STRUCTURED TRANSACTIONS AND SECURITIZATIONS
Category: Risk Management in Banking
Structured finance designates all specialized finance where credit risk is entirely dependent on a structure resiliency, the ability of this dedicated entity to sustain stressed conditions, rather than on the credit standing of a firm. The lender is not at risk with a counterparty that is a firm, as usual, but with an entity that has no credit standing by itself, that is an SPV. In all cases, structures are bundles of covenants and SPVs, which rule the functioning of the structure. Covenants play a key role in structured transactions since, without them, there would be no way to set up the transactions.
SPVs represent the most advanced stage of structuring. Securitizations are special kinds of transactions using SPVs. Securitizations allow banks to sell their assets, or to sell the risks of these assets, to an SPV that issues structured notes in the market bought by investors funding the assets or bearing their risks. They address portfolio management because securitizations are tools that reshape the banks portfolio risk-return profile.
Other classical structured transactions, such as project finance and LBOs, help in setting up loans that would be too risky without such special features.
The first subsection reviews the nature of structured transactions and the role of the SPV in LBOs and others. The second subsection describes securitizations and their basic mechanisms. The third subsection briefly reviews structure covenants.
Project Finance, LBOs and Others
SPVs serve in a variety of situations: as shields between high-risk projects and lenders. Examples are LBOs and project or asset financing, although they are very different transactions.
In project finance, the risk of the project, its size and characteristics would make standard loans prohibitively risky. The project sponsors create an SPV that acts as a shield, allowing risk reduction and sharing by several participants. The SPV serves to isolate the project free cash flows and allocate them to debt repayments.
For LBOs, the SPV serves for acquiring another company. The SPV is the holding company, NewCo, which gets a majority of voting rights of the target company. NewCo needs to hold at least 50% of equity of the target company. With assets of the target company worth 100, and equity equal to 50, the value of debt is the difference, 50. The investment in the target company shares necessary to control 50% is 50% x 50 = 25 of the equity. With a leverage of 4, we need only 10 to finance the 50 of equity, and the rest is a debt of 40. With 10, we acquire a total value of 100. NewCos purpose is to buy the shares of the target company using both equity and debt. A highly leveraged LBO uses a lot of debt, thereby minimizing the amount of equity committed for purchasing the target company. Leverage minimizes the amount of cash invested to acquire control. Since NewCos purpose is this acquisition only, it is possible to structure its debt and covenants in the best way for all lenders, senior ones as well as those willing to take more risk. Pledging NewCos assets to lenders does not provide much protection since these assets are shares of the target company. Should the target company fail to generate enough cash for NewCo to repay lenders, the shares would have little value.
In both examples of project finance and LBOs, the SPV is a bankruptcy remote structure, such that the failure of the SPV does not imply the failure of the sponsors. In project finance, the sponsors share the risk with lenders and investors. However, the project or the LBO failure would generate significant losses for the sponsors of the project, in addition to lenders, or to the shareholders of NewCo.
Structures and Securitizations
Other types of SPV, or funds, serve as vehicles for securitizations. Securitizations are transactions that transfer the funding and the risk of a pool of assets, originally held by a seller, to the market. The assets are consumer loans, mortgages, lease receivables, term loans and bonds, and receivables of a corporate firm (which becomes the seller in this latter case). The first step is a non-recourse sale to an SPV issuing, in the second step, structured notes to finance the sold assets that investors buy in the market. Securitization means turning illiquid assets into securities. The cash flows generated by the pool of assets serve to provide principal and interest payments to the note holders. Notes are structured because they differ in terms of seniority levels with respect to their prioritized access to the cash flows generated by the pool of assets of the SPV. In addition, several covenants rule the functioning of the structure during its life.
By customizing the risk-return profiles of these notes, the structuring of the transactions makes these notes tradable, hence the name securitization. The rationale for selling assets or risks is to arbitrage the cost of funding on-balance sheet and into the market, and/or off-load risks into the market to free up capital.
The structuring of notes issued by the SPV defines the amount, maturity and risk-return profile of each class of structured notes. The structured notes have various seniority levels, the subordinated notes providing a credit enhancement to the upper senior notes. Because subordinated notes have a subordinated claim on cash flows, any cash flow deficiency hits them first. When the deficiency gets larger, it hits sequentially all upper level notes. Senior notes are investment grade, while the last equity tranche concentrates a lot of risk. Return is commensurate with these differentiated risks in line with market risk-return trade-offs. The waterfall of cash flows ensures that the cash from the pool of assets flows first to senior notes and then to subordinated notes.
All securitizations, whether or not they serve for arbitraging the costs of funding, also off-load risk and free up capital. There are several types of securitizations. Securitizations allow funding in the market, through structured notes, of various kinds of assets: residential or commercial mortgages, lease receivables, consumer loans and credit card receivables, account receivables of corporate firms, loans of bonds. For short-term assets, it is necessary to reload periodically the SPV with new assets to prolong its maturity. Such securitizations are revolving. Amortizing transactions securitize long-term assets, and amortize the notes at the pace dictated by the amortization of long-term assets.
CLO (Collateralized Loan Obligation), CDO or CBO (Collateralized Bond Obligation) follow the same principles of a non-recourse sale of assets to a fund, and the financing through structured notes issued in the market. The assets sold, loans, bonds, high yield bonds, might be very risky. Risk depends on the nature of assets, tradable or not (loans) for the same reasons that make market risk differ from credit risk. Cash CDOs imply the actual sale of assets from seller to the fund. Synthetic CDOs transfer the risks only to the SPV, which frees up capital as well as cash securitizations. The mechanism relies on credit derivatives for the risk transfer from seller to the fund1. They develop whenever it is difficult to sell assets, for instance if an agreement with the borrower is a prerequisite to a sale. The credit derivatives serve as an insurance mechanism to provide the necessary credit enhancement for the notes issued by the fund.
Structure Covenants
Structure covenants rule the governance of the SPV. They ensure that the structure complies with all constraints that bound its various risks throughout its life. The covenants of structures depend on their types.
For LBOs or project finance, covenants pledge the future cash flows to repayments, and prevent any action that might reduce the lenders wealth, or any action that changes the risk-return profile of the transaction. They include limitations to cash outflows, diversification, dividends, and so on. A minimum DCR is common in cash flow-based structures. Any drop of this key ratio beyond a preset value would entail the repayment ability. A minimum multiple of Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) is also a common protecting clause.
For securitizations, covenants specify rules for the ramp-up period, when the portfolio of assets builds up over time at the early stage, whether repayments of all classes of notes occur in parallel, or sequentially (senior notes first and subordinated notes last), and what triggers a payout event during the subsequent life of the structure. A payout event implies early amortization of notes, letting all assets amortize progressively and repaying the principal and interest due on the various classes of notes, following the seniority rules of the term sheet.
This is a difference from loan covenants, where the covenants trigger cross-default and cross-acceleration, but do not necessarily result in a default because the philosophy is more to restructure the loan rather than suffer from an overall immediate loss. In structures, covenants effectively trigger early amortization. Such payout events avoid waiting too long before triggering amortization, which could result in further deterioration of risk and larger losses. For securitizations, many covenants tend to be quantitative.
For CDO-type structures, covenants include: over-collateralization ratios guaranteeing a minimum safety cushion; minimum diversification (quantified by a diversity score, as defined in Chapters 55 and 56) of the portfolio of assets; caps on individual risk concentrations of exposures; liquidation of collateral when its value declines below a certain threshold. For credit card-backed securitizations, target variables trigger the buildup of spread accounts, whose cash amounts serve as a first level of protection for note holders. The trigger variable is the excess spread, or the excess of the asset portfolio yield over charge-offs plus the weighted average cost of funding.
Modelling Recoveries
This chapter addresses the economic issue of guarantee values. The qualitative assessment of guarantees is the rule in most cases due to multiple intangible factors that affect their values. The quantitative assessment of guarantees is developing the extent feasible, for several reasons:
• A distinctive feature of the foundation approach consists of assigning recovery rates to facilities, and alleviating capital charge accordingly, which provides strong incentives for quantification.
• Certain guarantees are tangible enough to deserve recognition and valuation.
• The loss given default, or exposure minus recoveries, is a critical input for assessing credit risk.
• The expected loss is the product of the loss given default with default probabilities. It is the basis for economic provisioning.
• The expected loss as a percentage is equal to the default probability with zero recovery, and lower if recoveries are positive. Recovery rates allow us to define ratings with both default probability and loss under default, through the expected loss, which combines both. This provides a simple foundation for rating policies in the presence of guarantees.
In several instances, recoveries are reasonably certain, so that netting the exposures with recoveries is acceptable. With tangible securities as collateral, a common practice is to set the excess of collateral value over debt (haircut) at a level guaranteeing zero loss under default with a given confidence level.
Third-party protections relate to guarantees, support, insurances and credit derivatives. The value of these guarantees results from the gain in default probability that they provide. This gain is the difference between the borrowers default probability and the joint default probability of both borrower and guarantor, if we ignore legal risks. The New Accord does not recognize the full benefit of the double default probability and only allows us to assign the guarantors risk to the guaranteed facility. However, joint default probabilities are key inputs to evaluate all forms of insurance, making it worthwhile to relate them to their determinants: obligors default probabilities and correlations between their defaults.
Unlike third-party legal protection support might aggravate the risk while the former cannot. Support is so common that it deserves a separate assessment in the internal rating process qualifying its nature, its strength, and the credit standing of the supporting entity.
Covenants are obligations of borrowers and options for lenders contingent on many uncertainties, so that assessing their value remains beyond reach. However, it is relatively easy to specify how binding certain covenants are.
Finally, it is common to model recovery uncertainty by using a loss under default distribution. Recovery uncertainty increases the loss volatility. The beta distribution seems convenient because it fits various types of empirical recovery distributions, even though its usage remains tentative because of scarcity of data.
This chapter comprises six main sections addressing respectively: recoveries and rating policy; liquid collateral; third-party protections; support; recovery risk and its contribution to loss volatility and the beta distributions for modelling recovery risk; covenants.