirement, thereby making them more expensive and thus impacting on the economics of pure securities arbitrage conduits. Securities arbitrage conduits will have to find 97 Capital required = 7% x 8% x 50% x 1,000,000,000 = 2,800,000 98 Capital required = 20% x 8% x 50% x 1,000,000,000 = 8,000,000 99 Capital required = 100% x 8% x 50% x 1,000,000,000 = 40,000,000 100 Funding cost = 15 bps x 994,400,000 = 1,491,600 101 Funding cost = 15 bps x 984,000,000 = 1,476,000 102 Funding cost = 15 bps x 920,000,000 = 1,380,000 103 Tier 2 capital cost = 35 bps x 2,800,000 = 9,800 104 Tier 2 capital cost = 35 bps x 8,000,000 = 28,000 105 Tier 2 capital cost = 35 bps x 40,000,000 = 140,000 281

alternative sources of liquidity, e.g. extendible CP, or invest in lower-rated/higher spread assets to remain viable. 2.3 Evaluating the Impact of Basel II from an Originator s Perspective The regulatory capital treatment under Basel II will lead originators to modify securitisation structures and seek or create alternative forms of credit enhancement. Basel II will also change the attractiveness of different asset classes for securitisation. The issuance of RMBS may decline due to a decline in capital relief, but growing issuance can be expected for loan-backed CDOs and CMBS, where greater scope for capital release remains (Reardon, 2006:6). 2.3.1 The Impact of Basel II on the Structuring of Securitisation Transactions Chart 6.6 below shows the risk weight for each rating category under the Standardised approach and RBA for IRB banks respectively. Risk Weights under Standardised Approach 1400% 1200% 1000% 800% 600% 12 50 % 400% 200% 350% 350% 350% 0% 20% 20% 50% 50% 50% 100% 100% 100% AAA AA A+ A A- BBB+ BBB BBB- BB+ BB BB- B Source: BIS Base Case Risk Weights under IRB Approach 1400% 1200% 1000% 800% 600% 12 50 % 400% 650% 200% 425% 250% 0% 12 % 15% 18 % 20% 35% 50% 75% 10 0% AAA AA A+ A A- BBB+ BBB BBB- BB+ BB BB- B Source: BIS Chart 6.6: Comparing risk weights for Standardised and RBA rating categories 282

The graphs demonstrate that the risk weights for investment grade securitisation tranches rise gradually as credit ratings decline, but increase steeply for sub-investment grade and unrated securitisation tranches. The steep increase in the capital requirements for sub-investment-grade and unrated securitisation tranches might have the implications listed below for securitisation transactions. Originating banks will seek to minimise unrated retained exposures such as subordinated loans and will want to achieve a rating for residual risks where possible. Even small incremental rating improvements at the bottom of a securitisation structure will dramatically improve regulatory capital requirements. Although the unrated tranche is a small portion of a securitisation transaction, it represents a large percentage of the total capital requirement. Rating agency tranching, particularly the size of the unrated first-loss piece, will determine whether originating banks can reduce their regulatory capital requirements through the use of securitisation. Originating banks may increasingly structure securitisation transactions with excess spread-backed interest-only (IO) tranches as a means of providing first-loss credit enhancement instead of extending subordinated loans to the structure to fund the reserve account. Originating banks will seek to sell their rated and unrated first-loss credit enhancement exposures to investors such as hedge funds that are not subject to banking regulations. 2.3.2 The Impact of Basel II on the Securitisation of Different Asset Classes Under the Standardised approach to banking book credit risk, the regulatory capital requirement for retail assets will decrease significantly (Fitch Ratings, 2005:7). The capital requirement 106 for residential mortgages is reduced from 4% 107 to 2.8% 108. Other types of retail lending such as highly diversified lending to individuals and small businesses qualifies for a 6% capital requirement 109. Securitisation under the IRB approach does not distinguish between the Foundation and Advanced IRB approaches. All IRB banks will have to calculate the PD, LGD and EAD on their retail 106 Based on a 8% capital requirement 107 Capital requirement: 50% risk weight x 8% = 4% 108 Capital requirement: 35% risk weight x 8% = 2.8% 109 Capital requirement: 75% risk weight x 8% = 6% 283

portfolios and there is no explicit maturity adjustment, as the differences in term of retail assets are reflected in different correlation values. An important difference between the Standardised and IRB approaches to retail lending is that, while Standardised banks apply fixed risk weights (and thus fixed regulatory capital requirements) to exposures irrespective of borrower quality, the IRB risk weights will vary as a function of a borrower s risk profile. The regulatory capital requirements for different retail asset classes can be calculated and plotted on a graph, as shown in Chart 6.7 below: Chart 6.7: The impact of Basel II on the securitisation of different asset classes It is clear from the graphs that residential mortgage lending and to a lesser extent other retail lending will in future under Basel II require much lower regulatory capital than revolving credit and corporate exposures. Since the regulatory capital requirement for holding residential mortgage loans on a bank s balance sheet will be much reduced under Basel II, the regulatory arbitrage incentive for the securitisation of retail mortgages may therefore decline since little capital will be saved by securitising the assets. By contrast, the securitisation of corporate loans, commercial real estate loans and revolving credit exposures would still seem to offer attractive regulatory arbitrage opportunities, especially for lowerquality assets in these categories. 2.4 Evaluating the Impact of Basel II on the ABCP Market Under Basel II, a bank that sponsors an ABCP conduit or provides liquidity facilities and/or credit enhancement facilities to a conduit is considered to be an originating bank. Regulatory capital 284

requirements in terms of Basel II could have a significant impact, not only on the types of assets financed through conduits, but also on the liabilities that conduits issue to finance their purchase of assets (Kaur, 2004:1). The regulatory capital costs associated with liquidity facilities will accelerate the growth of extendible notes that limit the use of traditional liquidity facilities. Extendible notes use the cash flows from the assets in the conduit to repay CP. Apart from the greater use of extendible CP, alternative structures such as total return swaps may increasingly be used instead of liquidity facilities. The high risk weights applicable to non-investment grade assets will provide a further increase in the issuance of CDOs of ABS as banks sell their lower-grade ABS into these CDO structures, instead of keeping the ABS on their balance sheets. These CDO structures could be expected to issue senior ABCP tranches to replace at least part of the AAA notes that it normally issues. The lower cost of funding through CP issuance relative to the spreads demanded by AAA noteholders flows through to the equity holders in these structures and the increased returns on equity would facilitate the ease of execution of CDOs of ABS. 3. CONCLUSION Under Basel I, banks have been able to reduce regulatory capital held for various assets through the use of securitisation. The capital reduction is achieved without significantly reducing the actual risk exposure, since the originating bank would usually retain the most subordinate risks. Basel II aims to better align regulatory capital with economic capital and will thus eliminate many of the current regulatory arbitrage opportunities. In particular, banks using the IRB approach will have little incentive to securitise residential mortgage loans, but some opportunities will remain in corporate loans and revolving credit lines. A decline in the issuance of RMBS can thus be expected, conversely increasing issuance of CMBS and CDOs backed by corporate and SME loans. Nevertheless, despite the decline in regulatory capital relief that can be obtained, RMBS will remain a dominant securitisation asset class due to its importance as a diversified funding tool. Ahead of the Basel II implementation in 2008, banks may also complete RMBS transactions to benefit from capital relief for the remaining period before implementation. Basel II will dramatically reduce the regulatory capital requirement for highly rated securitisation exposures. For example, senior tranche risk weights decline from a 100% risk weight to as low as 7%. The lower risk weights would make these senior tranches more attractive assets for investing 285

banks and could lead to spread compression on these notes. The expected lower spreads would however have an impact on securities arbitrage ABCP conduits, which traditionally have been major investors in senior securitisation tranches. Securities arbitrage ABCP conduits would be further affected by the higher cost of the liquidity facilities extended to them, since these facilities will, under Basel II, require regulatory capital, unlike the current situation under Basel I, where these facilities require no regulatory capital, provided the term is less than 364 days. Under Basel II, the regulatory capital requirement for non-investment grade and unrated securitisation exposures would be significantly higher than the capital requirement for investment grade exposures. As a result, originating banks could be expected to seek to have their retained exposures rated, wherever possible. Originating banks may also seek to sell their retained positions to investors such as hedge funds that are not subject to the same regulatory requirements as banks. Otherwise, banks may want to make use of alternative forms of credit enhancement, such as the use of interest-only securities and credit derivatives. 286

CHAPTER SEVEN CONCLUSION AND RECOMMENDATIONS 1. INTRODUCTION Since its inception in the 1980s in the United States, securitisation has grown rapidly and has spread around the globe. In South Africa, the first securitisation transaction was completed in 1989, but the market did not really grow due to a number of factors such as the securitisation regulatory framework that was in place in the country at the time, investors lack of understanding of the technique, and the limited presence of rating agencies - all crucial components in the development of a securitisation market. In 2001, the South African Reserve Bank published amended securitisation regulations and from 2002 securitisation started growing exponentially and is now a recognised financing technique. Securitisation can be used by corporates and banks alike. The securitisation process involves an originator of future obligations, such as trade receivables or loan payments, selling the future cash flows to a newly-formed company specifically created to raise funding to buy these assets. Such a company is termed a special purpose vehicle (SPV), which is considered to be bankruptcy-remote, i.e. the SPV is unlikely to be adversely affected by a bankruptcy of the originator. To achieve bankruptcy-remoteness, the SPV s organisational structure strictly limits its permitted business activities. For a securitisation to be effective, the sale of the assets must be in the form of a true sale that in terms of bankruptcy law is able to remove the assets from the seller s bankruptcy estate. Despite the true sale of the assets, the sold assets are not considered to be off-balance sheet from an accounting perspective, because the seller often retains the major risks and rewards of such assets. Legally, however, there has been a clean transfer of the assets from the seller, which often allows the seller to raise cheaper funding because the funding is backed by a specific isolated pool of assets that is legally separate from the seller. If the credit quality of the isolated asset pool is perceived to be higher than the credit quality of the seller itself, the funding will be cheaper than the amount the seller would have been able to raise based on its own credit quality. The true sale principle underlying a securitisation transaction allows banks to treat the assets sold as off-balance sheet from a regulatory perspective, i.e. the bank does not have to hold regulatory capital against assets that have been securitised. To enable a bank to securitise its assets successfully and derive a regulatory capital saving, it has to comply with the securitisation regulations. 287

Securitisation is therefore used by corporates to gain access to cheaper funding, and by banks to manage their regulatory capital more efficiently. For both it is also a way to tap additional sources of funding, to diversify their funding and also to achieve a matching of the term of their assets and liabilities. Banks, especially, often fund their long-term assets such as home loans with short-term liabilities. Because the funding under a securitisation is usually medium- to long-term, a bank can attain natural asset-liability matching through the use of securitisation. In order for the SPV to purchase the assets from the seller under a securitisation transaction, it has to fund itself by issuing asset-backed securities in the capital markets. It is the bankruptcy-remote nature of the SPV that makes it acceptable to investors as an issuer of securities. The bankruptcyremoteness prevents creditors, other than the holders of the asset-backed securities, from having claims against the SPV that might force the SPV into bankruptcy. The SPV uses the cash flows from the assets it purchased to repay investors in the future. Consequently, investors are concerned only with the cash flows generated by these assets and are not much concerned with the financial position of the originator and seller of these assets since the assets have been isolated from the originator s financial condition. Although an isolated asset pool is often of better credit quality than the institution itself, additional credit enhancement is still required to make the asset-backed securities attractive to investors. There are several internal and external credit enhancement techniques, the most common being a senior/subordinated structure whereby the securities are divided into different classes according to seniority, with the most subordinated class being the first to absorb losses from defaulted assets in the underlying pool. The originator normally buys the most subordinated, or first-loss, class of securities. The subordinated structure is the most typical form of internal credit enhancement. Another type of credit enhancement often used is the build-up of a reserve account from excess spread (the difference between the SPV s income from the assets and the cost of servicing its debt) as a buffer against defaulted assets. External credit enhancement, conversely, is typically through a guarantee provided by a highly-rated third party. A securitisation transaction usually also benefits from liquidity support from a highly-rated third party to cover any timing mismatches between the receipt of cash flows by the SPV and the repayment of securities. The flexibility of securitisation allows almost any financial asset and cash flow to be securitised. The important requirements are that the assets must be identifiable and that there is historical information available about asset losses and recoveries. Although the financial assets that can be securitised encompass a wide variety of asset types, they are usually grouped in terms of the securities issued and 288

the type of asset class backing the security. The major securitisation types are mortgage-backed securities (MBS), which include securities backed by future cash flows from residential and commercial real estate loans, and asset-backed securities (ABS) that include securities backed by cash flows from other asset classes such as auto loans, equipment leases, credit card receivables and personal loan instalments. Esoteric asset classes such as the securitisation of music royalties are normally also included in the asset-backed securities asset class. The third major asset class is collateralised debt obligations (CDO). This encompasses the securitisation of bank loans to corporates as well as corporate bonds. An important type of securitisation technique is the asset-backed commercial paper (ABCP) conduit, which is strictly speaking not an asset class but a securitisation vehicle that can finance any type of underlying asset. Normally the conduits purchase bonds, trade receivables, home loans and other types of assets and fund themselves through the issuance of short-term commercial paper. The inherent asset-liability mismatch between long-term assets and short-term liabilities is covered by a liquidity facility equal to the total mount of the commercial paper issued and is usually provided by the sponsor of the conduit. A securitisation transaction can also be implemented in a synthetic format, where there is no physical transfer of the assets from the originator to the SPV. The asset remains with the originator, with only the risk of the asset transferred by using a credit derivative instrument. The seller of risk, i.e. the protection buyer, transfers credit risk to the buyer of risk, i.e. the protection seller. If a predefined credit event such as a borrower defaulting on its loan occurs, the credit derivative transaction terminates and the protection seller will make good the loss suffered by the protection buyer, either by paying the difference between the par value and defaulted value of obligation, or by buying the obligation at par value from the holder. For providing this cover, the protection seller is paid a regular premium by the protection buyer during the life of the transaction. Synthetic securitisations make use of credit derivatives to isolate and transfer credit risk. A credit derivative is similar to an insurance contract against credit losses, but unlike credit insurance, credit derivatives are tradable. Because they are tradable, credit derivatives appeal to a larger group of investors than does credit insurance. The ability to trade credit risk separately breaks the traditional link between lending money and assuming credit risk, without disturbing the relationship between the lender and the borrower. The rapid growth of the credit derivatives market has been supported by the development of standardised credit derivative contract terms and definitions. The development of standardised documentation has been greatly facilitated by the International Swaps and Derivatives 289

Association (ISDA) by publishing the 1999 credit derivative definitions and the updated version of that in 2003. The most popular credit derivative is the credit default swap, which is similar to an option rather than a swap. In a credit default swap contract the buyer pays the seller a premium to protect itself against the occurrence of a contractually-defined credit event on a specific underlying risk of a reference entity. Credit default swaps can be structured as single-name or portfolio transactions. A singlename swap transfers the credit risk of a single reference entity s obligations from the buyer to the seller, whereas a portfolio swap covers the credit risk of a basket of reference entities or obligations. By combining credit derivatives with securitisation techniques, synthetic securitisation was born. In a synthetic securitisation the credit risk of a pool of assets is transferred from an originator to investors, but the assets themselves are not sold and remain on the originator s balance sheet. Synthetic transactions have become popular in jurisdictions where it is difficult to undertake a cash transaction due to legal, regulatory or cross-border restrictions. Since the assets are not physically sold, it is generally also quicker and easier to implement a synthetic securitisation in comparison to a traditional cash securitisation. Since the inception of the first transactions, the market for synthetic securitisation has grown in scope, with continuing development of newer structures to meet differing originator and investor requirements. The typical synthetic securitisation transaction is the synthetic CDO, where, similar to cash CDOs, the underlying assets are loans or bonds, but no physical transfer of the assets takes place. Only the credit risk is transferred from the originator to the SPV, normally by using a credit default swap. Originally, synthetic CDOs were driven by banks seeking to gain capital relief on assets already on their balance sheet. As the market developed and became more liquid, banks, asset managers and hedge funds have increasingly been using synthetic CDOs for arbitrage rather than balance sheet purposes. Credit ratings play a very important role in securitisation transactions and the issuance of asset-backed securities. Securitisations are generally complex structures, which makes the task of assessing the credit risk difficult for investors. Credit ratings provide a simple and objective assessment of default risk in the form of symbols that provide a risk-grading scale that allows investors to make comparisons of relative risk. The ratings of the major credit rating agencies are generally comparable to each other. When a rating agency assesses the risk of default in asset-backed securities, it evaluates three types of risk namely credit risk, structural risk and legal risk. Credit risk is the risk of default by the borrowers in the underlying loan pool backing the securities which have been issued. Structural risk refers to the manner in which the transaction is structured to direct the cash flows from the 290

underlying assets (loans) to the investors in the securitisation. Legal risk refers to the compliance with various laws and regulations, and issues relating to a true sale of the assets, the bankruptcyremoteness of the issuer (SPV), and the legal enforceability of security. Although securitisation separates the credit risk of the underlying assets from the credit risk of the originator, an evaluation of the originator is nevertheless important in order to assess the ability of the originator to continue generating assets of acceptable quality, which is especially important in the case of revolving transactions. Banks are exposed to a number of risks, for instance credit risk, interest rate risk, market risk, operational risk, and solvency risk. To be able to survive, a bank has to manage these risks effectively. Because of high balance sheet gearing, banks are more exposed to bankruptcy than other commercial enterprises. Apart from bankruptcy, banks are also exposed to the risk of a run on deposits when depositors lose confidence in a bank. Such a loss of confidence in a bank, which usually leads to severe liquidity problems for the particular bank, normally derives from a deep-seated problem in the bank. Given the important role that banks play in a country s economy, bank failures may cause extensive damage to a country s economy, especially if it becomes systemic in nature. Throughout history, countries financial and banking systems have therefore been highly regulated by the authorities. Banking regulation and supervision are primarily geared to protect depositors from suffering losses. With the growth of international trade and investment, banks have also expanded internationally and established branch offices and subsidiaries abroad. Internationally, regulators have become concerned that these overseas branches and subsidiaries may not be adequately regulated. To address this issue, the Basel Committee on Banking Supervision (the Basel Committee) was established at the end of 1974. Members of the Basel Committee have to abide by agreements, even though the recommendations of the Basel Committee have no legal force. Initially, the Committee promoted international co-operation to improve the quality of banking supervision worldwide. Since the 1980s it has however became increasingly concerned about the level of banks capital adequacy and the discrepancy in capital adequacy regulations in different countries. To strengthen the international financial system the Basel Capital Accord (Basel I) was initiated in 1988, which was implemented by its member countries by 1992. Non-member countries followed and by 1999 around 100 countries worldwide had adopted Basel I. The Basel I Accord specified a minimum regulatory capital of 8% for banks and the required capital that a bank had to hold was 291

determined with regard to the perceived riskiness of the assets banks held. A bank had to categorise its assets into four specified risk bands, i.e. for sovereign exposures, bank exposures, residential mortgage loans and other loans. These asset categories were allocated separate risk weightings. By multiplying these risk weights with the 8% regulatory capital requirement, the total regulatory capital that a bank had to hold was determined. Basel I was initially successful in halting the decline in bank capital internationally, and led to some rebuilding of capital by banks. However, from its inception, it was recognised that Basel I had deficiencies. The capital ratio standards are for the most part arbitrary, because they do not flow from any particular insolvency probability standard. Moreover, Basel I did not take account of hedging, diversification and portfolio management techniques. Following the implementation of Basel I, financial products have become more complex and banks have become more sophisticated in their risk management. Many banks have developed internal risk models that they use to quantify the risks that they are exposed to, and to allocate capital to each risk so as to satisfy the bank s own risk management requirements. Thus, in the case where a group of loans attracts an internal capital charge that is lower than the regulatory capital requirement, the bank has a strong incentive to engage in regulatory arbitrage, which reflects the activities that allow a bank to reduce its risk-weighted assets and thus hold less regulatory capital than it otherwise would have had to. Securitisation became a widely used technique whereby banks reduced their regulatory capital requirements. Securitisation allows a bank to retain essentially the same risk and rewards of an asset portfolio, but holding an amount of regulatory capital against those assets similar to the amount of capital that would be required to cover the economic risks of that specific portfolio. Because the economic capital requirements for high-quality asset portfolios are less than the regulatory capital requirements in terms of the simplistic approach of Basel I (and the amount of economic capital required for high-risk portfolios is larger than the regulatory capital required by Basel I), banks have effectively been encouraged to securitise their high-quality, low-risk asset portfolios and retain their low-quality, high-risk portfolios. Since the one-size-fits-all nature of capital adequacy of Basel I has encouraged the growth of regulatory arbitrage by banks, regulators have become increasingly concerned that banks have not been holding sufficient capital for the risks that they are exposed to. To address these shortcomings of Basel I, the Basel Committee developed the new Basel II Accord. 292

The aim of Basel II is to better align the minimum regulatory capital required with the economic risks that banks face. Basel II consists of three mutually reinforcing pillars, which deal with minimum capital requirements, the supervisory review process and with market discipline. Basel II dispenses with the simple calculation of minimum capital levels and allows banks to use their own statistical information about their asset portfolios to calculate their regulatory capital requirements. In particular, it is the models provided by Basel II for the calculation of credit risk and the regulatory capital required to cover credit risk that are expected to have the greatest impact on the regulatory arbitrage activities of banks. The credit risk management approaches of different levels of sophistication will allow banks to choose the method of calculating regulatory capital commensurate with the level of sophistication. There are also now specific regulations for calculating regulatory capital for securitisation exposures. 2. MAJOR FINDINGS Because Basel II aims to better align regulatory capital with economic capital, it should eliminate many of the current regulatory arbitrage opportunities. It aims to achieve this in two ways: (1) by aligning the regulatory capital that a bank has to hold against its banking book assets more closely with the actual economic risk of those exposures, thereby reducing the regulatory capital requirements for high-quality assets (which are currently the assets that are typically securitised); and (2) by generally increasing the regulatory capital requirements for a bank s securitisation exposures. Regarding their banking book exposures, banks will have little incentive to securitise high-quality residential mortgage loans, but some opportunities will remain for securitising corporate loans and revolving credit lines such as credit card portfolios. Although a decline in the issuance of residential mortgage-backed securities can be expected, there might be growing issuance of commercial mortgage-backed securities as well as collateralised debt obligations backed by corporate and small business loans. Nevertheless, residential mortgage-backed securities will remain a dominant securitisation asset class due to its importance as a diversified funding tool. Ahead of the Basel II implementation in 2008, banks may also complete residential mortgage-backed securities transactions to benefit from capital relief for the remaining two years. Basel II should dramatically reduce the regulatory capital requirement for highly rated securitisation exposures, but the regulatory capital requirement for non-investment grade and unrated securitisation exposures, i.e. the exposures that originating banks usually retain in their securitisation transactions, will be significantly higher. As a result, it can be expected that originating banks will seek to have 293

their retained exposures rated, wherever possible. Originating banks may also seek to sell their retained positions to investors such as hedge funds that are not subject to the same regulatory requirements as banks. Otherwise, banks may want to make use of alternative forms of credit enhancement, such as the use of interest-only securities and credit derivatives. For senior securitisation tranches, the risk weights decline from a 100% risk weight to as low as 7%. The lower risk weights should make these senior tranches more attractive assets for investing banks and the increased demand may lead to spread compression on these tranches. The expected lower spreads would have an impact on securities arbitrage asset-backed commercial paper conduits, which traditionally have been major investors in senior securitisation tranches. Securities arbitrage assetbacked commercial paper conduits would be further impacted by the higher cost of the liquidity facilities extended to them, since these facilities will, under Basel II, require regulatory capital, unlike the current situation under Basel I where these facilities require no regulatory capital, provided the term is less than 364 days. These factors will have an impact on the economic viability of these types of conduits, which may result in the conduits changing their investment criteria and looking for alternative forms of liquidity support. Clearly, Basel II will have a major impact on the securitisation industry. At this stage it is difficult to say what the exact scope of the impact will be. Nevertheless, certain potential outcomes can already be identified and these are listed below. Since it is the stated rationale of Basel II to reduce the incidence of regulatory capital arbitrage, there would be fewer opportunities for achieving regulatory capital relief through the use of securitisation. As shown above, the various securitisation asset classes will be affected differently by Basel II, with some scope for regulatory capital relief remaining in certain asset classes and little scope in other classes. Basel II will in addition to its envisaged effect on bank capital management, also have an impact on the economics of certain types of securitisation structures. New securitisation structures and techniques are likely to be developed to mitigate the impact of Basel II. 294

It is likely that Basel II will result in greater participation in the securitisation industry by new and other types of market participants, such as hedge funds. Whatever the impact of Basel II may be in future, it will not slow the tremendous growth of the securitisation market. The reason for this is that the use of securitisation for regulatory arbitrage purposes has declined in recent years. Although securitisation remains a tool for efficient capital management, banks nowadays primarily use securitisation as a funding mechanism. Securitisation allows banks access to new sources of funding such as pension funds and asset managers. In addition, through securitisation, a bank can better match the tenor of its liabilities with that of its assets. 3. RECOMMENDATIONS One of the shortcomings of a study of this nature is that it is difficult to anticipate the impact of regulations that will only be implemented in the future. Often regulations may have unintended consequences, as shown by the history of Basel I. Initially Basel I succeeded in its aims, but the regulations created the opportunity for regulatory arbitrage and unexpectedly contributed to a situation where a bank could have held less capital than required to cover the economic risks to which the bank was exposed. As illustrated by the consequences of Basel I, it may take some time for the outcome of new regulations to manifest itself. Therefore, a recommended future avenue of research would be to study the impact of Basel II once it has been implemented. To allow for potential unintended consequences, such a study would produce the best results if it is undertaken after sufficient time has elapsed since the implementation of Basel II. 295

APPENDIX 1 LEGAL CONSIDERATIONS IN SECURITISATION A rating agency reviewing a securitisation transaction places great importance on the analysis of the legal issues and resulting structural protections in the transaction since the consequences of a poorly structured transaction may have severe implications for investors, including jeopardising the ownership of the transaction s assets (Greenberg et al., 2003:1). 1. True Sale Principle A key aspect of any securitisation transaction is the effective segregation of the assets sold to the SPV from the general property of the seller of such assets. According to the South African Securitisation Regulations (Securitisation Regulations) a true sale requires the transfer of all the risks and benefits of an asset to an SPV, without recourse to the seller, except as permitted in certain circumstances (Government Gazette, 2004:18). Under South African law a true sale may be achieved by a sale and cession. To achieve a true sale by sale and cession, a seller will agree to sell the assets to the purchasing SPV, and in pursuance of such a sale, will cede all related rights to the SPV. It is important for the fulfilment of the true sale requirements of securitisation transactions that no legal rights may be reserved by the seller, that is, the seller may not retain some benefit of ownership that is inconsistent with total transfer of the assets. Any derogation from a true sale may lead to the sale being reclassified as a loan, secured or unsecured. Generally, a sale and cession do not require a notice to, or consent from the obligor. In any case, this consent may be obtained in advance by virtue of a contractual provision allowing assignment without notice to the obligor. In terms of the Securitisation Regulations though, assets may not be sold to the securitisation SPV where such a transfer would breach the terms of the relevant underlying transaction, e.g. where a loan contains a covenant not to sell or assign the debt. 2. Insolvency Risks As part of the true sale nature of the transfer of assets in a securitisation transaction, it is important that the purchasing SPV will not be affected by the subsequent insolvency of the seller. Under South African insolvency laws, the high court controls the process of winding up, or otherwise dealing with, an insolvent company (Greenberg et al., 2003:2). Proceedings may be commenced through a petition of creditors or by application of the insolvent company. The court may (a) appoint a Judicial 296

Manager to run the affairs of the company (but such Judicial Manager will not have the power to bind creditors or deal with existing management to restructure the company); (b) sanction a scheme of arrangement or compromise between the creditors to allow the company to come out of the liquidation process; or (c) wind the company up and appoint a liquidator to deal with the assets and liabilities and distribute the proceeds to creditors. 2.1 Re-Characterisation Risk Any transaction, in respect of which the legal requirements of a true sale are not met, may be recharacterised by a court in an insolvency proceeding as either a secured or unsecured loan. It may be regarded as unsecured if it is not possible to infer an intention on the part of the seller to grant security. An unsecured loan will expose the SPV to the seller s corporate credit risk, and the claims of the SPV s investors will rank below those of any of the seller s secured creditors or creditors with a statutory preference, e.g. the tax authorities. If the sale is re-characterised as a secured loan the charged assets will remain part of the property of the seller and the SPV s deemed security interests may not be enforceable without taking into account the claims of other creditors of the seller. 2.2 Perfection Risk Where a true sale is not effective and any re-characterised security interests are not effective to give priority, e.g. by reason of the existence of any statutory priorities, or failure to perfect any security interests, it is possible under South African law that other creditors of the seller will be able to claim amounts paid in respect of the assets that were the subject of the securitisation transaction, including amounts already paid to investors (ibid.). Usually, in a securitisation transaction, the seller in its role as servicer, will continue to act as an agent of the SPV to collect payments in respect of the assets sold. Without notification that the assets have been sold, i.e. perfection has not taken place, obligors in relation to the assets may be under no obligation to pay the SPV. A failure to notify obligors may also be taken as an indication that the intention of the seller and the SPV was to achieve a secured lending instead of a true sale. Under South African law a true sale may be achieved without notifying the obligors. In order to cause as little disruption to the seller s business as possible, securitisation transactions will often not require notification to obligors until certain credit events have taken place in relation to the seller. An un-notified obligor, however, may set off any payments made to the seller after the seller s insolvency. If the obligor has been notified beforehand, then the debt the obligor owes the SPV will not be reduced by any payments the obligor made to the seller. 297

2.3 Claw-Back Risk In any transaction where the disposition of assets sold on a true sale basis to a purchaser SPV, a seller will generally have no further right in respect of the assets sold, and consequently creditors of the seller will have no claim on the assets, including in an insolvency of the seller. Potential exceptions to this rule are provisions relating to claw-back in relation to the seller. The dispositions listed below may be set aside. 2.3.1 Dispositions made not for Value The first is if the disposition was made more than two years before the winding-up of the seller and the appointed liquidator or judicial manager, as the case may be, proves that immediately after the disposition was made, the liabilities of the seller exceeded its assets. If the disposition was made within two years of the winding-up of the seller, it will be set aside unless the person who benefited from the disposition proves that, immediately after the disposition was made, the assets of the seller exceeded its liabilities. 2.3.2 Voidable Preferences If the disposition made by the seller within six months of its winding-up had the effect of preferring one creditor above another and, immediately after the disposition was made, the liabilities of the seller exceeded the value of its assets, it will be set aside. 2.3.3 Undue Preferences If the disposition was made by the seller at any time before its winding-up with the intention of preferring one creditor above another and when the seller made the disposition, its liabilities exceeded its assets, it will be set aside. 2.3.4 Set-Off A disposition may be set aside if set-off of debts is made within six months of the winding-up of the seller and was not made in the ordinary course of business. 298

2.3.5 Collusive Dispositions It may be set aside if the disposition was made by the seller at any time before its winding-up in collusion with another party which had the effect of prejudicing its creditors or of giving preference to one of its creditors above another. 2.3.6 Dispositions in Fraud of Creditors (action pauliana) A disposition made by the seller may be set aside under the common law, if it was made with the intention of giving one creditor an unfair advantage over the others in insolvency. Successfully claiming that one of the above applies to the transaction would have the effect of returning assets that were sold to the seller, to be dealt with as secured or unsecured borrowing, as part of the seller s insolvency. The rating agency therefore places great emphasis on the due diligence in relation to re-characterisation and claw-back risk, and requires a legal opinion to the effect that (a) the sale of assets will be effective to transfer the assets from the ownership of the seller, and (b) upon insolvency of the seller, the assets will not be regarded as part of the insolvent assets of the seller. Furthermore, an auditor s report may be required to confirm the sale has been for fair value. Agreements regarding the sale of assets and subsequent servicing thereof by the seller should include covenants prohibiting the seller from acting in any manner inconsistent with the SPV s ownership of and other rights in respect of the assets, e.g. the seller should covenant not to pledge the assets to any other party. All parties to the securitisation should covenant that they will not seek to commence insolvency proceedings against the SPV. The constitutional documents of the SPV should prohibit the voluntary winding-up of the SPV while investors are still owed amounts. If the seller, acting as agent collecting payments from obligors on behalf of the SPV, becomes insolvent there is a risk of commingling between obligor payments and the assets of the agent. Commingling arises when obligor payments owned by the SPV are initially directed to an account in the name of the seller. In the event of an insolvency of the seller, these commingled obligor payments may not be recoverable for some time, or not at all. The best solution to prevent commingling risk is to notify obligors that they must make their debt repayments directly into a designated bank account belonging to the SPV. This is not always practical, especially when there are a large number of obligors. In order to mitigate the effects of commingling risk, the seller/servicer of the assets should cede to the SPV its rights, title and interest in and to the bank accounts into which obligor payments are made. In addition, the transaction documents should provide that (a) obligor 299

payments are held as agent for the SPV, (b) will only be deposited into blocked accounts that can only be drawn for the benefit of the SPV, and/or (c) will be swept daily into the bank account of the SPV. 3. Use of an SPV In a securitisation transaction an SPV is used to (a) maintain insolvency remoteness between the SPV, and the seller, investors and other creditors of the SPV, and (b) provide as close a link as possible between the credit of the assets and investors and other creditors of the SPV. SPVs used in South Africa can take the form of either a company or a trust. 110 The SPV is owned by an owner trust that is established for the sole purpose to own, as beneficial shareholder, all of the ordinary shares in the capital of the SPV. The criteria for establishing and operating an SPV, as set out by the Securitisation Regulations, are broadly in line with the standards required by rating agencies (Moody s, 2003:6). The criteria which apply are listed below. 3.1 Limitations on Purpose The SPV s purpose should be restricted to purchasing assets and issuing securities to fund the purchase, so as to ensure that cash flows directed to meet the SPV s obligations are not exposed to any claims by any other parties, whether in insolvency or otherwise. 3.2 Prohibited Actions In general the SPV s powers are restricted both in its organisational documents and contractually in the securitisation transaction documents. Such restrictions may include: incurring indebtedness other than issuing securities for the purpose of the transaction; change of control, merger, consolidation, liquidation, or dissolution while the securities are outstanding; transfer or sale of assets while the securities are outstanding; and amendment of organisational documents. 110 SPVs in South Africa usually take the form of a company. 300

3.3 Independent Directors The Securitisation Regulations require that the SPV will have two directors (trustees) independent of the seller if the SPV is a company (trust). The following entities in relation to the seller may not be considered as being sufficiently independent: shareholders; directors; employees; major suppliers; and attorneys and accountants. 3.4 Separateness Covenants In order to benefit from the provisions of the Securitisation Regulations, the SPV must not only be organised as a separate entity, but also operated separately. The securitisation transaction documents should therefore contain appropriate covenants to ensure: no commingling of the SPV s and seller s money or assets; separate bank accounts for the SPV; separate books of account and financial statements for the SPV; the SPV has adequate capital for the scope of its business; the SPV pays its liabilities from its own funds; the seller is not providing any guarantees or pledges; 301

all transactions with the seller and its affiliates are at arms length; the SPV maintains good corporate governance; the SPV conducts business in its own name; and the SPV has separate stationery. 3.5 Non-Petition and Limited Recourse In order to minimise the risk of insolvency of the SPV, the following protections need to be included in the SPV agreement: a non-petition agreement to not take any action or join with any other party in taking action to commence proceedings in respect of the SPV for winding up or any form of administration, within two years of all the investors being paid in full; and a limited-recourse agreement that a party will not have any right to claim against the SPV or to enforce against any assets of the SPV, except to the extent provided in the priority of payments in the securitisation transaction documents. 4 South African Security Structure Under South African law it is possible to grant security directly to investors in respect of securities issued by the SPV. However it is not possible to grant similar security to other transaction creditors such as liquidity providers or hedge providers. Under debenture trust arrangements, as envisaged by the South African Companies Act, assets are held only for the benefit of debenture holders, and other transaction creditors are excluded from the security arrangements. 302

In order to provide security to all transaction creditors, as well as investors, a typically South African security structure has evolved (Greenberg et al., 2003:5): Issuer SPV Owner Trust Suretyship Security SPV Owner Trust Investors 100% 100% Issuer SPV Indemnity Security SPV Secured creditors Guarantee Security Cession Diagram A1.1: South African security structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) Under this structure, a Security SPV, beneficially owned by an owner trust, will hold any related security for the benefit of investors and other transaction creditors, and will bind itself under a guarantee to all transaction creditors, including investors, for any obligations of the Issuer SPV. The liability of the Security SPV pursuant to the guarantee will, however, be limited to the aggregate amount recovered by the Security SPV from the Issuer SPV in terms of the indemnity granted by the Issuer SPV to the Security SPV. The obligations of the Issuer SPV under the indemnity are secured by: a suretyship from the Issuer SPV s owner trust in favour of the Security SPV; as security for the suretyship granted to the Security SPV, the owner trust will pledge all of the shares held by it in the Issuer SPV to the Security SPV; and a security cession by the Issuer SPV in favour of the Security SPV of the Issuer SPV s right, title and interest in and to its assets. A typical example of a South African securitisation structure is that used by The Thekwini Fund. The mortgage rights reside with a bankruptcy-remote Guarantee Trust and not with the originator (SA Home Loans) or the issuer (Thekwini). The Guarantee Trust holds all the mortgage rights of the home loans originated by SA Home Loans, irrespective of the vehicle used to fund the home loans, 303

which means SA Home Loans can transfer home loans between funding vehicles without involving the deeds office, thus reducing time and costs (Bate, 2005:4). In terms of the structure, SA Home Loans grants a loan to a home loan borrower (mortgagor) and the property is purchased and registered in the name of the borrower. A first mortgage bond over the property is registered in the name of the Guarantee Trust, which issues a guarantee to SA Home Loans for the borrower s obligation to repay the loan. The borrower indemnifies the Guarantee Trust for its obligations under the guarantee to SA Home Loans. Mortgage bond and indemnity Home loan borrower Home loan SA Home Loans (Pty) Limited Guarantee Guarantee Trust Diagram A1.2: Mortgage guarantee trust structure (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) On the closing date of the securitisation transaction, Thekwini purchases the home loans from SA Home Loans and the Guarantee Trust assigns the guarantees backed by the mortgage bonds to Thekwini. Mortgage bond and indemnity Home loan borrowers SA Home Loans (Pty) Limited Guarantee Trust Guarantee Repays home Security SPV Security cession Purchases home loans The Thekwini Fund 5 (Pty) Limited Funding Assigns guarantees Investors Diagram A1.3: Assignment of mortgage guarantees (The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.) 304

APPENDIX 2 ACCOUNTING CONSIDERATIONS IN SECURITISATION The South African Statements of Generally Accepted Accounting Practice (GAAP) provides guidance as to the accounting implications of securitisation transactions. 1. Consolidation of the Securitisation SPV Accounting statement AC 132, Consolidated Financial Statements and Accounting for Investments in Subsidiaries, requires the consolidation of entities that are controlled by the reporting enterprise. Accounting statement AC 132 defines control as the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities. Although accounting statement AC 132 does not deal specifically with special purpose entities, the provisions of accounting statement AC 412, Consolidation: Special Purpose Entities, provide guidance on the consolidation of these entities in securitisation transactions. The consensus is that an SPV 111 should be consolidated when the substance of the relationship between an enterprise and the SPV indicates that the SPV is controlled by that enterprise. In the context of an SPV, control may arise through the predetermination of the activities of the SPV (operating on autopilot or otherwise). The four characteristics of control under AC 412 should therefore be assessed, and the following circumstances may indicate a relationship in which an enterprise controls an SPV, and consequently should consolidate the SPV, when: in substance, the activities of the SPV are being conducted on behalf of the enterprise according to its specific business needs so that the enterprise obtains benefits from the SPV s operation; in substance, the enterprise has the decision-making powers to obtain the majority of the benefits of the activities of the SPV or, by setting up an autopilot mechanism, the enterprise has delegated these decision-making powers; in substance, the enterprise has the right to obtain the majority of the benefits of the SPV and therefore may be exposed to risks incident to the activities of the SPV; and 111 The statement uses the term SPE. 305

in substance, the enterprise retains the majority of the residual or ownership risks related to the SPV or its assets in order to obtain benefits from its activities. Accounting statement AC 132 states that a parent which issues consolidated financial statements should consolidate all subsidiaries. The statement defines a parent as an enterprise that has one or more subsidiaries, a subsidiary as an enterprise that is controlled by another enterprise (known as the parent), and control as the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities. The statement on presentation of financial statements requires that transactions and other events are accounted for in accordance with their substance and economic reality, and not merely their legal form. Control over another entity requires having the ability to direct or dominate its decision-making, regardless of whether this power is actually exercised. Under the definitions of the statement, the ability to govern decision-making alone, however, is not sufficient to establish control. The ability to govern decision-making must be accompanied by the objective of obtaining benefits from the entity s activities. SPVs frequently operate in a predetermined way so that no enterprise has explicit decision-making authority over the SPV s ongoing activities after its formation, i.e. they operate on autopilot. Virtually all rights, obligations, and aspects of activities that could be controlled are predefined and limited by contractual provisions specified or scheduled at inception. In these circumstances, control may exist for the sponsoring party or others with a beneficial interest, even though it may be particularly difficult to assess, because virtually all activities are predetermined. However, the predetermination of the activities of the SPV through an autopilot mechanism often provides evidence that the ability to control has been exercised by the party formulating the predetermination for its own benefit at the formation of the SPV and is being perpetuated. 2. Derecognition of the Securitised Assets from the Originator s Financial Statements In terms of accounting statement AC 133, Financial Instruments: Recognition and Measurement, a financial asset is only derecognised when the enterprise loses control of the contractual rights that comprise the financial asset, either by realising the rights to the benefits specified in the contract, by the rights expiring or by surrendering those rights. In assessing whether the rights associated with an asset have been relinquished or realised, the risks associated with the asset should be considered. Where the originator has retained substantially all the risks of ownership, the asset should not be 306

derecognised form the originator s balance sheet. However, to the extent that the originator has transferred a substantive risk, derecognition of the transferred assets would not be precluded under accounting statement AC 133. 3. Accounting for the Securitised Assets by the Securitisation SPV As a contractual obligation to receive cash or another financial asset, the transferred assets should be accounted for according to the provisions of accounting statement AC 133. Based on the nature and intent behind acquiring the instrument, accounting statement AC 133 requires financial assets to be classified into one of the four classification categories, namely held for trading, originated loans and receivables, held-to-maturity or available-for-sale. The accounting treatment of the financial assets will depend on this classification. 3.1 Held for Trading All derivatives instruments and all financial instruments that were acquired with the principal intention of generating profit from short-term price fluctuations should be classified as held for trading. In addition, the SPV may elect to classify any instrument as held for trading, despite the instrument being acquired for non-trading purposes. Held for trading instruments are measured at fair value, with changes in fair value being reported in the income statement. Should the originator/seller elect to designate any financial instruments as held for trading at inception, such designation becomes irrevocable. 3.2 Originated Loans and Receivables Since the transferred assets would not be originated by the SPV, but rather by the originator, these assets should not be classified as originated loans and receivables in the SPV s books. However, in the event that the originator is required to consolidate the SPV, since the originator initially originated the loans, they would continue to be reflected as such in the originator s group accounts. In other words, in a consolidation scenario, the original classification of the asset is retained, irrespective of the fact that the classification by the SPV may differ in its own records. Originated loans and receivables are carried at amortised cost on an effective yield basis, with changes in the carrying value of the instruments being reported in the income statement. Unlike the held-to-maturity category (see held-to-maturity section) no tainting provisions apply to the originated loans and receivables category. This would also apply in the case of the refinancing or repayment of such loans by borrowers. 307

3.3 Held-to-Maturity Accounting statement AC 133 defines held-to-maturity investments as financial assets with fixed or determinable payments and a fixed maturity, which an enterprise has the positive intent and ability to hold to maturity. Held-to-maturity assets are measured at amortised cost through the income statement. Provided that the transferred assets have fixed or determinable payments and maturities, the SPV may classify them as held-to-maturity. Accounting statement AC 133 does, however, impose restrictions on the sale or transfer of held-to-maturity financial assets, and should a significant number of held-to-maturity assets be sold or transferred prior to maturity, it may taint the entire held-to-maturity category. If this were to occur, the entire portfolio of held-tomaturity assets would be reclassified as available-for-sale, and the held-to-maturity category would not be available for any financial assets for the current and subsequent two financial years. These tainting provisions would extend to the entire originator group. Due to the onerous tainting provisions of accounting statement AC 133, the transferred assets should not be classified as heldto-maturity if these assets are likely to be disposed of prior to maturity. Should the SPV classify the securitised loans as held-to-maturity in its own accounts, as discussed above, the originator may continue to classify such loans in the event that the SPV is consolidated. As a result, should the SPV sell an asset and be regarded as tainting the rest of the portfolio, such tainting would be restricted to the SPV itself and would not apply to the originator on consolidation. This is as a result of the fact that the loans would continue to be regarded as having been originated by the originator, and the fact that the tainting provisions do not apply to the originated loans and receivables category. In the event that the SPV classifies an asset as held to maturity, and the asset is subsequently repaid by the borrower, this would not be regarded as tainting the portfolio in the SPV s books. Such a scenario is analogous to a call option exercisable by the issuer, which may be classified as held to maturity, provided the holder (the SPV) intends and is able to hold the asset until its maturity or until it is called and the holder would recover substantially all of its carrying amount. The call option, if exercised, simply accelerates the asset s maturity. A similar effect would therefore also be achieved should the SPV grant borrowers a call option to repay the loan. However, should the SPV hold a put option on the loans, this could be regarded as inconsistent with the intention to classify such assets as held to maturity. Although puttable loans may be classified as held to maturity, care should be taken in such circumstances. Where an asset, instead of being repaid, is refinanced by the borrower, such refinancing would also not be regarded as tainting the remaining held to maturity portfolio. Although the standard does 308

not specifically deal with the refinancing of assets, such refinancing would be considered to be an extension of the maturity and renegotiation of the terms of the original loan, provided the holder (the SPV) intends, and is able to hold the asset until its maturity (whether original or extended), and the holder would recover substantially its entire carrying amount, no tainting would occur. 3.4 Available-for-Sale Financial assets that are not classified into one of the other three categories are classified as available-for-sale and measured at fair value, with gains and losses recognised either in the income statement or in equity according to the originator s policy. Depending on the nature of each transferred asset and whether they were acquired for trading purposes, the SPV is required to classify each transferred asset according to the accounting statement AC 133 categories. The accounting treatment of these assets will follow the classification. 4. Accounting for the Securitisation SPV s Interest Rate Hedging Activities Both interest rate swaps and forward rate agreements are considered to be derivative financial instruments under accounting statement AC 133 and are therefore required to be classified as held for trading and measured at fair value. In terms of accounting statement AC 133, changes in fair value should be reported in the income statement, except to the extent that the derivative is part of a qualifying hedge relationship. To qualify as a hedge, accounting statement AC 133 requires that certain conditions are met, including the prior documentation of the hedged risk, ongoing measurement of hedge effectiveness and the hedge actually being found to be highly effective. Accounting statement AC 133 defines the hedge of a future transaction, or the hedge of a variable instrument, as a cash flow hedge, while the hedge of a fixed rate instrument is treated as a fair value hedge. For a cash flow hedge that meets the hedge conditions on an ongoing basis, the fair value movements on the hedging derivative are reported directly in equity. These fair value movements of the derivative are removed from equity and reported in the income statement during the same period that the hedged item affects the income statement. Any hedge ineffectiveness is not included in equity, but rather reported in the income statement as it arises. For a fair value hedge that meets the hedge conditions, the fair value movements on the hedging instrument are reported in the income statement. Fair value movements on the hedged item, resulting from changes in the designated hedged risk, are similarly reported in the income statement. 309

APPENDIX 3 TAX CONSIDERATIONS IN SECURITISATION There is no specific provision in the South African Income Tax Act No 58 of 1962 (as amended) ( the Act ) that regulates the treatment of securitisation issues and general principles in respect of accrual, deductions, losses, bad debts, wear and tear, etc are to be applied to securitisation (South African Revenue Services, 2004:10). The South African Revenue Services (SARS) provided guidance on the tax treatment of securitisation transactions as described below. 1. Tax Treatment of a True Sale with Respect to the Originator 1.1 Nature of Selling Price of Receivables in the Originator s Hands The distinction between capital and revenue is important. If a taxpayer is intent on conducting a scheme of profit-making, the receipt will be of a revenue nature. Also, if the cash flows sold form part of the originator s ongoing business, the gain or loss on sale will be of a revenue nature. However, if the cash flows sold form part of a transaction in respect of which the originator has substantially sold its business through a securitisation, capital treatment may be attainable. When the originator sells its cash flows at face value, this may indicate that the originator had no intention of making a profit out of the sale. If the sale price is deemed to be of a capital nature, any discount will also be of a capital nature and not deductible by the originator. However, case law dealing with the discounting of promissory notes supports the position that discounts pursuant to factoring transactions are in the nature of revenue, irrespective if the intent is to raise capital. 1.2 Discount and Premium in Respect of the Sale Price If the transaction qualifies as a sale for tax purposes, any revenue gain (premium) on the sale of the income stream will form part of gross income and be recognised on the date of the transfer by the originator (in terms of the definition of gross income in section 1 of the Act). Likewise, any loss (discount) on the purchase price will effectively be a deductible expense incurred in the production of income in terms of section 11(a) of the Act. Section 24J of the Act does not find application in respect of either a gain/premium or loss/discount, as there is no continuing relationship between the originator and the SPV in a true sale that considers the time value of money over a future period of time. The arrangement between the originator and the SPV does not meet the definition of an 310

instrument 112 as defined in section 24J of the Act to which the provisions of the section can be made applicable. The agreement in a true sale in terms of which the originator disposes of its right to receive interest from the borrower, is an out and out sale of the originator s future income from interest and can therefore not be regarded as an interest-bearing arrangement from the perspective of the originator. 1.3 Bad Debt Deductions Bad debts are only deductible if the criteria set out in section 11(i) have been met, i.e. the debt must have become bad during the year of assessment in which it is ought to have been deducted and it must have been included in the taxpayer s income during that year of assessment or any previous year of assessment. After the originator has sold the receivables it can claim bad debts only up to the date of the sale, as future bad debts will have to be claimed by the SPV. The SPV will, however, not be able to claim a bad debt deduction in respect of the assets transferred, since this had not been included in the SPV s income. Interest accrued to the SPV which becomes bad may be claimed as a bad debt deduction. 1.4 Service and Administration Fees Any servicing and administration fees by the originator will be for services rendered and subject to income tax in terms of the definition of gross income in section 1 of the Act. 2. Tax Treatment of a True Sale With Respect to the SPV 2.1 Nature of Purchase Price of Receivables in the SPV s Hands The fact that the purchase price is either capital or revenue in the hands of the originator does not dictate that it will have the same nature in the hands of the SPV. The standard tests have to be applied to determine whether the acquisition of the right to the income stream is of a revenue or a capital nature and whether it is deductible or not in the SPV s hands. 112 Instrument means any form of interest-bearing arrangement, including any disposal of any right to receive interest. 311

2.2 Discount and Premium in Respect of the Purchase Price Although the arrangement between the originator and the SPV cannot be regarded as an interestbearing arrangement, in a true sale the SPV steps into the shoes of the originator and becomes the holder of the instrument in respect of the original borrower (obligor). Prior to the sale by the originator to the SPV, the originator was the holder in respect of the instrument and the original borrower was the issuer and therefore section 24J of the Act was applicable. The originator was entitled to interest in terms of such income instrument. After the sale by the originator to the SPV, the borrower is still the issuer of the original instrument and its accounting under section 24J of the Act should not be impacted by the securitisation. The SPV steps into the shoes of the originator and becomes the holder and a newly calculated discount/premium should be accounted for pursuant to section 24J of the Act by the SPV. The new calculation takes into account the premium/discount paid by the SPV and will not equal the amount calculated by the originator in terms of section 24J of the Act. This creates a mismatch between the originator and the SPV. If it is a discount, the mismatch is negative as the originator will deduct the discount at the time of the sale agreement whilst accruals to the SPV will only be over the term. On the other hand, if it is a premium, the mismatch is positive as the income is included in the taxable income of the originator at the date of the sale and is only allowed as a deduction to the SPV over the term. 2.3 Treatment of the Receivables in the Hands of the SPV Trading stock is defined in section 22(1) of the Act as anything the proceeds from the disposal of which forms or will form part of his gross income. In order for securitisation to fall within this definition, it must be shown that (a) there are proceeds, (b) from a disposal, and (c) that these proceeds form part of gross income. It could be argued that there are proceeds each time a payment from the underlying receivables is collected and that these proceeds would form part of gross income. These receipts, however, cannot be viewed as disposals, since the disposal took place at the time the SPV acquired the pool of receivables. The SPV thus cannot treat the receivables as trading stock. 2.4 Bad Debt Deductions Section 11(i) of the Act provides for a deduction in respect of debts due, which have become bad, provided the debt has previously been included in the taxpayer s income. This provision will not be afforded to the SPV, as the debts have not previously been included in the SPV s income. If the SPV qualifies as a moneylender, it may qualify for an allowance in respect of doubtful debts in terms of the 312

provisions of section 11(j) of the Act. This allowance is subject to the discretion of SARS and must be added back to income in the following year and a fresh allowance will be considered annually. Should the amounts prove to be unrecoverable they will be allowed as a deduction in terms of section 11(a) of the Act only if the SPV qualifies as a moneylender. The mere fact that the SPV stepped into the shoes of a moneylender originator does not necessarily mean that the SPV qualifies as a moneylender since the SPV itself must fulfil all the requirements for qualification as a moneylender. The following are guidelines which have been laid down in order to decide whether a taxpayer can be said to be carrying on the business of a moneylender (Davis, Emslie and Hutton, 1995:545). There must be an intention to lend to all and sundry provided they are, from his point of view, eligible (SIR v Crane, 1977 (4) SA 761). The lending must be done according to a system or plan which discloses a degree of continuity in laying out and recovering the capital for further use and which involves a frequent turnover of the capital. The obtaining of security is a usual, though not essential, feature of a loan made in the course of a money lending business. The fact that money has on several occasions been lent at remunerative rates of interest is not enough to show that the business of money lending is being carried on; there must be a certain degree of continuity and system in the transactions. The proportion of income from loans to total income is important. The proportion cannot, however, be decisive if the other essential elements of a money lending business exist. 2.5 Service and Administration Fees These fees will be deductible by the SPV in terms of section 11 of the Act, provided that they are market related. Excessive fees would not be deductible if it is not incurred in the production of income, or if it is not in substance a payment for services rendered. 313

2.6 Interest on the Commercial Paper and Senior Loans This interest will be deductible in the normal course of events in terms of section 11(a) of the Act, and the time of incurral will be in accordance with the provisions of section 24J of the Act. 3. Value Added Tax Treatment 3.1 Overview of the Value Added Tax Cycle A short general synopsis of a cycle of value added tax (VAT) transactions entered into by a registered vendor follows. Vendor A purchases goods for cash from vendor B to enable vendor A to manufacture a product. Vendor A would be entitled to an input tax deduction based on the fact that he has purchased goods for the purpose of making a taxable supply. Vendor A must however be in possession of a valid tax invoice in order to claim the input tax. Vendor B would account for output tax on the supply. When vendor A supplies his product, he must account for output tax irrespective of whether he supplies the product to a vendor or non-vendor. In the event that vendor A supplies his goods on credit, output tax must still be accounted for. Where vendor A decides to sell his book debts to an SPV, the supply of the book debts will be exempt for VAT purposes. 3.2 Tax Treatment of an Originator Selling a Loan Book The supply of financial services is exempt from VAT. In terms of section 2(1) of the Value Added Tax Act No 89 of 1991 ( The VAT Act ) financial services are deemed to be the issue, allotment, drawing, acceptance, endorsement or transfer of ownership of a debt security. A debt security is defined as an interest in or right to be paid money; or an obligation or liability to pay money that is, or is to be, owing by any person, but does not include a cheque;. The disposal of a loan book falls within the ambit of the definition of a financial service, and is accordingly exempt from VAT. The VAT Act also stipulates that a vendor who has transferred an account receivable at face value on a non-recourse basis to any person, shall not make a deduction in respect of such transfer. The originator is thus not entitled to any input tax deduction in respect of any loss suffered in the transfer of the accounts receivable to the SPV. 314

3.3 Granting of Loans The granting of a loan falls within the ambit of a financial service, and accordingly the supply is exempt from VAT. 3.4 Issuing of Preference Shares The issuance of preference shares is exempt from VAT. 3.5 Supplies Falling Outside the Ambit of Financial Services In certain circumstances the transfer of a financial service will not fall within the ambit of exempt supply. The term financial service does not include: the cession, assignment, transfer or other supply of any right to receive payment in relation to any taxable supply where, as a result of any such cession, assignment, transfer or supply, output tax in relation to that taxable supply would not be, or become attributable to, any tax period; the transfer of any interest in or right to be paid in money that is, or is to be, owing by any other person under a rental agreement; and the transfer of any interest in or right to be paid in money that is, or is to be, owing by any share block company under its loan obligation to any person who is or will be a shareholder of such share block company. The aforementioned supplies would be subject to VAT, and output tax must be accounted for in respect thereof. 3.6 Administration Fees Administration services rendered to the SPV for a fee fall outside the ambit of a financial service, and will attract VAT. 315

3.7 Recovery of Costs The recovery of costs by the originator from the SPV will be regarded as supplying a service to the SPV and will attract VAT. 4. Regional Services Councils Levies The Regional Services Councils (RSC) Act makes provision for the levying of a regional services levy (payroll tax) and a regional establishment levy (turnover tax). 4.1 Originator Establishment Levy The establishment levy is payable by every person carrying on, or deemed to be carrying on, an enterprise. An enterprise includes any trade, business, profession or other activity of a continuing nature, whether or not it is carried on for the purpose of deriving a profit. Applied to the facts of a typical securitisation, it appears unlikely that the sale of the income stream by the originator will attract the RSC levy. This is because the originator, although it may derive income from the sale of assets, does not normally trade in the pooling and selling of its debt book. 4.2 SPV Establishment Levy Certain financial transactions carried out by financial enterprises will be subject to an establishment levy. Financial enterprises include any enterprise in the course of which financial assets are traded in, or any company which carries on business as an investor of money. The SPV is considered to be a financial enterprise and will thus be subject to RSC levies. 5. Stamp Duty There is not a substantial stamp duty issue in respect of securitisations. 316

APPENDIX 4 FEATURES OF CREDIT DEFAULT SWAPS Credit default swaps have dominated the market as the building block for most credit derivative structures, and they are the building blocks for synthetic securitisations (Francis et al., 2003:95). There are no limits to the size or maturity of credit default swap contracts. However, internationally, most contracts fall between US $10 million and US $20 million in notional amount. Maturity usually ranges from one to ten years, with the five-year maturity being the most common term (Adelson et al., 2004:3). 1. DOCUMENTATION OF CREDIT DEFAULT SWAPS 1.1 Standardised Documentation for Credit Default Swaps Through its early stages of development, the credit default swap market has experienced many problems in the absence of widely accepted standardised documentation. The terms and conditions of contracts were not precise enough, resulting in disputes between buyers and sellers of protection when credit events occurred. The problem is that the protection buyer, as the insured, would want to interpret the scope of protection as widely as possible, while the seller, as the insurer, would want to interpret it narrowly and find a way to deny a claim and pay as little as possible (Adelson et al., 2004:5). If a protection seller disputes payment on a credit default swap, the buyer must enforce the claim in terms of the legal documentation underlying the swap. There is the potential risk that buyers cannot claim because of differences or ambiguities in the wording of the contracts. The use of standardised ISDA contracts has reduced this risk considerably compared to the early days of the market when terms and conditions were negotiated bilaterally (Rule, 2001:134). Rule (2001:135) outlines the key events that have shaped the development of standardised credit derivative documentation. Prior to 1998 the terms of a credit default swap were agreed bilaterally on a case-by-case basis. Russia s default on its debt in August 1998 revealed a number of ambiguities in these agreements. One dispute concerned a short delay in making payments on its debt by the City of Moscow. Some of the swap agreements did not provide for grace periods allowing for technical delays in payment by the reference entity. The courts ruled that the delayed payment was a credit 317

event under the terms of these contracts and that the protection seller must pay. The need to agree on a common approach to grace periods encouraged market participants to agree to the standard ISDA credit derivative definitions in 1999. In October 2000 the United States insurance company, Conseco, agreed to a restructuring of its bank debt involving a restructuring of loan maturities. Some of the bankers, as protection buyers, gave notice of a credit event on their credit default swaps, bought long-dated low-priced Conseco bonds and delivered them to the protection sellers for a par value consideration. The gain from this physical settlement of the swaps considerably exceeded the economic loss sustained by the banks in extending the maturities of their bank loans. Although the protection buyers contractual right to act in this manner was not challenged, market participants agreed that credit default swaps should not include a delivery option of this potential value. To address this issue, a restructuring supplement to the 1999 ISDA credit derivative definitions was announced in 2001, which puts limits on the maturity of obligations that can be delivered and excluded certain restructurings. In November 2000 the United Kingdom power company National Power split into two successor companies. The 1999 ISDA definitions allow for the possibility that a successor to a reference entity may assume all, or substantially all, of its obligations. However, when the obligations of a reference entity are divided relatively equally between more than one successor company, the situation becomes more difficult. The 2003 ISDA definitions addressed this issue. ISDA has published the following documents relating to credit derivatives (Standard & Poor s, 2003: section 2:11): the 1998 long-form confirmation; the 1999 ISDA credit derivative definitions (the 1999 ISDA Definitions ); three supplements to the 1999 definitions published in 2001: supplement relating to convertible, exchangeable, or accreting obligations; supplement relating to successor and credit events; and the restructuring supplement; and the 2003 ISDA credit derivative definitions (the 2003 ISDA Definitions ). Apart from incorporating the 2001 supplements these also modify some of the definitions. Key changes have been made to the credit event definitions, guarantees, notice of physical settlement, alternative 318

settlement procedure, physical settlement representations, dispute resolution and novation provisions. Every credit default swap trade is typically documented in a contract termed the confirmation. Terms used in the confirmation are defined in the credit derivative definitions published by ISDA. In addition to the confirmation, there should be a schedule and a master agreement. Despite standardised documentation, each credit default swap remains a unique contract the terms of which are negotiated between the purchaser and seller of the swap (Kessler, 2001:3), and terms such as the reference entity, credit event, reference obligation and settlement procedure need to be addressed with every swap. 1.2 Reference Entity Terms Credit default swaps are triggered by credit events on a broad range of obligations of a reference entity in addition to a specific reference obligation. The reference entity refers to the debt-issuing entity. The business activities and general credit quality of the reference entity will determine how a credit default swap performs on an MTM basis and whether it is ultimately triggered, rather than the performance of a specific reference obligation (Bowler and Tierney, 1999:11). Perhaps the single most important fundamental issue with a credit default swap is defining precisely which entity s credit risk is being transferred (Francis et al., 2003:60). Large corporate groups often consist of a network of subsidiaries of which various may have debt in one form or the other. The default risk of the different corporate entities within the same group is not necessarily identical and the expected recovery following default is likely to be different from entity to entity. The protection buyer should also take care that the reference entity actually has some debt outstanding during the term of the transaction. A further problem is that during the life of the credit default swap it is possible that, through a merger or other form of corporate restructuring, the debt of a reference entity could become debt of one or more different entities. Such situations require a methodology for determining whether the reference entity should also be replaced by successors. The latest ISDA definitions incorporate a successor supplement as the means of identifying successor reference entities. The tests for a successor to a non-sovereign reference entity are summarised in Diagram A4.1 below 319

Does new entity have > 75% of obligations? No Yes It is sole successor for the entire credit default swap Does new entity have < 25% of obligations? Yes Does reference entity still exist? Yes No change to contract No No Each successor assigned new credit default swap New entity taking largest % of obligations is successor Diagram A4.1: Reference entity successor test Where two parties each end up with between 25% and 75% of the reference obligations, or an equal proportion with no majority, they can both be successors and the protection is divided equally between the successor entities, the terms of which would be defined in a new swap transaction (Francis et al., 2003:62). 1.3 Credit Event Terms Credit events are events that trigger a credit default swap. The range of credit events in a credit default swap can be broader than simple default, which is when a debtor fails to pay interest or principal when due (Bowler and Tierney, 1999:12). Credit risk is generally viewed as the risk of loss following default. The risk of loss following events other than default is not captured by credit risk. It is defined this way largely for practical reasons because default is an event that can be predicted based on historical data. The market does not have comparable data for corporate events other than default, such as loan accelerations or certain types of debt restructurings (Tolk, 2001:4). The ISDA credit derivative definitions do not, however, unbundle credit risk from other risks. If not structured carefully, a credit default swap using the ISDA definitions can thus pass along risks other than credit risk. Typically, the swap may pass along the risk of loss following credit deterioration short of default (Tolk 2001:2). There are six types of credit events in terms of ISDA s credit derivative definitions (Francis et al., 2003:62). Although the 2003 definitions retain some form of all six credit events, market convention in developed countries generally defines the credit events as bankruptcy, failure to pay and 320

restructuring or no restructuring. The simplest credit derivative transaction is the one that contains only bankruptcy and failure to pay as credit events. Each of the other credit events creates greater ambiguity with respect to the definition of default (Standard & Poor s, 2003: section 2:14). With respect to bankruptcy as a credit event, it will be deemed to have occurred only if the default due to bankruptcy occurs with respect to the reference entity itself, whereas all other credit events will be deemed to have occurred if the default due to the relevant credit event occurs on any obligation. (Cunningham et al., 2003:2). The definitions are set out below. 1.3.1 Failure to Pay This requires a payment default on an obligation by the reference entity and is typically subject to a materiality threshold, if not specified otherwise, before a credit event could be triggered. 1.3.2 Bankruptcy Bankruptcy refers to an admission in writing of a general inability to repay debts by the reference entity as part of a judicial, regulatory or administrative proceeding or filing. 1.3.3 Obligation Acceleration This refers to a situation where, for reason of default, obligations of the reference entity have become due and repayable prior to maturity and have been accelerated. Once a declaration of acceleration is made, it qualifies as a credit event under the ISDA definitions only if a notice of this acceleration is available via publicly available information. Since 2002 it has been market convention for G7 corporate contracts not to use this credit event, although it is still used in certain emerging market contracts (Francis et al., 2003:62). 1.3.4 Obligation Default This would also be triggered by an event of default but requires only that an obligation has become capable of being made due and payable prior to maturity. In practise obligation default is almost never included as a credit event in credit derivative contracts (ibid.). 321

1.3.5 Repudiation/Moratorium A potential repudiation or moratorium can be triggered by an authorised officer of a reference entity or by a governmental authority refusing to honour obligations or impose a moratorium which would prevent an entity from making a payment. In particular, this credit event will only be triggered if it is followed by an actual failure to pay or restructuring within a specified timescale. Since 2002 it has been market convention for G7 corporate contracts not to use this credit event, although it is still used in certain emerging market contracts (ibid.). 1.3.6 Restructuring This is probably the most interesting but controversial credit event (Francis et al., 2003:63). Restructuring covers events as a result of which the terms, as agreed by the reference entity and the holders of the relevant obligation, governing the obligation have become less favourable to the holders than they would otherwise have been (Kothari, 2002:109). It is a contentious credit event due to two underlying issues. The first is that unlike failure to pay or bankruptcy, restructuring constitutes a soft credit event that is not truly a default and therefore would not necessarily result in losses if the protection seller actually owned the reference obligation. Soft credit events can be triggered on occasions when the relevant reference entity continues to perform, thereby exposing the protection seller to undeserved risk (Cunningham et al., 2004:3). The second is that there may be a greater price discrepancy in debt after a soft credit event than after a distressed debt exchange. Bonds with lower coupons and/or longer maturities may trade less favourably than bonds with higher coupons and/or shorter maturities. As a result the cheapest-to-deliver option available under the physical settlement of credit default swaps may be of great value to the protection buyer in soft restructuring events (Cunningham et al., 2003:3). The best known case study on restructuring happened in October 2000 when Conseco and its bankers agreed to a restructuring of its bank loans, which restructuring included an extension of loan maturity (Francis et al., 2003:70). With restructuring loosely defined in the 1999 ISDA documentation as a credit event, it meant compensation payments under credit default swaps would be triggered for protection sellers. Some bankers who had bought protection on Conseco gave notice of restructuring and then delivered long-dated bonds, which were trading significantly lower than the restructured bank loans, against par payment from the protection sellers. Protection sellers suffered an economic loss on a soft credit event that was a result of a credit deterioration, which fell short of a full default or bankruptcy. This caused a major controversy in the credit derivatives market, as protection sellers 322

were obliged to compensate for an event that is seen as a routine happening in lending practice. There were more pressing fears too of moral hazard as the protection sellers feared that protection buyers had virtually nothing to lose by agreeing to a restructuring (Kothari, 2002:117). ISDA acted promptly to resolve the issue and in May 2001 published its restructuring supplement (modified restructuring) to the 1999 definitions. This supplement has now been consolidated in the 2003 definitions, which reiterate several tests for determining whether a restructuring has occurred (Francis et al, 2003:63). The tests are whether there has been: a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals; a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates; a postponement or other deferment of a date or dates for either the payment or accrual of interest, or the payment of principal or premium; any change in the ranking in priority of payment of any obligation causing the subordination of such obligations to any other obligation; and/or any change in the currency or composition of payment of interest or principal to any currency, which is not a permitted currency. The definitions, however, exclude such occurrences where they do not directly or indirectly result from a deterioration in the creditworthiness or financial condition of the reference entity. An analysis of any case should focus on the facts and circumstances at the time of the relevant event. The 2003 definitions give counterparties the four choices shown below with regard to the restructuring credit event (Adelson et al., 2004:5). 1.3.6.1 No Restructuring (also called No-R) This option excludes restructuring altogether from the contract, eliminating the possibility that the protection seller may suffer a soft credit event that does not necessarily result in losses to the protection buyer. 323

1.3.6.2 Full Restructuring (also called Old-R) This allows the protection buyer to deliver bonds of any maturity after restructuring of debt in any form occurs. 1.3.6.3 Modified Restructuring (also called Mod-R) Modified restructuring, which has become popular in the United States, places limitations on deliverable obligations (Francis et al., 2003:69). Multiple Holder Obligations: Modified restructuring contracts (Mod-R) are subject to the multiple holder obligation restriction. This requires that the restructuring credit event can occur only with respect to an obligation that has at least four holders and that requires at least two thirds of the holders to agree to the restructuring. Thus a restructuring of a bilateral loan would not be a restructuring credit event. Restructuring Maturity Limitation: These provisions set restrictions on deliverable obligations when Mod-R applies and a restructuring credit event has occurred. In particular, Mod-R limits the ability of the protection buyer to deliver long-dated securities in settlement of the credit default swap. Maturity of the deliverable obligations is capped at the earlier of either 30 months following the restructuring date, or the latest final maturity date of any restructured bond or loan, subject to the limitation that the restructuring maturity limitation date can never be earlier than the scheduled termination date of the credit default swap contract, or later than 30 months after such date. Additionally, restructuring maturity limitation provisions apply only if the contract is triggered by the protection buyer and not the protection seller. Fully Transferable Obligation: Following a credit event under Mod-R, only fully transferable obligations are deliverable. Thus, loans that require the consent of the borrower for transfer to an eligible transferee are not deliverable. Eligible transferees are defined as being those on a list of institution types, notably banks, insurance companies, mutual funds and brokers, in each case subject to a minimum balance sheet. 324

1.3.6.4 Modified-Modified Restructuring (also called Mod-Mod-R) Mod-R never took hold in European markets for a variety of reasons (Francis et al., 2003:71), and Mod-Mod-R has been crafted to address some of those reasons. It is a modified version of the modified restructuring option, which resulted from criticism that it is too strict with respect to deliverable obligations. Under Mod-Mod-R, which is more popular in Europe, deliverable obligations can be maturing up to 60 months after a restructuring. It also provides for conditionally transferable obligations, which are less restrictive and allow for consent required obligations to be transferable if such consent for novation, assignment or transfer cannot be unreasonably withheld or delayed. One problem with Mod-R and Mod-Mod-R is that they do not address directly the soft features such as maturity extension. Rather they act to limit the classes of obligations on which the restructuring event can be triggered, and reduce the value to the protection buyer of the cheapest-to-deliver obligation following a restructuring credit event. For this reason parts of the US market have been strongly advocating scrapping the restructuring credit event completely (Francis et al., 2003:72). 1.4 Obligation Terms The scope of the term obligation 113 is of great importance in determining whether a credit event has occurred. The reference obligation is one particular obligation either issued by or guaranteed by the reference entity. The ranking of the reference obligation is determined at the later of the trade date or issue date, and pegs the seniority of the credit default swap in the capital structure of the reference entity. If no reference obligation is specified, the contract is assumed to relate to senior unsecured obligations of the reference entity (Francis et al., 2003:66). There are six obligation categories (Francis et al., 2003:64). The broadest of these is payment which covers any present, future or contingent payment or repayment whether borrowed or not. Other narrower obligation categories are borrowed money, bond, loan, bond or loan, or reference obligations only. Borrowed money is the most commonly used obligation category, and includes payments in respect of borrowed money, which includes a bond, loan, deposit, and a reimbursement obligation under a letter of credit. It excludes undrawn revolving credit facilities. A credit event with respect to any of these will trigger a payment from the protection seller to the protection buyer. 113 The terms reference obligation, reference credit, reference asset, and name mean the same and are used interchangeably. The most widely used term is reference obligation, meaning obligation of the reference entity. 325

Obligation characteristics allow the protection seller to further narrow down the types of obligation that can trigger a credit event. If not subordinated is selected, a default in subordinated debt of a reference entity would not constitute a credit event. The selection of specified currency would exclude credit events in other currencies. The not sovereign selection excludes defaults on obligations to governments and supranationals. The listed option restricts credit events to obligations that are listed or traded on an exchange. It is not the market custom in Europe and the USA to specify any obligation characteristics (ibid.). In terms of a physically settled credit default swap, the buyer of protection is entitled to deliver any qualifying obligation of the reference entity to the protection seller in return for a full notional amount cash payment. Thus if the reference obligation is a senior unsecured bond, then following a credit event, the protection buyer would deliver a debt obligation ranking pari passu with this reference obligation. However, the buyer does not necessarily have to deliver this specific obligation. The deliverable obligation is the defaulted reference obligation that will be delivered to a protection seller that has chosen physical settlement. If certain pari passu deliverable obligations are trading at different prices following a credit event, and if the deliverable obligation is not pre-specified, it is likely that the buyer will deliver the least favourable i.e. lowest price, or cheapest-to-deliver, obligation. The protection seller is therefore exposed to cheapest-to-deliver risk (Francis et al., 2003:65). In general the buyer that elected physical settlement can deliver the following obligations after a credit event (Adelson et al., 2004:6): direct obligations of the reference entity; obligations of a subsidiary of the reference entity, known as qualifying affiliate guarantees; and obligations of a third party guaranteed by the reference entity, known as qualifying guarantees. The pool of reference obligations can be static or dynamic. In a static pool no removal or substitution of reference obligations is allowed, whereas this is allowed in an open-ended dynamic pool. In such a case the credit quality of the pool will fluctuate as obligations are removed or substituted in the pool. There should be careful guidelines governing the removal and substitution, otherwise the risk exposure of the protection seller at inception of the swap may develop over time into a substantially different risk (Kessler, 2001:4). 326

1.5 Protection Period Terms It is market convention that the effective date, the date that protection starts, is the calendar day following the trade date. This T+1 settlement is applicable on a global basis and in particular also applies to emerging market sovereign and corporate credits (Francis et al., 2003:65). The protection ends on the scheduled termination date. However, with regard to the credit event of failure to pay, this is complicated by grace periods that may relate to the obligation in question. Many bonds or loans contain grace periods to guard against technical defaults due to factors such as settlement errors. A missed payment is not a credit event until any grace period expires. If the obligation does not contain a grace period, or only a very short one, then the ISDA definitions assume an automatic grace period of three business days. 1.6 Settlement Terms If a default, as defined by the credit event definitions, has occurred in the reference portfolio a settlement process will be initiated to establish the recovery value. Credit default swaps may provide for three types of settlement following a credit event (Bowler and Tierney, 1999:12). In a physically settled swap, the buyer of protection delivers to the seller a deliverable obligation of the reference entity that has experienced a credit event. The buyer will either already own the obligation or will have to purchase it in the market. There is a risk that the buyer will not be able to find an obligation or that it does not have the funds to purchase one. Under physical settlement the protection buyer can deliver any pari passu obligation to the protection seller, which exposes the seller to cheapest-to-deliver risk. The seller pays par for the asset, thus reimbursing the buyer for any default-related loss. Subsequently the protection seller will establish the recovery of the delivered obligation, either by selling the security or holding on to it for workout. Physical settlement is the most common form of settlement in the credit default swap market, and normally takes place within 30 days after the credit event (Adelson et al., 2004:5). In a cash-settled swap the buyer is not required to deliver the defaulted obligation, but values it by marking it to market or by using a final workout value, and is reimbursed by the seller for the loss, which is measured as the difference between par and the value following default (Tolk, 2001:3). Cash settlement is less common because obtaining the quotes for the distressed reference obligation often turns out to be difficult. A cash settlement typically occurs no later than five business days after the credit event (Adelson et al., 2004:5). 327

In a binary or digital credit default swap, which provides for a fixed recovery rate that is determined at inception and applied to all credit events (Advani, 2004:1), the seller pays a fixed amount or a fixed percentage of the notional amount of the swap 114. Before a credit event can trigger settlement under a credit default swap, at least one, and often three, notices must be served. If a credit event occurs during the term of the transaction i.e. prior to the scheduled termination date, a credit event notice must be served not later than 14 calendar days after the scheduled termination date, describing an event occurring prior to, or on, the scheduled termination date. In addition to the credit event notice, it will usually be necessary to serve a notice of publicly available information that confirms the source of information that communicated the credit event. If the swap is to be physically settled, it will be required to serve a notice of physical settlement within 30 days of the event determination date. This notice must detail what type of obligation the buyer will deliver to the seller. The buyer must deliver this obligation within 35 days from serving of the notice or risk losing its protection (Francis et al., 2003:68). 1.7 Loss Valuation Calculation In virtually every credit default swap transaction, the buyer of protection determines whether a credit event has occurred and calculates the severity of losses following a credit event. These transactions contain moral hazard risk in that the buyer has the incentive to construe credit events as expansively as possible and to calculate losses as generously as possible (Tolk, 2001:2). Setting aside moral hazard, risks also arise based on the inherent difficulty in valuing a defaulted reference obligation to determine the loss to the protection seller. Credit default swaps are intended to mimic the default performance of a reference obligation. A seller of protection should have the same risk of loss as if it held the reference obligation to its maturity. However, if soft credit events, i.e. credit events that are not truly defaults, are incorporated into the terms of the swap, then selling protection can be more risky than actually owning the reference obligation (Tolk, 2001:12). If the swap includes credit event terms associated with credit deterioration short of default e.g. obligation 114 If a company defaults, e.g. it fails to make a bond coupon payment, and 30 days thereafter its bonds are valued at 30 cents in the Rand. If the notional amount of a cash-settled credit default swap referencing the company s bonds is R100 million, the protection seller would be required to make a payment of R70 million to the protection buyer. In a physically settled swap the protection seller would buy the bonds from the protection buyer at par i.e. for R100 million and the bonds become the property of the seller. The seller would pursue traditional creditor remedies against the issuer of the bond. In a digital swap with a 50% recovery rate the seller would pay R50 million to the buyer. 328

acceleration or a broadly defined restructuring, then the transaction can be in default while the reference obligation is not 115. Because of the moral hazard inherent in credit default swap transactions, these should be structured in such a way that the occurrence and severity of losses can be objectively and independently identified, calculated and verified. The calculation of losses depends on liquidity, market conditions and the identity of the parties supplying bids. Tolk (2001:13) outlines the procedures that can be followed to achieve a robust calculation of losses. Occurrence of a Credit Event: The occurrence of the credit event should be published in a well-known news source, a corporate filing, or a court document. This should deter protection buyers, acting either alone or in collusion with a reference obligor, from staging credit events for the sole purpose of being reimbursed under the swap. There may be instances, however, where there is no published information available regarding a credit event. In such a case at least one senior officer of the protection buyer s credit department should confirm that a credit event has occurred and that the reference obligation is treated internally as a defaulted asset. Loss Severity Following a Credit Event: The amount of loss following a credit event should be calculated either by obtaining bids from third parties, which is the most common way, or by going through a formal workout process to arrive at a workout value. If it is not possible to obtain a public bid, the transaction terms should provide for a formal appraisal by an objective third party. The protection buyer should not be the sole source for determining its losses under the swap. Blind Pools: Occasionally, because of regulatory or legal restrictions, a buyer may not disclose certain names in a reference pool. This becomes a serious problem when a credit event occurs with respect to one of those names, since a meaningful bid cannot be obtained without disclosing the name to potential bidders. In these circumstances it may be possible to get comfortable with an appraisal by the buyer s auditors, so long as the buyer retains a portion of the loss e.g. 10% on each such name. 115 A protection seller has sold protection referencing a bond issued by corporate X. Because of credit deterioration, X violates some covenants on its outstanding bank debt, which leads X s bank to accelerate the loan. The bond however, is not accelerated, but now trades at 85% of par. The credit deterioration is not serious enough to lead to a default, and the bond is ultimately redeemed at par on its maturity. A cash investor in the bond would therefore have received the coupon for the remaining term of the bond and the full amount of principal back at the bond s maturity. By contrast, the protection seller would have suffered a loss of 15% if the swap transaction had included obligation acceleration as a credit event, which would have allowed the swap to be triggered if a bond or loan has been accelerated. 329

Recovery Assumptions: The buyer must determine which position is a senior secured, senior unsecured or subordinated obligation in the capital structure of the reference entity it will reference and MTM in order to calculate losses following default. If a specific obligation is referenced, that obligation, or an obligation that ranks pari passu in the capital structure and has at least the same level of security, should be the one that is valued following a credit event. Time to Valuation Following Default: The timing of the MTM following a credit event may affect the calculation of losses. In some cases, the longer the time between a credit event and the valuation, the higher the valuation will be. This is to be expected, since during the period immediately following the credit event, there will be a relative lack of information about the reference obligation and thus uncertainty as to expected recoveries. Market valuations should be done thirty days following a credit event to allow information to be priced into the market. Nature and Number of Bids Obtained: The pricing process must produce meaningful valuations following a credit event. Potential bidders must be entities that are actively involved in the market for the relevant obligations and are capable of providing meaningful bids. In addition most transactions call for a minimum number of bids. The highest bid is usually used for valuing the obligation. If the protection buyer is unable to obtain a minimum number of bids, due for example to a temporary market disruption, the bid solicitation process should be repeated two or more times until it is able to obtain the minimum number. Reference Obligations other than Corporate Obligations: Often protection is sold on structured finance obligations such as asset-backed securities. This presents unique challenges for classifying exactly what constitutes a credit event, and applying recovery assumptions following a credit event. Failure to pay may not be an appropriate credit event because certain payment failures are not considered defaults. Some structured finance securities can deter and capitalise missed interest payments without going into default. These securities are only considered defaulted if the security does not pay back all capitalised interest and original principal at maturity. Structured finance securities also raise issues concerning valuation following default. Recovery data on them has been scant as there have been very few defaults, and it is not clear what recovery assumptions to use. 330

2. THE PRICING OF CREDIT DEFAULT SWAPS Pricing a credit default swap requires information on two critical issues, first the probability that the credit event will occur and secondly the amount of the payment if the credit event occurs (Finnerty:23). If the credit event is the default by a reference entity, and assuming the payment is the difference between the par value and the recovery amount, then what is required to price the swap is the probability of default and the recovery percentage. 2.1 Pricing Credit Default Swaps Finnerty (23) describes three basic techniques for pricing credit default swaps and these are presented below. 2.1.1 Using Historical Data to Price Credit Default Swaps The major credit rating agencies have published extensive data concerning the probability of default for publicly issued bonds based on the debt s credit rating and how long the bonds were outstanding at the time of default. Each rating agency has also published fractional recovery rates according to the seniority of the debt. These data can be used to infer future default probabilities and recovery rates. Such inferences, however, may differ significantly from historical experience. In addition, bonds within a particular rating category are not identical, and recovery rates within each level of seniority can vary widely from one bankruptcy to another. 2.1.2 Using a Mathematical Model to Price Credit Default Swaps A model generally starts by mathematically representing the stochastic process that explains how the value of the reference entity s assets is determined. It uses this asset valuation process to assess the likelihood that the future value of the entity s assets might fall below the entity s debt service requirements so as to trigger a default. The problem with the use of mathematical models is that it requires simplifying assumptions, which can impair the model s accuracy. 2.1.3 Using Credit Spreads to Price Credit Default Swaps For each maturity the credit spread term structure shows the size of the credit spread that a fixed income investor would demand in deciding how much to pay for a zero-coupon bond with a specific 331

maturity and specified quality i.e. bond rating. The yield on a bond can be expressed as the sum of the yield on a comparable default-free bond and a credit spread. In the bond market, spreads are measured relative to a risk-free rate, usually the government bond, or treasury rate. The spread compensates the bondholders for the risk that the issuer of the bond might default on its debt service payment obligations sometime prior to maturity. The greater the risk, the greater the credit spread. Credit spreads therefore provide a good approximation of how much a credit default swap should cost. For example, a five-year credit default swap should cost the same as the spread on a five-year par-value bond with the same credit rating as the rating of the reference assets underlying the swap. However, the cost estimated in this manner is only an approximation because sufficient information to obtain the current spread curve for a particular issuer is not always available, and issuers may have multiple classes of debt with differing seniority, and thus different expected recovery rates and different credit spreads. The best method of approximating the spread for the reference debt underlying the credit default swap, is to estimate the spread curve for a whole class of bonds with a particular credit rating, and use that in pricing the swap. Example of Pricing Credit Default Swaps by Using Default Rates: Suppose that either an analysis of historical default rates, or a mathematical default model, indicates a 5% chance of default, and a 40% recovery rate based on rating agency historical data. Assume a 10% one-year risk-free interest rate. There is no payment under the swap unless the reference entity defaults. Thus the probability of the swap not paying is 0.95 and the probability of paying is 0.05. In the event of the swap paying, the shortfall would be 100 40 = 60%. The present value of the expected payoff under a one-year credit default swap would therefore be: ( 0.95*0) + (0.05*60) 1.10 = 2.73% of the face value of the underlying reference debt. 332

Example of Pricing Credit Default Swaps by Using Credit Spreads: Assume a five-year bond with a face value of 100 and a 10% annual coupon. Year Scheduled payment Zero-coupon treasury bond yield % Present value of payment Credit spread % Adjusted yield % Present value of payment 1 10 5.00 9.5238 0.50 5.50 9.4787 2 10 5.50 8.9845 0.75 6.25 8.8581 3 10 6.00 8.3962 0.95 6.95 8.1744 4 10 7.00 7.6290 1.15 8.15 7.3096 5 110 8.00 74.8642 1.35 9.35 70.3556 Total 109.3977 104.1764 Table A4.1: Using credit spreads to price a credit default swap The cost of the credit default swap is the difference between the present value of the underlying debt instrument s payment stream calculated at the risk-free treasury yield curve, and the present value of the payment stream calculated by adding the appropriate credit spread adjustment for default risk to each zero-coupon treasury yield, therefore: 109.3977 104.1764 = 5.2213. 2.2 Valuing Credit Default Swaps Francis et al., (13-18) describe three approaches to valuing credit default swaps, namely the asset swap approach, funding cost arbitrage, and default probability models. 2.2.1 Asset Swap Approach to Pricing Credit Default Swaps In terms of a cashflow profile, a credit default swap is most closely comparable with a par floating rate note funded at JIBAR or an asset swapped fixed rate bond financed in the repurchase, or repo market. Though default protection should logically trade at a spread relative to a risk-free asset, in practice it trades at a level that is benchmarked to the asset swap market. Though several sophisticated pricing models exist in the market to estimate default probability, credit default swaps are primarily valued relative to asset swap levels, and pricing is based on the arbitrage relationships between derivative and cash instruments. Rather than using complicated pricing models, simpler pricing mechanisms can be used, which assumes that the expected value of credit risk has already been captured by cash market credit spreads. This assumes that an investor would be satisfied with the same spread on a credit default swap as the spread earned by investing cash in the asset. 333

The price of a credit default swap will reflect several factors, of which the key inputs would include the following: probability of default of the reference entity and the protection seller; correlation between the reference entity and the protection seller; joint probability of default of the reference entity and the protection seller; the maturity of the asset swap; and expected recovery value of the reference asset. A credit default swap is equivalent to a financed purchase of a bond with an interest rate hedge. As a result, the relative value of a credit default swap is compared to an asset swap rather than a bond s underlying spread over the treasury curve. In a simplified model, the credit default swap should trade at the same level as an asset swap on the same bond. Credit default swap exposure can thus be replicated in the way shown in Diagram A4.2. 100 Jibar Corporate asset Investor Swap market T+corporate spread (Sc) T+swap spread (Ss) 100*(1-haircut) Repo rate (J+ x) Repo market Diagram A4.2: Replicating credit default swap exposure Step 1: Purchase a cash bond with a spread of T + S c for par. Step 2: Pay fixed on a swap (T + S s ) with the maturity of the cash bond and receive JIBAR (J). Step 3: Finance the bond purchase in the repo market. The repo rate is at a spread to JIBAR (J+ x). Step 4: Pledge bond as collateral with the bond charged a haircut 116 by the repo counterparty. 116 Discount 334

T S c S s x = treasury yield to maturity and J = JIBAR. = corporate spread. = swap spread. = implied repo premium. Without this interest rate swap hedge, the trade would be equivalent to a leveraged long position in the fixed rate corporate asset (T + S c - (J + x)). Since a credit default swap is an unfunded transaction requiring no initial cash outlay, the bond purchase needs to be financed. An unfunded position in the bond would have to be financed in the repo market. This financing is achieved with a bond repo in which collateral is traded for cash. The collateral seller borrows cash and lends collateral, which is a repo. Conversely, the collateral buyer borrows the collateral and lends cash, which is a reverse repo. Two important components of a repo trade are set out below. Haircut: This is the difference between the securities purchased and the money borrowed. The lender of cash charges a haircut for the loan in order to compensate for market risk of the collateral as well as counterparty risk. Repo rate: This is the financing charge for the collateral. It varies according to the demand to borrow the security. The haircut represents the capital in the trade. As a result, institutions with the cheapest cost of capital will be able to assume this credit exposure for the lowest net cost. If a zero haircut is assumed, the net cash flow is (S c - S s ) + x. If the repo rate for the bond was JIBAR flat (x = 0) the exposure would simply be the asset swap s spread (S c - S s ). This cash flow is similar to that received by a protection seller on a credit default swap, i.e. a simple annuity stream expressed in basis points for the life of the contract. If the bond defaulted, the repo would terminate and the investor would lose the difference between the purchase price and the recovery price of the bond. In efficient markets, arbitrage relationships should drive credit default swap levels towards the asset swap level. Any mispricing between the markets would be arbitraged away by market makers. For example, if the default premium is greater than the asset swap level, protection sellers would enter the market and drive the credit default swap premium down towards the asset swap level. 335

2.2.2 Funding Cost Arbitrage From the perspective of the protection buyer, there are arbitrage forces which tend to link the cash and default markets. If an investor has purchased a floating rate asset at par, it can fund it either through on-balance sheet borrowing or in the repo market. The investor s income would be the differential between the yield on the floating rate asset and the cost of borrowing. The break-even level the investor should be willing to pay for protection would be this differential between the floating rate asset s yield and the funding cost. Assume the following: Cost of funding for a AAA -rated institution = JIBAR 20 basis points; Cost of funding for a A -rated institution = JIBAR + 25 basis points; and Income from BBB -rated asset = JIBAR + 40 basis points. The net spread for the AAA -rated institution from holding the BBB -rated asset is JIBAR + 40 (JIBAR 20) = 60 basis points. The net spread for the A -rated institution from holding the BBB - rated asset is JIBAR + 40 (JIBAR + 25) = 15 basis points. If the AAA -rated institution wanted to reduce its risk to the BBB -rated asset without selling it in the public market, it could enter into a credit default swap as a protection buyer. If the A -rated institution wanted exposure to the BBB - rated asset, it would be more attractive to sell protection on the BBB -rated asset if the default premium was more than its net spread from buying the bond in the cash market, i.e. the default premium > 15 basis points. Assume the AAA -rated and the A -rated institutions enter into a credit default swap where the default premium is 25 basis points, which would result in the net spread for the AAA -rated institution (protection buyer) being 60 25 = 35 basis points, and the net spread for the A -rated institution (protection seller) would be 25 basis points since the swap is an unfunded transaction for the seller. The AAA -rated institution is now exposed to a credit whose rating is defined by the correlation between the BBB -rated asset and the A -rated counterparty. Assuming there is no correlation between the two, the synthetic asset created by a combination of these two would be rated AA-. The coupon on the synthetic asset is JIBAR + 40 25 = JIBAR + 15 basis points. Both institutions are better off after entering into the credit default swap transaction, as the AAA -rated institution has created a better quality synthetic asset, and the A-rated institution earns a higher spread than in the cash market for taking on a similar level of credit risk. For this arbitrage to work, the funding cost of the protection seller must therefore be greater than the funding cost of the protection buyer. 336

2.2.3 Default Probability Models In practice, supply and demand as well as arbitrage relationships with asset swaps tend to be the dominant factor driving the pricing of credit default swaps. Technical models for pricing credit default swaps tend to be used more for exotic structures and off-market credit default swap valuations, e.g. when a swap is cancelled. These models calculate the implied default probability of the reference entity as a means of discounting the cash flows in a credit default swap. While the mathematics of such models are complex, the essential inputs, credit spread and recovery rate, are used to interpolate the time-series of survival probabilities of the reference entity. A basic starting assumption is that market observable credit spreads capture the market view of the riskiness of an obligor s debt. This risk implied by the credit spreads depends on the probability of default as well as the severity of loss following default. Hence, for a given credit spread and under certain recovery assumptions, the probability of default can be approximated. Empirical studies by rating agencies have documented recovery rates of defaulted bond issuers over time. Although rating agency statistics may be a good proxy, there are reasons why the recovery rates in the bond market and the credit default swap market are not the same. The definition of recovery in the credit default swap market is different from the definition of recovery in the bond market. In the bond market recovery is defined as the percentage of par recovered by investors following default. In the credit default swap market, recovery is defined as the market price of the delivered obligation following a credit event. The definition of a credit event in the credit default swap market is also different from the definition of a default in the bond market. Default is defined as missed or delayed interest or principal payments, bankruptcy and distressed exchange, leaving investors with a diminished asset. The definition of default as used by the rating agencies is thus a more severe test than the definition of a credit event, which includes such soft events as restructuring or obligation acceleration. The expected recovery following a soft credit event is likely to be significantly higher than the recovery statistics of hard defaults as reflected by the rating agencies. The recovery rate assumption in a credit default swap must therefore reflect these differences. A credit default swap consists of two legs. The fixed leg is where the protection buyer makes payments to the protection seller until the earlier of a credit event or maturity of the contract. The floating, or contingent, leg is where the protection seller pays the difference between par and the recovery value of the deliverable obligation when a credit event occurs during the life of the contract. At the inception of the swap, the present value of the fixed leg must equal the present value of the floating leg i.e. on-market credit default swaps have zero net present value. Following a credit event 337

the protection seller is exposed to a payment of 100 R, where R is the recovery rate of the delivered obligation. The recovery rate is lowered by the protection seller s cheapest-to-deliver risk. Mathematically, the two sets of cash flows can be approximated in a simple model as: Risky PV FIXED N = S * DF i * SP i * α i i= 1 Risky PV FLOATING N = ( 1 R) * DFi *( SPi i= 1 1 SPi ) S N = the per-annum credit default swap spread. = the number of coupon periods. DF i = the riskless discount factor from time t o to t i. SP i = the survival probability of the reference entity from time t o to t i. α i R = the accrual factor from t i-1 to t i = the recovery rate on the delivered obligation. Hence, the value of the credit default swap contract to the protection buyer at any given point of time is the difference between the present value of the contingent leg, which the protection buyer expects to receive, and that of the fixed leg, which he expects to pay (Adelson et al., 2004:7): Value of credit default swap (to the protection buyer) = PV(contingent leg) PV(fixed leg) Adelson et al., (2004:7 to 10) explain in further detail the methodology to value a credit default swap. In order to calculate the value, one needs information about the default probability i.e. credit curve of the reference credit, the recovery rate in a case of default, and risk-free discount factors i.e. yield curve. A less obvious contributing factor is the counter-party risk. For simplicity, it is assumed that there is no counter-party risk. With regard to the fixed leg, on each payment date the periodic payment is calculated as the annual swap premium, S, multiplied by d i, the accrual days expressed in a fraction of one year between payment dates. For example, if the premium is 160 bps per annum and payments are made quarterly, the periodic payment will be: d i S = 0.25(160) = 40 basis points. 338

However, this payment is only going to be made when the reference credit has not defaulted by the payment date. So the survival probability, or the probability that the reference credit has not defaulted on the payment, must be taken into account. For instance, if the survival probability of the reference credit in the first three months is 90%, the expected payment at t 1, or 3 months later, is: q(t i )d i S = 0.9(.25)(160) = 36 basis points, where q(t) is the survival probability at time t. Then, using the discount factor for the particular payment date, D(t i ), the present value for this payment is D(t i )q(t i )Sd i. Summing up the present values for all these payments, gives the result: N i= 1 D( t ) q( t ) Sd -- (1) i i i In the fixed leg the accrued premium paid up to the date of default when default happens between the periodic payment dates must also be taken into account. The accrued payment can be approximated by assuming that default, if it occurs, occurs at the middle of the interval between consecutive payment dates. Then, when the reference entity defaults between payment date t i-1 and payment date t i, the accrued payment amount is Sd i /2. This accrued payment has to be adjusted by the probability that the default actually occurs in this time interval. The reference credit survived through payment date t i-1, but not to next payment date, t i. This probability is given by: {q(t i-1 )-q(t i )} Accordingly, for a particular interval, the expected accrued premium payment is: {q(t i-1 )-q(t i )}S d i /2 Therefore, the present value of all expected accrued payments is given by: N d D t i i ){ q( ti 1) q( ti )} S 2 i= 1 ( -- (2) Adding (1) and (2), gives the present value of the fixed leg: 339

340 PV (fixed leg) = = + N i i i i Sd t q t D 1 ) ( ) ( = N i i i i i d S t q t q t D 1 1 2 )} ( ) ( ){ ( -- (3) Next, the present value of the contingent leg is computed. Assume the reference entity defaults between payment date t i-1 and payment date t i. The protection buyer will receive the contingent payment of (1-R), where R is the recovery rate. This payment is made only if the reference credit defaults and therefore it has to be adjusted by {q(t i-1 )-q(t i )}, the probability that the default actually occurs in this time period. Discounting each expected payment and summing up over the term of a contract, results in: PV (contingent leg) = (1 R) = N i i i i t q t q t D 1 1 )} ( ) ( ){ ( -- (4) Substituting equation (3) and (4) into the equation in the beginning, results in a formula for calculating value of a credit default swap transaction. When two parties enter a credit default swap trade, the swap spread is set so that the value of the swap transaction is zero i.e. the value of the fixed leg equals that of the contingent leg. Hence, the following equality holds: = N i i i i Sd t q t D 1 ) ( ) ( + = N i i i i i d S t q t q t D 1 1 2 )} ( ) ( ){ ( = (1 R) = N i i i i t q t q t D 1 1 )} ( ) ( ){ ( Given all the parameters, S, the annual premium payment is set as: (1-R) = N i i i i q q t D 1 1 ) )( ( S = = N i i i i d t q t D 1 ) ( ) ( + = N i i i i i d q q t D 1 1 2 ) )( (

Pricing example: Consider a two-year credit default swap with quarterly premium payments. Spread is 160 basis points and the discount factors and the survival probability for each payment date are as shown below in Table A4.2. (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Month Discount Factor Survival Probability to Period (%) Fixed Periodic Payment (bps) Expected Value of Fixed Payment (bps) PV of Fixed Payment 1m x (4) x (1) Default Probability for the Period % Expected Accrued Payment (bps) (3)/2x(6) PV of Accrued Payment 1m x (7) x (1) Expected Contingent Payment (bps) at R=45% PV of Contingent Payment 1m x (9) x (1) (2) x (3) (1-R) x (6) 0 1 100.0 0 0.00 0 0.0 0.00 0.00 0.00 0 3 0.99 99.9 40 39.96 3,956 0.1 0.02 1.98 5.50 544 6 0.98 99.6 40 39.84 3,904 0.3 0.06 5.88 16.50 1,617 9 0.97 99.1 40 39.64 3,845 0.5 0.10 9.70 27.50 2,668 12 0.96 98.4 40 39.36 3,779 0.7 0.14 13.44 38.50 3,696 15 0.95 97.5 40 39.00 3,705 0.9 0.18 17.10 49.50 4,703 18 0.94 96.4 40 38.56 3,625 1.1 0.22 20.68 60.50 5,687 21 0.93 95.2 40 38.08 3,541 1.2 0.24 22.32 66.00 6,138 24 0.92 94.0 40 37.60 3,459 1.2 0.24 22.08 66.00 6,072 Sum of PV 29,814 Sum of PV 113.18 Sum of PV 31,125 Notional amount = R1 million Table A4.2: Default probability table for pricing credit default swaps Valuing fixed leg: fixed periodic payments The present value of all expected fixed payments is found by multiplying each period s fixed payment by the respective survival probability, discounted at the risk-free rate and summed over the term of the swap. The bottom number of column (5) in the table A4.2, (R29,814) is the present value of this leg for a R1 million notional amount. Valuing fixed leg: accrued payments Assuming a default occurs, in the middle of the time interval between two payment dates. The value of the accrued premium payment if a default occurs is a half of 40 basis points, or 20 basis points. The expected value of the accrued payment for each period is 20 basis points multiplied by the probability of default for that period, as in column (7) in table A4.2. Discounting these values for all periods, and summing them up over the term of the swap gives a value of R113.18 as per the bottom of column (8), which is the present value of expected accrued fixed payments. Because the value is a product of the default probability for each period, and the accrued payment if a default occurs is 20 basis points, which are both small numbers, the result is also a small number. From the above, it can 341

be seen that the present value of the fixed leg, or the present value of the expected payments by the protection buyer over the two-year term, is 29,814 + 113.18 = R29,927.18 for the notional value of R1 million. Valuing contingent leg The expected value of the contingent payment if a default occurs during each period is (1-R) multiplied by the probability of default for the period as in column (9) in Table A4.2. Assuming a recovery rate of 45%, the expected contingent payment is 0.55 multiplied by each period s default probability. The present value of expected contingent payments can be found by discounting the contingent payments for each period and summing up over the whole term of the swap, will result in a value of R31,125, as shown in column (10). Hence, the value of the credit default swap to the protection buyer, the fixed payer, when the spread is 160 basis points per annum is: Value of swap = PV (expected contingent payment) PV (fixed leg) = R31,125 - R29,927 = R1,198 for the notional value of R1 million. To see this result intuitively, the average default probability over the term of the swap is 3% per year (because the survival rate after two years is 94%), and with a recovery rate of 45%, the average expected loss per year is: (1-0.45)3% = 1.65%. The swap spread is 160 basis points per year, which means that in this example the protection buyer gets protection for credit risk with the expected loss of 165 bps for a premium of only 160 bps. This is a valuable transaction for the protection buyer, with a positive swap value of R1,198, or 11.98 basis points, for a R1 million notional. 2.3 Market Pricing of Credit Default Swaps Selling credit default swap protection on a particular reference obligation often generates a higher return than the return earned from owning the underlying cash bond. In general this is because the credit default swap price is greater than the asset swap price for the same name. During 2001 the average spread of the synthetic price over the cash price was 15 basis points in the five-year maturity area for BBB -rated obligations (Choudhry, 2003a:34). According to Choudhry, the two main reasons why credit default swap spreads tend to be above cash spreads are: the credit risk covered by the credit default swap includes trigger events that are not pure default scenarios, such as restructuring; and 342

on the occurrence of a credit event the amount of loss is calculated assuming that the reference asset was at an initial price of par, whereas in the cash market that security may have been bought at a discount to par 117. A credit default swap is thus a par product that does not hedge the loss on an asset such as a bond that is currently trading away from par (O Kane, 2001:27). If the bond is trading at a discount, a credit default swap overhedges the credit risk and vice versa. This becomes especially important if the bond falls in price significantly without a credit event. Credit default swap counterparties can therefore enter into transactions with smaller face values than that of the reference bonds, or otherwise use amortising credit default swaps in which the notional amounts of the swaps amortises to the face value of the bond as maturity is approached. 2.4 Mark-to-Market of a Credit Default Swap Even though the trigger for a credit default swap to pay out is defined in terms of a credit event, a credit default swap is very much a credit spread product (O Kane, 2001:28). On an MTM basis the value of a credit default swap changes in line with the credit quality of the reference entity as reflected in the reference entity s changing credit default swap spread. This is so because the MTM of the swap has to reflect the cost of entering into an offsetting transaction, e.g. a protection buyer has to sell protection with the same terms as the protection bought. If a credit event occurs, then both positions net out and terminate. Until the maturity date or the occurrence of the credit event, the combined positions result in a net spread payment on each spread payment date. The MTM is therefore given by (ibid.): MTM = (S(T) S(0)) x PV(01) Where S(T) is the current credit default swap spread to the maturity date, S(0) is the credit default swap spread at trade inception, and PV(01) is the present value of a zero-recovery, one basis point annuity with the maturity of the credit default swap that terminates following a credit event. Each cash flow in the annuity is weighted by the probability of the credit event not occurring before the cash flow date. Over time, the MTM of a credit default swap declines with its shortening maturity. If 117 Assume an investor (protection seller) buys a bond at a price discount to par of x, and that the obligor defaults. The physical security can then be sold at the new defaulted price of y, where x > y, resulting in a loss of (x y). If the investor had instead sold a credit default swap referencing the same name, the investor would pay the difference between par and y, which is a greater loss. Therefore the credit default swap price is higher to compensate for this. 343

a reference entity s credit quality deteriorates, the MTM of a credit default swap will widen, and vice versa. 344

APPENDIX 5 CREDIT RATING SYMBOLS AND DEFINITIONS 1. ISSUE CREDIT RATING SYMBOLS AND DEFINITIONS The purpose of ratings is to provide investors with a simple system of gradation by which relative creditworthiness of securities may be noted (Moody s Investors Service, 2003b:2). An issue credit rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial programme, including ratings on medium-term note programmes and commercial paper programmes (Standard & Poor s, 2002b:1). It takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and also takes into account the currency in which the obligation is denominated. The issue credit rating is not a recommendation to purchase, sell, or hold a financial obligation, inasmuch as it does not comment as to market price or suitability for a particular investor. Obligations carrying the same rating are not claimed to be of absolutely equal credit quality. In a broad sense, they are alike in position, but, since there are a limited number of rating classes used, the symbols cannot reflect the same shadings of risk that actually exist (Moody s Investors Service, 2003b:3). Issue ratings can be either long-term, i.e. more than 365 days, or short-term, i.e. 365 days or less. Short-term ratings are generally assigned to those obligations considered short-term in the relevant market. Medium-term notes are assigned long-term ratings (Standard & Poor s, 2002b:1). 1.1 Long-term Issue Credit Ratings Standard & Poor s long-term ratings definitions Long-term issue credit ratings are expressed in terms of default risk and are based on the following considerations: likelihood of payment, being the capacity and willingness of the obligor to meet its financial commitment on an obligation in accordance with the terms of the obligation, nature and provisions of the obligation, and protection afforded by, and relative position of, the obligation in the event of bankruptcy, reorganisation, or other arrangement under the laws of bankruptcy and other laws affecting creditors rights (ibid.). 345

AAA An obligation rated AAA has the highest rating. The obligor s capacity to meet its financial commitment on the obligation is extremely strong. AA An obligation rated AA differs from the highest-rated obligations only to a small degree. The obligor s capacity to meet its financial commitment on the obligation is very strong. A An obligation rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor s capacity to meet its financial commitment on the obligation is still strong. BBB An obligation BBB exhibits adequate protection parameters. Adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. BB An obligation rated BB is less vulnerable to non-payment than other speculative issues. Nonetheless, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor s inadequate capacity to meet its financial commitment on the obligation. B An obligation rated B is more vulnerable to non-payment than obligations rated BB, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor s capacity or willingness to meet its financial commitment on the obligation. CCC An obligation rated CCC is currently vulnerable to non-payment, and is dependent upon favourable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation. CC An obligation rated CC is currently highly vulnerable to non-payment. 346

C An obligation rated C is currently highly vulnerable to non-payment. The C rating may be used where a bankruptcy petition has been filed or similar action taken, but payments on the obligation are being continued. D An obligation rated D is in payment default. The D rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless the rating agency believes that such payments will be made during such grace period. The D rating will also be used upon the filing of a bankruptcy petition or the taking of similar action if payments on an obligation are jeopardised. The ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Obligations rated BB, B, CCC, CC, and C are regarded as having significant speculative characteristics. A BB rating indicates the least degree of speculation and a C rating the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions. Moody s Investors Service long-term ratings definitions Moody s long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. They address the possibility that a financial obligation will not be honoured as promised. Such ratings reflect both the likelihood of default and any financial loss suffered in the event of default (Moody s Investors Service, 2003b:6). Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk. Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk. A Obligations rated A are considered to be upper-medium grade and are subject to low credit risk. Baa Obligations rated Baa are subject to moderate credit risk. They are considered to be medium-grade and as such may possess certain speculative characteristics. 347

Ba Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk. B Obligations rated B are considered to be speculative and are subject to high credit risk. Caa Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk. Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. C Obligations rated C are the lowest rated class of bonds and are typically in default, with little prospect of recovery of principal or interest. Moody s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation rank in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Fitch Ratings long-term ratings definitions Long-term ratings are used as a benchmark measure of probability of default and are formally described as an issuer default rating (IDR). The rating scale set out below applies to foreign currency and local currency ratings (www.fitchratings.com). Investment grade AAA This means the highest credit quality. AAA ratings denote the lowest expectation of credit risk. They are assigned only in case of exceptionally strong capacity for payment of financial commitments. The capacity is very unlikely to be adversely affected by foreseeable events. 348

AA This refers to very high credit quality. AA ratings denote expectations of very low credit risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events. A This means high credit quality. A ratings denote expectations of low credit risk. The capacity for payment of financial commitments is considered to be strong. This capacity may, nevertheless, be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings. BBB This is good credit quality. BBB ratings indicate that there are currently expectations of low credit risk. The capacity for payment of financial commitments is considered adequate but adverse changes in circumstances and economic conditions are more likely to impair this capacity. This is the lowest investment grade category. Speculative grade BB This means speculative. BB ratings indicate that there is a possibility of credit risk developing, particularly as the result of adverse economic change over time; however, business or financial alternatives may be available to allow financial commitments to be met. Securities rated in this category are not investment grade. B This means highly speculative. For issuers and performing obligations, B ratings indicate that significant credit risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is contingent upon a sustained, favourable business and economic environment. For individual obligations, B ratings may indicate distressed or defaulted obligations with the potential for extremely high recoveries. Such obligations would possess a recovery rating of R1 (outstanding). CCC For issuers and performing obligations, default is a real possibility. Capacity for meeting financial commitments is solely reliant upon sustained, favourable business or economic conditions. For individual obligations, this may indicate distressed or defaulted obligations with potential for average to superior levels of recovery. Differences in credit quality may be denoted by plus/minus distinctions. Such 349

obligations typically would possess a recovery rating of R2 (superior), or R3 (good), or R4 (average). CC This means for issuers and performing obligations, default of some kind appears probable. For individual obligations, this may indicate distressed or defaulted obligations with a recovery rating of R4 (average) or R5 (below average). C This means for issuers and performing obligations, default is imminent. For individual obligations, this may indicate distressed or defaulted obligations with potential for below-average to poor recoveries. Such obligations would possess a recovery rating of R6 (poor). RD This indicates an entity that has failed to make due payments (within the applicable grace period) on some but not all material financial obligations, but continues to honour other classes of obligations. D This indicates an entity or sovereign that has defaulted on all of its financial obligations. Default is generally defined as one of the following: failure of an obligor to make timely payment of principal and/or interest under the contractual terms of any financial obligation; the bankruptcy filing, administration, receivership, liquidation or other winding-up or cessation of business of an obligor; or the distressed or other coercive exchange of an obligation, where creditors were offered securities with diminished structural or economic terms compared with the existing obligation. The modifiers + or - may be appended to a rating to denote relative status within major rating categories. Such suffixes are not added to the AAA rating category or to categories below CCC. 1.2 Short-term Issue Credit Ratings Standard & Poor s short-term ratings definitions (Standard & Poor s, 2002b:3) A-1 A short-term obligation rated A-1 has the highest rating. The obligor s capacity to meet its financial commitment on the obligation is strong. Within this category, certain obligations are designated with a plus (+) sign. This indicates that the 350

obligor s capacity to meet its financial commitment on these obligations is extremely strong. A-2 A short-term obligation rated A-2 is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher rated categories. However, the obligor s capacity to meet its financial commitment on the obligation is satisfactory. A-3 A short-term obligation rated A-3 exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. B A short-term obligation rated B is regarded as having significant speculative characteristics. Ratings of B-1, B-2, and B-3 may be assigned to indicate finer distinctions within the B category. The obligor currently has the capacity to meet its financial commitment on the obligation; however, it faces major ongoing uncertainties which could lead to the obligor s inadequate capacity to meet its financial commitment on the obligation. A short-term obligation rated B-1 is regarded as having significant speculative characteristics, but the obligor has a relatively stronger capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors. A short-term obligation rated B-2 is regarded as having significant speculative characteristics, and the obligor has an average speculative-grade capacity to meet its financial commitments over the short term compared to other speculative-grade obligors. A short-term obligation rated B-3 is regarded as having significant speculative characteristics, and the obligor has a relatively weaker capacity to meet its financial commitments over the short term compared to other speculativegrade obligors. C A short-term obligation rated C is currently vulnerable to non-payment and is dependent upon favourable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. D A short-term obligation rated D is in payment default. The D rating category is used when payments on an obligation are not made on the date due, even if the applicable grace period has not expired, unless the rating agency believes that such payments will 351

be made during such grace period. The D rating will also be used upon the filing of a bankruptcy petition, or the taking of similar action if payments on an obligation are jeopardised. Moody s Investors Service short-term ratings definitions Moody s short-term ratings are opinions of the ability of issuers to honour short-term financial obligations. Ratings may be assigned to issuers, short-term programmes or to individual short-term debt instruments. Such obligations have an original maturity not exceeding 13 months, unless explicitly noted (Moody s Investors Service, 2003b:7). P-1 Issuers rated Prime-1 have a superior ability to repay short-term debt obligations. P-2 Issuers rated Prime-2 have a strong ability to repay short-term debt obligations. P-3 Issuers rated Prime-3 have an acceptable ability to repay short-term debt obligations. NP Issuers rated Not Prime do not fall within any of the Prime rating categories. Fitch Ratings short-term ratings definitions A short-term rating has a time horizon of less than 13 months and thus places greater emphasis on the liquidity necessary to meet financial commitments in a timely manner (www.fitchratings.com):. F1 This is the highest credit quality and indicates the strongest capacity for timely payment of financial commitments. It may have an added + to denote any exceptionally strong credit feature. F2 This is good credit quality, representing a satisfactory capacity for timely payment of financial commitments, but the margin of safety is not as great as in the case of the higher ratings. 352

F3 This is fair credit quality. The capacity for timely payment of financial commitments is adequate; however, near term adverse changes could result in a reduction to noninvestment grade. B This is speculative. There is minimal capacity for timely payment of financial commitments, plus vulnerability to near term adverse changes in financial and economic conditions. C High default risk. Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon a sustained, favourable business and economic environment. RD Indicates an entity that has defaulted on one or more of its financial commitments, although it continues to meet other obligations. D Indicates an entity or sovereign that has defaulted on all of its financial obligations. 1.3 Local Currency and Foreign Currency Rating Scales Country risk considerations are a standard part of the rating agency s analysis for credit ratings on any issue, and currency of repayment is a key factor in this analysis. An obligor s capacity to repay foreign currency obligations may be lower than its capacity to repay obligations in its local currency due to the sovereign government s own relatively lower capacity to repay external versus domestic debt. These sovereign risk considerations are incorporated in the debt ratings assigned to specific issues (Standard & Poor s, 2002b:3). Rating agencies typically assign structured finance ratings on securitisation transactions using three different rating scales (Ernst, 2003:4) which are discussed below. 1.3.1 Global Rating Scale These are the traditional rating agency international (foreign currency) ratings that are used for all international debt instruments. Global scale ratings are comparable across countries irrespective of the type of debt issued, whether structured finance or regular bonds, or the issuer s nature, whether a corporate, bank, government or SPV. This type of foreign currency rating is usually constrained by the country ceiling because of the implied foreign exchange convertibility risk, that is, the possibility 353

that the government might impose a moratorium on all debts during a foreign currency crisis. However, it is possible to pierce the sovereign ceiling, e.g. in a cross-border future flow securitisation where the issuer s revenues are generated overseas in hard currency. In this case, the rating would normally be capped at the originator s local currency rating, simply because the rating will be linked to the originator s creditworthiness, as the solvency of the originator will be a condition for the generation of these receivables. 1.3.2 Local Currency Rating Scale The foreign currency moratorium and convertibility risk is irrelevant for notes denominated in local currency. Instead, ratings of local currency notes are generally capped at the Local Currency Guideline (LCG) for that country, which incorporates the country s domestic systemic risks, such as political, legal and financial system risk. The Local Currency Guideline is an indication of the highest possible local currency rating for a given country, which applies to all issuers domiciled in that country. 1.3.3 National Rating Scale National scale ratings are opinions of the relative creditworthiness of issuers and issues within a particular country, based solely on domestic analysis. They take into account all credit risks that have a bearing on timely and full payment of a debt obligation, including sovereign related risks such as relative vulnerability to political developments, national monetary and fiscal policies, and foreign currency convertibility and transfer risk (Moody s Investors Service, 2003b:21). The ratings are an assessment of credit quality relative to the rating of the best credit risk in a country (www.fitchratings.com). This best risk will normally, although not always, be assigned to all financial commitments issued or guaranteed by the sovereign state. Ratings on a national scale are not comparable with any other ratings outside of that country. A special identifier for the country concerned is added at the end of all national ratings 118. Using Fitch Ratings notation as an example, a rating of AAA(zaf) denotes the highest rating assigned in its national rating scale for South Africa. This rating is assigned to the best credit risk relative to all other issuers or issues in South Africa and will normally be assigned to financial commitments issued or guaranteed by the South African government. 118 For South Africa Fitch Ratings use (zaf) and Moody s use.za. 354

1.4 Other Ratings In addition to rating symbols, the rating agencies also use other rating terminologies to indicate, for example, opinions regarding the likely direction of a rating over the medium term. The Fitch definitions are used. 1.4.1 Rating Watch Ratings are placed on Rating Watch to notify investors that there is a reasonable probability of a rating change and the likely direction of such a change. These are designated as Positive, indicating a potential upgrade, Negative, for a potential downgrade, or Evolving, indicating whether ratings may be raised, lowered or maintained. Rating Watch is typically resolved over a relatively short period. 1.4.2 Rating Outlook An Outlook indicates the direction in which a rating is likely to move over a one to two-year period. Outlooks may be positive, stable or negative. A positive or negative Rating Outlook does not imply a rating change is inevitable. Similarly, ratings for which outlooks are stable could be upgraded or downgraded before an Outlook moves to positive or negative if circumstances warrant such an action. In cases where a fundamental trend cannot be identified, the Rating Outlook may be described as evolving. 1.4.3 Interest Only Interest Only ratings are assigned to interest strips. These ratings do not address the possibility that a security holder might fail to recover some or all of its initial investment due to voluntary or involuntary principal repayments. 1.4.4 Principal Only Principal Only ratings address the likelihood that a security holder will receive its initial principal investment either before or by the scheduled maturity date. 355

1.4.5 Withdrawn A rating is withdrawn when the amount of information available is deemed to be inadequate for rating purposes, or when an obligation matures, is called, or refinanced, or for any other reason deemed sufficient. 1.5 Comparison of Rating Symbols Although the rating agencies use different symbols, they can be compared with each other. Standard & Poor s Moody s Investors Service Fitch Ratings Long-Term Credit Ratings AAA Aaa AAA AA+ Aa1 AA+ AA Aa2 AA AA- Aa3 AA- A+ A1 A+ A A2 A A- A3 A- BBB+ Baa1 BBB+ BBB Baa2 BBB BBB- Baa3 BBB- BB+ Ba1 BB+ BB Ba2 BB BB- Ba3 BB- B+ B1 B+ B B2 B B- B3 B- CC+ Caa1 CC+ CCC Caa2 CCC CCC- Caa3 CCC- CC Ca CC C C C RD D D Short-Term Credit Ratings A-1 P-1 F1 A-2 P-2 F2 A-3 P-3 F3 B NP B C C RD D D Table A5.1: Comparing rating symbols The ratings, however, are not standardised. Ratings from the different rating agencies cannot be assumed to mean the same thing, first, because the definitions and rating methodologies are not the same across rating agencies, and, second, because the opinions and judgements of the analysts across agencies cannot be identical (Pinkes, 1997:3). 356

1.6 Comparing Rating Definitions Ratings can be compared in terms of their relative risk scale, as shown in the table below (Fitch Ratings). Long-term ratings from AAA to BBB are classified as investment grade, ratings from BB to B are classified as speculative, ratings from CCC to C are classified as having a high probability of default and the DDD to D ratings are considered to be in default, with varying rates of recovery. All short-term ratings in the F band are considered to be of investment grade, with ratings below that range from speculative to being considered to be in default. Rating Definitions International Long-Term International Short-Term Rating Symbol Risk Quality Rating Symbol Risk Quality AAA Highest F1+ Highest + Exceptional AA Very High F1 Highest A High F2 Good BBB Good F3 Fair BB Speculative B Highly Speculative B Speculative CCC High Default CC Default Probable C High Default C Default Imminent DDD 90% to 100% recovery DD 50% to 90% recovery D In Default D <50% recovery Table A5.2: Comparing rating definitions 1.7 Comparing the Cumulative Default Rates of Ratings The cumulative default probability of long-term ratings, based on historical observation, is shown in the table below (Fitch Ratings). Long-Term Average Annual Cumulative Default Rates (%) Year 1 Year 2 Year 3 Year 4 Year 5 AAA 0.00 0.00 0.00 0.00 0.00 AA 0.00 0.00 0.00 0.04 0.09 A 0.05 0.21 0.34 0.48 0.59 BBB 0.38 1.26 1.98 2.84 3.28 BB 1.92 5.05 6.34 8.03 8.34 B 2.49 5.25 5.43 5.31 5.71 CCC to C 26.55 30.46 24.32 30.39 34.18 Table A5.3: Comparing annual cumulative default rates The table shows that a AAA rated security is not expected to default within five years, while a AA rated security has an 0.04% cumulative probability of default in year 4. By contrast, securities rated in 357

the CCC to C band have a 26.55% probability of default in year 1 and a 34.18% cumulative probability of default by year 5. 1.8 The Role of Ratings The role of ratings is to provide, through a simple symbol system, an objective and independent opinion of relative credit risk that investors can use as a supplement to, but not as a substitute for, their own credit research. Ratings are not guarantees against loss or predictors of default; they are simply opinions about the relative probability of default and loss (Pinkes, 1997:1). To the extent that ratings accurately assign securities to consistent and comparable bands of risk, they are useful tools for risk management. From the investors perspective, ratings contribute (Pinkes, 1997:3) in the ways listed below. Ratings reduce uncertainty, which means greater investor confidence that encourages capital market growth, greater market efficiency and liquidity. Ratings widen investment horizons. Even sophisticated investors may not have the expertise to analyse the large number of potential debt instruments available to them. Ratings are often used as privately instituted benchmarks for setting credit risk limits, e.g. a pension fund may stipulate that its portfolio managers may not buy debt instruments below a certain level. Investors use ratings to assess the credit risk premium (yield) that they should demand in order to be compensated for the expected credit loss on the securities they buy. The purpose of ratings is to help investors understand and manage credit risk. It is important to remember that, ratings serve as a form of investor protection, only in relation to investors understanding of what a given rating opinion is intended to mean, and to the relative accuracy of that opinion in relation to its definition. Investors should understand how each rating system operates in order to understand and react appropriately to a rating agency s opinions. To do this, investors themselves need a firm grounding in credit analysis, which will enable them to make their own credit decisions and to evaluate the varying quality of rating agencies opinions as well as that of other market opinions. From the issuers perspective, ratings achieve the outcomes listed below (Pinkes, 1997:3). 358

Ratings can open the issuers debt to a larger number of potential investors, thereby allowing issuers to gain wider access to capital. Ratings contribute to issuers financing flexibility, since wider market access often translates into reduced funding costs. Ratings may also allow issuers to enter the capital markets more frequently and sell larger offerings at longer maturities. To be able to fulfil their role as market watchdogs, rating agencies must be independent. This also includes publishing opinions that issuers do not necessarily want published. Few issuers welcome a downgrade of their debt, yet investors would benefit from this information. If the rating agencies opinions and conclusions are perceived as serving any other group than that of the market, it would undermine confidence in the rating agencies. 359

APPENDIX 6 SUMMARY OF THE MINIMUM CAPITAL REQUIREMENTS IN TERMS OF THE BASEL II FRAMEWORK The calculation of the total minimum capital requirement for credit, market and operational risk is calculated using the definition of regulatory capital and risk-weighted assets. The total capital ratio must not be lower than 8%. Tier 2 capital is limited to 100% of Tier 1 capital. Risk-Weighted Assets: Total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 (the reciprocal of the minimum capital ratio of 8%), and adding the resulting figures to the sum of risk-weighted assets for credit risk. Regulatory Capital: The definition of regulatory capital, as outlined in the 1988 Accord, remains in place, except for a few modifications 119. Transitional Arrangements: For banks using the Internal Ratings Based (IRB) approach for credit risk, there will be a capital floor following implementation of the Basel II Framework. During the years that the floor will apply, banks must calculate the difference between the (i) the floor as defined in the following section and (ii) the regulatory capital requirement under the Basel II Framework. If the floor amount is larger, banks are required to add 12.5 times the difference to risk-weighted assets. The capital floor is based on the application of the 1988 Accord. It is derived by applying an adjustment factor to an amount calculated as: 8% of risk-weighted assets + Tier 1 and Tier 2 capital deductions less the amount of general provisions that may be recognised in Tier 2 capital. The regulatory capital requirement under the Basel II Framework is calculated as: 8% of the total riskweighted assets as calculated under the Basel II Framework the difference between total provisions 119 Deductions for investments must be made 50% from Tier 1 capital and 50% from Tier 2 capital. With respect to provisions under the Standardised approach to credit risk, general provisions can be included in Tier 2 capital subject to a limit of 1.25% of risk-weighted assets. Regarding provisions under the Internal Ratings-based ( IRB ) approach, the treatment of the 1988 Accord to include general provisions or general loan-loss reserves in Tier 2 capital is withdrawn. Banks using the IRB approach for securitisation exposures or the probability of default/loss-given-default approach for equity exposures must first deduct the expected loss (EL) amounts. Banks using the IRB approach for other asset classes must compare (i) the amount of eligible provisions with (ii) the total EL amount as calculated within the IRB approach. Where the total EL amount exceeds total eligible provisions, banks must deduct the difference on the basis of 50% from Tier 1 capital and 50% from Tier 2 capital. Where the total EL amount is less than total eligible provisions, banks may recognise the difference in Tier 2 capital up to a maximum of 0.6% of credit risk-weighted assets. 360

and the expected loss amount calculated under the IRB approach + other Tier 1 and Tier 2 capital deductions. The adjustment factor for banks using the Foundation IRB approach for the year beginning year-end 2006 is 95%. For banks using the Advanced approaches to credit and operational risk, the adjustment factor is 90% for the year beginning year-end 2007 and 80% for the year beginning yearend 2008. Table A6.1 illustrates the application of the adjustment factors. Foundation IRB approach Advanced approaches to credit and/or operational risk From year-end 2005 From year-end 2006 From year-end 2007 From year-end 2008 Parallel calculation 95% 90% 80% Parallel calculation or impact studies Parallel calculation 90% 80% Table A6.1: Basel II adjustment factors 1. THE CALCULATION OF THE CAPITAL REQUIREMENTS FOR BANKING BOOK CREDIT RISK IN TERMS OF THE STANDARDISED APPROACH The following section sets out the revisions to the 1988 Accord for risk-weighting banking book exposures (Basel Committee, 2004a:15 to 47). Exposures that are not explicitly addressed here retain the current treatment. In determining the risk weights in the Standardised approach, banks may use assessments 120 by external credit assessment institutions (ECAIs) recognised as eligible for capital purposes by national supervisors in accordance with specified criteria 121. Exposures should be riskweighted net of specific provisions. 120 The notations follow that used by Standard & Poor s and are used as an example only; those by some other ECAIs could equally well be used (Basel Committee, 2004a:15). 121 An ECAI must satisfy each of the following six criteria (Basel Committee 2004a:23): Objectivity: The methodology for assigning credit assessments must be rigorous, systematic and subject to some form of validation based on historical experience. Assessments must be subject to ongoing review and responsive to changes in financial conditions. An assessment methodology for each market segment, including rigorous backtesting, must have been established for at least one year and preferably for three years. Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. International access/transparency: The assessments should be available to both domestic and foreign institutions on equivalent terms. The general methodology used by the ECAI should be publicly available. Disclosure: An ECAI should disclose the following information: its assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessment, e.g. the likelihood of AA ratings becoming A over time. Resources: An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. 361

1.1 Individual Claims 1.1.1 Claims on Sovereigns Claims on sovereigns and their central banks are risk-weighted as depicted in Table A6.2. Credit AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Assessment Risk weight 0% 20% 50% 100% 150% 100% Table A6.2: Claims on sovereigns At national discretion, a lower risk weight may be applied to banks exposures to their sovereign or central bank. 1.1.2 Claims on Non-Central Government Public Sector Entities (PSEs) Claims on domestic PSEs will be risk-weighted at national discretion according to either option 1 or option 2 for claims on banks 122. When option 2 is selected, it is to be applied without the use of the preferential treatment of short-term claims. Subject to national discretion, claims on certain domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established. 1.1.3 Claims on Multilateral Development Banks (MDBs) The risk weights applied to claims on MDBs will generally be based on external credit assessments as set out under option 2 for claims on banks, but without the possibility of using the preferential treatment for short-term claims. A 0% risk weight will be applied to claims on highly rated MDBs approved by the Committee. Credibility: In addition, the reliance on an ECAI s credit assessments by independent parties (investors, insurers, etc.) is evidence of the credibility of the assessments of an ECAI. The credibility of an ECAI is also underpinned by internal procedures to prevent the misuse of confidential information. In order to be eligible for recognition, an ECAI does not have to assess firms in more than one country. 122 This is regardless of the option chosen for claims on banks. It does not imply that that when one option has been chosen for claims on banks, the same option should also be applied to claims on PSEs. 362

1.1.4 Claims on Banks There are two options for banks. National supervisors will apply one option to all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than that applied to claims on its sovereign. Under the first option, all banks incorporated in a country will be assigned a risk weight one category less favourable than that assigned to claims on the sovereign of that country. However, for claims on banks in countries with sovereigns rated BB+ to B-, and on banks in unrated countries, the risk weight will be capped at 100%. The second option bases the risk weighting on the external credit assessment of the bank itself with claims on unrated banks being risk-weighted at 50%. Under this option, a preferential risk weight that is one category more favourable may be applied to claims with an original maturity of three months or less, subject to a floor of 20%. This treatment will be available to both rated and unrated banks, but not to banks risk-weighted at 150%. Option 1 Credit Assessment of Sovereign Risk weight under Option 1 AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated 20% 50% 100% 100% 150% 100% Table A6.3: Risk weighting of banks under option 1 Option 2 Credit Assessment of Banks Risk weight under Option 2 Risk weight for short-term claims under option 2 123 AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated 20% 50% 50% 100% 150% 100% 20% 20% 20% 50% 150% 20% Table A6.4: Risk weighting of banks under option 2 123 These claims are defined as having an original maturity of three months or less. 363

1.1.5 Claims on Securities Firms Claims on securities firms are treated as claims on banks, provided these firms are subject to supervisory and regulatory arrangements comparable to those under the Basel II framework. Otherwise such claims would follow the rules for claims on corporates. 1.1.6 Claims on Corporates The table illustrates the risk weighting of rated corporate claims, including claims on insurance companies. Credit AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated Assessment Risk Weight 20% 50% 100% 150% 100% Table A6.5: Claims on corporates 1.1.7 Claims on Regulatory Retail Portfolios Qualifying 124 claims may included in a regulatory retail portfolio and be risk-weighted at 75%, except for past due loans. 1.1.8 Claims Secured by Residential Property Lending fully secured by mortgages on residential property that is occupied by the borrower, or that is rented, will be risk-weighted at 35%. 1.1.9 Claims Secured by Commercial Real Estate Claims secured by commercial real estate will attract a 100% risk weighting. 124 To be included in the retail portfolio, claims must meet the following four criteria. Orientation: The exposure is to an individual person or to a small business. Product: Revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business loans. Securities such as bonds and equities, whether listed or not, are specifically excluded from this category. Mortgage loans are excluded to the extent that they qualify for treatment as claims secured by residential property. Granularity: The supervisor must be satisfied that the regulatory retail portfolio is sufficiently diversified. One way of achieving this would be to set a limit that no aggregate exposure to one counterparty can exceed 0.2% of the portfolio. Low value of individual exposures: The maximum aggregated retail exposure to one counterparty cannot exceed an absolute threshold of 1 million. 364

1.1.10 Claims on Past Due Loans The unsecured portion of any loan (other than a qualifying residential mortgage loan) that is past due for more than 90 days, net of specific provisions including partial write-offs, will be risk-weighted as follows: 150% risk weight when specific provisions are less than 20% of the outstanding amount of the loan; 100% risk weight when specific provisions are not less than 20% of the outstanding amount of the loan; and 100% risk weight when specific provisions are not less than 50% of the outstanding amount of the loan, with supervisory discretion to reduce the risk weight to 50%. Qualifying residential mortgage loans that are past due for more than 90 days will be risk-weighted at 100%, net of specific provisions. If specific provisions are not less than 20% of the outstanding amount, the risk weight applied to the remainder of the loan can be reduced to 50% at national discretion. 1.1.11 Off-Balance Sheet Items Off-balance sheet items under the Standardised approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF). Commitments with an original maturity of up to one year and commitments with an original maturity of over one year will receive a CCF of 20% and 50% respectively. However, any commitments that are unconditionally cancellable at any time by the bank without prior notice, or that provide for automatic cancellation due to deterioration in the borrower s creditworthiness, will receive a 0% CCF. A CCF of 100% will be applied to the lending of banks securities or the posting of securities as collateral by banks; including repo-style transactions (i.e. repurchase/reverse repurchase and securities lending/borrowing transactions). 365

For short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralised by the underlying shipment), a 20% CCF will be applied to both issuing and confirming banks. CCFs not specified remain as defined in the 1988 Accord. 1.2 Implementation Considerations 1.2.1 The Mapping Process Supervisors will be responsible for assigning assessments from ECAIs to risk weights. The mapping process should be objective and should result in a risk weight assignment consistent with the level of risk. Banks must use the chosen ECAIs and their ratings consistently for each type of claim, both for risk weighting and risk management purposes. Banks will not be allowed to cherry pick the assessments provided by different ECAIs. Banks must disclose the ECAIs that they use for the risk weighting of their assets by type of claims and the risk weight associated with the particular rating grades as determined by supervisors through the mapping process. 1.2.2 Multiple Assessments If there is only one assessment by an ECAI for a claim, that assessment must be used to determine the risk weight of the claim. If there are two assessments that map into different risk weights, the one with the higher risk weight must be applied. If there are three or more assessments with different risk weights, the highest risk weight of the two assessments with the lowest risk weight must be applied to the claim. 1.2.3 Issuer versus Issue Assessment Where a bank invests in a specific issue that has an issue-specific assessment, the risk weight of the claim will be based on that assessment. If the claim is not issue-specific, the general principals listed below apply. Where the borrower has an assessment for issued debt, but the bank s claim is not an investment in that particular debt, the assessment on the issued debt may only be applied to the bank s 366

unassessed claim if this claim ranks pari passu or senior to the issued debt. If not, the unassessed claim will receive the risk weight of unrated claims. Where the borrower has an issuer assessment, this assessment typically applies to senior unsecured claims on that issuer and consequently only senior claims on that issuer will benefit from a high quality issuer assessment. Other unassessed claims of such an issuer will be treated as unrated. If an issuer has a low quality assessment, an unassessed claim on such issuer will be assigned the same risk weight applicable to such low quality assessment. 1.2.4 Short-Term Assessments Short-term assessments are deemed to be issue-specific for risk weighting purposes and can only be used to derive risk weights for rated claims. They may not be used to derive a risk weight for an unrated long-term claim. Rated short-term claims attract the risk weights seen in Table A6.6. Credit Assessment A-1/P-1 A-2/P-2 A-3/P-3 Others Risk Weight 20% 50% 100% 150% Table A6.6: Short-term risk weights 1.2.5 Level of Application of the Assessment External assessments for one entity in a corporate group cannot be used to risk-weight other entities within the same group. 1.2.6 Unsolicited Ratings As a general rule, banks should use solicited ratings from eligible ECAIs. National supervisory authorities may, however, allow banks to use unsolicited ratings in the same way as solicited ratings. 1.3 Credit Risk Mitigation under the Standardised Approach Banks use various techniques to mitigate the credit risk to which they are exposed. For example, a loan may be secured by first priority claims over property or other assets, a loan may be guaranteed by a third party, or a bank may buy a credit derivative to offset its credit risk. Banks may also agree to net loans owed to them against deposits from the same counterparty. Where these techniques meet 367

the requirements for legal certainty 125, Basel II allows for a wider range of credit risk mitigants than allowed under Basel I. 1.3.1 Overview of Credit Risk Mitigation Techniques A collateralised transaction is one in which banks have a credit exposure, which is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. Where banks take eligible collateral, they are allowed to take into account the credit risk mitigating effect of the collateral when calculating their capital requirements. A capital requirement is applied to both sides of a collateralised transaction, e.g. both repurchase agreements and reverse repurchase agreements are subject to a capital charge, as are securities lending and borrowing transactions. Banks may opt for either the simple approach or the comprehensive approach. The simple approach substitutes the risk weighting of the collateral for that of the counterparty, subject to a 20% floor. The comprehensive approach allows fuller offset of collateral against exposures by reducing the exposure amount by the value of the collateral. Banks must use haircuts to adjust the exposure as well as the collateral, to take into account potential future fluctuations in either because of market movements. This will result in volatility adjusted amounts for both exposure and collateral, unless either side is cash. Haircuts can be calculated using standard haircuts with parameters set by the Committee, or own-estimate haircuts that use banks own estimates of market price volatility. The choice of which type of haircut to use can be made independently of the bank s choice between the Standardised approach or IRB approach to credit risk. However, if a bank decides to use ownestimate haircuts, it must be used across all instrument types for which own-estimates are eligible, excluding immaterial portfolios where standard supervisory haircuts can be used. Banks may use either the simple or comprehensive approach, but not both, for their banking book exposures, and only the comprehensive approach for their trading book exposures. Partial collateralisation is recognised in both approaches, whereas mismatches between the maturity of the exposure and the collateral are only allowed under the comprehensive approach. For calculating capital requirements, banks can take account of guarantees or credit derivatives that are direct, explicit, irrevocable and unconditional. Only guarantees issued by, or protection provided 125 In terms of legal certainty, all documentation used in collateralised transactions and for documenting on-balance sheet netting, guarantees and credit derivatives must be binding on all parties and legally enforceable. Banks must have conducted a satisfactory legal review to verify this and have a well founded legal basis to reach this conclusion and to ensure continuing enforceability. 368

by, entities with a lower risk weighting than that of the counterparty will lead to reduced capital charges. The protected portion of the exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty. Where the residual maturity of the credit risk mitigation is less than that of the exposure, a maturity mismatch occurs. Where there is a maturity mismatch and the credit risk mitigation has an original maturity of less than one year, the credit risk mitigation is not recognised for capital purposes. Otherwise, partial recognition may be given, but not under the simple approach where maturity mismatches are not allowed. 1.3.2 Collateral 1.3.2.1 Eligible Collateral under the Simple Approach The following collateral instruments are eligible for recognition under the simple approach: cash as well as certificates of deposit or comparable instruments issued by the lending bank, on deposit with the bank which is incurring the counterparty exposure 126 ; gold; debt securities rated by a recognised ECAI where these are either at least BB- when issued by sovereigns or PSEs, or at least BBB- when issued by other entities, or at least A-3/P-3 for short-term debt instruments. debt securities not rated by a recognised ECAI where these are issued by a bank, listed on a recognised exchange and classified as senior debt, and all rated issues of the same seniority by the issuing bank are rated at least BBB- or A-3/P-3 by a recognised ECAI; equities, including convertible bonds, which are included in a main index; and 126 When cash on deposit, certificates of deposit or comparable instruments issued by the lending bank are held as collateral at a third-party bank in a non-custodial arrangement, and if they are unconditionally and irrevocably pledged to the lending bank, the exposure amount covered by the collateral will receive the risk weight of the third-party bank. 369

transferable securities in mutual funds where a price for the units is publicly quoted daily. For collateral to be recognised under the simple approach, the collateral must be pledged for at least the life of the exposure and must be MTM and revalued with a minimum frequency of six months. Those portions of claims collateralised by the market value of recognised collateral receive the risk weight applicable to the collateral instrument, subject to a floor of 20%, except under certain conditions 127. 1.3.2.2 Eligible Collateral under the Comprehensive Approach The following collateral instruments are eligible for recognition under the comprehensive approach: all the collateral instruments eligible for recognition under the simple approach; equities, including convertible bonds, which are not included in a main index but which are listed on a recognised exchange; and mutual funds which include such equities. For a collateralised transaction under the comprehensive approach, the exposure amount after risk mitigation is calculated according to the capital requirement formula 128. This exposure amount after risk mitigation is then multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralised transaction. 127 Transactions that fulfil the conditions for a zero haircut and are with core market participants receive a risk weight of 0%. If the counterparty is not a core market participant, the risk weight is 10%. Otherwise a 0% risk weight can be applied if the collateral is cash or is sovereign or PSE securities eligible for a 0% risk weight, and its market value has been discounted by 20%. Derivative transactions subject to daily MTM, collateralised with cash and with no currency mismatch will receive a 0% risk weight. Such transactions collateralised by sovereign or PSE securities qualifying for a 0% risk weight under the Standardised approach can receive a 10% risk weight. 128 The formula for the exposure amount is E* = max {0,[E x (1 + He) C x (1 Hc Hfx)]} where: E* = exposure value after risk mitigation; E = current value of the exposure; He = haircut appropriate to the exposure; C = current value of the collateral received; Hc = haircut appropriate to the collateral; and Hfx = haircut appropriate for currency mismatches between the collateral and exposure. Where the collateral is a basket of assets, the haircut on the basket will be H = i i i where a i is the weight of the asset in the basket and H i the haircut applicable to that asset. 370

The standard supervisory haircuts, assuming a daily MTM, daily remargining and a 10-day holding period, are set out in Table A6.7. Issue rating for debt securities Residual maturity Sovereigns Other issuers AAA to AA-/A-1 1 year 0.5% 1% > 1 year, 5 years 2% 4% > 5 years 4% 8% A+ to BBB-/A-2/A-3/P-3 and 1 year 1% 2% unrated bank securities > 1 year, 5 years 3% 6% > 5 years 6% 12% BB+ to BB- All 15% Main index equities, including convertible bonds, listed on a recognised exchange and Gold Other equities, including convertible bonds, listed on a recognised exchange Mutual funds 15% 25% Highest haircut applicable to any security in which the fund can invest Cash in the same currency 0% Table A6.7: Standard supervisory haircuts For transactions in which banks lend non-eligible instruments, e.g. non-investment grade corporate debt securities, the haircut must be the same as that for equity traded on a recognised exchange that is not part of a main index. Banks may also use own-estimate haircuts using their internal estimates of market price volatility. When debt securities are rated BBB-/A-3 or higher, supervisors may allow banks to calculate a volatility estimate for each category of security. In determining relevant categories, banks must take into account the type of issuer of the security, its rating, its residual maturity, and its modified duration. For debt securities rated below BBB-/A-3 or for equities eligible as collateral, the haircuts must be calculated for each individual security. No particular type of model is prescribed to calculate haircuts, as long as the model captures all material risks and complies with the parameters set out below. In calculating the haircuts, a 99 th percentile, one-tailed confidence interval must be used. The minimum holding period is dependent on the type of transaction and the frequency of the remargining or MTM. Banks may haircut numbers calculated according to shorter holding periods, scaled up to the appropriate holding period by the square root of the time formula. The minimum holding period for different transaction types is summarised in Table A6.8 below. 371

Transaction type Minimum holding period Condition Repo-style transaction Five business days Daily remargining Other capital market transactions Ten business days Daily remargining Secured lending Twenty business days Daily revaluation Table A6.8: Minimum holding periods When the frequency of remargining or revaluation is longer than the minimum holding period, the minimum haircut amount must be scaled up depending on the actual number of business days between remargining or revaluation using the square root of time formula 129. Banks must take into account the illiquidity of lower-quality assets, and the holding period must be adjusted upwards where necessary. The choice of a historical observation period for calculating haircuts must be a minimum of one year. Haircuts must be computed at least every three months. Supervisors may choose not to apply the haircuts specified in the comprehensive approach for repostyle transactions, and instead apply a zero haircut where the counterparty is a core market 129 In terms of the formula, H = H M N R + ( TM 1) T M where : H H M T M N R = haircut; = haircut under the minimum holding period; = minimum holding period for the type of transaction; and = actual number of business days between remargining for capital market transactions or revaluation for secured lending transactions. When a bank calculates the volatility on a T N day holding period which is different from the specified minimum holding period T M, the H M must be calculated using the square root of time formula: TM H M = H N where: TN T N = holding period used by the bank for deriving H N ; and H N = haircut based on the holding period T N. 372

participant 130 and provided certain conditions are satisfied 131. The effects of bilateral netting agreements 132 covering repo-style transactions will be recognised on a counterparty-by-counterparty basis if the agreements are legally enforceable upon the occurrence of an event of default, regardless whether the counterparty is insolvent. Netting across positions in the banking book and trading book will only be recognised when the netted transactions fulfil certain conditions 133. For banks using the standard supervisory haircuts or own-estimate haircuts, the exposure amount after risk mitigation and taking into account the impact of master netting agreements, is calculated 130 Core market participants may include the entities listed below. Sovereigns, central banks and PSEs. Banks and securities firms. Other financial companies, including insurance companies, eligible for a 20% risk weight in the Standardised Approach. Regulated mutual funds that are subject to capital or leverage requirements. Regulated pension funds. Recognised clearing organisations. 131 Conditions for a zero haircut. Both the exposure and the collateral are cash, a sovereign or PSE security qualifying for a 0% risk weight under the Standardised Approach. Both the exposure and the collateral are denominated in the same currency. Either the transaction is overnight or the both the exposure and the collateral are MTM daily and are subject to daily remargining. Following a counterparty s failure to remargin, the time that is required between the last mark-to-market before the failure to remargin and the liquidation of the collateral is no more than four business days. The transaction is settled across a settlement system proven for that type of transaction. The documentation covering the agreement is standard market documentation for repo-style transactions and the securities concerned. The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver a margin or otherwise defaults, then the transaction can be terminated immediately. Upon any event of default, regardless of whether the counterparty is insolvent or bankrupt, the bank has the legally enforceable right to immediately seize and liquidate the collateral for its benefit. 132 The netting agreements must: provide the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon an event of default, including in the event of an insolvency of the counterparty; provide for the netting of gains and losses on transactions terminated and closed out under it so that a single net amount is owed by one party to the other; allow for the prompt liquidation or set-off of collateral upon the event of default; and be legally enforceable upon an event of default regardless of the counterparty s insolvency. 133 The netting will only be allowed under the following conditions. All transactions are MTM daily. The collateral instruments used in the transactions are recognised as eligible financial collateral in the banking book. 373

through the capital requirement formula 134. As an alternative to the use of standard or own-estimate haircuts, banks may apply a value-at-risk (VaR) approach to repo-style transactions covered by bilateral netting agreements on a counterparty-by-counterparty basis. The VaR model approach 135 can only be used by banks that have received supervisory approval to use such an internal market risk model. The counterparty credit risk charge 136 for individual collateralised derivative transactions is calculated using the add-on from Basel I. 1.3.3 On-Balance Sheet Netting Provided it complies with certain conditions 137, a bank may use the net exposure of loans and deposits as the basis for its capital adequacy calculation in accordance with the capital requirement formula. Loans are treated as exposure, and deposits as collateral. The haircuts will be zero except when a currency mismatch exists. A 10-busines day holding period will apply when daily MTM is applied. 134 E* = max{0,[ (E) - (C)) + ( Es * Hs) + ( Efx* Hfx)]} where: E* = exposure value after risk mitigation; E = current value of the exposure; C = value of the collateral received; Es = absolute value of the net position in a given security; Hs = haircut appropriate to Es; Efx = absolute value of the net position in a currency different from the settlement currency; and Hfx = haircut appropriate for currency mismatch. 135 The calculation of the exposure is E* = max{0,[( E C) + (VaR output from internal model x multiplier)]} 136 Counterparty charge = [(RC + add-on) - C A ] x r x 8%, where: RC = replacement cost; Add-on = amount for future potential exposure calculated under Basel I; C A = volatility adjusted collateral amount under the comprehensive approach; and R = risk weight of the counterparty. 137 Netting can be applied when a bank complies with the conditions listed below. Has a well-founded legal basis for concluding that netting or offsetting agreement is enforceable regardless of whether the counterparty is insolvent. Is able at any time to determine those assets and liabilities with the same counterparty that are subject to the netting agreement. Monitors and controls its roll-of risks. Monitors and controls the relevant exposures on a net basis. 374

1.3.4 Guarantees and Credit Derivatives A guarantee or credit derivative must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures so that the extent of the cover is clearly defined and incontrovertible. Apart from non-payment by a protection buyer, the contract must be irrevocable, not capable of being unilaterally cancellable by the protection provider and unconditional. There are also additional requirements for guarantees 138 and credit derivatives 139. Only credit default swaps and total return swaps 140 that provide credit protection 141 equivalent to guarantees will be eligible for recognition. Other types 142 of credit derivatives are not recognised as eligible collateral. 138 The conditions set out below apply to guarantees. On the default or non-payment by the counterparty, the guarantor may make one lump sum payment of all monies under the documentation governing the transaction to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal action in order to pursue the counterparty for payment. The guarantee is an explicitly documented obligation assumed by the guarantor. The guarantee must cover all types of payments the underlying obligor is expected to make under the documentation governing the transaction. 139 The conditions set out below apply to credit derivatives. The credit events specified by the contracting parties must at a minimum cover failure to pay, bankruptcy, and restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees. The credit derivative must not terminate prior to expiration of any grace period required as a result of a failure to pay. Cash settlement is recognised insofar as there is a clearly specified period for obtaining post-credit event valuations of the underlying obligation. In the case of physical settlement, the protection buyer may not unreasonably withhold its ability to transfer the underlying obligation to the protection provider. The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined and must not be the sole responsibility of the protection provider. A mismatch between the underlying obligation and the reference obligation is permissible if the reference obligation ranks pari passu with or is junior to the underlying obligation, and the underlying obligation and reference obligation share the same obligor and legally enforceable cross-default or cross-acceleration clauses are in place. A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if the latter obligation ranks pari passu with or is junior to the underlying obligation, and the underlying obligation and reference obligation share the same obligor and legally enforceable cross-default or cross-acceleration clauses are in place. 140 Where a bank buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected, either through a reduction in fair value or by an addition to reserves, the credit protection will not be recognised. 141 Credit protection given by the entities listed below will be recognised. Sovereign entities, PSEs, banks and securities firms with a lower risk weight than the counterparty. Other entities rated A- or better, including in credit protection provided by parent, subsidiary or affiliate companies when they have lower risk weight than the obligor. 142 Cash funded CLNs (which fulfil the criteria for credit derivatives) issued by a bank against exposures in its banking book will be treated as cash collateralised transactions. 375

Regarding risk weights, the protected portion of the exposure is assigned the risk weight of the protection provider. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty. Materiality thresholds on payments below which no payment is made in the event of loss are equivalent to retained first-loss positions and must be deducted in full from the capital of the bank purchasing the credit protection. Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority, i.e. the bank and the guarantor share losses on a pro-rata basis, capital relief will be afforded on a proportional basis, and the protected portion of the exposure will receive the treatment applicable to eligible guarantees and credit derivatives, with the remainder being treated as unsecured. Where the bank transfers a portion of the risk of an exposure in one or more tranches to a protection seller and retains some level of risk exposure, and the risk transferred and the risk retained are of different seniority, banks may obtain credit protection for either the senior tranches, i.e. second loss portion, or the junior tranche, i.e. first-loss portion. Where credit protection is denominated in a currency different from that in which the exposure is denominated, the exposure amount deemed to be protected will be reduced by a haircut 143, H FX, based on a 10-business day holding period. If the bank uses the supervisory haircut, it will be 8%, otherwise the haircut must be scaled up using the square root of time formula. A lower risk weight may be applied to a bank s exposure to the sovereign where the bank is incorporated and where the exposure is denominated in domestic currency and funded in that currency. This treatment may also be extended to claims guaranteed by the sovereign. First-to-Default Credit Derivatives: Where a bank obtains credit protection for a basket of reference names, and the first default among the reference names triggers the credit protection, and the credit event also terminates the contract, regulatory capital relief will apply for the asset within the basket with the lowest risk-weighted amount, but only to the extent that the notional amount of the asset is less than, or equal to, the notional amount of the credit derivative. Where a bank provides credit protection through such an instrument, e.g. CLN, if the credit protection instrument has an external credit assessment from an ECAI, the risk weight is calculated in 143 G A = G x (1 -H FX ) where: G H FX = nominal amount of the credit protection; and = haircut appropriate for currency mismatch between the credit protection and underlying obligation. 376

fashion similar to that applied in securitisation tranches. If the instrument is not rated by an ECAI, the risk weights of the assets included in the basket must be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the instrument to obtain the risk-weighted asset amount. Second-to-Default Credit Derivatives: Where the second default among the reference names triggers the credit protection, the bank obtaining the credit protection will only be able to obtain capital relief if first-to-default credit protection has already been obtained or when one of the assets within the basket has already defaulted. Where a bank provides credit protection through such an instrument, the capital treatment is the same as that applied in first-to-default credit derivatives, with the exception that, in aggregating the risk weights, the asset with the lowest risk-weighted amount can be excluded from the calculation. 1.3.5 Maturity Mismatches A maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure. The effective maturity of the underlying exposure is the longest remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any grace period. For the hedge, embedded options which may reduce the term of the hedge should be taken into account so that the shortest possible effective maturity is used. Where a call is at the discretion of the protection seller, the maturity will always be at the first call date. If the call is at the discretion of the protection buying bank but the terms of the hedge at origination contain a positive incentive for the bank to call the transaction before contractual maturity, the remaining time to the first call date will be deemed the effective maturity. Hedges with maturity mismatches are only recognised if their original maturities are equal to, or longer than, one year. The maturity of hedges for exposures with original maturities of less than one year must be matched to be recognised. Hedges with maturity mismatches are not recognised if they have a residual maturity of three months or less. The hedge must be adjusted 144 when there is a 144 Pa =P x (t 0.25)/(T 0.25) where: Pa = value of credit protection adjusted for maturity mismatch; P = credit protection, e.g. collateral or guarantee amount, adjusted for any haircuts; and T = min (T, residual maturity of the credit protection arrangement) expressed in years. T = min (5, residual maturity of the exposure) expressed in years. 377

maturity mismatch with recognised credit risk mitigants such as collateral, on-balance sheet netting, guarantees and credit derivatives. 1.3.6 Pools of Credit Risk Mitigation Techniques In cases where a bank has multiple credit risk mitigation techniques covering a single exposure, e.g. a bank has both collateral and guarantee partially covering an exposure, the bank must subdivide the exposure into portions covered by each type of credit risk mitigation technique, e.g. the portion covered by collateral, the portion covered by guarantee, and the risk-weighted assets of each portion must be calculated separately. When the credit protection provided by a single protection provider has differing maturities, these maturities must be subdivided into separate protection as well. 2. THE CALCULATION OF THE CAPITAL REQUIREMENTS FOR BANKING BOOK CREDIT RISK IN TERMS OF THE INTERNAL RATINGS BASED APPROACH Banks that have received supervisory approval to use the IRB approach to credit risk may rely on their own estimates of risk components 145 in determining the capital requirement for a given exposure. In some cases, banks may be required to use a supervisory formula as opposed to internal estimates of the risk components. The IRB approach is based on measures of unexpected losses (UL) and expected losses (EL). The risk-weight functions produce requirements for the unexpected loss, UL, portion of exposures. Expected losses, EL, are treated separately within the IRB approach. Risk components serve as inputs to the risk-weight functions that have been developed for separate asset classes, e.g. there is a risk-weight function for corporate exposures and another one for qualifying revolving retail exposures, to name just two asset classes. Banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given for a given exposure. In some cases banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components. 145 PD LGD EAD M = Probability of default = Loss-given-default = Exposure at default = Effective maturity 378

2.1 Mechanics of the IRB Approach 2.1.1 Categorisation of Exposures In terms of the IRB approach, banks have to categorise their banking book exposures into broad asset classes with different risk characteristics. The asset classes comprise corporate, sovereign, bank, retail and equity. Within the corporate asset class, there are five sub-classes of specialised lending, and within retail there are three sub-classes. Within the corporate and retail asset class, a distinct treatment for purchased receivables may also be applied, provided certain conditions are met. 2.1.1.1 Definition of Corporate Exposures A corporate exposure is generally defined as a debt obligation of a corporation, partnership or proprietorship. Exposures to small and medium-sized entities (SMEs) can be distinguished separately. Five sub-classes of specialised lending are identified in terms of their legal form or economic substance and these are presented below. The exposure is typically to an entity, e.g. an SPV, which was created specifically to finance and/or operate physical assets. The borrowing entity has little or no material assets or activities and little or no independent capacity to repay its obligations, apart from the income that it receives from the assets being financed. Therefore, the primary source of repayment of the obligation is the income generated by the assets, rather than the independent capacity of the broader enterprise. The terms of the obligation give the lender a substantial degree of control over the assets and the income that it generates. The five sub-classes of specialised lending are project finance, object finance, commodities finance, income-producing real estate and high-volatility commercial real estate. Definition of Project Finance: Project finance is a method of funding in which the lender looks primarily to the revenues generated by a single project, both as a source of repayment and as security for the exposure. Project finance may take the form of financing of a new capital installation or the refinancing of an existing installation. The borrower is generally an SPV that is not permitted to 379

perform any function other than owning and operating the installation. Repayment depends primarily on the cash flow from the installation s output and the security value of the installation. Definition of Object Finance: Object finance refers to the financing of physical assets, e.g. ships, where the repayment is dependent on the cash flow generated by the specific asset that has been pledged to the lender. A primary source of the cash flows may be lease contracts with third parties. Definition of Commodities Finance: Commodities finance refers to structured short-term financing of inventories or receivables of exchange-traded commodities, e.g. crude oil, where the exposure is repaid from the sale of the commodity and the borrower has no independent capacity to repay the exposure. This would be the case where the borrower has no other activities and no other material assets on its balance sheet, and the structured nature of the financing is designed to compensate for the weak credit quality of the borrower. Definition of Income-Producing Real Estate: Income-producing real estate refers to the funding of real estate, e.g. office buildings, where the repayment and recovery of the exposure depend primarily on the cash flows generated by the asset. The cash flows would generally be lease payments or the sale of the asset. The borrower may be, but is not required to be, an SPV, or an operating company focused on real estate construction or holdings, or an operating company with sources of revenue other than real estate. The distinguishing feature of income-producing real estate, in comparison with other corporate exposures that are secured by real estate, is the strong positive correlation between the prospects for repayment and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by the property. Definition of High-Volatility Commercial Real Estate: High-volatility commercial real estate lending is the financing of commercial real estate that exhibit higher loss rate volatility, i.e. higher asset correlation, compared to other types of specialised lending and is listed below. Commercial real estate exposures secured by properties that are categorised by the national supervisor as having high default rate volatilities. Loans financing the land acquisition, development and construction of such properties. 380

Loans financing the land acquisition, development and construction of such properties where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is uncertain. Supervisors are required to make public their determination of high-volatility commercial real estate exposures in their jurisdictions. 2.1.1.2 Definition of Sovereign Exposures This asset class covers all exposures to counterparties treated as sovereigns under the standardised approach, and includes sovereigns and their central banks, MDBs and PSEs. 2.1.1.3 Definition of Bank Exposures This asset class covers all exposures to banks and claims on securities firms that are subject to supervisory and regulatory arrangements comparable to those under the Basel II framework. Bank exposures also include claims on domestic PSEs that are treated like banks under the Standardised approach and MDBs that do not meet the criteria for a 0% risk weight under the Standardised approach. 2.1.1.4 Definition of Retail Exposures An exposure is categorised as a retail exposure if it meets all of the criteria listed below. Exposures to individuals 146 are generally eligible for retail treatment regardless of exposure size, although regulators may establish exposure thresholds to distinguish between retail and corporate exposures. Residential mortgage loans are eligible for retail treatment regardless of the exposure size, as long as the credit is extended to an individual who is an owner-occupier of the property. 146 Exposures to individuals comprise revolving credits and lines of credit (including credit cards and overdrafts), and personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance). 381

Loans extended to small businesses and managed as retail exposures are eligible for retail treatment, provided the total exposure of the banking group to a small business borrower is less than 1 million. The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis. Retail exposures have to be categorised in three separate sub-classes: (a) exposures secured by residential properties; (b) qualifying revolving retail exposures 147 ; and (c) all other retail exposures. 2.1.1.5 Definition of Equity Exposures In general equity exposures are defined on the basis of their economic substance and include both direct and indirect 148 ownership interests, whether voting or non-voting, in the assets and income of a commercial enterprise or of a financial institution that is not consolidated or deducted 149 in terms of the Basel II Framework. Equity exposures must meet all the requirements shown below. The exposures are irredeemable in that the return of invested funds can be achieved only by the sale of the investment or the liquidation of the issuer. The exposures do not embody any obligations on the part of the issuer. 147 All of the criteria below must be satisfied for a sub-portfolio to be treated as a qualifying revolving retail exposure. The exposures are revolving, unsecured and uncommitted. Revolving exposures are defined as those where borrowers outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the bank. The exposures are to individuals. The maximum exposure to a single individual is 100,000 or less. Because the asset correlation assumptions for the qualifying revolving retail exposures risk-weight function are markedly below those for the other retail risk-weight function at low probability of default values, banks must demonstrate that the use of the qualifying revolving retail exposures risk-weight function is restricted to portfolios that have exhibited low volatility of loss rates relative to their average level of loss rates. The supervisor must concur that the treatment as a qualifying revolving retail exposure is consistent with the underlying risk characteristics of the sub-portfolio. 148 Indirect equity interests include holdings of derivative instruments tied to equity interests, and holdings in corporations, partnerships and limited liability companies that issue ownership interests and are engaged principally in the business of investing in equity instruments. 149 Significant minority investments in banking, securities and other financial entities where control does not exist are excluded from a banking group s capital by deduction of the equity and other regulatory investments. 382

The exposures convey residual claims on the assets or income of the issuer. The exposures are instruments with the same structures as those permitted as Tier 1 capital 150 for banking organisations. The exposures are instruments that embody obligations on the part of the issuer that meet certain conditions. 151 Debt obligations and other securities, partnerships, derivatives or other vehicles structured with the intent of conveying the economic substance of equity ownership are considered an equity holding and include liabilities from which the return is linked to that of equities. Conversely, equity holdings that are structured with the intent of conveying the economic substance of debt holdings or securitisation exposures would not be regarded as an equity holding. 2.1.1.6 Definition of Eligible Purchased Receivables Eligible purchased receivables are divided into retail and corporate receivables. Retail Receivables: Purchased retail receivables are eligible for the top-down approach as permitted within the existing standards for retail exposures, provided the purchasing bank complies with the IRB rules for retail exposures. Corporate Receivables: For purchased corporate receivables, banks are expected to assess the default risk of individual obligors consistent with the treatment of other corporate exposures. 150 Tier 1 capital is defined as shareholders equity plus disclosed reserves, and non-cumulative preferred shares. 151 The instrument must meet any of the conditions set out below. The issuer may defer indefinitely the settlement of the obligation. The obligation requires, or permits at the issuer s discretion, settlement by issuance of a fixed number of the issuer s equity shares. The obligation requires, or permits at the issuer s discretion, settlement by issuance of a variable number of the issuer s equity shares and ceteris paribus any change in the value of the obligation is attributable to, comparable to, and in the same direction, as the value of the issuer s equity shares. The holder has the option to require that the obligation be settled in equity shares, unless in the case of a traded instrument, the supervisor is content that the instrument trades more like the debt than the equity of the issuer, or in the case of a non-traded instrument, the supervisor is content that the instrument should be treated as debt. 383

However the top-down 152 approach may be used, provided that the purchasing bank s programme for corporate receivables complies with both the criteria for eligible receivables and the minimum operational requirements of this approach. The use of the top-down purchased receivables treatment is limited to situations where it would be an undue burden on a bank to be subjected to the minimum requirements for the IRB approach to corporate exposures that would otherwise apply. The topdown approach is intended primarily for receivables that are purchased for inclusion in asset-backed securitisation structures, but banks may also use this approach, with the approval of the supervisor, for on-balance sheet exposures that share the same features. The existence of full or partial recourse to the seller does not disqualify a bank from adopting the top-down approach, as long as the cash flows from the purchased receivables are the primary protection against default risk. 2.1.2 Foundation and Advanced Approaches For each of the asset classes covered under the IRB approach, there are three key elements. Risk Components: These are estimates of risk parameters provided by banks some of which are supervisory estimates. Risk Weight Functions: These are the means by which risk components are transformed into riskweighted assets and thus capital requirements. Minimum Requirements: These are the minimum standards that must be met in order for a bank to use the IRB approach for a given asset class. 152 To be eligible for the top-down treatment, purchased corporate receivables must satisfy the conditions below. The receivables are purchased from unrelated, third party sellers and the bank has not originated the receivables either directly or indirectly. The receivables must be generated on an arm s length basis between the seller and the obligor. Intercompany accounts receivable and receivables subject to contra-accounts between firms that buy and sell to each other are ineligible. Contra-accounts involve a customer buying from and selling to the same firm. The risk is that the debt may be settled through payments in kind rather than cash. This practice can defeat a security interest when challenged in court. The purchasing bank has a claim on all proceeds from the pool of receivables or a pro-rata interest in the proceeds. Claims on tranches of the proceeds, e.g. first loss position, would fall under the securitisation treatment. Supervisors must establish concentration limits above which capital charges must be calculated using the minimum requirements for the bottom-up approach for corporate exposures. Such concentration limits may refer to one or a combination of the following measures: the size of one individual exposure relative to the total pool, the size of the pool of receivables as a percentage of regulatory capital, or the maximum size of an individual exposure in the pool. 384

For many of the asset classes, the committee has made available two broad approaches. Foundation IRB Approach: Under the Foundation approach, as a general rule, banks will provide their own estimates of PD and will rely on supervisory estimates for other risk components. Advanced IRB Approach: Under the Advanced approach, banks will provide more of their own estimates of PD, LGD, EAD and their own calculation of M and will rely on supervisory estimates for other risk components, subject to meeting minimum standards. For both the Foundation and Advanced approaches, banks must always use the risk-weight functions provided in the Basel II Framework for the purpose of deriving capital requirements. This is discussed below. 2.1.2.1 Corporate, Sovereign and Bank Exposures Under the Foundation approach, banks must provide their own estimates of PD associated with each of their borrower grades, but must use supervisory estimates for LGD, EAD and M. Under the Advanced approach, banks must calculate the effective M and provide their own estimates of PD, LGD and EAD. There is an exception to this general rule for the five sub-classes of specialised lending. 153 2.1.2.2 Retail Exposures For retail exposures, banks must provide their own estimates of PD, LGD and EAD, and there is no distinction between the Foundation and Advanced approaches for this asset class. 153 With respect to specialised lending the regulations are described below. Banks that do not meet the requirements for the estimation of PD under the corporate foundation approach for their specialised lending assets are required to map their internal risk grades to five supervisory categories, each which is associated with a specific risk weight. Banks that meet the requirements for the estimation of PD are able to use the foundation approach to corporate exposures to derive risk weights for all classes of specialised lending except high-volatility commercial real estate. Banks that meet the requirements for the estimation of PD, LGD and EAD are able to use the advanced approach to corporate exposures to derive risk weights for all classes of specialised lending except high-volatility commercial real estate. 385

2.1.2.3 Equity Exposures There are two broad approaches when calculating risk-weighted assets for equity exposures not held in the trading book: a market-based approach and a PD/LGD approach. 2.1.2.4 Purchased Receivables For eligible corporate receivables, both the Foundation and Advanced approaches are available subject to certain operational requirements being met. For eligible retail receivables, there is no distinction between the Foundation and Advanced approaches. Once a bank adopts an IRB approach, it is expected to extend it across the entire banking group. Some exposures in non-significant business units as well as asset classes that are immaterial in terms of size and risk profile may be exempted, subject to supervisory approval. Capital requirements for such exposures will be determined according to the Standardised approach. Notwithstanding the above, once a bank has adopted the IRB approach for all or part of its corporate, bank, sovereign or retail asset classes, it will be required to adopt an IRB approach for its equity exposures. Supervisors may require a bank to employ one of the IRB equity approaches if its equity exposures form a significant part of the bank s business, even though the bank may not employ an IRB approach in its other asset classes. Furthermore, once a bank has adopted any IRB approach for corporate exposures, it will be required to adopt the IRB approach for the specialised lending sub-classes within the corporate exposure class. Banks adopting an IRB approach are expected to continue employing an IRB approach. 2.2 Rules for Corporate, Sovereign and Bank Exposures 2.2.1 Risk-Weighted Assets for Corporate, Sovereign and Bank Exposures For exposures not in default, the formula for calculating risk-weighted assets is: 386

Risk-weighted assets (RWA) = K 154 x 12.5 x EAD. The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD and the bank s best estimate of expected loss. 2.2.1.2 Firm-Size Adjustment for SMEs Banks will be permitted to distinguish exposures separately to SME borrowers, defined as corporate exposures where the reported sales for the consolidated group of which the firm is part is less than 50 million, and use a firm-size adjustment. 155 2.2.1.3 Risk Weights for Specialised Lending Banks that do not meet the requirements for the estimation of PD under the corporate IRB approach will be required to map their internal grades to five supervisory categories, each of which is associated with a specific risk weight. The risk weights for unexpected losses associated with each supervisory category are set out in Table A6.9. Strong Good Satisfactory Weak Default 70% 90% 115% 250% 0% Table A6.9: Risk weight categories for specialised lending Each supervisory category broadly corresponds to a range of external credit assessments as shown below. Strong Good Satisfactory Weak Default BBB- or better BB+ or BB BB- or B+ B to C- N/A Table A6.10: Mapping supervisory categories to external ratings 154 The capital requirement (K): = [LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD] x (1 1.5 x b)^-1 x (1 +(M -2.5) x b) where correlation (R) = 0.12 x (1 EXP(-50 x PD))/(1 EXP(-50)) + 0.24 x [1 (1 EXP(-50 x PD))/(1 EXP(-50))] with maturity adjustment (b) = (0.11852 0.05478 x ln(pd))^2. N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with a mean of zero and variance of one is less than or equal to x). G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N(x) = z). The normal cumulative distribution function and the inverse of the normal cumulative distribution function are available in Excel as the functions NORMDIST and NORMSINV. Ln denotes the natural logarithm. 155 The firm-size adjustment (0.04 x (1 (S 5)/45)) is made to the corporate risk weight formula for exposures to SME borrowers. S is expressed as total annual sales in millions of Euros with values of S falling in the range of equal to or less than 50 million or greater than or equal to 5 million. Reported sales of less than 5 million will be treated as if they were equivalent to 5 million for the purpose of the firm-size adjustment for SME borrowers. Correlation (R) adjusted: = 0.12 x (1 EXP(-50 x PD))/(1 EXP(-50)) + 0.24 x [1 (1 EXP(-50 x PD))/(1 EXP(-50))]-(0.04 x (1 (S 5)/45)) 387

Banks that meet the requirements for the estimation of PD will be able to use the Foundation IRB approach for the corporate asset class to derive risk weights for specialised lending sub-classes. Banks that meet the requirements for the estimation of PD and LGD and/or EAD will be able to use the Advanced IRB approach for the corporate asset class to derive risk weights for specialised lending sub-classes. 2.2.1.4 Risk Weights for High-Volatility Commercial Real Estate Banks that do not meet the requirements for estimation of PD must map their internal grades to five supervisory categories, each of which is associated with a specific risk weight. Strong Good Satisfactory Weak Default 95% 120% 140% 250% 0% Table A6.11: Supervisory categories for high-volatility commercial real estate Banks that meet the requirements for the estimation of PD will use the same formula for the derivation of risk weights that is used for other specialised lending exposures, but with a different correlation formula. 156 Banks that do not meet the requirements for the estimation of LGD and EAD for high-volatility commercial real estate exposures must use the supervisory parameters for LGD and EAD for corporate exposures. 2.2.2 Risk Components for Corporate, Sovereign and Bank Exposures 2.2.2.1 Probability of Default (PD) For corporate and bank exposures, the PD is the greater of the one-year PD associated with the internal borrower grade to which that exposure is assigned, or 0.03%. For sovereign exposures, the PD is the one-year PD associated with the internal borrower grade to which that exposure is assigned. The PD of the borrowers assigned to a default grade, consistent with the reference definition of default, is 100%. 156 (R) = 0.12 x (1 EXP(-50 x PD))/(1 EXP(-50)) + 0.30 x [1 (1 EXP(-50 x PD))/(1 EXP(-50))] 388

2.2.2.2 Loss Given Default (LGD) LGD under Foundation IRB Under Foundation IRB, senior claims on corporates, sovereigns and banks not secured by recognised collateral are assigned a 45% LGD. All subordinated claims on corporates, sovereigns and banks not secured by recognised collateral are assigned a 75% LGD. In addition to the eligible financial collateral recognised in the Standardised approach, some other forms of collateral known as eligible IRB collateral are also recognised. These include: receivables 157 ; specified commercial and residential real estate 158 ; and 157 Eligible financial receivables are claims with an original maturity of less than, or equal to, one year where repayment will occur through the commercial or financial flows related to the underlying assets of the borrower. This includes both self-liquidating debt arising from the sale of goods or services linked to a commercial transaction and general amounts owed by debtors. Eligible receivables do not include those associated with securitisations, sub-participations or credit derivatives. Financial receivables will only be eligible for recognition as collateral for corporate claims if both of the following operational requirements are met. The legal mechanism by which collateral is given must be robust and ensure that the lender has clear rights over the proceeds from the collateral. There should be a framework that allows the lender to have a perfected first priority claim over the collateral. All documentation used in collateralised transactions must be binding on all parties and legally enforceable. The collateral arrangements must be properly documented with a clear and robust procedure for the timely collection of collateral proceeds. The bank must have a sound process for determining the credit risk of the receivables and maintain a continuous monitoring process that is appropriate for the specific exposures. The receivables pledged by the borrower should be diversified and not be unduly correlated with the borrower. 158 Eligible commercial and retail real estate collateral for corporate, sovereign and bank exposures are defined as shown below. Collateral where the risk of the borrower is not materially dependent upon the performance of the underlying property or project, but rather on the underlying capacity of the borrower to repay the debt from other sources. As such, repayment of the facility is not materially dependent on any cash flow generated by the underlying commercial or residential real estate serving as collateral. Additionally, the value of the collateral pledged must not be materially dependent on the performance of the borrower (excluding situations where purely macro-economic factors affect both the value of the collateral and the performance of the borrower). Income producing real estate that falls under the SL asset class is specifically excluded from recognition as collateral for corporate exposures. Commercial and retail real estate will only be eligible for recognition as collateral for corporate claims if all of the operational requirements listed below are met. Legal enforceability: any claim on collateral taken must be legally enforceable. Objective market value: the collateral must be valued at or less than the current fair value under which the property could be sold under private contract between a willing seller and an arm s-length buyer on the date of valuation. Frequent valuation: the bank is expected to value the collateral on a frequent basis and at a minimum once every year. 389

other collateral 159 that meet certain minimum requirements. The methodology for the recognition of eligible financial collateral closely follows that outlined in the comprehensive approach to collateral in the Standardised approach. The simple approach to collateral in the Standardised approach will not be available to banks applying the IRB approach. Following the comprehensive approach, the effective loss given default, LGD*, is expressed as a formula 160. Where repo-style transactions are subject to a master netting agreement, a bank may choose not to recognise the netting effects in calculating capital. Banks that want to recognise the effect of master netting agreements on such transactions must satisfy the applicable criteria of the Standardised approach. As in the Standardised approach, for transactions where the conditions for a zero haircut are met and the counterparty is a core market participant, supervisors may choose not to apply the haircuts specified under the comprehensive approach, but instead apply a zero haircut. The methodology for determining the effective LGD under Foundation IRB for cases where banks have taken eligible IRB collateral to secure a corporate exposure is explained below. Exposures where the minimum eligibility criteria are met, but the ratio of the current value of the collateral received (C) to the current value of the exposure (E) is below a threshold level of C* (i.e. the required minimum collateralisation level for the exposure), will receive the appropriate LGD for unsecured exposures or those secured by collateral which is not eligible IRB collateral. Documentation: the types of commercial and retail real estate collateral accepted by the bank and lending policies when this type of collateral is taken must be clearly documented. Insurance: the property taken as collateral must be adequately insured against damage or deterioration. Permissible prior claims: the bank must monitor on an ongoing basis the extent of any permissible prior claims, e.g. tax, on the property. Environmental liability: the bank must appropriately monitor the risk of environmental liability arising in respect of the collateral, such as the presence of toxic material on a property. 159 Supervisors may allow certain other physical collateral for which liquid markets for the disposal of collateral exist. 160 LGD* = LGD x (E*/E) where: LGD is that of the senior unsecured exposure before recognition of collateral (45%); E is the current value of the exposure, i.e. cash lent or securities lent; and E* is the exposure value after risk mitigation as determined in the Standardised approach. This concept is only used to calculate LGD*. Banks must continue to calculate EAD without taking into account the presence of any collateral, unless otherwise specified. Banks that qualify for the Foundation IRB approach may calculate E* using any of the ways specified under the comprehensive approach for collateralised transactions under the Standardised approach. 390

Exposures 161 where the ratio of C to E exceeds a second, higher threshold level of C** (i.e. the required level of over-collateralisation for full LGD recognition), will be assigned an LGD according to table A6.12: Minimum LGD Required minimum collateralisation level of the exposure (C*) Eligible financial collateral 0% 0% N/A Receivables 35% 0% 125% Commercial and residential real 35% 30% 140% estate Other collateral 40% 30% 140% Table A6.12: Determining effective LGD Required level of overcollateralisation for full LGD recognition (C**) The methodology for determining the effective LGD of a transaction under Foundation IRB, for cases where banks have taken both financial collateral and other eligible IRB collateral, is aligned to the treatment under the Standardised approach, as described below. In cases where a bank has obtained multiple forms of credit risk mitigation, it will be required to subdivide the adjusted value of the exposure (after the haircut for eligible financial collateral) into portions each covered by only one credit risk mitigation type, e.g. the portion covered by eligible financial collateral, the portion covered by receivables, the portion covered by commercial and residential real estate, the portion covered by other collateral, and the unsecured portion. Where the ratio of the sum of the value of commercial and residential real estate and other collateral to the reduced exposure, after recognising the effect of eligible financial collateral and receivables collateral, is below the associated threshold level (i.e. the minimum degree of collateralisation of the exposure), the exposure will receive the unsecured LGD value of 45%. The risk-weighted assets for each fully secured portion of exposure must be calculated separately. 161 With respect to exposures: Senior exposures are to be divided into fully collateralised and uncollateralized portions. The part of the exposure considered to be fully collateralised, C/C**, receives the LGD associated with the type of collateral. The remaining part of the exposure is regarded as unsecured and receives an LGD of 45%. 391

LGD under Advanced IRB Subject to certain minimum requirements 162, supervisors may permit banks to use their own internal estimates of LGD for corporate, sovereign and bank exposures. LGD must be measured as the loss given default as a percentage of the EAD. Banks that want to recognise the effect of master netting agreements on repo-style transactions in calculating capital must satisfy the applicable criteria of the Standardised approach. To determine the exposure value after risk mitigation, E*, for use as the EAD, banks must apply the methodology used in the Standardised approach. Banks may use their own estimates of LGD. In the use of credit risk mitigation techniques under the Advanced IRB, banks may use their internal estimates of LGD. However, the use of such credit risk mitigation techniques must not reflect the effect of double default, meaning that the adjusted risk weight will not be less than that of a comparable direct exposure to the protection provider. Consistent with the Standardised approach, banks may choose not to recognise credit protection, if doing so would result in a higher capital requirement. In terms of the Advanced IRB, banks may reflect the risk-mitigating effects of guarantees and credit derivatives through their own estimates of PD and LGD, as long as the adjusted risk weight is not less than that of comparable direct exposures to the protection provider. 2.2.2.3 Exposure at Default The EAD on drawn amounts should not be less than the sum of (1) the amount by which a bank s regulatory capital would be reduced if the exposure were written-off fully; and (2) any specific provisions and partial write-offs. When the difference between the instrument s EAD and the sum of (1) and (2) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of discounts. On-balance sheet netting of loans and deposits will be recognised subject to the same conditions as under the Standardised approach. The treatment for currency or maturity mismatches also follows the Standardised approach. 162 A bank must estimate an LGD for each facility that reflects the economic downturn conditions where necessary to capture the relevant risks. This LGD cannot be less than the long-run default-weighted average loss rate given default calculated based on the average economic loss of all observed defaults within the data source for that type of facility 392

For off-balance sheet items, exposure is calculated as the committed but undrawn amount multiplied by a CCF. There are two approaches for the estimation of CCFs as described below. EAD under Foundation IRB The types of instruments and CCFs applied to them are the same as those in the Standardised approach, with the exception of commitments, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs), to which a CCF of 75% will be applied regardless of the maturity of the underlying facility. A 0% CCF will be applied to facilities that are uncommitted, unconditionally cancellable, or that effectively provide for automatic cancellation, e.g. due to deterioration in a borrower s creditworthiness, at any time by the bank without prior notice. The amount to which the CCF is applied is the lower of the value of the unused committed credit line and the value that reflects any possible constraining availability of the facility, such as the existence of a ceiling on the potential lending amount which is related to a borrower s reported cash flow. In order to apply a 0% CCF for unconditionally and immediately cancellable corporate overdrafts and other facilities, banks must demonstrate that they actively monitor the financial condition of the borrower. EAD under Advanced IRB Banks which meet the minimum requirements for the use of their own estimates of EAD will be allowed to use their own internal estimates of CCFs across different product types, provided the exposure is not subject to a CCF of 100% as in the Foundation IRB above. Exposure measurement for currency, interest rate, equity, credit and commodity-related derivatives will be calculated according to the rules for the calculation of credit equivalent amounts, i.e. based on the replacement cost plus potential future exposure add-ons across the different product types and maturity bands. 2.2.2.4 Effective Maturity For banks using Foundation IRB, effective maturity (M) will be 2.5 years, except for repo-style transactions where the effective maturity will be six months. Banks using any element of the Advanced IRB approach must measure effective maturity for each facility as the greater of one year and the remaining maturity in years as defined according to a 393

formula. 163 In all cases, M must not be greater than five years. If a bank is not able to calculate the effective maturity of the contracted payments through the formula, it may use a more conservative measure of M such that M equals the maximum remaining time in years that the borrower is permitted to take to discharge its contractual obligation fully under the terms of the loan agreement. Where there is no explicit adjustment, the effective maturity M assigned to all exposures is set at 2.5 years. The treatment of maturity mismatches is identical to that used in the Standardised approach. The one-year floor does not apply to short-term exposures with an original maturity of one year. In such cases, the maturity would be calculated as the greater of one day and the effective maturity M as consistent with the defined formula. For derivatives subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the explicit maturity adjustment. The notional amount of each transaction should be used for weighting the maturity. For repo-style transactions subject to master netting agreements, the weighted average maturity of the transactions, using the notional amount of each transaction, should be used when applying the explicit maturity adjustment. A five-day floor applies to the average. 2.3 Rules for Retail Exposures 2.3.1 Risk-Weighted Assets for Retail Exposures There are three separate risk-weight functions for retail exposures that are based on separate assessments of PD and LGD as inputs to the risk-weight functions. None of the three retail riskweight functions contains an explicit maturity adjustment. Specified formulas are used to assign risk weights as listed below. Residential mortgage exposures 164. 163 For an instrument subject to a determined cash flow schedule, the effective maturity is defined as: Effective Maturity (M) = t t t *CF CF t t where CF t denotes the cash flows payable by the borrower in period t. 164 Residential mortgages risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K) = LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD. Correlation (R) = 0.15 394

Qualifying revolving retail exposures 165. Other retail exposures 166 that are not in default. The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD and the bank s best estimate of expected loss. 2.3.2 Risk Components for Retail Exposures 2.3.2.1 Probability of Default and Loss Given Default Banks must provide an estimate of the PD and LGD for each pool of retail exposures. The PD for retail exposures is the greater of the one-year PD associated with the internal borrower grade to which the pool of retail exposures is assigned or 0.03%. 2.3.2.2 Recognition of Guarantees and Credit Derivatives Banks may reflect the risk-reducing effects of guarantees and credit derivatives through an adjustment of either the PD or LGD estimate. The effect of double default must be excluded, i.e. the adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. Consistent with the Standardised approach, banks may choose not to recognise credit protection if doing so would result in a higher capital requirement. 2.3.2.3 Exposure at Default Both on and off-balance sheet retail exposures are measured gross of specific provisions or partial write-offs. The EAD on drawn amounts should not be less than the sum of (1) the amount by which a bank s regulatory capital would be reduced if the exposure were written-off fully; and (2) any specific provisions and partial write-offs. When the difference between the instrument s EAD and 165 Qualifying revolving retail risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K) = LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD. Correlation (R) = 0.04 166 Other retail risk-weighted assets = K x 12.5 x EAD where: Capital requirement (K) = LGD x N[(1 R)^-0.5 x G(PD) + (R/(1 R))^0.5 x G(0.999)] PD x LGD. Correlation (R) = 0.03 x (1 EXP(-35 x PD))/(1 EXP(-35)) + 0.16 x [1 (1 EXP(-35 x PD))/(1 EXP(-35))] 395

the sum of (1) and (2) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of discounts. On-balance sheet netting of loans and deposits will be recognised, subject to the same conditions as under the Standardised approach. To the extent that foreign exchange and interest rate commitments exist within a bank s retail portfolio, banks are not permitted to use their internal assessments of credit equivalents amounts and must apply the rules of the Standardised approach. 2.4 Rules for Equity Exposures 2.4.1 Risk-Weighted Assets for Equity Exposures Risk weights for equity exposures 167 in the banking book can be calculated by means of two approaches: a market-based approach and a PD/LGD approach. Supervisors will decide which approach a bank may use. 2.4.1.1 Market-Based Approach Under the market-based, approach institutions can calculate the minimum capital requirements for their banking book equity holdings using two methods: the simple risk weight model or an internal model method. The method chosen must be consistent with the complexity of the bank s equity holdings. Simple Risk Weight Method: Under the simple risk weight method, a 300% risk weight is applied to equity holdings that are publicly traded and a 400% risk weight to all other equity holdings 168. Short cash positions and derivative instruments held in the banking book can offset long positions in the same individual security provided that these instruments have been explicitly designated as hedges of specific equity holdings and that they have remaining maturities of at least one year. Other short positions are treated as if they are long positions with the relevant risk weight applied to the absolute value of each position. With respect to maturity mismatched positions, the methodology used for corporate exposures must be applied. Internal Models Method: IRB banks may use internal risk measurement models to calculate their riskbased capital requirements for equity holdings. Banks must hold capital equal to the potential loss on 167 Risk-weighted assets for equity exposures in the trading book are subject to market risk capital rules. 168 A publicly traded equity holding is defined as any equity security traded on a recognised security exchange. 396

their equity holdings, calculated through internal VaR models subject to the 99 th percentile, one-tailed confidence interval of the difference between quarterly returns and an appropriate risk-free rate, computed over a long-term sample period. The capital so calculated is then multiplied by 12.5 (the inverse of the 8% risk-based capital requirement) to derive the amount of risk-weighted equity assets. Capital charges under the internal models method may be not be less than the capital that would be calculated under the simple risk weight method using a 200% risk weight for publicly traded equity holdings and a 300% risk weight for other equity holdings. These minimum capital charges must be calculated separately using the simple risk weight methodology, and the minimum risk weights applied at the individual exposure level, rather than at the portfolio level. 2.4.1.2 PD/LGD Approach The minimum requirements and methodology for the PD/LGD approach to equity exposures are the same as those for the IRB Foundation approach for corporate exposures, subject to the specifications set out below. The bank s estimate of the PD of a corporate in which it holds an equity position must satisfy the same requirements as the bank s estimate of the PD of a corporate entity where the bank holds debt. If a bank does not hold debt of the corporate in whose equity it has invested, a 1.5 scaling factor must be applied to the risk weights derived from the corporate risk-weight function, given the PD set by the bank. An LGD of 90% must be used in deriving the risk weight for equity exposures. The risk weight is subject to a five-year maturity adjustment. A minimum risk weight of 100% applies to the following equities as long as the portfolio is managed in the manner outlined below. Public equities where the investment is part of a long-term customer relationship and no capital gain is expected to be realised in the short term. Private equities where the returns on the investment are based on regular and periodic cash flows not derived from capital gains, and there is no expectation of future capital gain or realising any existing gain. 397

For all other equity positions, capital charges may not be less than the capital that would be calculated under the simple risk weight method using a 200% risk weight for publicly traded equity holdings and a 300% risk weight for all other equity holdings. When the sum of the UL and EL associated with the equity exposure results in less capital than would be required from application of one of the minimum risk weights, the minimum risk weights must be used, i.e. the minimum risk weights must be applied if the risk weights calculated above, plus the EL associated with the equity exposure multiplied by 12.5, are smaller than the minimum risk weights. The maximum risk weights for the PD/LGD approach to equity exposures is 1250%, i.e. the maximum risk weights can be applied if the risk weights calculated above plus the EL associated with the equity exposure multiplied by 12.5 exceed the 1250% risk weights. Hedging for PD/LGD equity exposures is, as for corporate exposures, subject to an LGD of 90% on the exposure to the provider of the hedge. Equity positions will be treated as having a five-year maturity. 2.4.1.3 Exclusions to the Market-Based and PD/LGD Approaches Equity holdings in entities whose debt obligations qualify for a zero risk weight under the Standardised approach can be excluded at the discretion of the supervisor. Equity holdings made under legislative programmes that provide significant subsidies for the investment to the bank and involve some form of government oversight on the equity investment may be excluded. Equity holdings may be excluded from the IRB treatment based on materiality. Equity exposures are considered material if their aggregate value, excluding exposures in terms of legislative programmes, exceeded on average over the prior year, 10% of the bank s Tier 1 plus Tier 2 capital. This materiality threshold is is lowered to 5% of a bank s Tier 1 plus Tier 2 capital, if the equity portfolio consists of fewer than 10 individual holdings. 398

2.4.2 Risk Components for Equity Exposures In general, an equity exposure is based on the fair value presented in the financial statements of the entity in which the bank has invested. 2.5 Rules for Purchased Receivables 2.5.1 Risk-Weighted Assets for Purchased Receivables For purchased receivables there are IRB capital charges for both default risk and dilution risk. 2.5.1.1 Risk-Weighted Assets for Default Risk For receivables belonging unambiguously to one asset class, the IRB risk weight for default risk is based on the risk-weight function applicable to that particular exposure type. For hybrid pools containing mixtures of exposure types, the highest capital charge will apply if the bank cannot separate the exposure by type. Purchased Retail Receivables: For purchased retail receivables, a bank must meet the risk quantification standards for retail exposures but can utilise eternal and internal reference data to estimate the PDs and LGDs. Such calculation of PDs and LGDs must be calculated on a stand-alone basis that is without regard to any recourse or guarantees from the seller or other parties. Purchased Corporate Receivables: For purchased corporate receivables, the purchasing bank must apply the existing IRB risk quantification standards for the bottom-up approach. However, subject to supervisory approval, a bank may apply a top-down procedure in the instances set out below. The purchasing bank must estimate on a stand-alone basis the pool s EL, expressed as a percentage of the exposure amount, i.e. the total EAD amount owed to the bank by all obligors in the receivables pool. Given the EL estimate for the pool, the risk weight for default risk is determined by the risk weight function for corporate exposures. The precise calculation of risk weights for default risk depends on the bank s ability to decompose EL into its PD and LGD components in a reliable manner. Banks can use external and internal data to estimate PDs and LGDs. 399

Foundation IRB Treatment: If the purchasing bank is unable to decompose EL into its PD and LGD components, the risk weight is determined from the corporate risk-weight function using the following specifications; if the exposures are exclusively senior claims to corporate borrowers, an LGD of 45% can be used. The PD is then EL divided by the 45% LGD. EAD is calculated as the outstanding amount, minus the capital charge for dilution prior to credit risk mitigation (K Dilution ). For non-senior claims, the LGD will be 100%. For a revolving purchase facility the EAD is the sum of the current amount of receivables purchased, plus 75% of any undrawn purchase commitments minus K Dilution. If the purchasing bank is able to estimate the PD in a reliable manner, the risk weight for the purchased receivables is determined from the corporate risk weight function according to the specifications for LGD, M and the treatment of guarantees under the Foundation approach. Advanced IRB Treatment: A bank may use an appropriate PD estimate to infer the long-run defaultweighted average LGD, or use a long-run default-weighted average LGD to infer the appropriate PD. In either case, the LGD used cannot be less than the long-run default-weighted average LGD. The risk weight for the purchased receivables is determined by using the bank s estimated PD and LGD as inputs to the corporate risk-weight function. EAD is calculated as the outstanding amount minus the capital charge for dilution prior to credit risk mitigation (K Dilution ) and EAD will be the sum of the current amount of receivables purchased plus 75% of any undrawn purchase commitments minus K Dilution. For drawn amounts, M will be equal to the pool s exposure-weighted average effective maturity and this value of M will also be used for undrawn amounts under a committed purchase facility, provided that the facility contains effective covenants, early amortisation triggers or other features that protect the purchasing bank against a significant deterioration in the quality of the future receivables. In the absence of such protections, the M for undrawn amounts will be calculated as the sum of the longest-dated potential receivable under the purchase agreement and the remaining maturity of the purchase facility. 2.5.1.2 Risk-Weighted Assets for Dilution Risk For both corporate and retail receivables, the treatment of dilution 169 risk is as follows: at the level of either the pool as a whole (top-down approach), or the individual receivables making up the pool (bottom-up approach), the purchasing bank must estimate the one-year EL for dilution risk, expressed as a percentage of the receivables amount. Banks can use external and internal data to 169 Dilution refers to the possibility that the receivable amount is reduced through cash or non-cash credit to the receivable s obligor. 400

estimate stand-alone EL. To calculate the risk weights for dilution risk, the PD must be set equal to the estimated EL and the LGD set at 100%. If the bank can demonstrate that the dilution risk is appropriately monitored, an M of one year may be allowed. 2.5.2 Recognition of Credit Risk Mitigants Guarantees provided by sellers or third parties are treated using the IRB rules for guarantees, regardless of whether the guarantee covers default or dilution risk. If the guarantee covers both the pool s default and dilution risk, the bank must substitute the risk weight for an exposure to the guarantor in place of the pool s total risk weight for default and dilution risk. If the guarantee covers only default or dilution risk, but not both, the bank must substitute the risk weight for an exposure to the guarantor in place of the pool s risk weight for the corresponding default or dilution risk. The capital requirement for the other component will then be added. If the guarantee covers only a portion of default or dilution risk, the uncovered portion must be treated according to the credit risk mitigation rules for proportional or tranched coverage, i.e. the risk weights of the uncovered risk components will be added to the risk weights of the covered risk components. 2.6 Treatment of Expected Loss and Recognition of Provisions 2.6.1 Calculation of Expected Losses A bank must sum the EL amount (defined as EL multiplied by the EAD) associated with its exposures (excluding the EL amount associated with equity exposures under the PD/LGD approach and securitisation exposures) to obtain a total EL amount. Expected Loss for Exposures other than Specialised Lending subject to the Supervisory Slotting Criteria: Banks must calculate an EL as PD x LGD for corporate, sovereign, bank and retail exposures that are not in default. For corporate, sovereign, bank and retail exposures that are in default, banks must use their 401

best estimate of EL. For equity exposures subject to the PD/LGD approach, the EL is calculated as PD x LGD. Expected Loss for Specialised Lending Exposures subject to the Supervisory Slotting Criteria: The EL amount is determined by multiplying 8% by the risk-weighted assets produced from the appropriate risk weights, as specified below, multiplied by the EAD. Supervisory Categories and EL Risk Weights for Other Specialised Lending Exposures Strong Good Satisfactory Weak Default 5% 10% 35% 100% 625% Table A6.13: Supervisory risk weights for specialised lending Supervisory Categories and EL Risk Weights for High-Volatility Commercial Real Estate Strong Good Satisfactory Weak Default 5% 5% 35% 100% 625% Table A6.14: Supervisory risk weights for high-volatility commercial real estate 2.6.2 Calculation of Provisions Exposures subject to the IRB Approach: Total eligible provisions are defined as the sum of all provisions 170 that are attributed to exposures treated under the IRB approach. Specific provisions set aside against equity and securitisation exposures must not be included in total eligible provisions. Portion of Exposures subject to the Standardised Approach: Banks using the Standardised approach for a portion of their credit exposures, either on a transitional basis or on a permanent basis if the exposures subject to the Standardised approach are immaterial, must attribute total general provisions on a pro rata basis according to the proportion of credit risk-weighted assets subject to the Standardised and IRB approaches. 2.6.3 Treatment of EL and Provisions Banks using the IRB approach must compare the total amount of eligible provisions with the total EL amount as calculated within the IRB approach. Where the total EL amount exceeds total eligible provisions, the bank must deduct the difference on the basis of 50% from Tier 1 capital and 50% from Tier 2 capital. When the calculated EL amount is lower than the total eligible provisions of the 170 This is the total of specific provisions, partial write-offs, portfolio-specific provisions or general provisions and may include any discounts on defaulted assets. 402

bank, its supervisors may allow the difference to be included in Tier 2 capital up to a maximum of 0.6% of credit risk-weighted assets. If specific provisions exceed the EL amount on defaulted assets, the difference may be allowed to offset the EL amount on non-defaulted assets. The EL amount for equity exposures under the PD/LGD approach is deducted 50% from Tier 1 and 50% from Tier 2 capital. Provisions or write-offs for equity exposures under the PD/LGD approach will not be used in the EL-provisioning calculation. 3. THE CALCULATION OF THE CAPITAL REQUIREMENTS FOR SECURITISATION EXPOSURES 3.1 Definitions and General Terminology Originating Bank: A bank is considered to be an originator with regard to a securitisation transaction if it meets either of the following conditions: the bank originates directly or indirectly the underlying exposures included in the securitisation transaction; or the bank serves as a sponsor of an ABCP programme or similar programme that acquires exposures from third-party entities. In the context of such programmes, a bank would generally be considered a sponsor if it, in fact or substance, manages or advises the programme, places securities in the market, or provides liquidity and/or credit enhancement facilities. Asset-Backed Commercial Paper (ABCP) Programme: An ABCP programme predominantly issues commercial paper with an original maturity of one year or less, which is backed by assets or other exposures held in a bankruptcy-remote SPV. Clean-Up Call: A clean-up call is an option that permits the asset-backed securities to be called before all of the underlying exposures have been repaid. In the case of traditional securitisations, this is generally accomplished by repurchasing the remaining securitisation exposures once the pool balance or outstanding securities have fallen below some specified level. In the case of synthetic securitisations, the clean-up call may take the form whereby the credit protection is extinguished. 403

Credit Enhancement: A credit enhancement is a contractual arrangement in which the bank retains or assumes a securitisation exposure and, in substance, provides some degree of added protection to other parties to the transaction. Credit-Enhancing Interest-Only (IO) Strip: A credit-enhancing IO is an on-balance sheet asset that (a) represents a valuation of cash flows related to future margin income and (b) is subordinated. Early Amortisation: Early amortisation provisions are mechanisms that, once triggered, allow investors to be paid out prior to the originally stated maturity of the securities issued. An early amortisation can be controlled or non-controlled. A controlled early amortisation must meet all of the conditions set out below. The bank must have an appropriate capital/liquidity plan in place to ensure that it has sufficient capital and liquidity available in the event of an early amortisation. Throughout the duration of the transaction, including the amortisation period, there must be the same pro rata sharing of interest, principal, expenses, losses and recoveries based on the bank s and investors relative shares of the receivables outstanding at the beginning of each month. The bank must set a period for amortisation that would be sufficient for at least 90% of the total debt outstanding at the beginning of the early amortisation period to have been repaid or recognised as in default. The pace of repayment should not be any more rapid than would be allowed by straight-line amortisation over the period set out above. A non-controlled early amortisation is an amortisation provision that does not meet the requirements for a controlled early amortisation. Excess Spread: Excess spread is generally defined as gross finance charge collections and other income received by the trust or SPV minus certificate interest, servicing fees, charge-offs and other senior trust or SPV expenses. Implicit Support: Implicit support arises when a bank provides support to a securitisation in excess of its predetermined contractual obligation. 404

Special Purpose Entity or Vehicle (SPE or SPV): An SPV is a corporation, trust or other entity organised for a specific purpose, the activities of which are limited to those appropriate to accomplish the purpose of the SPV, and the structure of which is intended to isolate the SPV from the credit risk of an originator or seller of exposures. 3.2 Operational requirements for the recognition of risk transference The following operational requirements are applicable to both the standardised and IRB approaches of the securitisation framework. 3.2.1 Operational Requirements for Traditional Securitisations An originating bank may exclude securitised exposures from the calculation of risk-weighted assets only if all of the conditions listed below have been met. Significant credit risk associated with the securitised exposures has been transferred to third parties. The transferor does not maintain effective or indirect control 171 over the transferred exposures. The assets must be legally isolated from the transferor in such a way that the exposures are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership. These conditions must be supported by an opinion provided by a qualified legal counsel. The securities issued are not obligations of the transferor. Thus, investors who purchase the securities only have claim to the underlying pool of exposures. The transferee must be an SPV and the holders of the beneficial interests in that entity have the right to pledge or exchange them without restriction. Clean-up calls must satisfy the conditions pertaining to clean-up calls. 171 The transferor is deemed to have maintained effective control over the transferred credit risk exposures if it: is able to purchase from the transferee the previously transferred exposures in order to realise their benefits; or is obligated to retain the risk of the transferred exposures (the transferor s retention of servicing rights to the exposures will not necessarily constitute indirect control of the exposures). 405

The securitisation does not contain clauses that: require the originating bank to alter systematically the underlying exposures such that the pool s weighted average credit quality is improved unless this is achieved by selling assets to independent and unaffiliated third parties at market prices; allow for increases in a retained first-loss position or credit enhancement provided by the originating bank after the transaction s inception; and increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to deterioration in the credit quality of the underlying pool. Banks meeting these conditions must still hold regulatory capital against any securitisation exposures they retain. 3.2.2 Operational Requirements for Synthetic Securitisations For synthetic securitisations, the use of credit risk mitigation techniques, i.e. collateral, guarantees and credit derivatives for hedging the underlying exposures may be recognised only if the conditions below are satisfied. Credit risk mitigants must comply with the requirements for credit risk mitigants under the Standardised approach. Eligible collateral is limited to collateral as specified under the Standardised approach. Eligible collateral pledged by SPVs may be recognised. Eligible guarantors are as defined under the Standardised approach. Banks may not recognise SPVs as eligible guarantors in the securitisation framework. Banks must transfer significant credit risk associated with the underlying exposure to third parties. 406

The instruments used to transfer credit risk may not contain terms or conditions that limit the amount of credit risk transferred, such as: clauses that materially limit the credit protection or credit risk transference, e.g. significant materiality thresholds below which credit protection is deemed not to be triggered, even if a credit event occurs or those clauses that allow for the termination of the protection due to deterioration in the credit quality of the underlying exposures; clauses that require the originating bank to alter the underlying exposures to improve the pool s weighted average credit quality; clauses that increase the bank s cost of credit protection in response to a deterioration in the pool s quality; clauses that increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the reference pool; clauses that provide for increases in a retained first-loss position or credit enhancement provided by the originating bank after the transaction s inception; an opinion must be obtained from qualified legal counsel that confirms the enforceability of the contracts in all relevant jurisdictions; and clean-up calls must satisfy the conditions pertaining to clean-up calls. For synthetic securitisations, the effect of applying credit risk mitigation techniques for hedging the underlying exposure and maturity mismatches are treated in terms of the Standardised approach. When exposures in the underlying pool have different maturities, the longest maturity must be taken as the maturity of the pool. Maturity mismatches may arise when a bank uses credit derivatives to transfer part or all of the credit risk of a specific pool of assets to third parties. When the credit derivatives unwind, the transaction terminates, which means that the maturity of the tranches in the synthetic securitisation may differ from that of the underlying exposures. 407

Banks that originate synthetic securitisations must treat such maturity mismatches as set out below. A bank using the Standardised approach for securitisation must deduct all retained positions that are unrated or rated below investment grade. A bank using the IRB approach for securitisation must deduct unrated retained positions if the treatment of the position is specified in the IRB approach. Accordingly, when deduction is required, maturity mismatches are not taken into account. For all other securitisation exposures, the bank must apply the maturity mismatch treatment as per the Standardised approach. 3.2.3 Operational Requirements for Clean-Up Calls For securitisation transactions that include a clean-up call, no capital will be required if the conditions below are met. The exercise of the clean-up call must not be mandatory, in form or in substance, but at the discretion of the originating bank. The clean-up call must not be structured to avoid allocating losses to credit enhancements or positions held by investors, or otherwise structured to provide credit enhancement. The clean-up call must only be exercisable when 10% or less of the original underlying asset pool, or issued securities, remains, or in the case of synthetic securitisations, when 10% or less of the original reference portfolio value remains. Securitisation transactions that include clean-up calls that do not meet all of the criteria above will result in a capital requirement for the bank. For a traditional securitisation, the underlying exposures must be treated as if they were not securitised. Additionally, banks must not recognise in regulatory capital any gain-on-sale. 408

For synthetic securitisations, the bank purchasing protection must hold capital against the entire amount of the securitised exposures as if they did not benefit from any credit protection. If a synthetic securitisation incorporates a call, other than a clean-up call, that effectively terminates the transaction and the purchased credit protection on a specific date, the bank must apply credit risk mitigation techniques for hedging the underlying exposure and maturity mismatches in terms of the Standardised approach. When exposures in the underlying pool have different maturities, the longest maturity must be taken as the maturity of the pool. Maturity mismatches may arise when a bank uses credit derivatives to transfer part or all of the credit risk of a specific pool of assets to third parties. When the credit derivatives unwind, the transaction terminates, which means that the maturity of the tranches in the synthetic securitisation may differ from that of the underlying exposures. Banks that originate synthetic securitisations must treat such maturity mismatches as set out below. A bank using the Standardised approach for securitisation must deduct all retained positions that are unrated or rated below investment grade. A bank using the IRB approach for securitisation must deduct unrated retained positions if the treatment of the position is specified in the IRB approach. Accordingly, when deduction is required, maturity mismatches are not taken into account. For all other securitisation exposures, the bank must apply the maturity mismatch treatment as per the Standardised approach. If a clean-up call, when exercised, is found to serve as credit enhancement, the exercise of the cleanup call will be regarded as a form of implicit support provided by the bank and must be treated in accordance with the supervisory guidance pertaining to securitisation transactions. 3.3 Treatment of Securitisation Exposures 3.3.1 Calculation of Capital Requirements Banks are required to hold regulatory capital against all of their securitisation exposures, including those arising from the provision of credit risk mitigants to a securitisation transaction, investments in asset-backed securities, retention of a subordinated tranche and extension of a liquidity facility or 409

credit enhancement. Repurchased securitisation exposures must be treated as retained securitisation exposures. Deduction: When a bank is required to deduct a securitisation exposure from regulatory capital, the deduction must be taken 50% from Tier I capital and 50% from Tier 2 capital. Credit enhancing IOs, net of the amount that must be deducted from Tier 1 capital as a gain-on-sale, are deducted 50% from Tier 1 capital and 50% from Tier 2 capital. Deductions from capital may be calculated net of any specific provisions taken against the relevant securitisation exposure. Banks must deduct from Tier 1 capital any increase in equity capital resulting from a securitisation transaction, such as that associated with future margin income resulting in a gain-on-sale that is recognised in regulatory capital. Securitisation exposures do not contribute to the expected loss provision as calculated under the IRB approach. Similarly, any specific provisions against securitisation exposures are not included in the measurement of eligible provisions. 3.3.2 Operational Requirements for the use of External Credit Assessments The following operational criteria concerning the use of external credit assessments apply to both the Standardised and IRB approaches of the securitisation framework. To be eligible for risk-weighting purposes, the external credit assessment must take into account and reflect the entire amount of credit risk exposure the bank has with regard to all payments owed to it. The external credit assessment must be from an eligible ECAI as recognised by the bank s national supervisor and must be publicly available. Eligible ECAIs must have a demonstrated expertise in assessing securitisations, which may be evidenced by strong market acceptance. A bank must apply external credit assessments from eligible ECAIs consistently across a type of securitisation exposure. A bank cannot use the credit assessment issued by one ECAI for one or more tranches and those of another ECAI for other tranches within the same securitisation structure. Where two or more eligible ECAIs are used and they assess the credit risk of the same securitisation exposure differently, the one with the higher risk weight must be applied. If there 410

are three or more assessments with different risk weights, the highest risk weight of the two assessments with the lowest risk weight must be applied to the claim. Where credit risk mitigation is provided directly to an SPV by an eligible guarantor, and such mitigation is reflected in the external credit assessment assigned to the securitisation exposure, the risk weight associated with that external credit assessment should be used. In order to avoid any double counting, no additional capital recognition is permitted. If the credit risk mitigation provider is not a recognised guarantor, the covered securitisation exposure should be treated as unrated. In the situation where a credit risk mitigant is not obtained by the SPV but rather applied to a specific securitisation exposure within a given structure, e.g. a specific tranche, the bank must treat the exposure as if it is unrated and then use the credit risk mitigant treatment under the Standardised or IRB approaches to recognise the hedge. 3.3.3 Standardised Approach for Securitisation Exposures Banks that use the Standardised approach to credit risk for their underlying corporate or retail exposures must use the Standardised approach under the securitisation framework. 3.3.3.1 Risk Weights Applied to Securitisation Exposures The risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the exposure by the appropriate risk weight in accordance with the Tables A6.15 and A6.16: Long-term rating category External credit AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ and below or unrated assessment Risk weight 20% 50% 100% 350% Deduction Table A6.15: Supervisory risk weights for long-term securitisation exposures Short-term rating category External credit A-1/P-1 A-2/P-2 A-3/P-3 All other ratings or unrated assessment Risk weight 20% 50% 100% Deduction Table A6.16: Supervisory risk weights for short-term securitisation exposures 411

For off-balance sheet exposures, banks must apply a CCF and then risk-weight the resultant credit equivalent amount. If such an exposure is rated, a CCF of 100% must be applied. For exposures with long-term ratings of B+ and below and short-term ratings other than A-1/P-1, A-2/P-2, A- 3/P-3, the amount must be deducted 50% from Tier 1 capital and 50% from Tier 2 capital. Unrated exposures must also be deducted apart from the exceptions described in the following section. The capital treatment of exposures retained by originators, liquidity facilities, credit risk mitigants and securitisations of revolving exposures are identified separately. Only third-party investors, as opposed to banks that serve as originators, may recognise external credit assessments that are equivalent to BB+ to BB- for risk-weighting purposes of securitisation exposures. Originating banks must deduct all retained securitisation exposures rated below investment grade, i.e. BBB-. 3.3.3.2 Exceptions to the Treatment of Unrated Securitisation Exposures Unrated securitisation exposures must be deducted apart from the exceptions listed below. Unrated Most Senior Exposures in a Securitisation: If the most senior exposure in a securitisation is unrated, a bank that holds or guarantees such an exposure may determine the risk weight by applying a look-through treatment, provided the composition of the pool is known at all times. Banks are not required to consider interest rate or currency swaps when determining whether an exposure is the most senior in a securitisation for the purpose of applying the look-through treatment. In the lookthrough treatment, the unrated most senior position receives the average risk weight of the underlying exposures subject to supervisory review. Where the bank is unable to determine the risk weights assigned to the underlying exposures, the unrated exposure must be deducted. Exposures that are in a Second Loss Position or Better in ABCP Programmes: Deduction is not required for those unrated securitisation exposures provided by sponsoring banks to ABCP programmes that satisfy all the requirements set out below. The exposure is economically in a second-loss position or better and the first-loss position provides significant credit protection to the second-loss position. The associated credit risk is the equivalent of investment grade or better. 412

The bank holding the unrated securitisation exposure does not retain or provide the first-loss position. Where these conditions are satisfied, the risk weight is the greater of (a) 100% or (b) the highest risk weight assigned to any of the underlying individual exposures covered by the facility. Risk weights for eligible liquidity facilities: For eligible liquidity facilities, and where the conditions for the use of external credit assessments are not met, the risk weight applied to the exposure s credit equivalent amount is equal to the highest risk weight assigned to any of the underlying individual exposures covered by the facility. 3.3.3.3 Credit Conversion Factors for Off-Balance Sheet Exposures For risk-based capital purposes, banks must determine whether an off-balance sheet securitisation exposure qualifies as an eligible liquidity facility or an eligible servicer cash advance facility. All other off-balance sheet securitisation exposures will receive a 100% CCF. Eligible Liquidity Facilities: Banks are permitted to treat off-balance sheet securitisation exposures as eligible liquidity facilities if certain minimum requirements are satisfied. The facility documentation must clearly identify and limit the circumstances under which it may be drawn. Draws under the facility must be limited to the amount that is likely to be repaid fully from the liquidation of the underlying exposures and any seller-provided credit enhancements. In addition, the facility must not cover any losses incurred in the underlying pool of exposures prior to a draw, or be structured in such a way that a draw-down is certain as indicated by regular or continuous draws. The facility must be subject to an asset quality test that precludes it from being drawn to cover credit risk exposures that are in default. In addition, if the exposures that the liquidity facility is required to fund are externally rated securities, the facility can only be used to fund securities that are externally rated investment grade at the time of the funding. The facility cannot be drawn after all transaction-specific and programme-wide credit enhancements from which the liquidity would benefit have been exhausted. 413

Repayments of draws on the facility, i.e. assets acquired under a purchase agreement or loans made under a lending agreement must not be subordinated to any interests of any noteholder in the programme or subject to deferral or waiver. Where these conditions are met, the bank may apply a 20% CCF to the amount of eligible total liquidity facilities with an original maturity of one year or less, or a 50% CCF, if the facility has an original maturity of more than one year. However, if an external rating of the facility itself is used for risk-weighting the facility, a 100% CCF must be applied. Eligible Liquidity Facilities Available Only in the Event of a Market Disruption: If the liquidity facility is an eligible facility as defined above, banks may apply a 0% CCF to eligible liquidity facilities that are only available in the event of a general market disruption, i.e. where more than one SPV over different transactions is unable to roll over maturing commercial paper and the inability is not the result of an impairment in the SPVs credit quality or in the credit quality of the underlying exposures. Additionally, the funds advanced by the bank to pay holders of the commercial paper when there is a general market disruption must be secured by the underlying assets, and must rank at least pari passu with the claims of holders of commercial paper. Treatment of Overlapping Exposures: Banks sometimes extend overlapping facilities that provide duplicative coverage to underlying exposures. In the case of overlapping facilities where a draw under one facility precludes a draw under another facility provided by the same bank, the bank does not need to hold additional capital for the overlap. Where the overlapping facilities are subject to different CCFs, the bank must attribute the overlapping part to the facility with the highest CCF. However, if overlapping facilities are provided by different banks, each bank must hold capital for the maximum amount of the facility. Eligible Servicer Cash Advance Facilities: Subject to national discretion, servicers may advance cash to ensure the uninterrupted flow of payments to investors, so long as the servicer is entitled to full reimbursement and this right is senior to other claims on cash flows from the underlying pool of exposures. Such undrawn servicer cash advances that are unconditionally cancellable without prior notice may be eligible for a 0% CCF. 414

3.3.3.4 Treatment of Credit Risk Mitigation for Securitisation Exposures Credit risk mitigants for securitisation exposures include guarantees, credit derivatives, collateral and on-balance sheet netting. Collateral: Collateral in this context means the collateral used to hedge the credit risk of a securitisation exposure rather than the underlying exposures of the securitisation transaction. Eligible collateral is limited to that recognised under the Standardised approach for credit risk mitigation. Collateral pledged by SPVs may be recognised. Guarantees and Credit Derivatives: Credit protection provided by entities listed in the Standardised approach may be recognised. SPVs cannot be recognised as eligible guarantors. Banks can take account of guarantees or credit derivatives that fulfil the minimum requirements under the Standardised approach in calculating capital requirements for securitisation exposures. When a bank other than the originator provides credit protection to a securitisation exposure, it must calculate a capital requirement on the covered exposure as if it were an investor in that securitisation. If a bank provides protection to an unrated credit enhancement, it must treat the credit protection provided as if the bank were directly holding the unrated credit enhancement. Maturity Mismatches: The capital requirement for maturity mismatches will be determined in terms of the Standardised approach. When the exposures being hedged have different maturities, the longest maturity must be used. 3.3.3.5 Capital Requirements for Early Amortisation Provisions An originating bank is required to hold capital against all, or a portion of, both the drawn and undrawn balances related to the securitised exposure when: it sells exposures into a structure that contains an early amortisation feature; and the exposures sold are of a revolving nature, which involves exposures where the borrower is permitted to vary the drawn amount and repayments within an agreed limit under a line of credit, e.g. credit card receivables. 415

For securitisation structures where the underlying pool comprises revolving and term exposures, a bank must apply the relevant early amortisation treatment to that portion of the pool containing revolving exposures. For a bank subject to the early amortisation treatment, the total capital charge for all its positions will be subject to a maximum capital requirement equal to the greater of (a) that required for retained securitisation exposures, or (b) the capital requirement that would apply had the exposure not been securitised. In addition, banks must deduct the entire amount of any gain-on-sale and credit enhancing IOs arising from the securitisation transaction. The originator s capital charge for the investors interest is calculated as the product of (a) the investors interest, (b) the appropriate CCF, and (c) the risk weight appropriate to the underlying exposure type as if the exposure had not been securitised. The CCFs depend upon whether the early amortisation repays investors through a controlled or non-controlled mechanism. They also differ according to whether the securitised exposures are uncommitted credit lines, such as credit card receivables or other credit lines, for instance revolving corporate facilities. A line is considered uncommitted if it is unconditionally cancellable without prior notice. Banks are not required to calculate a capital requirement for early amortisations in the following situations: replenishment structures where the underlying exposures do not revolve and the early amortisation ends the ability of the bank to add new exposures; transactions of revolving assets containing early amortisation features that mimic term structures, i.e. where the risk on the underlying facilities does not return to the originating bank; structures where a bank securitises one or more credit lines and where investors remain fully exposed to future draws by borrowers even after an early amortisation event has occurred; and the early amortisation clause is solely triggered by events not related to the performance of the securitised assets or the selling bank, such as material changes in tax laws or regulations. 3.3.3.6 Determination of CCFs for Controlled Early Amortisation Features For uncommitted retail credit lines in securitisations containing controlled early amortisation features, banks must compare the three-month average excess spread to the point at which the bank is 416

required to trap excess spread as economically required by the structure, i.e. the excess spread trapping point. In cases where the transaction does not require excess spread to be trapped, the trapping point is deemed to be 4.5 percentage points. The bank must divide the excess spread level by the transaction s excess spread trapping point to determine the appropriate segments and apply the corresponding conversion factors as outlined in Table A6.17. Controlled early amortisation features Uncommitted Committed Retail credit lines 3-month average excess spread CCF 90% CCF 133.33% of trapping point or more = 0% CCF Less than 133.33% to 100% of trapping point = 1% CCF Less than 100% to 75% of trapping point = 2% CCF Less than 75% to 50% of trapping point = 10% CCF Less than 50% to 25% of trapping point = 20% CCF Less than 25% of trapping point = 40% CCF Non-retail credit lines 90% CCF 90% CCF Table A6.17: Credit conversion factors for credit lines with controlled early amortisation All other securitised revolving exposures, i.e. those that are committed and all non-retail exposures with controlled early amortisation features will be subject to a CCF of 90% against the off-balance sheet exposures. 3.3.3.7 Determination of CCFs for Non-Controlled Early Amortisation Features For uncommitted retail credit lines in securitisations containing non-controlled early amortisation features, banks must compare the three-month average excess spread to the point at which the bank is required to trap excess spread as economically required by the structure, i.e. excess spread trapping point. In cases where the transaction does not require excess spread to be trapped, the trapping point is deemed to be 4.5 percentage points. The bank must divide the excess spread level by the transaction s excess spread trapping point to determine the appropriate segments and apply the corresponding conversion factors as outlined in Table A6.18 on the next page. 417

Non-controlled early amortisation features Uncommitted Committed Retail credit lines 3-month average excess spread CCF 100% CCF 133.33% of trapping point or more = 0% CCF Less than 133.33% to 100% of trapping point = 5% CCF Less than 100% to 75% of trapping point = 15% CCF Less than 75% to 50% of trapping point = 50% CCF Less than 50% of trapping point = 100% CCF Non-retail credit lines 100% CCF 100% CCF Table A6.18: Credit conversion factors for credit lines with non-controlled early amortisation All other securitised revolving exposures, that is those that are committed and all non-retail exposures with controlled early amortisation features will be subject to a CCF of 100% against the off-balance sheet exposures. 3.3.4 IRB Approach for Securitisation Exposures Banks that have received approval to use the IRB approach for their underlying corporate or retail exposures must use the IRB approach for securitisations. Conversely, banks may not use the IRB approach if they do not have approval to use it for their underlying exposures. If the bank is using the IRB approach for some exposures and the Standardised approach for other exposures in the underlying pool, it should generally use the approach corresponding to the predominant share of exposures within the pool. Where there is no specific IRB treatment for the underlying asset type, originating banks that have received approval to use the IRB approach must calculate capital charges on their securitisation exposures using the Standardised approach in the securitisation framework, and investing banks that have received approval to use the IRB approach must apply the Ratings- Based Approach (RBA). The RBA must be applied to securitisation exposures that are rated or where a rating can be inferred. Where an external or an inferred rating is not available, either the Supervisory Formula (SF) or the Internal Assessment Approach (IAA) must be used. However, the IAA is only available to exposures such as liquidity and credit enhancement facilities that banks extend to ABCP programmes. Securitisation exposures to which none of these approaches can be applied must be deducted. Under the IRB approach to securitisation, the maximum capital a bank must hold against its securitisation exposures is equal to the IRB capital requirement that would have been calculated in terms of the IRB approach against the underlying exposures had they not been securitised. 418

3.3.4.1 Ratings-Based Approach Under the RBA, the risk-weighted assets are determined by multiplying the amount of the exposure by the appropriate risk weights as per the tables below. The risk weights depend on: (i) the external rating grade or an inferred rating; (ii) the short-term or long-term rating; (iii) the granularity of the underlying pool; and (iv) the seniority of the position 172. RBA risk weights when the external assessment is a long-term rating or long-term inferred rating External rating Risk weights for senior Base risk weights (Illustrative) positions AAA 7% 12% 20% AA 8% 15% 25% A+ 10% 18% A 12% 20% A- 20% 35% BBB+ 35% 50% BBB 60% 75% BBB- 100% BB+ 250% BB 425% BB- 650% Below BB- and unrated Deduction Table A6.19: Long-term risk weights under the RBA Risk weights for tranches backed by non-granular pools 35% In Table A6.19 above, banks may apply the risk weights for senior positions if the effective number of underlying exposures is six or more and the position is senior. When the underlying exposures are 172 In terms of the RBA, a securitisation exposure is treated as a senior tranche if it is backed by a first claim on the entire amount of the assets in the securitised pool. Generally this includes only the most senior position within a securitisation transaction, but there may sometimes be other claims that in a technical sense may be more senior in the waterfall, but which may be disregarded in determining which positions are subject to the senior tranches column in the table. Examples: In a synthetic securitisation, the super-senior tranche would be treated as a senior tranche, provided that all the conditions for inferring a rating from a lower tranche are fulfilled. In traditional securitisation where all the tranches above the first-loss tranche are rated, the most highly rated position would be treated as a senior tranche. However, when there are several tranches that share the same rating, only the most senior tranche in the waterfall would be treated as senior. If the liquidity facility in an ABCP programme is sized to cover all outstanding commercial paper, it can be viewed as covering all losses on the underlying receivables pool that exceed the amount of over-collateralisation/reserves provided by the seller, and as being most senior. As a result, the RBA risk weights in the left-most column can be used for such positions. On the other hand, if the liquidity facility constitutes a mezzanine position in economic substance rather than a senior position, than the Base risk weights column is applicable. 419

fewer than six, the risk weights in column four of the table apply. In all other cases, the risk weights in column three in the table above apply. The risk weights in Table A6.20 below apply when the external or inferred ratings are short-term credit ratings. RBA risk weights when the external assessment is a short-term rating or short-term inferred rating External rating (Illustrative) Risk weights for senior positions Base risk weights A-1/P-1 7% 12% 20% A-2/P-2 12% 20% 35% Risk weights for tranches backed by non-granular pools A-3/P-3 60% 75% 75% All other ratings/unrated Deduction Table A6.20: Short-term risk weights under the RBA A bank must attribute an inferred rating to an unrated position when the following minimum operational requirements below are satisfied. These requirements are intended to ensure that the unrated position is senior in all respects to an externally rated securitisation exposure termed the reference securitisation exposure. The reference securitisation exposure must be subordinate in all respects to the unrated securitisation exposure. Credit enhancements, if any, must be taken into account when assessing the relative subordination of the unrated exposure and the reference securitisation exposure. For example, if the reference securitisation exposure benefits from any third-party guarantees or credit enhancements that are not available to the unrated exposure, then the latter may not be assigned an inferred rating based on the reference securitisation exposure. The maturity of the reference securitisation exposure must be equal to, or longer than, that of the unrated exposure. The inferred rating must be updated on an ongoing basis to reflect any changes in the external rating of the reference securitisation exposure. The external rating of the reference securitisation exposure must satisfy the general requirements for the recognition of external ratings. 420

3.3.4.2 Internal Assessment Approach A bank may use its internal assessments of the credit quality of the securitisation exposures, i.e. liquidity facilities and credit enhancement facilities, which the bank extends to ABCP programmes. These internal assessments of exposures provided to ABCP programmes must be mapped to equivalent external ratings of an ECAI and those rating equivalents used to determine the appropriate risk weights under the RBA for purposes of assigning the notional amounts of exposures. In order to use internal credit assessments in determining the IRB capital requirement, a bank s internal assessment process must meet the operational requirements below. For the unrated exposure to qualify for the IAA, the ABCP must be externally rated and the ABCP itself is subject to the RBA. The internal assessment of a securitisation exposure to an ABCP programme must be based on ECAI criteria for the asset type purchased and must be equivalent to at least investment grade when initially assigned to an exposure. In order for banks to use the IAA, supervisors must be satisfied that (a) the ECAI meets the ECAI eligibility criteria and (b) with the ECAI rating methodologies used in the process. Banks must be able to demonstrate how their internal assessments correspond with the relevant ECAI s standards. A bank s internal assessment process must identify gradations of risk. Internal assessments must correspond to the external ratings of ECAIs so that supervisors can determine which internal assessment corresponds to each external rating of the ECAI. A bank s internal assessment process must be at least as conservative as the publicly available rating criteria of the major ECAIs that are rating the ABCP. In the case where the ABCP is externally rated by two or more ECAIs, and the different ECAIs benchmark stress factors require different levels of credit enhancement to achieve the same external rating equivalent, the bank must apply the ECAI stress factor that requires the most conservative or highest level of credit protection. A bank cannot use an ECAI s rating methodology if it is not publicly available, and consequently the IAA may not be used. 421

Internal or external auditors, an ECAI or the bank s internal credit function, independent from the ABCP programme business line, must perform regular reviews of the internal assessment process and the validity of the internal assessment. The bank must track the performance of its internal assessments over time to evaluate them and make adjustments to the internal assessment process when the performance of the exposures diverges from the assessments assigned to those exposures. The ABCP programme must have credit and investment guidelines and must establish minimum asset eligibility criteria that inter alia exclude the purchase of defaulted or past due assets, limit excess concentration to an individual obligor or a geographic area and limit the term of the assets to be purchased. The ABCP programme should have collections processes established that consider the operational capability of the servicer and mitigate servicer risk. The ABCP programme must incorporate structural features into the purchase of assets in order to mitigate potential credit deterioration of the underlying portfolio. 3.3.4.3 Supervisory Formula The risk-weighted assets generated through the use of the SF are calculated by multiplying the capital charge by 12.5. Under the SF, the capital charge depends on five bank-supplied inputs as listed below. (K IRB ): The IRB capital charge had the underlying exposures not been securitised. (L): The tranche s credit enhancement level. (T): The tranche s thickness. (N): The pool s effective number of exposures. (LGD): The pool s exposure-weighted average loss-given-default. 422

The tranche s IRB capital charge equals the amount of exposures that has been securitised times the greater of (i) 0.0056*T, or (ii) (S[L +T] S[L]); where the function S[.] is defined by the Supervisory Formula 173. When the bank holds only a proportional interest in the tranche, that position s capital charge equals the pro rata share of the capital charge for the entire tranche. Definition of K IRB : K IRB is the ratio of (a) the IRB capital requirement including the expected loss portion for the underlying exposures in the pool to (b) the exposure amount of the pool, e.g. the sum of drawn amounts related to securitised exposures plus the EAD associated with undrawn commitments related to securitised exposures. Quantity (a) must be calculated in accordance with the applicable minimum IRB standards as if the exposures were held directly by the bank. This calculation should reflect the effects of any credit risk mitigant that is applied on the underlying exposures either individually or to the entire pool, and hence benefits all of the securitisation exposures. For structures involving an SPV, all the assets of the SPV that are related to the securitisations are to be treated as exposures in the pool, including assets in which the SPV may have invested a reserve account such as cash collateral. K IRB is expressed in decimal format, e.g. a capital charge equal to 10% of the pool would be expressed as 0.10. In cases where a bank has set aside a specific provision or has a non-refundable purchase price discount on an exposure in a pool, quantity (a) and quantity (b) must be calculated using the gross amount of the exposure without the specific provision, or non-refundable purchase price discount. In this case, the amount of the non-refundable purchase price discount on a defaulted asset or the specific provision can be used to reduce the amount of any deduction from capital associated with the securitisation exposure. If the risk weight 173 The Supervisory Formula is defined as: S[L]= L when L K IRB S[L]= ω (KIRB L K IRB + K[L] K[K IRB ] + (d. K IRB /ω)(1 - e / K IRB ) when K IRB < L Where h = (1 - K IRB /LGD) N c = K IRB /(1 h) ( LGD K IRB ) K + 0.25(1 LGD) KIRB IRB v = N v+ K 2 (1 K f = [ IRB 1 h - c 2 IRB IRB ] + (1 h) τ g = ( 1 c)c f - 1 a = g.c b = g.(1 c) d = 1 (1 h).(1 Beta[K IRB ; a, b]) K[L] = (1 h).((1 Beta[L; a, b])l + Beta[L; a +1, b]c) Where Beta[L; a, b] refers to the cumulative beta distribution with parameters a and b evaluated at L. The supervisory-determined parameters are τ = 1,000 and ω = 20. ) K v 423

resulting from the Supervisory Formula is 1250%, banks must deduct the securitisation exposure 50% from Tier 1 capital and 50% from Tier 2 capital. Credit Enhancement Level (L): L is measured in decimal form as the ratio of (a) the amount of all securitisation exposures subordinate to the tranche in question to (b) the amount of exposures in the pool. Banks will be required to determine L before considering the effects of tranche-specific credit enhancements such as third-party guarantees that benefit only a single tranche. Any gain-on-sale or credit enhancing IOs associated with the securitisation are not to be included in the measurement of L. The size of the interest rate or currency swaps that are more junior than the tranche in question may be measured at their current values without the potential future exposures in calculating the enhancement level. If the current value of the instrument cannot be measured, the instrument should be ignored in the calculation of L. If there is any reserve account funded by accumulated cash flows from the underlying exposures that is more junior than the tranche in question, this can be included in the calculation of L. Unfunded reserve accounts may not be included if they are to be funded from future receipts from the underlying exposures. Thickness of Exposure: T is measured as the ratio of (a) the normal size of the tranche of interest to (b) the notional amount of the exposures in the pool. In the case of an exposure arising from an interest rate or currency swap, the bank must incorporate the potential future exposure. If the current value of the instrument is non-negative, the exposure size should be measured by the current value plus the add-ons as in the 1988 Accord. If the current value is negative, the exposure should be measured by using the potential future exposure only. Effective Number of Exposures (N): The effective number of exposures is calculated by means of a formula 174. Multiple exposures to the same obligor must be consolidated, i.e. treated as a single instrument. In the case of resecuritisation, i.e. the securitisation of securitisation exposures, the formula applies to the number of securitisation exposures in the pool and not the number of underlying exposures in the original pools. If the portfolio share associated with the largest exposure, C i, is available, the bank may compute N as 1/ C i. 174 Effective number of exposures N = in the pool. 2 ( EADi ) i 2 EADi i where EAD i represents the EAD associated with the i th instrument 424

Exposure-Weighted Average LGD: The effective number of exposures is calculated by means of a formula 175. In the case of resecuritisation, an LGD of 100% must be assumed for the underlying securitised exposures. When default and dilution risks for purchased receivables are treated in an aggregate manner, e.g. a single reserve or over-collateralisation is available to cover losses from either source within a securitisation, the LGD input must be constructed as a weighted average of the LGD for default risk, and a 100% LGD for dilution risk. The weights are the stand-alone IRB capital charges for default risk and dilution risk, respectively. Simplified Method for Computing N and LGD: For securitisation involving retail exposures, banks may implement the Supervisory Formula by using the simplifications: h = 0 and v = 0. Under certain conditions 176, banks may employ a simplified method for calculating the effective number of exposures N and the exposure-weighted average LGD. 3.3.4.4 Liquidity Facilities Liquidity facilities are treated as any other securitisation exposure and receive a CCF of 100% unless: the facility can only be drawn in the event of a general market disruption; or when it is not practical for a bank to use either the bottom-up or top-down approach for calculating K IRB. If the facility is externally rated, the bank may rely on the external rating under the RBA. If the facility is not rated and an inferred rating is not available, the bank must apply the Supervisory Formula, unless the IAA can be applied. 175 The exposure-weighted average LGD = i LGD.EAD i i EAD i i 176 Let C m denote the share of the pool corresponding to the sum of the largest m exposures, e.g. a 10% share corresponds to a value of 0.10. The level m is set by each bank. If the portfolio share associated with the largest exposure C 1 is no more than 3% of the underlying pool, then for purposes of the Supervisory Formula, the bank may set LGD = 0.50 and N equal to the following amount: C C N = ( 1 ( ) ) 1 C 1 C + m m max{1 mc 1,0} m 1 If only C 1 is available and this amount is no more than 3%, then the bank may set LGD = 0.50 and N = 1/ C 1. 425

An eligible liquidity facility that can only be drawn in the event of a general market disruption as defined in the Standardised approach to securitisation is assigned a 20% CCF under the Supervisory Formula. If the eligible liquidity facility is externally rated, the bank may rely on the external rating under the RBA provided it assigns a 100% CCF rather than a 20% CCF to the facility. When it is not practical for a bank to use either the bottom-up or top-down approach for calculating K IRB, the bank may on an exceptional basis and subject to supervisory approval, temporarily be allowed to apply the method described below. If the liquidity facility meets the definition in the Standardised approach to securitisation of an eligible liquidity facility or an eligible liquidity facility only available in the event of a market disruption, the highest risk weight assigned under the Standardised approach to any of the underlying individual exposures covered by the liquidity facility can be applied to the liquidity facility. If the liquidity facility meets the definition in the Standardised approach of an eligible liquidity facility, the CCF must be 50% for a facility with an original maturity of one year or less, or 100% if the facility has an original maturity of more than one year. If the liquidity facility meets the definition in the Standardised approach of an eligible liquidity facility only available in the event of a market disruption, the CCF must be 20%. In all other cases, the notional amount of the liquidity facility must be deducted. 3.3.4.5 Treatment of Overlapping Exposures In the case of overlapping facilities where a draw under one facility precludes a draw under another facility provided by the same bank, the bank does not need to hold additional capital for the overlap. Where the overlapping facilities are subject to different CCFs, the bank must attribute the overlapping part to the facility with the highest CCF. However, if overlapping facilities are provided by different banks, each bank must hold capital for the maximum amount of the facility. 426

3.3.4.6 Eligible Servicer Cash Advance Facilities Subject to national discretion, servicers may advance cash to ensure the uninterrupted flow of payments to investors so long as the servicer is entitled to full reimbursement, and this right is senior to other claims on cash flows from the underlying pool of exposures. Such undrawn servicer cash advances that are unconditionally cancellable without prior notice may be eligible for a 0% CCF. 3.3.4.7 Treatment of Credit Risk Mitigation for Securitisation Exposures As with the RBA, banks are required to apply the credit risk mitigation techniques as specified in the Foundation IRB approach. The bank may reduce the capital charge proportionally when the credit risk mitigant covers first losses, or losses on a proportional basis. In all other cases, the bank must assume that the credit risk mitigant covers the most senior portion of the securitisation exposure, i.e. that the most junior portion of the securitisation exposure is uncovered. 3.3.4.8 Capital Requirements for Early Amortisation Provisions An originating bank must use the methodology and treatment described under the Standardised approach to securitisation for determining if any capital must be held against the investors interest. For banks using the IRB approach to securitisation, investors interest is defined as investors drawn balances related to securitisation exposures and EAD associated with investors undrawn lines related to securitisation exposures. In order to determine the EAD, the undrawn balances of securitised exposures would be allocated between the seller s and investors interests on a pro-rata basis, based on the proportions of the seller s and investors shares of the securitised drawn balances. For IRB purposes, the capital charge attributed to the investors interest is determined by the product of (a) the investors interest, (b) the appropriate CCF, and (c) K IRB. 427

APPENDIX 7 BASEL II CAPITAL REQUIREMENTS ON SAMPLE PORTFOLIOS The rating agency, Fitch Ratings, has compared the Basel II capital requirements on a number of sample portfolios (Hansen, 2005:14 to 20). The approach followed was to calculate the expected Basel II capital requirement on asset portfolios that are not securitised, and then calculate what the capital requirements will be if the same portfolios are securitised. The results are set out in the tables that follow. 428

429

430

431

432

433

434

435

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