Securitization in Financial Markets Development: An
Emerging Market Perspective
Dr. JAY SA-AADUChester A. Phillips Professor of
Finance and Real EstateUniversity of Iowa, U.S.A
African Capital Markets: The Next Investment Frontier
• Our Financial Field of Dreams– Develop new Financial Instruments– Develop deeper, more liquid , sounder and
more resilient capital markets– Raise capital more efficiently
• Remember the following two principles– Capital has no Conscience, and it is very more
mobile– Prosperity Makes Friends, adversity tries
Focus of My Talk
• Winds of Positive Change in Emerging Markets• The Financial Innovation of Structured Finance
and Securitization• Origin of the Sub-prime Mortgage (SPM) Debacle• Lessons from SPM Related Securitization• Using Securitization to Develop and Deepen
Domestic Bond Markets• Necessary Infrastructure Conditions• Areas of Focus and Potential benefits of
Securitization for African Capital Markets
Winds of Challenge: Perfect Alignment of Capital Market “gods”
• Capital Markets are springing up across the continent
• Spreads on emerging market bond index at historically low points
• Emerging market bonds constitute an important asset class
• International Investors starting to purchase local currency bonds
• African sovereign bond issues on the go• Critical vote of confidence in future financial and
economic stability
Appropriate Steps Taken to consolidate & enhance gains
• Enhanced macroeconomic performance– Better Monetary and Budget Policies– Currency stabilization and redenomination– Taming Inflation– Building Legal, accounting, regulatory infrastructures to
facilitate entry and exit all investors
• But much more needed to be done to reach potential– Outstanding emerging bond market only 40% of GDP,
compared to 140% for matured markets
The Innovation in Securitization: Don’t be Thirsty in the Middle of the River
• What is Structured Finance ?• What is Asset Backed Securitization ?
– Leveraging on good assets– Raise Capital at better terms– Manage Balance sheet– Risk Diversification– Transparency– Cash flows based solely on credit quality of underlying asset – Credit Enhancement Transfer asset risk to those best able to shoulder them
• The global outstanding ABS now in excess of US $10 trillion
Exhibit 1: The Basic structure of ABS
Sponsoring Company
•Assets
Special Purpose Vehicle
Sale orassignment
•Assets
The Separation of Two Business: Origination and Funding
IssuesAsset BackedCertificates
Servicing agreement
Asset securitization makes sense when the assets are worth more outside the company than within. But what makes them worth more?
Risk Transfer InstrumentsRisk Transfer Instruments
Traditional ProductsTraditional Products Capital Market Products**Capital Market Products**
SecuritizationSecuritization Credit DerivativesCredit Derivatives Other InstrumentsOther Instruments
Asset Backed Securities (ABS)Mortgage-Backed Securities (MBS)Collateralized Debt Obligations (CDO)
Credit Default Swaps (CDS)Total Return SwapsCredit Spread Options
Loan SalesBond TradingAsset Swaps
Credit InsuranceSyndicated LoansFinancial Guarantee
Collateralized Loan Obligations (CLO)Collateralized Bond Obligation (CBO)
Hybrid ProductsHybrid Products
“Synthetication”“Synthetication” “Pool of Pools- Hybrids”“Pool of Pools- Hybrids”
Credit-linked Notes (CLN)Synthetic CDOs
CDOs of CDOsCDOs of ABSs
Exhibit 2: Overview of Credit Risk Transfer (CRT) Instruments
Our focus
Primitive Assets/ReceivablesPrimitive Assets/Receivables
Basic Structured Finance (ABS)Basic Structured Finance (ABS)
Structured ABS with TranchingStructured ABS with Tranching
Synthetic CDO SecuritizationSynthetic CDO Securitization
Multiple Class of Tradable Derivative Securities(Structured Claims)
Single Class Tradable Derivative Security
Credit Risk transfer (CDS)Without Asset transfer
1ST Stage InnovationWhat is the innovation?
2nd Stage InnovationWhat is the innovation?
3rd StageInnovationWhat is theInnovation?
Mortgages, consumer credit (auto loans, credit card), equipment leasescommercial loans, student loans, aircraft lease, royalties, future flows, etc
Illiquid Assets (Primitive Asset)
Exhibit 3:Stages and Innovations Structured Finance (Securitization)
The Technology has Evolved Through Several Stages
Conventional CDOConventional CDO
Multiple Class TradableDerivative Securities Tranching & SubordinationOf Cash flows
4th Stage
Extensive use of Credit Derivatives
Originator(Asset Seller)
Special PurposeVehicle (SPV)
Investment Banks
Capital MarketInvestors
Sale of Asset Portfolio
Asset Cash Flows
Placement
PurchasePrice
Placement
PurchasePricePurchase Price
Obligors
Pla
cem
ent
PurchasePrice
Rating Agency •Debt Account•Collection of Principal & Interest
Trustee
•Paying office•Administration of transferred assets
Servicer Issued Securities•Single•Multiple•Equity (unrated)
CashFlow
Cash Flow
1ST Step: Sales of Assets to SPV 2nD Step: Issuance of Securities on the market
Other Keyparticipants
Credit Enhancement, Liquidity Support
Typically Provided byoriginator
Exhibit 4: Structural Characteristics of ABS Transaction
0
5
10
15
20
25
30
35
Default Frequency
1 2 3 4 5 6 7 8 9 10 11 12
Confidence Interval (99.5%)
Economic Risk Transfer
Before securitization
After Securitization
Expected Loss Unexpected Loss
Covered by economic capital
transferred risk exposure
Default Loss
Exhibit 5: Economic Risk Transfer to Capital Markets and Economic Capital Reduction
Before SecuritizationCovered by earned riskpremium and loan lossprovisionAfter Securitization
Retained risk exposure(First Loss Protection)
Origins of Subprime Mortgage Debacle: “Exuberant” Search for High Yields
• What are Subprime Mortgages?• Convergence of many factors -- 1997-2005
– Global Liquidity– Low Interest Rates– High Yield Securities -- MBS and CDO– Investment Banks– Growth and Stability– Subprime Mortgage Credit– Asset Price Bubble– Credit squeeze
• Bubble started to burst after 2Q 2006• The Rest is History• Question: Do you think SPM are bad and should be
banned?
Some Lessons from SPM Related Securitization
• Lesson #1: Real Business operations that create the assets and their credit quality are fundamental to financial and investment success of securitization
• Lesson #2: The complexity of some securitization structures may conceal the real risk of the new securities
• Lesson #3: Securitization may be susceptible to principal-agent problem
• Lesson #4: The value chain may only be as strong as its weakest link – systemic dependence or diffused responsibility
• Lesson #5: The prospect of the contagion – ability to provide liquidity support may diminish
Some More Lessons
• Lesson #6: Rating and Rating Agencies matter a lot for the well-functioning of markets for financial assets, especially, asset backed securities (ABS)
• Lesson #7: Back to Basic– Cash Flows come real business operation or LHS, not RHS of the balance sheet
• These are important lessons, BUT• Do not exaggerate or overreact
Mr. Chicken Little, Is the Sky of Securitization Falling?
• NO! Stay Calm, the Sky is Not Falling• The genie of financial innovation is already out of
the bottle, and is a good genie -- WHY?• Securitization has created dynamic & beneficial
relations between individual and business borrowers on one side, and the vast global capital markets that were previously non existent
• It has broadened access to credit for individuals and businesses at reasonable terms
How Does Securitization Create Value?
• Securitization creates value by rearranging the balance sheet to mitigate one or more markets imperfections– Information asymmetries– Incomplete Markets– Economic capital– Regulatory Capital– Taxes
• Translation: Capital Structure may not be irrelevant!
The Economics of Asset Securitization
“The Chicken Theory”
$6.99
Can you make money by cutting up the chicken? Where did Colonel Saunders get his idea from?
Whole chicken is worth $6.99
Incomplete market
$1.25
$2.95$1.40
$1.98
Cut and enhanced chicken $7.58Whole Chicken 6.99Economic Value Added $0.59
The Economics of Asset Securitization:
“The Chicken Theory”
How? “Go ask the Colonel for his secret recipe or you can homebrew your Own”
Should African Capital Markets “Enter the Kingdom of Securitization”?
• Emerging Economies of Africa should consider wading in the waters of the innovation of structured finance and securitization -- gradually– Several emerging markets have already embraced the
technology– Credit default swap (CDS) now constitute about 20% of
face value of emerging market debt– The World Food Program has sold futures on Ethiopian,
rains – Now that is EXOTIC– Argentine GDP-linked bonds
• Securitization may very well be a form of financial inoculation for African Capital Markets
What Should be the Priority Objective?
• Development of more inclusive and flexible debt market, characterized by efficient risk transfer , sound risk management , lower cost of capital, with all the necessary shock absorbers
• Complete Markets• Well-functioning capital markets will make
crucial contribution to growth and stability
The Necessary Conditions
• Uphold and protect the sanctity of property rights• Improve the legal environment to foster the use of
financial innovation• Strong standard for investor protection• Protection and enforcement of creditor rights• Prudent (not excessive) regulation and
supervision, by central banks an other regulatory bodies
• Subscribe to the maintenance of stable macroeconomic framework -- value proposition
The Necessary Conditions
• Overall improvement of financial infrastructure• Improve financial architecture• Appropriate governance and transparency• Clear and transparent bankruptcy code• Appropriate yield curves across all maturity
spectrum• Effective underwriting and hard-nosed auditing of
assets -- Where are the rating agencies?• Most of all financial transparency and honesty
What Do African Capital Markets Get for This Tall Order? -- The Benefits
• Inclusive and Flexible Capital Markets• Securitization of Future Flows to accelerate economic
growth• Access to capital markets for SMEs• Long Term Financing for Housing and Infrastructure• Transparency in risk pricing, mitigation and transfer• Capital Markets Integration• Lower cost of capital • Broader access to capital markets• More efficient capital utilization
Concluding Remarks
• I WOULD LIKE TO READ THIS