THE VIABILITY OF ASSET BACKED SECURITISATION IN EMERGING MARKETS

WITH REFERENCE TO SOUTH AFRICA.

STEWART MAKURA

A research report submitted in partial fulfillment of the requirements for the degree of

MASTER OF BUSINESS ADMINISTRATION

in the

INSTITUTE OF FINANCIAL MANAGEMENT

UNIVERSITY OF WALES BANGOR AND

UNIVERSITY OF MANCHASTER

OCTOBER 2002

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 ACKNOWLEDGEMENT

I wish to express my appreciation and gratitude to the following persons and without

whom this project would not have been completed:

• Colleagues at Standard Corporate and Merchant Bank for the provision of data,

discussions and support provided towards the success of this research report.

• Mr Ismail Erturk of the Manchester Business School, my supervisor for his guidance

and support.

• My family and friends especially my late sister Gennis Varaidzo for their

encouragement and support during my period of study.

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 TABLE OF CONTENTS

1. THE MECHANICS OF ASSET BACKED SECURITISATION 6

1.1 Research Objectives and Methodology 7

1.2 The parties and processes in Asset Backed Securitisation 7

1.3 Development of Asset Backed Securitisation 14

1.3.1 The United States of America 14

1.3.2 Europe 15

1.3.3 South Africa and Other Emerging markets 17

2 REGULATORY ENVIRONMENT 21

2.1 Regulatory framework in the Developed World 21

2.1.1 United States of America 21

2.1.2 Developed markets in Europe 22

2.1.2.1 United Kingdom 22

2.1.2.2 Germany 24

2.1.2.3 France 26

2.2 Regulatory Environment in Emerging markets 27

2.2.1 Malaysia 27

2.2.2 Hong Kong 28

2.2.3 South Africa 30

3 LEGAL,TAXATION AND ACCOUNTING FRAMEWORK 34

3.1 Legal and Taxation 34

3.1.1 United Kingdom 34

3.1.1.1 Legal 34

3.1.1.2 Taxation 36

3.1.2 The French Credit Foncier de France (“FCC”) 38

3.1.3 Australia 38

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3.1.4 Hong Kong 39

3.1.5 Malaysia 40

3.1.6 South Africa 41

3.1.6.1 Legal 41

3.1.6.2 Taxation 45

3.2 Accounting 49

3.2.1 United Kingdom 49

3.2.2 Australia 50
3.2.3 South Africa 50

4 ASSET AND ORIGINATOR CHARACTERISTICS 54

4.1 Residential Mortgage Loans 54

4.2 Asset Backed Commercial Paper (ABCP) Conduits 58

4.2.1 Credit Enhancement in ABCP 61

4.2.2 Non eligible assets 64

4.3 Commercial Mortgage Backed Securitisation (CMBS) 65

5 MARKET INFRASTRUCTURE AND INVESTORS 69

5.1 Size and depth of the financial markets 69

5.2 Credit risk and Investor demand and attitude 71

6 CONCLUSION 78

7. REFERENCES 81

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TABLE OF FIGURES AND TABLES

Figure 1.1 A typical asset backed securitisation transaction

Figure 1.2. European MBS/ABS Issuance by Asset Type, 1997 and 1998

Figure 2.1 Growth of the UK ABS Market

Figure 2.3: Risk weighting applicable to banks investing in ABS in South Africa

Figure 4.1: Distribution of South African Mortgage Lenders Ranked by Mortgage

Assets as of December 2000

Figure 4.2 An illustration of the parties and cashflows in multi-seller ABCP

Table 5.1:Composition of Exchange Traded Securities by Market Value, 2000

Figure 5.1: Domestic Equity and Bond Investments by SA Institutions

Figure 5.2: Movement in the Government Bond Yield Curve

Figure 5.3 Summary of ABS instruments issued in SA since December 2001

Table 5.2 An estimate of funds available for investment in ABS and Corporate

Bonds

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1. THE MECHANICS OF ASSET BACKED SECURITISATION

Before presenting the research methodology and findings a literature review was

considered appropriate to provide readers with the necessary background to the

concepts and components of asset backed securitisation (“ABS”). In the context of

this report ABS will be applied to mean all forms of asset backed securitisation

including mortgage backed securitisation (“MBS”) which of are distinguished in most

American literature. In this chapter a broad overview will be given outlining the

processes and parties involved in concluding an ABS transaction. A brief overview of

the historical development of ABS in the USA, Europe and more recently in emerging

markets will be discussed. Further an introduction into the various asset classes that

can be securitised and the benefits sought after by those who participate in

securitisation will be made.

Several definitions have been suggested to describe ABS amongst the more prominent

are the following:

”A device of structured financing where an entity seeks to pool together it’s interest in

identifiable cashflows over time, transfer the same to investors either with or without

the support of further collaterals and thereby achieve the purpose of financing”(V

Kothari, 1999).

“ a means by which providers of finance fund a specific block of assets rather than the

general business of a company”(Accounting Standards Board, 1994).

“Asset securitisation is the structured process, whereby interests in loans and other

receivables are packaged, underwritten, and sold in the form of “asset backed

securities….”(US Office of Comptroller, 1997).

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In essence the process of ABS entails transformation of illiquid financial assets into

securities that can be traded. Put another way the assets are monetised through the

issuance of asset backed securities. The assets in question can be in theory be any

assets that provide a predictable stream of cashflows, amongst the most common types

of assets that are used in ABS transactions are; residential mortgage loans, credit card

receivables, loans and trade receivables.

1.1 Research Objectives and Methodology

Asset backed securitisation is rapidly becoming a financial tool and concept in the South

African funding and investor scene. The main objective of this report is to predict the

viability and extent to which the application of this tool will be put to use in the South

African market and other emerging markets given the experience in the developed

world.

The research methodologies employed to meet the objectives of this report comprise;

• A review of the available literature to trace and highlight the developments of

securitisation in emerging markets relative to the developed world.

• In particular an in-depth comparison of the regulatory environment, legal and

regulatory framework, asset types and originator characteristics, as well as investor

and market characteristics.

• Input of my experiences as an arranger of asset backed securitisation deals in

South Africa over the last two years.

1.2 The parties and processes in Asset Backed Securitisation

The main parties to an ABS are the originator, servicer, issuer, credit enhancers and

liquidity providers, rating angecies, placement agents and the investors. Each of these

party’s role in the ABS transaction will be discussed briefly in turn.

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The originator also referred to as the seller or transferor is the entity that owns the

asset prior to conducting an ABS. They have a need to raise funding generally at

attractive rates and or a need to free up their balance sheet. The main characteristics

sought in the assets is a predictable stream of cashflows that are capable of being

pooled and securitised.

The issuer usually takes the form of a bankruptcy remote special purpose vehicle (SPV)

owned by and independent trust. The SPV is specially created to perform solely the

functions of buying and pooling of assets from one or more originators. It then raises

funding in the capital markets, money markets or by private placement through issuing

securities backed by or representing and interest on such assets. Generally the SPV is

designed to have limited powers which permit only the needs of the ABS transaction.

It is made bankruptcy remote to ensure that it is sufficiently separate from the

originator and holds the assets that have been transferred to it by way of a “true sale”.

When the sale and transfer of assets to the issuer is completed, the issuer appoints a

servicer to monitor the performance of assets. His main tasks also include collecting

cashflows and ensuring that they are properly distributed. Quite often the originator

is appointed as the servicer usually with a backup/fallback servicer in the event of the

originator not keeping up with the prescribed servicing requirements.

Depending on the required credit rating on the assets, credit enhancers are usually

employed to provide credit enhancement so that the assets can attain the required

rating. The credit enhancement comes in various forms including guarantees issued by

appropriately rated and acceptable institutions, pool insurance policies and special

harzard policies. In some cases the originator provides the first level of credit

enhancement through either selling goods at a discount or a deferred purchase price

arrangement. Asset backed securities can also be credit enhanced through insurance

wraps provided for either certain classes of paper issued or for entire issuances. All

providers of credit enhancement are called credit enhancers.

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Liquidity providers may also be required in ABS transactions. The main purpose for

liquidity facilities are to provide for liquidity in the event of cashflow mismatches

between the receipt of cashflows from the assets and the payments due on the asset

backed securities on a payment date. In transactions, which are funded through the

issuance of short dated securities on a rolling basis, liquidity facilities are often used to

provide liquidity if there are market disruptions during the rollover period.

The other important party in ABS transactions is the rating agency. There will be at

least one but usually two rating agencies per transaction. They rate the asset backed

securities issued by the issuer on the basis of the credit quality of the underlying

assets, the structural features of the transaction and any credit enhancements

(including the credit quality of the credit enhancer) of the underlying assets or the

asset-backed securities themselves.

When asset backed securities are being distributed into the capital markets, money

market or in the private market, underwriters and or placement agents will purchase

and distribute/place the securities in the markets. Interaction between the various

parties is generally initiated and co-ordinated by the arranger hired usually by the

originator. Other parties that are involved include auditors and lawyers.

There are a number of varieties of "securitisation" and a number of different

structures. However, there is a common theme and process to all of these transactions,

which is illustrated in Figure 1.1 and briefly explained below.

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 Obligors Trust
(Assets)

3
2
Originator/ Issuer SPV Investors
Servicer

4 5

Liquidity Facility
Provider Administrator Credit Enhancement
Provider

Source: V Khotari, 1999

Figure 1.1 A typical asset backed securitisation transaction

1. Assets are originated by an Originator company, and funded on that company's

balance sheet.

2. When a suitably large portfolio of assets has been originated, the assets are

analysed as a portfolio, and then sold or assigned to the SPV. Administration of the

assets is then sub-contracted back to the Originator who becomes the servicer by

the SPV.

3. The SPV issues tradeable "securities" to fund the purchase of the assets. The

performance of these securities is directly linked to the performance of the assets.

Investors purchase the securities relying upon a rating and the expectation that the

securities will be paid in full and on time from the cash flows available in the asset

pool.

4. As cash flows arise on the assets they are collected by the servicer for the SPV,

5. These are used by the SPV to repay funds to the investors in the securities.

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There are generally seven reasons why companies consider securitisation:

• to improve their return on capital, since securitisation normally requires less

capital than traditional on-balance sheet funding;

• to raise finance when other forms of finance are unavailable (in a recession

banks are often unwilling to lend - and during a boom, banks often cannot keep up

with the demand for funds);

• to improve return on assets - securitisation can be a cheap source of funds, but

the attractiveness of securitisation for this reason depends primarily on the

costs associated with alternative funding sources;

• to diversify the sources of funding which can be accessed, so that dependence

upon banking or retail sources of funds is reduced;

• to reduce credit exposure to particular assets (for instance, if a particular class

of lending becomes large in relation to the balance sheet as a whole, then

securitisation can remove some of the assets from the balance sheet);

• to match-fund (liquidity) certain classes of asset - mortgage assets are

technically 25 year assets, a proportion of which should be funded with long

term finance; securitisation normally offers the ability to raise finance with a

longer maturity than is available in other funding markets;

• to achieve a regulatory advantage, since securitisation normally removes certain

risks which can cause regulators some concern, there can be a beneficial result

in terms of the availability of certain forms of finance (for example, banks are

increasingly using securitisation as a means of managing the restriction on their

wholesale funding abilities).

Establishing the primary rationale for the securitisation activity, is a vital part of the

preparation for a securitisation transaction, since it influences the sorts of

administrative tasks which need to be developed as well as the transaction structures

themselves.

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Assets, which can be securitised easily generally, have a number of characteristics,

which include:

• Cash-flow- A principal part of the asset is the right to receive a cash flow from

a debtor in certain amounts (or amounts defined by reference to a market or

administered rate) on certain dates i.e.: the asset can be analysed as a series of

cash flows.

• Security-If the security available to collateralise the cash flows is valuable,

then this security can be realised by the SPV. For instance, for a mortgage loan,

there is security over the property and other collateral, which will make a

significant contribution towards recovering any losses, which might otherwise

arise. Consequently, if there is default, an effective method of ensuring that the

SPV can gain the benefit of the security will be required (otherwise

securitisation will be an uneconomic way of arranging funding).

• Concentration risk-Assets should be well diversified. For instance a single

retail loan should be relatively small in value in the context of the available

supply of retail loans. Generally limitations are placed on the acceptable

maximum exposure to a single person/entity within a given portfolio of assets.

This way, the performance of a single asset is not likely to distort the

performance of the entire portfolio. Consequently, the entire portfolio can be

considered as a single asset, with a predictable performance.

• Homogeneity-Assets have to be relatively homogeneous - this means that there

are not wide variations in documentation, product type or origination

methodology. Otherwise, it again becomes more difficult to consider the assets

as a single portfolio.

• No executory clauses-The contracts to be securitised must work, even if the

Originator goes bankrupt. Certain clauses are therefore difficult to include in a

securitisable contract –for example in equipment leasing, the inclusion of a clause

stating that the Originator will maintain the equipment would make that lease

difficult to securitise. These sorts of contract are normally referred to as

"executory contracts".

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• Capacity-It must be possible for the necessary transactions which are needed

for the securitisation to take place in relation to the assets concerned - for

instance, if the assets contain specific prohibitions against assignment, then

they will not be securitisable in the traditional sense.

• Independence from Originator-The on-going performance of the assets must

be independent of the existence of the Originator. This tends to be a wider

restriction than the example given above about executory contracts. A number

of technical matters can arise, for instance, if asset yields are quoted only by

reference to the Originator (eg; as the Originator's rate), then this will cause a

structural difficulty in the event of the Originator's insolvency.

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1.3 Development of Asset Backed Securitisation

1.3.1 The United States of America

The United States of America is currently the largest asset backed securitisation

market in the World. It is the only market in the World where ABS market draws

participation from both institutional as well as individual investors. This market also has

the most number of securitisation applications than any other. In terms of global

volumes in ABS three-quarters are originated from the USA. This indicates the

tremendous significance of USA in global securitisation market, which extends to issues

originating from other countries, including Japan, Europe and some of the emerging

markets. The total volume of securitisation in USA was estimated at over $2.8 trillion

at the end of 2000. With the bulk of it ($1.9 trillion) dominated by the government-

sponsored programmes popularly known as Ginnie Mae, Fannie Mae, and Freddie Mac,

which support housing finance and account for almost $9 out of every $10 in the MBS

market. Other major components of the ABS market include commercial mortgages

($200 billion), credit-card receivables and home-equity loans ($220 billion), and

automobile loans ($75 billion). Secondary trading in mortgage backed securities in the

US has recorded average daily volumes of over $70,9 billion in 1998.

The main causes of the establishment of the ABS market in the US include, the need

and willingness of the government to channel funds from the securities market to the

home loans market by providing guarantees on the mortgage backed securities

generated by regional and local government agencies. The technology and expertise

developed in the mortgage backed securities led to the development and packaging of

other bank assets. There was an increased significance in ABS during the 1970’s and

1980’s due to the debt crises in the US which emanated from debts extended to

developing countries which were being poorly serviced by the borrowers. In an attempt

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to manage the pending liquidity crises most banks sold their assets in the form of asset

backed securitisation schemes.

The main key drivers for growth of ABS in the US include; the associated saving in

regulatory capital required for normal bank funded loans. The increased possibilities in

earning fee-based income generated as banks participated in these asset backed

securitisation transactions in various roles such as sponsors, arrangers or underwriters.

Other key attractions included cheaper and diversified sources of funding for the

originators and better returns for the investors.

1.3.2 Europe

There is evidence that schemes similar in nature to the modern United States form of

asset backed securitisation existed in Denmark where a mortgage credit system has

existed in Denmark for over 20 years now. There is also pfandbrief market in Germany,

which is a secondary mortgage market. Although a form of securitisation has been in

existence in the German and Danish mortgage markets for a long time, securitisation in

the modern sense only emerged in Europe in the mid- 1980s. Growth of asset backed

securitisation in Europe has progressed at a slow pace and has only recently evolved into

a viable and rapidly advancing sector.

The number and value of European issues in the ABS market increased significantly in

1999, as a result of favourable regulatory changes, and the introduction of the Euro.

According to estimates by Moody's Investors Services, annual issuance of European

MBS/ABS was less than $10 billion until 1996, when it jumped to $30 billion, then

further increased to $45.4 billion in 1997. Volume for 1998, however, was about the

same as 1997, at $46,6 billion, as the flight to quality towards the end of 1998 due to

the Asian and Russian crises led to widening in ABS spreads and reduced issuance. The

total outstanding volume of European ABSs has been estimated to be about $130 billion,

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of which perhaps half is MBSs. Figure 1.2 illustrates the growth trend of asset backed

securitisation in Europe in the late 1990’s.

Asset Type 1997 Percentage of Total 1998 Percentage of Total

MBS $11.0 24 % $22.7 49 %

CMBS $2.6 6% $2.6 6%

CBO/CLO $14.6 32% $8.5 18%

Other ABS $17.3 41% $12.9 27%

Source: Moody' s Investors Services

Figure 1.2. European MBS/ABS Issuance by Asset Type, 1997 and 1998 (Dollars in Billions)

In Europe, the previous action in the ABS market had centered mainly on residential

mortgages and, to a lesser extent, on the credit card-backed issues that are popular in

the United States ABS circles.

“For mortgage backed securities, the United Kingdom has been the major source of

collateral; in fact, until the past year or two, three countries (the United Kingdom,

France and Spain) provided the collateral for almost all MBS issues. However, in a sign

of the gradual progress of securitisation, in 1998 seven other countries were also

represented in MBS deals (although the United Kingdom, France and Spain still

accounted for two-thirds of the collateral). In 1999 £13.6 billion and £15.1 billion in

2000 of diverse assets including residential and commercial mortgages, credit cards,

housing associations, nurses homes, airport landing fees, student loans, private finance

initiatives and pubs were securitised.” (Morgan Stanley Dean Witter, 2001)

Europe's largest economy German has approximately DM1.9 trillion of mortgages,

thousands of banks, and some of the world's most powerful and sophisticated industrial

and service corporations, and all the more, one of the leading financial centres in

Europe. It is ranked only third in the European ABS market. The stumbling block that

seemed to inhibit the growth of securitisation markets in Germany seems to have been

removed. Asset-backed financing was considered to be in its infancy as an alternative to

traditional banking instruments in Germany. One of the reasons is deemed to be the

16
uncertainty regarding the legal structure, validity, and enforceability of the many

transactions involved in a securitisation program. The Bundesaufsichtsamt fhr das

Kreditwesen, the German Supervisory Authority for the Banking and Capital Markets

Industry has recently passed a rule which gives securitisations their official blessing

and will contribute to the acceptance of securitisation as an effective commercial law

financing instrument under German law.

1.3.3 South Africa and Other Emerging markets

The history of securitisation in South Africa dates back to 1989 when the first

securitisation issue a R250 million mortgage-backed issue by the then Allied Building

Society (United Bank of South Africa Limited). Another public issue took place in 1991

offered by Sasfin Limited comprising the securitisation of lease rentals from leasing of

machinery and equipment for R30 million. In South Africa, the concept of

securitisation was not widely accepted despite the two issues, noted above and the

other worth an estimated R3,5bn placed on the market in the late 1980s and early

1990s through private placements. The limited success of the earlier securitisation

transactions was due to little interest from the banks. Most of the banks felt no need

to securitise their assets, as they were not faced with capital constraints and had little

or no pressure from shareholders to improve on returns.

In addition a weak regulatory environment, significant limited sovereign issuance and a

generally illiquid and undeveloped corporate debt market hindered the development of

asset backed securitisation in South Africa.

Toward the end of 1997 The National Housing Finance Corporation, (NHFC) a South

African Government sponsored body decided to employ securitisation to provide

liquidity to the mortgage market to support home ownership in the medium to lower end

of the market. The ideas were based on a structure similar in nature to the Fannie Mae

structure of the United States. The intention was to have the securitised assets

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housed in Gateway (Pty) Ltd a subsidiary of NHFC formed to create housing

opportunities for low and moderate income borrowers in 1999, from where funding

would be sourced directly from the capital markets. Several originators were

identified, generally tier two banks to originate a pool of qualifying loans using funding

provided by the NHFC. By the end of 1999 approximately R750 million worth of home

loans were in the special purpose vehicle and the originating banks were facing large

constraints in attracting deposits to write further loans. This was mainly due to the

lack of confidence in tier two banks. The need to access the capital markets funding

was more crucial than ever before. An arranger was mandated by the NFHC, who

managed to put in place the various parties to the transaction. It was however felt that

an additional amount of money would be required to increase the pool value to about R1

billion to reduce the liquidity premium associated with smaller issuances. However the

national government was not willing to issue guarantees to possible “warehouse” funding

providers (funders that facilitate building of a portfolio prior to approaching investor

markets). This led to the collapse of the Gateway program as some large banks, which

held shareholdings in the tier two banks ended up purchasing the assets from the pool

as the originator banks were closed or absorbed into their parent entities.

South African Home Loans (SAHL) commenced operations in 1999 as the first non-bank

securitised mortgage loan provider. The business model is based on an Australian

equivalent.

The business strategy is to capture a share of the homeloan market by offering low

cost mortgages to highly creditworthy borrowers. The current portfolio of SAHL is

less than 0,5% in a market where over 90% of the country’s mortgage market is

controlled by the country’s largest five banks. At the end of 2001 The Thekwini Fund 1

Limited a securitisation SPV issued R1,2 billion worth of asset backed bonds. The notes

were structured into three tranches 92% Class A notes, 6% Class B notes supported by

a 2% reserve/equity fund and were heavily oversubscribed in the capital markets

despite the absence of major bank investors due to the lack of regulatory stimulation.

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Shortly after the issuance of SAHL securities the South African Reserve Bank (SARB)

issued regulations which designate securitisation as an activity not falling within the

meaning of "the business of a bank", and gives guidelines as regards securitisation

schemes in December 2001. These mandatory guidelines form the first step towards

the prospect of creating asset backed securities which would in turn attract large

amounts of capital, which they would otherwise not have been able to attract, from

countries such as the United States of America and Japan. Although demand for

securitised assets from large institutional investors is already immense and growing,

there are many features, such as, transfer duties, value-added tax ("VAT") at the

special-purpose vehicle level and VAT on custodial and trustee services which continue

to impede development of asset backed securitisation in emerging markets. Other

regulators in South Africa are clearly faced with a challenge to review the impediments

to legitimate and prudent securitisation within their jurisdiction and to work towards

removing such impediments where appropriate. Other limitations include ignorance on

the part of investors who prefer to invest in listed companies with established track

records. There are also legislative and accounting problems.

In most emerging markets in Asia asset backed securitisations have been characterised

by novel, one –off means of fund raising. The main characteristics responsible for the

limited growth include uncertain or unhelpful legal and regulatory environments.

In Korea for example the Act on Asset Backed Securitisation came into being in

September 1998 prior to this act issues by Korean companies and banks were few and

restricted to non-Korean assets. Many attempts to securitise loan and lease

receivables were unsuccessful due to practical and legal issues particularly security

issues. Korea has taken the first step towards providing certainty for the development

of asset backed securitisation. It is hoped that increased utilisation of this alternative

funding method will be the result contrary to Thailand where an equivalent

securitisation decree was issued but remains largely unused in 1997.

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Activity of ABS has been slow to develop in New Zealand in comparison to other

jurisdictions. This is partly due to the small size of the New Zealand market, but

however new entrants are building significant asset pools suitable for securitisation.

And increasingly New Zealand originated assets are being sold into international

portfolios. There are few regulatory issues in this country and it is unlikely to be

required since there are no regulatory agencies that restrict the origination of assets.

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2 REGULATORY ENVIRONMENT

Regulators’ understanding of the concepts and their facilitation through regulations

particularly pertaining to the financial industry with emphasis on the banking regulator

have a strong influence on the state of the development of securitisation markets

across the world. In this chapter brief description of the various changes experienced

in the US, Europe and some emerging markets are discussed and comparisons drawn

including the environment and other events which influenced such decisions.

2.1 Regulatory framework in the Developed World

2.1.1 United States of America

As previously alluded to in Chapter 1, the onset of securitisation in the US where it was

first used as a major source of funding was fully backed by the US government. Central

to the regulatory requirements regarding securitisation in the US is the Securities Act

of 1933. It provides that public offerings of securities including ABS must be

registered with the Securities and Exchange Commission (“SEC”). As such the

prospectus used to offer these securities must meet specified disclosure standards.

Private placements can also be made under the guidance of Rule 144 of the SEC, which

stipulates that the level of disclosure is dependent on the number of issuers and the

number of investors. It also takes into consideration the level of sophistication of the

investors also known as accredited investors who have the necessary knowledge to

judge the offered securities without the level of disclosure required in a registered

offering. This rule is complemented by Rule 144a, which provides the framework for

promoting secondary trading of the securities including ABS.

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2.1.2 Developed markets in Europe

However in Europe the development of ABS was slow and cumbersome in most countries

prior to the introduction of laws, regulations and guidelines from the respective bank

supervisors. The absence of such guidelines excluded and restricted the participation

of regulated entities such as banks that now form the largest group of originators of

assets used in ABS. Spectacular growth has been witnessed post 1998 as various

securitisation techniques have emerged across Europe. Some of the more important

developments in specific countries and their impact on the development of the ABS

markets in Europe are discussed in turn below.

2.1.2.1 United Kingdom

The UK, which is the largest securitisation jurisdiction in Europe and has also, hatched

exotic applications of securitisation. Guidance for securitisation regulations affecting

financial institutions emanates from the capital adequacy requirements in relation to

the transfer of assets. The Financial Services Authority (“FSA”) has issued a number

of notes relating to the use of securitisation by regulated entities. The most recent

being the chapter on “Securitisation and Loan Transfers”, which forms part of a new

Guide to Banking Supervisory Policy. As the capital requirements in financial

institutions have become very important partly due to the increased regulatory capital

prescriptions. And the trend towards increased emphasis on return on capital employed

as opposed to asset building. The guidelines as provided by FAS allow the structuring

of transactions in ABS to restructure the risk profiles of assets and consequently

lower risk weighting for these assets.

It also makes provision for allowing for the assets to be removed from the regulatory

balance sheet of the financial institution, in accordance with the guidelines, thus leaving

the institution with more capital for new lending activities. This is all done without any

serious implications for the underlying customers since the originator would continue to

service and collect these assets. The guideline sets out a number of primary and

22
secondary conditions that must be met to effect a securitisation. These also include

requirements in relation to the provision of swaps and the pricing thereof.

In addition bank originators of mortgage loans for example also have to comply with the

Department of Environment Statement of Practice on the transfer of mortgages issued

in November 1989. This deals with the issue of obtaining consent of the underlying

borrowers to the securitisation scheme. It lays down rules relating to whether a

general or specific consent would be required from the underlying mortgagors. In

instances were the underlying borrowers are individuals consumer protection legislation

and data protection legislation may be relevant and transactions would have to be

structured to ensure compliance with relevant regulations.

Two of the most common statutes in the UK are the Consumer Credit Act, 1974 and the

Data Protection Act, 1998.

In the case of revolving assets such as credit card backed securitisation increased legal

and moral risks have attracted additional requirements which are stipulated in section 7

of the “Securitisation and Loan Transfers” structure. These include guidelines for

ensuring equal terms of interest, principal, expenses, losses, and recoveries between

the originator and the investors in securities backed by credit card receivables. Such

schemes may be eligible for off balance sheet treatment by the FSA on meeting

predetermined regulations. In addition the FSA requires conviction that the originator

has proper plans to manage it’s liquidity to cope with funding requirements on the

occurrence of scheduled or early termination of the scheme.

The introduction of the guidelines and regulations amongst other factors contributed to

the jump starting of significant securitisation in the UK in 1988. Subsequent changes in

the guidelines and the introduction of FAS has largely been responsible for the

exponential growth experienced in the ABS market in the UK between 1996 and present

as illustrated in Figure 2.1.

23
 The growth experienced in the UK was across various sectors including residential,

commercial mortgage, credit cards, operating companies private finance initiative and

housing associations, student loans and pubs. The bulk of these transactions occurred

in residential mortgage backed securitisations (52%), with the remainder being

introduced on the back of familiarity of the RMBS. The market developed rapidly until

1995, when it experienced a decrease in mortgage lending and the securitisation of

other loans became more significant. As more asset classes were introduced the size of

fluctuations due to a decline in one asset class has been minimised.

Source: Morgan Stanley Dean Witter

T h e S te rlin g A B S M a rk e t H a s G ro w n D ra m a tic a lly

16
1 5 .1

14 1 3 .6

12

10 9 .5
Sterling (billions)

8 .5

8
7 .1

4 3 .6
2 .7 2 .8 2 .9
2 .6 2 .4
2
1 1
0 .6
0 .0 5 0
0
1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000
Y e a rs

Figure 2.1 Growth of the UK ABS Market

2.1.2.2 Germany

In 1997 the German Banking Supervisory Authority (Bundesaufsichtsamt für das

Kreditwesen or BAK) published a 'Circular Regarding the Sale of Customer Receivables

of Credit Institutions in Connection with ABS Transactions'. The Circular was designed

to provide credit institutions with planning and legal certainty in respect of ABS

transactions and to enable their completion without the prior involvement of the BAK.

It provides banking supervisory guidance on two main issues (i) the possibility of capital

relief for the originator; and (ii) safeguarding the interests of the debtors of the

receivables sold, particularly data protection and bank secrecy.

24
Other important factors that are highlighted in the German regulations include,

• a legal valid transfer of the receivables to the SPV (a 'true sale');

• limited recourse against the originator;

• repurchase of the receivables sold to the SPV is only permitted for the purposes of

finalising the transaction and is limited to a rest-portfolio of less than 10% of the

receivables sold to the SPV at their then current value (the clean up call option).

• restrictions for the originator nor any of its affiliates to participate in the

financing of the SPV during the transaction. And purchases of ABS by the

originator in the secondary market must be at the current market price and must

not involve the granting of credit to the SPV.

• to avoid the deterioration of the originators’ risk profile due to the sale and

transfer of high quality receivables in ABS transactions, the BAK requires that the

receivables be selected randomly from the originator's receivables portfolio. The

auditor's report on the audit of the annual accounts of the originator must comment

on any material deterioration of the portfolio caused by an ABS transaction. This

may lead the BAK to assess whether 'special circumstances exist, requiring a

revision of the own funds assessment; and

• To facilitate ABS transactions by credit institutions, the Circular provides that no

consent from the debtor of the receivable is required for the transmission of data.

The introduction of the regulations in Germany saw an increase in the assets being

securitised. In particular diversification to a range of assets comprising mainly trade

receivables, credit card transactions and other ‘exotic’ assets. The clear guidelines and

resultant transactions catapulted Germany into second place behind the UK,

contributing 17% and 18% in ABS issuance in Europe for 1999 and 2000 respectively.

This excludes the residential mortgage issuances, which are mainly in the form of the

traditional Pfandbrief.

25
With an outstanding of almost DEM 2 trillion, the overall German Pfandbrief market is

the largest capital market segment in the world's non-government sector.

2.1.2.3 France

Recent legal developments have taken place aimed at advancing securitisation markets in

France. The original French legislation on securitization was implemented by the Act of

1988. Under this legislation, credit institutions, insurance companies and the Caisse des

dépôts et consignations (a public entity) were permitted to sell their receivables to a

vehicle, the fonds commun de créances or FCC (equivalent of the SPV known in other

markets), which would be financed by issuing units on the market. Amendments in 1997

extended the scope of the legislation by taking into account most of the objections of

market practitioners. It allowed an FCC to purchase and issue from time to time any

type of receivables (including doubtful receivables or receivables of different types),

whether denominated in French francs or in other currencies. The 1998 amendments

have further expanded the scope of securitisation by making it possible for commercial

companies to also use FCC to securitise their assets - earlier, the facility was limited to

financial intermediaries such as credit institutions and insurance companies alone.

Second, the originator is no longer required to notify the debtors of the assigned

receivables of the transfer of their receivables - which was required earlier and was

found to be detrimental to the interests of the originator.

Until 1993 securitisation of bank to bank loans dominated the French market accounting

for up to 70% of total transactions. The securitisation law was adopted with the main

objective of promoting the securitisation of mortgage loans. However the market has

been dominated by personal loan transactions. These assets are easier to securitise

mainly due to high margins that could afford to pay transaction fees and still offer the

underlying investors a good spread. With issuers gaining experience and modifications

in the law in 1995. FFr 5 billion worth of residential mortgage backed securities were

issued. Up to 1998 more than 120 FCC's had been set up by way of public offering,

representing approximately 150 billion French francs. The market has continued to grow

accounting for about 10% of the ABS issuance in Europe 1999.

26
2.2 Regulatory Environment in Emerging markets

The introduction of regulations and their subsequent influence in the developed world

on ABS advancement as discussed above has generally been positive. Evolvement of

similar regulations in emerging markets is examined and discussed below with the aim of

establishing influence on the development of securitisation in these markets.

Regulators’ attitudes and levels of understanding of ABS is on the increase in most

emerging markets. Basic securities laws are being passed, a trend is emerging to

redefine laws governing capital reserve requirements for lenders and investors. Most

regulators also perceive securitisation as the tool that will add impetus to the

development of capital and money markets, especially increasing the size of corporate

loans.

2.2.1 Malaysia

Securitisation started in Malaysia in 1986 with the establishment of the government-

owned National Mortgage Corporation. This is a secondary mortgage market agency,

which issues debt securities commonly known as Cagamas Bonds. Cagamas is by far the

largest issuer of ABS in Malaysia. The Malaysian government presented Budget 2000,

which was hailed as expansionary, and growth oriented. Among a number of measures to

boost capital markets, there is a proposal to encourage companies to opt for

securitisation. The budget 2000 proposed that the instrument used in the transfer of

assets be exempted from stamp duty. Subsequently ABS guidelines were released in

April 2001.

The regulations seek to provide clear and transparent criteria for securitisation

transactions. Some of the key aspects include;

27
• Requirement for all securities issued to be approved by the Malaysian Securities

Commission based on standards setout in the guidelines on the Offering of Private

Debt Securities;

• The originator should have had at least six months interest in the debts prior to

securitising them.

• Transfer of assets to the SPV should be by way of a true sale to ensure a

bankruptcy remote characteristic.

• ABS guidelines prohibit an originator from, holding a direct or indirect equity stake

in the SPV.

• Purchase of securities by originators in a securitisation transaction without

Malaysian Securities Commission permission is limited to10%.

The positive developments in terms of the regulatory environment in Malaysia and the

region have been met with limited action. There was increased interest and mandates in

the period leading up to the Asian financial crisis, however most of these deals had to

be abandoned. Since 1999 there has been a re-invigoration of the market. Like in the

UK over 50% of the deals completed are backed by mortgages and new asset classes

are being introduced. However, largely due to the macro economic environment

potential remains far greater than the activity. The pullback in lending during the Asian

crisis produced strong bank liquidity. In Malaysia there is also a concern over the

potential for the unexpected reintroduction of capital controls similar to the foreign

exchange controls recently introduced. More changes are in the pipeline from the

regulators to facilitate securitisation. Another important factor is that whilst the

regulations are in place, most issuers tend to see securitisation as a sign of weakness,

as the market will think they are under pressure to sell assets.

2.2.2 Hong Kong

The Hong Kong Monetary Authority's (“HKMA”) supervisory policy towards asset

securitisation and mortgage backed securities enacted in 1990 includes policy guidelines

that set out;

28
• the supervisory tests applied to asset securitisation schemes to decide if the assets

concerned can be excluded from the seller's balance sheet for capital adequacy

purposes; and

• the criteria for MBS to qualify for a 50% risk weight;

• Authorised institutions intending to conduct any securitisation transaction have to

inform the HKMA of their intention well in advance.

• How to determine whether the assets have transferred in the form of a “clean

sale”;

• An institution may undertake the role of servicing the pool of assets held under the

securitisation scheme.

• It is the HKMA’s view that the concessionary risk weighting of 50% should not be

applied to the subordinated tranches of any MBS issue. The purpose of

subordinated tranches of MBS is to absorb the credit losses, which may arise in the

mortgage portfolio which support the MBS. They should accordingly be weighted at

100%.

Whilst Hong Kong clearly has an advantageous regulatory environment, issuance levels

are much less than in the developed world. There is a significant lack of issuers in Hong

Kong due to the strong balance sheets that corporates generally have, and can

therefore fund at relatively low cost in the traditional bank market. In Hong Kong

securitisation began with a few residential mortgage backed security issuances and

some credit card deals. This was later complemented by several commercial mortgage

deals after the Asian crisis. Hong Kong has managed to generate approximately 60% of

the Asian market.

Many analyst believe that the Hong Kong market has reached stagnation as most of the

banks now look at property securitisation mainly for liquidity management as opposed to

capital reserve reduction since the passing of the new laws which prescribe a 50% risk

weighting for mortgage backed securities.

29
2.2.3 South Africa

In many respects development of asset backed securitisation in South Africa followed

in the framework of the European securitisation market particularly that of the UK. In

1991 the Office For Deposit Taking Institutions at the South African Reserve Bank

issued a paper on the Guidelines Regarding Securitisation. This paper acknowledged the

need for a proper regulatory framework for securitisation stating that, “securitisation

is a desirable financial market development tool in that it broadens the funding base

and profitability of deposit taking institutions whilst enhancing liquidity in the market

through the creation of negotiable asset backed instruments.” The key issues

discussed in these guidelines related to the legal status of transfer of the assets,

outlining of the risks associated with a securitisation scheme, recourse with respect to

the assets transferred to the SPV and the general management aspects of the SPV.

Following the paper discussed in the above paragraph, a Securitisation Schedule, Notice

153 of 3 January 1992 was gazetted under paragraph cc within the Banks Act 94/90

under the definition of the business of the bank. Whilst the general reference in the

Act implied that the business of securitisation was not limited to banks alone, the

definition of the originator only made reference to banks. The associated amendment

to the Banks Act under the same paragraph cc further enforced the limitation of

securitisation to banks. It stated that a finance entity other than a bank is not

permitted to issue debt instruments to fund its operations. The net result was that

securitisation had to be routed through a bank.

During the early 1990s the South African financial sector was characterised by

majority shareholders that are corporate conglomerates. This structurally resulted in

easier and greater accessibility to capital for the banks, making securitisation a less

attractive option to raise capital. The general measure for competitiveness for banks in

South Africa was relative size and headline earnings. This again discouraged the

development of securitisation, which results in a reduction of the size of the balance

30
sheet. Further the strict foreign exchange regulations restricted the outflow of

capital from South Africa with the result that the banking industry as a whole was

adequately capitalised. Securitisation was also considered as off balance sheet

financing for the bank involved, therefore attracting 100% risk weighting for

calculating capital adequacy. This provided no incentives for bank to securitise their

mortgage loan assets for example, which were risk weighted 50% on the balance sheet.

Similar to most European countries, the introduction of legislation managed to stimulate

discussions and interest in the subject in South Africa. But due to the economic

arguments presented above and the technical nature of the regulations which were

cumbersome to interpret no public transactions were completed after the introduction

of the regulations. By the end of the 1990s, SARB realised that the existing regulatory

criteria were diverging from the standardised approach being adopted by the majority

of the G10 countries. For example, an originating bank was restricted in providing

credit enhancement and liquidity facilities to securitisation schemes. In addition, the

growth in demand for credit-related instruments, particularly short-dated credit linked

notes and deposits, had led to market participants requesting regulatory action to help

increase the liquidity of the South African corporate debt market. The new capital

adequacy framework of 1999 from Basle Accord (Bank of International Settlements)

introduced a new impetus for securitisation in South Africa. Of particular interest was

the guidance on the treatment of capital relief derived from the application of

different risk weightings on rated financial assets. A working group including

interested and affected parties was established to make the necessary changes to the

existing legislation to stimulate and facilitate asset backed securitisation.

On 13 December 2001, the South African Reserve Bank ("SARB") published in the

Government Gazette (Vol. 438, No. 22948) new regulations governing securitisation in

South Africa (the "Regulations"). The Regulations were developed and agreed after a

detailed review by SARB of different international regimes, including the draft capital

adequacy proposals of the Bank of International Settlement ("BIS") in June 1999.

31
The Regulations encompass all institutions, whether or not within a banking group.

Nevertheless, where an institution, which is a member of a banking group, is involved in

a securitisation scheme, there are a number of additional rules, which apply. The main

aspects of these regulations are highlighted below:

• Provisions under which institutions within a banking group and other institutions not

within a banking group may participate in securitisation schemes are clearly outlined.

• no transactions other than transactions directly relating to the securitisation

scheme shall be entered into by, or on behalf of, the special-purpose institution.

• Conditions relating to limitation of association with assets for the originator

particularly with respect to banking institutions.

• Conditions relating to the provision of liquidity facilities and credit enhancement

facilities as well as underwriting.

• The applicable risk weightings based on the Basle Accord for rated commercial

paper are also adopted in the regulations, which are as follows:

Since the inception of the latest amendment in the Banks Act of November 2001, a hive

of activity has been experienced in the asset backed securitisation market. JP Morgan

and Standard Bank brought the first MBS transaction, Thekwini Fund 1, a domestic

Rand 1.25 billion to the market in November 2001. The first-ever

Commercial Paper Rating Risk Weighting
AAA to AA- (or the equivalent) 20%
A+ to A- (or the equivalent) 50%
BBB+ to BBB- (or the equivalent) 100%
BB+ to BB- (or the equivalent) 150%
B+ (or the equivalent) or below First-loss credit enhancement facility for capital purposes
Unrated Similar risk weighting to the underlying assets being securitised
Source: SARB

Figure 2.3: Risk weighting applicable to banks investing in ABS in South Africa

synthetic collateralised debt obligation was launched by FirstRand Bank Limited, called

Fresco 1, which totals Rand 12.5 billion (U.S. $12.3 million) of which R1 billion was placed

in the market.

32
The two deals took more time to complete than in other markets because they were of

the first in the jurisdiction and also because there were some issues that had not been

previously encountered in the local market. The South African asset backed

securitisation market has become very active and the volume has picked up significantly

this year. According to Fitch Ratings, there are several deals in the pipeline. "The

market in South Africa is almost exploding, from the point of view of comparing it to

some of the other markets that we work on in the emerging markets sector. It's very

busy in terms of the local participants in South Africa that are actively pursuing a

number of opportunities in their market. It's an increasing realisation by the local

participants that this is a form of funding that is available for them or in this case, an

opportunity for capital relief by the major banks." (Alex McKay, Fitch Ratings)

33
3 LEGAL,TAXATION AND ACCOUNTING FRAMEWORK

Securitisation has become an acceptable funding technique for well over a decade in the

United States and in Europe the technique has enjoyed increasing popularity since

inception and is becoming more complicated with the use of synthetic securitisations

and credit derivative arrangements. Synthetic securitisation transactions are in many

respects similar to traditional securitisation transactions without the necessity for

asset transfer through the use of credit derivatives. The capability to execute the

increasingly complex and diverse asset backed securitisation transactions require an in

depth understanding of the legal, accounting and taxation frameworks operating in

these jurisdictions. This chapter provides an outline of the necessary legal, accounting

and taxation frameworks in various nations, which facilitate the implementation of ABS

programs. Some details relating to common changes that have been implemented and

the difficulties encountered by the authorities are compared.

3.1 Legal and Taxation

From a legal perspective there are several common components which require

clarification and legal opinion prior to the execution of a securitisation transaction.

Treatment of these components which includes the method of transfer, true sale,

funding methodologies, solvency considerations, security, enforceability of securities

and documentation, as well as duties which differ between the various jurisdictions.

The main similarities and differences are discussed in turn below to highlight the

disparities between the developed and developing markets.

3.1.1 United Kingdom

3.1.1.1 Legal

The English legal system is known world over as common law. English common law

distinguishes between tangible and intangible property commonly expressed as choses in

possession and choses in action.

34
The latter are transferable only by a written conveyance. Hence, the Law of Property

Act 1925 required a written agreement to transfer actionable claims and a notice to

debtors was also required. However, traditional English law has always recognised

equitable transfers, that is, transfers that do not comply with the legal requirement of

law, but would be recognised as setting up a legal relationship between the transferor

and transferee. This means that the right of the assignee under an equitable transfer

is a right against the assignor, and not a independent right against any and all.

In almost all securitisations the legal mechanism for transferring assets varies with the

underlying asset classes and the most convenient method of achieving such transfer.

Such methods include assignment, novation, and declaration of trust, subrogation and

contractual participation. Inevitably the most appropriate method of achieving a valid

transfer will be detected by the terms of the underlying contracts which result in the

receivables being considered for securitisation. To ensure that the transfer of assets

is a valid transfer which is isolated from the credit risks of the originator it is normally

structured as a true sale which is not capable of being set aside by the insolvency

officer of the originator or by a court. In most cases a robust legal opinion, which

states that the risk is either non existence or negligible is sought.

Other legal requirements in the UK pertain to the funding method and the regulations,

which govern them. A range of funding mechanisms have been utilised which range from

bank market funding, or the use commercial paper and bond issuances including

Eurobonds. The various compliance regulations, which govern all the various funding

options, have to be complied with, to attain a structure with the least legal risk. In

addition the requirements of the regulator as discussed in Chapter 2 also need to be

legally complied with. And finally all the associated documentation and agreements

between the various parties in a securitisation transaction have to be valid and

enforceable under English law.

35
3.1.1.2 Taxation

Securitisation transactions in the UK attract stamp duty. A stamp duty of 3.5% to 4%

is payable on assignment of receivables. There is no stamp duty imposed on the sale of

mortgage receivables, but there is one on sale of non-mortgage receivables.

Generally parties to a securitisation get around this additional cost by executing

documents outside the jurisdiction, as the duty is payable at the place where the

agreement is executed. However, there is a common stamp law provision that if an

agreement executed outside the country but relating to property in the country comes

to the country after execution, it will be stampable then. Thus, execution of the

agreement outside the country defers the stamp duty implication till it is necessary to

bring the document into the country for the purpose of enforcement.

A transfer within the group can also obtain stamp duty relief, that is, by establishing

the SPV as a subsidiary of the originator. In UK practice, however, stamp duty is not

paid, as most securitization transactions are structured as equitable assignments and

not perfected legal transferes. When the transaction were to be perfected into a full

fledged sale of receivables, the document will attract stamp duty: therefore, the

originator is required to provide for full payment of duty. But this is usually regarded as

a theoretical tax - very rarely have circumstances arisen where the duty has actually

become payable.

As far as withholding tax on interest is concerned, the payer of interest is required to

withhold tax at the basic rate, unless the lender is a bank. Since securitisation SPVs are

not banks, transfer of loans to SPVs surely gives rise to the problem of withholding tax.

To get around these onerous withholding taxes a number of securitisation transactions

are structured as "participation" transfers, rather than true sales.

Value Added Tax is not applicable on sale of receivables in the UK.

36
There are no pre-defined income-tax rules on securitization in the UK but the tax

treatment is understood with reference to general tax law and practice. The basic

question to be decided for the originator is whether the disposition of the receivables

will be taken as a sale or financing. The question would, in most cases, be decided by

reference to the originator's accounting treatment. If the assets in question are

business assets, and they are being transferred, business profits/loss may arise. In

certain cases, the asset being transferred may be held as capital assets - for example,

in case of lease transactions. Ideally, in such cases, the physical asset and the

receivables therefrom should be split, and the receivables should only be transferred

rather than the physical asset. The other significant tax issue for the originator is the

deductibility of the initial fees of the issue. Incidental costs of raising finance may, if

properly structured, be deductible by the issuer under the FA 1996 rules. Accounting

Standard FRS4 will generally require issue costs, and thus the tax deductions, to be

amortised over the period of the notes.

An investor's UK tax position will be reasonably straightforward. Notes will generally

fall within the withholding tax exemption for quoted Eurobonds. In general, it is

believed that the accounting method employed by the investor for books will be adopted

for taxation too.

It is important that the SPV tax status is neutral. This can be achieved by matching

incomes and expenses. The payments made by the SPV will be principal and interest on

the bonds, of which interest will be tax deductible - principal will not be. Interest paid

by the SPV on a participating loan, that is, a loan with a right to participate in profits

(normally given by the originator as his contribution-credit enhancement) is not tax

deductible. Such interest is also not taxable in the hands of the originator.

37
3.1.2 The French Credit Foncier de France (“FCC”)

The French legal process to facilitate the conduct of securitisations is the FCC. The

creation and operation of an FCC requires the participation of (i) investors (ii) a bank or

financial institution where the funds of the FCC will be deposited and (iii) a management

company to conduct the investment policy of the FCC. The FCC is a legal concept, not a

legal entity. With this system assets of FCC are regarded as the joint ownership of the

investors. Interest in an FCC, that is, the interest held by the investors, is itself a

transferable property. The activities of the FCC must consist exclusively of the co-

ownership of receivables and not of other types of securities such as shares. The

transfer mechanism provided for in the securitization law is inspired by the Loi Dailly

mechanism. Title to the receivables is transferred by the execution and dating of a

certain instrument, called bordereau.

3.1.3 Australia

As in other jurisdictions the law plays a vital role in the structure and regulation of

many securitisation programs that have been implemented in Australia. In the

Australian market both equity and debt securities are issued in lieu of asset backed

securitisations. However due to prohibitive stamp duty requirements on equities the

debt instruments are more popular. The main difference between the issuance of notes

in Australia compared to the rest of the world is that asset backed securities are

issued by the trustees as opposed to SPV’s. The trustee holds the securitised assets

on trust and the liabilities under the notes are limited to the proceeds from the

underlying assets that are available. The use of trusts to issue debt securities

introduces a series of unique trust issues, which include the roles of the trustees and

the indemnities, and liabilities that affect the trustees. Further the Australian

Corporations Law regulates all asset backed securities issued to the extent that they

are debentures, or an interest in a managed investment scheme.

38
It is an obligation of the Corporations Law to ensure that prospectus that are used to

canvass investments make a minimum set of positive disclosures and outlines the civil

liabilities associated with breach of these provisions.

Securitization SPVs will be taxed as per the general law applicable to taxation of

companies or trusts, whichever way the SPV is organised. If organized as trusts, the

trust can qualify for taxation a "flow through" vehicle, that is, as a pass through or tax

transparent entity provided all the unitholders are currently entitled to the entire

income of the trust. That is to say, if the trust is non-discretionary as to its income, it

will be a tax transparent entity. If the trustees have discretion as accumulation of the

income or reinvestment of cashflows, the trust will be liable to normal income tax

principles.

3.1.4 Hong Kong

Hong Kong is one of the most securitization-friendly jurisdictions in Asia. The legal

system is based in general terms on English Law. This makes it quite straightforward to

structure "true sale" transactions from a legal, regulatory and accounting perspective.

The legal framework, in particular bankruptcy law, is well developed, with a mixture of

legislation and case law. Most securitisation transactions in Hong Kong follow the

"equitable assignment" route, without giving a notice to the obligors. Registration of

equitable assignments is not insisted upon. However, transfer of mortgages would

require registration with the Land Registry offices.

Unlike other Asian countries in Hong Kong there is no withholding tax on interest

payments to a non-resident, making the securitization offshore of interest-bearing

receivables much simpler. Stamp duties, which are generally required in other

countries, are not applicable on equitable assignments. However, transfer of mortgages

would be treated as transfer of interests in land, and would attract duty of 2.75%.

Hong Kong does not have any Value-added tax.

39
3.1.5 Malaysia

The Malaysian legal system is partly based on Roman Dutch law and partly on English

common law. Sec. 4 (3) of Malaysian Civil Law Act, 1956 requires that the assignment of

a debt be notified to the debtor. This requirement generally acts as a hindrance to

execution of securitisation transactions and discourages originators from participating

since it is very onerous and usually not cost effective. An alternative based on the

British concept of equitable assignment has been introduced in Malaysia. (Assignment

of receivables, that is, transfer of a debt, can either be full fledged legal transfer or

can be a transfer not documented as a legal transfer but recognised by courts as an

effective transfer for purposes of enforcement. "Equity" means fairness, that is, to

meet the ends of justice. In English law, there were separate courts of Equity, which

would deal with equitable claims. In the Malaysian legal system, equity courts do not

exist: yet, courts do follow principles of equity to enforce claims, which are otherwise

not contractually enforceable.)

The Malaysian companies law contains provisions for avoiding a transfer made in

contemplation of bankruptcy. This, however, can be resolved by establishing that the

transfer took place at fair values. In case of an offshore SPV, numerous exchange

control issues will also arise - the Malaysian Exchange Control Act 1953 will be

applicable.

There was a stamp duty implication of 4% on transfer of receivables. In an attempt to

encourage securitisation transactions and to develop the corporate debt capital

markets Stamp duty has been abolished. For property transactions capital gains tax on

transfer of assets, has also been exempted in case of SPVs. To qualify for exemption

the SPV require exemption from the Securities Commission.

40
There are no specific provisions in the income-tax law on securitisation. Pass through

SPVs are expected to be tax exempt based on conduit rules, but other securitization

SPVs are likely to come for entity-level taxation. Malaysia currently does not have any

tax on capital gains. Hence, if the sale of receivables or assets by the originator can

qualify for a capital gains treatment, it can escape upfront taxation of profits on

securitization.

A withholding tax of 15% is applicable on interest payments to non-resident persons.

Normal practice for Malaysia is to incorporate the SPV in Labuan, an offshore financial

centre, in which case the withholding tax is not applicable.

3.1.6 South Africa

3.1.6.1 Legal

The legal system in South Africa is mainly based on Roman Dutch law with large

influences from the English common law. Aspects of the law that are generally taken

into consideration when concluding a transaction in South Africa include incorporation,

validity and enforceability of documentation, transfer and security, and restrictions..

It is essential to ensure that the SPV issuing asset backed securities is a company that

has been duly incorporated and validly existing under the laws of South Africa. And to

the extent that it is owned by a trust that such trust(s) are also legally incorporated.

The company and all other parties should also have the legal capacity and corporate

power to perform the functions required to execute its obligations under the

agreements.

41
There are no governmental or regulatory consents, approvals, authorisations or orders

required in the Republic of South Africa by the Issuer or registration, filing or similar

formalities in connection with the issue of asset backed securities to ensure the

legality, validity or enforceability with the exception of the following;

• the approval of the listing of the asset backed securities by the Bond

Exchange of South Africa ("BESA") for listed securities. BESA should also

make an application to the Financial Services Board ("FSB") for the Notes to

be declared a financial instrument by notice in the Government Gazette by

the FSB in terms of the definition of "financial instrument" in the Financial

Markets Control Act, 1989 ("FMCA"). The instruments should then be

included in the list of financial instruments, which may be dealt in on BESA.

• approval of the Offering Circular by the Central Depository Limited; and

• the lodging with the Registrar of Companies in terms of the Companies Act,

of the Subscription Agreement by the placement agents who are usually the

arranging banks.

Under South African law, in order to sell a personal right, the seller and the purchaser

must enter into an agreement of sale (the obligatory agreement) in terms of which the

identity of the parties, the personal right to be sold and the price at which it is to be

sold are agreed. In order for the seller to transfer ownership of the personal right to

the purchaser, the parties must have the intention to transfer ownership coupled with

delivery of the personal right. A personal right is delivered by way of cession and the

seller and the purchaser can thus give effect to the transfer of ownership by an

agreement of cession (the transfer agreement) between the transferor (the cedent)

and the transferee (cessionary). The consequence of a valid sale and cession by the

seller of the receivables is that such seller is divested of its right to payment (and all

other rights), which will vest in the purchaser (SPV). A creditor of the seller can no

longer attach the right and, the subsequent liquidation of the seller will not affect the

situation.

42
A creditor of the relevant seller would only be able successfully to challenge the sale

and cession if any of the following apply;

• where the person granting the security ("the debtor") (such as a surety,

insurance company, guarantor or mortgagor) and the creditor have agreed

that the latter may not cede or transfer the right then, if this agreement

forms an integral part of the agreement creating the right, South African

law may treat the right as inherently limited and incapable of transfer

without the express consent of the debtor;

• under common law restrictions a transfer will be unenforceable to the extent

that it weakens the debtor's position or renders it more onerous than it was

prior to the cession. For this reason, in general a transfer of a portion of a

debt is invalid except with the consent of the debtor;

• where a debtor and a creditor have agreed that a debt can be transferred

only if certain formalities are complied with, a transfer effected in defiance

of these agreed formalities will be legally ineffectual unless the formalities

are waived by the party in whose favour they are stipulated (usually the

debtor);

• where the contract creating the right is of an intensely personal nature (in

the sense that whether the transferor or, alternatively, the transferee

exercises the right makes a reasonable or substantial difference to the

debtor's position) the rights may not be transferred (for instance, an

employment or partnership contract);

• statutory restrictions prohibiting the transfer of incorporeal rights include

the Insolvency Act, 1936 ('the Insolvency Act") (for instance, an insolvent’s

rights to his earnings cannot be transferred), the Statutory Pensions

Protection Act, 1962 (a pensioner’s right to his pension may not be

transferred), the Alienation of Land Act, 1981, the Matrimonial Property Act,

43
 1984 (a spouse’s right to share in the accrual may not be transferred) and

the Public Service Act, 1994.

As a general rule, cession takes place without the co-operation, consultation or consent

of the debtor. In addition to not requiring the prior consent of the debtor for the sale

and cession of the right to repayment it is also not necessary for the validity of a

cession that the debtor be given notice of the cession after it has taken place. Despite

the fact that the cession of a personal right is valid as between cedent and cessionary

without notice to the relevant debtor, the debtor under an agreement that is ceded

(such as a Loan Agreement and its Related Security) may validly continue to discharge

his obligations to the cedent under such cession if the debtor has not been provided

adequate notice of such cession. Similarly, the debtor may apply set-off in respect of

amounts owed to him by the seller (to the extent that set-off is not precluded by the

agreement between the debtor and the seller) until such time as the debtor is given

notice of the cession.

In securitisation transactions to give effect to the priority of payments and ranking of

creditors applied to the rated asset backed securities the parties undertake not to

take legal proceedings that may lead to bankruptcy of the SPV (non petition language).

A contractual undertaking not to sue another person or not to institute action for the

winding up of a person for a specified period or until the occurrence of some

contingency is referred to in South Africa as the "pactum de non petendo" and is a well

established principle in South African case law. An undertaking not to sue does not

affect the wrongfulness of the action, it merely excludes the remedy which the

plaintiff would otherwise have had.

South African law recognises the concept of a ring-fenced, bankruptcy remote entity,

which is formed to perform a specific function ("an SPV"). Such an entity may take the

form of a company or of a trust.

44
3.1.6.2 Taxation

In terms of section 3 of the Stamp Duties Act, 1968 any "instrument" described in

Schedule 1 to the Stamp Duties Act will be subject to stamp duty in South Africa if it

is executed in the Republic of South Africa or if it is executed outside the Republic and

relates to "the transfer or hypothecation of any property situated in the Republic or to

any matter or thing to be performed or done therein". Prior to the alterations of this

act in 2002 (encouraged by developments in other countries) Stamp duty was payable on

cessions of bonds in the amount of R0,20 per R100 of the maximum amount of the debt

secured under the bond. Further Stamp duty was payable on the issue of the asset

backed securities registered at an exchange in the amount of R0,05 per R20 or part

thereof of the issue price. These changes have been made mainly to encourage the

development of the corporate capital market and to encourage trading of assets as is

facilitated through securitisation.

In terms of the Marketable Securities Tax Act, 32 of 1948, as amended, (the "MST

Act"), a tax is imposed on the purchase of marketable securities through the agency of

or from a person admitted as a member of the Stock Exchange at the rate of 0,25

percent of the consideration for which those securities are so purchased. Section 3(d)

of the MST Act exempts the purchase of any interest-bearing debentures listed on a

financial exchange as defined in the FMCA Act from the payment of such marketable

securities tax. Accordingly, the purchasers of the asset backed securities will not be

liable for the payment of the marketable securities tax.

Stamp duty of R0,50 per cession is, in terms of item 18(7) of schedule 1 to the Stamp

Duties Act, levied on the cession of an insurance policy or of any interest under such a

policy.

In terms of section 7 of the Stamp Duties Act, the person liable for stamp duty in the

case of a cession is the cedent. Failure to stamp an instrument when required does not

necessarily render such instrument invalid, an instrument which is not duly stamped may

45
not be produced or given in evidence or be made available in any court of law. The court

is given discretion under the section to direct that, subject to the payment of a

penalty, the instrument be stamped and to admit it in evidence once this has been done.

This opens structuring opportunities similar to those undertaken in the UK, although it

will be largely unnecessary considering the cancellation on stamp Duty Requirements

introduced in South Africa in 2002.

Other taxes that are applicable to securitisation in South Africa include income tax,

value added tax (“VAT”), transfer duties, and even capital gains tax. Unlike other

countries that have actively promoted securitisation, and have provided clear guidelines

and frameworks for such transactions. An example of this is the United States tax

provisions (Sections 860H through 860L) which treat a trust which has been formed as

an SPV and which satisfies certain conditions, as a tax transparent entity. A trust

which satisfies these conditions is know as a “Financial Assets Securitisation

Investment Trust”, or FASIT. If a FASIT is used in a securitisation transaction, the

sale versus loan, and tax issues relating to the SPV, do not arise under United States

taxation legislation. This means that various tax issues are based on interpretation of

existing laws in the context of the securitisation transaction. There is also no case law

as far as taxation of securitisation transactions in South Africa is concerned, which

could cause potential originators to be more cautious about entering into these

transactions.

Capital Gains Tax (“CGT”) in South Africa became effective from 1 October 2001. CGT

is a tax on an increase in the value of a capital asset, where the proceeds on the selling

price of such asset, above the original cost, have not been subject to normal income tax.

This is thus an additional tax, which traps an increase in the value of capital assets,

which would previously have been treated as capital gains not subject to any form of

taxation.

There are not many situations where CGT will be applicable, since in most cases the

asset being sold should have decreased in value, due to a portion of the debt having

46
been paid off. Where the asset being physically transferred is fixed property, then it

is quite possible that the asset will have increased in value, and the surplus above

original cost will be liable for CGT. However, securitisation of fixed property normally

involves the securitisation of the rental stream, or else of the outstanding loan

commitment, and not of the asset itself. There is thus no physical transfer of the

asset, but merely a transfer of the right to the lease payments, or alternatively to the

loan obligation with the mortgage bond being used as security.

Value Added Tax (VAT) is an indirect tax which was introduced in South Africa in 1991,

and is applicable to all enterprises with a turnover in excess of R300,000 per annum.

Where an institution that is registered for VAT sells an asset or supplies services it is

legally obliged to levy VAT on the transaction, unless it has supplied an exempt supply.

Exempt supplies are defined in Section 12(a) of the VAT Act, and include “the supply of

financial services”. Financial services include “the transfer of ownership of a debt

security” and “the provision of credit under an agreement by which money is provided to

another person who agrees to pay in the future a sum exceeding in the aggregate the

amount of such money. ”It can therefore be interpreted that the sale of a debt or a

debt security or of an income stream based on the debt (a financial service so long as

the income stream comprises solely of interest), would not be subject to VAT. Rights

arising out of mortgage bonds or pledge are also exempt from VAT.

The net result should be that the South African Receiver of Revenue (SARS), for VAT

purposes, is placed in the same position he would have been in had the securitisation not

taken place. It can surely be argued that Revenue should not get more, since there has

been no value added, but merely a transfer of the ownership of an asset, which is a

financial transaction. Should the Receiver, through some mechanism employed in the

structuring of the transaction, receive less than he would have been entitled to before

the securitisation, then he will in all likelihood attempt to remedy the situation.

The SPV is in effect nothing more than a conduit, providing a source of income to a

number of investors, and providing a source of financing for the originator, who uses

47
the receivables as collateral in order to reduce the funding cost. As such the SPV

should not be subjected to income tax, but should remain in a neutral tax paying

position. This should not be difficult to achieve, since all the income derived by the

SPV is distributed to the investors. It would not be acceptable to structure the

transaction is such a way that the receipts from the originator’s debtors are treated as

income, whilst the disbursements to the investors are disallowed as a deduction. The

investor would be the loser in this transaction, since the receipts will have been taxed

in the hands of the SPV, and will then probably also be taxed in the investors hands.

The net result of the double taxation will mean that the investment would not be viable

to an investor, since the amount paid for the receivable would not have priced in a

double taxation liability. Alternatively, pricing in a double deduction would in all

likelihood have resulted in the originator not wanting to enter into the transaction, due

to the low price being offered for the assets.

As there are no specific tax laws governing the taxation of securitisation transactions,

nor any taxation cases on which to base most of the subjective issues, it would be

beneficial to obtain rulings from SARS. These rulings would simplify matters for all

concerned, and would help assure investors that problems such as double taxation,

which will materially affect the viability of the investment, will not occur. Presently

most arrangers rely on opinions on the interpretation of the tax laws that are

expressed by lawyers.

To assist the promotion of securitisation transactions, and to avoid lengthy court cases

which may occur as a direct result of taxpayers interpreting the tax laws incorrectly.

The SARS should take cognisance of the efforts of other countries, such as the United

States of America, and provide relevant guidelines or rulings. These rulings could be

similar to the tax laws relating to FASIT, as has already been discussed, and would

clear up a number of issues regarding taxation of the SPV, especially those relating to

VAT. Uncertainty regarding double taxation could be an obstacle in obtaining investors,

and rulings from the SARS should go a long way towards increasing investor confidence.

48
3.2 Accounting

3.2.1 United Kingdom

Depending on the originator’s objectives the effect on his balance sheet and the

accounting treatment is generally discussed and thoroughly investigated by the

auditors. In most UK securitisations, the SPV is structured as "an orphan subsidiary"

with the shareholding transferred to a charitable trust. Therefore, even though there

is no direct control of the originator on the SPV. This ownership structure of the SPV

is devised to avoid consolidation, both from bankruptcy as well as accounting viewpoint.

If the transaction has been properly structured, the accounting treatment should

follow the requirements of the UK Accounting Standards Board’s Financial Reporting

Standards 5 (“FRS 5”) through a linked presentation. The main tests for whether or

not the assets sold by the originator should be shown on their balance sheet depends on

whether not the significant benefits and risks associated with these assets have been

transferred to the SPV. Derecognition of assets in part is allowable on a pro-rata basis

or on the transfer of a legally separable portion of an asset. When the conditions for

derecognition have been met a gain or loss is recognised for the difference between

the carrying value and the fair value of the proceeds.

Whether or not the originator should consolidate the SPV based on ownership. FRS 5

requires consolidation of ‘quasi subsidiaries’ which are controlled entities but do not

meet the legal definition of a subsidiary. Through the concept of linked presentation

the securitised assets are shown on the face of the balance sheet net of the non

recourse portion of the securitisation proceeds. Any transfers that do not meet the

criteria for derecognition or linked presentation continue to be shown as assets at their

original amount and the proceeds received are shown as liabilities.

However, as far as accounting consolidation is concerned, International Accounting

Standards Board (“IASB”) SIC 12 has given an interpretation according to which a

consolidation is almost inevitable if the originator provides credit enhancements. To

49
avoid consolidation from legal and accounting viewpoint, the originator must hold no

equity interest, and no residual interest in the SPV. Therefore, very convoluted

methods are followed in UK practice for extraction of the originator's profit from the

transaction. These include: deferred consideration, an intermediary trust holding legal

interest on behalf of both the originator and the issuing SPV, interest rate swap,

retained interest, management fee, brokerage, etc.

3.2.2 Australia

Australian accounting standards do not directly deal with accounting for securitisations,

but Australia has generally adopted international accounting standards and most

Australian accountants follow the International Accounting Standards (“IAS”) 39 which

provides the rules covering recognition and derecognition. Following the issuance of

SIC 12 regarding consolidation of securitization SPVs, the Australian Urgent Issues

Group (UIG) in July 1999 issued UIG 28 to narrate the circumstances under, which a

securitisation SPV will be consolidated with the parent. SIC 12 refers to quasi-

subsidiaries and says that if the effective control over an SPV is being exercised by

the originator, the SPV ought to be consolidated with the parent.

3.2.3 South Africa

In South Africa Generally Accepted Accounting Practice (GAAP) is applied for the

accounting treatment of Asset Backed Securitisation Transactions. Since ABS

transactions generally involve sale of assets and SPV’s two main statements namely AC

133 dealing with de recognition and AC 412 dealing with consolidation of special purpose

entities apply.

Following on the guidance from IAS 39 and FRS5 the South African standard AC412

proceeds on the basis of substance over form, and hence the SPV should be

consolidated when the substance of the relationship between an originator and the SPV

indicates that the SPV is controlled by that originator. In determining the substance

50
over form principle, which may lead to consolidation the SPV the following tests are

applied:

• If the activities of the SPV are in substance being conducted on behalf of the

enterprise directly or indirectly created on the SPV according to its specific

business needs. For example if the SPV is principally engaged in providing a funding

source to the originator to support its ongoing operations. Or if the SPV provides

goods or services that are consistent with the originator’s ongoing operations, which

without the existence of the SPV would have to be, provided by the originator

itself.

• If the originator, in substance has the power to control or obtain control of the

SPV or its assets including certain decision making powers coming into existence

after the formation of the SPV. Such powers may also have been delegated by

establishing an auto pilot mechanism. This includes the power to dissolve the SPV

unilaterally, to change the SPV’s charter or bylaws or the power to veto any of the

above powers.

• If the originator has rights to obtain a majority of the benefits of the SPV. An

indication of control may also be obtained by evaluating the risks of each party

engaging in transactions with the SPV.

AC 133 from South African GAAP is entitled Financial Instruments: Recognition and

Measurement deals with amongst other things the derecognition of assets sold to the

SPV to effect the securitisation transaction. AC 133 requires that an enterprise should

derecognise a financial asset (such as the receivables) when, and only when, the

enterprise loses control of the contractual rights that comprise the financial asset. AC

133 recognises that determining whether an enterprise has lost control of a financial

asset depends both on the enterprise's position and that of the transferee.

Consequently, if the position of either enterprise indicates that the transferor has

retained control, AC 133 requires that the transferor should not remove the asset from

51
its balance sheet. In such a case, the transferor should account for the transaction as

a collateralised borrowing.

The situations envisaged by AC 133 in which the transferor retains control are those

where the transferor has a contractual right to reacquire the transferred assets (or

related benefits) or has retained substantially all of the risks and rewards of

ownership. The tests applied are based on the following extracts from the IAS 39

Implementation Guidance provides a basis for determining whether the seller has

retained control of the receivables:

• Question 35-2 of the IAS 39 Implementation Guidance deals with the situation

where the transferor retains the right and obligation to service the underlying

financial assets, which may indicate that the transferor has retained control of

those assets. However, provided that the servicing agreement precludes the

transferor from using or benefiting from the cash it collects on behalf of the

transferee and requires the transferor to remit the cash on a timely basis, the

transferor is regarded as providing the servicing activities in the capacity of agent

for the beneficial owners of the assets.

• Question 37-1 of the IAS 39 Implementation Guidance specifically deals with the

situation where an enterprise sells receivables, including the transfer to the buyer

of interest rate risk and the rights to receive cash flows from the assets, but

provides a credit enhancement facility. In such a situation, where the receivables

are not only subject to credit risk and substantial interest rate risk is transferred

to the buyer, the transferor has lost control over the receivables because the

transferee has the ability to obtain the benefits of the transferred assets and the

risk retained by the transferor is limited to credit risk in the case of default.

Rather than retain the receivables on its balance sheet, the transferor would

recognise a separate financial liability in respect of the credit enhancement facility.

52
AC 133 suggests that the transferor generally has lost control of a transferred

financial asset only if the transferee has the ability to obtain the benefits of the

transferred asset. That ability is demonstrated, for example, if the transferee is an

SPV whose permissible activities are limited, and either the SPV itself or the holders of

beneficial interests in the SPV have the ability to obtain substantially all of the

benefits of the transferred asset.

Until recently most securitisation structures executed in the developed markets have

generally managed to obtain the off balance sheet treatment. However in the wake of

accounting controversies, which have become apparent in the USA during 2001 and

2002 it is increasingly more difficult to attain off balance sheet treatment and

accounting standards are being revised across the world.

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4 ASSET AND ORIGINATOR CHARACTERISTICS

Descriptions of various asset classes and their originators, highlighting the suitable

conditions for asset classes and general originator characteristics. Typical pool sizes,

historical data availability and systems etc. The typical assets that are discussed

include residential mortgages, asset backed commercial paper programmes, commercial

mortgages.

4.1 Residential Mortgage Loans

These are the most common type of assets that have been securitised. Usually they

are also the first to have been securitised in most jurisdictions as discussed in Chapter

1. They are generally monitised through the issuance of residential mortgage backed

securities. Residential mortgage loans are offered to the underlying borrowers through

a variety of options, which include interest-only mortgages, deferred, interest

mortgages hybrid products (i.e., fixed-rate over an initial period, reverting to floating

rate). Despite the numerous product types the mortgages typically have a number of

common variables, including a term of 20 to 40 years, a floating or fixed interest rate,

full amortisation over the life of the loan, and a first charge (i.e., lien/mortgage) on the

property held by the lender as security.

Generally the loans are separately determined by each lender, the interest rate is closely

linked to a specified base rate. For example in the UK the Bank of England’s Monetary

Policy Committee determines the bank base rate (indirectly via changes to its minimum

lending rate to commercial banks) at its monthly meetings. A similar process is also applied

in other countries such as South Africa, Australia and the US.

More recently flexible mortgages, which originated in Australia in the early 1990s, and have

proven extremely popular with consumers in markets like South Africa and UK. In a flexible

mortgage the repayment structure provides for full amortisation of the principal over the

54
life of the loan. The core feature of a flexible mortgage is a borrower’s ability to prepay

and subsequently redraw principal without incurring a penalty. Flexible mortgage

prepayments are applied to reduce the outstanding principal balance on the mortgage and

provide borrowers with a means of decreasing future monthly payments and/or reducing the

mortgage’s average life. Most lenders also permit payment holidays, enabling a borrower to

underpay or even temporarily suspend monthly repayments (with certain restrictions on the

timing, length, and frequency of such non-payment periods.).

The other form of mortgage product is the interest-only mortgage whereby principal is

repaid as a bullet at the mortgage’s maturity. The borrower pays the interest cost to

the lender throughout the life of the mortgage, while simultaneously making

contributions to a savings vehicle that will ultimately make the bullet payment. The

savings vehicle is usually held at the lending institution, but not always. A range of

savings vehicles have been used over time including endowment policies, pension plans

and tax-exempt savings accounts, etc.).

Reverse mortgages or equity release mortgages are first lien mortgages secured by a

property. This type of mortgage is designed for older homeowners who do not have

steady income and want to access the equity in their homes. Interest on a reverse

mortgage accrues at a fixed rate and the loan is typically repaid when the borrower

passes away or moves into long-term care (i.e., the house is sold and the proceeds are

used to repay the loan). There is a maximum loan to value (“LTV”) allowed for reverse

mortgages (e.g., approximately 50%) and borrowers must reach a certain minimum age

to apply. Norwich Union Equity Release Limited completed the second reverse mortgage

RMBS transaction (Equity Release Funding No. 1 plc) in March 2001 in the UK. The

analysis of a reverse mortgage RMBS transaction focuses on actuarial methods (i.e.,

mortality tables) to estimate when an originator will receive the proceeds from a home

sale.

Mortgage lenders in most countries fall into three basic categories namely, banks,

building societies, and specialised mortgage lenders. The UK market is dominated by the

55
largest lenders, which are primarily banks. At the end of 2000, the top five lenders

owned over 60% of UK mortgage assets and the top ten lenders controlled over 80% of

these assets. For example following the recent merger of Halifax and the Bank of

Scotland (September 2001), HBOS (the merged entity) owns nearly 25% of all UK

residential mortgage assets.

This distribution is similar to that reflected in the South African market, whereby the

four largest banks have captured over 80% of the total home loan mortgage market of

the total outstanding of R194 billion. Other lenders such as large corporations and non

bank organisations like SAHL make up the remainder of the lenders in South Africa.

The distribution of the SA mortgage loans as of December 2001 by lenders are shown

Figure 4.1.

12% 1%

ABSA
30%
10% SBSA
Nedc or
F irs t Rand B ank
12% BOE
O ther
S A HL
16% 19%

Source: South Africa Reserve Bank

Figure 4.1: Distribution of South African Mortgage Lenders Ranked by Mortgage Assets as

of December 2000

Origination of mortgage loans is mainly conducted by the lending bankers. However in

the recent past most countries have experienced an increase in the amount of activity

of brokers participating in residential mortgage based lending. These are generally

firms or individuals that act as intermediaries between estate agents and banks

receiving a commission for services provided in this role.

56
Other important characteristics of mortgages that are utilised by rating agencies to

determine the credit quality analysis of the mortgage loan pools to be securitised

include foreclosure frequency predictions and loss severity (loss that would be realised

in the event of a foreclosure). For example Standard and Poor’s in order to quantify

the potential losses associated with the entire pool, they determine the weighted

average foreclosure frequency and a weighted average loss severity at each rating level.

The product of these two variables estimates the required loss protection, which can be

directly related to a rating level. To determine the foreclosure frequency and the loss

severity, rating agencies normally conduct independent analysis of the following factors;

• Loan to value (LTV): This is defined as the ratio of the aggregate mortgage debt

divided by the value of the property. This ratio is a key foreclosure predictor with

low LTV ratios associated with lesser probabilities of loan default. A low LTV ratio

also indicates the amount of equity the borrower has invested in the property as

well demonstrate the borrowers involvement in prior financial management. In

South Africa generally mortgages with LTV values of less than 90% are considered

for securitisation. Typical LTVs in Spain are generally below 60%.

• Loan Repayment type: As discussed above various loan types are offered to

homeowners in the various markets. The overriding principle is that the portfolio of

loans to be securitised need to be homogeneous and underwritten with standardised

loan contracts for ease of analyses. Armotising profiles are perceived to be less

risky compared to interest only loans with a bullet payment risk.

• Loan size: Large loans are considered to have more inherent risk than the smaller

loans owing tot the increased sensitivity of these borrowers to changes in their

financial situation in terms of recession.

• Affordability/ Payment to income ratio (PTI): This is a measure of the

borrower’s long term income available for loan repayment. It is determined by a

borrowers monthly mortgage payment divided by his or her gross monthly salary.

Lower PTI ratios indicate that a borrower can sustain temporary financial set backs

57
 with out affecting their capability to service their loans. In South Africa PTI

ratios vary between 20% and 30%.

• Seasoning: This is a term used to describe the age of the mortgages that

make up a portfolio. Historical data indicates that the most likely period for a

borrower to default on their loans is in the first 12 to 18 months following

completion. A mortgage that has been outstanding for longer periods and is not in

arrears is considered to have a lower likelihood of foreclosure.

• Geographic Diversification: A geographically diverse pool signifies that a regional

economic downturn will not adversely affect the whole pool. Diversification of

borrowers by employing industry also distributes risk in a pool.

4.2 Asset Backed Commercial Paper (ABCP) Conduits

An ABCP conduit is a limited-purpose finance company that issues commercial paper to

finance the purchase of assets. Some asset types include receivables generated from

trade, credit card receivables, auto loan, auto and equipment leasing obligors, as well as

collateralised loan, obligations and collateralised bond obligations. Asset-backed

commercial paper conduits are typically established and administered by major

commercial banks. The main aim of these originators is to provide flexible and

competitive low cost financing to their customers. Unlike stand-alone term

securitisations, asset-backed commercial paper conduits are ongoing concerns and do

not wind down after a few years. In a typical asset backed commercial paper conduit,

maturing commercial paper is paid down with the proceeds of newly issued commercial

paper. This type of securitisation is the second most common type following RMBS in

the world in terms of assets under securitisation.

To evaluate these programs rating agencies normally analyze the risks associated with

credit, liquidity, interest rates, foreign currencies, the financial viability of the asset

originator, legal issues, structural features, and cash flows. The conduits can either be

partially enhanced, or fully enhanced through the use of credit enhancement facilities.

58
These credit enhancement facilities are generally provided by financial institutions to

cover partial or 100% of the credit, liquidity, and legal risks. The 100% enhancement

also covers other risks that may be present such as interest rate, servicer, and program

administrator risks. In these conduits, the risk to commercial paper investors is that

the credit enhancer will become insolvent, not that the assets will default. On the

other had investors in partially enhanced asset-backed commercial paper programs are

exposed to the losses on the underlying receivables if these losses exceed the partial

credit enhancement.

Asset-backed commercial paper conduits may also be described as being single-seller or

multiseller programs. Single-seller programs are set up to benefit an individual asset

originator by providing a way to finance its receivables pool. Multiseller programs on

the other hand acquire receivables from numerous asset originators and are typically

sponsored by large commercial banks. A single-seller, asset-backed commercial paper

conduit is a limited-purpose, bankruptcy remote company that issues commercial paper

as a way to finance the assets of a single originator. Such conduits are most suitable

for asset originators with large pools. Single-seller conduits provide credit

enhancement consistent with the commercial paper rating and 100% liquidity support

from providers rated at least as high as the conduit. Expressed another way these

programs are fairly similar to commercial paper programmes of the originator, except

they are backed by specified assets and not the balance sheet of the originator.

Multiseller commercial paper conduits serve the financing needs of several unaffiliated

originators by combining their assets into one diverse portfolio supporting commercial

paper issuance as illustrated in Figure 4.2. The multiseller conduit is a bankruptcy-

remote, special purpose vehicle.

The asset portfolio is managed for the asset-backed commercial paper conduit by a

program administrator (typically the sponsoring bank) according to the conduit’s credit

and investment guidelines. The program administrator, who is in many cases a provider

of credit enhancement and/or liquidity lines, is key to the analysis of these programs

59
for purposes of rating. The program administrator’s role is to originate and refer new

asset originators to the conduit, to negotiate with third-party credit enhancement and

liquidity banks, and to closely monitor the performance of each transaction in the

conduit. Because the multiseller conduit finances assets from a variety of sellers, the

administrator also manages the conduit’s

Source: Standard and Poor’s

Figure 4.2 An illustration of the parties and cashflows in multi-seller ABCP

portfolio risk and cash flows. A review of each new pool is made before it is funded.

Review of transactions entering the conduit is based on the following factors:

• the conduit’s portfolio diversification,

• the amount of program wide enhancement,

• the liquidity funding formulas,

• the strength of conduit management and operating procedures,

• the target customer base,

• the credit and investment policies,

• the experience of the underwriting and surveillance staff,

60
• the conduit track record regarding portfolio performance and adherence to

underwriting guidelines,

• the maximum commercial paper maturity, and

• the transaction amortization events and conditions for issuing commercial paper.

4.2.1 Credit Enhancement in ABCP

Generally, there are two levels of credit enhancement in asset-backed commercial paper

conduits (1) pool-specific enhancement and (2) program wide level enhancement. Pool-

specific enhancement should include protection against losses, dilution and in the case

of non interest bearing assets, carrying costs. Pool-specific enhancement is generally

provided in the form of overcollateralisation, third-party credit enhancement, excess

cash flow, or recourse to the asset originator. Pool-specific enhancement only covers

defaults on a specific originator’s receivables and cannot be used to fund losses on any

other pool. Levels of pool specific credit enhancement are determined based on the

historical performance of the pool and the associated expected losses. Detailed

modelling methods can then be applied to assess the amount of pool credit enhancement

also known as first loss credit enhancement.

Programwide enhancement is made available to pay for losses in excess of pool specific

enhancement. It covers all pools in the conduit and is generally in the form of a bank

letter of credit, bond insurance policy, cash collateral, or some combination. The

programwide enhancement provider rating has to be rated as high as the commercial

paper program. Fitch Ratings has been assigning credit enhancement levels for

programmes with the highest short term rating (F1+) of 5% for conduits that have been

in existence for more than three years in Europe and the US.

However for newly established ABCP conduits such as the newly established Blue

Titanium in South Africa a 10% level was considered appropriate until such time the

asset performance levels become ascertained.

61
Credit risks arise in a conduit when the credit quality of a transaction deteriorates and

when in some cases the financial condition of the asset originator erodes. An analysis

of a pool of receivables for an originator relies on the transaction summary provided by

the program administrator. The transaction summary includes the asset originator’s

overall risk profile, underwriting standards, collection procedures, pool selection

process, historic receivable performance statistics, and the receivable characteristics.

To date no ABCP programme in the world has resulted in investors loosing their money

since inception of this asset class.

The asset originator’s risk profile includes its historic and expected financial

performance, competitive strengths and weaknesses, and competitive position and

strategy in the business line from which assets are being sold. Underwriting and

collection policies include historic and current lending criteria, as well as audit

procedures and accounting systems. The review of standard asset types, such as credit

card receivables and auto loans, will usually rely on the program administrator’s review

of the asset originator. In some cases, particularly for new asset types, for asset

originators in new markets, and for conduits that do not have program enhancement,

rating agencies particularly Standard & Poor’s may meet with the asset originator’s

management to review business and financing strategies, credit and collection polices,

and computerized receivable management systems.

Experiences in the South African market for ABCP assets has shown that most

potential originators do not have well documented procedures detailing the

requirements set out above. This generally results in increased pool credit

enhancement requirements, which occasionally makes the securitisation transaction

unprofitable for the originator.

Another major issues is the lack of data dating back to the required three to five year

period. This is mainly due to the legacy computer systems that were used for data

storage, which are not compatible with the newer systems.

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Default risk is analyzed in all asset types, starting with a review of pool data provided

by the program administrator. The pool data includes;

• customer concentrations,

• historic and prospective value of tangible assets securing the receivables,

• historic pool origination and payment characteristics,

• delinquency and loss characteristics of the receivables pool.

Provided underwriting standards and target markets have not changed, historic

delinquencies and write-off performance are considered the best indicators of current

pool credit quality.

In sizing a transaction’s credit enhancement, an expected loss case is first established.

Expected loss performance is then increased by an appropriate stress factor to

determine the levels of credit enhancement needed to arrive at the desired rating. The

stress factor is a function of the asset type, volatility of historic loss rates, and the

rating level. Typically, the higher the volatility of historic loss rates the higher the

stress multiple used for sizing the level of enhancement.

Obligor concentration is another factor that is incorporated into the sizing of

enhancement. Some receivable pools contain substantial obligor concentrations, which

add credit risk to the transaction. For example, if a pool has one obligor that

represents 20% of the total pool, and that obligor were to become insolvent, the

transaction could risk losing the entire receivables amount of that large obligor.

Therefore, it is important to establish concentration limits that prevent obligors from

becoming too large a percentage of a transaction. In some cases, limitations on industry

concentration may also be required.

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4.2.2 Non eligible assets

Assets falling in the following categories are generally defined as non eligible assets

and may not be purchased into the conduit;

Delinquent and defaulted accounts: These are generally defaulted receivables and

receivables that are past due beyond a specified delinquency category.

Excess concentration: To limit investor exposure to a default by a large obligor,

most structures set size limitations for individual obligors. Such concentration limits

are generally set on the basis of the credit rating of the obligor.

Unperformed contracts: Receivables billed before completion of service or delivery

of a product are generally limited for two reasons. First, obligors are less likely to pay

for a service or product that has not been received. Second, the receivables may be

considered an executory contract that could be rejected by the originator on its

insolvency.

Bill and hold receivables: In these instances, the supplier sells the goods to the

customer, but holds the inventory until the customer needs it. In the event of an

insolvency of the supplier, the customer may attempt to stop payment on products that

have not been shipped. In addition, collecting payment on other shipments to the

customer may be difficult if there is bill and hold inventory that has been paid for, but

is not in the possession of the customer.

Tenor: The tenor of the receivables is limited to lower credit risk. For example,

for an auto lease transaction, eligible leases might be limited to leases with an original

tenor of 24 months. Generally, 60-month leases have more credit risk than 24-month

leases because the originator is exposed to the default risk of the obligor for a longer

period of time.

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Obligor characteristics. Eligibility criteria also define obligor characteristics. For

example, a pool may exclude receivables from affiliates of the originator or receivables

from obligors who are past due on other receivables. A pool may also exclude

receivables from obligors in a jurisdiction where it may be difficult to perfect the

conduit’s lien interest in such receivables. In a revolving structure, the pool is screened

periodically and receivables that have become high risk are continually removed from

the eligible pool. The conduit is typically entitled to receive a share of all collections. If

the pool of eligible receivables falls below the conduit’s net investment (amount paid by

the conduit to the seller) plus the required reserves and is not topped up within a cure

period (one to five days), the transaction will enter early amortization. As with early

pool amortization events, a strong set of eligibility criteria will help to lower credit

enhancement levels.

4.3 Commercial Mortgage Backed Securitisation (CMBS)

Commercial Mortgage Backed Securities (CMBS) comprise securities backed by

commercial mortgage whole loans, which are in turn secured by first liens on the

underlying commercial property. These underlying properties could be office buildings,

retail shopping malls, neighbourhood shopping centres, industrial warehouses, hotels or

multifamily residential properties.

There are three basic types of commercial mortgage securitization transactions namely:

• The property-specific transaction (i.e., a transaction involving one single property

with one borrower, a transaction involving multiple properties with one borrower,

• The pool transaction (i.e., pools of performing loans, and

• The credit lease transaction.

Each of these types of transactions has a number of variations and may involve any one

of several property types described above. Regardless of the type of property-specific

transaction utilized, the structure of the transaction will generally take the following

65
form. It involves a transfer usually by way of a sell by the originator to an SPV secured

by one or multiple properties and assignment of rentals and leases. The SPV will then

issue rated securities that are backed by the receivables under the loan obligations on

the mortgage loans bought from the originator.

The general approach to commercial mortgage backed securities by most rating

agencies is similar across jurisdictions. With certain adjustments that are required to

accurately reflect the specific issues presented by different markets. This includes

the terms of commercial property particulars, lending practice or legal framework. In

the United Kingdom, for example, most leases tend to be long-term “fully-repairing &

insuring” leases (triple net leases), with lenders benefiting from the creditor-friendly

legal system. In Italy, France and Spain, on the other hand, shorter-term leases are

more common, and the foreclosure process takes substantially longer. Due to the fact

that commercial mortgages tend to be heterogeneous and relevant historical

information is limited a large part of the asset analysis is based on a fundamental

assessment of the underlying properties securing the mortgages.

Unlike many other types of securitised assets, commercial mortgages are not

homogeneous, and relevant industry-wide loss information, is rarely available. As a

result, it is not possible to rely on a statistical analysis of historical performance data

to estimate the credit risk of a pool of commercial mortgage assets. Generally rating

agencies analyse the fundamental real estate credit risk of each asset to estimate the

expected frequency and severity of losses in the mortgage pool.

According to Moody’s the credit risk of a mortgage loan will depend primarily on the (1)

characteristics of the underlying properties securing the loan (cash flow, quality, type

of property, tenants, diversity), as well as on the (2) loan structure (leverage,

amortisation profile, interest rate, reserves, cross-collateralisation, seasoning and

delinquency history). The interaction between these two factors may be reflected to a

66
large extent in the debt-service coverage ratio (DSCR) and the loan-to-value ratio

(LTV) associated with the mortgage loan.

DSCRs and LTVs are therefore considered good proxies for the credit risk on a

commercial mortgage loan. Moody’s believes that DSCR is the main driver of frequency

of loss, while LTV is the key determining factor for the expected severity of loss. The

credit risk of the mortgage pool will depend on the credit risk of each loan as well as on

the overall portfolio diversification and other factors, such as the transaction

structure, legal risk and servicing quality.

The bulk of the fundamental credit analysis is carried out at the individual property

level, and therefore most of the analysis is based on property-related data. The results

are consolidated at the loan level and ultimately at the overall mortgage pool level. The

amount of time spent on analysing each property and loan will depend on the number of

assets included in the securitisation and the importance of any specific asset. One of

the first steps is to estimate how much cash flow can be generated by each property on

a long-term sustainable basis. Moody’s focuses on net cash flow (NCF), defined as

earnings before interest, corporate tax, depreciation and amortisation (i.e. EBITDA, or

net operating income), less capital expenses and other fixed charges. NCF provides an

accurate picture of actual funds available to service the debt on a long-term basis.

Ideally, at least three years of historical (audited) financial statements as well as

projections for the following year are analysed. This process can be altered if such

information is not available; however, the resulting numbers are likely to be more

conservative to reflect the lower confidence level associated with the calculations.

Expenses, such as rates/taxes, insurance, operating costs, management fees and/or

overhead costs are deducted from revenues to estimate EBITDA. Expenses borne by

the landlord vary significantly by property type and from one country to the next. For

example, in most triple net leases found in the UK and South Africa, tenants are

responsible for paying rates and practically all costs associated with operating the

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property. Minimal costs are borne by the landlord so long as tenants are in occupancy

and honouring their obligations. This expense assumption will be greater in countries

such as Germany where the landlord is generally responsible for paying a larger portion

of expenses.

Quality grade on a property reflects an assessment of the quality of that property

relative to the national market for such property type, taking into account factors such

as construction quality, neighbourhood, local market, competition, tenancy profile and

quality of income. In other words, this grade measures the desirability of a property

within a certain property type, also reflecting as a result the volatility of the property

cash flows. The quality grade of a property also takes into account the credit quality of

the tenants, hence if a property is leased to a highly rated entity through to the

maturity of a fully amortising loan, the default probability under the mortgage loan will

be directly derived from the credit rating of the tenant. The ranking by property type

is reflected by Moody’s as follows: multifamily, anchored retail, industrial, unanchored

retail, office, and hotel.

The types of underlying loans also influence the determination of the quality of the

securities to be issued by the SPV. For example interest-only loans and partially

amortising loans are likely to have a lower probability of default during their term, as

debt service is limited. However, the probability of default at maturity may be

significantly higher as the likelihood of a successful refinancing will depend, inter alia,

upon the marketability of the property and the interest rate environment at that time.

In the US mortgage loans are typically structured to provide for a substantial balloon

payment at maturity, many European CMBS transactions include fully amortising loans.

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5 MARKET INFRASTRUCTURE AND INVESTORS

The success of asset backed securitisation is dependant upon the responses of the

ultimate lenders. Issues that are of importance for the investors include the size and

depth of the financial markets, credit risk and investor demand and attitude, which are

briefly discussed below.

5.1 Size and depth of the financial markets

There has been an increase in the corporate bond activity in emerging markets of the

world particularly in Europe, Australia and in South Africa where investors and issuers

are being compelled to consider corporate bonds. Corporate bond markets are taking

off as bank debt maintains a dominance over bonds and equities in most emerging

economies. A brief glimpse of the state of the debt markets of some emerging

economies is shown in Table 5.1 below. The markets are generally undeveloped as

governments have issued very little debt. The absence of a decent benchmark yield

curve makes it difficult to trade corporate debts of a lower

Source: FIBV

Table 5.1:Composition of Exchange Traded Securities by Market Value, 2000

quality. Other aspects responsible for slow development of corporate debt market

include weak balance sheets, inadequate public disclosure, non-transparent corporate

structures and poor corporate governance. This was exacerbated by the lack of

independent assessment intermediaries such as rating agencies. The generally bullish

69
equity markets of the early 1990s translated to strong demand for raising cash through

the equity markets.

In South Africa most of the issues cited above are minimal. The country has a highly

liquid government debt market and a well established yield curve. And the corporates in

most parts have a better standard than those in Asia particularly when considering

disclosure, corporate governance and transparency. Following the effects of the

emerging market crisis of 1997-1998 corporate bonds are now recognised as a key

mechanism for financial system and economic stability as they diversify funding sources

and facilitates competition in the financial services. By providing a liquidity

management tool, a thriving corporate debt market helps banks to manage turbulent

times more effectively. The long-term form of finance provided by bonds provides

some insulation to corporates from the rapid withdrawals of short-term credit that is

associated with liquidity events. A liquid market in non-government debt should lead to

an increase in competition, lowering of prices and increasing product choice for

consumers. “The listing of asset-backed securities facilitates new entry and increased

efficiency in such markets as home mortgages and consumer finance.”(RMB and BESA,

2001)

Capital markets particularly the corporate bond markets are more advanced in the

developed world. In most of these markets the costs in terms of capital requirements

of holding corporate debt on-balance-sheet are high. This is mainly driven by the Basle

capital adequacy requirements for corporate debt and an increased focus on return on

equity capital (ROE) by bank shareholders. This has led to a serious reassessment by

banks in the United States, Europe and Australia of the appropriate pricing of

corporate debt to achieve the required returns. A similar trend towards higher ROE

ratios has started to take hold among the South African bank shareholders. And the

SARB has recently adjusted the capital adequacy requirements from 8% to 10%. This

together with the new securitisation regulations that incorporate the new risk

weightings recommended after Basle is bound to encourage the migration of corporate

debt from bank balance sheets to the capital markets. There are indications that

70
banks in South Africa are under increasing pressure to price corporate debt

effectively.

5.2 Credit risk and Investor demand and attitude

Generally on the onset of issuance of asset backed securities the initial thoughts in the

mind of the investor pertain to portfolio compatibility. This is mainly with regards to

how these securities would fit into the investor’s portfolio. Annuity type of portfolios

would present the initial best fit.

The market is generally characterised by different investors with different risk

appetites. Through the variety of tranches that are issued during a securitisation,

funds with higher risk mandates can also be attracted to the mezzanine and junior

tranches. In South Africa ddomestic institutions have traditionally been among the

most important investors in government and quasi-government bonds. These instruments

have generally been used to offset long-term rand liabilities as these occur in defined

benefit pension schemes and ‘immediate’ annuities on the books of pension funds.

Fourteen percent of the amounts invested by these institutions, was invested in

domestic bonds comprising only government and government-guaranteed bonds. The

allocation to bonds is far below the R512 billion, or 51 percent, that was allocated to

domestic equities. Figure 5.1 shows how that pattern is consistent across all the types

of institutions.

The allocation in funds to bonds shown in Figure 5.1 is low by comparison with the

typical asset allocation seen in funds in Europe and the United Kingdom. In these

markets bonds commonly comprise one-third of a portfolio with shorter term more

liquid bonds often comprising as much as half of the portfolio. To achieve a bond

weighting of 33 % the allocation of funds to bonds would have to more than double

implying an additional investment into bonds of R197 billion more than the current

71
Source: Genisis

Figure 5.1: Domestic Equity and Bond Investments by SA Institutions (as a % of total assets)

levels. The current South African government’s management of the national budget has

seen a significant fall in fiscal deficits as privatisation receipts continue to reduce the

debt. As the government gradually reduces its dominant role in the debt market, non-

government debt will take over some of the functions previously carried out by

government bonds. Such as the provision of a yield curve against which the private

economy can price long-term debt, and so provide capital for projects. New benchmarks

for pricing medium- and long-term debt will be required.

In addition to offering replacement to the decreasing bond offering from the

government corporate bonds including asset backed securities also offer an increased

diversification for investors. Asset backed securities have been widely accepted and

embraced by many investors in the more developed global markets. Asset backed

securities are generally considered to be more secure than corporate debt bonds which

are usually unsecured. The attraction to ABS bonds for most investors across the

world has been the identifiable source of cashflows to support the principal and

interest payments on the bonds. Rating agencies have become adept at analysing

structured securities and investors have gained confidence in their ability to accurately

rate and monitor ABS deals.

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In South Africa the introduction of ABS is gaining momentum with the investors. The

asset classes offers a yield pick up over the government bonds of equal credit quality.

This is offering good relative value in the face reducing government bond yields as

illustrated in Figure 5.2. Spreads are generally wide with the first issuances relative to

other markets as the initial deals attract the first issuance premium. The combination

of high quality credit and relatively attractive credit spreads creates a good selling

point to many investors.

Source: Bond Exchange of South Africa

Figure 5.2: Movement in the Government Bond Yield Curve

The risks that investors in asset backed securities contend with are numerous as they

relate to the different asset classes and their pertinent characteristics. When dealing

with floating rate armotising bonds such as the Thekwini Bonds backed by home loans

prepayment risk is a key consideration. Managing the risk of prepayment over time as

the interest rates rise and fall and prepayments rise and fall in response. Prepayment

risk is introduced through receipt of principal payments in excess of the contractually

required principal payment. The arrangers of the deal calculate the constant

prepayment rate (CPR)- which is the proportion of the pool of assets that is expected

to prepay on an annual basis.

73
The CPR is constantly reviewed and updated for the benefit of investors. This risk

could also be mitigated through structuring of special tranches to absorb such risks.

Hedging of interest rate and foreign exchange risks is important for investors in ABS.

The swap market and foreign exchange market have developed significantly in the last

decade providing various options to manage the exposures that could be created by

investing in asset backed securities. Investors may also manage exposures through the

use of credit derivatives, which have been recently introduced to the South African

market place.

Liquidity poses a problem as many investors still buy –and hold. The secondary market is

lagging behind the primary market in terms of liquidity for corporate bonds and asset

backed securities. This generally leads to a liquidity premium being charged on most

issuances of asset backed securities. As a rule of thumb issuance of volumes lower than

R750 m attract significant liquidity premium since it is anticipated that there will be a

limited secondary market. However as the number of transactions increases the

tradability and liquidity of asset backed securities is expected to increase. Placement

agents and lead managers of these issuances should also provide market-making

facilities to encourage liquidity in the asset backed securities market to reduce the

spreads towards comparative levels available in the developed markets.

Following the promulgation of Securitisation Regulations in South Africa in December

2001, five ABS transactions have been brought to the market. Figure 5.3 below

provides a brief summary of the transactions. When the issues were offered to the

market subscription was generally between two and three times the issue sizes. Various

roadshows and discussions with the larger investors conducted by SCMB through out

the year confirmed the large appetites for ABS securities by the market. The spreads

indicated in Figure 5.3 were normalised and an indication of the yield curve for ABS

bonds in South Africa is beginning to take shape as illustrated in Figure 5.4.

74
Issuer SPV Issue Rating Size Fixed 3m Jibar Issue Date Maturity
Name (Rm) Rate % Spread(bp) at Date
Issue
On the Cards CARD1 Aaa 1,730 N/A 90 29-Jul-02 30-Jun-05
Invest.
CARD2 Baa 200 N/A 220 29-Jul-02 30-Jun-05
FRESCO FRE1A AAA 190 10.50 30 20-May-02 28-Feb-07
INV.LTD
FRE1B AA 180 10.90 120 20-May-02 28-Feb-07
FRE1C A 190 11.20 130 20-May-02 28-Feb-07
PROCUL PROA11 AAA 1,000 13.65 45 06-Jun-02 31-Aug-10
LIMITED
PROA21 AAA 282 12.99 55 06-Jun-02 31-Aug-10
PROB1 AA 150 13.69 125 06-Jun-02 31-Aug-10
PROC1 A 200 14.34 190 06-Jun-02 31-Aug-10
PROD1 BBB 128 15.44 300 06-Jun-02 31-Aug-10
PROE1 BB 110 18.44 600 06-Jun-02 31-Aug-10
PROF1 B 90 24.44 1200 06-Jun-02 31-Aug-10
Thekwini THE1A AAA 1,250 N/A 70 01-Nov-01 21-Nov-05
THE1B BBB 100 N/A 230 29-Nov-01 21-Nov-05
Source: SCMB

Figure 5.3 Summary of ABS instruments issued in SA since December 2001

Relative Spreads over JIBAR

300

250
Basis Point Spread

200

150

100

50

0
ABCP Conduit AAA (5Yr) AA (5Yr) A (5Yr) BBB (5Yr)

Source: SCMB

Figure 5.4 An indicative yield curve emerging in South African ABS

The information in Figure 5.4 may be applied by issuers to predict the expected yield

for ABS issuances they may be considering in South Africa. This curve should be

treated with caution and for indicative purposes only as it contains information from

instruments that have only been to the market once and still reflect the new product

75
issuance premium which investors generally charge on new instruments. In addition the

sample used to create the yield curve can not be considered a representative sample.

In 2001, corporate issues including securitisation amounted to R 17 billion representing

significant growth on 2000. This was in part driven by investor appetite for credit on a

relative value basis and by a reduction in the overall level of government debt issuance

in the local market. Table 5.2 summarises the transactions that occurred in 2001 and

the expected estimates for 2002 and 2003. The high levels of issuance of corporate

debt in 2001 were supported by the low interest rate environment, with the benchmark

government bond, R150 reaching a best level of 9.94%, before the decline in the value

of the rand late in 2001 to R13.85 per United States Dollar. There is also likely to be a

further increase in the depth and liquidity of the securitisation market as a number of

issuers do repeat transactions and investors become more comfortable with various

asset classes. This process is likely to be supported by increased use of securitisation

by large banks in South Africa as they increasingly focus on capital efficiency given the

change from 8% to 10% capital adequacy requirements for banks as already illustrated

by First Rand Bank transactions issued by Fresco and Procul shown in Figure 5.3 above.

Table 5.2 below indicates a conservative estimate of institutional cash flow (new money)

for 2002 of R108 billion. If the traditional portfolio weightings of the last couple of

years is maintained, then R41 billion will be invested in fixed income paper. With the

government panning to buy back R11 billion worth of Government bonds in 2002, there is

an estimated R5 billion supply of new bonds. Therefore, R36 billion (R41bn less R5bn) is

theoretically available to invest in fixed income paper supporting the notion that

demand substantially exceeds supply.

76
Current Income 2000 Estimate 2001 Estimate 2002
Long-Term Insurers R28 bn R37 bn R27 bn
Pension and Provident Funds R18 bn R17 bn R18 bn
PIC R25 bn R35 bn R37 bn
Unit Trust R18 bn R13 bn R13 bn
Short-Term Insurance R 3bn R3 bn R3 bn
Total R92 bn R105 bn R108 bn
Source: (SARB Quarterly Bulletin)

Table 5.2 An estimate of funds available for investment in ABS and Corporate

Bonds

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6 CONCLUSION

Securitisation, which has been a feature of the capital and money markets in the

developed world especially in Europe and the USA in the past two decades, has now

become an alternative or potential funding source in the developing world. This has

been evidenced by the number of countries in the emerging markets that are in

different levels of developing this financial tool. Such countries are scattered across

the world including Latin American nations, Asian nations, some continental and Eastern

European nations as well as in Africa. The key attractions to usage of this method of

funding include; the reduced cost of funding, diversified funding source including access

to foreign hard currency markets, liquidity provision through longer term funding and

balance sheet treatment. Most of the countries in the emerging markets are using or

exploring ways to create sustainable markets for securitised assets.

As discussed in this report the key elements for the evolvement and sustainability of

asset backed securitisation is dependent on some key factors that have been

highlighted in the report. These are the regulatory environment, legal tax and

accounting framework and the capital markets infrastructure.

For securitisation to work in any nation it must be supported by an enabling regulatory

environment. In Chapter 2 this has been demonstrated by the regulatory changes that

have been implemented in the developed nations and the resultant upsurge of asset

backed securitisation as a funding tool. This highlights how the regulators overall

attitude and understanding of securitisation can greatly influence the development of

securitisation. Various attempts by regulators in some emerging markets were

discussed in Chapter 2 and successes and short comings were pointed out. The

regulators in emerging markets are generally guided by the developments that occurred

in the developed world. However, adaptations of some of these principles have to be

implemented taking into consideration the implications on the emerging economies.

Particularly in the global economic environment where it is vital to develop a robust

78
financial system with increased efficiency in the operation of capital markets and the

creation of an effective solvency regime. Most important for regulators in stimulating

the development of securitisation is to ensure clear and reasonable guidelines. For

example on the issue of capital reserve requirements for securitisation assets and the

test to determine whether or not assets meet the requirements of a securitisation to

receive favourable treatment. The South African regulations of 1992, which were

ambiguous and unclear, led to the stagnation of securitisation activity, which was later

revived by the sweeping clear changes introduced in December 2001.

Changes in the banking regulatory environment alone will suffice for the development of

asset backed securitisation in emerging markets. The ability to securitise assets

effectively will depend on existing laws governing bankruptcy, transfer of assets,

perfection of the rights to assets and title and many other laws.

It is therefore of vital importance that in certain jurisdictions where aspects of the

law that enable securitisation are non existent such laws would have to be enacted or

securitisation transactions would have to be exempted. Various examples have been

given in Chapter 3 of the main enabling laws and how some countries have successfully

dealt with it. Taxation regimes are widely varied across the world and in certain

countries taxation laws impede the development of securitisation. The American

FASIT companies provide guidance on possible ways in which the taxation system can

encourage securitisation. Clear and reasonable rules governing withholding tax, capital

gains tax, stamp duty and income tax are necessary to ensure that securitisation is not

relatively more expensive than traditional funding methods. However the challenge for

most tax authorities is to ensure that such qualifying SPV are not utilised in tax

planning that effectively reduce corporate tax payments. The laws pertaining to the

transfer of assets should be clear and non hindering. It has been demonstrated in the

report that laws governing the title registration of loans, as well as stamp duty or taxes

on transferred assets will affect the willingness of originators to securitise their

assets as they often negate the benefits offered by securitisation.

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Recent developments in accounting with particular the derecognition of assets sold by a

corporate have serious implications for securitisation transactions. In particular for

transactions where the originator provides credit enhancement by retaining some of the

risks associated with the securitised assets it has become increasingly difficult to

derecognise these assets from his balance sheet. Hence the use of securitisation as an

off balance sheet funding mechanism has significantly diminished. Securitisation can

however still be used for balance sheet management where all risks associated with the

securitised assets are passed on to external credit enhancers and investors. The

various accounting authorities across the world are currently engaged in debate relating

to the future of accounting treatment for securitised assets.

In most emerging market countries domestic debt markets are just developing. The

existing debt markets consists mainly of short term borrowings mainly due to sustained

periods of hyper inflation. The development of an asset backed securities market will

only occur if a long-term debt market exists or is developed. In South Africa where a

long term government debt market has been in existence for some time, it is being used

as the basis for launching corporate and asset backed securities with longer terms.

The viability of assets backed securitisation in emerging markets is dependent on the

various factors discussed in the report. Separate and simultaneous developments of

the various aspects are a requisite for the sustainable usage of asset backed

securitisation as an alternative funding tool.

80
7. REFERENCES

Bowers W,C, “Global Securitisation Yearbook 2000/2001 Country Review: United

States”. Euromoney Publication, England 2000.

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