Securitization and Customer Equity

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Skiera, Bernd / Bermes, Manuel / Horn, Lutz (2011), "Customer Equity Sustainability Ratio: A New Metric for Assessing a Firm’s Future Orientation", Journal of Marketing, Vol. 75 (May), 118-131

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Securitization and Customer Equity

  1. 1. Customer Equity Sustainability Ratio: A New Metric for Assessing a Firm’s Future Orientation<br />Skiera, Bernd / Bermes, Manuel / Horn, Lutz (2011), "Customer Equity Sustainability Ratio: A New Metric for Assessing a Firm’s Future Orientation", Journal of Marketing, Vol. 75 (May), 118-131<br />
  2. 2. Paper in Journal of Marketing<br />2<br />Skiera, Bernd / Bermes, Manuel / Horn, Lutz (2011), "Customer Equity Sustainability Ratio: A New Metric for Assessing a Firm’s Future Orientation", Journal of Marketing, Vol. 75 (May), 118-131.<br />© 2011, American Marketing Association<br />
  3. 3. Aim and Contribution of Our Research<br />Customer equity should play a more prominent role in financial reporting<br />The aim and contribution of our research are to …<br /><ul><li>Outline the problems associated with a shift from long-term value creation to short-term profit realization
  4. 4. Emphasize the importance of reporting forward-looking metrics
  5. 5. Propose customer equity reporting (CER) and the customer equity sustainability ratio (CESR) as potential means to increase transparency in financial statements
  6. 6. Provide stakeholders with valuable information about the long-term value of a customer base
  7. 7. Argue that more forward-looking metrics might have diminished the devastating consequences of the current financial crisis</li></ul>3<br />
  8. 8. Securitization in Non-Financial Businesses (1/2)<br />Soccer club realizes earnings from ticket sales<br />soccer entertainment<br />earnings from ticket sales<br />$100,000,000<br />soccer club<br />soccer club fans<br /><ul><li>5 years considered; 20 games per year; 50,000 spectators per game; $20 per ticket
  9. 9. Total earnings of the soccer club from ticket sales: $100,000,000 ($20,000,000 each year)</li></ul>4<br />
  10. 10. Securitization in Non-Financial Businesses (2/2)<br />Soccer club transfers its future ticket sales to a bank<br />soccer entertainment<br />one-time earnings from securitization<br />$75,815,735<br />soccer club<br />earnings from ticket sales over next five years<br />soccer club fans<br />bank<br />$100,000,000<br /><ul><li>Discount rate: 10%
  11. 11. Discounted net present value of total earnings: $75,815,735</li></ul>5<br />
  12. 12. European Union’s Trouble with Greece <br />6<br />Banks went to Athens to pitch complex products to defer debt.<br />In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come.<br />Story, Landon, and Schwartz (2010), "Wall Street Helped to Mask Debt Fueling Europe’s Crisis", Wallstreet Journal, February 14<br />
  13. 13. Securitization in Financial and Non-Financial Industries<br />(e.g., Bermes 2011; Bessler 2007; Jobst 2002)<br />7<br />
  14. 14. Basic Idea of Securitization in Banking (1/2)<br />Traditional banking business is to borrow and lend money (buy and hold)<br />bank<br />loan granter<br />t0: loans<br />Non-securitization<br /><ul><li>Loans (mortgages, business financing, consumer loans etc.) are offered mainly to bank’s own customers
  15. 15. Amortization can be paid e.g. annually or at the end of the contract period (bullet loan) depending on the loan structure
  16. 16. Interest is paid by borrowers constantly (often monthly or annually) on loan volume outstanding
  17. 17. Banks earn money from the margin between the interest rate of the loan and the refinancing costs minus provisions for expected loan losses
  18. 18. Banks receive the interest margin constantly over the lifetime of the loan contract (for bullet loans)</li></ul>t1 to tn: interest<br />and amortization<br />loan borrowers<br />8<br />
  19. 19. Basic Idea of Securitization in Banking (2/2)<br />Traditional banking business is extended to securitization (originate and distribute)<br />SPV<br />investors<br />bank<br />loan granter<br />trustee<br />t0: price for<br />loan claims<br />t0: loans<br />t0: price for<br />securities<br />t0: loan claims<br />t0: loan claims<br />t0: securities<br />Securitization<br /><ul><li>Loans are sold to special purpose vehicles (SPV) and therewith handled outside the bank’s balance sheet
  20. 20. Loans are packed and structured into investment tranches with different underlying risk levels
  21. 21. Tranches are distributed to investors
  22. 22. A trustee collects interest and amortization cash flows from borrowers and redirects them to investors
  23. 23. Investors face the risk of loan defaults</li></ul>t1 to tn: interest<br />and amortization<br />t1 to tn: interest<br />and amortization<br />loan borrowers<br />9<br />
  24. 24. Underestimated Risk in Securitized Assets<br />“First round“ collateralized debt obligations (CDO)<br />Securitization<br />“Second round” collateralized debt obligations (CDO2)<br />Securitization<br />10<br />
  25. 25. Previous Research on Securitization in Finance<br />11<br />Credit and market risk<br />Liquidity risk and funding<br />Through securitization, ...<br /><ul><li>Banks can manage credit and market risks of the underlying loan portfolios</li></ul>E.g.:<br /><ul><li>Ambrose, Lacour-Little, and Sanders (2005)
  26. 26. Coval, Jurek, and Stafford (2009)
  27. 27. Franke and Krahnen (2008)
  28. 28. Lockwood, Rutherford, and Herrera (1996)
  29. 29. Luo, Tang, and Wang (2008)
  30. 30. Purnanandam (2009)</li></ul>Through securitization, ...<br /><ul><li>Banks can reach stronger liquidity positions
  31. 31. Banks can easier fulfill regulatory requirements such as Basel II/III</li></ul>E.g.:<br /><ul><li>Ambrose, Lacour-Little, and Sanders (2005)
  32. 32. Calem and LaCour-Little (2004)
  33. 33. Jones (2000)
  34. 34. Purnanandam (2009)
  35. 35. Twinn (1994)</li></li></ul><li>Banking Example: Assumptions and Calculation Basis<br /><ul><li>We distinguish between a non-securitizing and a securitizing bank
  36. 36. The banks each issue a five-year loan volume of $100,000 to customers at the beginning of each year
  37. 37. The annual net interest margin of the loans is 1% (5% interest rate; 3.5% refinancing expenses; 0.5% loan loss provisions)
  38. 38. No other deductions or costs occur
  39. 39. Discount rate is 10%
  40. 40. The non-securitizing bank gets the interest income at the end of each year
  41. 41. The securitizing bank sells the whole loan volume and the related annual interest income to new investors and receives the non-interest income at the end of each year
  42. 42. Customer equity is valued as of the end of each year
  43. 43. Equity is $30,000
  44. 44. We analyze two cases:
  45. 45. Distribution case: The banks pay out all of their earnings as dividends at the end of each year
  46. 46. Reinvestment case: The banks reinvest the earnings at a return rate of 10%</li></ul>12<br />
  47. 47. Banking Example: Non-Securitizing Bank<br />13<br />
  48. 48. 14<br />Banking Example: Securitizing Bank<br />
  49. 49. 15<br />Banking Example: Effects of Securitization on Earnings (Distribution Case)<br />
  50. 50. 16<br />Banking Example: Effects of Securitization on Return on Equity (Distribution Case)<br />
  51. 51. Customer Metrics to Increase Transparency in Financial Reports<br />CER and CESR provide comprehensive transparency information<br /><ul><li>CER provides stakeholders with valuable information about the long-term value of a bank’s current customer base (Wiesel, Skiera, and Villanueva 2008)
  52. 52. CER publishes detailed customer structures with related earnings and costs in absolute numbers
  53. 53. CER can issue a forward-looking statement</li></ul>Customer Equity Reporting(CER)<br />Newly developedCustomer EquitySustainability Ratio(CESR)<br /><ul><li>CESR compares the likely future earnings of the existing customers to current earnings
  54. 54. CESR identifies shifts in value realizations over time
  55. 55. CESR reports the sustainability of the bank’s earnings as a relative number in a simple and substantial way</li></ul>17<br />
  56. 56. Customer Equity Sustainability Ratio (CESR)<br />CESR is a new metric to quantify the intensity of long-term value creation<br /><ul><li>Defining CESRjas the metric of the PV of all future earnings to the corresponding customer lifetime value (CLV) of a customer and rearranging it leads to:</li></ul>(1)<br /><ul><li>CESR for all current customers is:</li></ul>(3)<br />(2)<br />18<br />
  57. 57. Relationship Between Customer Equity (CE) and Customer Equity Sustainability Ratio (CESR)<br />19<br />CE (high)<br />Short-TermProfit Realizationwith a StrongCustomer Base<br />Long-TermValue Creationwith a StrongCustomer Base<br />CESR (low)<br />CESR (high)<br />Short-TermProfit Realizationwith a WeakCustomer Base<br />Long-TermValue Creationwith a WeakCustomer Base<br />CE (low)<br />
  58. 58. 20<br />Banking Example Revisited: Effects of Securitization on CE (Distribution Case)<br />
  59. 59. 21<br />Banking Example Revisited: Effects of Securitization on CESR (Distribution Case)<br />
  60. 60. 22<br />Empirical Study About Transparency of Securitization in Banks’ Financial Reports (1/2)<br />
  61. 61. 23<br />Empirical Study About Transparency of Securitization in Banks’ Financial Reports (2/2)<br />
  62. 62. Empirical Study of Countrywide:General Information<br />Countrywide was the market leader in mortgage banking<br /><ul><li>Countrywide Financial Corporation (CFC) was the U.S. market leader in mortgage lending and origination between 2004 and 2007
  63. 63. Countrywide provides a detailed view of the shift from long-term value creation to short-term profit realization
  64. 64. Countrywide was heavily engaged in subprime mortgage-backed securities (MBS) transactions
  65. 65. Countrywide needed a rescue from Bank of America in February 2008
  66. 66. As a subsidiary of Bank of America, Countrywide no longer publishes its own financial statements, so our analysis comprises 1998-2007</li></ul>24<br />
  67. 67. 4<br />Empirical Study of Countrywide:Securitization of Mortgage Loans<br />Total Mortgage Loans Volume (in m USD)<br />468,172<br />499,301<br />123,969<br />68,923<br />415,634<br />66,740<br />92,881<br />363,364<br />434,864<br />251,901<br />4%<br />5%<br />96%<br />95%<br />90%<br />89%<br />86%<br />86%<br />82%<br />72%<br />65%<br />59%<br />2005<br />2001<br />2006<br />2000<br />1999<br />2007<br />1998<br />2004<br />2003<br />2002<br />% of Volume of Mortgage Loans Hold<br />% of Volume of Mortgage Loans Sold<br />25<br />
  68. 68. Empirical Study of Countrywide:Earnings Structure<br />26<br />
  69. 69. 27<br />Empirical Counterfactual Analysis of Countrywide: Total Earnings<br />
  70. 70. 28<br />Empirical Counterfactual Analysis of Countrywide: Difference in Total Earnings<br />
  71. 71. 29<br />Empirical Counterfactual Analysis of Countrywide: Customer Equity<br />
  72. 72. Empirical Counterfactual Analysis of Countrywide: CESR<br />0.673<br />Factor 3.2<br />0.210<br />30<br />
  73. 73. 31<br />Empirical Counterfactual Analysis of Countrywide: Factors in CESR<br />
  74. 74. 32<br />Securitization in Industries Outside Banking (1/2)<br />
  75. 75. 33<br />Securitization in Industries Outside Banking (2/2)<br />
  76. 76. Discussion and Conclusion<br />CER and CESR provide valuable information for the firm’s stakeholders<br /><ul><li>Customer equity reporting (CER) and the customer equity sustainability ratio (CESR) are feasible in a real-world setting
  77. 77. CER and CESR as forward-looking customer metrics provide stakeholders with transparency about the long-term value of a firm’s current customer base
  78. 78. CESR can better identify shifts in value realizations over time
  79. 79. CESR reports the sustainability of the firm’s earnings in a simple and substantial way
  80. 80. CER and CESR provide insights into how investors and firms can be supported to avoid some of the challenges of a future financial crisis</li></ul>34<br />
  81. 81. Customer Equity Sustainability Ratio: A New Metric for Assessing a Firm’s Future Orientation<br />Need more Information? Contact one of us!<br />35<br />

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