Securitisation What went wrong?

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

What is securitisation?
Simplest form: ABS (asset-backed securities) Salomon Brothers 1970s

Rating agencies
Rating

Fee
Bonds

Bank

Sale of loans

SPV
Cash
Cash Protection Fee

Investors

Loans

Debt service (cash)

Borrowers
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Monoline insurer (Credit Enhancement)

BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest 2

What can be securitised?

Virtually, any type of financial assets, claims and/or pure risk
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Loans (commercial, mortgages, ..., etc) MBS = mortgage-backed securities; CLO = collateralized loan obligations Receivables (credit card, leasing, etc.) Future assets (future flows like export earnings, migrants transfers) Credit risk (CDOs)

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

Reason for securitisation

Originally: For the bank: - transfer of assets (true sale), decreasing capital burden - keeping fee income related to loans + servicing (handling) fee - decrease of risk

For the investor: - access to new asset types - higher return on invested funds - limited risk due to credit enhancement, rating In practice: For the bank: - risk may return - a part of ABS kept on B/S intentionally

For the investor: - risk higher than expected

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

How securitisation bonds function?/1

Waterfall principle: all income stemming from underlying assets first go to higher class tranches

Segmentation of risk (tranches) (example)

Low Risk Return High

AAA 75% Other A 10%

First Income flows Last

BBB+ and other B 5%

Equity tranche 10%

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

How securitisation bonds function?/2

Theory: AAA tranche affected only if defaults exceed 25%. Even in this case, insurers may step in

Practice: In low-quality (subprime) MBS defaults may be over 25%. Tranche AAA loses its AAA rating even if default rate is under 25%. Due to downgrading, value of bonds falls (markettomarket principle). Monoline insurers may be downgraded too, also resulting in downgrading of the bonds

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

Complex securitisation models 1

Transfer of underlying assets is replaced by transfer of risk only (onbalance sheet securitisation) in the form of CDS (credit default swap)

CDO = Collateralized Debt Obligation

1)

Synthetic Balance Sheet CDO

Return R + margin

Bank

CDS

Bonds

SPV
Fee Rating
Cash Fee

Investors
Cash
Return R

Rating agency

Investment in riskfree assets

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Complex securitisation models 2

The bank buys protection against default of its borrowers and transfers risk to SPV. If some of these borrowers default, investors have to cover losses. Risk-free borrowers like Lehman, OM, Bearn Stearns, Icelandic banks Borrowers grouped by their rating (AAA, AA, A, etc.). Lower rating higher price of protection.

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

Complex securitisation models 3

2) Synthetic Arbitrage CDO
Return R + margin

Market

CDS

Bonds

SPV
Fee Rating Cash Fee Cash Return R

Investors

Rating agency

Investment in riskfree assets

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

Complex securitisation models 4

Under this scheme, SPV may issue protection against any credit risk in the market without obtaining any assets.

Not any more linked to mother banks Balance Sheet

Consequences: - more complex CDOs like CDO2, CDO3 appear where underlying risk is compiled of other CDOs.

- trading starts, indexes appear

- link to underlying assets largely lost

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BACEE's Intensive Training Course on Bank Analysis 27-29 June 2011, Budapest

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