THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS OF BANKS

(1)

THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS

OF BANKS

Wilhelm Pieter Campe Smith Dissertation

submitted in fulfillment of the requirements for the degree

Magister Commercii in

Economics in the

Faculty of Economic Science at the

University Of Johannesburg

JOHANNESBURG Supervisor: Dr. R. Hattingh

(2)

ACKNOWLEDGEMENTS

The author wishes to express his gratitude to Dr. Hattingh and Dr. Schoeman for their advice and guidance.

(3)

SYNOPSIS

The securitisation industry started in the early 1970s in the United States when securities, backed by pools of home loans, were issued for the first time. During the 1980s, securities supported by other types of financial assets such as auto loans and credit card receivables were issued. Since then, securitisation has expanded rapidly into many countries, including South Africa. The first securitisation transaction in South Africa was a securitisation of home loans in 1989, but very few securitisations came to the market after that. In December 2001 the South African Reserve Bank amended the securitisation regulations, which had been in existence since 1992. This created greater certainty for arrangers and investors, and from 2002, the South African securitisation market has grown quickly, driven by frequent securitisation issues by banks. Securitisation is attractive for banks, because it is an additional funding source and allows for the matching of the maturity of a bank’s assets and liabilities. Another reason for the attractiveness of securitisation for banks is that it is a mechanism for managing the regulatory capital that a bank is required to hold.

In a securitisation transaction, a loan originator such as a bank sells loans on its balance sheet to an independent company, which issues asset-backed securities to fund the acquisition of loans. Provided the transaction complies with the securitisation regulations, the transaction will result in the bank having to hold less regulatory capital compared to a situation where it had not securitised the loans. This “regulatory capital arbitrage” has been a major factor in banks’ securitising loans. Regulatory capital arbitrage is possible because of the relatively simplistic manner in which the Basel I capital adequacy guidelines calculate the regulatory capital a bank is required to hold.

Given the worldwide growth of the securitisation industry, regulators have become increasingly concerned that banks may not be holding adequate capital as a buffer for the economic risks to which banks are exposed. The Bank for International Settlements, through its Basel Committee on Banking Supervision, has therefore devised a new set of capital adequacy guidelines to replace the Basel I guidelines. The aim of the new Basel II framework is to achieve a greater alignment of regulatory capital with economic risks and to improve risk management practices in banks. Although the Basel Committee cannot enforce its recommendations, it is expected that most regulators throughout the world will adopt the Basel II framework.

It is generally expected that the implementation of Basel II will have a substantial impact on banks’ securitisation activities, especially to the extent that securitisation has been used for regulatory capital arbitrage purposes.

(4)

LIST OF DIAGRAMS

Diagram 2.1: Generic securitisation structure

Diagram 2.2: Commercial mortgage-backed securitisation structure Diagram 2.3: Credit-tenant lease structure

Diagram 2.4: Covered bond structure Diagram 2.5: Registering SPV structure Diagram 2.6: SUBI structure

Diagram 2.7: Future flow securitisation structure Diagram 2.8: Inventory pledge structure

Diagram 2.9: Inventory sale structure

Diagram 2.10: Whole business securitisation structure Diagram 2.11: Intellectual property secured loan structure Diagram 2.12: Intellectual property true sale structure Diagram 2.13: Single-seller ABCP conduit structure Diagram 2.14: Multi-seller ABCP conduit structure Diagram 3.1: Total return swap

Diagram 3.2: Credit default swap Diagram 3.3: Credit spread option Diagram 3.4: Credit-linked note Diagram 3.5: CLN issued by an SPV

Diagram 3.6: Different generations of synthetic CDOs Diagram 3.7: Unfunded synthetic portfolio CDO Diagram 3.8: Unfunded synthetic CDO with an SPV Diagram 3.9: Funded synthetic portfolio CDO

Diagram 3.10: Partially funded synthetic portfolio CDO

Diagram 3.11: Synthetic portfolio CDO with protection buyer as super-senior counterparty Diagram 3.12: Synthetic CSO (collateralised swap obligation) transactions

Diagram 3.13: Hybrid synthetic transaction Diagram 3.14: Single-tranche synthetic structure Diagram 3.15: Synthetic CDOs of CDOs

Diagram 3.16: Standard tranches of credit default swap indices Diagram 3.17: Arbitrage synthetic CDO

Diagram 4.1: The securitisation rating process Diagram 5.1: Structure of the Basel II Accord

(5)

Diagram A1.1: South African security structure Diagram A1.2: Mortgage guarantee trust structure Diagram A1.3: Assignment of mortgage guarantees Diagram A4.1: Reference entity successor test

(6)

LIST OF TABLES

Table 2.1: Thekwini floating rate notes Table 2.2: Rating multipliers

Table 2.3: Characteristics of various CDO types Table 5.1: Causes of banking problems

Table 5.2: Capital management options

Table 5.3: Comparing default rates with confidence intervals Table 5.4: Comparing measures of capital

Table 5.5: Risk weights per asset category

Table 5.6: Credit conversion factors per asset category Table 5.7: Add-on amounts for derivative transactions Table 5.8: Reasons for Basel II

Table 5.9: Risk weights in the Standardised approach for banking book risk Table 5.10: Asset classes in the IRB approach

Table 5.11: Retail correlation factors

Table 5.12: Eligible collateral under the Standardised and IRB approaches Table 5.13: Comparing the Standardised and IRB approaches

Table 5.14: Standardised risk weights for securitisation exposures Table 5.15: Different risk weights for investing and originating banks Table 5.16: RBA risk weights for long-term rated securitisation exposures Table 5.17: RBA risk weights for short-term rated securitisation exposures

Table 5.18: Comparing risk weights under the Standardised approach and the RBA Table 5.19: Comparing the Standardised and IRB approaches

Table 6.1: Comparing return on regulatory capital

Table A4.1: Using credit spreads to price a credit default swap Table A4.2: Default probability table for pricing credit default swaps Table A5.1: Comparing rating symbols

Table A5.2: Comparing rating definitions

Table A5.3: Comparing annual cumulative default rates Table A6.1: Basel II adjustment factors

Table A6.2: Claims on sovereigns

Table A6.3: Risk weighting of banks under option 1 Table A6.4: Risk weighting of banks under option 2 Table A6.5: Claims on corporates

(7)

Table A6.7: Standard supervisory haircuts Table A6.8: Minimum holding periods

Table A6.9: Risk weight categories for specialised lending Table A6.10: Mapping supervisory categories to external ratings

Table A6.11: Supervisory categories for high-volatility commercial real estate Table A6.12: Determining effective LGD

Table A6.13: Supervisory risk weights for specialised lending

Table A6.14: Supervisory risk weights for high-volatility commercial real estate Table A6.15: Supervisory risk weights for long-term securitisation exposures Table A6.16: Supervisory risk weights for short-term securitisation exposures

Table A6.17: Credit conversion factors for credit lines with controlled early amortisation Table A6.18: Credit conversion factors for credit lines with non-controlled early amortisation Table A6.19: Long-term risk weights under the RBA

(8)

LIST OF CHARTS

Chart 4.1: Vintages of loans

Chart 4.2: Static default data for one vintage Chart 4.3: Static default data for different vintages Chart 4.4: Loss probability distribution

Chart 4.5: Variations in probability distributions Chart 5.1: Value at risk for different rating categories Chart 5.2: Distribution of losses

Chart 5.3: Confidence level for potential losses

Chart 6.1: Multiple of the SF capital requirements to RBA capital requirements Chart 6.2: Difference between SF and RBA varies across securitisation tranches Chart 6.3: Disparity between SF and RBA evident across all asset classes Chart 6.4: Multiple of unsecuritised to securitised capital requirements Chart 6.5: Comparing unsecuritised and securitised assets under Basel II Chart 6.6: Comparing risk weights for Standardised and RBA rating categories Chart 6.7: The impact of Basel II on the securitisation of different asset classes

(9)

LIST OF ABBREVIATIONS

ABCP: Asset-Backed Commercial Paper ABS: Asset-Backed Security

AMA: Advanced Measurement Approach BATS: Bond Automated Trading System CBO: Collateralised Bond Obligation CCF: Credit Conversion Factor CDO: Collateralised Debt Obligation CDS: Credit Default Swap

CLN: Credit Linked Note

CLO: Collateralised Loan Obligation

CMBS: Commercial Mortgage-Backed Security CMO: Collateralised Mortgage Obligation CP: Commercial Paper

CPR: Conditional Prepayment Rate CRM: Credit Risk Mitigation

CSO: Collateralised Swap Obligation CTL: Credit Tenant Lease

DSCR: Debt Service Coverage Ratio EAD: Exposure at Default

ECAI: External Credit Assessment Institution ECN: Extendible Commercial Note

EL: Expected Loss

FHLMC: Federal Home Loan Mortgage Corporation FNMA: Federal National Mortgage Association FRN: Floating Rate Note

GIC: Guaranteed Investment Contract

GNMA: Government National Mortgage Association HVCRE: High-Volatility Commercial Real Estate IAA: Internal Assessment Approach

IMF: International Monetary Fund IO: Interest Only

IPRE: Income Producing Real Estate IRB: Internal Ratings-Based

(10)

JIBAR: Johannesburg Interbank Agreed Rate LIBOR: London Interbank Offered Rate LGD: Loss-Given-Default

LTV: Loan-to-Value

MBS: Mortgage-Backed Security MDB: Multilateral Development Bank MTM: Mark-to-Market

MTN: Medium-Term Note NIF: Note Issuance Facility NPL: Non-Performing Loan OTC: Over the Counter

PAC: Planned Amortisation Class PC: Participation Certificate PD: Probability of Default PO: Principal Only

PSA: Public Securities Association PSE: Public Sector Entity

RBA: Ratings-Based Approach

RMBS: Residential Mortgage-Backed Security RUF: Revolving Underwriting Facility

RWA: Risk-Weighted Asset

SDA: Standard Default Assumption SF: Supervisory Formula

SLN: Secured Liquid Note SMM: Single-Monthly Mortality SIV: Structured Investment Vehicle SPV: Special Purpose Vehicle

STRIP: Separately Traded Registered Interest and Principal SUBI: Special Unit of Beneficial Interest

TAC: Targeted Amortisation Class UL: Unexpected Loss

VADM: Very Accurately Determined Maturity VaR: Value at Risk

WAC: Weighted-Average Coupon WAM: Weighted-Average Maturity

(11)

CHAPTER ONE

INTRODUCTION AND FRAMEWORK

1. INTRODUCTION

The object of this dissertation is to examine critically the implications of the new Basel II capital adequacy framework1_{on the regulatory capital arbitrage deriving from banks’ participation in} securitisation transactions.

In primitive societies people made use of barter to satisfy their needs. Given the difficulty of finding a double coincidence of wants between two people, societies have, over the ages, adopted common measures of value such as gold or silver. Later on paper notes backed by these precious metals, or

specie, started replacing gold and silver coins as stores of value and mediums of exchange. Later

cheques, i.e. orders by depositors to the goldsmiths and bankers to make payments on their behalf to someone else, became widely accepted as a means of payment. In this way claims on deposits and orders to make transfers between deposits came to dominate specie itself as a means of payment. Yet another important development was when bankers realised that they need not hold specie fully equal to their liabilities in the form of banknotes and deposits in order to be able to meet their promise to pay on demand. This was because few depositors wanted to be repaid their deposits at one and the same time. Banks began to lend out money in greater amounts than the specie kept in their custody, and earned interest on these loans. This process constituted the origin of the fractional reserve banking system, for whenever a banker granted a loan without receiving full specie in exchange, money was created. In this way the rigid link that existed between specie and the money supply was broken and banks as institutions that accept deposits and extend loans came into being.

Legal definitions of what constitutes a bank vary from country to country, but it has become widely accepted that the activity that makes banks special is the taking in of deposits, since deposits, specifically demand deposits, constitute funds on call that can be used as a means of payment and settling debts with third parties. Consequently, banks find themselves at the centre of the payments system, the efficiency of which is very important for a country’s economy, and the whole financial system.

(14)

A country’s financial system comprises the arrangements embracing the lending out of funds by savers to borrowers, either between savers and borrowers contracting directly with each other, or through the intervention of financial intermediaries. The financial system’s primary function is to mobilise savings and allocate those funds among competing borrowers on the basis of expected risk-return. This process can be carried out in two competing ways: either through financial intermediation or through financial disintermediation.

Financial intermediation refers to the process whereby financial intermediaries such as commercial banks take in deposits from savers with the aim of on-lending to borrowers. Depositors’ and borrowers’ risk appetite, term preferences, savings availability and borrowing requirements, however, are seldom matched. Depositors tend to save smaller amounts for shorter periods than the amounts and periods required by borrowers. Depositors are also risk averse and do not have the resources available to assess the risks that borrowers might not repay their loans. Banks bridge this divide by means of maturity transformation and by risk diversification. Maturity transformation refers to the process whereby banks take in generally short-term deposits from savers, and lend the funds so procured out to borrowers for generally longer periods. In doing so the banks expose themselves to liquidity risk, credit risk and price or market risk. Liquidity risk refers to the inability of a bank to meet its commitments on time, specifically the commitment to repay depositors their deposits when they require these, which is an inherent risk of maturity transformation. Credit risk refers to the potential inability of a borrower to repay its loan in full. Market risk refers to the risk of unexpected movements in, for example, interest rates and the impact thereof on the bank. For taking on these risks they charge an interest rate spread, which is the margin between the interest rate paid on deposits and the interest rate charged on loans to borrowers. Banks attempt to ameliorate these risks by diversification of their loans across different borrowers, and across different market sectors, something that would be very difficult for an individual saver to do.

Despite the difficulties of savers and borrowers matching their different requirements, and therefore using financial intermediaries such as banks to do this, the process of financial disintermediation has grown rapidly. Disintermediation is the process whereby financial intermediaries are bypassed and savers contract directly with borrowers. The markets that bring savers or investors directly together are the money markets and the capital markets. The money market deals in short-term financial instruments usually with a maturity of less than one year, whereas the capital market deals in longer-term instruments. Investors in the money and capital markets are institutional investors such as insurance companies, pension funds and asset managers, while borrowers tend to be large corporates. The credit risk is borne by the investors, who are assisted in the risk assessment and risk monitoring

(15)

by credit rating agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. Liquidity, e.g. the ability for an investor to liquidate its investment is provided by the secondary market, which is the market for trading financial instruments after they have been issued originally in what is termed the primary or new issue market. Both the money market and the capital market have a primary and secondary market. Typically, the financial instruments issued and traded in the money market are negotiable certificates of deposit, promissory notes and commercial paper, which are all certificates of indebtedness with maturities ranging from a few days to 364 days. Instruments with maturities in excess of 364 days that are issued and traded in the capital market are fixed coupon bonds, zero coupon bonds and floating rate notes. The different money market instruments are technically very much the same, whereas the various capital market instruments are distinguished by their different interest rate profiles. On a fixed rate bond the investor receives a fixed interest payment, called the coupon. A zero coupon bond does not pay a coupon over its lifetime, but is issued at a discount and redeemed at its nominal or face value. The difference between the issue price the investor pays for the zero coupon bond, and the redemption amount reflects the investor’s return on the instrument. Floating rate notes are bonds that pay a variable rate coupon, which is linked to a specified reference interest rate.

Traditional financial intermediation is an inherently costly process because the intermediary requires, and is required by, the regulators to hold sufficient capital to protect itself against default risk, which adds a layer of cost to the process. It comes as no surprise that financial intermediaries such as banks have been steadily losing market share to the process of disintermediation. Disintermediation as such is not a new phenomenon, as financial markets have been trading equities and bonds for over a century. The greater acceptance by investors of credit ratings provided by rating agencies, as well as more liquid secondary markets, has greatly encouraged the growth of disintermediation during recent times. Disintermediation has gained additional impetus from the development of the securitisation market over the last 25 years. Until the development of securitisation, disintermediation only really applied to the issue by large creditworthy corporates of relatively large amounts of debt into the money and capital markets. Securitisation however allows much smaller amounts of consumer and business debt to be funded through the money and capital markets. Through securitisation, which is a more elaborate process of disintermediation than the issuance of corporate bonds or commercial paper, illiquid consumer loans such as residential mortgages, vehicle finance and credit card receivables can be repackaged into liquid financial instruments.

(16)

− Origination, which is the process carried out by the financial institution that extended the loans and comprises the acquisition and credit appraisal of loans.

− Structuring, which entails the creation of a special legal entity known as a special purpose vehicle (SPV) for the sole purpose of purchasing loans from the originating institution, using the assets so purchased as collateral for asset-backed securities issued into the capital market to fund the purchase.

− True sale, the principle whereby assets are legally sold to the SPV and the SPV has no recourse to the originator if some of the assets default, nor do the originator’s creditors have any claim against the assets if the originator becomes insolvent.

− Bankruptcy remoteness, whereby the SPV is limited by its constitutive documents to engage only in the purchase of specified assets and the issue of asset-backed securities to finance the purchase.

− Credit enhancement, which is the technique whereby the credit quality of the asset pool is improved to such an extent that the asset-backed securities that are issued on the strength of the collateral plus the credit enhancement are of a sufficiently high credit rating assigned by a rating agency to make them attractive to investors. Often the originator provides credit enhancement through a subordinated loan to the SPV. Otherwise, external credit enhancement can be procured from an insurer that provides a guarantee, or internal credit enhancement can be used by way of creating an internal reserve.

− Underwriting and placing, whereby the asset-backed securities are placed with investors.

− Hedging, the process whereby all interest rate and currency risk is hedged out through financial derivatives in order to protect investors.

− Servicing, being the process of collecting interest and principal debt from the borrowers and paying it over to the SPV for disbursement to investors. Servicing is usually performed by the originator.

The securitisation market had its beginnings in the early 1970s with the sale of pooled mortgage loans guaranteed by United States government agencies, namely the Government National Mortgage

(17)

Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). In the United States a lender can extend a conventional mortgage loan based on the credit of the borrower and on the mortgage collateral. The lender may also take out mortgage insurance from these government agencies to provide a guarantee for the fulfilment of the borrower’s obligations. Because the United States government guarantees the loans, these guaranteed mortgage loans are of a high quality and became obvious candidates for securitisation. In 1985 the first securitisation transaction backed by assets other than mortgage loans, in this instance computer leases, was launched in the United States. Later in that same year the first auto loan-backed securities were issued, followed by the first credit card-backed securities in 1987. Since then the securitisation market has expanded, as has the range of assets that have been repackaged into securities. While the United States market still accounts for the largest share of the global securitisation market, securitisation has become increasingly popular in Europe and Asia as well as emerging markets. The flexibility and applicability of the securitisation concept itself means that virtually any asset is a candidate for transformation into securities. Generally speaking, the securitisation market is composed of mortgage-backed securities (MBS), where the underlying assets that are being securitised are mortgages, and the asset-backed securities (ABS) market, which includes all other asset classes except mortgages. Each type can be further subdivided, for example, the MBS market can be subdivided into residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). As a rule of thumb, the nature of the underlying assets determines what the securities are called.

The original mortgage securitisations were structured as pass-through transactions, in which case the regular repayments by borrowers (being payment of interest and capital) and pre-payments, are directly passed through to investors. The investor’s return is equal to the underlying cash flow from the asset, minus a servicing fee paid to the originator, and other transaction fees. Subsequently, pay-through structures were developed whereby the cash flows emanating from the underlying assets are not passed through to investors as the cash flows are received, but captured in the SPV and allocated to investors according to certain rules. These pay-through structures allow for different classes, called tranches, of MBS and ABS to be issued, each tranche having a different cash flow and risk profile. A securitisation SPV could for instance issue three tranches rated ‘AAA’, ‘AA’ and ‘BBB’ by a credit rating agency. The repayment method can be sequential, which means that all the cash flows are first used to retire the ‘AAA’ debt, then the ‘AA’ debt, and only finally the ‘BBB’ rated securities. Because the ‘AAA’ securities are retired first, they are the least exposed to any losses on the underlying assets, which is why they carry the highest rating reflecting the lowest risk. On the other hand, the ‘BBB’ securities have the highest risk exposure, since they stand last in line for payment and are liable to

(18)

sustain most of any losses. If, for instance, 5% of the total securities issued by the SPV is rated ‘BBB’ and eventual losses on the underlying assets amount to 5%, then ‘BBB’ investors will lose all of their investment, whereas ‘AAA’ and ‘AA’ investors will be repaid in full. If losses exceed 5% then the ‘AA’ investors will be the next in line to suffer losses. This tranching of securities and the so-called “waterfall of payments”, where the higher rated securities are paid first from the available cash flow is a common feature of pay-through securitisation structures.

Investors in securitisation transactions rely considerably on the credit ratings provided by a credit rating agency. The rating agency conducts a due diligence on the pool of assets, and rates the securitisation structure, including the adequacy of the cash flows, credit enhancement and administrative competence of the originator as service provider. Based on these factors, it gives a rating to the asset-backed securities. During the life of the securitisation transaction the rating agency monitors the transaction every month and provides a quarterly surveillance report.

Securitisation transactions, where the assets are physically sold by the originator to the SPV, are called cash transactions. Another form of securitisation that has become popular is what is called “synthetic” securitisation. In a synthetic transaction the originator does not sell the assets to the SPV, but only the credit risk of the assets is transferred to the SPV. This is done through the use of credit derivative instruments.

Financial derivatives, of which credit derivatives represent but one type, have grown exponentially since their inception 30 years ago, around the same time as when the concept of securitisation started. The origin of the derivatives industry can be traced back to 1975 when Fischer Black and Myron Scholes published their now famous “Black-Scholes option pricing methodology” in the Journal of Political Economy. This led to the birth of today’s huge financial derivatives industry and the concept of financial engineering, whereby mathematical techniques are used to manipulate financial flows. In the June 2004 Quarterly Review of the Bank for International Settlements the aggregate turnover of exchange traded financial derivatives contracts amounted to US $272 trillion during the first quarter of 2004. The amount of outstanding over-the-counter (OTC – meaning that counterparties deal with each other directly outside of a derivatives exchange) derivatives stood at US $197 trillion at the end of 2003.

A derivative contract assumes its value from the price of an underlying item such as a commodity, financial asset or an index. The underlying item could be a physical good such as wheat, copper or frozen pork bellies or a financial instrument such as equities, bonds or currencies, where a derivative’s

(19)

price is affected by expectations about future supply and demand factors. Generally a financial derivative contract derives a future price for a specific asset on the basis of that asset’s current price (the spot price) and interest rates (the time value of money). In the case of financial derivatives the underlying assets are typically based on interest rates or currency exchange rates.

A relatively recent derivative instrument is the credit derivative of which the credit-default swap is the preferred instrument of use in synthetic securitisation transactions. A credit default swap (CDS) is a credit derivative in which a bank that owns a portfolio of assets purchases credit protection on the portfolio from a protection seller, usually another financial institution. To the extent that any defaults occur on the portfolio, the protection seller will make good the losses to the protection buyer. In return for taking on the risk of the asset portfolio the protection seller receives a regular payment, the premium, from the protection buyer.

Synthetic securitisation is a combination of securitisation and credit derivative techniques. In a synthetic securitisation there is no true sale of bank assets (reference assets); however, asset risk is transferred through a credit derivative, usually a credit default swap from the bank to the securitisation SPV. Because the reference assets are not removed from the bank’s balance sheet, synthetic securitisations are easier to execute than cash-funded structures. This is particularly so in the case of bank loans, which may require borrower notification and consent, or have other restrictions on loan sales. Synthetic securitisation transactions are typically used by banks to achieve a reduction in the regulatory capital they are required to hold against the loans on their balance sheets.

Securitisation is particularly attractive to banks because of the regulatory arbitrage opportunities it offers. Regulatory arbitrage is the process whereby banks restructure their asset categories so as to attract a lower regulatory capital adequacy charge. It must be borne in mind that governments heavily regulate banks and the rules on capital adequacy are the most prominent of these regulations. This prominence results from the central role banks play in financial intermediation and the payments system in an economy; the systemic risks posed to the economy if a bank fails; the importance of sufficient bank capital for bank soundness; and the efforts of the international community to adopt common capital adequacy standards.

Capital, of course, carries a cost. Bank shareholders would prefer the minimum amount of capital consistent with the risks the bank takes, so as to have the highest possible return-on-equity. Regulators, on the other hand, are mostly concerned with the safety and soundness of banks and would therefore prefer more rather than less capital. Countries such as the United States had first

(20)

begun to lay down minimum capital standards for banks in the early 1980s. Many other countries had prudential approaches, but without specified minimum capital adequacy standards. Capital as a percentage of assets had seen a long-term decline throughout banking systems across the world and there was a concern that there would be a further erosion of bank capital thus making the banking system more risky. Capital adequacy regulations also differed across countries thereby giving banks in some countries a competitive advantage, forcing banks operating in a more restrictive environment to lower their pricing in order to compete, thus potentially weakening their capital base.

When banking systems in a number of industrial countries weakened in the late 1980s, pressure developed for a harmonisation of bank regulations among these industrial countries. The harmonisation was driven by the need to prevent banking failures in one country from spreading to another, and also “levelling the playing fields”, so that banks in different countries would not gain a competitive advantage through different regulatory requirements. In order to address the situation, the central banks and bank regulators of the so-called Group of Ten (G10) countries, in effect the major industrial countries of the world, agreed on a common approach to bank capital regulations. The design of the new international regulatory regime was delegated to the Basel Committee on Banking Supervision (Basel Committee) based at the Bank for International Settlements in Basel, Switzerland. The Basel Committee completed the accord on capital adequacy regulations, called the Basel Accord or “Basel I”, in 1988 for implementation by member G10 countries by the beginning of 1993. Over time the benefits of standardised capital adequacy regulations were realised by other countries, including emerging economies, and by 1999 Basel I had been adopted by around 100 countries worldwide.

The major contribution of Basel I was to lay down minimum capital guidelines for banks and a standard methodology for the assessment of a bank’s capital adequacy. Since the beginning of 1993 banks incorporated in G10 countries have been obliged to comply with a minimum capital to risk-weighted assets ratio of 8%2_{, also known as the Cooke ratio. The ratio is defined as capital as a} percentage of the total of risk-weighted on-balance sheet assets plus the risk-weighted credit equivalent for off-balance sheet exposures. Basel I divided assets into four risk buckets, namely: for a bank’s exposure to sovereign governments (0%); exposures to other banks (20%); exposures to residential mortgages (50%); and lastly all claims on the non-bank sector, irrespective of the credit quality of the exposure (100%). It is especially this last “one size fits all” calculation that opened the door for regulatory arbitrage. For example, a bank loan to a corporate with a good credit rating carries, under Basel I, exactly the same risk weight (and therefore capital allocated) as a loan to a risky

(21)

start-up company. Because of the higher risk, the bank would charge a higher interest rate on the start-up loan, thus achieving a higher return on the capital that the bank is required to hold. Basel I therefore provided the incentive for banks to shift towards more risky asset portfolios for which they could command higher interest rates, while having to hold the same amount of capital, as the bank would have to hold against low-risk assets. These activities that allow the bank to assume greater risk without any increase in its regulatory capital requirements are the oldest form of regulatory capital arbitrage. Securitisation is a newer form of arbitrage that achieves the same result. When a bank sells assets to a securitisation SPV, it normally retains most of the risk of the assets sold because of the credit enhancement the bank provides to the transaction. In terms of Basel I, a bank must hold regulatory capital against the full amount of credit enhancement provided to the transaction, if the bank previously owned the assets. It follows that, if the credit enhancement amounts to less than 8% of the asset portfolio that has been securitised, the bank has reduced its regulatory capital requirement despite being exposed to essentially the same risk it faced before the securitisation.

Initially, Basel I was a significant success and global average levels of bank capital increased. However, over time the shortcomings of specifying the same risk-weight for corporate loans irrespective of the risk thereof became apparent. The consequences of this were that banks migrated to higher-margin higher-risk lending; pricing in corporate lending continued to be undifferentiated by risk; activities that carried no explicit risk-weight such as asset management and custodial services were seen to be risk-free; and regulatory arbitrage became widespread, primarily through the use of securitisation, whereby high-quality low-margin lending is removed from a bank’s regulatory balance sheet without a commensurate reduction in economic risk. The end result is that the current Basel I Accord has encouraged a reduction in overall bank solvency standards, rather than the increase that was originally envisaged.

The shortcomings of Basel I led the Basel Committee to devise improved international capital adequacy regulations starting in 1999 with the development of what was to become the Basel II framework. The overall objective of Basel II is to increase the soundness of the international banking system by establishing regulatory capital requirements that more accurately reflect the true economic risks that banks face. This means more capital will be required for more risky activities and less where there is less risk, thus departing from the “one size fits all” approach of the Basel I Accord. The final Basel II document was published in June 2004 (followed by an updated version in 2005), with implementation to commence as of year-end 2006 in countries that plan to fully implement Basel II. Banks in these countries will have three years, from 2007 to 2009, to make the transition to compliance. In South Africa, full implementation of Basel II is planned for January 2008. The new

(22)

framework proposes a system based on three mutually reinforcing pillars, which are briefly discussed below.

Pillar 1 specifies minimum capital requirements for banks’ exposures to credit risk (substantially revised and enhanced from Basel I), market risk (unchanged from the 1997 Amendment to Basel I), and operational risk (new in Basel II). The rules contained in Pillar 1 set out the minimum ratio of capital to risk-weighted assets. The current definition of capital and the 8% minimum capital requirement remained unchanged; however, risk weights will become more risk sensitive.

In terms of credit risk, Pillar 1 of Basel II draws a distinction between non-securitised assets on the bank’s balance sheet, and the treatment of a bank’s exposure to securitisation transactions as originator and investor. For the credit risk of bank assets Basel II advances three approaches, namely the Standardised approach, and the Internal Ratings-Based Foundation and Advanced approaches.

The Standardised approach is a relatively simple method conceptually in line with the existing approach under Basel I, but with more risk weight categories. Instead of only one risk weight category for corporate lending (100%), there will be four categories (20%, 50%, 100%, and 150%). Banks will slot assets into weighting categories to be referenced to a credit rating provided by an approved rating agency.

The Internal Ratings-Based (IRB) Foundation approach allows banks to categorise exposures based on the banks’ internal risk assessments. If a bank has had in place a system, recognised by its supervisor, for internally rating borrowers for at least three years, it will be able to use its own ratings to slot loans into probability-of-default (PD) bands. The bank will be able to choose as many bands as it wishes, with the capital requirement for each band set according to a formula. A set loss-given-default (LGD) factor is applied to produce the actual capital charge, reflecting the likelihood of recoveries, given the type of collateral. The IRB Advanced approach will allow banks to recognise any form of collateral and will allow banks to set their own LGD factors.

For the credit risk of a bank’s securitisation exposures Basel II advances two approaches, being the Standardised approach and the IRB approach.

Banks that apply the Standardised approach to credit risk for the type of underlying assets that will be securitised must use the Standardised approach under the securitisation framework. The capital treatment of positions retained by originators, liquidity facilities, credit risk mitigants, and

(23)

securitisation of revolving exposures are identified separately. The risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the position by the appropriate risk weight determined in accordance with specified tables.

Banks that have received regulatory approval to use the IRB approach for the type of underlying exposures securitised must use the IRB approach for securitisation. Conversely, banks may not use the IRB approach to securitisation unless they have received approval from their national supervisor to use the IRB approach for the underlying assets. Under the IRB approach for securitisation, a hierarchy of approaches is proposed, depending on whether assets are rated or not. The Ratings-Based Approach (RBA) must be applied to securitisation exposures that are rated, or where a rating can be inferred. Under the RBA, the risk-weighted assets are determined by multiplying the exposure by a specified risk weight that depends on the external rating grade, the diversification (granularity) of the underlying asset pool, and the seniority of the exposure. Where an external or inferred rating is not available, either the Supervisory Formula (SF) or the Internal Assessment Approach (IAA) must be used. The IAA is only available to exposures that banks extend to asset-backed commercial paper (ABCP) programmes. Under the SF, the capital charge for a securitisation tranche depends on five bank-supplied inputs: the IRB capital charge had the underlying assets not been securitised; the tranche’s credit enhancement level and thickness; the asset pool’s number of exposures, and the pool’s exposure-weighted average loss-given-default. A bank may use its internal assessments of the credit quality of the securitisation exposures the bank extends to ABCP programmes, only if the bank’s internal assessment process meets the approval of the bank’s national supervisor. The internal assessment of exposures must be mapped to equivalent external ratings of a rating agency.

In terms of Pillar 1, there is no change in the calculation of market risk from the current Accord. For operational risk there are three possible approaches: the Basic approach, Standardised approach, and the Advanced Measurement approach. It is not foreseen that this risk element will influence banks’ involvement in securitisation, since securitisation is mainly used as a regulatory capital management tool and as a source of funding.

The second Pillar provides for the supervisory review of banks’ capital adequacy and their internal assessment processes. National supervisors will be responsible for evaluating and ensuring that banks have sound internal processes in place to assess the adequacy of their capital, and may intervene to prevent a bank’s capital from falling below the level required by the bank’s specific risk requirements.

(24)

Pillar 3 will promote market discipline through enhanced disclosure requirements for banks. This increased transparency should give market participants a better idea of a bank’s risk profile and its capital buffer.

Basel II is expected to have an even more profound impact on the banking industry than its predecessor. It will have an equally important impact on the securitisation industry. The objective of Basel II is, inter alia, to achieve a much greater congruence between regulatory and economic capital and reduce the regulatory arbitrage that is currently achievable through securitisation transactions. The new regulatory capital treatment of bank assets and banks’ securitised exposures will therefore have a major impact on banks’ participation in securitisation transactions, and it is expected that Basel II will lead to significant shifts in the securitisation market.

It will be the aim of this study to investigate to what extent and in what manner the new Basel II regulations will impact on securitisation. More specifically, the aim will be to investigate to what extent the economically more realistic treatment of securitisation under Basel II will influence the use of securitisation by banks to manage their regulatory capital.

2. FRAMEWORK OF THE STUDY

The investigation will attempt to trace the development of securitisation with reference to banks in particular and the importance of banking regulations with respect to securitisation, and to analyse the new Basel II framework and its potential impact on securitisation, to the extent that banks use securitisation as a regulatory arbitrage tool.

The research methodology proposed is a literature study. This method is proposed since a field study will not be helpful, as Basel II will only be implemented from 2008 onwards in South Africa. A literature study is feasible and would fit the chosen objective.

It is proposed that only the potential impact of Basel II on banks’ participation in securitisation, in so far as it is used as a regulatory arbitrage technique, be covered in the research. The use of securitisation by banks for purposes other than regulatory arbitrage, e.g. for funding, will therefore not form part of this study. The aspects of Basel II that would influence the use of securitisation by banks the most profoundly are the new regulations regarding credit risk. The effects of other parts of Pillar I, e.g. market risk and operational risk, will not be investigated. Likewise, Pillars II and III are

(25)

not regarded as having a major impact on banks’ decisions whether, or not, to participate in securitisation transactions. These restrictions should not influence the validity of the research.

The study will be divided into the chapters set out below. Chapter 2 will provide an overview of cash flow securitisation. Chapter 3 will present an overview of synthetic securitisation. Chapter 4 will investigate the role of the credit rating agencies.

Chapter 5 will offer an overview of capital adequacy and the Basel regulations.

Chapter 6 will investigate the implications of Basel II in regard to the use of securitisation by banks for purposes of regulatory arbitrage.

(26)

CHAPTER TWO

AN OVERVIEW OF CASH FLOW SECURITISATION

1. INTRODUCTION

The purpose of this chapter is to examine the history and development of securitisation and its use in the financial markets. The parties to a securitisation, the reasons for securitisation, the key features of a securitisation transaction, the various securitisation structures and different asset classes are described.

Securitisation is a financing tool for selling assets in the form of receivables. Assets in this context can be defined as rights or access to future economic benefits controlled by an entity as a result of transactions concluded in the past. Through the process of securitisation, assets from corporates or banks are pooled, repackaged and sold as asset-backed securities. These asset-backed securities are collateralised or “backed” by the pooled assets, and are therefore not considered as obligations of the sellers. Investors only consider the cash flows from these assets as repayment of their investments in the securities. Securitisation has become established as an important method of finance, whereby an investor effectively agrees to evaluate only the credit risk of the relevant pool of assets, thus divorcing the credit risk from the original owner of the assets.

Asset securitisation differs from collateralised debt or traditional asset-based lending, in the sense that the assets, such as loans or other financial claims, are assigned or sold to a third party, typically a special purpose vehicle (SPV) constituted as a company or trust. This third party, in turn, issues asset-backed securities to fund the purchase of the assets. Securitisation can thus be seen to have evolved from the process of factoring, where a corporate sells short-term assets, such as trade receivables at a discounted price to a third party such as a collection agency. In the factoring process, the seller retains no interest in the receivables (which are usually sold at a significant discount), and no longer controls the collection of the cash flows.

In a securitisation transaction however, the seller (also referred to as the originator) of the assets continues to administer and collect the cash flows from the assets. The originator also retains a substantial part of the profit generated by the underlying assets by extracting this profit from the SPV. The SPV is established with the strictly limited purpose of only purchasing specified assets and funding them only in the capital markets. This structure effectively isolates the underlying assets from

(27)

the originator, which makes the asset-backed securities attractive to investors, thereby allowing relatively low cost funding, unlike factoring, which is a relatively expensive source of funding.

Over the past three decades, the use of securitisation as a financing tool has grown rapidly, not only in the United States where securitisation can be said to have started, but also globally. It has become an important source of funding for corporates, but especially for banks and other financial institutions. Securitisation transactions vary in complexity depending on specific structural, accounting, tax and legal considerations as well as on the type of asset that is being securitised.

The development of the securitisation market over the last few decades has had a number of beneficial effects on capital markets. The introduction of a new class of debt instruments has broadened the capital markets. Securitisation allows investors to invest in assets, which they otherwise could not have accessed, and greatly contributes to the availability of highly-rated bonds to investors.

2. HISTORY AND DEVELOPMENT OF SECURITISATION

Securitisation is a widely used financial methodology applied by banks and corporates to raise funding and also used by banks to manage their risks. In normal market parlance, the term “securitisation”3 has had two primary meanings. Initially, the term was applied to the process of disintermediation, or the substitution of securities issued for bank lending. More recently, the term has been used to refer to structured finance, the process whereby relatively homogeneous, but illiquid, assets are pooled and repackaged, with claims to the incoming cash flows and other economic benefits generated by the asset pool sold to investors as financial securities (Lumpkin, 1999:25). In its simplest form, securitisation is a method of funding receivables such as mortgage debts, leases, loans, or credit card balances by the creation of freely tradable securities backed by these assets (Pulido, 2004:1). Andrews

et al., (2004:2) describe securitisation as the process of setting up a credit-enhanced asset-holding

structure, which is legally remote from the bankruptcy of the original owner of those assets. Typically a company or a bank that originates assets such as receivables or loans sells these assets to an SPV4_, which issues tradable securities to investors to fund the purchase. Cash flows collected from the assets are used by the SPV to make repayments of principal and interest to the investors.

3_{Also called securitization.}

(28)

The earliest securitisation transactions date back to the early 1970s in the form of pooled mortgage loans sold by the Government National Mortgage Association (GNMA or Ginnie Mae) in the United States (Gangwani, 1998:1). These transactions were followed by transactions from the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae) in the early 1980s. The first non-mortgage asset-backed securities transaction was originated by Sperry Lease Corporation of the United States in a computer lease transaction in 1985 (Henderson, 1997:3). The United States market is the largest, most liquid, most innovative and most sophisticated debt market. Securitisation has grown concurrently with other developments affecting banks and savings and loans institutions, which include: increased competition following financial deregulation; regional imbalances in capital flows in the United States; the search for fee rather than margin income as margins have deteriorated; the imposition of capital adequacy standards; and increased emphasis on return on capital rather than returns on asset. As securitisation techniques matured, United States corporate borrowers started disintermediating the bank sector by directly accessing the public money and capital markets. From the mid-1980s, receivables-backed financing became a mainstream source of corporate finance.

Until 1995 the United States was the main source of securitisation transactions. Since 1996 there has been rapid growth in Europe, and since 1997, also in Japan and Australia (De Paauw and Ross, 2000:4). By 2004 the total outstanding issuance of securitisation securities worldwide has reached a level of approximately seven trillion dollars (Pulido, 2004:1). In South Africa R7.5 billion of new securitisation issues came to the market during 2004, increasing total issuance volume to R29.5 billion (Bate and Leegerstee, 2005:1).

Henderson (1997:4) identifies three irreversible trends in debt financial markets that have promoted the growth of securitisation. Firstly, whether it would ever be traded or not, debt is increasingly presented in tradable format, and a network of dealers, market makers and clearing houses have already created a liquid market for debt securities. Secondly, securitisation participates in the wider trend towards outsourcing and functional specialisation. It treats each part of the process of originating, administering and funding of an asset portfolio as separate elements. Such a division of labour and appreciation of constituent risks is made possible by the third trend, which is the application of computer technology to capture and manipulate large databases, and to model outcomes under assumed scenarios.

Recent trends include a blurring of the distinction between structured finance and corporate finance, increased use of derivatives and securitisation in the same transaction, and the securitisation of new

(29)

asset classes. In some countries (in Eastern Europe for example) the basic legal, regulatory, tax and accounting infrastructure for securitisation has been implemented for the first time, while in others such as South Africa certain refinements have been introduced to existing securitisation legislation.5

3. MOTIVATIONS FOR SECURITISATION

The motivation for securitisation in terms of its benefits for a number of participants such as corporates, banks, regulators and investors is set out below (European Securitisation Forum, 2002:13).

3.1 Motivation for Securitisation for Corporates

Cheaper Funding: Securitisation is an attractive financing alternative. By segregating the underlying

assets from the credit risk of the corporate, the corporate can reduce the corporate credit risk premium and can therefore fund itself more cheaply irrespective of its own credit-worthiness on a stand-alone basis.

Alternative Funding: Securitisation broadens the range of funding alternatives available to a corporate.

Without disturbing the existing relationships with lenders, securitisation extends the pool of available funding sources by bringing in a new class of investors such as insurance companies, asset managers and pension funds that may not have been available other than through a securitisation (Kothari, 2003:113). For smaller and unrated corporates that are not sufficiently large to issue debt in their own name, securitisation is an ideal way to access the capital markets. In addition, in a time of financial stress or during a cyclical downturn, the asset-backed market may be relatively more open than the unsecured debt market (Moody’s, 2003a:3).

Higher Funding: Banks lend money to corporates for working capital purposes, taking a cession of

assets such as trade receivables as security. Typically a bank will only lend an amount that is a fraction of the assets on the balance sheet of a borrower. Securitisation investors consider future cash flows rather than assets on the balance sheet only. A corporate may thus acquire a higher amount of funding through securitisation than by conventional funding methods (Kothari, 2003:114).

5

(30)

3.2 Motivation for Securitisation for Banks

Capital Management: A bank can reduce its risk-based capital requirements, thereby freeing up capital to

generate more assets or to reallocate capital to other business lines, thereby improving the return on risk-weighted assets. Securitisation thus allows a bank to increase the leverage of its capital base.

Credit Management: Securitisation allows a bank to improve the management of its exposure to

particular economic sectors or business lines.

Funding Diversification: Securitisation can diversify the bank’s funding sources.

Additional Funding: Securitisation is a source of additional funding and can supplement the bank’s core

deposit base.

Asset-Liability Management: A bank can reduce its asset-liability mismatches (funding mismatches) by

using long-term securitisation funding to match long-term bank loans, thereby replacing the short-term deposit-based funding of long-short-term bank loans.

Client Relationships: Securitisation allows the bank to manage credit concentrations while maintaining

critical client relationships. It allows continuation of the client relationship while capping or reducing credit exposure to the client.

Risk Transfer: Securitisation allows the bank to transfer “catastrophic credit risk” to credit

enhancement providers and investors. Catastrophic credit risk is the risk of loss above and beyond the amount expected (Merrit, Stroker and Weinstein, 1999:4). In a securitisation, credit risk retained by the originating bank is in effect capped at a residual amount, generally the excess spread and the retained first-loss portion. In the event of a decline in the asset pool’s performance, excess spread is used to absorb the losses, thereby reducing profit extraction back to the bank. Should excess spread become depleted, the first-loss portion held by the bank is used to absorb the risk, followed by the remaining default risk (catastrophic risk), which is then transferred to credit enhancement providers and investors.

Additional Products: With securitisation as a low cost alternative financing technique, the bank can

(31)

Additional Income: The bank can generate fee income by providing advisory services and from credit

enhancement, liquidity facilities, and placement of the securities to securitisation transactions.

3.3 Motivation for Securitisation for Regulators

Regulators recognise securitisation as a financing technique that can assist banks by improving the management of banks’ exposure to particular economic sectors or business lines; introducing transparency through third party review and market discipline to asset origination and servicing processes; and encouraging asset-liability matching and the diversification of funding away from the short-term interbank market.

3.4 Motivation for Securitisation for Investors

Secure Investment: The investors have a direct claim over a portfolio of diversified and credit-enhanced

assets. Because of the isolation of the underlying asset pool from the insolvency of the originator, investors are not affected by any of the risks that may beset the originator. The securities are supported by the cash flows from the isolated assets, and are divorced from corporate credit risk. Asset-backed securities are largely immune from event risk, the risk of a rating downgrade of a single borrower resulting from takeovers, restructurings and other events that effectively alter the credit status of senior unsecured corporate debt (Giddy, 2000:20). Investors can also take comfort from the highest level of structural and legal review in a securitisation transaction. Investing in asset-backed securities is therefore safer than investing directly in the debt or the equity of the corporate. In Europe, for example, there has been no instance of default of securitisation issuance in almost a decade (Kothari, 2003:119).

Diversification: Investing in asset-backed securities allows diversification into new asset classes and

along the credit spectrum. Since securitisation transactions are typically backed by diversified pools of assets, investors can diversify their portfolios by purchasing asset-backed securities that are, by definition, diversified. Investors can also reduce their direct exposure to corporates, while retaining exposure to the sectors in which such corporates operate.

Flexibility: Asset-backed securities tend to be issued in a number of tranches with different risk-return

characteristics and maturities. These give investors greater flexibility in matching their investment objectives.

(32)

Rating Resilience: Rating resilience means the stability of the rating of a security after issuance i.e. what

the likelihood is of it being downgraded over time. The likelihood of downgrades is mirrored by past history of downgrades collectively called ratings migration. For securitisation issuance the rating agencies have published rating migration studies, which indicate that securitisation investments are considerably safer than investments in corporate debt (Kothari, 2003:119).

Transparency: The quality of information available from a securitisation transaction, with regard to the

assets generating the cash flows, is specific and transparent. There is also ongoing monitoring by the rating agency of rated assets.

4. GENERIC SECURITISATION STRUCTURE AND MECHANICS

Through securitisation, financial assets are pooled together and their cash flows redirected to support payments on related securities, referred to as asset-backed securities (ABS)6_{, which are then sold to} investors. The basic concept of securitisation may be applied to virtually any asset that has a reasonably ascertainable value, or that generates a reasonably predictable future income stream. Although the list of potentially securitisable assets is almost endless, the fundamentals of securitisation are relatively basic and are common to nearly all types of transactions. As a result, the process of securitisation, including the structures that are used, and the roles and functions of the key transaction participants, will be similar to a meaningful degree wherever the securitisation concept is applied. These similarities are present even in various countries under different legal and regulatory regimes.

At the most basic level, the intended goal and effect of securitisation transactions is to isolate the financial assets that support payments on the related ABS (European Securitisation Forum, 1999:1). This isolation ensures that payments on the securities are derived exclusively from the performance of a segregated pool of financial assets (and any related credit and liquidity enhancements that are part of the transaction), rather than from the entity that originated or held the assets. In this sense securitisation may be distinguished from traditional forms of debt and equity financing, in which case returns to investors are derived from the profit-making potential of an ongoing business enterprise.

Both the science and art of securitisation transactions lie in the structure. In the context of securitisation, structure is a generic term embracing a wide range of considerations, from the very general to the very detailed. Complex structural features such as accounting, tax, legal and regulatory

(33)

considerations, the selection of appropriate liquidity facilities and credit enhancement facilities, and profit extraction techniques will often depend on the particular asset class to be securitised. The requirements of the originator and investors may give rise to transaction-specific structural issues.

Although the asset types in a securitisation transaction may differ in nature, and thus the dynamics of the cash flows to be securitised, there are several components common to all securitisation transactions. The originator is the original owner of the assets that are sold to the special purpose vehicle, referred to as the issuer SPV or just SPV. In order to pay for the purchase of the assets the SPV issues ABS into the money and capital markets. After the sale, the debtors, or obligors, make repayments on their debt directly to the SPV. The originator will, however, continue to provide the debt administration and collection function to the obligors in accordance with its existing credit and administration procedures. This function is referred to as servicing, and the originator, in carrying out this function, is referred to as the servicer. Depending on the nature of the transaction and the assets, the structure may have to be supported by a variety of liquidity facilities, credit enhancement facilities and hedging facilities in order to achieve the desired risk profile for the debt securities being issued. The transaction is invariably rated by one or more credit rating agencies7_{so that investors can} ascertain the risks of the securities issued. Where the securities are to be listed on a recognised financial exchange, it will be important to ensure compliance with the relevant listing rules.

(34)

4.1 Typical Securitisation Structure

Diagram 2.1 depicts the cash flows and the major participants in a typical South African securitisation structure8_.

Diagram 2.1: Generic securitisation structure

(The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships).

4.2 Securitisation Transaction Steps

1. The originator extends financing to the obligors.

2. On the issue date the Issuer SPV, which is 100% owned by the Issuer SPV Owner Trust, purchases the assets from the originator for a cash consideration.

3. The Issuer SPV funds the purchase of assets by the issuance of securities to investors, and makes interest and principal repayments to investors at regular intervals.

8_{Adapted from the rating report on Fintech Receivables 1 (Proprietary) Limited, a South African lease receivables}

securitisation rated by Moody’s, dated 2 December 2002.

Obligors Issuer SPV Investors Liquidity Facility Provider Credit Enhancement Facility Provider Hedge Facility Provider Administrator Originator Issuer SPV Owner Trust Security SPV Owner Trust Security SPV 9 100% 100% 1 2 3 4 5 6 8 7

(35)

4. Subsequent to the sale of the assets, the obligors make their payments directly to the Issuer SPV. The originator will perform the role of servicer in terms of which it will manage the collection and payment by the obligors.

5. The Issuer SPV enters into liquidity, credit enhancement and hedging agreements with various counterparties.

6. The Issuer SPV outsources its day-to-day operations to an administrator.

7. The Security SPV, which is 100% owned by the Security SPV Owner Trust, guarantees the Issuer SPV’s obligations to the secured creditors, including investors, subject to the priority of payments.

8. The Issuer SPV indemnifies the Security SPV in respect of claims made under the Security SPV guarantee. The Issuer SPV’s obligations under the indemnity are secured by a cession in securitatem

debiti of its assets in favour of the Security SPV.

9. The Issuer SPV Owner Trust binds itself as surety to the Security SPV of the Issuer SPV’s obligations under the indemnity. The surety is secured by a pledge of the ordinary shares of the Issuer SPV in favour of the Security SPV.

4.3 Structural Variations in Securitisation Transactions

A number of different securitisation structures can be identified in terms of their cash flow allocation, and these are set out below.

4.3.1 Pass-Through Structure

A pass-through structure, whereby direct participations in the underlying pool of assets are sold to investors, is the simplest form of securitisation. A pass-through certificate represents an ownership interest in the underlying assets and thus in the resulting cash flows (International Finance Corporation, 2004:7). In the pass-through structure the cash flows received from the underlying assets are passed directly through to investors to pay down the securities (De Paauw and Ross, 2000:25). Pass-through securities are fully amortising, meaning that principal is returned to investors throughout the life of the transaction.

THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS OF BANKS