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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
Develop the skillset essential to successful securitisation swaps management Securitisation Swaps is a complete practitioner's guide to this unique and complex class of derivatives. This detailed examination follows the entire life cycle of securitisation swaps to give quants, structurers, traders, originators, issuers and lawyers a common reference for understanding their shared objective. Broad in scope to provide a common-ground perspective -- yet detailed enough to promote full understanding -- the discussion takes a distinctly cross-disciplinary approach that encompasses the multi-faceted knowledge base required to successfully execute these complex trades. Despite the fact that the size of the market is trillions of dollars in notional principal, securitisation swaps have thus far been neglected in both academic and practitioner literature. The numerous stakeholders that work together on these complex deals will all greatly benefit from a thorough understanding of their underlying risks and gain deep insight into the perspectives of each stakeholder. This invaluable guide provides multi-disciplinary insight that allows practitioners to: * Manage securitisation swaps more effectively, from pre-trade structuring and modelling to post-trade risk management and accounting * Understand the elements of securitisation and covered bonds, and how swaps mitigate risk in these types of transactions * Explore how securitisation swaps differ from other derivatives and delve into their three specific risk factors -- swap prepayment risk, swap extension risk and downgrade risk * Learn practical methods and strategies of risk management, accounting, pricing and transaction execution When securitisation trades go wrong, they become front-page news -- but when each participant understands accurate modelling, risk mitigation, optimal structuring, costs, pricing, commercial backgrounds and other integral practices, they are able to work together to achieve a shared objective. Securitisation Swaps provides the essential knowledge that streamlines and safeguards these important trades.
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Table of Contents
Cover
About the Author
Foreword
Acknowledgements
CHAPTER 1: Introduction
Notes
CHAPTER 2: Overview of Structured Funding
FUNDING
FUNDING INSTRUMENTS
SECURITISATION
COVERED BONDS
DOCUMENTARY FRAMEWORK
STRUCTURED FUNDING MARKETS
RISKS
Notes
CHAPTER 3: Asset‐Backed Debt Structures
LOAN POOL DYNAMICS
SECURITISATION STRUCTURES
COVERED BOND STRUCTURES
COMPARISON OF STRUCTURES
Notes
CHAPTER 4: Swaps in Structured Funding
AN OVERVIEW OF VANILLA SWAPS
ASSET SWAPS
LIABILITY SWAPS
STANDBY SWAPS
SWAP PRIORITY AND FLIP CLAUSES
Notes
CHAPTER 5: Swap Prepayment Risk
WHAT IS SWAP PREPAYMENT RISK?
MONTE CARLO MODELLING OF SWAP PREPAYMENT RISK
GREEKS, HEDGING AND VaR
XVA
MITIGATION STRATEGIES
SYSTEM ISSUES AND WHOLE‐OF‐LIFE DEAL MANAGEMENT
Notes
CHAPTER 6: Swap Extension Risk
WHAT IS SWAP EXTENSION RISK?
A SIMPLE PRICING FRAMEWORK FOR 1‐FACTOR STOCHASTIC FX
FULL PRICING FRAMEWORK IN A MULTI‐FACTOR SETTING
MITIGATION STRATEGIES
Notes
CHAPTER 7: Downgrade Risk
RATING AGENCY CRITERIA
BASEL III AND THE LIQUIDITY COVERAGE RATIO
LIQUIDITY TRANSFER PRICING
CONTINGENT FUNDING VALUATION ADJUSTMENT
RISK LIMITS
MITIGATION STRATEGIES
REPLACEMENT RISK
Notes
CHAPTER 8: Deal Management
PRICING
DEAL CHECKLIST FOR SWAP PROVIDERS
CLOSING THE DEAL
MARKET RISK MANAGEMENT
ACCOUNTING
Notes
Glossary
References
Index
End User License Agreement
List of Tables
Chapter 2
TABLE 2.1 Inception covered bond issuance and regulation in common law countr...
Chapter 5
TABLE 5.1 An array of market objects used to compute pathwise greeks.
TABLE 5.2 Direction and indicative magnitude of MTM movements of an unhedged ...
TABLE 5.3 Advantages and disadvantages of three different methods for computi...
Chapter 7
TABLE 7.1 Long‐term senior credit ratings of 41 major banks in developed coun...
TABLE 7.2 Local regulation implementing the Basel III liquidity requirements.
TABLE 7.3 An S&P ratings transition matrix for ‘All Financials’ that are AA‐r...
Chapter 8
TABLE 8.1 Total securitisation swap costs assembled from the component charge...
TABLE 8.2 When risk metrics are well within risk limits, approaching risk lim...
TABLE 8.3 The range of possible responses to prepayment risk events.
TABLE 8.4 The range of possible responses to extension risk events.
TABLE 8.5 The range of possible responses to downgrade risk events.
List of Illustrations
Chapter 2
FIGURE 2.1 Relative levels of risk to investors from various funding instrument...
FIGURE 2.2 Cash flows of a securitisation.
FIGURE 2.3 Overview of structured funding participants.
FIGURE 2.4 Tranching of a securitisation: credit and duration transformation vi...
FIGURE 2.5 Comparison of standalone SPVs and master trusts.
FIGURE 2.6 Covered bond payment obligations.
Chapter 3
FIGURE 3.1 Monthly paydown schedule of a 30‐year principal amortising loan with...
FIGURE 3.2 Monthly paydown schedule of a 7‐year principal amortising loan with ...
FIGURE 3.3 WAL (in years) as a function of CPR for two principal amortising loa...
FIGURE 3.4 Credit and cash flow perspectives on RMBS master trusts. The A notes...
FIGURE 3.5 Cash flow waterfall following a non‐asset trigger event.
FIGURE 3.6 Cash flow waterfall following an asset trigger event.
FIGURE 3.7 A credit card ABS pool with a revolving period and a controlled amor...
FIGURE 3.8 The three covered bond structures: hard bullet, soft bullet and CPT.
Chapter 4
FIGURE 4.1 Cash flows in a fixed/floating interest rate swap with constant noti...
FIGURE 4.2 Cash flows in a fixed/floating cross‐currency swap with constant not...
FIGURE 4.3 An intermediated asset swap. The swap with the SPV is called the
fro
...
FIGURE 4.4 Cash flow transformation via asset and liability swaps in a securiti...
FIGURE 4.5 Four different types of single/cross‐currency and fixed/floating lia...
FIGURE 4.6 Liability swaps can have a wide variety of embedded risks.
FIGURE 4.7 A standby swap provider.
Chapter 5
FIGURE 5.1 Typical hedging arrangement of a BGS.
FIGURE 5.2 Using an OU process to model realised prepayment.
FIGURE 5.3 Discounting cash flows under the spot measure in a Monte Carlo simul...
FIGURE 5.4 100 Monte Carlo paths for an arbitrary metric transformed into seven...
FIGURE 5.5 Asset swap intermediation.
FIGURE 5.6 Monthly prepayment time series for two Australian prime RMBS mortgag...
FIGURE 5.7 Prepayment volatility decreases as the number of loans increases (gr...
Chapter 6
FIGURE 6.1 An example of extension risk – amortisation profiles with the call e...
FIGURE 6.2 Typical arrangement where a swap provider has transacted a vanilla h...
FIGURE 6.3 Possible amortisation schedules following a covered bond issuer defa...
FIGURE 6.4 An extended swap.
FIGURE 6.5 A collateralised back swap.
Chapter 7
FIGURE 7.1 A typical centralised LTP process in a bank.
FIGURE 7.2 Example LTP and collateral exposures at different rating levels for ...
FIGURE 7.3 Monte Carlo paths for an AUD/EUR cross‐currency swap produced by
Qua
...
Guide
Cover
Table of Contents
Begin Reading
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Securitisation Swaps: A practitioner handbook
MARK AARONS
VLAD ENDER
ANDREW WILKINSON
This edition first published 2019
© 2019 Mark Aarons, Vlad Ender, Andrew Wilkinson
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Library of Congress Cataloging-in-Publication Data
Names: Aarons, Mark, 1975- author. | Ender, Vlad, 1974- author. | Wilkinson, Andrew, 1979- author.
Title: Securitisation swaps : a practitioner's handbook / Mark Aarons, Vlad Ender, Andrew Wilkinson.
Description: Chichester, West Sussex, United Kingdom : Wiley, 2019. | Series: Wiley finance series | Includes bibliographical references and index. |
Identifiers: LCCN 2018041666 (print) | LCCN 2018048782 (ebook) | ISBN 9781119532347 (ePub) | ISBN 9781119532309 (Adobe PDF) | ISBN 9781119532279 (hardcover) | ISBN 9781119532309 (ePDF) | ISBN 9781119532330 (ebook)
Subjects: LCSH: Derivative securities—Handbooks, manuals, etc.
Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 A2325 2019 (print) | DDC 332.64/57—dc23
LC record available at https://lccn.loc.gov/2018041666
A catalogue record for this book is available from the British Library.
ISBN 978‐1‐119‐53227‐9 (hardback) ISBN 978‐1‐119‐53234‐7 (ePub)ISBN 978‐1‐119‐53230‐9 (ePDF) ISBN 978‐1‐119‐53233‐0 (Obook)
Cover Design: WileyCover Image: © chain45154 / Moment / Getty Images
To Suzanne, Alex, Will and Jacqui with love and gratitude
– M.A.
To Irena and Anna – you gave me support and love when I needed it
– V.E.
To Amy, who never fails to shine a guiding light for me
– A.W.
About the Author
Mark Aarons was Head of FICC Structuring at the National Australia Bank from 2010 to 2017, where he built a leading securitisation swap business in both Australia and the UK. Mark is currently Head of Investment Risk at a leading Australian funds manager and is also an Adjunct Associate Professor in the Centre for Quantitative Finance and Investment Strategies at Monash University. He has degrees in Law and Science from Monash University and a PhD in Mathematics jointly from the Max Planck Institute for Gravitational Physics and the Free University of Berlin, Germany. He resides in Melbourne with his wife and three children.
Vlad Ender is a director at Kauri Solutions, a financial markets consulting practice. Prior to founding Kauri Solutions in 2015, Vlad spent eight years at National Australia Bank's London office. He served as an Executive Director in the FICC Structuring team, providing bespoke derivatives to NAB's clients, including innovative solutions for asset and liability swaps to support RMBS and covered bond issuance by some of the largest UK issuers. Before joining NAB, Vlad was a partner at a New Zealand IT consultancy delivering tailored solutions to the financial sector. Vlad holds an MBA from London Business School and a Masters degree in Computer Science from Charles University, Prague.
Andrew Wilkinson is currently a senior legal counsel in Australia where he specialises in bespoke derivatives and securitisation. Previously, Andrew spent a decade in London working through the financial crisis and beyond for leading law firms Linklaters LLP and Weil, Gotshal & Manges. Through this period Andrew worked on some the most complex and innovative transactions in the market, providing advice to securitisation and covered bond issuers and arrangers across UK, Europe and Asia. He has extensive experience in structured finance, securitisation and derivatives across all asset classes. Andrew holds a Masters of Banking and Financial Services Law from the University of Melbourne and Bachelors degrees in Law and Arts from Monash University.
Foreword
I first met Mark in London in March 2007. He had taken a transfer from head office in Australia to join our UK Market Risk team as a model validation quant. Mark's timing was impeccable – the start of the global financial crisis and one of the most extraordinary chapters in the history of financial markets was only a few months away. By September, depositors were queuing outside Northern Rock and within a year Lehman Brothers would collapse. These events, and those that followed, would shape our careers and lead to the book you hold today.
Shortly after Mark started, chatter about the new ‘risk guy’ began to emerge. Mostly that he might have a personality, but also that he was a problem‐solver, someone eager to learn and work with front office to get things done. It didn't take long for him to make an impression on me either with his enquiring mind and intellect (who gets a maths PhD and a law degree?).
The collapse of Lehman's was the defining moment of the crisis, when the sheer scale of the credit and liquidity binge was finally laid bare for all to see, leaving the financial universe staring into the abyss. It was at this point that I was tasked with taking over the bank's capital markets structuring portfolio. That team had avoided CDOs and CLOs (not the bank however, where we had billions of dollars of CDOs in an SPV) but there was still correlation, credit and funding risk not being captured or valued and requiring serious work to sort out. With that transpired one of the easiest decisions I have ever had to make: just over a year after starting in Market Risk, Mark moved to front office to manage the portfolio.
A few months later Mark and I had a meeting with the Head of Secured Funding of our UK retail bank. Historically we had had little relationship with them, not having the capability to price or book their balance guarantee swaps. That meeting proved to be the genesis of this book. The swap provider to their master trust programme had given notice and no one else would step in (at least not for a price that was anywhere near reasonable). It was left to the parent bank as the AA‐rated entity, and more specifically to us, to find a solution. We were going to have to solve the complex quantitative and operational challenges necessary to price, risk manage and book the trades, which this book so comprehensively discusses.
Given the amount and complexity of work involved, Vlad was the ideal additional person to bring on board to work with us on the task at hand. Vlad had started as a programmer consulting to the New Zealand subsidiary of ours a few years earlier. After moving to London, he had shown great aptitude in building the systems for the nascent inflation swap business. His curiosity and smarts led him to take a keen interest in the structuring and risk management side of that business where his value was soon realised by Sales and Trading.
Over the following months and years, I watched Mark and Vlad break down and solve each of the various challenges discussed in this book. Along with other colleagues, they created a suite of analytics, wrote the code, built interfaces to core bank systems, developed risk and finance policies, worked on the transaction documents with legal counsel, influenced myriad stakeholders to support us and then took it all through the hierarchy of risk committees. All these years later, I can still picture Vlad sitting at his desk in London, headphones on, trying to work out how we would ever get the accompanying basis swap into our systems.
The rest is history. Approvals were granted and our first UK securitisation swap took place shortly after. This new capability, when allied to our AA rating at a time when the incumbent, lower‐rated swap providers were pulling out, was to prove a compelling proposition. Over the following years we built out a strong distribution capability and went on to close numerous notable and high‐profile transactions, both for our own issuance and as a third‐party swap provider in both the UK and Australia. Throughout this period there was no guide book or paper we could find to teach us how to price balance guarantee swaps. To the best of my knowledge there still isn't – which is what makes this book so invaluable.
Around the same time I met Mark, a young lawyer was also embarking on a similar journey. Andrew arrived in London from Australia in early 2008 to join the structured finance team of a leading law firm, just in time for the financial crisis. As the crisis began to take hold Andrew found himself right in the middle of it, whether it be advising financial institutions to access the emergency liquidity measures introduced by Bank of England or working on the Lehman Brothers administration itself. As the focus shifted from deal origination to restructuring, Andrew was on the frontline, working on many innovative solutions to address the issues arising from the crisis. This proved to be the perfect breeding ground for when he later came to work with Mark back in Australia to help navigate the complex legal and regulatory framework, which has since burgeoned around both securitisation and derivatives.
On reflection, there are several points to make. Firstly, we came to appreciate the elegance of securitisation and to distinguish it from the seemingly non‐existent credit standards of sub‐prime securitisation. Amongst other benefits, securitisation allows non‐bank lenders to flourish and provide finance to many who are viewed as ‘non‐conforming’ by high street banks. Secondly, and where this book is of such value, secured financing treasury teams often do not have the ability to price or challenge swap pricing. Instead, the focus is on the headline coupon or floating margin. What really matters is the landed cost of funds inclusive of swap execution cost. For that to occur, each of the features of the swap have to be priced and negotiated. I would also commend this book to those in bank securitisation relationship teams – the ability to understand and challenge their traders swap pricing is now at hand!
In my experience, quantitatively talented people are not that unique. What is unique however is when, together with that, they also have ambition, resilience, wit and, most importantly, the ability to distil complex quantitative topics into simple, concise and easily understandable points. It is these attributes that enabled us to take complex risk features through a conservative risk environment and it is the same attributes that make this book so compelling. I may be biased, but Mark, Vlad and Andrew have done an outstanding job in the quality and breadth of content and its sheer accessibility.
Chauncy Stark
Sydney, July 2018
Acknowledgements
As many authors before us have observed, writing a book has turned out to be a significantly larger task than first imagined. It is a good thing that many authors only realise this in hindsight, else there may be considerably fewer books! It is therefore with great pleasure that we acknowledge the following people for their invaluable assistance to us over this journey, for their thoughtful comments and expert insight across quantitative finance, securitisation origination, derivatives and securitisation law, product control, risk management and structuring. We sincerely thank: Craig Stevens, David Addis, Dmitry Pugachevsky, Glen Rayner, Jamie Ng, Jenny Schlosser, Michael Liberman, Robert Phillips and Rohan Douglas. Any errors that remain are solely our own. We would also like to thank Alan Brace for permission to quote his mixed measure result in Chapter 5 and Quantifi for providing analytics for an XVA example in Chapter 7.
We also wish to thank many of our former/current colleagues and friends for assisting the build out of a successful securitisation swaps business. Particular thanks are due to Chauncy Stark and Lee Kelly for their vision, leadership, support and business acumen; Tony Kelly, Grant Armstrong and Andrew Downes for their outstanding skill, dedication and good humour; Jacqui Fox and Sarah Samson for their fantastic collaboration and leadership in building Australia's top‐rated securitisation origination business; and Dennis Craig for his high calibre expertise and support. We also acknowledge our other wonderful colleagues in the departments of Risk, IT, Legal, Finance, Treasury, Operations and Front Office and our many clients across financial institutions in Australia and the United Kingdom.
CHAPTER 1Introduction
There are literally trillions of dollars of face value of swaps embedded in securitisation and covered bond structures globally. These embedded swaps – which we shall call securitisation swaps – have several highly distinctive features that make them quite different from other derivatives. Despite these differences and the sheer size of the market, securitisation swaps have long been neglected in both the practitioner and academic literature.
Amongst the participants of structured funding markets the emphasis is (rightly) on the funding task for originators and the relative value proposition for investors. Much attention and discussion are lavished on the size of the coupon on residential mortgage‐backed securities (RMBS), asset‐backed securities (ABS) and covered bonds and whether it is tighter or wider than recent comparable issuance. Yet for originators the key metric is not the coupon but rather the landed cost of funds, that is the cost of funding once all expenses, including swap fees, are included.1 This is almost never publicly disclosed – but that certainly does not diminish its central importance. In this vein, securitisation swaps deserve more prominence as they are, in many cases, a material proportion of the overall funding cost.
In addition to impacting the landed cost of funds, securitisation swaps incorporate new risks and complexity into structured funding transactions. For instance, a credit rating downgrade of the swap provider can, in certain circumstances, lead to a downgrade of the associated bonds without any change in the creditworthiness of the underlying loan pool. Securitisation swaps can also be a significant impediment to restructuring deals,2 which can blindside investors who aren't fully aware of the consequences of having swaps embedded in structured funding deals.
It therefore makes good sense for practitioners to understand how securitisation swaps are priced, what risks they carry and how the price and risk varies across the myriad structuring options. As for any financial instrument, the pricing depends on the qualitative and quantitative nature of the risks being transferred. So, understanding the risk management of securitisation swaps by those who provide them is useful knowledge. It is the authors' contention that having a deeper understanding of the structuring, pricing and risk management of securitisation swaps will be of great benefit to everyone involved in structured funding, whether directly or as a service provider.
What makes securitisation swaps different? Securitisation swaps are different because they are inextricably linked to the inner workings of the underlying structured funding. The dynamics of the underlying loan pool and cash flow waterfalls – which are usually highly tailored – need to be incorporated in to the modelling of the swaps. This is in contrast to derivatives used by corporations, fund managers and other entities to manage risk. For example, consider a fund manager who owns USD200 million of offshore assets and hedges them back to domestic currency with foreign exchange (FX) forwards. It doesn't matter if the offshore asset is a portfolio of stocks or a power station, the FX forward is a simple currency risk management overlay, which can be easily bolted‐on. In contrast, securitisation swaps are not bolted‐on, but embedded.
The embedding of swaps in securitisation and covered bond structures is designed to remove market risk from funding deals. When underlying cash flows change, whether due to prepayment rates in the loan pool, a trigger feature in a cash flow waterfall or the originator hasn't called its bonds at a call date, any associated securitisation swap will have its cash flows altered in lockstep. This de‐risking of structured funding enables the issuance to receive a very high credit rating – often AAA – from credit rating agencies. In turn, these very high ratings enable structured funding to be a highly efficient form of funding for banks and non‐bank lenders.
Imagine if a securitisation swap was not in place on a structured funding issuance into, say, US dollars (USD) from a sterling (GBP) denominated loan pool. The currency volatility would expose the US investors to significant potential loss without any deterioration in the credit risk of the underlying pool of assets. For example, in 2008, GBP plunged 30% in value from buying around 2.00 to 1.35 USD in a matter of months. Removing this currency risk is an absolute necessity for any issuer hoping to achieve a AAA rating on such bonds. Likewise for interest rate risk and other market risks. But market risk can only be totally removed if the swap provides a perfect hedge – and this requires the swap cash flows to be in total alignment with the underlying cash flows from the structured funding vehicle.
Of course, the converse of the de‐risking of structured funding deals is that the provider of the swap is assuming those risks. It goes without saying that anyone assuming such complex cross‐asset risks needs to have significant expertise or else they could incur very material financial losses and risk management pain. This is equally true no matter whether the swap provider is also the originator or whether it is a third‐party provider.
The risks from providing a securitisation swap are complex because there are multiple moving parts. Not only are the underlying cash flows subject to change, but markets are moving at the same time, specifically spot FX rates, interest rates and basis curves. The good news and key message of this book is that rigorous modelling and a wide variety of risk‐mitigating structures can tame these complex risks. In this regard, the swap structuring techniques described in this book, and the legal mechanisms to incorporate them into deals, are just as important as the quantitative modelling. A thorough understanding of risk‐mitigating structures for securitisation swaps should be an important part of the toolkit for anyone involved in structured funding.
We devote an entire chapter to each of the three key distinctive risks of securitisation swaps. Chapter 5 is dedicated to swap prepayment risk. This is the risk of simultaneously adverse moves in both loan pool prepayment rates and market risk factors. Swap prepayment risk is more complex than prepayment risk since it is concerned with the consequential impact of prepayment risk together with changes in market risk factors on derivatives valuation.
Chapter 6 concentrates on swap extension risk. This is the risk that the weighted average life (WAL) of the underlying ABS, RMBS or covered bond may extend, causing associated securitisation swaps to also extend. Extension events can be caused by originators not calling their bonds as expected (for securitisations) or by an issuer event of default (in the case of covered bonds). Extension risk is concerned with a single low probability, high impact event. In contrast, swap prepayment risk is concerned with a series of high probability, low impact events.
Chapter 7 is devoted to downgrade risk. Downgrade risk arises from swap providers having to comply with strict obligations linked to their own credit ratings. These obligations are defined by the rating agencies and arise from the fact that swap providers are usually rated lower than the structured funding they are supporting. The obligations are designed to de‐link the swap provider's rating from that of the structured issuance. Downgrade risk consists of two underlying risks: (i) the risk of posting collateral one‐way if its own credit rating falls to a prespecified trigger level; and (ii) the risk of being forced to novate out of a swap if its credit rating falls to a (lower) prespecified trigger level. Both events can be costly. The risk of posting collateral also entangles securitisation swaps with Basel III liquidity regulation and requires a new derivative valuation adjustment (yet another XVA!) to account for it.
This book is intended for a wide audience – for everyone involved in structured funding in some capacity. This includes originators, sponsors and arrangers, investors, swap providers, rating agencies and regulators. Relevant staff at swap providers includes derivative structurers, sales, traders, quants, risk managers, lawyers, product controllers and system developers. This book focuses primarily on swaps in structured funding transactions where the underlying debt is residential mortgages in predominantly floating rate markets (such as Australia and the UK), auto loans or credit card receivables. Nevertheless, much of the content of this book will still be broadly applicable, with some modification, to other underlying asset classes such as corporate loans, commercial real estate and student loans, and to other jurisdictions.
The book can be referred to in discrete parts or read cover‐to‐cover. Readers with a strong background in securitisation can skip Chapters 2 and 3 and begin with the discussion on swaps in Chapter 4. Readers with a derivatives background, but little or no securitisation knowledge, should start at Chapter 2 where they can learn about securitisation quickly, with the material tailored to build a foundation for securitisation swaps specifically. Worked numerical examples are available in a spreadsheet on this book's website at www.securitisationswaps.com.
Notes
1
For banks, who must hold credit risk capital against loans on their balance sheet, the landed cost of funds should also include the cost of capital
savings
from transferring securitised loans off their balance sheets. This does not apply to non‐bank originators.
2
For example, the Federal Reserve Bank of New York's Maiden Lane III portfolio of legacy AIG assets faced these problems. See
https://tinyurl.com/y9bmg7c6
.
CHAPTER 2Overview of Structured Funding
Never invest in a business you can't understand.
– Warren Buffet
FUNDING
Banks, building societies and non‐bank lenders are in the money business. Money, in all its forms, is for these institutions what inventories are for other businesses. As such, these institutions must raise money. A profitable institution will then loan the money out to borrowers at a higher average interest rate than the aggregate cost of its funding. The difference between these two rates is known as the net interest margin (NIM) and it is a key metric for all for‐profit financial institutions.
Banks need money for a multitude of reasons: for capital, liquidity and regulatory purposes. Interestingly enough, banks do not need to raise money to fund loans at inception. Alan Holmes, who managed the Federal Reserve System Open Market Account, wrote in 1969 that ‘in the real world banks extend credit, creating deposits in the process, and look for the reserves later’.1 Thus, in the process of writing loans banks are able to independently create money themselves in the form of deposits. In contrast, shadow banks require funding in order to be able to extend credit as they are unable to take deposits.
Whether or not the cash raised is used to fund loans, the term funding is still used ubiquitously in the financial services industry to describe the raising of money and will be used in this book as well.
All funding instruments have a cost to the issuer. The whole‐of‐life cost is comprised of two components: the market cost of funds and transaction costs.
The market cost of funds is the sum of the various risk premia that investors require as compensation for taking risk, including the term credit, interest rate, liquidity and complexity premia. It is the cost of funding prior to the inclusion of any transaction costs.
The market price of risk is the return in excess of a benchmark rate,2 such as a relevant bond yield, that the market wants as compensation for taking on credit and other risks. A credit index, such as iTraxx Senior Financials, can provide an indication of this level. The market price of risk is a highly dynamic feature across securities markets and, in times of market stress, can blow out by several orders of magnitude.
There are two main drivers of the perceived credit risk attaching to a funding instrument: seniority and tenor. The more senior the instrument, the greater the chance the investor will be repaid in the event of an issuer default. Longer‐term funding instruments generally cost more as investors require higher compensation for the extended loss of liquidity, the increased risk of default and greater uncertainty that longer time horizons inherently produce.
Transaction costs comprise an inception issuance cost and running costs. The inception cost depends on the complexity of the instrument and how tailored it is to particular investors' requirements. Standard market instruments, such as bank bills and short‐term repurchase agreements (‘repos’) have very low inception issuance costs due to their generic, ‘cookie cutter’ nature. On the other hand, new capital instruments, long‐term debt and especially secured, complex or bespoke funding instruments will involve a great deal of work to put together, which is reflected in higher costs. Running costs will vary depending on how much reporting and disclosure is required and the level of active management the funding requires and whether external parties such as special purpose vehicles (SPVs) are involved.
One would expect that a financial institution should try to obtain the cheapest possible funding available to it, but that could expose the institution to unwanted risks and restrict its business model. For example, the cheapest funding in the market is generally a short‐term repo. A repo is a form of short‐term, structured funding, whereby the seller of a security agrees to buy it back at a specified time and price. However, a repo involves having a stock of high‐quality collateral available to be repurchased in the market. Before the Global Financial Crisis (GFC) many AAA‐rated instruments were accepted in the repo market as high‐quality collateral. However, the repo market has developed so that only collateral issued by certain governments or some supranational organisations will be accepted as high quality. Furthermore, as some governments pare back the volume of their debt issuance, the availability of collateral and hence the size of the repo market has declined, leading to this cheap source of funding drying up.
Similarly, unsecured short‐term interbank loans, another staple of cheap funding prior to the GFC, have also declined in importance. This has contributed to an overall decline in the centrality of IBOR rates, which were the rates at which banks would offer unsecured lending to one another. No bank will offer the same rate on unsecured lending to all of its peers now.
More generally, the GFC has shown very dramatically that overreliance on any form of short‐term funding can be extremely dangerous. A significant number of financial institutions failed during the GFC when short‐term funding evaporated. While excessive leverage, poor credit quality and rating agencies were also major contributing factors, lack of liquidity was, arguably, the most important culprit.
Thus financial institutions must consider more factors than simply cost when designing their funding plan. The stability and diversity of their funding mix are critical factors to ensure resilience during periods of market stress. Indeed, various new Basel III regulatory reforms – for example, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) – have compelled institutions to extend the tenor and diversity of their funding. As a result, the issuance of more costly instruments is an even more important part of the funding mix of every financial institution.
FUNDING INSTRUMENTS
Financial institutions, like all corporations, may be funded via a mix of debt and equity. However, financial institutions generally have a much higher proportion of debt funding than other corporations, which is likely why they have developed a larger array of debt funding instruments, with myriad characteristics, purposes, advantages and disadvantages. Broadly speaking, we can identify the following four attributes of funding instruments:
Seniority
. This defines an investor's priority in claiming assets in the event that a financial institution fails. Equity confers ownership rights but the lowest seniority. Debt ranks higher but is graded from senior to subordinated. Deposits have the highest seniority.
Tenor
. This can range from very short‐term funding like on demand deposits, through short‐term bills, long‐dated bonds and finally equity that is perpetual.
Security
. Unsecured or secured by a segregated pool of assets. Structured funding includes repos; single‐recourse debt instruments such as
asset‐backed securities
(
ABS
),
residential mortgage‐backed securities
(
RMBS
) and
collateralised loan obligation
s (
CLO
s); and dual recourse debt instruments such as covered bonds.
Complexity
. This ranges from very simple instruments such as common equity, term deposits or senior unsecured bonds to highly structured and/or tailored instruments such as convertible bonds, ABS and RMBS.
Figure 2.1 shows the most common forms of funding instruments and relative levels of risk that can be attributed to them.
FIGURE 2.1 Relative levels of risk to investors from various funding instruments.
Note that securitised debt is listed several times in Figure 2.1 as the tranching process (described below) can create a number of debt securities with very different credit risk.
SECURITISATION
The Securitisation Process
Securitisation is the process by which non‐tradeable debt, such as residential mortgages, auto loans and credit card receivables, is converted into a tradeable debt security issued to investors. The principal and interest from the underlying contractual debt is used to pay the investors. In principle, any receivable with regular, predictable cash flows can be securitised.
Investors buying securitised debt are assuming the credit risk on the pool of underlying debt and are compensated accordingly via the credit spread they receive in the bond coupons. They are not assuming any direct credit risk on the institution that originated the underlying debt.3 This is known as bankruptcy remoteness. It means that even if the institution that wrote all the underlying mortgages defaults, the securitised debt built from those mortgages can continue to repay investors.
In order to achieve bankruptcy remoteness, a legal separation is required. Some terminology is needed to clearly define this. The originator is the institution that originated the underlying debt; that is, it is the bank that wrote the mortgage or the finance company that provided the auto loan. The issuer, on the other hand, is the legal entity that has issued the securitised debt to investors and is responsible for its repayment.
The legal entity used to issue the securitised debt is called a SPV. In common law jurisdictions,4 SPVs usually have the legal form of a trust, although companies may also be used. In reality, the SPV is simply a holding vehicle used to achieve legal separation from the originator. Note that certainty of law is a key fundamental requirement for the securitisation process to work. Although this is a given in developed market jurisdictions, it cannot always be assumed elsewhere.
The process works as follows:
The originator establishes an SPV.
The SPV purchases receivables from the originator, funded by a loan from the originator.
The SPV issues one or more bonds to investors that are secured against the principal and interest cash flows it has purchased from the originator, and uses the proceeds to repay the loan from the originator.
The trust pays a company, called a servicer, to
service
the assets, that is, to collect payments, manage arrears and resolve defaults. In the UK and Australia this is usually the originator. In the USA it is commonly a third party.
The trust uses the money it receives from the servicer to pay expenses and investors. Excess spread may be returned to the originator.
Figure 2.2 illustrates the basic structure.
FIGURE 2.2 Cash flows of a securitisation.
Structured Funding Participants
Originator/Seller The originator, sometimes also called the seller, is the entity behind the securitisation or covered bond that is responsible for originating the assets and owning the income stream from the receivables being securitised. For example, in a securitisation backed by residential mortgages, the bank that underwrites and advances the mortgage loans will be the originator. Therefore, the obligations arising with respect to securitised assets are originally owed to the originator before the transfer to the issuer takes place. Originators can include banks, building societies, non‐bank lenders, captive financial companies of the major car manufacturers, insurance companies and other financial institutions. Occasionally, the seller may be a third party who buys the pool with the intention to securitise it thereafter.
There are a number of non‐mutually‐exclusive reasons why an originator may choose to securitise its assets rather than holding them, including: to achieve a lower cost or alternative source of funding; to accelerate cash receipts and remove assets from on‐balance sheet; to engage in regulatory capital arbitrage.
Issuer In a securitisation transaction, the issuer will hold the assets and issue the securities. The issuer will normally take the form of a newly created SPV that is structured to be bankruptcy remote. In practice, this means that the issuer:
has no shareholders or employees;
is a new company with no existing creditors that could potentially raise competing claims with noteholder in the event of an insolvency event; and
has limited constitutional objects, which restrict it from undertaking any business other than issuing notes within the context of a securitisation.
The SPV commonly takes the legal form of a trust, though may also exist as a corporation, partnership or a limited liability company.
In a covered bond transaction, the issuer is the financial institution issuing the bonds.
Servicer The servicer is the entity that services the assets, including collecting the principal and interest payments from the underlying pool. More often than not the originator of the loans will continue to act in the role of servicer on the basis that this will involve no change to the documented payment collection procedures and that enforcement and recovery procedures will already be established to deal with customers in default. From the perspective of the borrower of a loan this means that it is often very difficult to tell if a loan has been securitised. The servicer is typically compensated with a fixed servicing fee.
Trustee In a structured funding transaction the primary duty of the trustee is to protect the interests of the noteholders and to administer the duties of the SPV within the documentary framework. Because the trustee acts in a fiduciary capacity this means that it is legally obliged to act in the best interests of the noteholders and preserve their rights within the transaction.
The trustee performs a fundamental role, which can be broken down into two distinct areas of responsibility: the notes and the security. It is important to distinguish between the capacities of the note trustee and the security trustee. The note trustee holds the issuer's covenant to pay on trust for the noteholders, whereas the security trustee holds the benefit of the security interests on trust for all of the secured parties, that is, the noteholders and other various transaction parties (including the swap counterparty) that may also be granted security.
In some transactions these roles may be separated so that there is a separate note trustee and a security trustee, but in other transactions the same trustee may perform both of these functions with no distinction being made between these obligations. It should be noted that where the trustee role is combined there may be obligations towards the noteholders (under the notes) and the noteholders and other transaction parties (under the security) that could give rise to a potential conflict of interest, which would need to be addressed within the documentation.
For the sake of ease and convenience here we have split out the note trustee and security trustee to give a better idea of the different roles but note that it is not unusual for these to be combined into a single trustee role.
Note Trustee The note trustee represents and co‐ordinates the group of noteholders, which in turn provides the issuer with a single point of contact. One of the main advantages of the trust structure is that a single trustee can be utilised to deal with a multitude of different investors. As a trustee, the note trustee holds certain duties and responsibilities that are enshrined in legislation and the general principles of equity under the common law.
The note trustee role is largely administrative and the acting note trustee will be empowered to agree certain minor or technical amendments without consultation with the wider group of noteholders. This can alleviate some of the administrative burden associated with the transaction. However, while there are various discretions to act, in practice, it is extremely unlikely that the note trustee will take any material actions unless it has received instructions to do so (which in a bond transaction may involve convening a meeting with a quorum of noteholders) and unless it has been indemnified against any cost, expenses or liabilities that it may incur as a result of taking such action. Because the role of the note trustee is relatively mechanical and limited in scope, the fees earned by a note trustee for acting in the role are generally quite low.
Security Trustee An issuer will grant security over all of its assets and an undertaking in order to secure its obligations to noteholders and certain other transaction parties (which become collectively known as the ‘secured creditors’). The only transaction parties who tend not to be secured creditors are the arranger and managers who take their fees on day one and then have little involvement in the remainder of the securitisation. The security is not granted to each secured creditor on an individual basis but rather to the security trustee, who will hold that security on behalf of all of the secured creditors. Again, this provides the issuer with a single point of contact and makes the management of the security interests easier.
The security trustee is responsible for enforcing the security and distributing the proceeds of the security. Because there may be numerous secured creditors with different priorities and size of claims against the security there may need to be a pre‐determined method for how the security trustee takes instructions (an ‘intercreditor arrangement’), which can vary depending on the size and complexity of the transaction. The security trustee will distribute proceeds following the enforcement of security in accordance with the post‐enforcement priority of payments (also known as the post‐enforcement waterfall). This process allows any available cash to cascade down to the relevant parties dependent on their ranking in the waterfall, which is commercially negotiated considering a number of factors, including overall amount and size of risk that the party is taking within the transaction.
As with the note trustee, the security trustee is also usually paid a relatively low fee, which reflects the fact that the role of the security trustee is intended to be largely administrative and that the security trustee is not being paid to assume significant risks. As the fee is quite low, the security trustee will generally not take any issue against the issuer without being indemnified for any expenditure or liability it may be exposed to.
Arranger and Managers The arranger function in a securitisation is normally performed by an investment bank. The lead arranger will be instructed by the originator to structure and price the funding transaction on its behalf. Importantly, it is the lead arranger who will manage the relationship with the rating agencies. The lead arranger will typically be assisted by other appointed managers, who market the notes to prospective investors on investment roadshows. The role of the lead arranger and managers is to subscribe for the securities offered by the issuer and then distribute these to the investors, upon which the role the lead arranger and the other managers play in the transaction concludes. This is sometimes why the arranger and joint managers are referred to as the underwriters.
Third Parties
Account Bank As money is being paid to and from the issuer throughout the life of a transaction it will need to maintain bank accounts and the account bank provides these. In a securitisation there may be many different bank accounts, including a principal and interest cash flow collection account into which most of the money it receives is paid. Other accounts may include reserve accounts that are set up for credit enhancement (CE) purposes, principal and income receipts accounts, a liquidity account and swap collateral accounts for use in connection with any underlying swaps. To perform the function of account bank, a financial institution will be required to have a sufficiently high and stable credit rating under the relevant counterparty criteria.
Cash Manager
