Preface
This purpose of this book is to provide a broad, comprehensive introduction to structured finance. It is intended for people generally knowledgeable in financial markets who want to learn the fundamentals of structured finance and also for experts in certain areas of structured finance who would like to broaden their knowledge in other areas. This preface briefly walks through an outline of the book and introduces the reader to some of its more important concepts and terms
Our introduction in Chapter 1 recognizes that structured finance is a broad field and that not everyone even agrees on how structured finance is defined and where the boundaries are. We summarize a survey of experts on the definition of structured finance and conclude that our definition should include not only securitization and most applications of credit derivatives, but also leasing, project finance, the use of complex derivatives, and most other unusual, complex financing transactions. We also summarize another survey of experts on how the Enron debacle tested the boundaries of structured finance.
Our definitional survey confirms that derivatives and securitization are the most fundamental building blocks of structured finance. We show numerous combinations of those building blocks as we explain the most important instruments of structured finance in Chapters 2 through 10, followed by a discussion of leasing and project finance in Chapters 11 through 13.
While an interest rate derivative contract does not in itself constitute structured finance, the use of derivatives is one of the features that distinguish large structured financings. Chapter 2 includes coverage of interest rate swaps, interest rate options, and their specialized variations, including caps, floors, and collars.
While interest rate and currency derivatives were the most important financial innovations of the 1980s, credit derivatives were among the most important in the 1990s. In Chapter 3, we explain the structure and the uses of the major types of credit derivatives, including documentation, key terms and a discussion of credit default swaps (single name, basket, and index credit default swaps), asset swaps, and total return swaps. The credit derivatives explained in this chapter are essential components of structured finance products described in later chapters of this book such as synthetic collateralized debt obligations, synthetic securitizations, and credit-linked notes.
Then we have two chapters on securitization, starting with the basic principles of securitization in Chapter 4. We cover the motivations for securitization from the issuer's perspective, the benefits of securitized debt instruments for investors, the basic mechanics of a securitization, the role of the special purpose vehicle, and how investors and rating agencies analyze asset-backed securities, including the way they measure and monitor the cash flows of the pool of assets that serves as collateral backing a securitization.
In Chapter 5, we show how interest rate derivatives are used in a securitization and we explain credit enhancement mechanisms. We discuss external credit enhancement mechanisms, such as letters of credit and bond insurance, and internal credit enhancement mechanisms, such as senior-subordinate structures, overcollateralization, and reserve funds.
The next two chapters are concerned with collateralized debt obligations (CDOs). We explain the basis structure of cash flow CDOs in Chapter 6, discussing how CDOs are categorized according to the motivations of their sponsors and how the quality of the collateral pool is monitored through compliance tests, including quality tests and coverage tests.
With a synthetic CDO, discussed in Chapter 7, the credit risk of a pool of assets is transferred from the sponsor or originator to investors by means of credit derivative instruments. We discuss the motivations for synthetic CDOs as well as the mechanics, investor risks, and variations such as arbitrage and balance sheet CDOs.
Then, in Chapter 8, we explain the various securitized and synthetic money market funding structures, including commercial paper and medium-term notes structured as synthetic securitizations. We show how total return swaps can be combined with commercial paper and medium-term note issuance vehicles in structures that are similar in purpose to repurchase agreements (repos).
Credit derivatives may be either funded or unfunded. With unfunded credit derivatives such as credit default swaps, the protection seller does not make an upfront payment to the protection buyer. Credit-linked notes (CLNs), described in Chapter 9, are funded credit derivatives. The investor is the credit protection seller, which makes an upfront payment to the protection buyer, the issuer of the note. There are numerous forms of CLNs, but in all of them there is a link between the return they pay and the credit performance of the underlying pool of assets.
In Chapter 10, we explain and show numerous examples of structured notes. Compared to traditional bonds with fixed principal amounts and due dates, and coupon interest rates that are either fixed or floating at a fixed spread to a reference rates, structured notes have one or more embedded options with much more complicated provisions for the interest rate payable, the redemption amount, or the timing of the principal repayment. For investors, structured notes may offer the opportunity to enhance yield or gain exposure to alternative asset classes. For the issuer, creating a customized product for the investor may be an opportunity to reduce funding cost.
Next we devote two chapters to leasing, starting with the fundamentals of large-ticket leasing in Chapter 11. We compare leasing with other methods of financing; show various types of tax-oriented and nontax-oriented leases; describe different types of lessors, lease programs, lease brokers, and financial advisors; explain synthetic leases; discuss accounting, tax, and financial reporting issues; and explain how leases are valued from the perspective of the lessee.
Leveraged leases, which allow lessees to harness lessors' capital and allow lessees to reduce their financing costs by passing depreciation tax benefits to lessors, are explained in Chapter 12. We show the parties to a leveraged lease, how the debt financing is arranged, various applications ranging from equipment to large industrial facilities, and the steps in structuring, negotiating, and closing a transaction.
In Chapter 13, we provide an introduction to project finance, in which lenders look to the cash flows of the project being financed rather than the credit of the project sponsors. As with securitization, project finance uses a special-purpose vehicle, but project finance involves cash flows from operating assets whereas securitization involves cash flows from financial assets such as loans or receivables. We explain the reasons for jointly owned or sponsored projects, the credit exposures for lenders during the course of project construction and operation, the key elements of a successful project financing, risks and causes for project failures with recent case examples, accounting and tax considerations, and recent trends.
And that's not all! We have lots more useful information in the appendices.
In recent years, the motivations for large banks to securitize have been driven partly by complex capital adequacy regulations. In Appendix A, we explain the Basel capital rules for banks, starting with the Basel I rules for core (Tier 1) and supplementary (Tier 2) capital and the requirement for banks to hold capital equal to 8% of risk-weighted assets. We proceed to explain the three pillars of Basel II: new capital requirements for credit risk and operational risk, a requirement for supervisors to take action when they see a bank's risk profile rise, and a requirement for banks to disclose more about their underlying risks. Basel II applies to all European financial institutions but only the largest banks in the United States. It is expected to give those large banks a competitive advantage by allowing them to categorize assets according to their own internal risk assessment systems and justify thinner capital charges than would be allowed under more standardized risk measurement systems. We explain the impact of the Basel rules on securitization and credit derivatives.
In Appendix B, we discuss synthetic mortgage-backed securitization, a way of removing the credit risk associated with a pool of mortgages by means of credit derivatives. The originator, typically a mortgage bank, is the credit protection buyer, which retains the ownership as well as the economic benefit of the assets. Synthetic mortgage-backed securitization follows similar principles, has similar funded and unfunded structures, and is done for similar reasons as synthetic CDOs, discussed in Chapter 7.
We follow with two articles from the Journal of Structured Finance (reprinted with the permission of Institution Investor) on unusually interesting applications of structured finance.
The article in Appendix C is the story of a structured financing for the recently opened Busch Stadium, home of the St. Louis Cardinals. The article describes how a special-purpose vehicle was formed to originate contracts giving rise to contractually obligated income (COI) pledged to support the ballpark financing in a way that isolated the COI receivables from the credit risk of the team. The authors also describe why this structure was chosen instead of a hybrid securitization/leveraged lease structure and complications that arise when different financing disciplines such as leasing, project finance, and securitization must be reconciled in one hybrid transaction.
The article in Appendix D reviews how future-flow securitizations have allowed public and private companies in below-investment-grade countries access to affordable international financing, how a municipal future-flow mechanism was developed in Mexico based on the principles of future-flow securitization, and the opportunities and problems in applying this mechanism in other developing countries. The Mexican municipal future-flow mechanism is based on the use of administrative trusts into which tax-sharing revenues are deposited directly by Federal authorities, and out of which debt service payments are made directly to bondholders.
The last six appendices to this book contain rating agency presales reports from Moody's Investors Service (Appendices E and F), Standard & Poor's Ratings Services (Appendices G and H), and FitchRatings (Appendices I and J) representing six different types of securitized debt issues. The analyses cover factors such as legal, transaction, and payment structure; collateral analysis; historical portfolio performance; cash flow modeling; and the agencies' overall evaluation of the transactions' credit strengths and weaknesses.
The cash flow stream for the Crown Castle Towers securitization in Appendix E comes from leases of site space on Crown Castle International Corporation's wireless communication towers to wireless service providers. Credit strengths cited by Moody's include the quality of the collateral, cross-collateralization of a large pool with diverse sites, and revenues from telephony tenants. The agency's concerns include lack of principal amortization during the term of the loan, the borrower's right to release collateral, and special arrangements with Verizon an AT&T-Cingular.
The MVL Film Finance revolving credit securitization facility, described in Appendix F, provides partial financing for Marvel Studios' production of 10 live-action and animated films. The special purpose vehicle issuing the securities owns film rights to the characters and the film library featuring the characters. Cash flow for debt service is provided by film revenues net of participations, residuals, and print, advertising and distribution expenses.
In the case of the Honda Auto Receivables retail auto loan securitization described in Appendix G, credit enhancement takes the form of subordinated certificates, a reserve fund, excess spread, and a yield-supplement account. The analysis describes the payment distribution schedule in order of priority, Honda's performance as originator and servicer of the receivables, the portfolio's loss performance, its delinquencies and repossessions, and characteristics of the collateral pool such as the auto loans' weighted term to maturity, their weighted-average annual payment rate (APR), and the average FICO score of the borrowers.
ACG Trust III, covered in Appendix H, is a securitized portfolio of aircraft operating leases and residual cash flows. A financial guarantee policy provides for an AAA rating on the most senior tranche. Standard & Poor's rating is based the credit quality of the aircraft lessees, collateral pool characteristics such as ages and models of the aircraft, the legal and cash flow structure of the transaction, the cash flow modeling of stress tests, the experience of the servicer, and the role of the aircraft remarketing agent.
In the CNH Equipment Trust, notes are backed by retail installment contracts on new and used agricultural and construction equipment. Fitch's rating, as described in Appendix I, is based on the geographic diversity of obligors; loan attributes such as seasoning, contract balance, and APR; historic portfolio performance; the possibility that a weak economic environment could accelerate near-term repossessions and losses; the role of the master servicer and a named back-up servicer; integrity of the transaction's legal structure; cash flow stress tests; other structural considerations such as a prefunding account, interest and principal allocation, the payment waterfall, and events of default; and an operations review covering origination, underwriting, collections, and servicing.
Finally, in the CIT equipment collateral securitization described in Appendix J, notes are backed by equipment lease contracts on new and used technology and other small-ticket equipment. Credit strengths cited by Fitch include the financial strength of the seller/servicer, the quality of the collateral, and the geographic diversity of the lessees. The agency's concerns include vendor and equipment concentration.
Frank J. Fabozzi
Henry A. Davis
Moorad Choudhry