Gerling Global Financial Products
Pricing Structured Finance, Project Financeand Credit Enhancement
Paul R. Hussian, FCAS
Seminar on Reinsurance
June 15, 2000
Gerling Global Financial Products
Transaction Examples
• Trade Receivables
• Debt pools: Bonds (CBO), Bank Loans (CLO)
• Entertainment: Film Receivables
• Real estate finance: Commercial and residential mortgages (MBS)
• ...
Gerling Global Financial Products
Corporate Debt Ratings
Moody's S&P
Aaa AAAAa1 AA+Aa2 AAAa3 AA-A1 A+A2 AA3 A-
Baa1 BBB+Baa2 BBBBaa3 BBB-Ba1 BB+Ba2 BBBa3 BB-B1 B+B2 BB3 B-
Caa CCC
* Ratings reflect both frequency and severity of default
Gerling Global Financial Products
Structure
Assets(Collateral)
Receivables
Bonds,Corp Loans,Mortgages
Films
Real Estate
CashFlow
Aaa
Tranches
Senior 1
Senior 2
Mezzanine
Equity
Ba3
NR
Aa2
(Insurer)
Pari Passu
Equity
Unwrapped Notes
Insurer
Aa2 Aa2
NR
Structure 1 Structure 2
Gerling Global Financial Products
Two Pricing Perspectives
• Actuarial/Insurance
– premium
• Capital Markets
– yield spread: over Treasuries/LIBOR
Gerling Global Financial Products
Actuarial/Insurance Pricing
• Identify assets/cash flows
• Identify risk(s)
• Gather data
• Build cash flow model
• Run cash flows through deal structure
• Determine Premium, Profit, ROE
Gerling Global Financial Products
Assets / Cash Flows
• Receivables Collection cycle
• CBO/CLO Pools of debt (bonds, bank loans)
• Entertainment Film receipts
• Real estate Commercial/residential property
Gerling Global Financial Products
Risks (Quantitative)
• Receivables Credit defaults, price/volume
• CBO/CLO Bond/loan defaults, interest rates
• Entertainment Film performance
• Real estate Property value, rent income
• All transactions Correlation to economy
Gerling Global Financial Products
Data Sources
• Commodities Commodities futures exchange, Bloomberg,
company
• CBO/CLO Moody’s, S&P, sponsoring bank/company
• Entertainment MPAA, company
• Real estate Company, FHA, FDIC, private industry study
• All transactions Offering Memorandum
Gerling Global Financial Products
Cash Flow Modeling – Common Challenges
• Company’s business model / economics of industry
• Stochastic modeling / simulation– mean, standard deviation, distribution of key variable(s)
• Scenario testing– stress tests; where is deal’s “break point”?
– effect of recession
• Correlations– between variables
– between assets/cash flows
– to economy (cyclical, counter-cyclical, recession-proof)
Gerling Global Financial Products
Receivables - Cash Flows
• Credit defaults on receivables
– historical ratio: defaults receivables
– strength of obligors
• Price/volume of commodity being produced
– range of price fluctuation
– effect of recession on price, volume
– obligor concentration risk
Gerling Global Financial Products
Sample Receivables Loss Data
1.0
2.0
3.0
4.0
5.0
Pool Origination Date
% T
ota
l Lif
eti
me
Lo
ss
es
Historically 3%, stable
Historically 3%,
volatile
Increasing Loss
Trend
Gerling Global Financial Products
Receivables – Sample Average Monthly Price Data (Heavy Crude Oil)
$5
$10
$15
$20
$25
Jan-
91
Jul-9
1
Jan-
92
Jul-9
2
Jan-
93
Jul-9
3
Jan-
94
Jul-9
4
Jan-
95
Jul-9
5
Jan-
96
Jul-9
6
Jan-
97
Jul-9
7
Jan-
98
Jul-9
8
Jan-
99
Jul-9
9
US
$/ba
rrel
Gerling Global Financial Products
CBO/CLO – Cash Flows(Default Rates)
• Default Rate (frequency) = % of bonds/loans defaulting
– Annual, multi-year
• Moody’s/S&P credit ratings of bonds/loans in portfolio (Aaa, Aa1, …)
• Correlation between bonds/loans
– Diversity Score: translate portfolio into homogeneous, independent debt
securities
• Binomial distribution
Gerling Global Financial Products
CBO/CLO – Cash Flows (Severity)
• Severity = 1 - Recovery Rate
• Recovery Rate = post-default market value par value
• Moody’s/S&P credit ratings of portfolio notes (Aaa, Aa1, …)
• Normal, Lognormal distribution
• Correlation between frequency, severity
• Loss rate = Default rate x Severity
Gerling Global Financial Products
One-Year Default Rates by Year and Rating
Aaa
Aa
A
Baa
Ba
B
0.00
5.00
10.00
15.00
20.00
25.00
Defa
ult
Rate
%
Year
Gerling Global Financial Products
Average Cumulative Default Rates by Rating
1 4 7
10
13
16
19
Aaa
Aa
A
BaaBa
B
0.00
10.00
20.00
30.00
40.00
50.00
60.00
Defa
ult
Rate
%
Age in Years
Gerling Global Financial Products
CBO/CLO –Historical Recovery Rates 1977-98
Seniority and Security AverageStandard Deviation
Senior Secured Bank Loans 70.26% 21.33%Equipment Trust 65.93% 28.55%Senior Secured Public Debt 55.15% 24.31%Senior Unsecured Public Debt 51.31% 26.30%Senior Subordinated Public Debt 39.05% 24.39%Subordinated Public Debt 31.66% 20.58%Junior Subordinated Public Debt 20.39% 15.36%All Subordinated Public Debt 34.12% 22.35%All Public Debt 45.02% 26.77%
Gerling Global Financial Products
CBO/CLO – Moody’s Diversity Score
• Avg default rate = p, Diversity score = n, Recovery rate = r– p = weighted avg of individual bond default rates
• n selected to equate loss variance
• Decreasing n increasing volatility & correlation– binomial C.V. =
– n depends on industry concentration
• S&P method: increase p with industry concentration, assume independence
np
p1
Gerling Global Financial Products
CBO/CLO - Example
# bonds = 5par value = 60,000,000
p = 5.0%n = 3 r = 50%
# of BinomialDefaults Prob Loss
0 85.7375% - 1 13.5375% 10,000,000 2 0.7125% 20,000,000 3 0.0125% 30,000,000
Expec Loss = 1,500,000 Loss Rate = 2.5%
Gerling Global Financial Products
Entertainment – Cash Flows (Film Co.)
• Coverage ratio = film revenue production cost– mean
– standard deviation
• Box office, licensing, pay-per-view, international
• Film revenue stream
• Correlation between films
Gerling Global Financial Products
Real Estate – Cash Flows
• Occupancy rates
• Average rents
• Capital structure (debt, equity)
• Property value
– cash flow discount rate
• Mortgages unrated, use industry data (FHA, FDIC)
• Strong correlation to economy
Gerling Global Financial Products
Modeling Deal Structure
• Tranched (layered) vs Syndicated (pari passu) securities
• Cash flow waterfall
• Equity, subordination structure
• Early amortization triggers
• Indemnification provisions
• Floating rates
• Impact on insurer’s profit & risk
Gerling Global Financial Products
Capital Markets Pricing
• Premium vs. yield spread between unwrapped notes and insurer credit rating
• Insurance vs. levered investment in unwrapped securities
(insurer = investor)
Gerling Global Financial Products
Current Spreads Over Treasuries (Financials)
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
Aaa
Aa1
Aa2
Aa3 A1 A2 A3
Baa1
Baa2
Baa3 Ba
1
Ba2
Ba3 B1 B2 B3 C
aa
3-yr
5-yr
10-yr
Investment Grade
Sub-Inv Grade
Gerling Global Financial Products
Example
5-yr bond: par value = $100M
insurer rating = Aa1 145 b.p. over T
unwrapped notes = Ba3 415 b.p.
over T
insurer premium = (415 – 145) b.p. x $100M =
$2.7M/yr
present value = $10.1M
Gerling Global Financial Products
Example
Levered Investment: Insurance:(1) (2) (3) (4)=(2)-(3) (1) (2) (3) (4)=(2)+(3)
(Ba3) (Aa1) (Aa1) (Ba3)Bond Insurer BondO/S Paid to Debt Insurer O/S Paid to Insurer Total
Year Principal Bond Service Profit Year Principal Bond Premium Paid0 100 0 1001 100 4.15 1.45 2.70 1 100 1.45 2.70 4.152 100 4.15 1.45 2.70 2 100 1.45 2.70 4.153 100 4.15 1.45 2.70 3 100 1.45 2.70 4.154 100 4.15 1.45 2.70 4 100 1.45 2.70 4.155 0 4.15 1.45 2.70 5 0 1.45 2.70 4.15
PV Profit--> $10.07 PV Profit--> $10.07
Aa1 spread = 1.45%Ba3 spread = 4.15%T = 6.50%
In $ millions
Gerling Global Financial Products
Model Metrics
• Debt service coverage ratios = cash flow / debt service
• Balance sheet: equity, debt– % collateralization (value of collateral / full limits loss)– CBO collateral/CBO principal– loan/value (real estate, mortgages)
• Default probability & Loss rate (principal, interest, premium) – compare to Moody’s ratings
• Transaction break point
• Insurer present value profit/(loss)
• Relative risk/reward of tranches (IRR)
Gerling Global Financial Products
CBO Example
p = 24.5% T = 6.5%r = 50.0% Expenses = 1.00%s.d. (r) = 25.6% Insurer Prem = 2.25%Maturity = 5 yrs Insurer Rating = Aa2
CashFlow
Aaa
Senior
CBO
3.50% + T
0.60% + T
$385 mm
$65 mm
$50 mmEquity
NR
Mezzanine(Insurer)
Ba2
Assets(Collateral)
50 Hi-Yield Bonds"Junk"
Avg Rating =
B1
Yield =4.10% + T
Par =$500 mm
Diversity = 30
Gerling Global Financial Products
Model Output
AllSenior Mezz Equity Tranches
Loss Rate 0.002% 4.238% 46.486% 10.179%
Insurer Expec Profit NA $2,789 $2,770 ($15,161)
Insurer ROE NA 18.0% 35.5% -17.4%
Insurer Loss Prob NA 16.5% 41.0% 77.4%
Rating Aaa Ba2 NR B1
Offered Spreads 0.60% 3.50% - 4.10%
Market Spreads 0.30%-0.60% 4.50%-5.00% - 4.00%-6.00%
All figures on present value basis.Results from 5000 iterations.In $000s.