Asset backed securities and structured finance

Content

Abbreviations II

1 Introduction

2 Asset Backed Security
2.1 Definition of an Asset Backed Security
2.2 Basic structure of an ABS transaction
2.3 Features required of a receivables’ portfolio
2.4 Variations in traditional asset securitisation
2.4.1 Payment management
2.4.2 Number of originators
2.4.3 Frequency of assets purchase
2.4.4 Kind of assets

3 ABS as possibility for companies to refinance
3.1 Advantage of ABS
3.2 Disadvantage of ABS

4 Structured finance
4.1 Definition
4.2 Basic structure of SF products
4.3 Features of the underlying assets
4.4 CDO – a structured finance product
4.5 Source of value within CDOs
4.5.1 Tranching
4.5.2 Market completion and segmentation

5 Current market situation and development prediction

Appendix 1

Sources

Abbreviations

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1 Introduction

Almost all companies do have an effective debenture management nowadays. Nevertheless, it is not unusual for companies to have very high values in receivables. Especially for companies with a turnover of more than € 100 million the receivables grow to a value of € 10 million or more (IKB (2005), p.1). This capital is usually unavailable for the company; it may become available using Asset Securitisation to refinance the receivables. The influence of Basel II on the behaviour of credit institutions further reinforces the importance of Asset Securitisation as a tool for companies to improve the capital costs and the balance sheet rations as the investigation in this paper will point out. This again has implications for the rating of enterprises.

Due to the growing interest in Asset Securitisation, a lot of research has been done by the European financial institutions.

In the second part of this paper, the question of a definition and of the basic structure of an Asset Backed Security will be examined. Furthermore the requirements for an Asset Securitisation in respect to the portfolio of assets will be explained.

The third part of this paper is concerned with the possibilities of traditional ABS for companies, that are carried on by the advantages and disadvantages of Asset Securitisation for the participants.

Within structured finance the questions of adding value for the different participants within structured finance transactions is examined.

In the forth part the possible use of structured finance products for enterprises is described examining especially the question of where value is added.

Finally the last part gives an overview of the current situation of the European market for structured finance products and ABS and its projected development.

2 Asset Backed Security

2.1 Definition of an Asset Backed Security

The concept of an Asset Backed Security is very much self explanatory. It is a security that is backed up by an asset or a pool of assets. Usually that asset is not one specific object or financial instrument, but a pool of objects or financial instruments. In its most basic structure, ABS are used to extract receivables from the balance sheet of the company – therefore it is also called an off-balance sheet solution. In accordance to that, the instrument ABS is used to refinance the outstanding receivables of a company. (Vgl. Helfrich (2005), p. 1f)

2.2 Basic structure of an ABS transaction

The basic idea behind the securitisation of receivables is to free the capital that is tied up in the receivables. To do this, the receivables will be grouped to a pool and then sold to a legally independent entity, a so called special purpose vehicle (SPV) or special purpose entity. This SPV is only founded for the purpose of buying the receivables and emitting a security. Through the transaction with the SPV, the company gains liquidity. The SPV finances the price of the receivables using the emission of a security – the Asset Backed Security. The interest and repayment of the securities are paid out of the cash flows that are generated from the receivables in the company.

The ABS transactions proceeds in detail as follows (see also Fig. 1, p. 4):

At first the company (originator) groups the assets, that will generate cash flows in the future, in a pool. The company will try to diversify this pool as much as possible according to the demands of the market. The portfolio of the pool has to undergo an inspection of the arranging bank or financial institution (arranger) and, as the case may be, of a rating agency, concerning the degree of diversification and the historical probability of default within the receivables’ portfolio. Furthermore, the debenture management of the company will be examined concerning its efficiency as it will continue to be responsible for the receivables of the company in the future.

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Figure 1 : ABS transaction

As a result of the analysis, the transaction structure will be developed and on its basis the transaction contract between the company and the SPV, which is to be founded only for this transaction, will be set up. Especially lawyers, rating agencies, auditors and certified public accountants participate in this process. The special purpose entity has to be completely independent of the originator and even in the case of the originator’s insolvency it has to be legally unaffected. Furthermore the SPV has to restrict its activities to functions that are directly connected to the ABS transaction (Vgl. v. Hinten (2005), p. 7). A trustee is usually appointed to keep the SPV under surveillance.

The receivables become the property of the SPV with the signing of the contract including their risk of default. The company gets the price agreed upon and will pay the financing costs of the securities that are emitted by the SPV throughout the lifetime of the security. These financing costs are generated through the interest and repayment payments of the companies obligors.

To refinance the price agreed upon, the special purpose vehicle will emit a security (ABS). To get an appropriate rating, the transaction is usually arranged in a way that includes credit enhancements such as over collateralisation and credit insurances (Vgl. IKB (2005), p. 2f).

2.3 Features required of a receivables’ portfolio

The high costs generated by the examination of the asset pool and the company are the reason for the high minimum requirements of an asset pool which is about € 15 million (Vgl. IKB (2005), p. 4). Otherwise the transaction would not make economic sense. However, only 3.4% of the European issues (meaning originated in Europe) between 1997 and 2003 had a total volume of less than US$ 50 million and only 10.2% less than US$ 100 million (Vgl. Cuchra (2005), p. 13). As a result, asset securitisation is an alternative only for companies with a turnover higher than € 100 million (Vgl. IKB (2005), p. 4).

Traditional asset backed securities may be constructed out of numerous different kinds of receivables, as long as they have a homogenous lifetime and generate regular and predictable cash flows. However the different kinds of receivables get never mixed in a traditional ABS. Additionally the individual assets should be legally and economically independent. The diversification mentioned above should include geographical as well as industry specific aspects.

The following receivables are most commonly securitised:

- Receivables from business customers
- Receivables from leasing contracts
- Receivables from franchising contracts
- Receivables from real estate cash flows (e.g. rents)
- Licensing fees
- Consumer credits (Vgl. IKB (2005), p. 3).

These are just some examples. Basically all possibilities are imaginable, as long as they can be placed on the capital markets. The securitisation of possible future returns from the sale of CDs, of tickets for theatres or cinemas or returns from credits taken for education or advanced training may be thought of (Vgl. Helfrich (2005), p. 2).

To force an inexpensive placement of the ABS, the asset portfolio should have only a small number of historic defaults and cash flow dysfunctions. To be able to evaluate the underlying portfolio, rating agencies expect a minimum of three years of historic data, especially monthly data about payment flows, payment dysfunctions, overdue payments, payment methods, defaults and structures of the different lifetimes within the portfolio. Moreover concentration risks concerning countries, customers, industries, etc. and possible insurances against such or other risks have to be documented.

The company has to produce monthly reports about all of the date mentioned above during the lifetime of the ABS. The reports have to be available for the arranging financial institution and the investors.

2.4 Variations in traditional asset securitisation

2.4.1 Payment management

One possible configuration is the arrangement of the payment flows. On the one hand the payments to the originator may be forwarded directly to the investors. This is called a pass-through structure. On the other hand the obligor payments might be concentrated in a pool and paid to the investors on predefined dates. This pool is usually managed by a trustee, who also controls the SPV. A structure arranged in such a way is called a pay-through structure (Vgl. v. Hinten (2005) p. 11f).

2.4.2 Number of originators

A single-seller transaction is characterised by the fact that the SPV buys all assets from one originator only. The ABS transaction is therefore specially arranged for one company. However, the enterprise has to carry all costs of the transaction and generate enough assets to reach the minimum requirements for a cost-efficient transaction.

Contrary the arranger might set up a multi-seller transaction where the SPV buys the assets of different originators. In a transaction structured like this, investors buy usually securities of a commercial paper programme with a short lifetime (30 to 60 days). The necessary minimum volume decreases for each originator when the number of originators increases. However a larger number of originators may also increase the total volume of the transaction an reduce the proportional transaction costs for each participant. The initial costs to set up the SPV are, however, higher for multi-seller transactions. Multi-seller transactions are often arranged by financial institutions as a service within their investment banking (Vgl. v. Hinten (2005) p. 11f).

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