Master in Business Finance

Praloy Majumder
ICAI
Mumbai
May 2010
 What is a structured
finance
 A structured finance is a financial procedure to suit the
need of the borrower as per its specific requirement.
 In many cases, a borrower may not get funding on a plain
vanilla method .However, by properly structuring the
process the borrower can be funded.
 Similarly by securitising the loans funding can be
arranged to meet the specific requirement of the issuer of
loan.
 Structured finance serves several purpose starting from
increase in fund flows in the system to risk mitigation of
the system.
 Funding of a weak
company
 In the case of plain vanilla lending, a lending
institution can lend to a borrower only if it can
meet the following criteria :
 Profitability : 10% of net sales .
 Current Ratio : 1.33
 Leverage Ratio : 1.75
 The lender from its internal model finds that
these are the parameters required at a
particular point of time to avoid delinquency.
 The main concern of the lender is to avoid
delinquency.
 Funding of a weak
company
 A Company has the following criteria :
 Profitability : 3% of net sales .
 Current Ratio : 1.03
 Leverage Ratio : 2.75
 The lender wants to finance this Company .
 The major concern for the lender is that if a company
can not meet the above criteria , there is a probability
that the Company would default.
 The lender can address this concern by entering into a
structured finance agreement with the company.
 Funding of a weak
company
 The lender sits with the company and analyses
the customer profile of the company .
 The lender rates these customers and segregate
the best rated customers from the rests.
 Now lender enters into agreement with the
borrower in such a way that these customers
would pay directly to the lender.
 The lender overcollateralise the installment by 2
to 3 times .
 This is an example of structured finance through
escrowing of receivable.
 Securitisation

 It is used to mean a device of structured financing

where an entity seeks
 to pool together its interest in identifiable cash

flows over time;

 transfer the same to investors either with or

without the support of further collaterals;

 and thereby achieve the purpose of financing.
 Requirement of
Securitisation
 Securitisation is used for fulfilling the
following purpose :
 It reduces the capital requirement imposed
by the regulator.
 It gives an opportunity of investors to suit
their requirement as per their subjective risk
preferences.
 It also reduces the risk of the system .
 Terminology in
Securitisation
 The entity that securitises its assets is called the originator: the name signifies the
fact that the entity was responsible for originating the claims that are to be ultimately
securitised.
 There is no distinctive name for the investors who invest their money in the
instrument: therefore, they might simply be called investors.
 The claims that the originator securitises could either be
 existing claims, or existing assets (in form of claims), or
 expected claims over time. In other words, the securitised assets could be either existing
receivables, or receivables to arise in future. The latter, for the sake of distinction, is
sometimes called future flows securitisation, in which case the former is a case of asset-
backed securitisation.
 In US markets, another distinction is mostly common: between mortgage-backed
securities and asset-backed securities. This only is to indicate the distinct
application: the former relates to the market for securities based on mortgage
receivables, which in the USA forms a substantial part of total securitisation markets,
and securitisation of other receivables.
 Terminology in
Securitisation
 Since it is important for the entire exercise to be a case of transfer of
receivables by the originator, not a borrowing on the security of the
receivables, there is a legal transfer of the receivables to a
separate entity. In legal parlance, transfer of receivables is called
assignment of receivables.
 An entity is created solely for the purpose of the transaction:
therefore, it is called a special purpose vehicle (SPV) or a special
purpose entity (SPE) or, if such entity is a company, special
purpose company (SPC).
 The originator transfers the assets to the SPV, which holds the assets
on behalf of the investors, and issues to the investors its own
securities. Therefore, the SPV is also called the issuer.
 Terminology in
Securitisation
 These securities could either represent a direct claim of the investors
on all that the SPV collects from the receivables transferred to it: in this
case, the securities are called pass through certificates or
beneficial interest certificates as they imply certificates of
proportional beneficial interest in the assets held by the SPV.
 Alternatively, the SPV might be re-configuring the cash flows by
reinvesting it, so as to pay to the investors on fixed dates, not matching
with the dates on which the transferred receivables are collected by the
SPV. In this case, the securities held by the investors are called pay
through certificates.
 The securities issued by the SPV could also be named based on their
risk or other features, such as senior notes or junior notes, floating
rate notes, etc.
 Asset Backed Securities (
ABS)
Asset Backed Securities in a general sense

CDO
Mortgage ABS in a
Backed Narrower
Securities Sense
( MBS) •Credit Card
Residential •Equipment
Mortgage •Student Loan
CLO CBO
Commercial •Music Royalties Loan owned Bonds
Mortgage By Traded in the
Bank Market
 Process of securitisation

Credit Originator /
Enhancer Servicer
Provides Credit Receives Loan sale Receives inflow
Enhancement Fund From reference
Transfer
Of Assets Issuer of
Trustee S.P.V. Underwriter
Principal Debt
And Interest Securities
Minus
Servicing Revenues from
Fees Debt Distribution
Securities Of
Disburses
Revenues to Debt Securities
Investors Investors
 CDO
 In a Collateralised Debt Obligation ( CDO) structure, the issuer
repackages ( corporate or sovereign ) debt securities or bank
loans in to a reference portfolio ( the collateral) , whose proceeds
are subsequently sold to investors in the form of debt securities
with various levels of senior claim on this collateral.
 The issued securities are structured in so called senioritised credit
tranches, which denote a particular class of debt securities
investor may acquire when they invest in a CDO transaction.
 The tranching can be done by means of various structural
provisioning governing the participations of investors in the
proceeds and losses stemming from the collateral.
 CDO
 Subparticipation is one of the most convenient vehicles for attaching
different levels of seniority to categories of issued securities, so that losses
are allocated to the lowest subordinate tranches before the mezzanine and
senior tranches are considered.
 This process of filling up the tranches with periodic losses bottom up
results in a cascading effect .
 Both interest and losses are allotted according to investor seniority.
 This prioritisation of claims and losses from the reference portfolio
guarantee that senior tranches carry a high investment grading ( AAA) ,
provided sufficient junior tranches have been issued to shield more senior
tranches from credit losses.
 Types of CDO
 The classification of CDOs depends on possible variability in the
valuation of the collateral ex post the issuance of the securities.
 In Market value CDO , the allocation of payments to various tranches
depends on the mark to market returns on the reference portfolio
underlying the transactions.
 The market value form of CDO s is generally applied in cases of
distressed reference portfolio of bonds or loans such that the credit
and trading expertise of the originator of these assets might provide
grounds for arbitrage gains from the differences in prices between the
distressed assets on the bank books and their aggregate valuation
when bundled in a reference portfolio underlying securities.
Various form of structure
enhancement – Waterfall
CDO Tranches
AAA Senior Tranches

Portfolio
Payment A Mezzanine Tranches
X 1000 Made

BB Subordinated Tranches
Y 2000
Equity Tranches
Z 4000
 Collateralized Debt Obligations
( CDO)

 In the case of CDO , the SPV has invested

cash in a basket of n assets.
 It has then repackaged and allocated the
assets into several tranches.
 In a CDO, a default in any ass in the basket
leads to a loss of coupon and notional
amount for investors of junior tranche .
 CDO

Asset 1 Sr.
Coupon Coupon
Tranche
Cash
Cash SPV Mznine.
Asset 2
Tranche

Asset 3
Junior
Tranche
 Collateralized Debt Obligations
( CDO)
 Junior tranches incur the highest risk and receive the highest
coupon, which can be as high as 30%.
 The criterion of success of a CDO is generally related to the
success of selling the junior tranche.Consequently the SPV may
have to keep the junior tranches in its own portfolio or their parent
institutions acquire it.
 Mezzanine tranches, which incur losses if the losses of junior
tranches are complete , usually have credit rating from B to AA.
 Senior tranches , which is usually the largest are commonly rated
AA to AAA.
 Synthetic CDOs
 The difference between cash CDO and synthetic CDO lies in the fact
that
 the SPV in the synthetic CDO does not acquire the original assets

in a standard cash transaction.,

 but gains long credit exposure to the assets via selling credit

protection I.e. default swap.

 The SPV uses the cash from the sale of the tranches and the default
swap premium to purchase risk free bond .
 The increase in popularity of synthetic CDO is primarily due to non
transfer of ownership legally to the SPV.
 SPV has no operational risk with respect to the original asset.
 Synthetic CDO
Risk
Free
Asset
Seller
Sr
Cash + Ds Coupon Tranche
Premium
Ast 1 DS
premium Cash
Mz
SPV Coupon
Tranche
Ast 2
Payment
In the event
Ast 3 Of default Jr
Tranche
 Motivation of CDO
 For the SPV it is income motivated. The SPV gets fees for
placing,structuring and managing the CDO.
 The fees can be quite substantial . They can go up to 10% of the
notional amount.
 The SPV can resort to CDO for removing the asset from its
balance sheet and thus reducing the regulatory capital.This is
called balance sheet CDO.
 The motivation of the owners of the asset is to transfer the credit
risk without informing the borrower.
 The motivation for the tranches in primarily the yield
enhancement.
 Various form of structure
enhancement
 Over collateralisation : Volume of assets
is more than volume of issued notes.
 Excess Spread: Difference between
interest payment from assets and CDO
coupons are collected in an account.
 Guarantee by the originator.
 Insurance by the third party.
Credit Enhancement Process
 Requirement of Credit
Enhancement
 Issuers standalone rating is not as per the
requirement
 Lower rating would increase the cost of borrowing
 Improved credit rating with the help of credit
enhancement
 Rating can be enhanced to a targeted rating with
the help of credit enhancement
 Types of credit enhancement

 Identification of dedicated revenue stream and

escrowing the same with a standard escrow agreement
 Full guarantee from another entity with superior credit
profile
 Partial guarantee by way of :
 Partial cash flow pledging
 Graded guarantee
 Partial interest guarantee
 Pool financing
 Pool Financing
ULB 1

SPV INVESTORS

Legend
ULB 10 Structured Bonds
Issue Proceeds
Bonds
Subscriptions
Subsequent Repayments
 Importance of pool financing

 Smaller cash flows can be pooled together

 These cash flows can be structured to meet the
payment requirement of different SPV depending
on their cash flow requirement
 Besides government guarantee can be arranged
over this cash flows
 This would meet the requirement of the local
bodies
 Credit Enhancement

 The credit enhancement in the process of direct

funding is better option than guarantee mechanism
 The funding can be structured to incentivise the
efficient functioning of the issuer
 The penalty provisions should also be there
 Milestone based subsidy credit is better options
Non Fund Based Facility
 Non Fund Based Facility

NFB

LC BG DPG
 LC

LC

Replacing
Purchase on
Creditor with
Credit
Bank Borrowing
 Letter of Credit
Payment Transmitted
Sends Confirmation

Issuing Bank/ Sends Documents Negotiating

Opening Bank Bank
Bank
Opens
Sends documents

Payments Made to Bank

for Acceptance

Accepts documents

LC

For Negotiation
Submits Documents

Payment Made
Advising Bank/
Applies to bank

Confirming
Bank

Advises
LC

Applicant/ Goods Receipt Ships Goods

Beneficiary/
Buyer/ Seller/
Drawee Drawer
Sends Invoice
 Bill Discounting

Bill Discounting

Drawer Bill Drawee Bill

Discounting Discounting

With LC Without LC
 Bill Discounting

Bill Discounting

Drawer Bill Drawee Bill

Discounting Discounting

Replacing creditor in OCL

Receivable
with
Financing
Other bank

Replacing Receivable
Financing with
Bill
 Drawee Bill Discounting
Pays on due date
Sends documents
LC
Negotiating
LC Bank
opened
Issuing
Bank
Advising
Accepts documents and deposits

Opening
Approaches for LC Bank

Seller gets Payment

Pays on due date

Advises

Buyer Approaches
Selller

Buyer/ Goods dispatched Seller/

Drawee Seller Asks Drawer
Buyer to
Open
Sends LCof Exchange
Bills
And other Documents
 Bank Guarantee

Bank Guarantee

Mobilisation Performance
Bid Bond
Advance Guarantee

No Asset Asset No Asset

 SLC and Trade Credit

Domestic
Foreign Domestic NFB
Limit Limit Limit

Supplier Borrower