Global Financial Crisis And Securitisation

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Global Financial Crisis And Securitisation

  1. 1. GLOBAL FINANCIAL CRISIS The Influence of Accounting Rules for Securitisation by Andrew Read 1
  2. 2. SECURITISATION  What is securitisation?  Accounting for securitisation  Contribution to global financial crisis  Issues for regulators 2
  3. 3. WHAT IS IT?  A process of changing non-tradable debt into tradable debt by  combining the non-tradable debt into a portfolio and  issuing tradable debt financial instruments secured by the portfolio  Frequently used for consumer and small business debt  Home mortgages  Credit cards  Personal loans  Student loans  Small business loans 3
  4. 4. REASON 1 – AVAILABILITY OF FUNDS  Increase the amount of funds available for these types of loans be getting funds from debt markets  Pension and superannuation funds  Insurance companies  Corporations with excess cash 4
  5. 5. REASON 2 – LIQUIDITY  Consumer loans like mortgages are for long terms  25 years in Australia  40 years in USA  Investors reluctant to commit their cash for that long  Securitisation financial instruments are tradable which makes them liquid 5
  6. 6. REASON 3 – DIVERSIFICATION  Combining different debt instruments in one portfolio reduces unsystematic risk  Apartments, small houses, large houses  Different cities (and countries)  Non-mortgage debt 6
  7. 7. DIVERSIFICATION THEORY – MARKOWITZ MODEL n n  p    X j X k  j  k r jk j 1 k 1 X = proportion of security σ = standard deviation r = correlation coefficient j, k = security 7 p = portfolio
  8. 8. DIVERSIFICATION THEORY CONTINUED  As long as rjp < 1  Correlation between existing portfolio and new security  And  σj ≤ σp  Risk of new security less than or equal to risk of existing portfolio  Adding additional securities will reduce the risk of the portfolio 8
  9. 9. VANILLA PROCESS Promoter Originator Borrower Securitisation entity Financial markets 9
  10. 10. VANILLA PROCESS – ARRANGING THE MORTGAGE  Mortgage originator negotiates loan with consumer  Aussie Home Loans is an example of an originator  Gets a fee for doing so  Promoter creates securitisation entity  Gets a fee for doing so  Securitisation entity provides money to consumer and receives principal and interest payments over the life of the loan  Payments may be passed via the originator 10
  11. 11. VANILLA PROCESS – POOLING  Securitisation entity repeats the process of providing mortgages  Common to issue 200 – 300 mortgages to create the portfolio 11
  12. 12. VANILLA PROCESS - SECURITISATION  Securitisation entity issues debt instruments (bonds) to financial markets  CMO bonds – collateralised mortgage obligation bond  CDO bonds – collateralised debt obligation bond  ABS – asset backed security 12
  13. 13. ADD-ON – GUARANTEE  To improve the credit rating of securitisation debt, the entity can purchase a guarantee  Typically provided by a financial institution  A major part of Fannie Mae’s business was to sell these guarantees  The originator, the promoter or another entity may be the guarantor 13
  14. 14. COST OF DEBT BY RATING S&P Rating Basis Points over LIBOR AAA 30 AA+ 45 Ashcraft, A. B., & Schuermann, T. (2008). Understanding the Securitization of Subprime Mortgage Credit. SSRN eLibrary. Retrieved AA 47 April 27, 2009, from http://papers.ssrn.com/sol3/papers.cfm?abstra AA- 48 ct_id=1071189. A+ 53 A 56 A- 69 BBB+ 135 BBB 150 BBB- 308 14 BB+ 375
  15. 15. ADD-ON – OVER-COLLATERALISATION  To improve the credit rating, the promoter may put more assets into the portfolio than needed  The promoter will receive any surplus when the portfolio is liquidated  The originator or another entity may be the promoter 15
  16. 16. ADD-ON – TRANCHING  A proportion of the bonds issued (called a tranche) may be given a higher priority for repayment  High ranking tranches get a better credit rating (hence, lower interest rate) than low ranking tranches 16
  17. 17. ACCOUNTING FOR SECURITISATION  Typically, securitisation entities are not consolidated by:  Originator  Promoter  Guarantor  Use structures to get around consolidation standard  Special purpose entities 17
  18. 18. GAME PLAYING USING SECURITISATION  Non-consolidation of securitisation entities encourages game playing  Lowering leverage ratios 18
  19. 19. REGULATION OF FINANCIAL INSTITUTIONS  Financial institutions must maintain sufficient capital under national and international regulations  Called capital adequacy  Debt to asset ratio < 92%  This is a simplification  Securitisation entities are not regulated 19
  20. 20. THE GAME  Sell assets (mortgage assets typically) to a securitisation entity  Use proceeds to repay debt 20
  21. 21. EXAMPLE – PART 1  Bank Ltd has $1,000m in assets (receivables on mortgages and other loans) and $920m in liabilities  Debt to asset ratio 92.0%  Sells $100m in assets to securitisation entity for $99m and uses proceeds to repay debt  Assets now $900m and liabilities $821m  Debt to asset ratio now 91.2% 21
  22. 22. EXAMPLE – PART 2  Bank Ltd sells guarantee to securitisation entity for $1m and uses proceeds to repay debt  Assets now $900m, liabilities $820m  Debt to asset ratio now 91.1%  Better debt to asset ratio means:  Lower marginal cost of debt – maybe  Less chance of breaching government regulations  Capital adequacy 22
  23. 23. BUT  Has the risk of Bank Ltd changed as a result of these transactions? 23
  24. 24. CONTRIBUTION TO GFC  First, the impacts:  On guarantors  On holders of bonds  Then, the contribution 24
  25. 25. GUARANTORS  The increase in default level on mortgages has required the guarantors to pay on the guarantee  Some of the largest guarantors were:  AIG  Lehmann Bros  Fannie Mae 25
  26. 26. HOLDERS OF BONDS  If the bonds were not guaranteed or if the guarantor is insolvent and  If there have been a large number of defaults on the mortgages in the portfolio  Then the holders of bonds will not be getting their principal and/or interest payments 26
  27. 27. TOXIC ASSETS  Bonds which are not paying interest and/or principal are one type of “toxic asset”  The secondary market for these bonds has disappeared so holders cannot sell or liquidate them 27
  28. 28. IMPACT ON REPORTS  Most bonds are required by IAS 39 (and equivalent SFAS and AASB) to be recorded at fair value  With changes in fair value recorded in the income statement 28
  29. 29. IMPACT ON CAPITAL ADEQUACY  If the holder of the bonds is a financial institution  The reductions in fair value of the bond assets can send its debt to asset ratio above 92%  In breach of capital adequacy requirements 29
  30. 30. IMPACT ON DEBT COVENANTS  Debt contracts often contain restrictions (covenants) based on leverage ratios  If the permitted leverage is exceeded then  Penalty interest rates apply and/or  The loan must be repaid immediately  Write-downs of bonds can place a company in breach of its debt covenants 30
  31. 31. CONTRIBUTION – SECURITISATION ACCOUNTING  Ability to use securitisation as an OBF vehicle may have led to excessive securitisation  Inadequate disclosure of exposure to risks from securitisation may have led to incorrect risk assessments by shareholders and creditors 31
  32. 32. CONTRIBUTION – WRITE-DOWN OF CMOS  Write-down of bonds may have put companies in breach of debt covenants and capital adequacy rules  Forced companies to repay debts or pay higher interest when they have insufficient cash  Insolvency or government bail-out 32
  33. 33. CONTRIBUTION – INDIRECT  One of the immediate impacts of the GFC was to make companies re-evaluate credit risk  also called counter-party risk  Fear and distrust of accounting reports may have caused adverse selection problem  led to collapse of inter-bank market which caused  massive contraction in money supply which caused  worst recession in 80 years 33
  34. 34. ISSUES FOR REGULATORS – SECURITISATION  How to report securitisation?  Options for regulators:  Require consolidation – but by whom?  Originator  Promoter  Guarantor  Require disclosure in notes  Net or gross?  No change 34
  35. 35. ISSUES FOR REGULATORS – REPORTING WRITE-DOWNS  When bonds’ values falls  Adjust to fair value and record loss in income statement  Adjust to fair value and record loss in reserves  Do nothing until realised 35
  36. 36. ISSUES FOR REGULATORS – MARKET COLLAPSE  The market for bonds has collapsed  No-one is buying  Cannot observe fair value  How should fair value be reported?  At $0  Based on DCF estimating default and risk-adjusted discount rate (mark to model)  At last observed market price 36

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