Transcript Slide 1

Securitization in Financial
Markets Development: An
Emerging Market Perspective
Dr. JAY SA-AADU
Chester A. Phillips Professor of
Finance and Real Estate
University of Iowa, U.S.A
African Capital Markets: The
Next Investment Frontier
• Our Financial Field of Dreams
– Develop new Financial Instruments
– Develop deeper, more liquid , sounder and
more resilient capital markets
– Raise capital more efficiently
• Remember the following two principles
– Capital has no Conscience, and it is very more
mobile
– Prosperity Makes Friends, adversity tries
Focus of My Talk
• Winds of Positive Change in Emerging Markets
• The Financial Innovation of Structured Finance
and Securitization
• Origin of the Sub-prime Mortgage (SPM) Debacle
• Lessons from SPM Related Securitization
• Using Securitization to Develop and Deepen
Domestic Bond Markets
• Necessary Infrastructure Conditions
• Areas of Focus and Potential benefits of
Securitization for African Capital Markets
Winds of Challenge: Perfect Alignment
of Capital Market “gods”
• Capital Markets are springing up across the
continent
• Spreads on emerging market bond index at
historically low points
• Emerging market bonds constitute an important
asset class
• International Investors starting to purchase local
currency bonds
• African sovereign bond issues on the go
• Critical vote of confidence in future financial and
economic stability
Appropriate Steps Taken to
consolidate & enhance gains
• Enhanced macroeconomic performance
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Better Monetary and Budget Policies
Currency stabilization and redenomination
Taming Inflation
Building Legal, accounting, regulatory infrastructures to
facilitate entry and exit all investors
• But much more needed to be done to reach
potential
– Outstanding emerging bond market only 40% of GDP,
compared to 140% for matured markets
The Innovation in Securitization: Don’t be
Thirsty in the Middle of the River
• What is Structured Finance ?
• What is Asset Backed Securitization ?
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Leveraging on good assets
Raise Capital at better terms
Manage Balance sheet
Risk Diversification
Transparency
Cash flows based solely on credit quality of underlying asset
Credit Enhancement
Transfer asset risk to those best able to shoulder them
• The global outstanding ABS now in excess of US $10
trillion
The Separation of Two Business: Origination and Funding
Exhibit 1: The Basic structure of ABS
Sponsoring Company
•Assets
Sale or
assignment
Asset securitization makes sense
when the assets are worth more
outside the company than within. But
what makes them worth more?
Servicing agreement
Special Purpose Vehicle
•Assets
Issues
Asset Backed
Certificates
Exhibit 2: Overview of Credit Risk Transfer (CRT) Instruments
Risk Transfer Instruments
Traditional Products
Credit Insurance
Syndicated Loans
Financial Guarantee
Our focus
Capital Market Products**
Securitization
Asset Backed Securities (ABS)
Mortgage-Backed Securities (MBS)
Collateralized Debt Obligations (CDO)
Credit Derivatives
Credit Default Swaps (CDS)
Total Return Swaps
Credit Spread Options
Other Instruments
Loan Sales
Bond Trading
Asset Swaps
Collateralized Loan Obligations (CLO)
Collateralized Bond Obligation (CBO)
Hybrid Products
“Synthetication”
Credit-linked Notes (CLN)
Synthetic CDOs
“Pool of Pools- Hybrids”
CDOs of CDOs
CDOs of ABSs
The Technology has Evolved Through Several Stages
Exhibit 3:Stages and Innovations Structured Finance (Securitization)
Extensive use of Credit Derivatives
Credit Risk transfer (CDS)
Without Asset transfer
Multiple Class Tradable
Derivative Securities
Tranching & Subordination
Of Cash flows
Multiple Class of Tradable
Derivative Securities
(Structured Claims)
Single Class Tradable
Derivative Security
Synthetic CDO Securitization
3rd Stage
Innovation
Conventional CDO
Structured ABS with Tranching
Basic Structured Finance (ABS)
Primitive Assets/Receivables
What is the
Innovation?
2nd Stage Innovation
What is the innovation?
1ST Stage Innovation
What is the innovation?
Illiquid Assets (Primitive Asset)
Mortgages, consumer credit (auto loans, credit card), equipment leases
commercial loans, student loans, aircraft lease, royalties, future flows, etc
4th Stage
Exhibit 4: Structural Characteristics of ABS Transaction
1ST Step: Sales of Assets to SPV
2nD Step: Issuance of Securities on the market
Sale of Asset Portfolio
Originator
(Asset Seller)
Asset Cash Flows
Purchase Price
Purchase
Price
Obligors
Other Key
participants
Placement
Placement
Special Purpose
Vehicle (SPV)
Purchase
Price
Investment
Banks
Purchase
Price
Capital Market
Investors
Credit Enhancement, Liquidity Support
Cash Flow
Servicer
Rating Agency
•Debt Account
•Collection of
Principal & Interest
Typically
Provided by
originator
Cash
Flow
Trustee
•Paying office
•Administration of
transferred assets
Issued Securities
•Single
•Multiple
•Equity (unrated)
Exhibit 5: Economic Risk Transfer to Capital Markets and Economic Capital Reduction
Economic Risk Transfer
Expected Loss
Unexpected Loss
35
30
25
Default Frequency
20
15
Before securitization
10
After Securitization
5
0
1
2
3
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5
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7
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9
Confidence Interval (99.5%)
10
11 12
Default Loss
Before Securitization
Covered by earned risk
premium and loan loss
provision
Covered by economic capital
After Securitization
Retained risk exposure
(First Loss Protection)
transferred risk exposure
Origins of Subprime Mortgage Debacle:
“Exuberant” Search for High Yields
• What are Subprime Mortgages?
• Convergence of many factors -- 1997-2005
– Global Liquidity
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Low Interest Rates
High Yield Securities -- MBS and CDO
Investment Banks
Growth and Stability
Subprime Mortgage Credit
Asset Price Bubble
Credit squeeze
• Bubble started to burst after 2Q 2006
• The Rest is History
• Question: Do you think SPM are bad and should be
banned?
Some Lessons from SPM
Related Securitization
• Lesson #1: Real Business operations that create the assets
and their credit quality are fundamental to financial and
investment success of securitization
• Lesson #2: The complexity of some securitization structures
may conceal the real risk of the new securities
• Lesson #3: Securitization may be susceptible to principalagent problem
• Lesson #4: The value chain may only be as strong as its
weakest link – systemic dependence or diffused
responsibility
• Lesson #5: The prospect of the contagion – ability to
provide liquidity support may diminish
Some More Lessons
• Lesson #6: Rating and Rating Agencies matter a
lot for the well-functioning of markets for financial
assets, especially, asset backed securities (ABS)
• Lesson #7: Back to Basic– Cash Flows come real
business operation or LHS, not RHS of the
balance sheet
• These are important lessons, BUT
• Do not exaggerate or overreact
Mr. Chicken Little, Is the Sky of
Securitization Falling?
• NO! Stay Calm, the Sky is Not Falling
• The genie of financial innovation is already out of
the bottle, and is a good genie -- WHY?
• Securitization has created dynamic & beneficial
relations between individual and business
borrowers on one side, and the vast global capital
markets that were previously non existent
• It has broadened access to credit for individuals
and businesses at reasonable terms
How Does Securitization Create
Value?
• Securitization creates value by rearranging the
balance sheet to mitigate one or more markets
imperfections
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Information asymmetries
Incomplete Markets
Economic capital
Regulatory Capital
Taxes
• Translation: Capital Structure may not be
irrelevant!
The Economics of Asset Securitization
“The Chicken Theory”
$6.99
Whole chicken is worth $6.99
Incomplete market
Can you make money by cutting up the chicken? Where
did Colonel Saunders get his idea from?
The Economics of Asset Securitization:
“The Chicken Theory”
$2.95
$1.98
$1.40
$1.25
Cut and enhanced chicken $7.58
Whole Chicken
6.99
Economic Value Added
$0.59
How? “Go ask the Colonel for his secret recipe or you can
homebrew your Own”
Should African Capital Markets “Enter the
Kingdom of Securitization”?
• Emerging Economies of Africa should consider
wading in the waters of the innovation of structured
finance and securitization -- gradually
– Several emerging markets have already embraced the
technology
– Credit default swap (CDS) now constitute about 20% of
face value of emerging market debt
– The World Food Program has sold futures on Ethiopian,
rains – Now that is EXOTIC
– Argentine GDP-linked bonds
• Securitization may very well be a form of financial
inoculation for African Capital Markets
What Should be the Priority
Objective?
• Development of more inclusive and flexible
debt market, characterized by efficient risk
transfer , sound risk management , lower
cost of capital, with all the necessary shock
absorbers
• Complete Markets
• Well-functioning capital markets will make
crucial contribution to growth and stability
The Necessary Conditions
• Uphold and protect the sanctity of property rights
• Improve the legal environment to foster the use of
financial innovation
• Strong standard for investor protection
• Protection and enforcement of creditor rights
• Prudent (not excessive) regulation and
supervision, by central banks an other regulatory
bodies
• Subscribe to the maintenance of stable
macroeconomic framework -- value proposition
The Necessary Conditions
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Overall improvement of financial infrastructure
Improve financial architecture
Appropriate governance and transparency
Clear and transparent bankruptcy code
Appropriate yield curves across all maturity
spectrum
• Effective underwriting and hard-nosed auditing of
assets -- Where are the rating agencies?
• Most of all financial transparency and honesty
What Do African Capital Markets Get
for This Tall Order? -- The Benefits
• Inclusive and Flexible Capital Markets
• Securitization of Future Flows to accelerate economic
growth
• Access to capital markets for SMEs
• Long Term Financing for Housing and Infrastructure
• Transparency in risk pricing, mitigation and transfer
• Capital Markets Integration
• Lower cost of capital
• Broader access to capital markets
• More efficient capital utilization
Concluding Remarks
• I WOULD LIKE TO READ THIS