Master Thesis - Structured Finance and SME 2009-06-26...

MAGISTERARBEIT

Titel der Magisterarbeit

„ European SME Financing and Structured Finance “

Verfasser

Philip Chlupacek, BSc

angestrebter akademischer Grad

Magister der Sozial- und Wirtschaftswissenschaften

(Mag. rer. soc. oec.)

Wien, Juni 2009

Studienkennzahl lt. Studienblatt: A 066 915

Studienrichtung lt. Studienblatt: Betriebswirtschaft

Betreuer: Univ.-Prof.Dr. Alexander Stomper

European SME Financing and Structured Finance

iii

Contents

Abbreviations .................................................................................................. vii

Figures .............................................................................................................. ix

Tables ................................................................................................................ xi

1 Introduction.................................................................................................. 1

2 Small and Medium-sized enterprises......................................................... 32.1 SME Definitions ............................................................................................... 3

2.1.1 European Union.......................................................................................... 32.1.2 North America............................................................................................. 4

2.2 Characteristics of SMEs.................................................................................. 42.2.1 Corporate governance and management ................................................... 42.2.2 Value Management..................................................................................... 5

2.3 Financial issues associated with SMEs ........................................................ 72.3.1 Structure of financial environment .............................................................. 72.3.2 Funding....................................................................................................... 8

3 The Basel Capital Accord ......................................................................... 133.1 Development of the Basel Accord ............................................................... 133.2 Basel II ............................................................................................................ 14

3.2.1 Pillar 1: Minimum capital requirements..................................................... 163.2.2 Pillar 2: Supervisory review ...................................................................... 183.2.3 Pillar 3: Market discipline .......................................................................... 18

3.3 Effects of Basel II on SMEs........................................................................... 19

4 Financing alternatives............................................................................... 214.1 Equity.............................................................................................................. 22

4.1.1 Private equity ............................................................................................ 234.1.2 Venture capital.......................................................................................... 234.1.3 IPO............................................................................................................ 23

4.2 Debt................................................................................................................. 244.2.1 Bank loans ................................................................................................ 244.2.2 Factoring................................................................................................... 244.2.3 Leasing ..................................................................................................... 254.2.4 Bonds........................................................................................................ 254.2.5 Commercial Paper programmes............................................................... 26


iv

4.3 Hybrid financing ............................................................................................ 264.3.1 Participation certificates............................................................................ 264.3.2 Silent partnerships .................................................................................... 264.3.3 Convertible bonds..................................................................................... 27

5 Structured finance ..................................................................................... 295.1 Development of asset securitisation ........................................................... 29

5.1.1 Definition of securitisation......................................................................... 295.1.2 Origins and development.......................................................................... 315.1.3 Market situation ........................................................................................ 34

5.1.3.1 Market volumes and shares............................................................................345.1.3.2 Subprime crisis ...............................................................................................35

5.2 Concept of asset securitisation ................................................................... 395.2.1 Securitisation players................................................................................ 405.2.2 Types of transactions................................................................................ 42

5.2.2.1 “True sale” ......................................................................................................425.2.2.2 Synthetic .........................................................................................................43

5.2.3 Credit enhancement ................................................................................. 445.2.3.1 External credit enhancement ..........................................................................445.2.3.2 Internal credit enhancement ...........................................................................45

5.2.4 Payment methods..................................................................................... 465.2.4.1 Pass Trough ...................................................................................................465.2.4.2 Pay Through ...................................................................................................47

5.2.5 Securitisation process............................................................................... 475.3 Effects of securitisation ................................................................................ 50

5.3.1 Benefits associated with securitisation ..................................................... 505.3.2 Risks associated with securitisation ......................................................... 535.3.3 Effects on SME financing.......................................................................... 555.3.4 Effects on European economy.................................................................. 57

6 Conclusion ................................................................................................. 59

Bibliography .................................................................................................... 61

Annex I: Summary of U.S. small business Size Standards ...................... 71

Annex II: Relationship of SMEs and banks in Europe .............................. 73

Annex III: Main distinctive features of equity, debt and hybrid capital ... 77

Annex IV: Standard & Poor’s credit ratings definitions............................ 79


v

Abstract: English .......................................................................................... 81

Abstract: Deutsch......................................................................................... 83

Curriculum Vitae.............................................................................................. 85


vii

Abbreviations

A Austria

ABCP Asset Backed Commercial Paper

ABS Asset Backed Security

AMA Advanced Measurement Approaches

B Belgium

Basel I Basel Capital Accord

Basel II New Basel Capital Accord

BCBS Basel Committee on Banking Supervision, Committee

BIS Bank for International Settlements

CBO Collateralised Bond Obligation

CDO Collateralised Debt Obligation

CDS Credit Default Swaps

CH Switzerland

CLO Collateralised Loan Obligation

CLN Credit Linked Notes

CMBS Commercial Mortgage Backed Security

Committee Basel Committee on Banking Supervision, BCBS

CP Commercial Paper

D Germany

DK Denmark

E Spain

EEA European Economic Area

EL Greece

Europe-19 Austria, Belgium, Denmark, Finland, France, Germany,

Greece, Ireland, Italy, Luxembourg, Netherlands,

Portugal, Spain, Sweden, United Kingdom, Island,

Lichtenstein, Norway, Switzerland

EU European Union

EU-15 Austria, Belgium, Denmark, Finland, France, Germany,

Greece, Ireland, Italy, Luxembourg, Netherlands,

Portugal, Spain, Sweden, United Kingdom


viii

F France

FIN Finland

Fannie Mae FNMA, Federal National Mortgage Association

FGI Financial Guarantee Insurance

FHLMC Freddie Mac, Federal Home Loan Mortgage

Corporation

FNMA Fannie Mae, Federal National Mortgage Association

Freddie Mac FHLMC, Federal Home Loan Mortgage Corporation

GSE Government Sponsored Entity

I Italy

IO Interest Only

IPO Initial Public Offering

IR Ireland

IRB Internal Ratings-Based Approach

IS Island

L Luxembourg

L/C LOC, Letters of Credit

LI Lichtenstein

LOC L/C, Letters of Credit

MBS Mortgage Backed Security

NL Netherlands

NO Norway

NYSE New York Stock Exchange

P Portugal

PO Principle Only

S Sweden

SBA U.S. Small Business Administration

SIV Single Investment Vehicle

SME Small and Medium-sized Enterprise

SPE Single Purpose Entity

SPV Single Purpose Vehicle

SRP Supervisory Review Process

UK United Kingdom


ix

Figures

Figure 1: Percentage of SMEs using debt financing in EU-15, by country.......... 9

Figure 2: Equity ratio by sector, enterprise size, and country ........................... 10

Figure 3: Architecture of Basel II – The Three-Pillar Model .............................. 16

Figure 4: SME development stages .................................................................. 22

Figure 5: ABS outstanding ................................................................................ 34

Figure 6: Volume of outstanding securitised loans, $trn ................................... 36

Figure 7: Housing subsidence, ABX.HE 7.2 AA index, % of face value............ 37

Figure 8: Relation of US house prices and US foreclosures ............................. 38

Figure 9: Securitisation players ......................................................................... 41

Figure 10: Synthetic securitisation structure ..................................................... 43

Figure 11: Phases of a securitisation ................................................................ 48

Figure 12: Fundamental investment risks in asset securitisation ...................... 54

Figure 13: Reasons for dissatisfaction with the most important bank, by

enterprise size (in percent), in Europe-19 ................................................... 74


xi

Tables

Table 1: New thresholds for SMEs...................................................................... 3

Table 2: Possible weaknesses of owner-managers ............................................ 5

Table 3: Most important sources of security for the involved parties .................. 7

Table 4: Chronology of Basel Accords .............................................................. 15

Table 5: Main areas Pillar 2 of Basel II.............................................................. 18

Table 6: Phases of growth financing ................................................................. 21

Table 7: Types of ABS and used assets ........................................................... 30

Table 8: Global securitisation impetus .............................................................. 32

Table 9: Examples of securitised assets ........................................................... 33

Table 10: European securitisation market......................................................... 35

Table 11: ABS structures commonly used before the subprime crisis .............. 37

Table 12: Basic requirements for securitisation ................................................ 39

Table 13: Examples of interchangeable expressions used in securitisation ..... 46

Table 14: Analysis performed during feasibility study phase ............................ 49

Table 15: Tasks performed during pre-closing phase ....................................... 50

Table 16: Value added through securitisation ................................................... 51

Table 17: Main motives for securitisation in true-sale transactions................... 52

Table 18: Benefits of securitisation ................................................................... 53

Table 19: ABS techniques involving SME-related payment claims................... 56

Table 20: Percentage of SMEs with credit lines, by number of banks and

sectors in Europe-19 ................................................................................... 73

Table 21: Percentage of SMEs with credit lines, by number of banks and size

class in Europe-19....................................................................................... 73

Table 22: Percentage of SMEs, by maturity period for the largest bank loan and

sector in Europe-19 ..................................................................................... 74


xii

Table 23: Most important reason for changing a major bank account, by size

class (in percent), in Europe-19 .................................................................. 75

Table 24: Most important reason for not obtaining additional bank loans, by size

class (in percent), in Europe-19 .................................................................. 75

Table 25: Main distinctive features of equity, debt and hybrid capital ............... 77

Table 26: Standard & Poor’s long-term issue credit ratings definitions............. 79

1 Introduction

1

1 Introduction

The financial sector has changed significantly during recent decades. Higher

competitive pressure and a greater concentration of banks have diverse

impacts on lending practices. The new Basel Capital Accord, Basel II, is

supposed to harmonise international capital requirement standards in banking

and to enhance the financial system’s security and solidarity. Such changes in

the financial environment may have substantial effects on the access to finance

of small and medium-sized enterprises (SMEs), which generally tend to face

significant problems in accessing equity as well as debt. Many financial

institutions issue securitised debt on various asset classes. However, in

Continental Europe, where SMEs are of especially great economic importance,

securitisation would represent an interesting alternative to traditional finance

channels. This paper focuses on such structured finance instruments as a

financing alternative, in particular for SMEs.

The following section explains the characteristics of SMEs, in terms of size,

corporate governance, and value management. Subsequent, financial issues

associated with SMEs are discussed. Section 3 provides an overview of the

development and the structure of Basel II and discusses possible effects on

SME finance. After a brief outline of equity, debt and hybrid finance alternatives

in Section 4, Section 5 focuses on the main topic of this paper, structured

finance, describing its development and concept. Finally it elaborates on the

benefits and risks associated with securitisation, including its effects on SME

financing and on he European economy as a whole. Section 6 concludes.

2 Small and Medium-sized enterprises

3


2.1 SME Definitions

2.1.1 European Union

On the 1 January 2005, there was a new definition for Small and Medium-sized

Enterprises (SME) entered into force by the European Commission (see

Table 1). It introduces three different categories of enterprises. An enterprise is

by definition “any entity engaged in an economic activity, irrespective of its legal

form”.1

Enterprise

category Headcount Turnover or Balance sheet total

Medium-sized < 250 ≤ € 50 million ≤ € 43 million

Small < 50 ≤ € 10 million ≤ € 10 million

Micro < 10 ≤ € 2 million ≤ € 2 million

Table 1: New thresholds for SMEs2

For staff and financial calculation, data from the last approved annual accounts

must be used. Another important aspect concerning the used data is the

autonomy of the SME. An enterprise is only autonomous if it is independent, it is

holding less than 25% of capital or voting rights (whichever is higher) in one or

more enterprises and/or outsiders do not have 25% or more of capital or voting

rights in the enterprise; so called minority partnerships. Enterprises with

1 see European Commission (2003b) pp.6f. 2 European Commission (2005).


4

holdings of up to 50% are partner enterprises. If the stake is more than 50% the

enterprises are linked.3

2.1.2 North America

The U.S. Small Business Administration (SBA) has established widely used

small business size standards - 500 employees for most manufacturing and

mining industries, and $6.5 million in average annual receipts for most

nonmanufacturing industries. However, as these are only the primary size

standards by industry, there is no single definition in the U.S. due to many

exceptions.4 Page 71 provides a summary of the U.S. small business Size

Standards by Industry.

Canada’s national statistics agency Statistics Canada defines SMEs “… as

enterprises with less than 250 employees and less than $50 million in total

revenue”.5 Industry Canada, Canada’s national industry agency, uses similar

standards as the EU. A small business is defined as one that has fewer than

100 employees (if goods-producing business) or fewer than 50 employees (if

service-based business). A business with fewer than 500 employees is

classified as a medium-sized business, while firms with 500 or more employees

are classified as large businesses. A micro business is defined as a business

with fewer than five employees.6

2.2 Characteristics of SMEs

2.2.1 Corporate governance and management

The word “entrepreneur” usually describes a person who plans, founds and

runs a business at his own risk. Most SMEs are under the legal form of

individual enterprises or partnerships such as private limited companies.

3 see European Commission (2003b) pp.11-25. 4 see U.S. Small Business Administration (2009). 5 Canada Statistics (2009). 6 Canada Industry (2008).


5

Especially in small enterprises like family businesses the owners manage the

business. It can be observed that most of these SMEs perform highly qualified

work, especially the very small ones. However, in many cases, management is

rather poor due to the executive management’s technical background. Also, as

the key decision makers, owner-managers tend to be reluctant to change,

transparency and openness. Examples of possible management weaknesses of

owner-managers are listed in Table 2.

Weak leadership and people skills

Personal weaknesses of executive management

Only partial focus on diverse business segments

Insufficient strategic planning

Weak forecasts due to lacking planning activities

Inadequate information due to deficient accounting and controlling

Missing succession plan

Little information on competition

Table 2: Possible weaknesses of owner-managers

Another characteristic of SMEs is that long term independence tends to be

considered as more important than profit. This leads to rather risk-averse

behaviour.7

2.2.2 Value Management

For some time, Value Management was understood as increasing Shareholder

Value, the value of an enterprise for the benefit of its owners. Considering the

value of total equity being equal the value of the total enterprise, the aim to

increase Shareholder Value equals increasing the total value of the enterprise.

The underlying principle is that whoever bears the consequences has the right

to decide.8

One may argue that executive management should care about more than

profitability. Especially in Continental Europe, but also in the USA and in Great

7 see Marx (1993) pp.5-8,18-45; Janßen (2003) pp.90-92. 8 see Spremann (2001) pp.27,28.


6

Britain, executive management has to consider interests of competing groups of

stakeholders.9 This approach, the Stakeholder Value approach, is the

predecessor of the Shareholder Value approach, from a historical point of view.

Ralph Cordiner10 claimed already in the 1950s that top management of public

companies is responsible to a variety of stakeholders beyond shareholders,

such as customers, employees and suppliers. However, the supporters of the

Stakeholder Value approach failed to develop a way to measure the value owed

to each group of stakeholders. Finally, top management had to consider

interests of all groups of stakeholders, having eventually no responsibility at all,

providing always reasons for bad performance and low return. Even more,

customers are actually no stakeholders because they have no interest in the

company itself but only in the product or service the company provides. 11

Family businesses are especially important in Continental Europe. In most

cases, the understanding of creating and increasing value is different for family

businesses than for large corporations. The family business forms a major part

of the family’s property. Family members tend to manage the business (see

2.2.1 Corporate governance and management). Unlike portfolio investors, who

diversify their investments, family businesses run high risk of total loss.

Tradition and reputation are considered as extremely important. Families

owning a business care about long-term success, for several generations.

Long-term independence is the prime objective, rather than short-term profit.

The basic principle of the so-called Family Value is sustainability. Table 3

provides an overview of the three enterprise models and the interests of

involved parties.12

9 see Spremann (1996) p.481. 10 Former CEO of General Electric. 11 see Malik (2004) p.63, Reichheld, Teal (1996) p.161. 12 see Spremann (2001) pp.48-50.


7

Shareholder Value Stakeholder Value Family Value

- Market-driven behaviour

- No limitations

- Continuity

- Striving for value

- Outperformance

- Sustainability

- Long-term independence

Table 3: Most important sources of security for the involved parties13

On may argue that the purpose of an enterprise is valorisation. However,

increasing in value can never be neither aim nor purpose of an enterprise.

Being valuable is simply not a purpose. Purpose or aim may be competitiveness

in a certain market. Hence, the purpose of an enterprise would be satisfying the

customer, rather than employees or shareholders. Therefore, the purpose is

increasing the Customer Value. In that sense, the aim of shareholders is not

necessarily equal the aim of the enterprise. Furthermore, not all investors are

entrepreneurs. However, each entrepreneur is certainly an investor, but only

few investors are entrepreneurs. An investor acts time-oriented. He is only

interested in return and may sell his shares in difficult times. The entrepreneur

on the other side is interested in the competitiveness of the enterprise and

struggles through hard time. He cares for the enterprise. His motives may be

divers. In order to trade, an investor needs stock markets while an entrepreneur

does not.14

2.3 Financial issues associated with SMEs

2.3.1 Structure of financial environment

Progress in information and communication technologies, deregulation and

globalisation have been changing the financial sector continuously, over the last

decades. These changes may have both positive and negative effects on

13 Spremann (2001) p.50. 14 see Malik (2004) pp.63-68.


8

SMEs. On the positive side, higher cost effectiveness may lead to decreasing

charges and interest rates, a broader range of financial products may facilitate

SMEs' access to finance, and increasing use of electronic banking services

leaves human resources for a more client-based approach rather than a

product-based approach. On the other hand, the mergers and acquisitions

process may lead to a reduction in the number of banks available in their

region, a reduction of the total credit amount attributed to SMEs, and a

weakening negotiation power due to the increasing relative difference between

the size of the SME and the size of the bank.

Basically, there exist two financing systems in Europe: a bank-based system, as

in Germany and Austria, and a market-based financial system as in the United

Kingdom. In a bank-based financial system banks play the most important role

as finance provider because bank loans are the preferred source funding.

Market-based financial systems rely on competitive markets. Among other

forms of finance, equities and bonds are more important than bank loans.

Despite a varying importance of bank borrowing, the majority of European

SMEs depend on bank financing, revealing a lack of alternative funding

sources.15

2.3.2 Funding

SMEs and large companies face basically the sme problem in financing, i.e. the

funding and provision of capital. However, large companies are able to invest

smoothly over time, due to their size. SMEs on the other hand, face financing

problems, as investments may be larger relative to their size. In other words,

large companies have many small investments over time, while small

companies have few but large investments compared to their size.

Another problematic characteristic of SMEs are frequently too large inventories.

These are usually caused by poor logistics. Furthermore, SMEs tend to be more

dependent on single customers. Reasons are insufficient cash reserves and the

risk of bad debt of large customers.

15 see European Commission (2003) pp.13,19.


9

Traditionally, SMEs have close relationships to their main banks. This long-term

cooperation is based on deep trust and may lead to a kind of dependence of the

entrepreneur. The smaller the enterprise, the worse tends to be the rating, the

higher is the default risk, the more expensive gets the funding, and the stronger

is the dependence. If banks are reluctant to lend, small companies tend to face

bigger troubles.16

Figure 1: Percentage of SMEs using debt financing in EU-15, by country17

Most European SMEs still rely on a traditional relationship to one single bank

despite growing importance of alternative ways of funding. The prime focus

tends to lie on short-term financing. Trade credit is one of the most favourite

16 see Marx (1993) pp.64-66. 17 European Commission (2003) p.20. The survey was conducted among independent medium-sized enterprises (50-250

employees). Source: Grant Thornton, The European Business Survey, London, 2001.

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forms of short-term financing. Compared to large corporations, SMEs face a

competitive disadvantage due to higher interest rates and bank charges.18

Figure 1 gives an indication of the different types of debt finance used by SMEs.

The majority of SMEs use mainly bank finance and leasing. Factoring seems to

be important only in France.

There are various relevant ratios and performance indicators. Nevertheless, the

most important ratio to banks when lending to companies is the equity ratio19.

Studies show that European SMEs have on average weaker equity ratios than

larger companies.20

Figure 2: Equity ratio by sector, enterprise size, and country21

Figure 2 provides an overview on SMEs’ equity ratios by sector, size and

country. Among SMEs, there seems to be no clear link between the equity ratio

and firm size. Differences in the equity ratio by country may be explained by

different taxation systems, financial systems, legal framework conditions, and

financing traditions. Differences by sector may be primarily caused by different

capital demands. In general, SMEs show lower equity ratios than larger

enterprises and a higher demand for external finance. The density of

18 see European Commission (2003a) p.5. 19 Equity ratio = equity as a percentage of total capital. 20 see Marx (1993) pp.67-70. 21 European Commission (2003) p.21.

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11

investments22 of large enterprises is generally higher than of SMEs. Larger

enterprises seem to be rather able to own the fixed assets, such as buildings

and office equipment, instead of renting or leasing them. And, SMEs have a

relatively higher need for working capital requirements. Furthermore, SMEs

tend to be more indebt than large enterprises.

SMEs heavily rely on bank lending. Table 20 on page 73 shows that some 40 %

of European SMEs have credit lines with only one single bank. Even more,

more than half of SMEs having credit lines concentrate them in one single bank.

The smaller the enterprise, the closer tends to the bank relationship. Micro

enterprises usually have credit lines only with one single bank (see Table 21 on

page 73). Also, the attributes of credits indicate SMEs’ bank financing. More

than half seem to have bank liabilities of more than € 100 000. As Table 22 on

page 74 shows, the majority of SMEs’ largest bank loans have a maturity period

of over three years. Compared to lending to larger enterprises, lending to SMEs

is more often a matter of collateral. Therefore, insufficient guarantee collateral is

a major reason for banks refusing to grant additional loans to requiring small

enterprises. However, Table 24 on page 75 shows that unsatisfying business

performance and insufficient information provided are more significant reasons

for medium sized enterprises not to receive required credit.

Most SMEs seem to be satisfied with services banks provide. Dissatisfaction

has its root cause in poor service, high bank charges, high interest rates and

unsuitable solutions. Figure 13 on page 74 provides an overview of various

reasons for dissatisfaction, broken down by enterprise size. Normally, SMEs do

not switch banks. It is considered as complex and brings little financial benefit. If

SMEs decide to change banks, the main reasons are more favourable

conditions and better service (see Table 23 on page 75).23

22 Ratio of fixed assets to total assets. 23 see European Commission (2003) pp.21-28.

3 The Basel Capital Accord

13


3.1 Development of the Basel Accord

Established on 17 May 1930, the Bank for International Settlements (BIS) is the

world’s oldest financial organisation and fosters international monetary and

financial cooperation. Based in Basel, Switzerland, the BIS serves as a bank for

central banks. Currently, the BIS has 55 member central banks and 560 staff

from 49 countries.24

The most important committees are the Markets Committee, the Committee on

the Global Financial System, the Committee on Banking Supervision, and

Committee on Payment and Settlement Systems.25

The Basel Committee on Banking Supervision (BCBS), hereafter the

Committee, was established by the central bank Governors of the Group of

Ten26 countries at the end of 1974. Current members are Belgium, Canada,

France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,

Switzerland, United Kingdom and United States.

The Committee has no formal supranational supervisory authority. Therefore,

the Committee’s conclusions do not have any legal force. Rather more, it

formulates supervisory standards and guidelines, which are expected to be

implemented by individual authorities in order to fit their own national systems.

24 Algeria, Argentina, Australia, Austria, Belgium, Bosnia and Herzegovina, Brazil, Bulgaria,

Canada, Chile, China, Croatia, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hong Kong SAR, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Latvia, Lithuania, the Republic of Macedonia, Malaysia, Mexico, the Netherlands, New Zealand, Norway, the Philippines, Poland, Portugal, Romania, Russia, Saudi Arabia, Singapore, Slovakia, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom and the United States, plus the European Central Bank; Bank for International Settlements (2008).

25 see Bank for International Settlements (2008). 26 Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland,

United Kingdom and United States; Bank for International Settlements (2008).


14

One important objective has been a thoroughly international supervision, based

on two principles:

that no foreign banking establishment should escape supervision

that supervision should be adequate.

Over the last few years, the Committee has promoted solid supervisory

standards worldwide and developed together with many non-G-10 supervisory

authorities the „Core Principles for Effective Banking Supervision“ and the „Core

Principles Methodology“.27

In order to harmonise international capital requirement standards in banking,

the Basel Committee on Banking Supervision created the Basel Accord, Basel I,

in 1988. Primarily focusing on credit risk, Basel I set the minimum capital

requirements at 8% of the banks’ standardised risk-weighted assets. Since

1996, the risk of market prices has been considered in Basel I, due to the

increasing importance of international trade. Initially, Basel I targeted only at

international banks. In the meantime, however, it is respected and implemented

worldwide.

However, Basel I considered the bank’s economical risks only roughly. New

financial instruments such as credit derivatives and asset securitisation are

almost entirely ignored. Furthermore, Basel I only took into account credit and

market risk as basis for the capital requirement. 28

3.2 Basel II

Based on Basel I, the aim of the new Basel Accord, Basel II, is to enhance the

financial system’s security and solidarity. Therefore, capital requirements are

more dependent on the underlying risks and new developments in financial

markets and risk management are considered. Additional focus lies on

increased banking supervision and stronger market discipline.29

27 see Bank for International Settlements (2008). 28 see Deutsche Bundesbank (2001) pp.16,17. 29 see Deutsche Bundesbank (2007).


15

In 1999, the Committee revised the Basel I with the following objectives:

to bring capital requirements closer to the actual risk profile of banks

to cover banking risks with requirements which create incentives for

advanced implementation and

to allow banks to use in-house methods.30

Three consultative papers on Basel II were published from 1999 until 2003 in a

two-year rhythm. In 2004 Basel II was finally published and entered into force at

the end of 2006. Table 4 lists the chronology of the Basel Accords.

Month Year Item

July 1988 Publication of Basel Accord (Basel I)

End 1992 Entry into force of Basel I

January 1996 Basel market risk paper

June 1999 First consultative paper on revising the Capital Accord (Basel II)

January 2001 Second consultative paper on Basel II

May 2003 Third consultative paper on Basel II

June 2004 Publication of the Framework for the new Basel Capital Accord

(Basel II)

July 2005 Extension of the Framework by trading book aspects and the

treatment of double default effects for guarantees

End 2006 Entry into force of Basel II

Table 4: Chronology of Basel Accords31

30 see Oesterreichische Nationalbank (2008). 31 Deutsche Bundesbank (2007).


16

With Basel II, the Committee aimed at a more qualitative banking supervision

because risk-adequate capital cannot, despite its importance, sufficiently

guarantee solvency of banks and stability of the banking system. That is why

Basel II consists of three complementing pillars: the minimum capital

requirements, the supervisory review, and the market discipline (see

Figure 3).32

Figure 3: Architecture of Basel II – The Three-Pillar Model33

3.2.1 Pillar 1: Minimum capital requirements34

The minimum capital requirements include credit market, market risk and

operational risk. Three risk measurement methods can be applied for

calculating the capital ratio35: the basic, the standardised approaches as well as

more advanced and more risk-sensitive approaches that are based on internal

32 see Deutsche Bank (2001) p.17. 33 Oesterreichische Finanzmarktaufsicht (2008). 34 see Basel Committee on Banking Supervision (2004) pp.12-136. 35 also capital coefficient.


17

ratings. The capital ratio is supposed 8% at least and is calculated the following

way:

€

CapitalSum of all risk - weighted assets

≥ 8%

with

€

Sum of all risk - weighted assets = Sum of credit risk - weighted assets + + (capital charges for market risk + operational risk) x 12.5

Basel II offers two approaches for measuring credit risk: the Standardised

Approach, which is supported by external credit assessments, and the more

sophisticated and more risk sensitive Internal Ratings-Based approach (IRB),

which is subject to the explicit approval of the bank’s supervisor. The Standard

Approach, which is fairly similar to Basel I, considers SME loans the same way

as loans of retail customers.

Operational risk, as defined in Basel II, is “…the risk of loss resulting from

inadequate or failed internal processes, people and systems or from external

events”. It includes legal risk, but excludes strategic and reputational risk. Three

methods for calculating operational risk capital charges: (i) the Basic Indicator

Approach; (ii) the Standardised Approach; and (iii) Advanced Measurement

Approaches (AMA). Similar to credit risk measurements, the more advanced

methods are also more risk sensitive. Continuous evolution on risk

management methods are expected, especially related to AMA, which is

supposed to be applied in particular by international banks with high operational

risk. The simpler approaches on the other hand, i.e. the Basic Indicator

Approach and the Standardised Approach, are meant for banks with lower

operational risk.


18

3.2.2 Pillar 2: Supervisory review36

The aim of the Supervisory Review Process (SRP), which is a qualitative

approach, is to ensure that banks have adequate capital to support all the risks

in their business and encourage continuous development and use of risk

management techniques in monitoring and managing institute-specific risks.

The three main areas are described in Table 5.

Main areas of Pillar 2 Examples

Risks considered under Pillar 1 that are not fully

captured by the Pillar 1 process

Credit concentration risk

Factors not taken into account by the Pillar 1

process

Interest rate risk in the banking book,

business and strategic risk

Factors external to the bank Business cycle effects

Table 5: Main areas Pillar 2 of Basel II

In addition, Pillar 2 enables supervisors to assess compliance with the minimum

standards and disclosure requirements of the more advanced methods in

Pillar 1.

3.2.3 Pillar 3: Market discipline37

The area of discretion, which internal rating assessments provide, enhanced

disclosure requirements and transparency requirements are designed to

support the first two pillars. Pillar 3 requirements cover the application of the

capital rules, the amount and structure of capital, and quantitative and

qualitative capturing of risks. The adjustment of disclosure requirements with

36 see Basel Committee on Banking Supervision (2004) pp.158-174. 37 see Basel Committee on Banking Supervision (2004) pp.175-190.


19

national accounting rules is considered as highly important in order to avoid

conflicts.

3.3 Effects of Basel II on SMEs

Possible negative effects on SMEs caused serious concerns during the

development of Basel II. After all, SMEs are considered are enormously

important to economical growth, employment and investment. The main

concern, Basel II leads to an inappropriate increase of financing cost of SMEs,

would result in significantly rising capital requirements. Several exemptions

were introduced to counteract such negative effects, e.g. the effect of

diversification in loan portfolios.

Depending on the applied approach, the Standardised Approach or the IRB.

cost of unsecured loans without external rating do not increase. Small

enterprises may even benefit from the recognised effect of diversification of

loans. However, credit spreads may increase as a result of improved rating

systems. In general, credit ratings will get increasingly important.38

38 Taistra (2003) pp.16-21.

4 Financing alternatives

21


According to Merton and Miller, Nobel Prize winners, the development of

companies is absolutely independent from its capital structure. In reality, the two

extreme categories of financial instruments i.e. equity and debt differ

dramatically in terms of interests, incentives and rights of the respective investor

as well as the degree of information provided. Thus, financial instruments are

also used to balance interests and risks related to business financing. Table 25

on page 77 provides an overview of the main distinctive features of equity, debt

and hybrid capital.

Phase Comment

0. Seed Development of ideas, pre-production, preparation phase

1. Start-Up Foundation of enterprise

2. Early Stage

( Early Stage-financing)

Development of product prototype

3. Second Stage Achieving market leadership in relevant market segment

4. Third Stage Expansion, up-scaling

5. Fourth Stage or Bridge

( Bridge-financing)

Pre-IPO, preparation of going public

6. IPO Consolidation and saturation

7. Post-IPO-Phase Internationalisation and acquisitions

Table 6: Phases of growth financing39

Technology-based one-product-businesses, competing in a dynamic growth

market typically, run through the same phases, described in Table 6.40

39 Grabherr (2001) p.33.


22

Figure 4 provides an overview of SME development and suitable financial

instruments per stage.

Figure 4: SME development stages41

4.1 Equity

Equity owners are the ultimate owners of the company and participate in the

profits of the company via dividends. Equity capital can be created by issuing

new shares or by retaining profits.42

40 see Grabherr (2001) pp.31-36. 41 see European Commission (2009). 42 see Coyle (2002) p.3.


23

4.1.1 Private equity

The most important source of capital through equity financing is retained profits.

This financing method keeps the entrepreneur independent from other

investors. And, it prevents creditors getting confidential information on the

company’s financial situation via credit assessments. Another benefit of

retained profits is the opportunity of strengthening the equity ratio. 43

4.1.2 Venture capital

Venture capital has got more and more important during the last two decades.

Many well-known companies like Apple Computers, Intel, Lotus and Microsoft

grew with venture capital.44 Typically, the venture capital industry applies a

limited partnership as organisational form. In such a partnership, venture

capitalists manage the fund while investors are limited partners and cannot get

involved in the day-to-day business. Such a partnership is usually

predetermined to ten to thirteen years.45

In Europe, debt is still much more relevant than venture capital. One reason

may be that entrepreneurs are reluctant to admit investors having a say in

running the business.46

4.1.3 IPO

Traditionally, SMEs do not have direct access to organised capital markets.

This makes strengthening the equity ratio complicated. The only way is going

public, an Initial Public Offering (IPO), which requires, however, a change of the

legal form of the company.47

43 see Marx (1993) p.70. 44 see Gompers, Lerner (2006) p.1. 45 see Gompers, Lerner (2006) pp.10,14. 46 see Steiner, Starbatty (2003) p.33. 47 see Marx (1993) pp.71,72.


24

4.2 Debt

Debt capital is borrowed money. The borrowed capital has to be repaid, maybe

at a premium. In addition, interests on the capital have to be paid to the

lender.48 Debt instruments include loans, factoring, leasing, bonds and

commercial papers.

4.2.1 Bank loans

Due to their relatively small size, SMEs face constraints in borrowing. After all,

only certain forms of financing are available to SMEs. Therefore, the traditional

bank loan is of greater importance the smaller the enterprise. What is more, the

higher default risk compared to large companies results in higher charges.49

The credit crunch caused by the recent economic and financial crisis

increasingly hits SMEs.50 In addition, since Basel II, large banks even aim at

reducing lending to SMEs. That is why alternative forms of financing get more

and more important in order to reduce the dependence on the main bank.51

4.2.2 Factoring

Similar to Asset Backed Securities (ABS)52, Factoring is basically selling

receivables. Unlike ABS however, Factoring requires smaller volumes because

no cost of capital market transaction occur. That is why Factoring has been of

great importance to SMEs. Since single receivables are rated rather than the

seller, the credit rating of the eventual debtor is relevant for the result of the

rating. Factoring does not extend financial resources. It is only a short-term

financing alternative as merely outstanding receivables are made to cash at an

early stage.53 And, Factoring is not appropriate for all industries. The

48 see Coyle (2002) pp.2,3. 49 see Marx (1993) pp.74-76. 50 see European Commission (2008) pp.8,9. 51 see Steiner, Starbatty (2003) p.19. 52 see Part 5 of this paper. 53 see Steiner, Starbatty (2003) pp.30-32.


25

construction business, for instance, finances long-term projects, for which other

financing forms are more appropriate.54

4.2.3 Leasing

Leasing has become an important alternative to the traditional bank loan. It is a

bit comparable to renting. The main difference is that, depending on the agreed

contract conditions, the lessee becomes the owner of the leased item at the end

of the leasing period. One advantage of leasing is, besides its flexibility, the fact

that leased items are booked as liabilities. Debt financed purchases are booked

as assets. Hence, leasing has positive effects on the balance sheets compared

to loan-based investments.55 In addition, it does not tie up capital. However,

leasing is usually more expensive than loans.56

4.2.4 Bonds

The capital market as funding source is particularly relevant in Anglo-Saxon

countries. In other European countries, such as Germany and Austria, bank

loans are much more common due to the traditionally close entrepreneur-bank

relationship. Bonds and loans differ inter alia in the fact that the bank organises

and places the issue rather than being the contractual partner.

External ratings are enormously important to companies issuing on capital

markets. Failed issues would cause significant costs and would damage the

issuers’ reputation. Bonds are, due to high cost and large volumes required,

primarily suitable for large companies.57

54 see Gaubatz (2003) pp.301,302. 55 see Steiner, Starbatty (2003) pp.28-30. 56 see Marx (1993) p.78, European Commission (2003a) p.8. 57 see Steiner, Starbatty (2003) pp.22-24.


26

4.2.5 Commercial Paper programmes

Commercial Paper (CP) programmes are a series of corporate bonds, which

are issued little by little. Contract conditions are agreed on in a framework

contract and are adjusted to current market conditions. The total programme

runs usually two to seven years. SMEs rarely use CP programmes due to high

cost related and large volumes required.58

4.3 Hybrid financing

Hybrid financial instruments combine features of both, equity and debt. Hybrid

securities enable companies to raise capital at reasonable cost and provide at

the same time investors with a supplement to debt and equity to their

investment portfolios.59

4.3.1 Participation certificates

Participation certificates are basically non-voting shares and represent a

proportional ownership of participating capital. This type of investment

guarantees a share in the issuer’s profit, but no voting rights. In addition,

holders participate in any liquidation of the company and have the right to

subscribe for new shares. Participation certificates allow the issuer access to

non-voting, low-par-value equity capital, which is publicly tradable after the

initial offering.60

4.3.2 Silent partnerships

Silent partnerships are very typical for the German market. It is a debt-like

financing instrument that “…can be explained by return requirements and the

anticipated proportion of buy-backs, underlining the role of public-private

58 see Steiner, Starbatty (2003) pp.24-26. 59 see Coyle (2002) pp.2,4. 60 see Swiss Exchange (2009), Deutsche Börse (2009).


27

partnership agencies in Germany”.61 So-called typical silent partners participate

in the company’s profits, but have limited control rights. Typical silent

partnerships are considered as liability position. On the other hand, atypical

partners also participate in the company growth and the company liquidation.

That is why it represents an equity position.62

4.3.3 Convertible bonds

Convertible bonds are unsecured fixed-interest bonds. Holders of convertible

bonds have the option to exchange their bonds for common stock of the same

corporation at a preordained price. The ratio of exchange, i.e. stocks for bonds,

is called conversion ratio. While issuers benefit from lower interest rates,

investors appreciate the combination of bond-like attributes and growing

potential of stocks.63

61 see Bascha, Walz (2001) pp.5,13. 62 see Müller (2008) p.154 footnote 613. 63 See Haugen (2001) p.11, Coyle (2002) p.8, Kimes (2009).

5 Structured finance

29


5.1 Development of asset securitisation

5.1.1 Definition of securitisation

With securitisation, one party can transfer risk, e.g. credit risk, to another party,

the investor. In most cases so-called Asset Backed Securities (ABS) are used

for this transaction. Its cash flows and credit rating depend entirely on its

securitised assets.64

Securitisation can be simply defined as packaging individual debt instruments

and converting the package into tradable securities.65 Asset securitisation or

“Asset Based Finance” respectively, is basically selling bundled debt on the

capital markets rather than holding them until the due date. The resulting cash

flow is used for refinancing the own business.66

Focusing on the substance rather than on the process, securitisation “consists

of the use of superior knowledge about the expected financial behaviour of

particular assets, as opposed to knowledge about the expected financial

behaviour of the originator of the chosen assets, with the help of a structure to

finance the assets more efficiently”.67

In many countries, the term “Structured Finance” is a synonym for asset

securitisation, as well as for rating agencies. However, swaps, futures and any

kind of ‘Taylor Made’ finance can be called structured finance.68

64 see GBRW (2004) p1. 65 see Kendall (1996) pp.1f. 66 see Bertl (2004) p.1. 67 see Kravitt (1996) p.1. 68 see Bär (1997) p.37 footnote 45.


30

Today, many different variations of ABS exist. The following three steps

however, are common to all:

• Transfer of assets from the original owner to a Special Purpose Vehicle

(SPV).

• Emission of securities by this SPV.

• (Almost) exclusive dependency of servicing the securities from an

economical perspective through the transferred assets.69

Basically, all kind of assets may be used for securitisation. Depending on the

underlying asset, three main types of ABS exist, as described in Table 7:

Mortgage Backed Securities (MBS), Collateralised Debt Obligations (CDO), and

ABS in a narrower sense.

MBS CDO ABS (narrower sense)

RMBS (Residential Mortgage

Backed Securities):

residential mortgages

CMBS (Commercial Mortgage

Backed Securities):

commercial mortgages

CLO (Collateralised Loan

Obligations): loans

CBO (Collateralised Bond

Obligation): tradable loans

Credit card receivables

Leasing receivables

Trade receivables

Consumer receivables

Table 7: Types of ABS and used assets70

Mortgage Backed Securities (MBS) are debt obligations representing pools of

mortgage loans, usually on residential property.71 There are two broad types of

real estate property used: residential and nonresidential properties. Residential

property includes houses accommodation up to four families. Nonresidential

properties include commercial properties such as office buildings.72

69 see Bertl (2004) pp.5,6. 70 see Thonabauer, Noesslinger (2004) p.13. 71 see U.S. Securities and Exchange Commission. 72 see Fabozzi (2001) p.3.


31

Collateralised Debt Obligations (CDO) issue debt and equity. Like a company,

CDO invests the raised money in financial assets like corporate loans and

MBS.73 However, CDO tend to invest in several assets making categorising

difficult. That leads to various definitions. Collateralised Loan Obligations (CLO)

and Collateralised Bond Obligations (CBO) are very similar. Both issue debt

and equity backed by loans exclusively in the case of CLO and high-yield

assets such as high-yield corporate bonds, emerging markets bonds in the case

of CBO, and bank loans.74

5.1.2 Origins and development

Emerging in the financial markets since the 1930s, securitisation has been

significantly influencing the way of meeting borrowing needs of both, consumers

and businesses.75 The New Deal, a framework for financial expansion, was a

response to growing concerns regarding the expansion of speculative and

consumptive credit over the course of the 1920s. It introduced a barrier between

financial markets and deposits through a separation of commercial and

investment banking. Moreover, caps on interest payments were introduced, and

a federal system of securities markets regulation and the thrift industry were

created. The New Deal period also laid the foundations for the rise of

institutional investors like insurance companies and pension funds.76 During the

pre-deregulation, the cartel era of 1933 until 1980 in America was characterised

by very costly and highly structured ways of doing business. At that time

securitisation was rather seen as “…the substitution of more efficient public

capital markets for less efficient, higher cost, financial intermediaries in the

funding of debt instruments”77.

Deregulation and a severe shortage of funds in the late 1970s and 1980s, and

the increasing use of pension fund and other managed accounts nourished a

73 see Lucas, Goodman, Fabozzi (2006) pp.3,4. 74 see Dunlevy, Devito (1998) p.241, Thompson (1998) p.237,Tavakoli pp.27,28. 75 see Kendall (1996) p.1. 76 see Konings (2009) pp.82-84. 77 John Reed, former Chairman and CEO of Citicorp, Citibank, and post-merger, Citigroup,

and former Chairman of the New York Stock Exchange (NYSE).


32

wide range of new financial products.78 The neoliberal and monetarist

transformation of American finance during the late 1970s and early 1980s was

characterised by a deregulation process nourishing new financial innovations.79

In the 80’s, tradable securities such as syndicated credits replaced more and

more the traditional credit business. The term ‘Securitisation’ refers to this trend.

However, in the meantime, it refers in a narrower definition to an innovative

financing form, the ‘Asset Securitisation’. Today, the main instruments are ABS

and MBS.80

Several forces, listed in Table 8, gave impetus to securitisation getting global,

starting with the United Kingdom at first, following continental Europe and other

international markets.

Issuer demand

• Basel Accords (capital adequacy ratios)

• Balance sheet/Liquidity management

• Efficient funding mechanism

Investor demand

• High-quality assets with attractive returns

Profit opportunity for Wall Street firms

Table 8: Global securitisation impetus81

The international banking community established the Basel Accords, which

went into force in 1992 (see The Basel Capital Accord). At that time capital was

in short supply. Securitisation offered an opportunity to regulated financial

institutions to manage their balance sheets and liquidity to the new standards,

serving as an efficient way of funding. At the same time, ABS offered attractive

78 see Kendall (1996) pp.1-16. 79 see Konings (2009) pp.90,91. 80 see Bär (1997) pp.21-27. 81 Myerberg (1996) p.140.


33

returns to investors seeking high-quality assets. Finally, securitisation was a

profit opportunity to Wall Street firms.82

In most countries, the securitisation market developed through MBS. In the

meantime, the types of assets that are securitized are broadened.83 Following

the success of MBS, several other ABS market segments evolved (see

Table 9), based on assets such as leasing contracts, automobile credits and

credit cards.84

Aircraft Leases

Auto Loans (Prime and Sub-prime)

Auto Leases

Boat Loans

Credit Card Receivables

Equipment Leases

Home Equity Loans

Manufactured Housing Contracts

Marine Shipping Containers and Chassis Leases

Mortgages (Residential and Commercial)

Railcar Leases

Real Estate

Recreational Vehicle Loans

Royalty Streams

Stranded Utility Costs

Trade Receivables

Train Wagon Leases

Truck Loans

Table 9: Examples of securitised assets85

Although first American securitisations took place already in the 1970s, started

to evolve only in the early 1990s.86 The evolvement of the securitisation market

in Europe and the USA is different from a regulations perspective. Only the

United Kingdom is to some extend similar to the United States, which can be

explained by the tradition of common law. Securitisation may evolve freely as

long as law does not prohibit any new developments. In Continental Europe,

civil law traditions require passing new laws to allow the securitisation market to

develop. Therefore, the market catches up constantly depending on the

82 see Myerbeg (1996) pp.139-151. 83 see PricewaterhouseCoopers (2007) p.4. 84 see Bertl (2004) pp.51-58 85 PricewaterhouseCoopers (2004) p.4. 86 see GBRW (2004) p.1.


34

regulators. Conversely, the market flourishes and regulators have to catch up.87 88

5.1.3 Market situation

5.1.3.1 Market volumes and shares

Until the subprime crisis, securitisation had been the largest growing

contribution to global capital markets. The European market, for instance, grew

by 40% in 2006 and reached a new high of nearly € 460 billion. This trend was

supported by economic recovery, lower levels of credit defaults and

consequently higher investor confidence in the market. The main growth drivers

were RMBS, CDO and CMBS.89

Figure 5: ABS outstanding90

87 see Kravitt (1996) pp.3-7. 88 Baums and Wymeersch (1996) provide on overview of the legal and accounting conditions

for Austria, Belgium, Denmark, Finland, France, Germany, Great Britain, Greece, Italy, The Netherlands, Norway, Spain, Sweden, and Switzerland.

89 see PricewaterhouseCoopers (2004) p.4; PricewaterhouseCoopers (2007) p.5. 90 Sources: Thomson Financial, Bloomberg, SIFMA.

0

500

1,000

1,500

2,000

2,500

3,000

$ bi

llion

s

Other

Student Loans

Manufacturing Housing

Home Equity Loans

Equipment Leases

Credit Card Receivables

Automobile Loans


35

Figure 5 describes the evolution of world wide outstanding ABS during the last

ten years, breaking down the key market sectors.

Due to the requirement of a certain level of expertise, there is a concentration in

investment and insurance companies, as shown in Table 10.91

Investment Companies 43%

Insurance Companies 22%

Asset Management 16%

Federal/State/Local Government 5%

Corporations 4%

Mutual Funds 3%

Pension Funds 2%

Other 5%

Table 10: European securitisation market

5.1.3.2 Subprime crisis

The American residential mortgage market flourished in the late 1970s due to

the strong desire for home ownership and escalating house prices. Freddie Mac

and Fannie Mae, so-called government sponsored entities (GSE), set and

monitored underwriting standards and offered quasi-government guaranties on

high yield products.92

The immense growth in subprime lending was nourished by expectations of

rapidly rising house prices and strong investor appetite for higher-yielding

securities.93 At the same time, securitisation gave originators, mainly banks,

more balance-sheet flexibility and investors better access to all sorts of credit

91 see PricewaterhouseCoopers (2004) p.5. 92 see Kendall (1996) p.6. 93 see Kiff, Mills (2007) p.7.


36

risk. By 2006 the volume of outstanding securitised loans had reached $28

trillion (see Figure 6). 2005, three-fifths of America's mortgages and one-quarter

of consumer debt were bundled up and sold on.

Figure 6: Volume of outstanding securitised loans, $trn94

ABS structures, which were commonly used by banks but whose popularity

heavily suffered during the subprime crisis, are briefly explained in Table 11.95

Apart from CDO and CLO, CDO squared, also called multisector CDO or CDO2

emerged in 1999 to satisfy the investors’ need to securitise their own structured

products portfolios. The collateral of CDO squared may vary, being backed by

differently rated tranches of CDO. Structured Investment Vehicles (SIV)

emerged in the 1980s and are offshore SPE. Many are incorporated in the

Cayman Islands. SIV invest in assets and issue notes at very low funding cost.

This way a kind of arbitrage can be achieved. SIV may be set up for various

purposes, including for creative accounting.96

94 The Economist (2008a). 95 see The Economist (2008a). 96 see Tavakoli (2003) pp.301-303.


37

Collateralised Debt Obligations (CDO) repackage ABS

CDO squareds resliced and repackaged CDOs

Collateralised Loan Obligations (CLO) repackage corporate loans

Structured Investment Vehicles (SIV) and

Conduits

used by banks to keep some of their exposure

off their balance sheets

Table 11: ABS structures commonly used before the subprime crisis

In January and February 2007, one started to realise that many 2006 borrowers

would default on their loans that year. A few months later, the losses of two

Bear Stearns hedge funds were revealed and investors realised the potential

threat of these defaults to the structured-credit market. The full impact of the

credit crunch seemed to hit in summer 2007. Figure 7 shows the fall of value of

ABS, as measured by the ABX index97, in 2007.

Figure 7: Housing subsidence, ABX.HE 7.2 AA index, % of face value98

97 The ABX, launched in January 2007, serves as a benchmark of the market for securities

backed by home loans issued to borrowers with weak credit. (Wong, 2009)) 98 The Economist (2007).


38

Prices of securities rated AA, except a brief point in September 2007, when the

worst seemed to be over, crashed down to just over 45. This level finally

distressed debt trades. Even prices of AAA notes, went down to between 80-

82.5 cents, a level much too low for their rating. Table 26 on page 79 explains

Standard & Poor’s ratings definition.

The reason for this downfall was the underlying loans. Those who took out

mortgages in 2006, tended to borrow more than they could hope to repay. They

were either hoping to make quick profit by selling the property soon again or to

refinance within a couple of years. But when house prices started to fall, the first

option did not work anymore. As soon as low interest rates expired, borrowers

were unable either to refinance or to afford the higher monthly payments.99

As a result, banks claimed back the property used as collateral, but nothing

more. When housing prices dropped below the size of the mortgage, banks had

to sell the properties at a loss.

Figure 8: Relation of US house prices and US foreclosures100

99 see The Economist (2007). 100 The Economist (2008b).


39

The vicious circle started because the housing slump fed on itself. Only as little

as half the value of the mortgage from a foreclosure may be recovered after

legal and other costs. Furthermore, foreclosures nourished house-price falls by

adding to the stock of unsold houses (see Figure 8).101

5.2 Concept of asset securitisation

According to Kendall102, seven basic requirements, listed in Table 12, are

substantial for successful securitisation programs. Furthermore, three elements

are key for the success of the securitisation system:

• Attraction of private capital.

• Competitive forces providing lower cost credit and greater choice.

• Stability by managing risks inherent in lending and investing.

Standardised contracts Standardisation of servicer quality

Grading of risk via underwriting Reliable supply of quality credit enhancers

Database of historic statistics Computers to handle complexity of analysis

Standardisation of applicable laws

Table 12: Basic requirements for securitisation103

Standardised contracts strengthen the securitisation participants’ confidence

that the respective collateral allows meeting the contractual obligations.

Professional underwriters evaluate the nature and grade of risk associated with

the collateral. A database of historic statistics allows stress test in order to

examine the performance under different conditions. Recognised standards in

the application of law create confidence critical to liquidity and efficient pricing

and trading. Similarly critical is the standardisation of the quality of servicers.

101 see The Economist (2008b). 102 see Kendall (1996) pp.6-8. 103 Kendall (1996) p.5.


40

The credit enhancer is frequently the weakest link in the transaction, putting

pressure on the entire security’s rating. There, each credit enhancer is rated

individually. If its rating changes, the rating of the issue it guarantees, changes

too. Finally, computers enable modelling securitised structures with high

volumes, tracking cash flows, and overseeing all relevant information on a daily

basis. 104

5.2.1 Securitisation players

ABS can have many different structures, depending on the transaction.105

Figure 9 provides a basic overview of a securitisation transaction and the

involved participants.

The originator, who normally initiates the securitisation originally owned the pool

of assets, assigns assets or risks in a securitisation transaction. Possible

incentives may be cheap funding or management of the balance sheet and risk

(see 5.3 Effects of securitisation).106

The SPV, also called Special Purpose Entity (SPE), separates legally the pool

of assets transferred from the originator. Its activities are limited as the only

purpose of the SPV is to hold the assets and to contact investors on its own

behalf. An SPV may be a corporation, trust or other entity.107

104 see Brendsel (1996) pp.22-25. 105 see Riegler (2004) p.158. 106 see Bertl (2004) p.7. 107 see Basel Committee on Banking Supervision (2004) §552.; Bertl (2004) pp.7,8.


41

Figure 9: Securitisation players108

The investor buys the securities and overtakes the risks. In addition to the

directly involved players, there is also the group of service providers. The

servicer does administrative work and collects principal and interest payments.

The servicer is commonly the originator but especially in non-performing loans

transactions, roles are separated from each other. The back-up servicer

replaces the servicer in case of its default. The trustee takes legal responsibility

for the activities of the securitisation vehicle and for the coupon payments. The

investment bank is responsible for structuring, underwriting and marketing the

transaction. Tax and accounting advisers are in charge of accounting and tax

implications. The rating agency sets the credit enhancement level of the asset

portfolio. This includes an evaluation of servicing capabilities and monitoring

performance of the transaction. The payment agent makes principal and

interest payments to security holders. Legal advisers develop the sale and

108 PricewaterhouseCoopers (2007) p.10.

Benefits for borrowers

Better credit terms: borrowers benefit from the increasing availability of credit terms, which lenders may not have provided if they had kept the loans on their balance sheets. For example, lenders can extend fixed rate debt, which many consumers prefer over variable rate debt, without overexposing themselves to interest rate risk because of the existence of a market for Mortgage-Backed Securities. Credit card lenders can originate very large loan pools for a diverse customer base at lower rates. Nationwide competition among credit originators, coupled with a strong investor appetite for securities, has significantly expanded both the availability of credit, and the pool of cardholders over the past decade.

1.6 Securitisation players

This section describes the players involved in a securitisation transaction. In addition to directly involved parties, there are a number of other parties, generally defined as service providers, which are also involved in the securitisation process. Below you find an overview of the most relevant parties:

Originator The securitisationvehicle Investors

Assets

Cash

Securities

Cash

The securitisation service providers

Servicer Trustee Investment banks

Paying agent Rating agencies

Tax and accounting advisors Auditors Legal advisors

Credit enhancement providers Calculation and reporting agents

Back-up servicer Asset managers Liquidity providers

Obligors

Payment over Time

Goods or services

Obligors/Borrowers

Obligors owe the originator a payment on the underlying loans/assets and are, therefore, ultimately responsible for the performance of the issued note. As obligors often are not informed about the sale of their loans, the originator, in many cases, maintains the customer relationship. From a credit risk perspective, securitisation groups obligors by letter or popular categories.

•

Securitisation in Luxembourg10 PricewaterhouseCoopers

Originator

The entity that assigns assets or risks in a securitisation transaction. Usually it is the party (lender) who originally underwrote and securitised the claims (loans). The obligations arising with respect to such loans are, therefore, originally owed to this entity before the transfer to the SPV takes place. Occasionally, the originator may be a third party who buys the pool with the intention to securitise it thereafter; in that case, the originator is also named as “sponsor”. Originators include captive financial companies of the major car manufacturers, other financial companies, commercial banks, building societies, computer companies, manufacturers, insurance companies and securities firms.

Investors

Investors buy the notes that are issued by the SPV and are, therefore, entitled to receive the repayments and interests which are due to the underlying assets. Collaterals are the pecuniary claims from these assets and, therefore, just the cash flow. Investors do not participate directly in the cash flow generated by the assets. The largest purchasers of securitised assets are typically pension funds, insurance companies, fund managers and, to a lesser degree, commercial banks. The most compelling reason for investing in Asset-Backed Securities is their higher rate of return relative to other assets of comparable credit risk.

Servicer

The entity that collects principal and interest payments from obligors and administers the portfolio after transaction closing. It is very common in securitisation transactions that the originators act as servicers though this is not always the case. For example, in most Non-Performing Loans (NPL) transactions, specialised servicers tend to carry out this role. Servicing includes customer service and payment processing for the obligators in the securitised pool and collection actions in accordance with the pooling and servicing agreement. Servicing can also include default management, collateral liquidation and the preparation of monthly reports. The servicer is typically compensated with a fixed servicing fee.

Back-up servicer

In case the original servicer defaults, the back-up servicer replaces them. They take over all the responsibilities which where allocated to the servicer.


42

purchase agreement, and provide its legal opinion on the “true sale” of the

portfolio. The credit enhancement provider guarantees the principal and the

interest payments to the security holders. The calculation and reporting agent

calculates the waterfall principal and interest payments to the note holders.

Liquidity providers provide the SPV with cash, in the form of some kind of bridge

loan, in order to avoid any unsteadiness of cash flows to investors. Liquidity

providers are usually banks. The asset manager selects the underlying assets

and monitors the portfolio. 109

5.2.2 Types of transactions

There are two forms of transactions, natural securitisation and synthetic

securitisation, depending on the transfer of rights of assets.

5.2.2.1 “True sale”

Natural securities are based on the direct payment of interest and principal.110

In its Third Consultative Paper on The New Basel Capital Accord (Basel II), the

Basel Committee on Banking Supervision of the Bank for International

Settlements (BIS) defined a traditional securitisation as “…a structure where the

cash flow from an underlying pool of exposures is used to service at least two

different stratified risk positions or tranches reflecting different degrees of credit

risk. Payments to the investors depend upon the performance of the specified

underlying exposures…”.111 In a traditional “true sale” transaction, the originator

sells a pool of assets to a SPV. The vehicle is funded through the issue of

tranches of securities. The securities are rated by an agency. Therefore, the

SPV is isolated from the originator’s credit risk.112 In a “true sale” transaction,

the loan originators get credits off their balance sheet, thus achieve a reduction

109 see PricewaterhouseCoopers (2007) pp.10-12. 110 see Kendall (1996) p.8. 111 Basel Committee on Banking Supervision (2004) §539. 112 see PricewaterhouseCoopers (2007) p.8.


43

of their economic and regulatory capital charge. At the same time, generated

funds may be used to refinance future lending activities.113

5.2.2.2 Synthetic

Synthetic securities involve the recycling of cash flows or credit risk from natural

securities revise the bundles of rights and characteristics.114 In a synthetic

securitisation, the originator does not sell any assets but buys protection

through a series of credit derivatives. These transactions transfer risk and

reduce regulatory capital requirements, instead of providing the originator with

funding. Figure 10 shows such a typical synthetic securitisation structure.

Figure 10: Synthetic securitisation structure115

113 see Jobst (2006) pp.4,5. 114 see Kendall (1996) pp.8-11. 115 PricewaterhouseCoopers (2007) p.8.

ABS represents the residual part of the securitisation market, which is characterised by the heterogeneity of the underlying assets. The underlyings of ABS-transactions may vary from consumer loans, secured credit card receivables, trade receivables, student loans to the securitisation of life insurance policies.

True sale vs. synthetic transactions

With regards to the transfer of rights of an asset, there are two forms of securitisation transactions:

True sale transactions

In a traditional true sale structure, the originator sells a pool of assets to a Special Purpose Vehicle by removing these from its balance sheet. The vehicle funds the purchase by issuing notes, which are rated by an agency. The rating of the notes reflects the fact that the SPV is isolated from any credit risk of the originator and the credit enhancement of the pool. Thus, the originator transfers both the legal and beneficial interest in the assets to the SPV. As a result, the investor of the SPV receives a legal and beneficial right to the underlying assets.

Synthetic transactions

In a synthetic securitisation, the originator buys protection through a series of credit derivatives instead of selling the asset pool to the SPV. Such transactions do not provide the originator with funding. They are typically undertaken to transfer credit risk and reduce regulatory capital requirements.

As a general rule, the owner of the assets (which we can refer to as the “Protection Buyer”) transfers the credit risk of a portfolio of assets (a “Reference Portfolio”) to another entity (the “Protection Seller”) or directly to the capital markets. Although the credit risk of the Reference Portfolio is transferred, actual ownership of the Reference Portfolio remains with the Protection Buyer.

The transfer of credit risk may be accomplished in a number of ways:

The Protection Buyer might issue credit-linked notes to the Protection Seller or directly to investors. The terms of the notes would provide for a reduction of the Protection Buyer’s repayment obligation on the notes upon defaults or other credit events arising with respect to the Reference Portfolio;

•

Securitisation in Luxembourg8 PricewaterhouseCoopers

Alternatively, the Protection Buyer can enter into a credit default swap, total return swap or other credit derivative transaction with the Protection Seller. The Protection Seller agrees, in return for certain payments, that upon default or another credit event in respect of a Reference Portfolio, to pay an amount to the Protection Buyer. This is calculated by reference to the amount of payment defaults or on the diminution of market value of the defaulted Reference Portfolio.

The figure below shows a typical synthetic securitisation structure:

Originator

Portfolio

SPV

First Loss

SuperSenior

AAA

BBB

A

Investors

Collateral

CDS

CDS

CLN

CDS

The credit risk is structured and transferred by credit derivatives. CDS are negotiated with the counterparties of the Super Senior Tranche and the First Loss Pieces. Credit Linked Notes (CLN) are more often used for tranches which are publically issued for a wide range of investors.

1.5 Benefits of securitisation

Below is a listing of the common benefits of securitisation, which may offer one or more of the benefits described below. However, securitisations are complex structured financings and it is critical that potential issuers understand the range of options and related implications to make informed decisions. While these benefits have varying degrees of importance for different originators, the common hallmark of securitisations is the desire for lower capital cost.

•


44

In general, the owner of the assets transfers the credit risk of the assets of his

portfolio to the SPV. At the same time, he remains the owner of his assets. The

structured credit risk is then transferred through credit derivatives. Credit

Default Swaps (CDS) are used for the Super Senior Tranche and the First Loss

Pieces, while Credit Linked Notes (CLN) are more common for publicly issues

tranches.116 CLN are generic debt securities created out derivative structured

claims on securitised assets.117

Basel II defines a synthetic securitisation as “…a structure with at least two

different stratified risk positions or tranches that reflect different degrees of

credit risk where credit risk of an underlying pool of exposures is transferred, …,

through the use of … credit derivatives or guarantees…. Accordingly, the

investors’ potential risk is dependent upon the performance of the underlying

pool”.118

5.2.3 Credit enhancement

Credit enhancement providers guarantee principal and interest payments to the

security holders. Commonly, either a third party insurer or a parent company of

the originator provides the credit enhancement. Credit enhancement protects

investors. Without credit enhancement, the investors would bear all the credit

risk in the pool of assets. Credit enhancement can be external or internal. 119

5.2.3.1 External credit enhancement

In the case of a third party guarantee, losses up to a certain amount are

reimbursed. Rated insurance companies or parent companies of the seller

usually provide these reimbursements. Such a guarantee may be based on

various means of credit enhancement.

116 see PricewaterhouseCoopers (2007) p.8. 117 see Jobst (2006) p.5. 118 Basel Committee on Banking Supervision (2004) §540. 119 see PricewaterhouseCoopers (2004) pp.6,7.


45

Financial Guarantee Insurance (FGI) guarantees the timely interest and

principal payment to investors. Therefore, it normally produces the highest

possible rating, which is secured through strict regulations and continuous

controls. Prior, the originator has to ensure an investment grade rating through

additional credit enhancements in order to achieve a Financial Guarantee.120

A Pool-based Insurance, compared to a Financial Guarantee, guarantees the

value of the pooled assets only under concretely defined conditions.

Furthermore, such insurance normally covers only a certain loss limit rather

than 100% of the pool or tranche. While Financial Guarantees are usually only

provided on investment grade securities in combination with other credit

enhancement forms, Pool-based Insurance covers higher risks, too.

Letters of Credit (LOC, L/C)121 provide the guarantee that financial institutions

cover the possible losses, may it be interest or principal. The financial

institutions are required to have cash readily available. This guarantee,

however, is not in all cases irrevocable.122

5.2.3.2 Internal credit enhancement

There are two main groups of internal credit enhancement, Overcollateralisation

and Subordination123. Either the originator covers part of the risk or priorities of

payments from the asset pool are to be adjusted.

Overcollateralisation is when the value of the underlying pool assets exceeds

the amount of securities. This way, more assets are available to cover possible

losses.

Subordination is to prioritise cash flows to protect senior tranches by

subordinate tranches in case of losses (Table 13 explains common tranches).

Instead of emitting only one single tranche, the asset pool is divided in several

120 Financial Guarantees are also called Surety Bonds. 121 Two types of Letters of Credit may be differentiated, i.e. Standby Letters of Credit and

Commercial Letters of Credit. 122 see Bertl (2004) pp.179-202. 123 Subordination is also called Senior/Junior Structure or Cash Flow Bifurcation.


46

tranches, which may differ in several aspects such as risk, duration, and interest

and principal payment modalities.124

Description Common term Alternative term

Unrated tranches ranking in

payment priority ahead of

rated AAA tranches

Super-senior tranches

ABS rated in the A to AAA

range

Senior tranches Junior tranches

ABS rated in the B to BBB

range

Mezzanine tranches

ABS rated below B or unrated

junior ranking instruments

Junior tranches

The most junior position in a

securitisation

Equity tranche First Loss Piece

Table 13: Examples of interchangeable expressions used in securitisation125

5.2.4 Payment methods

5.2.4.1 Pass Trough

A Pass Through is a passive structure without cash flow management, which

was mainly used, in the early times of securitisation. Payments made by the

SPV to the investors take place in the same period as the receivables. Cash

flows are simply passed through. Consequently, investors bear the risk of

fluctuations and early repayments.126

124 see Bertl (2004) pp.206, 217, 222-223; PricewaterhouseCoopers (2004) p.7. 125 GBRW (2004) p.12. 126 see Bertl (2004) p.236, 217, 222-223; PricewaterhouseCoopers (2004) p.21.


47

5.2.4.2 Pay Through

Unlike the Pass Through, Pay Through is a payment method, where cash flows

to investors are prefixed in terms of pattern and maturity.127 Hence, cash flows

from the SPV to the investors are managed and not directly dependent on the

payments of the receivables.

Tranches, which are fragments or slices of a securitisation deal, are commonly

used to create ABS with differing payment structures. An Interest Only (IO)

Tranche, also called IO-Bond, is an extreme example where the investor has

only the right to interest payments, but not to principle payments. A Principle

Only (PO) Trance, on the other hand, entitles the investor only to one single

payment similar to a Zero-bond. Combined, both tranches represent a tranche

with coupons.

Further methods of cash flow management are Zero-bonds, also called Accrual

Bonds where interest and principal payments are hold for certain periods but

are paid at the end together with the final principal payment.128

5.2.5 Securitisation process

The typical securitisation process can be outlined as shown in Figure 11. During

the feasibility study phase, corporate finance analysts review the asset

origination, servicing, reporting processes, and performances of previous

securitisations. Table 14 provides an overview of the analysis performed during

the Feasibility Study phase.129

127 see PricewaterhouseCoopers (2004) p.21. 128 see Bertl (2004) pp.237-242. 129 see PricewaterhouseCoopers (2004) p.8.


48

Figure 11: Phases of a securitisation130

The Operations/Infrastructure Review phase is a self-assessment before the

undertaking the transaction and is part of the evaluation and planning process.

Analysis on the asset origination and servicing and reporting is imperative to

outsiders. Concerning the asset origination, items such as the credit review

process, documentation, and any possible legal issues are reviewed. The

servicing and reporting system is reviewed regarding its robustness, flexibility,

and readiness. Furthermore, the system needs to generate appropriate

operating and management reports.

During the Collateral Analysis phase, the evaluation of the collateral portfolio

includes the assessment of the portfolio’s credit quality, which is typically based

on historical financials, and sufficiency of asset files. Portfolio data analysis

includes reviewing historical asset performance. In addition, the completeness

of physical asset files and the saleability of assets in terms of data

inconsistencies and deficiencies are reviewed.

130 PricewaterhouseCoopers (2004) p.8.

Structuring Securitisation Transactions in Luxembourg8

1.9 Phases of the securitisation process

The different aspects of a securitisation transaction are outlinedbelow. Though not exhaustive, the list should give a good idea ofthe processes involved in a typical transaction.

1.9.1 Feasibility study phase

A company considering a securitisation issue or program must beable to delineate its objectives and the constraints under whichit operates. To ensure that the transaction gets off of the ground,corporate finance analysts must review the asset origination,servicing, and reporting processes as well as information aboutpast performance of the assets to be securitised. For many newissuers, this phase is the most critical because it brings relevantfactors and options to light that may significantly influencethe direction taken. As a result, the company’s objectives are morecompletely realised. Typical areas to review include among others:

• Operations overview: systems, policies, responsibilitiesof each party.

• Portfolio performance: compare to standard securitisationindustry practices.

• Financial overview: funding alternatives, profitabilitymeasurement, current funding sources.

• Legal overview: asset segregation, existing covenants andagreements.

• Tax implications: impact on tax liability, tax advantagedstructures.

• Credit overview: rating of individual obligors and portfoliooverall, level of concentration, risk disclosure and riskmanagement policies, and originator and servicer credit quality.

• Regulatory overview: National, EU or US requirements andimpact of securitisation.

• Strategic: What business model achieves the highest overallprofitability? What are the risk-reward trade-offs? What isthe best way to raise capital in this business model?

• Identification and evaluation of alternatives to achieveobjectives and to mitigate weaknesses for key areas suchas: operations, systems, cash flow, financial reporting, legal,tax, regulatory, and credit.

If a structured financing is to be executed, it is in the issuer’sinterest to complete a self-assessment before presentinginformation to outside parties. The next two sections discussoperations and financial review; these phases are completedas part of the evaluation and planning processes beforeundertaking a transaction.

1.9.2 Operations/infrastructure review phase

Invariably, practical problems arise in a company’s ability toprovide historical data and information concerning the asset poolor with their ongoing ability to meet servicing and reportingrequirements. It is imperative for outside parties to evaluatereceivables and servicing systems as well as assess underwritingstandards and collection policies. Items to consider include:

Asset origination• What is the credit review process? Do policies exist and are

they consistently applied? Can credit review be made moreefficient through system improvements, staffing enhancements,credit scoring, etc.?

• Is application processing timely and efficient from originatorand obligor perspectives? Can it be streamlined or expedited?

• Is documentation standardised (to the extent possible)?• Are there any legal issues, such as enforceability?

Servicing and reporting• Is the system sufficiently robust and does it have the flexibility

to address servicing and reporting requirements ofa securitisation?

• Can necessary data be made available in a timely manner?• Are appropriate operating and management reports generated

to make decisions regarding allocation of servicing resources,front-end pricing, performance triggers and trends, etc.

1.9.3 Collateral analysis phase

In conjunction with the aforementioned review of reporting systemsand servicer collection policies and procedures, an evaluation ofthe collateral portfolio must be undertaken. In order to effectivelyassess the credit quality of a given portfolio, the major ratingagencies typically review historical financials and sufficiency ofasset files. This will include:

Portfolio data analysis• Review of 10 years historical asset performance information;• Analyse a static pool of assets which are isolated over

a static three or five year period. Principal/interest, prepayment,and delinquency/default performance characteristics evaluatedper origination time period.

Asset file review• Review completeness of physical asset files;• Identify all possible source documents and reports.

Ensure saleability of assets• Identify data inconsistencies and deficiencies;• Analyse the company’s charge-off policy.

End-to-End Securitisation Transaction Management

Definition ofobjectives

andconstraints

for theoperation

Review ofasset

originationprocess

Analysis ofhistoricalfinancials

andasset files

Ensurebest

presentationto therating

agency

Financialoptimisation

ofsecuriti-sation

transaction

Financingteam

definitionin charge

of theoperations

On-goingprocedures

definition

Phases of a securitisation

Feas

ibili

tySt

udy

Oper

atio

ns/

Infra

stru

ctur

eRe

view

Colla

tera

lAn

alys

is

Prep

arat

ion

for

Ratin

gAg

enci

es

Stru

ctur

ing

Pre-

clos

ing

Post

-clo

sing


49

Operations overview systems, policies, responsibilities of each party

Portfolio performance compare to standard securitisation industry practices

Financial overview funding alternatives, profitability measurement, current funding

sources

Legal overview asset segregation, existing covenants and agreements

Tax implications impact on tax liability, tax advantaged structures

Credit overview rating of individual obligors and portfolio overall, level of

concentration, risk disclosure and risk management policies, and

originator and servicer credit quality

Regulatory overview national, EU or US requirements and impact of securitisation

Strategic business models, risk-reward trade-offs, ways to raise capital

Evaluation Identification and evaluation of alternatives to achieve objectives and

to mitigate weaknesses for key areas such as operations, systems,

cash flow, financial reporting, legal, tax, regulatory, and credit

Table 14: Analysis performed during feasibility study phase

The presentation of the securitisation transaction to the rating agencies is

important for the final rating and consequently the overall enhancement levels.

The Structuring phase focuses on the financial impact of the securitisation

transaction including funding approaches, funding sources, credit

considerations, and legal issues.

During the Pre-closing phase, a financing team, selected by originators and

transferors, coordinates the negotiation of business and pricing terms, and the

presentation to credit analysts. Included tasks are listed in Table 15.


50

Assemble financing team Present structure to credit and business

analysts

Prepare legal and disclosure documents Validate data

Finalise deal structure Price transaction

Table 15: Tasks performed during pre-closing phase

After completing the securitisation transaction, issuers are responsible for

certain tasks. The Post-closing phase includes: servicer statement preparation,

investor reporting, internal management and operations reporting, procedures

review/surveillance and related reporting of findings, tax calculations, financial

reporting, portfolio and transaction performance tracking.131

5.3 Effects of securitisation

In short, securitisation provides funding and liquidity by converting illiquid assets

into cash.132 Furthermore, asset securitisation allows the provision of credit to

market processes rather than through financial intermediaries. It “… converts

regular and classifiable cash flows from a diversified portfolio of illiquid present

or future receivables … of varying maturity and quality … into negotiable capital

market paper (“tranches”) …”. The economic reasoning of securitisation

depends on whether the issuer succeeds in making profits and maximising its

shareholder value. Securitisation mainly brings a competitive financial

advantage through efficient asset funding, active balance sheet restructuring,

market-oriented risk management of credit risk and diversified liquidity.133

5.3.1 Benefits associated with securitisation

Basically, securitisation has proven its benefits as an efficient funding and

capital management system helping to mitigate the required minimum level of

131 see PricewaterhouseCoopers (2004) pp.8,9. 132 see Tavakoli (2003) p.14. 133 see Jobst (2006) pp.3-6.


51

capital and to facilitate risk management.134 Table 16 lists the main differences

between loans and securitised assets.

Loans Securities

Illiquid Liquid/tradable

Collateral valuation subjective and periodic Market determines value

Originator assesses risk Third parties assess risk

Originators’ operating costs high Originators’ operating costs low

Investor market local Investors market national/global

Limited terms and rates offered borrowers Buffet of terms and rates offered borrowers

Table 16: Value added through securitisation135

While benefits and the degree of their importance may vary, the main

advantages of securitisations, the provision a lower cost capital and liquidity,

are common.136

From an economic point of view, the two main objectives are:

i. easing regulatory capital charge, and/or

ii. reducing economic cost of capital.

Mostly traditional, true-sale, transactions are used to achieve the first objective

through a curtailment of the balance sheet growth by moving assets off the

balance sheet. Derivative, synthetic, transactions may qualify for achieving the

second objective by lower bad debt provision though risk transfer.137

134 see Jobst (2002a) p.2. 135 Kendall (1996) p.5. 136 see PricewaterhouseCoopers (2007) p.8-10. 137 see Jobst (2002b) pp.9,10.


52

Strategy Dynamic Balanced Defensive

Key motivation Funding growth Liability management De-leveraging

Primary benefit Funding Accessing long term

money

Release of

Regulatory Capital

Secondary benefit Release of

Regulatory Capital

Release of

Regulatory Capital

Long term funding

Assets securitised Core product assets Any suitable portfolio Any suitable portfolio

Use of released

resources

New core product

originated

Any desirable asset

class/portfolio

None

Table 17: Main motives for securitisation in true-sale transactions138

Motives of originating banks differ, as well as the relative importance of various

benefits. Table 17 provides an overview of the main motives for securitisation in

true-sale transactions. The labels “Dynamic”, “Balanced” and “Defensive” are

only rough categories of feasible strategies. The ranking of benefits may also

differ.139

From an issuer perspective, securitisation is mainly an alternative source of

funds. Associated benefits may include shortening the balance sheet and

reducing economic cost of capital. Moreover, securitisation improves the

efficiency of risk management by easing regulatory capital requirements. The

efficient access to capital markets enables lower cost of capital than the

originator’s rating would allow.140 Originators may also use structured finance

vehicles to seek shelter from potential operating liabilities. Finally, structured

finance vehicles can be used for tax management.141

138 GBRW (2004) p.30. 139 see GBRW (2004) pp.29-30. 140 see Jobst (2006) p.4. 141 see Tavakoli (2003) p.14.


53

Benefits to consumers-borrowers

1. Lower cost of funds

2. Increased buffet of credit forms

3. Competitive rates and terms nationally and locally

4. Funds available consistently

Benefits to originators

5. Ability to sell assets readily

6. Profits on sales

7. Increased servicing income

8. More efficient use of capital

Benefits to investors

1. High yields on rated securities

2. Liquidity

3. Enhanced diversification

4. Potential trading profits

Benefits to Wall Street (investment bankers)

1. New product line

2. Continuous flow of originations and fees

3. Trading volume and profits

4. Potential innovation and market expansion

Table 18: Benefits of securitisation142

Table 18 provides an overview of benefits of securitisation, broken down by

player. However, benefits of securitisation are closely link to the existence of

imperfect markets. With perfect information, administration and marketing costs

of securitisation transactions would have no counterbalancing benefit.143

5.3.2 Risks associated with securitisation

Securitisation allows separating the risk exposure from the related assets.

Balance sheet risks are converted into marketable securitised debt through

142 Kendall (1996) p.13. 143 see Jobst (2002b) p.7.


54

complicated financial structures. This influences the security’s credit (or asset)

risk, market risk, liquidity risk and operational risk (see Figure 12).144

Figure 12: Fundamental investment risks in asset securitisation145

Holders of fixed income assets commonly face interest rate risks or risks

associated with fluctuations in the market value of these assets. Holders of

structured products deal with additional risks specific to such investments. For

holders of mortgage assets, the prepayment risk creates uncertainty with

respect to the timing of cash flows. This makes securities collateralised by

mortgage products difficult and expensive to hedge.146

Many other problems arise from delinquencies and charge-offs, inaccurate

investor reporting, and bad publicity.

Reputation risk is of qualitative nature. Bad reputation may result in poor

underwriting and risk assessment. This leads to increased costs and decreased

profitability. Effective measures for controlling reputation risk are a sound

144 see Jobst (2006) p.11. 145 Jobst (2006) p.12. 146 see Fabozzi et al. (2007) p.16. ! "#!

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Credit RiskStructural Risk

Legal Risk

Market Risk Liquidity Risk Operational Risk

Interest rate risk:

• reinvestment risk (! interest rate term structure)

• interest rate differential (base risk)

Currency risk

Reference portfolio:

• degree of diversification & asset correlation

• asset granularity

• domicile of assets

Structural provisions:

• internal (credit enhancement through overcollateralisation or excess spread)

• external (counterparty risk of third-party guarantee)

• security design: senioritisation and tranche specification

Liquidity risk:

• balance sheet-based liquidity risk: prepayment risk (! maturity mismatch)

• market-based liquidity risk: high trading costs and loss of market power of issuers due to low market volume in primary/secondary markets

Agency cost of:

• adverse selection

• ex ante/ex post moral hazard

• principal-agent problem

Fundamental legal framework & compliance:

• trade law

• tax law

• national/international supervisory regulation

Implementation of legal claims:

• corporate law

• insolvency law

• private law

Data availability:

• confidentiality & data disclosure

• banking laws

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55

business plan and a comprehensive, effective risk management and control

framework.

Long-term impacts of the envisaged securitisation on operations, profitability,

and asset/liability management are to be analysed in order to assess the

strategic risk. Long-term resource needs need to be in line with projected

volumes of planned securitisation transactions.

The transaction risk arises from inefficiencies associated with servicing, such as

processing problems of the transaction, inefficient collection of delinquent

payments, inaccurate performance reporting to the investor. To reduce the

exposure to transaction risk, adequate staffing, skill levels, and capacity of

systems is required to deal with planned type and volume of transactions.

The liquidity risk arises from probability that large asset pools require balance

sheet funding at unexpected or inopportune times. As part of day-to-day liquidity

management, all outstanding should be monitored and plans of future funding

requirements should be aligned. In addition, funding alternatives have to be

assessed.

The compliance risk is related to respecting laws, rules, regulations, prescribed

practices, or ethical standards. Non-conformance may lead to fines, civil money

penalties, payment of damages, and the voiding of contracts resulting in a

diminished reputation, limited business opportunities, lessened expansion

potential, and lack of contract enforceability.147

5.3.3 Effects on SME financing

Increasing internationalisation of business and use of capital markets promote

asset securitisation as efficient corporate finance method for non-financial

enterprises. In this relation the main motives are both funding at competitive

capital cost and proactive management of balance sheet growth. While

especially large companies have replace traditional on-balance sheet debt and

equity finance by securitised debt, SMEs still largely depend on bank lending

147 Office of the Comptroller of the Currency (1997) pp.33-49.


56

and private equity. Low turnover, weak public disclosure of accounts and high

monitoring effort hamper the access to capital markets. At the same time,

decreasing margins in interest-based deposit business and the new regulatory

capital standards outlined in Basel II (see 3 The Basel Capital Accord) put

pressure on banks’ lending policy. This affects primarily risky borrowers, such

as SMEs tend to be, who suffer both, increasing borrowing cost of traditional

lending and difficult access to capital markets. In addition, technical barriers to

entry like critical amounts securitisable asset exposure and excessive start-up

costs hinder SMEs to access capital markets without the support of financial

institutions.

Securitised asset refinancing by corporations (“corporate securitisation”)

Indirect: Multi-seller ABCP programmes sponsored by financial institutions facilitate

funding of selected assets on a short-term basis

Direct: Companies themselves securitise own payment claims, such as long-term

revenues from entire operations, particular line of business (whole business

ABS) or defined project cash flows (project ABS)

Securitised asset refinancing by banks

Banks securitise medium-term and long-term SME credit exposures in large scale asset-backed

transactions, so-called SME CLOs

Table 19: ABS techniques involving SME-related payment claims

Two forms of securitisation, CLO and Asset Backed Commercial Paper (ABCP)

programmes, offer the required flexibility in terms of security design, underlying

asset type, and disclosure requirements for SMEs (see Table 19). Originators

sell assets like trade receivables, consumer loans, mortgages as well as lesser-

known asset classes, such as auto rentals and revenues from whole business

and project finance. Financial institutions use ABCPs for refinancing their own

lending activity and sponsor multi-seller ABCP securitisation programmes for


57

funding corporate clients. Both enable banks to extend loans to corporate

customers. In particular SMEs benefit from cost efficient funding through ABCP

programmes.

ABCP programmes have usually lower overall refinancing costs compared to

conventional on-balance sheet external finance, such as bank debt and

standalone off-balance sheet funding, like project finance ABS and whole

business ABS. The cost reduction is achieved through the diversification effect

of pooling individual assets and the resulting higher rating classification of

ABCP programmes. ABCP have become popular especially in countries with

restrictive bank lending.148

5.3.4 Effects on European economy

Günter Verheugen reckons that „micro, small and medium-sized enterprises

(SMEs) are the engine of the European economy. They are an essential source

of jobs, create entrepreneurial spirit and innovation in the EU and are thus

crucial for fostering competitiveness and employment”.149

On average, European enterprises are smaller than American and Japanese

ones. In the European Economic Area (EEA) and Switzerland 99% of all

enterprises are SMEs and 93% of all employ less than ten employees.150 Given

these figures, vitality of SMEs plays a crucial role for the European economy.151

However, SMEs frequently face troubles in obtaining capital or credit. Basel II

and greater sensitivity to the effects of economic cycles have made banks more

reluctant to lend to SMEs with low equity ratios.152

Despite increasing trends observed globally, securitisation activities increased

particularly in Europe during the decade after the introduction of the euro.

Factors such as the further integration of European financial markets and a

148 see European Commission (2003a) pp.7,8. 149 Günter Verheugen cited in European Commission (2003b) p.3. 150 see European Commission (2002) p.4. 151 see GBRW (2004) p.6. 152 see Kreditanstalt für Wiederaufbau (2003) p.16-18; GBRW (2004) p.6.


58

move to a more market-based financial system change the role of banks related

to lending from “originate and hold” to “originate, repackage and sell”

Furthermore, this increases the supply of lending because “…securitisation

provides banks with additional flexibility to face changes in market

conditions…”.153 Today, the two main markets for SME securitisation in Europe

are Germany and Spain.

So far, securitisation has been relatively ineffective in distributing risk

associated with lending to SMEs. However, developments related to Basel II

may help increasing efficiency of the risk transfer process. This development

and the flexibility of securitisation as a gateway to capital markets may indeed

aid SMEs access to finance.154 From a broader economic point of view,

securitisation entails a risk sharing mechanism, which mitigates disparities in

the availability and cost of credit, thus improving overall market efficiency. Debt

securities issued in securitisation transactions are generally less risky than the

original credit risk of the underlying because of diversification and a variety of

incorporated security mechanisms.

153 see Altumbas et al. (2007) pp.7-9,24. 154 see Kreditanstalt für Wiederaufbau (2003) pp.21,22,52-58.

6 Conclusion

59

6 Conclusion

Previous Sections explain various characteristics typical for SMEs, related

difficulties in accessing finance, possible effects of Basel II on SME financing

and some financing alternatives. Finally, various forms of structured finance

products are reviewed, involved parties discussed and the benefits and

drawbacks associated with asset securitisation assessed. Overall, one can say

that securitisation has proven its benefits as efficient funding and capital

management method.

Decision-makers of SMEs are typically owner-managers. In particular small

enterprises are family businesses. In this respect, sustainability and long-term

independence are considered as superior to short-term profit. Basel II will

further lead to higher credit spreads due to the growing importance of credit

ratings. This puts further pressure on SMEs that have commonly low equity

ratios.

Considering increasing costs of traditional borrowing, as a result of shrinking

margins in interest-based deposit business and the effects of Basel II, asset

securitisation seems a promising funding alternative, especially for SMEs. In

particular Continental European SMEs still heavily rely on traditional bank

lending and SME securitisation has been largely limited to indirect securitisation

transactions lead by banks. Dried up traditional funding of riskier borrowers,

such as SMEs tend to be, might further encourage SMEs to consider asset

securitisation to meet funding needs. In future, smaller corporation may

participate in securitisation transactions arranged by banks, which is already

quite common in capital markets-based financial systems. SMEs may benefit in

particular from such cost efficient funding through ABCP programmes

sponsored by financial institutions. Considering the continuously changing

structure of the financial environment and the significant economic importance

of SMEs in Europe, it seems safe to say that asset securitisation will soon join

ranks with traditional debt finance.

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61

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Appendix

Appendix

71

Annex I: Summary of U.S. small business Size Standards155

Construction

• General building and heavy construction contractors: $33.5 million

• Special trade construction contractors: $14 million

• Land subdivision: $7 million

• Dredging: $20 million

Manufacturing

• About 75 percent of the manufacturing industries: 500 employees

• A small number of industries: 1,500 employees

• The balance: either 750 or 1,000 employees

Mining

• All mining industries, except mining services: 500 employees

Retail Trade

• Most retail trade industries: $7 million

• A few (such as grocery stores, department stores, motor vehicle dealers

and electrical appliance dealers), have higher size standards, but none

above $35.5 million.

Services

• Most common: $7 million

• Computer programming, data processing and systems design: $25

million

155 U.S. Small Business Administration.

Appendix

72

• Engineering and architectural services and a few other industries have

different size standards.

• The highest annual-receipts size standard in any service industry: $35.5

million

• Research and development and environmental remediation services: the

only service industries with size standards stated in number of

employees

Wholesale Trade

• For small business Federal contracts: 100 employees, and the firm must

deliver the product of a small domestic manufacturer, as set forth in

SBA’s nonmanufacturer rule, unless waived by the SBA for a particular

class of product. For procurements made under the Simplified

Acquisition Procedures of the FAR and where the purchase does not

exceed $25,000, the nonmanufacturer may deliver the goods of any

domestic manufacturer.

• For loans and other financial programs: 100 employees is applicable for

all industries.

Other Industries

• Divisions include agriculture; transportation, communications, electric,

gas, and sanitary services; and finance, insurance and real estate.

• Because of wide variation in the structure of industries in these divisions,

there is no common pattern of size standards.

For specific size standards as of January 1 of each year, refer to the size

regulations in 13 CFR §121.201. SBA's Table of Small Business Size Standards

includes all changes and modifications made since January 1 of the most recent

year.

Appendix

73

Annex II: Relationship of SMEs and banks in Europe156

Table 20: Percentage of SMEs with credit lines, by number of banks and sectors in

Europe-19157

Table 21: Percentage of SMEs with credit lines, by number of banks and size class in

Europe-19158

156 European Commission (2003) pp.22-28. 157 Source: ENSR Enterprise Survey 2002. 158 Source: ENSR Enterprise Survey 2002.

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Appendix

74

Table 22: Percentage of SMEs, by maturity period for the largest bank loan and sector in Europe-19159

Figure 13: Reasons for dissatisfaction with the most important bank, by enterprise size

(in percent), in Europe-19160

159 Source: ENSR Enterprise Survey 2002. 160 Source: ENSR Enterprise Survey 2002.

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Appendix

75

Table 23: Most important reason for changing a major bank account, by size class (in

percent), in Europe-19161

Table 24: Most important reason for not obtaining additional bank loans, by size class (in

percent), in Europe-19162

161 Source: ENSR Enterprise Survey 2002. 162 Source: ENSR Enterprise Survey 2002.

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Appendix

77

Annex III: Main distinctive features of equity, debt and hybrid

capital

Equity Hybrid capital Debt

Liability At least to the capital

share

Only to the extend of

convertible

No

Profit participation Aliquot on profits and

losses

Profit-related interest No

Asset participation Aliquot Option No

Voting rights Yes, as a rule Possible No

Time limit No Temporary equity Yes, as a rule

Collateral No No Loan security

Drain on finances Not fix, only dividends Low interest

payments

Fix interest payments

Tax burden Tax on profits Interest payments

deductable

Interest payments

deductable

Table 25: Main distinctive features of equity, debt and hybrid capital163

163 see Grabherr (2001) p.32.

Appendix

79

Annex IV: Standard & Poor’s credit ratings definitions164

Investment Grade

AAA Highest rating; obligor's capacity to meet its commitment is extremely strong.

AA Only small difference to ‘AAA’; obligor's capacity to meet its commitment is

very strong.

A Obligor’s capacity to meet its commitment is still strong.

BBB Weakened obligor's capacity to meet its commitment.

Non-Investment Grade165

BB Obligor's capacity could be inadequate to meet its commitment.

B More vulnerable to nonpayment; obligor's capacity or willingness to meet its

commitment is likely to be impaired.

CCC Currently vulnerable to nonpayment; in event of adverse conditions, obligor is

not likely to have the capacity to meet its commitment.

CC Currently highly vulnerable to nonpayment.

C Currently highly vulnerable to nonpayment; perhaps bankruptcy.

D Payment default.

Plus (+) or

minus (-)

Plus (+) or minus (-) may be added to 'AA' to 'CCC' to show relative standing

within the major rating categories.

NR No rating or insufficient information

Table 26: Standard & Poor’s long-term issue credit ratings definitions

164 see Standard & Poor’s (2008) pp.3-5. 165 also called Junk Bonds; are regarded as having significant speculative characteristics.

Appendix

81

Abstract: English

The financial sector has changed significantly during recent decades. Higher

competitive pressure and a greater concentration of banks have diverse

impacts on lending practices. The new Basel Capital Accord, Basel II, is

supposed to harmonise international capital requirement standards in banking

and to enhance the financial system’s security and solidarity. Such changes in

the financial environment may have substantial effects on the access to finance

of small and medium-sized enterprises (SMEs), which generally tend to face

significant problems in accessing equity as well as debt.

Decision-makers of SMEs are typically owner-managers. In particular small

enterprises are family businesses. In this respect, sustainability and long-term

independence are considered as superior to short-term profit. Basel II will

further lead to higher credit spreads due to the growing importance of credit

ratings. This puts further pressure on SMEs that have commonly low equity

ratios.

Considering increasing costs of traditional borrowing, as a result of shrinking

margins in interest-based deposit business and the effects of Basel II, asset

securitisation seems a promising funding alternative, especially for SMEs. Many

financial institutions issue securitised debt on various asset classes. However,

in particular Continental European SMEs still heavily rely on traditional bank

lending and SME securitisation has been largely limited to indirect securitisation

transactions lead by banks. Dried up traditional funding of riskier borrowers,

such as SMEs tend to be, might further encourage SMEs to consider structured

finance to meet funding needs. In future, smaller corporation may participate in

securitisation transactions arranged by banks, which is already quite common in

capital markets-based financial systems. SMEs may benefit in particular from

such cost efficient funding through Asset Backed Commercial Paper (ABCP)

programmes sponsored by financial institutions. Considering the continuously

changing structure of the financial environment and the significant economic

importance of SMEs in Europe, it seems safe to say that asset securitisation will

soon join ranks with traditional debt finance.

Appendix

83

Abstract: Deutsch

Der Finanzsektor hat sich über die Jahrzehnte signifikant verändert. Stärkerer

Wettbewerb und eine konsolidierte Bankenlandschaft haben diverse

Auswirkungen auf die Kreditvergabepraktiken. Die neue Baseler Eigenkapital-

Vereinbarung, Basel II, soll die internationalen Standards für die

Kapitalanforderungen an Banken harmonisieren und die Sicherheit und

Solidarität des Finanzsystems stärken. Diese Veränderungen in der Finanzwelt

können substantielle Auswirkungen auf den Zugang zu Kapital von kleinen und

mittleren Unternehmen (KMU) haben, wobei KMUs ohnehin tendenziell

Probleme haben Eigenkapital wie auch Fremdkapital aufzubringen.

Die Entscheidungsträger von KMUs sind typischer Weise Eigentümer-

Unternehmer. In der Regel sind kleine Unternehmen Familienbetriebe.

Diesbezüglich genießt Nachhaltigkeit und langfristige Unabhängigkeit eine

höhere Bedeutung als kurzfristiger Profit. Basel II wird wegen der zunehmenden

Bedeutung der Bonität von Unternehmen zu größeren Credit Spreads führen,

was KMUs aufgrund der allgemein schlechteren Eigenkapitalausstattung weiter

unter Druck setzt.

Berücksichtigt man die steigenden Kosten der traditionellen Kreditvergabe, als

Folge von schrumpfenden Margen des Einlagengeschäfts und den

Auswirkungen von Basel II, erscheint die Verbriefung von Forderungen

besonders für KMUs eine vielversprechende Finanzierungsalternative zu sein.

Viele Finanzinstitutionen emittieren verbriefte Forderungen auf verschiedenste

Kategorien von Aktiva. Dennoch vertrauen besonders Kontinentaleuropäische

KMUs noch immer sehr auf die traditionelle Bankenfinanzierung während KMU-

Verbriefungen größten Teils auf von Banken geleitete indirekte Verbriefungen

beschränkt sind. Die sich immer schwieriger gestaltende traditionelle

Kreditvergabe an riskante Kreditnehmer wie viele KMUs wird möglicherweise

KMUs ermutigen strukturierte Finanzprodukte als Finanzierungsalternative in

Betracht zu ziehen. Kleine Unternehmen werden vielleicht an von Banken

durchgeführten Transaktionen teilnehmen, wie es bereits in marktbasierten

Finanzsystemen üblich ist. KMUs könnten von kosteneffizienten

Appendix

84

Finanzierungsformen wie Asset Backed Commercial Paper (ABCP)

Programmen besonders profitieren. Berücksichtigt man die sich permanent

verändernde Struktur der Finanzwelt und die beträchtliche Bedeutung von

KMUs in Europa, dann wird aller Voraussicht nach die Bedeutung der

Forderungsverbriefung jene traditioneller Finanzierungsformen erreichen.

Appendix

85

Curriculum Vitae

Personal Information Name Philip Chlupacek Date of birth 28 September 1979 Place of birth Vienna, Austria Nationality Austrian Education Oct 1999 – Jan 2006 Studies of Business Administration at Oct 2005 – Jan 2006 The University of Vienna, Austria Mar 2008 – May 2009 Majors Bachelor: Management Master: Finance, Operations Management Sept 2004 – May 2005 Studies of Commerce at The University of Birmingham, UK Scholarship with Merit Major: Business Management & Organisation Sept 1998 – May 1999 Military Service, Austria Sept 1990 – June 1998 High School in Vienna, Austria Professional Experience July – Aug 2003 European Central Bank Mar 2006 - Feb 2008 Frankfurt am Main, Germany Organisational Planning Dec 2004 – May 2005 National Express London, Birmingham, et al., UK Management of Rail Replacement Service 1998 - 2004 Tennis Instructor (self-employed) Vienna region, Austria Sept 2002 Bank Austria – Creditanstalt, Vienna

Treasury Operations Sept 2001 Capital Invest, Vienna Stock Fund Management Aug 2000 Geyer & Geyer Steuerberatung, Vienna Accounting May 1999 Creditanstalt, Vienna Customer Service Languages

German, English, Spanish, French, Latin

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