Securitization Manual: Structure, Analysis, and

Implementation*
By
Ghassem A. Homaifar
Professor of Financial Economics
Middle Tennessee State University, Murfreesoro T! "#$"% USA
2009
* & 'ould li(e to than( Mostafa Beheshtirouy )e*uty Mana+in+ )irector of the Parsian
Ban( for his insi+ht on various issues relevant to this *ro,ect that sustantially im*roved
my understandin+ of the microeconomics of the securiti-ation *rocess in &ran. The author
also e.*resses +ratitude to /euen 0yle, 1im Feller, Ste*hanie 2ri+ht, 3arol 2hite,
Fran( Michello, Bicha(a Fayissa and Mahmod Haddad for readin+ and su++estin+
revisions that im*roved the clarity of my *resentations. My research assistants Andre'
3oleman, Adam )utton, 1oey Scavone, 3hristo*her 2hitely, 1onathan Adon+o and Gao
Guan+'ei *rovided valuale in*uts in editorial assistance and com*letion of this *ro,ect.
As al'ays the author remains solely res*onsile for any remainin+ errors.
I: Introduction 1
II: Major Players 2
II.1 atin! A!ency"s #unction in a $ypical Securitization %
III: &redit 'n(ancement %
III.1: ')ternal &redit 'n(ancements *
III.2: Internal &redit 'n(ancements +
III.2.1. ,-ercollateralization +
III.2.2. Senior.Su/ordinated Structure 9
III.2.0. eser-e #unds 10
I1: 2ynamics o3 4nder5ritin! Process 11
1: In-estors 12
1I.1. e6uirements 3or Success3ul Securitization 17
1I.2. Secondary Mar8et Pro-ider 19
1I.0. :ene3its o3 Securitization 1%
1I.7. &ost o3 Securitization 1*
1I.7.1. #i)ed and 1aria/le &osts o3 Securitization 19

1II. ;ome o5ners(ip 3acts 20
1III. #inancial 'n!ineerin! Process 21
1III.1. Is t(e 3irm 3acin! (i!(er 3undin! cost4 22
1III.2. &(aracteristics o3 Assets to :e Securitized 20
1III.0. Structure o3 t(e Assets &reated in a Securitization 29
1. esidential Mort!a!e :ac8ed Securities M:S 29
2. &ommercial Mort!a!e :ac8ed Securities &M:S 2*
0. Pass<t(rou!( &erti3icates P& 00
7. &M,s 00
1I1. e!ulatory &apital e6uirements 07
1I1.1 =e!al and Structural Issues 0%
1I1.2: Sale Accountin! 09
1I1.05 Sales o3 =oans 09
1I1.7: Assi!nment 71
1I1.9: Participation 71
>: =e!al #rame5or8 70
>I: Macro 'conomics o3 Securitization 77
>II: Implications 91
>II.1: &onstruction o3 Mont(ly &as( #lo5 3or Pass<t(rou!( Securities 91
>II.2: Multi &lass Se6uential<Pay Pass<t(rou!( 99
>III.1: In-erse #loater 9*
>III.2: Accrual :onds %0
>I1: &ross :order Securitization %1
>I1.1: ?apanese Securitization o3 @P=s %2
>1: #uture #lo5 Securitization %%
>1.1: &(aracteristics o3 #uture #lo5 Securitization %*
>1.2: Miti!atin! is8 in #uture #lo5 Securitization $ransactions *0
>1.2.1: Per3ormance ris8 *9
>1.2.2: Product ris8 *%
ii
>1.2.0: So-erei!n ris8 *%
>1.2.7: 2i-ersion ris8 *%
>1I: ')ternal #actors *%
>1I.1: #rozen :an8 Accounts *%
>1I.2: =i6uidity &risis **
>1I.0: ;i!( In3lation **
>1I.7: =ost Purc(asin! Po5er **
>1I.9: S(arp &urrency 2epreciation *+
>1I.%: =oan Per3ormance 2eterioration *+
>1II: Ad-anta!es o3 #uture #lo5</ac8ed Securitization *+
>1III: &apital &(ar!es 3or Securitized 2e/ts
>1I1: Potential 3or #uture #lo5 ecei-a/le Securitization in Islamic epu/lic o3
Iran +7
>>: Synt(etic Securitization +%
>>.1. &redit<=in8ed @otes +*
>>.2. Synt(etic &ollateralized =oan ,/li!ations +*
>>.0. ,/jecti-es o3 Structurin! &=, +9
>>.7: Synt(etic &=, 90
>>.9: Synt(etic Ar/itra!e &=, 91
>>.%: Synt(etic :alance S(eet &=, 90
>>.*: &apital Ade6uacy e6uirements 97

>>.+: &redit ')posure Met(od 67
>>.9: $otal eturn S5aps 9*
>>.10: Moti-ations o3 t(e ecei-er o3 $S 9+
>>.11: =e-era!e Impact o3 &apital Structure on :an8 :alance S(eet 100
e3erences 102
Appendi) 1 100
Appendi) 2 110
iii
Fore'ord
8ver the *ast %9 years the 'orld has e.*erienced remar(ale chan+es in its economic
affairs. Perha*s most im*ortant amon+ those chan+es are a reduction in the role of
+overnment as a re+ulator of *rivate usiness, dramatically seen in the demise of
communism, the retrenchment of socialist economies, and the ra*id e.*ansion of
economic interde*endence across the 'orld. 8ne *roduct of oth of those chan+es is an
e.*losion of innovation in financial services. Financial innovation has ta(en many forms
from the +ro'th of hu+e multinational financial service *roviders to the develo*ment of a
myriad of ne' financial *roducts and services. Those ne' financial *roducts include
asset:ac(ed securities, the su,ect of this manual.
)r. Homaifar has *rovided the reader 'ith a com*lete discussion of the *rocess y 'hich
illi;uid financial assets are transformed into mar(etale securities. An e.am*le of this
*rocess may e a security ased on residential mort+a+es. An individual *urchases a
house 'ith a loan secured y the house and *ro*erty and a+rees to re*ay the loan on a
re+ular re*ayment schedule. The mort+a+e is a valuale financial asset in the form of that
e.*ected future stream of *ayments. &t is, ho'ever, not readily mar(etale and,
individually, su,ect to ris( from several sources. Securiti-ation is the *rocess y 'hich a
*ortfolio of such mort+a+es is or+ani-ed to create a security that is oth mar(etale and
less ris(y than the ori+inal mort+a+es. As a result, securiti-ation enefits society y
lo'erin+ costs to oth orro'ers and lenders.
The manual e+ins 'ith an e.amination of the foundations of this *rocess of
securiti-ation from definitions and e.am*les of ty*es of assets that may form the asis for
the securities. The introduction outlines the *rocess, identifies the *artici*ants in creation
of the security, and discusses the enefits and cost of securiti-ation. !e.t the manual
thorou+hly e.amines the ste*s of creatin+ a securiti-ed asset. &t concludes 'ith the
descri*tion of im*ortant e.am*les of securiti-ed assets.
This manual re*resents the *roduct of a +reat deal of meticulous research of a
hi+hly so*histicated financial tool. &n rin+in+ this research to+ether )r. Homaifar has
made the to*ic accessile to *ractitioners, academic *rofessionals, and students. &t is a
most im*ressive *iece of scholarly 'or(., ,ust another e.am*le of )r. Homaifar<s
e.em*lary scholarshi* as a researcher and teacher.
/euen 0yle
Professor, Economics and Finance )e*artment
Middle Tennessee State University
iv
I. Introduction
Securitization, a *rocess y 'hich illi;uid financial assets are transformed into tradale
commodities, is one of the most si+nificant innovations of the $6#=s. Havin+ ori+inated
in $6#= in mort+a+e mar(ets in the USA, securiti-ation has already converted over >6=
trillion 'orth of non:tradale assets into mar(etale securities. As a *o'erful tool of
li;uidity and ris( mana+ement securiti-ation has had a tremendous im*act on the 'elfare
of the 'orld economy. &n mort+a+e mar(ets in many countries it *rovides a chea*er
source of financin+, and thus *romotes the demand for housin+. &n the an(in+ sector,
securiti-ation is 'idely used for allocatin+ ca*ital more efficiently, transformin+ ris( into
a tradale security, and reducin+ the overall cost of ca*ital. &t has enaled develo*in+
countries to finance infrastructure *ro,ects at lo'er costs, and has allo'ed emer+in+
mar(et institutions to raise their soverei+n ratin+s ceilin+s and therey ta* international
ca*ital mar(ets for lo'er:rate financin+.
Securiti-ation, also (no'n as asset:ac(ed securiti-ation or structured financin+, has
een defined as a financin+ instrument 'herey a com*any transfers ri+hts in current or
future receivales or other financial assets to an entity that serves as a ?s*ecial *ur*ose
vehicle@ ASPBC, 'hich in turn issues securities to ca*ital mar(et investors and uses the
*roceeds from the issue to *ay for the financial assets. The source of the receivales
could e any ri+ht of *ayment or asset that +enerates an income 'ith a stale cash flo'.
The e.istin+ or future receivales could e the income +enerated, amon+ others thin+s y
residential or commercial mort+a+es, credit card receivales, automoile loans, student
loans, airline tic(et *ayments, health care receivales, insurance fee receivales, royalties
on intellectual *ro*erty, sales of oil, ta. receivales or any other income source that is
re+ular and *redictale.
Former chairman of 3iticor*, 1ohn /eed, defines securiti-ation as ?D the sustitution
of more efficient *ulic ca*ital mar(ets for less: efficient, hi+her cost, financial
intermediaries in the fundin+ of det instruments.@
$
As lon+ as re+ulatory constraints
*revent entry into the loan ori+ination usiness, an(s and thrift institutions 'ill not e
under *ressure to com*ete and offer com*etitive rates in their lendin+ to orro'ers.
Ban(s and other de*ository institutions in the United States, havin+ een insulated from
*rice com*etition throu+h re+ulations in the cartel era of $6"" throu+h $6E=
%
, o*erated
'ith oth hi+h costs of fundin+ and hi+h ori+ination costs 'ith re+ard to det
instruments. 8nce com*etition 'as *ermitted in the ori+ination of loans as a result of
dere+ulation and the resultin+ favorale re+ulatory environment of the mid:$6E=s, ne'
*layers such as third:*arty credit enhancers, ratin+s a+encies, investment an(ers,
under'riters, li;uidity enhancers Asecondary mar(et *layersC, *rivate conduits, and trusts
entered the mar(et, and securiti-ation *aved the 'ay for disintermediation of the various
functions in a hi+hly efficient manner. The outcome 'as increased com*etition,
innovative ne' instruments 'ith +reater a**eal to roader classes of investors, and
reduced fundin+ costs. These tri++ered *ositive e.ternalities to individual orro'ers in
*articular, and the overall economy in +eneral.
Securiti-ation can also e considered a form of aritra+e et'een a less:efficient
traditional det mar(et and a more:efficient ca*ital mar(et 'here old securities are
dressed u* as ne' asset:ac(ed securities y financial firms for *rofit. Therefore, the
$
See 0endall and Fishman, ?A *rimer on Securiti-ation,@ The M&T Press %===.
%
&id.
$
slicin+ and dicin+ of cash flo's and credit ris(s of the underlyin+ *ools of assets into
securiti-ed *roducts 'ith varyin+ ris(Freturn *rofiles and maturity s*ectra, and the
s*readin+ of ris( amon+ 'ider classes, serves the interest of consumers, orro'ers, and
the nation at lar+e.
)ata from A3all /e*ortC y the Federal Financial &nstitution E.amination 3ouncil reveals
that on avera+e, commercial an(s 'ith total assets +reater than >%.9 illion securiti-e %=
*ercent of their assets ;uarterly AMar(ose G )on+, %==9C. Securiti-ation of mort+a+es
inte+rates real estate finance 'ith the overall ca*ital mar(et, lo'ers the mort+a+e interest
rate, and eliminates the re+ional variations in mort+a+e interest rates 1affee and /enaud
A$669C, 1affee and /osen A$66=C and 8lson A$66=C.
8n the other hand, 1affee and /osen A$66=C sho' that risin+ mort+a+e foreclosure
rates, increases in ad,ustale:rate mort+a+e AA/MC securities, and a *otentially decreased
role for federali-ation in mort+a+e mar(ets e.ert a ne+ative influence on mort+a+e
securiti-ation.
3alomiris and Mason A%=="C investi+ate the de+ree to 'hich securiti-ation *ermits
an(s to otain +reater return on ca*ital y avoidin+ re+ulatory ca*ital re;uirements,
thou+h they focus on securiti-ation of credit card receivales rather than home loans.
3alomiris and Mason *oint out that the enefits of securiti-ation stem from three sources.
First, less ca*ital is re;uired to e held in su**ort of the securiti-ed loans. Second,
securiti-ation reduces other re+ulatory costs associated 'ith on:alance:sheet assets.
Third, the value of the e;uity in the an(s is increased +iven that the de*osit insurance
*remia remains the same.
Elul A%==9C summari-es the main le+al factors and +overnment re+ulations that act as
drivers of asset securiti-ation. He *oints out that securiti-ation is driven y the an(<s
desire to reduce indirect an(ru*tcy costs. S*ecifically, the an( is aimin+ to alleviate the
difficulties in raisin+ funds. &f the an( retains the mort+a+es, investors have to share the
ris(s incurred y the mort+a+e. As a result, investors 'ill offer a relatively lo' *rice for
these securities. Hoan salesI ho'ever, se*arate the underlyin+ assets from the an( so that
creditors do not have any claim on these assets. Therefore, investors 'ould e 'illin+ to
*ay a hi+h *rice for the securities. 3onse;uently, the an(<s indirect costs of raisin+ funds
are reduced. Elul also mentions that *ension fund re+ulations 'hich restrict funds<
holdin+s of lo':rated securities e.*lain the +ro'th of securiti-ation.
Houts(ina A%==9C studies the effect of securiti-ation on an( lendin+. She su++ests that
securiti-ation increases an(s< lendin+ and alleviates the effect of restrictions in
availaility of funds on an(s loan su**ly. &n *articular, securiti-ation 'ea(ens the lin(
from monetary *olicy to an( lendin+ activity.
!umerous *revious literature, for e.am*le, 0lein A$6#%C, 8<hara A$6E"C, and Mar(ose
and )on+ A%==9C, assume that an(s are o*erated to ma.imi-e *rofit or the return on
e;uity A/8EC. 8<hara A$6E"C also considers the a+ency *rolem and assumes that an(
mana+ers ma.imi-e their utility su,ect to the constraints im*osed y oth the re+ulators
and the shareholders. Mar(ose and )on+ A%==9C e.*lore an(<s *rofit:ma.imi-in+
o*eration y securiti-ation 'ith the constraints of insolvency ris( and interest rate ris(.
The multi:*eriod theoretical model sho's that securiti-ation *rovides incentives for asset
accumulation. &n addition, Mar(ose and )on+ A%==9C find that an(s tend to securiti-e
more assets if credit ris(, li;uidity ris(, and ca*ital ade;uacy re;uirement are e.*ected to
increase. 2ith a +iven ris( level, securiti-ation ma(es the an( more solvent and
%
increases its /8E. 3ost of securiti-ation, ho'ever, is ne+atively related to the *ortion of
securiti-ed assets, 'hich clearly ma(es sense. Another interestin+ findin+ of Mar(ose and
)on+ is that, they find that an(s 'ith middle ran(in+s of asset value securiti-e more of
their assets Aincludin+ mort+a+e loans and other ty*es of assetsC. At the same time, those
an(s have hi+her /8E.
/ecent events hi+hli+hted y the su:*rime mort+a+e mess in the financial mar(ets have
cast considerale douts on the aility of the financial mar(ets to 'eather a financial storm
induced y the action of ma,or *layers, i.e., an(s, hed+e funds, investment an(ers,
under'riters, ratin+ a+encies in *articular, and re+ulators at lar+e. As a result systematic ris(
has risen to a *oint that threatens the 'ell ein+ of the economy.
8ver the course of the last three decades, 'e have 'itnessed ma,or restructurin+ in the
'orld economy e.+. floatin+ rate arran+ements in $6#", increased inte+ration of financial
mar(ets around the 'orld, +reater coo*eration of economic units, lierali-ation of trade
*olicies, friendly or la. re+ulatory environments, and a mushroomin+ innovative
financial *roducts that increased levera+e and encoura+ed e.cessive ris( ta(in+ raisin+
e.*osure for the ma,or *layers such as an(s, insurers, investments an(s, and hed+e
funds. 8ver the course of the last $= years macro ris( has continued to rise as reflected in
the *henomenal +ro'th of hi+hly levera+ed transactions AHHTsC in derivatives 'ith
notional *rinci*al of over >7== trillion, accordin+ to the &nternational S'a*s and
)erivatives Association A&S)AC survey of %==E. The increase in mar(et AsystematicC ris(
to socially unacce*tale level needed only a tri++er event to send shoc( 'aves around the
+loe. This tri++er 'as the >$ trillion su:*rime mort+a+e ori+inated in the real estate
oom of early %=== at teaser rate Ainitial lo' interest rateC and 'as ste**ed u* in %==#.
The resultin+ hi+her mort+a+e *ayments induced mountin+ foreclosures, 'hich had a
sno'all effect leadin+ to the colla*se of real estate mar(ets and mar(ets for e;uities and
det.
Securiti-ation of the su:*rime mort+a+e into mar(etale securities of investment
+rade com*lement of ratin+ a+encies asence of fiduciary res*onsiilities to investors in
+eneral and society at lar+e *roved to e a catalyst for creatin+ credit tsunami in the
financial mar(et. The action of ma,or *layers in the securiti-ation *rocess namely the
+reedy mort+a+e an(ers, investment an(ers, and ratin+ a+encies led to severe loss of
confidence and melt do'n of e;uity and real estate *rices in the +loal 'orld. By and
lar+e ratin+ a+encies ear most of the res*onsiilities as an inde*endent and ultimate
a**raiser of the underlyin+ collateral that *roved to e almost 'orthless. For their share
in this mess investors +ave vote of no confidence of tri*le F to ratin+ a+encies.
The increased innovations in derivative *roducts has *roven to e a t'o ed+e s'ordI
raisin+ efficiency of financial intermediation and increasin+ levera+e cou*led 'ith little
re+ulatory oversi+ht, 'hich has een very costly for the ma,or *layers in +eneral and the
US and 'orld economy in *articular. For e.am*le, some of the innovations such as
default insurance Acredit default s'a*C initially hailed as one of the most im*ortant
vehicles for transferrin+ counter*arty credit ris(, is at the heart of the ma,or colla*se or
near colla*se for such 2all street +iants as A&G, Hehman Brothers, and Bear Sterns.
Aas(in!ton Mutual A2AMUC filed for 3ha*ter $$ an(ru*tcy *rotection on Se*temer
%7, %==E one day after re+ulators sei-ed its assets and sold it to 1PMor+an 3hase in the
lar+est an( failure in the United States. The 8ffice of Thrift Su*ervision A8TSC sold
2AMU<s assets to 1PMor+an 3hase for >$.6n AJ$nC after >$7.#n of de*osits had een
"
'ithdra'n in $= days. 2AMU 'as hit y mort+a+e defaults due to its si+nificant
e.*osure to su:*rime and other ris(y mort+a+es as 'ell as the colla*se of the US
housin+ mar(et. The an( had a**ro.imately >"=#n of assets ut only aout >$EEn of
de*osits, 'hich meant it, had to raise funds on money mar(ets, 'hich had ecome
increasin+ly e.*ensive.
=e(man :rot(ers" holdin+ com*any filed for 3ha*ter $$ an(ru*tcy *rotection on
Se*temer $K, %==E, ut none of the U.S. susidiaries such as its ro(era+e:dealer
susidiaries, asset mana+ement unit, and investment mana+ement division are su**osed
to continue o*eratin+ as normal. &ndividual investors 'ho have accounts 'ith Hehman<s
ro(er:dealer susidiaries are su**osed to e *rotected, as their assets are not availale to
Hehman<s creditors, and their accounts are further *rotected y the Federal Securities
&nvestor Protection 3or*oration.
An ordinary an(ru*tcy *etitioner such as an airline or a manufacturin+ com*any, +ets
immediate *rotection from its creditors 'hich *revents those creditors from +oin+
for'ard 'ith la'suits and sei-in+ the detor<s assets. /uns on an(s are *revented, and
mana+ement +ets time to or+ani-e its affairs in a 'ay that 'ill, theoretically, ma.imi-e
value for all creditors, and maye even allo' the com*any to re:emer+e in sound health.
Ho'ever, 'ith a financial institution the automatic stay offers no *rotection a+ainst many
of its most im*ortant creditors. &n a trend that e+an in $6#E and 'as +reatly e.*anded in
%==9, most financial contracts L includin+ securities contracts, s'a*s, re*urchase
a+reements, commodities contracts, and for'ard trades L are unaffected y automatic
stays. As Hehman<s *arent cor*oration filed for an(ru*tcy *rotection , the counter*arty
L an(s or other institutions that entered into a securities contract 'ith Hehman L are
allo'ed to cancel the contract and sei-e 'hatever collateral may cover it. The
counter*arties are *rovided the o**ortunity to free themselves immediately from
Hehman<s troules rather than +ettin+ mired in a an(ru*tcy *roceedin+. This is intended
to reduce s*illover effect of an investment an( or commercial an( failure to the rest of
the economy. &n the $66=s the Federal /eserve Ban( of !e' Mor( decided to *lace Hon+
Term 3a*ital Mana+ement AHT3MC 'ith an(s and other institutions 'ith 'hich it had
*rime ro(era+e relationshi*s instead of lettin+ it to colla*se.
I. Major Players
The *rocess of transformin+ relatively homo+enous illi;uid assets Areceivales5 current
or futureC off:alance sheet, throu+h assi+nment or ?true sale@, into hetero+eneous asset:
ac(ed mar(etale securities for sale to third *arty investors is (no'n as securitization.
The asic *rocess of creatin+ asset ac(ed securities involves ma,or *layers to *erform
the follo'in+ functions5
Hoan 8ri+inator AS*onsorC
Third Party Guarantor A3redit enhancerC
/atin+ A+ency
S*ecial Pur*ose Behicle ASPBC
Arran+er Aunder'riterC
Hi;uidity Enhancer Asecondary mar(et *roviderC
S'a* 3ounter*arty
K
&nvestors
The loan ori+inator ma(es the loan, or s*onsors loans ori+inated y others, y *oolin+
them into a *ortfolio. The ori+inator may continue to service the loans y collectin+
*ayments from the ori+inal orro'ers to *ass throu+h to the ultimate investors in the
asset:ac(ed securities collaterali-ed y the *ool of loans. The *rocess of creatin+ asset:
ac(ed securities is sho'n in fi+ure $.$.
The assets removed are le+ally se*arated Aasset isolationC from the o'nershi* of the *arty
'ho is ori+inatin+ As*onsorin+C the asset securiti-ation. Securiti-ation involves a transfer
Aassi+nmentFsaleC from the ori+inator to investors. Therefore, an intermediary (no'n as a
S*ecial Pur*ose Behicle ASPBC, is re;uired to act as an inde*endent entity on ehalf of
investors.
The SPB can e a trust, a limited *artnershi*, or a s*ecial *ur*ose enter*rise. All ty*es
of SPBs encoura+e and facilitate roader *artici*ation y non:ori+inatin+ entities or
investors that may include an(s, *ension funds, insurance com*anies, or other
institutional investors. The SPBs are usually incor*orated in lo':ta. or ta.:free areas and
are li(ely to e dissolved as the underlyin+ assets e.*ire.
The methods em*loyed to transfer and ta(e assets off:alance sheet involve direct sales
usin+ SPBs or other conduits. There are three ty*es of conduits5 sin+le:seller SPB, multi:
seller conduits, and securities aritra+e vehicles. The sin+le:seller SPB *urchases assets
from a sin+le ori+inator. Ban(s ori+inatin+ lar+e uniform assets Amort+a+e detsC usually
use these instruments. Multi:seller conduits are le+al entities administered and serviced
y the an(s to *rovide funds either throu+h direct loans or asset *urchase a+reements
under 'hich the SPB *urchases trade receivales. The ori+inatin+ an( normally
*rovides direct credit enhancements and *rovision of li;uidity facility to the conduit.
Securities aritra+e vehicles are or+ani-ed to uy rated securities that are funded throu+h
9
the structure of the *ro+ram, rather than y the underlyin+ assets. That is, the conduit
must e structured so as to ensure a steady inflo' of ne' assets or oli+ations. The assets
Acurrent or future receivalesC are transferred from an ori+inatin+ As*onsorC alance sheet
to the alance sheet of an SPB as sho'n in fi+ure $.%.
#i!ure 1.2: $ypical Securitization
8nce the receivale is sold to the SPB it +enerates immediate cash for the ori+inator,
therey roadenin+ the com*any<s fundin+ sources. The cost of fundin+ is lo'er and
there is also access to lon+er:term fundsI further, the access to funds is easier and faster
once the securiti-ation vehicle is in *lace. &n a ty*ical structure the SPB issues, for
e.am*le, three tranches of rated securities, credit:enhanced y a third *arty +uarantor,
'ith relatively homo+enous ris( return characteristics.
The first tranche investors are 'illin+ to sacrifice yield for the enefits of reduced ris(
'hich is usually rated AAA or AA y four ratin+ a+encies. The Me--anine tranche, the
medium ris( class is suordinate to the first tranche, and only asors loss in the
de*letion of the first loss. The third tranche is suordinate to the *revious tranches, as the
SPB usually ta(es a 9 *ercent first loss in ali+nin+ its interest 'ith that of the creditors of
other tranches, as demonstrated in fi+ure $.%.
Receivables:
Current or
Future
Issues Asset
Backed
Securities
ABS
Receivables:
Current or
Future
Originator Balance Sheet
Tranche $5 Ho'est /is(, rated AAA or AA
Tranche %5 Me--anine Medium /is(
Tranche "5 Hi+h:/is( SPB Ta(es 9N First
Hoss

.
Special Purpose Vehicle Balance Sheet
7
The ratin+s a+encies< ma,or role in the securiti-ation *rocess is to hel* investors to ma(e
informed decisions re+ardin+ investment in the underlyin+ securities. As +uardians of the
*ulic throu+h their research, analysis, and +radin+ of various ris(s, ratin+ a+encies are
e.*ected to *rotect investors a+ainst ta(in+ e.cessive credit ris(. The ratin+s a+encies
rate asset:ac(ed securities not +uaranteed y the U.S. +overnment or any of its
s*onsored a+encies such as Fannie Mae and Freddie Mac. The ratin+s allo' institutions
such as insurance com*anies and *ension funds, 'ho are *rohiited to invest in securities
rated elo' investment +rade y their res*ective re+ulators, to actively *artici*ate in the
securiti-ed mar(et as investors. &nvestment +rade ratin+ conveys information to the
investors that the underlyin+ instrument 'ill *ay cou*on interest and *rinci*al accordin+
to the terms of the indenture. An e.am*le of the summary of cor*orate ond ratin+s
systems and symols 'ith rief descri*tion is *resented in Tale $.$.
$a/le 1.15 &orporate :ond atin!s
Summary of Corporate Bond Ratings Systems and Symbols
Moodys S&P Fitch Brief Definition
Investment Grade: High Credit Quality
Aaa AAA AAA Gilt edge, prime, timely
payment of interest
ma!imum safety
Aa" AA# AA#
Aa$ AA AA %ery high grade, high
&uality
Aa' AA( AA(
A" A# A#
A$ A A )pper medium grade
A' A( A(
Baa" BBB# BBB#
Baa$ BBB BBB *o+er medium grade
Baa' BBB( BBB(
,istin-tly Spe-ulative: *o+ Credit+orthiness
Ba" BB# BB#
Ba$ BB BB *o+ grade, spe-ulative
Ba' BB( BB(
B" B# B#
B$ B B Highly spe-ulative
B' B( B(
.redominantly Spe-ulative: Substantial Ris/ or in ,efault
CCC#
Caa CCC CCC Substantial ris/, in poor
standing
CCC(
Ca CC CC 0ay be in default,
#
e!tremely spe-ulative
C C C 1ven more spe-ulative
than those above
CI CI2 In-ome bonds3 no
interest is being paid
,,, ,efault
,,
, ,
/atin+ a+encies *lay a *ivotal role in the securiti-ation *rocess as the ultimate a**raiser
of the underlyin+ *ool of collateral. &n their *rocess of a**raisin+ and evaluatin+ the
li(elihood of default y su,ectin+ the cash flo's of the *ool of underlyin+ assets to
stress tests under severe mar(et conditions, various ris(s are *riced to determine the fair
mar(et value of the ne' securities. &nvestors< acce*tance of the ratin+s as a 'ell: defined
standard, as 'ell as the a**ro*riateness of the amount of credit enhancement, are
*aramount for a successful securiti-ation *rocess for ABS, as they need not *erform
individual a**raisals for the ne' instruments that could e *rohiitively costly. Assumin+
credit ris( analysis is underta(en for a rated security, the decision to invest turns into
consideration of mar(et or interest rate ris(, and analysis of duration and conve.ity of the
underlyin+ instrument.

&ssuers see( ratin+s to im*rove the li;uidity and mar(etaility of their issue, and to
ca*ture the interest rate savin+s associated 'ith a hi+her ratin+I 'ithout a ratin+, the
issuer mi+ht not secure credit, or mi+ht secure it only at a sustantially hi+her cost.
Furthermore, state and federal la's e.*licitly incor*orate ratin+s in investment decisions
of financial institutions. For e.am*le, under the &nvestment 3om*any Act, money mar(et
funds can not hold more than 9 *ercent of their assets in securities that are rated lo'er
than the to* tier ratin+ of the t'o ratin+s a+encies.
II.1 atin! A!ency"s #unction in a $ypical Securitization5
Analy-es individual assets in the *ool, com*ares them to the historical
*erformance of assets in its data an(, and su,ects the *ool to stress tests ased
on severe mar(et conditions.
Hoo(s at the seasonin+ of the *ool, as mort+a+es are more li(ely to default in the
first four years.
Evaluates +eo+ra*hic diversification of the loans.
Pro,ects the amount of credit enhancement needed ased on the 'orst:case
scenario.
Secures le+al certification that assets transferred to the SPB are ?true sale@, and
thus le+ally isolated from the reach of ori+inator.
/atin+s a+encies and investors *refer a diversified *ool of mort+a+es s*read across
the nation as o**osed to one concentrated in a *articular re+ion, as re+ional recessions
E
may ,eo*ardi-e the *erformance of the *ool. Furthermore, a lar+er *ool *rovides enefits
to oth investors and the conduits, as the fi.ed cost of securiti-ation is s*read over a
lar+er amount, thus *rovidin+ economies of scale. The ;uality of the *ool of the loans and
+eo+ra*hic dis*ersion determines the ;uality of the underlyin+ securities credit:enhanced
y a third *arty. Private mort+a+e conduits are financial entities usually affiliated 'ith
ma,or an(s, insurance, and or manufacturin+ com*anies that uy residential or
commercial loans and *ool them into a *ortfolio from 'hich asset ac(ed securities are
issued to investors in the ca*ital mar(et. The *rivate conduits com*ete 'ith +overnment:
s*onsored enter*rises AGSEsC such as Ginnie Mae, Fannie Mae, and Freddie Mac, in
reducin+ the overall cost of fundin+ for an avera+e home uyer in the United States. The
to* three *rivate conduits are Prudential, GMA3, and GE 3a*ital: all three, 'hich are
susidiaries of Prudential &nsurance, General Motors and General Electric res*ectively,
accounted for over K6 *ercent of all *rivate conduit securiti-ation in the United States.
"

Securiti-ation ta(es *lace in a ne+otiated mar(et in 'hich ori+inator or s*onsor
ne+otiates 'ith various *arties concernin+ the ty*e of securities i.e. fi.ed or floatin+ rate
to e issued, the si-e of the e.cess collateral, the amount of credit enhancement, the
amount of fees for the under'riter or arran+er, and other costs that *ertain to the
re+istration of the entire issue.
III: &redit 'n(ancement
3redit enhancement is used to im*rove the li;uidity, mar(etaility, a**eal, and safety of
the underlyin+ cash flo's Ainterest and *rinci*alC of a ne' instrument in the ca*ital
mar(et. &t is a form of dressin+ u* an illi;uid asset y eefin+ u* its *ay:off, 'hile
reducin+ the variaility of cash flo's so that 'ider classes of investors find the rate of
return commensurate 'ith ris(. The amount and ty*e of credit enhancement de*ends on
the e.tent to 'hich one 'ishes to ma(e the ne' instrument in *ar to a hi+hly:rated
security. For e.am*le, assumin+ an issuer 'ishes to see( a *articular ratin+ for its issue,
the ratin+ a+encies can determine the amount of credit enhancement that is re;uired to
rin+ the underlyin+ *ool of collateral to a *oint 'here the ne' issue 'ill e rated, say,
tri*le A, doule A or sin+le A. There are t'o ty*es of credit enhancement5 e.ternal and
internal. The follo'in+ section descries each ty*e.
III.1: ')ternal &redit 'n(ancement
This ty*e of enhancement is offered y a third:*arty insurer 'ho +uarantees the first loss
of, say, five or ten *ercent of the *ool of the collateral. For e.am*le, assumin+ an
underlyin+ collateral is >%9= million, #O *ercent, %9 year residential mort+a+es from
'hich a *ass:throu+h security is created: y uyin+ a five *ercent first loss for the *ool
from a tri*le A:rated insurance com*any. This credit enhancement insures the *ass:
throu+h investors u* to >$%.9 million loss on the underlyin+ collateral. E.ternal credit
enhancements come in variety of different forms and financial mar(ets continue to
en+ineer ne' vehicles to *rotect a+ainst *articular losses. These include5 letters of credit,
cor*orate +uarantees, *ool insurance, ond insurance, and credit default insurance.
A letter o3 credit is usually issued y a third:*arty an( or insurance com*any that
*rovides *rotection a+ainst default or foreclosure of the underlyin+ *ool of collateral u*
to certain *re:s*ecified amount that ensures safety of the *rinci*al and interest of the
"
See 0orell, M. A%===C, A Primer on Securiti-ation M&T Press.
6
senior class. The *arties that issue letters of credit or *rovide third:*arty cor*orate
+uarantees in a securiti-ation *ro+ram are usually hi+hly:rated com*anies 'ith a tri*le:A
ratin+. 8ther'ise, the ratin+ of the securiti-ed instruments may e adversely affected as
the do'n+rade of the third *arty insurer *rom*ts the ratin+ a+encies to do'n+rade
securiti-ed loans, des*ite the fact that the underlyin+ collateral assets are conformin+ and
*erformin+ assets. This is the ?'ea(est lin(@ a**roach that ratin+ a+encies use in
assi+nin+ a ratin+ to a securiti-ed *roduct. Assumin+ an ori+inator 'ishes to see( tri*le:A
ratin+ for the ne' securities, the third *arty +uarantor cannot e a sin+le:A or doule:A
institution. Therefore, the ratin+ of the third *arty +uarantor has to e as hi+h as the ratin+
of the securiti-ed instrument.
Principal mort!a!e insurance PM& is a ty*e of *ool insurance that is intended to
*rovide sto*:losses for individual home loan mort+a+es 'ith loan:to:value AHTBC ratios
aove E= *ercent. Pool insurance *ays $== *ercent of losses on defaulted and foreclosed
*ro*erties after the e;uity in the *ro*erty and any other *rimary insurance is e.hausted,
and the a++re+ate *ool level covera+e is reached at sto*:loss as sho'n in e.hiit $.$. The
amount of covera+e say for e.am*le five *ercent of the *ool continues over the life of the
underlyin+ collateral. Ho'ever, some *ool insurance is structured so that the amount of
covera+e continues to decline as the underlyin+ *ool seasons, aleit assumin+ ratin+
a+encies are 'illin+ to allo' such structure *rovided that the *erformance of the
underlyin+ *ool is not deterioratin+ over time. The losses stemmin+ from other than
default and foreclosure such as fraud arisin+ in the ori+ination *rocess, events not
covered y homeo'ners insurance, and other unforeseen events need to e covered y
other su**lementary insurance such as ond insurance.
E.hiit $.$
2e3ault Insurance This is an over:the:counter A8T3C contract et'een t'o *arties,
'here party A, the uyer of the *rotection, *ays an annuity Ainsurance *remiumC over the
life of the contract or the occurrence of the ?events,@ 'hichever comes first, to party B,
the seller of the *rotection on the ris(y det instrument ?reference asset or assets@ issued
y party C, oli+atin+ *arty B to *ay the face value of the reference assetAsC tri++ered y
the default or any other chan+e in the credit ;uality of the issuer, as outlined in the
contract. The default insurance is therefore similar to an insurance *olicy 'here the uyer
of the *rotection *ays an annuity of, say, E= asis *oints on a five:year det issued y
*arty 3 'ith the notional *rinci*al of >$= million over the five:year *eriod or the
occurrence of si+nificant ?events,@ 'hichever comes first, and is e.*ected to receive the
*ar value of the ond less the recovery value of defaulted reference asset.
$=
III.2: Internal &redit 'n(ancements
These come in several different forms and are custom desi+ned to enhance the ;uality of
the underlyin+ *ool of the collateral. They *ossily may alter characteristics of the cash
flo' of the securiti-ed *roducts. They can e classified as follo's5
8ver:collaterali-ation
SeniorFsuordinate structure
/eserve funds
E.cess s*read
III.2.1. ,-er<collateralization Estalishes more collateral than the underlyin+ asset
ac(ed securities created from the *ool, the amount of 'hich de*ends on the cou*on
rates underlyin+ the collateral and the rates offered to investors, the ty*e of ratin+ sou+ht,
and the *sycholo+y of the mar(et at the time of the issue, amon+ other thin+s. For
e.am*le, su**ose 'e estimate the 'ei+hted avera+e cou*on 2A3 of $#.E *ercent from
the *ool of $%%,"== residential loans 'ith 'ei+hted avera+e maturity 2AM of #.% years
assumin+ *ass:throu+h rate of %= *ercent. Fe'er *ass:throu+h securities have to e
issued. &n our hy*othetical e.am*le, for every >$ million denomination *ass:throu+h,
there needs to e >$.$%"9699 million in collateral to cover ,ust the interest income to
investors. Allo'in+ for e.cess s*read of t'o *ercent over the *ass:throu+h rates of %=
*ercent, %".96 *ercent over:collaterali-ation is needed. Ho' much over:collaterali-ation
is needed in our *revious e.am*le4 Ans5er 1.209999 million. This amount of collateral
'ith 2A3 of $#.E *ercent can su**ort a *ass:throu+h 'ith an interest rate of %= *ercent
and an e.cess s*read of % *ercent for all other *arties in the securiti-ation *ro+ram. This
re*resents a %".96 *ercent over collaterali-ation in our e.am*le. The amount of over:
collaterali-ation of the first +eneration of the *ass:throu+h 'as 9= *ercent or more in the
late #=s in the United States. E.hiit $.% *rovides an indication of the amount of over:
collaterali-ation levels for various securities issued in the United States in the early
$66=s.
')(i/it 1.2: Indication o3 o-er<collateralization le-els 3or traditional and
de3easance mort!a!e /ac8ed /onds Bpercent o3 parC
Bond
Type of collateral Traditional Defeasance
G!MA *ass:throu+h $%=:$K= $$=:$%=
F!MAFFHHM3 MBSs $"=:$K9 $$=:$%=
US Treasuries $$=:$"= $=9:$%=
3ollaterali-ed mort+a+e oli+ations $"=:$9= !o standard
2hole loans Afi.ed rateC $99:$#9 !o standard
2hole loans Afloatin+ rateC $7=:$6= !o standard
3or*orate onds AAAA:BC $"9:%== !o standard
$$

Source5 Federal /eserve Board.
III.2.2. Senior.Su/ordinated Structure
This is a self:im*osed structure y the issuer to *rovide *rotection for a class of senior
ondholders at the e.*ense of another A,uniorC class throu+h *rioriti-in+ cash flo' of the
entire *ool of the underlyin+ collateral. This is also the most 'idely used internal credit
enhancement structure in securiti-ation of credit here in the United States and else'here.
The senior class of ondholders is 'illin+ to sacrifice yield in securin+ *riority of claims
over suordinate classes in the event of an(ru*tcy or default of the issuer. The
suordinate class therefore is com*ensated 'ith hi+her yields for assumin+ first loss in
the underlyin+ *ool. For e.am*le, assume an underlyin+ *ool of residential mort+a+es is
e;ual to >9== million. Furthermore, su**ose a 6= *ercent senior class has een carved out
of the *ool that is >K9= million, leavin+ $= *ercent suordination level or >9= million
suordinated class. The *ool can asor u* to >9= million loss on the underlyin+
mort+a+es efore the senior class 'ill start to incur any losses thereafter. Su**osin+ the
*ool reali-es a >"9 million losses, the suordinate class 'ill asor this loss or "9F9=, a
loss of #= *ercent. 8n the other hand if the loss is >99 million, the suordinate class is
'i*ed out y asorin+ a >9= million loss or a loss of $== *ercent, the remainin+ >9
million loss to e asored y senior class or a loss of 9FK9=, $.$$$ *ercent.
The hi+her the default ris( of the underlyin+ collateral, the +reater 'ill e the ris(
*remium for the suordinate class. The default ris( *remium is not static and has a
tendency to increase or decrease over the economic cycles, risin+ durin+ recessionary
*hase and fallin+ durin+ the time of economic *ros*erity. Ho'ever, for a +eo+ra*hically
'ell:diversified *ortfolio of residential mort+a+es, default ris( is e.*ected to increase in
the first four years and decline after'ard as underlyin+ mort+a+es season and the
mort+a+ors uild e;uity on the underlyin+ *ro*erties as 'ell as enefit from risin+
*ro*erty values.
All securiti-ation *ro+rams involvin+ seniorFsuordinated structures have incor*orated
a s(i3tin! interest structure, 'hich allo's dis*ro*ortionate redistriution of
*re*ayments of the underlyin+ collateral from suordinate class to senior class accordin+
to a 'ell:defined *re:s*ecified schedule. An e.am*le is *rovided in tale %5
$a/le 2: S(i3tin! Interest Structure
Months Percenta+e of
Pre*ayments
)irected to
Senior 3lass
$:7= #=
7$:#% 7=
#":EK K=
E9:67 %=
6#:$=E $%
$=6 P *ro rata
$%
Source5 Fran( 1. Fao--i, ?Bond Mar(ets, Analysis, and Strate+ies.@ Fifth Edition, %==K,
Prentice Hall P. %"K.
Shiftin+ interest structure is intended to miti+ate future losses y redirectin+ *re*ayments
from suordinate to senior class so that sufficient insurance is outstandin+ for asorin+
une.*ected losses. Because of this feature the level of suordination may increase over
time *articularly 'hen the underlyin+ mort+a+es *re*ay ;uic(ly and the *ool e.*eriences
a lo' default rate. For e.am*le, assumin+ underlyin+ collateral *re*ays of >K= million y
year four, the rate of the level of suordination in the *revious e.am*le rises to 9=FAK9=:
K=C, or $%.$6 *ercent 'ithout any net losses to the suordinated class. Su**osin+ the
suordinated class asors >9 million cumulative losses y year four, the rate of
suordination level 'ill e A9=:9CFAK9=:K=C, or $=.6# *ercent.
III.2.0. eser-e #unds5 There are t'o ty*es of reserve fundsI cas( reser-e 3unds and
e)cess ser-icin! spread account.
&as( reser-e 3unds are created from the *roceeds of the under'ritin+ *rofit of
creatin+ asset:ac(ed securities. These cash de*osits are +enerated from the s*read
et'een the cou*on of the underlyin+ collateral and the cou*on *aid to ABS investors,
and are dedicated to a fund that invests the cash de*osits in money mar(et instruments.
This reserve is used to retire a *articular class of ond, or used in con,unction 'ith
e.ternal credit enhancements, such as a cor*orate +uarantee or a letter of credit, to asor
une.*ected losses in the *ool.
')cess ser-icin! spread accounts are created 'hen the e.cess s*read et'een the
cou*on of the collateral and the cou*on of the *ass:throu+h, net of servicin+ fees, costs of
trust administration, and other e.*enses, are de*osited into an account on a monthly
asis. For e.am*le, assumin+ the 2A3 of the underlyin+ collateral is $% *ercent,
servicin+ fees are %9 asis *oints, costs of trust administration are 9= asis *oints, the
under'ritin+ cost is 9= asis *oints, and the 'ei+hted:avera+e of cou*on of ABS is $=.9=
*ercent, %9 asis *oints remain to e de*osited in the e.cess:servicin+ s*read account.
This account is e.*ected to +ro' over time, and can e used to *ay for une.*ected losses
in the *ool not covered y other forms of insurance.
The under5riter or arran!er has the res*onsiility to *rice, mar(et, custom ma(e, and
distriute various security classes 'ith the clientele to 'hich it is most li(ely to a**eal.
The under'ritin+ team, havin+ an understandin+ of mar(et forces, the le+al re;uirements
of the investors, and the issuer, can *rovide the SPB 'ith ona fide information re+ardin+
the ty*e of the security and the *rice at 'hich the ABS 'ill e sold to the investors under
e.istin+ mar(et condition. The under'riter or lead arran+er may also act as s5ap
counterparty to the SPB for miti+atin+ interest rate ris( for the floatin+:rate tranche, or
for mana+in+ forei+n currency e.chan+e rate ris( involvin+ cross:order securiti-ation.
I1: 2ynamics o3 4nder5ritin! Process
&t is useful to s*ell out issues involved in the financial en+ineerin+ and *ricin+ of a ne'
Participation &erti3icates AP3sC as related to the dynamics of the under'ritin+
AsyndicationC *rocess. Stoc(s, onds, and ne' securiti-ed *roducts are not sold in the
$"
*rimary mar(et the 'ay real +oods and services such as home, food, icycles are sold.
The *rocess of sellin+ financial assets ta(es a fe' 'ee(s to several months from start to
finish, as it has its o'n idiosyncratic 'rin(les that need to e ironed out y the financial
en+ineerin+ team. A hy*othetical time tale for an under'ritin+ *rocess is set do'n
elo', aleit variations e.ist de*endin+ on the s*ecific mar(et, instrument, economic
sector, and investor mood *revalent at the *articular time of issue. The *rocess descried
elo' *rovides an e.am*le of a Euroond issue, and differs from that involvin+ loan
syndications, li;uidity facility, &P8s, and ne' securiti-ed *roducts: althou+h the asic
structure and ideas 'ill e similar.
$. The 'ee( of ):%$5 Mana+er is chosen and +iven the mandate. &ssuin+ strate+y is
'or(ed out, follo'ed y documentation of the ta*e:to:file.
%. The 'ee( of ):#5 )ocumentation is com*leted, and co:mana+ers are chosen.
". ):)ay5 ?Haunch@ date. The P/ e+ins 'ith sendin+ fa. or e:mail to under'riter
and sellin+ +rou* memers. &ssue is *ulished in the ne's *a*er.
K. )P$=5 Preliminary allotment 'or(ed out y lead mana+er.
9. )P$$5 Pricin+ day, 'hich 'e e.*ect to ta(e a lon+er time in &ran<s ca*ital mar(et
for ne' P3s.
7. )P$95 8fferin+ day.
#. )P"=5 Payment day. The *roceeds from the issuance of P3s are distriuted to the
an(s ori+inatin+ residential mort+a+es in the *ool.
&n emer+in+ mar(et economies, si+nificant deviations in terms of oth timin+ and le+al
*rocedure may occur in an actual under'ritin+ *rocess. Ho'ever, the ste*s descried are
necessary for successful im*lementation of the *rocess.

1: In-estor
&nvestors *rovide fundin+ for the securiti-ation *rocess. Therefore, securiti-ed assets
offered should *rovide investors 'ith +ood yields on hi+h:;uality assets, li;uidity,
diversification, *otential tradin+ *rofits, and match their liailities in terms of duration for
alancin+ asset liaility mana+ement. &nvestors< desire for an array of financial assets
'ith varyin+ maturities, lon+ and short, fi.ed or floatin+ rate, o*tion:emedded Ai.e.,
callale, convertile, e.tendale, e.chan+eale, or *utaleC is accommodated in the
securiti-ed mar(et. This has ta(en *lace in the United States and Euro*e as the
investment ase has een e.*andedI non:mort+a+e investors, domestic and forei+n, have
invested in mort+a+e:ac(ed securities.
To a**reciate ho' investors are attracted to securiti-ed mar(ets one must loo( at the
nature of their liailities that dictate the ty*e of instrument they are li(ely to uy, as 'ell
as their attitude to'ard ris(, *reference for li;uidity, and the investment *hiloso*hy that
determines the investment choices. For e.am*le, financial institutions are li(ely to uy
floatin+:rate notes to lessen their e.*osure to interest rate ris( in their fundin+ Aon the
ri+ht hand side of alance sheetC. 8n the other hand, insurers and *ension funds are li(ely
to invest in the lon+:dated fi.ed:rate instruments, as 'ell as on tranches of collaterali-ed
mort+a+e oli+ations that miti+ate *re*ayment ris(. The former 3hairman of Aetna Hife
$K
&nsurance ele+antly descries ne' securiti-ed *roducts and mar(ets in the follo'in+
*ara+ra*h.
K

?2hen a family of investment *roducts reaches mar(et, the learnin+ curve tends to e stee*:
aleit uneven from firm to firm. 2ith standardi-ed *roducts, 'e are still early on that learnin+
curve for many investors. This ma(es the field more interestin+ and more ris(y than it may e
later. & am concerned *articularly aout some of the mar(etin+ illusions that have +ro'n u*
around securiti-ed *roduct. The illusion of li;uidity, the illusion of the tri*le:A ratin+, as 'ell as
the illusion of yield should e addressed.@
2all Street has a tendency to *romote the (ey features of ne' *roducts to +ive
investors a false sense of hi+her:than:attainale true total returns. For e.am*le, most
money mana+ers *romote their *erformance in terms of arithmetic returns as o**osed to
the +eometric returns that reflect true economic returns. The tri*le:A ratin+ does not
+uarantee the timely *ayment of *rinci*al, it only ensures that the underlyin+ security is
hi+hly li(ely to *ay the cou*on and *rinci*al *ayment. 3M8s are *articularly *la+ued
'ith the *romise of hi+h returns that may not e reali-ed in the hetero+eneous securities
offered in this mar(et. Furthermore, the li;uidity of the underlyin+ securities are affected
y the very structure of the securities as 'ell as the underlyin+ collateral and the amount
of levera+e that is attached to a *articular tranche: 'ith varyin+ amounts of duration and
conve.ity that corres*ond to si+nificant chan+es in *rice level o'in+ to small chan+es in
interest rates.
&nvestors have effectively *rovided a free *ut o*tion to orro'ers as there are no
*re*ayment *enalties. This free *ut o*tion is not free after all, as orro'ers are li(ely to
*ay hi+her interest rates for havin+ the o*tion to *ut the ond to the investor usually in
the 'orst time 'hen rates have fallen. The callale onds Aall mort+a+e onds residential
and commercial are callaleC sell at discount to their non:callale counter*arts, and
differentials in *rice reflect the value of the short call o*tion +ranted to the orro'ers y
investors. As rates fall the call is activated and an issuer is li(ely to call the ond to
reissue at a lo'er rateI ho'ever, as rates +o u* the call is out of the money, and the issuer
is not li(ely to *re*ay. Thus, the maturity of the issue is e.tended, e.*osin+ investors to
e)tension ris8. Furthermore, the res*ective yield on the underlyin+ securities must e
sufficient and com*etitive to entice investors to uy these instruments. The mar(et
im*erfections of the cartel era *rovided the financial en+ineers in the 2all Street the
o**ortunities to address shorta+es of fundin+ in various sectors *articularly the housin+
sector to innovate securiti-ation as a vehicle in miti+atin+ the fundin+ *rolem.
1I: 1alue &reated in Securitization
Assets off:alance sheet are 'orth more than on it. The volume of securiti-ed
instruments in the United States and the rest of the 'orld im*licitly confirms the value
added throu+h securiti-ation. This value added is filtered do'n to various *layers in a
securiti-ation *rocess that ma(es every *layer etter off 'ithout ma(in+ some one 'orse
off, therey increasin+ overall economic 'elfare for the +loal economies. Fi+ure $.9
illustrates the value added and increased trans*arency throu+h securiti-ation y
com*arin+ assets AloansC on alance sheet and the asset ac(ed securities ABS created
off:alance sheet usin+ the *ool of loans as collateral in the Fi+ure $.9.
K
0ochen .!, A%===C, iid.
$9
#i!ure 1.9: 1alue &reated in Securitization
Loans on balance sheet Asset backed securities ABS off-balance
sheet
&lli;uid and non:tradale Hi+hly li;uid and tradale
!ot trans*arent Trans*arent
Balued y ori+inator Balue is determined in the mar(et daily
/is( assessed y ori+inator /is( assessed y ratin+ a+encies
8ri+inator has hi+h cost of
fundin+
8ri+inator has lo' cost of fundin+
Have lo'er ratin+s 3redit enhanced 'ith hi+her ratin+s
3oncentration ris( is hi+h )iversified
Mar(et is local Mar(et is national and +loal
Himited in terms, rates, duration,
conve.ity, etc.
8ffers investorsForro'ers variety of o*tions
Securiti-ation needs to e distin+uished from ?factorin+@ of account receivale, as the
former is related to the securiti-ation of current and future flo's, 'hile the latter is
related to securiti-in+ *ast flo's, or money already due. Assets off:alance sheet are
converted to mar(etale asset:ac(ed securities, therey increasin+ li;uidity, reducin+
ris(, and increasin+ overall economic efficiency.
Securiti-ation *rovides more trans*arency of transactions in terms of standardi-ation of
a**licale +overnin+ la's, contracts, under'ritin+ *rocesses, and ris(s that reduce costs
and im*rove li;uidityI investors are 'illin+ to acce*t lo'er returns. The costs of funds to
the ori+inator and the orro'er or oli+or are +enerally lo'er even after includin+ costs
of credit enhancements and securiti-ation fees, due to access to a roader and more
diversified ase of investors.
1I.1. e6uirements 3or Success3ul Securitization
To sum u* the ar+ument in favor of securiti-ation 'e need to have three necessary
conditions satisfied in order to convert it to a *o'erful mechanism for lo':cost financin+
y connectin+ orro'ers at a minimum under'ritin+ and other costs to investors in the
ca*ital mar(et. These conditions are5 3han+es in securities and investment la'sI chan+es
in information and com*utin+ technolo+yI and chan+es in investors understandin+ aout
securiti-ation *rocess. The mar(ets for credit securiti-ation need to have the follo'in+
structure in *lace for successful im*lementation. These re;uirements are listed in Fi+ure
$.7.
9
#i!ure 1.%: Summary o3 t(e /asic re6uirements 3or Securitization
Standardi-ation of contracts
Standardi-ation of under'ritin+ and a**raisal *rocess
Actuarial analysis of ris(
Standardi-ation of +overnin+ la's
Historical data ase for estimation of default and delin;uencies
9
see iid.
$7
/eliale secondary mar(et *layers
/eliale su**ly of third *arty +uarantor
/eliale mana+ement information system
The standardi-ed contract increases the inte+rity of transactions y outlinin+ the terms,
si-e, ty*e of the collateral, and the le+al oli+ations of the *arties in the transaction that is
enforceale in a court of la'. An under'riter arran+er determines the mar(et value of the
asset ac(ed securities and matches the su**ly of the securities 'ith the demand y
intermediatin+ et'een investors and the ultimate orro'ers. &n this *rocess the
under'riter analy-es various ris(s to 'hich investors are e.*osed, and focuses on any
s*ecific ris(AsC a class of investor 'ishes to avoid y custom tailorin+ asset:ac(ed
securities that meet the investors< desire in terms of *rice, yield, and other characteristics.
Standardi-ation of a**licale la's smooth a+ency relations and *rolems associated
'ith the securiti-ation *rocess y ensurin+ that a uniform code across various local,
states, and federal la's conforms investors< and issuers< ri+hts to a securiti-ed instrument
into a le+ally enforceale contract in the ,urisdiction of the issuer. This uniformity in the
a**licale la's is essential to im*rovin+ li;uidity and efficient *ricin+ of the securiti-ed
instruments. &nvestors are *rotected from the an(ru*tcy of the ori+inator As*onsorC
andFor servicin+ entity, since the underlyin+ *ool of collateral is an(ru*tcy:remote and
the ori+inator has no recourse to transferred assets that are clearly identified and
trans*arent to the mar(et *artici*ants in a securiti-ed transaction.
There e.ist reliale historical data that ratin+s a+encies can use for +radin+ ris( and
estimatin+ the *roaility of default for ratin+ various classes of securities issued to
investors. This ;uantification of ris( ensures the ca*ital mar(et investors 'ith res*ect to
the ;uality of the underlyin+ *ool of collaterals and reco+nition and *ricin+ of various
ris(s to 'hich they are e.*osed. The t(ird party !uarantor, usually a an( or insurance
com*any that *rovides credit enhancement to the securiti-ed instrument, must *ossess the
hi+hest credit ratin+ and *referaly have no si+nificant relationshi* 'ith the ori+inal
oli+ors. For e.am*le, a third *arty +uarantor 'ith sin+le QA< ratin+ can not +uarantee a
securiti-ed instrument 'ith ratin+ of QAA< or hi+her. Furthermore, asence of correlation
et'een third *arty +uarantor and oli+ors ensures that in the event the oli+orAsC fallAsC
into an(ru*tcy, this 'ill not *reci*itate do'n+radin+ credit enhancer.
1I.2. Secondary Mar8et Pro-ider
The *resence of a reliale secondary mar(et *layer is essential for successful
securiti-ation ecause the li;uidity of the securiti-ed instruments is directly related to the
readth and de*th of the volume of transactions. The securiti-ation mar(et in the United
States o'es its success to +overnment s*onsored a+encies, such as Ginnie Mae, Fannie
Mae and Freddie Mac, 'hich *rovide li;uidity in the secondary mar(ets. Finally, a
reliale mana+ement information system needs to e in *lace for dia+nosis of *rolem
loans, analysis and trac(in+ of cash flo's in timely fashion, and *ricin+ various
instruments y *lacin+ loans 'ith different maturities, rates, and other idiosyncratic
structures into a *ool from 'hich asset:ac(ed securities are created.
The success of the *rocess is measured to the e.tent the fundin+ re;uirements of
various sectors of the economy are met throu+h reduced cost of transferrin+ funds from
$#
investors to the orro'ers. Ban(s and Savin+s GHoans 'ere lar+ely res*onsile for
*erformin+ all functions of originating, servicing, credit risk taking and managing it,
and investing in a ty*ical mort+a+e loan. 3urrently, disintermediation has shuffled
various functions into different entities that are s*eciali-ed to *erform them. For e.am*le,
an ori+inator does not need to use its o'n funds to finance a mort+a+e. /ather, usin+ the
ca*ital mar(ets to ac;uire funds chea*ly has created thousands of mort+a+e com*anies,
therey increasin+ *rice com*etition and the ran+e of availale *roducts. The volume of
securiti-ed instruments s*ea(s loudly of the success, as securiti-ation encoura+es ne'
entrants for *rice and *roduct com*etition that have *rovided *ositive e.ternalities in
disintermediation of various s*eciali-ed functions and allo'in+ for efficient division of
laor amon+ the ma,or *layers. The enefits of the securiti-ation *rocess have not een
evenly distriuted across all sectors of the economyI some sectors have fared etter than
others. The housin+ sector has rea*ed the most enefit, as the evolution of securiti-ation
in mort+a+e det instruments and its synthetic variants *rovided the mar(et 'ith an array
of *roducts that meet the investors< and orro'ers< needs. The (eys for the success of
mort+a+e dets securiti-ation in the United States are related to the follo'in+
*henomena5
Attractin+ *rivate ca*ital to the housin+ sector y meetin+ investors needs.
Providin+ lo'er cost financin+ for home o'nershi* throu+h increased *rice and
rate com*etition amon+ various lenders in a securiti-ation *rocess.
/educin+ overall ris(iness of the *ool of mort+a+es throu+h diversification to
increase income staility and enhance the mana+ement of ris(s inherent in
mort+a+e *roducts.
To e.*and investors ase Freddie Mac introduced collaterali-ed mort+a+e oli+ations
A3M8sC in $6E", 'here the investors received dis*ro*ortionate cash flo's ased on 'ell
defined rules from the *ool of the underlyin+ mort+a+es that could a**eal to roader
classes of investors. The first 3M8 had three tranches 'here investors 'ere *aid off
*ro+ressively in the shortest *eriod to the lon+est *eriod. The third tranche 'as lon+ term
in nature and a**ealed to uy and hold investors such as insurance com*anies.
')ample5 3onsider a home uyer in Murfreesoro Tennessee 'ho a**lies for a >$9=,===
loan ori+inated y Guarantee Trust 'ho has ;uoted 7 O *ercent $9 year 'ith one *ercent
ori+ination fee. The ori+inator< ;uote reflects the *rice that secondary mar(et *roviders
such as Fannie Mae, Freddie Mac, and other *rivate conduits are 'illin+ to *ay for a
mort+a+e det 'ith characteristics in line 'ith their under'ritin+ re;uirements *lus a
*rofit mar+in and cost of servicin+ and *rocessin+ of the loan. As lon+ as the mort+a+e
ori+inated meets the under'ritin+ and a**raisal +uidelines of loan uyersI that the
orro'er 'ill e ale to service its det oli+ation and the ;uality of collateral is
sufficient in the event of foreclosure the ori+inator is assured that the fundin+ 'ill e
availale for the ori+ination of the loan.
The uyer of the loan finances the *urchase of the loan in the secondary mar(et y
re*ac(a+in+ the *ortfolio of loans and credit:enhancin+ mort+a+e ac(ed securities
AMBSC y +uaranteein+ the interest and *rinci*al *ayment to investors even if the
underlyin+ mort+a+es default. The yield that is offered to mar+inal investors in the asset:
ac(ed securities determines the mort+a+e interest rate *aid y an avera+e home uyer
that is com*etitively determined y the su**ly and demand forces in the ca*ital mar(et.
The MBS are sold throu+h a net'or( of secondary mar(et *layers, o'n dealers and
$E
dealers in 2all Street to an(s, insurers, *ension funds, money mar(et and other s*ecialty
funds. The outcome of the aove *rocess enales the home uyers in the United States to
access funds in the +loal ca*ital mar(et very com*etitively.
Gro'th and evolution of the financial mar(et has een affected y chan+es in ta. la's,
accountin+ and re+ulatory reforms that enaled hi+hly re+ulated investors, domestic and
forei+n, such as thrifts, insurers, *ension funds, and other institutions to uy asset:ac(ed
securities. The mort+a+e and other asset:ac(ed securities are no e.ce*tion.
1I.0. :ene3its o3 Securitization
The enefits of securiti-ation to the ma,or *layers such as orro'ers, ori+inators,
investment an(ersFarran+ers, and investors are summari-ed from the *ers*ective of a
*articular *arty as follo's5
Benefits to orro'ersFconsumers
Access to com*etitive rates and terms
Access to chea*er financin+
Availaility of array of financin+ alternatives
Fundin+ availaility for all ty*es of orro'ers
/educed *rocessin+ time

Benefits to ori+inators
/educe fundin+ cost
&m*rove *rofit mar+in on asset and e;uity
/emovin+ illi;uid assets off:alance sheet
&m*rove assetFliaility mana+ement
/educe concentration ris(

Benefits to arran+erFinvestment an(ers
&ncreased *roduct lines and fees
&ncreased o**ortunities to e.*and o*eration nationally and +loally
&ncreased tradin+ volume and *rofit
&m*roved efficiency and s*eciali-ation
Benefits to investors
Attractive yields on rated securities
)iversification of ris(
&m*roved li;uidity
Availaility of vast array of *roducts that meet their desire in terms of duration,
conve.ity, etc
$6
1I.7. &ost o3 Securitization
The *rocess of securiti-ation in the United States has +one throu+h a trial:and:error
*hase, 'ith chan+es in le+al, accountin+, re+ulatory, ta., and other issues, occurrin+.
First, numerous mort+a+e:ac(ed securities 'ere *erfected. Then the *rocess 'as a**lied
to other classes of receivales. To address a risin+ demand for housin+ credit, and to
increase the su**ly of funds, seasoned mort+a+es 'ere used y thrifts as collateral to
collaterali-e mort+a+e:ac(ed onds. 2hile issuin+ this ty*e of det instrument reduced
the cost of funds for thrifts, it did not *rovide necessary ca*ital to meet the demands of
the *ulic at lar+e. The ne'ly:issued mort+a+e:ac(ed onds 'ere over:collaterali-ed at
t'o to three times the face amount of home loans, therey ma(in+ them inefficient in the
use of collateral to attract fundin+ to the housin+ sector.
To esca*e doule ta.ation a ne' security must convey all ri+hts and ta. oli+ations
from the ori+inator to investors. The first tri*le:A rated "=: year *ass:throu+h security
issued y Ban( of America in $6##, entitled the investor to a *ro rata share of the cash
flo's from the underlyin+ *ool of mort+a+es 'ithout creatin+ doule ta.ation for the
issuer and investor. &t turned out that ne' *ass:throu+h security y the /lue<s8y la5s, the
states le+al investment la's, did not ;ualify as an investment vehicle e.ce*t in fifteen of
the fifty states in the union.
Freddie Mac e.em*tion from the lue:s(y la's as a federal a+ency *roved to e
crucial for the creation and 'ides*read distriution of the *ass:throu+h securities y 2all
Street. &n this *rocess Freddie Mac *urchased illions of dollars of seasoned mort+a+e
securities and issued *ass:throu+h securities y +uaranteein+ interest and *rinci*al 'ith a
relatively hi+her yield to attract 'ider classes of investors. The underlyin+ "=:year fi.ed
rate *ool of mort+a+es that could *re*ay or default and 'ere used as collateral for issuin+
"=:year MBS a**ealed to fe'er investors in the mar(et. As initial "=:year *ass:throu+h
securities e.*osed investors to *re*ayment ris( it 'as difficult if not im*ossile to
estimate duration as 'ell as fair mar(et value of this class of securities. The mar(et
needed to offer 'ider array of securities 'ith a maturity s*ectrum of a fe' years to thirty
years that could accommodate far more classes of investors in the ca*ital mar(et.
The aility to *redict the avera+e life of a *ool of mort+a+es and determination of the
'ay in 'hich mort+a+ees reacted to chan+in+ economic fundamentals 'as crucial to
sustainin+ and e.*andin+ the ase of investors. Furthermore, ecause of the com*le.ities
of the ne' *ass:throu+h securities, 'ith un(no'n cash flo's, investors needed to e
educated aout these securities. The (ey 'as to convince investors that ne' securities
offered them relatively more yield than com*arale securities in their *ortfolio.
Therefore, these securities initially issued relatively chea* in order to entice investors to
hold in their *ortfolio. The ne.t *hase in securiti-ation came in creation of collaterali-ed
mort+a+e oli+ations A3M8sC that solved many of the earlier *rolems. 3M8s allocate
cash flo's dis*ro*ortionately accordin+ to 'ell defined rules amon+ various classes 'ith
maturities ran+in+ from one to thirty years 'ith se*arate cou*ons *riced at a s*read over
treasuries 'ith the same maturity.
Securiti-ation 'as e.tended to other loans includin+ second mort!a!es u* until the
early $6E=s as the U.S. economy faced doule:di+it inflation and interest rates. /isin+
%=
interest rates caused the mar(et value of homes *articularly in 3alifornia to dro*
sustantially. The second mort+a+es sold and successfully securiti-ed early on *roved to
e disastrous, as homeo'ners in 3alifornia, havin+ secured a second mort+a+e in the
*ro*erty from a lender at relatively hi+h a**raisal value to +et ac( their e;uity, 'al(ed
out of their residence y turnin+ over the *ro*erty to the lender in the real estate scam of
the century.
Securiti-ation of mo/ile (omes 'as also a soerin+ e.*erience for the industry. As it
turns out, unli(e home mort+a+es, moile homes are detached units 'ith no land or lot as
security interest. The underlyin+ asset tends to de*reciate, rather than a**reciate, over
time. The aility to estimate actuarial e.*erience of default is crucial for successful
im*lementation of securiti-ation involvin+ any ty*e of assets. For e.am*le, securiti-ation
of air*lane leases is difficult as a sin+le air*lane crash can e catastro*hic for the
underlyin+ ond issue. The cost of credit enhancement for such a deal can e e.tremely
*rohiitive.
The elimination of emedded call *rotection on the early *ass:throu+hs has raised
residential mort+a+e rates, as investors re;uire hi+her *remiums for holdin+ onds that
are callale y the issuer. As rates fall, the issuer is li(ely to call the ond and refinance at
a mar+inally lo'er rate, leavin+ investors e.*osed to contraction ris8 and reinvestment
rate ris(. Ho'ever, as rates rise, durations of the *ass:throu+hs are e.tended e.*osin+
investors to e)tension ris8 as mort+a+ees are not li(ely to *re*ay, and investors are
saddled 'ith a security 'hose *rice is li(ely to fall more than a non:callale det
instrument.
Securiti-ation of other *roducts, such as !raduated payment mort!a!es AGPMC
initially desi+ned to *rovide home o'nershi* to youn+ families 'ho could not afford in
early years to ma(e re+ularly:scheduled monthly *ayments in a standard thirty:year
mort+a+e, *roved a failure. The GPM allo'ed homeo'ners to ma(e +radually lar+er
*ayments in future *eriods, *redicated on the assum*tion that their incomes 'ould rise
faster than their mort+a+e *ayments. Unfortunately, GPMs *roved to have relatively
much hi+her default rates than the actuarially allo'ale rate of three to four *ercent.
Securiti-ation of early ad,ustale:rate mort+a+es AA/MsC, first introduced in 3alifornia
also *roved to have much hi+her default rates than actuarially acce*tale standards. The
mar(et develo*ed insurance *roducts such as ca*s, floors, and collars in res*onse to
risin+ default rates for the A/Ms. The *ayment ca*s effectively reduced cash flo's
accruin+ to investors on the underlyin+ securities in risin+ interest rates scenarios, and
reduced their relative values. These came to e (no'n on 2all Street as Qsin8ers< as
o**osed to Qfloaters<.
The securiti-ation of home loans contriuted to an(ru*tcy of the thrifts, com*liments
of the federal +overnment, 'hen /e+ulation R ceilin+s on de*osit rates 'ere eliminated
in the late $6#=s, e.*osin+ thrifts to mismatched thirty:year fi.ed:rate loans financed
'ith short term orro'in+ at floatin+ interest rates. The doule:di+it inflation of years
$6##:E=s, alon+ 'ith risin+ mar(et interest rates, 'ere *rimary factors in the
disintermediation of credit caused y removal of ceilin+s on savin+s rates for thrifts. As
de*osits left the thrift institutions in *ursuit of hi+her yieldin+ securiti-ed mort+a+e:
ac(ed *ass:throu+hs offered y 2all Street, and as the yield curve e+an to e inverted
in $6E$, the mismatch of duration for orro'in+ short term and lendin+ lon+ term,
%$
cou*led 'ith hi+her rollover ris( induced y securiti-ation, effectively caused the
colla*se of the SGH industry in the United States.
1I.7.1. #i)ed and 1aria/le &osts o3 Securitization
The costs of securiti-ation +enerally include fees for estalishin+ the le+al entity as
SPB, havin+ the SPB rated y the ratin+ a+encies, addin+ credit enhancement features,
and coverin+ servicin+ fees, s*ecial reserve fees, value:added ta.es, 'ithholdin+ ta.es,
stam* duties, and other such costs. These costs can e ro(en do'n into fi.ed and
variale costs. Fi.ed costs include arran+ement fee, le+al fees for oth transferor and the
arran+er, and auditin+ costs. Bariale costs include the fee for the use of SPBs, dealer
costs for the issuance of asset ac(ed securities, and the cost of li;uidity commitment
secured from the ori+inatin+ or s*onsorin+ institution to enhance the credit 'orthiness of
the issue should there e events adversely affectin+ credit ;uality of the asset:ac(ed
securities in the mar(et.
Furthermore, the total cost also de*ends on the si-e of the *ool, ty*e of asset, and the
+eo+ra*hic location of the ori+inator. Fi.ed costs are etter s*read over lar+er *ools,
*rovidin+ increasin+ economies of scale. Arran+ement and le+al fees are less sensitive to
the si-e of the transactions. Assets such as mort+a+e dets, credit card receivales, and
auto loans 'ith a sim*le collection *rocess cost less to securiti-e than assets 'ith more
com*le. structure. The cost is also lo'er in ,urisdictions havin+ e.*erience in *revious
securiti-ation *rocesses, such as !orth America and Euro*e, as o**osed to Eastern
Euro*ean and develo*in+ economies 'here there has een less e.*erience.
/ecent studies conducted for the *ool of assets that 'ere common*lace in each of the
four +eo+ra*hic locations in Euro*e5 vehicle finance in Germany, consumer loans in
France, credit cards in U0, and e;ui*ment lease in &taly, shed some li+ht as far as the
fi.ed and variale costs of ABS and AB3P securiti-ation. The variale costs for each of
the cate+ories for tranches rated QA< or etter y Standard G Poors or QA$< y Moody<s
are estimated as 'ei+hted avera+e of a mar+in over EU/&B8/ or H&B8/.
AB3P funded securiti-ation is a lo'er cost alternative source to an( loans, short term
det, and *ulic offerin+s in the onds mar(et. &n the U0 mar(ets for nine securiti-ation
transactions for ABS of credit cards, the variale costs 'ere at avera+e mar+in of $6.%E
asis *oints, sli+htly more y $:% asis *oints than the AB3Ps *ro+ram.
7
For vehicle
securiti-ation in Germany, the avera+e variale mar+in 'as %7." asis *oints, that is, $:%
asis *oints hi+her than AB3P. For asset ac(ed consumer loan securiti-ation in France,
the avera+e variale mar+in for tranches QA< or etter 'as %#.$6 *ercent. This is e;ual to
the mar+in for the French AB3P *ro+ram.
#
8n the other hand on the less develo*ed
securiti-ed mar(et of &taly, for asset ac(ed e;ui*ment finance lease, the avera+e variale
mar+in 'as "E.K asis *oints. This is 9 to $= asis *oints hi+her than 'ould e e.*ected
in an AB3P funded securiti-ation.
E
The hi+her variale mar+in in &taly reflects lac( of the
reath and de*th of the ABS mar(et as com*ared to the same mar(et in the U.S.
Furthermore, AB3P *ro+ram is ne' in &taly and over time &talian financial and non:
financial cor*orations 'ill em*loy this *ro+ram for an alternative and chea*er source of
fundin+ and the +a* is e.*ected to diminish et'een the ABS and the AB3P
securiti-ation *ro+ram.
7
See iid.
#
See iid.
E
See iid.
%%
Fi.ed costs are related to the si-e of the transaction, the arran+er, and dynamics of the
mar(et that can e ne+otiated. They include le+al fees, re+istration costs, ratin+ a+ency
fees, auditin+, *rintin+, trustee, and structurin+ fees. These costs may add u* to %= to %9
asis *oints for ABS *ro+rams.
6
Similar costs are normally no more than 9 to $= asis
*oints for securiti-ation of the AB3P *ro+ram in the Ban( 8!E study.
$=
The fi.ed costs
associated 'ith the ABS transactions are amorti-ed over the life of the issue 'ith a lon+er
tenor than transactions for the AB3P *ro+rams, *rovidin+ accountin+ advanta+es for the
ABS transactions. 2hen oth fi.ed and variale costs are considered, the Euro*ean
funded AB3P securiti-ation *ro+ram can cost si+nificantly less than its ABS counter*art.
1II. ;ome o5ners(ip 3acts
Freddie Mac *urchased >"EK illion of sin+le:family A$:K unitC mort+a+es in %==$.
Freddie Mac *urchased %,EK9,E7E sin+le:family mort+a+es in %==$.
The median alance of a sin+le:family mort+a+e *urchased y Freddie Mac in %==$ 'as
>$"K,6#9.
Freddie Mac has financed homeo'nershi* for more than "= million families since $6#=.
Freddie Mac *urchased one mort+a+e every 7 seconds in %==".
The hi+hest mort+a+e rate ever re*orted on Freddie MacSs 'ee(ly national survey 'as
$E.7"N the 'ee( of 8ctoer 6, $6E$.
The lo'est mort+a+e rate ever on the Freddie Mac survey 'as 9.%$N the 'ee( of 1une$%th, %=="
Source Freddie Mac
Since $67E, Fannie Mae has *rovided >9.6 trillion of mort+a+e financin+ for 7= million families.
Source Fannie Mae
1III. #inancial 'n!ineerin! Process
Securiti-ation is financial en+ineerin+ in a classic sense. The *rocess of financial
en+ineerin+ is *resented in fi+ure $.# as follo's5
2ia!nosis5 is the firm facin+ hi+h fundin+ cost4
Analysis5 Are the assets suitale for securiti-ation4
Production5 /e*ac(a+in+ and unundlin+ the *ool into mar(etale securities
Aunder'ritin+C
Pricin!5 The structure of securities created from the *ool. 2hat is the ris(Freturn *rofile
of ne' securities and ty*es of credit enhancement attached to them4
&ustomization5 Tailorin+ the ne' *roduct to the s*ecific needs of customers
=e!al #rame5or85 The la' +overnin+ securiti-ation in the country of issuance.
#i!ure 1.*: #inancial 'n!ineerin! Process
6
See iid.
$=
See 2orld Trade E.ecutive, &nc. 1anuary $9, %==K. *$%
%"
1III.1. Is t(e 3irm 3acin! (i!(er 3undin! cost4 The lender is li(ely to securiti-e its loan
assets 'hen removin+ assets than 'hen (ee*in+ them on alance sheet creates more
value. Firms rated QAAA< can secure credit in the mar(et at a sustantially lo'er cost than
their counter*arts 'ith lo' ratin+s and 'ith hi+her fundin+ cost. &t is the latter ty*e
institutions that +arner most enefits from securiti-ation than the former ty*e. The *rice
at 'hich assets are sold to the SPB, 'hich in turn issues asset:ac(ed securities
determines the relative success of the securiti-ation *rocess.
The ne' secondary securities issued y the SPB are ac(ed y the underlyin+ assets,
'hose ;uality and history of loss can e a si+nificant factor in the *ricin+ of the ne'
issue alon+ 'ith the credit enhancement Ainternal and or e.ternalC attached. The ne'ly
issued securities in the mar(et are usually e.*ected to *rovide hi+her returns as com*ared
to *rimary securities of the same maturity class, since mar(et conditions such as su**ly
and demand, investors< *erce*tions and attitudes to'ard ne' securities, the readth and
de*th of the mar(et, and the *resence or asence of secondary mar(et 'ill determine
their ris( *remium.
Securiti-e or not securiti-e5 )oes the firm need cash to +ro' and e.*and its e.istin+
o*eration, to retire maturin+ det, or uy ac( firm<s o'n stoc(s4 2hat are the
alternatives cost of fundin+4 Are det fundin+ and or e;uity fundin+ a**ro*riate +iven
the current state of the economy and the state of the firm4 &f det is issued 'hat is the
li(ely effect on the ratin+ of the com*any as det e;uity ratio rises4 These and other
Ty*es of Asset
ein+
Securiti-ed
Structure of
Securities
3reated
3redit
Enhancement
Attached
He+al G +overnin+
Princi*le
)ia+nosis5 &s
the firm fundin+
cost hi+h4
%K
;uestions mi+ht arise 'hen a firm considers the issue of securiti-in+ its illi;uid assets as
an alternative to an unsecured or secured fundin+.
')ample5 3onsider 3om*any A 'ith the follo'in+ alance sheet Asee Panel AC that
needs to raise >%9 million cash.
Panel A
Balance Sheet of 3om*any A as of =$F=%FTTTT in A===C
3ash %,=== Short term notes $,===
/eceivales $9,=== Senior notes %6,===
/esidential mort+a+es %9,=== Su:dets %=,===
8ther $E,=== E;uity ca*ital $=,===
First alternative5 The firm can orro' >%9 million y issuin+ #:year unsecured det at
all:in:cost of #.%9 *ercent from its an(. Second alternative5 Secured det can e issued
y *led+in+ mort+a+e loan assets as collateral at all:in:cost of 7.#9 *ercent. Both fundin+
scenarios are achieved y increasin+ assets and liailities on alance sheet. The ratin+ of
the ne' det is ca**ed y the current ratin+ of the firm and dets covenants may
suordinate ne' det to the e.istin+ dets in the alance sheet therey raisin+ the cost of
orro'in+. As com*any issues ne' det, the det e;uity ratio increases from 9.= to #.9
due to an increase in levera+e Asee Panel BC.

Panel :
Balance Sheet of 3om*any A as of =$F=%FTTTT in A===C
3ash 2*,000 Short term notes $,===
/eceivales $9,=== Senior notes %6,===
/esidential mort+a+es %9,=== Su/<de/ts K9,===
8ther $E,=== E;uity ca*ital $=,===
The third alternative is to securiti-e residential mort+a+es. Su**ose securiti-ation can
e structured so that the assets removed from the alance sheet 'ill meet the
re;uirements of the FASB $%9 or its e.tension FASB $K=, and can e considered as true
sale for ta. and accountin+ *ur*oses as cash *roceeds from the sales are added to the
assets and transferred and sold assets are ta(en off:alance sheet. Usin+ the transferred
assets, the SPB issues asset:ac(ed securities, credit:enhanced y the an( ori+inatin+
securiti-ation 'ith E= *ercent QAAA<, $9 *ercent QBBB< rated suordinated det, and the
com*any retains 9 *ercent unrated as a first lost tranche in ali+nin+ its interest 'ith the
investors in the rated classes. The result of this restructurin+ in the alance sheet is seen
in APanel 3C.
Panel &
Balance Sheet of 3om*any A as of =$F=%FTTTT in A===C
3ash 29,*90 Short term notes $,===
%9
/eceivales $9,=== Senior notes %6,===
&nvestment in mort+a+es 1,290 Su:dets %=,===
8ther $E,=== E;uity ca*ital $=,===
As can e verified from Panel 3, the cash increased y >%",#9= A69 *ercent of the assets
soldC, and the investment in mort+a+es decreased y >%",#9= as it 'as transferred off:
alance sheet, and retention of the 9 *ercent of the assets as an unrated interest to asor
9 *ercent first loss is seen in investment in mort+a+es of >$,%9=. To the e.tent the
*roceeds from the sale of asset ac(ed securities E= *ercent QAAA<, $9 *ercent QBBB<,
and 9 *ercent unrated that is retained after ad,ustin+ for the cost of securiti-ation such as
arran+er and under'ritin+ fees, cost of credit enhancement, mar(etin+ and distriution
fees, and le+al and auditin+ fees e.ceeds the *roceeds from other fundin+ alternatives, the
com*any is etter off and therefore has achieved a lo'er cost of fundin+.
1III.2. &(aracteristics o3 Assets to :e Securitized
The assets suitale for successful securiti-ation 'ith minimal credit enhancement are
e.*ected to have the follo'in+ ;ualities5

Homo+eneous

)iversified

Predictale actuarial loss history

Similarity in maturity and other terms

The assets in the *ool should e homo+enous in terms of rates, ty*es, maturity,
*re*ayments, default and delin;uencies, and date of issue. To reduce and or eliminate
sin+le catastro*hic losses the assets should e fairly diversified. There should e
e.tensive historical dataases 'ith stale loss history from 'hich future default ris( on
com*arale assets can e estimated. The *roailities of default for different ty*es of
oli+ors, usinesses, and individuals must e estimated and tested for their reliaility. The
ratin+ a+encies use e. *ost loss e.*erience to chec( the ;uality of the data in determinin+
the loss *roaility e.:ante. The *oorer the ;uality of the data, the +reater is the forecast
error, and the lar+er the discount offered on the face amount of the asset that is to e
securiti-ed.
3redit enhancements such as default insurance, standy letter of credit, or over:
collaterali-ation Ade*ositin+ more assets into the *ool than the assets soldC can e used to
im*rove the ;uality of the assets in the *ool and reduce or cut the si-e of the discount
offered for the assets sold in a securiti-ation. The *rocess of *oolin+ lar+e homo+eneous
+rou*s of assets increases the li(elihood of creatin+ value and trans*arency as 'ell as
facilitatin+ an actuarial analysis of their ris(s. The aove *rocess hel*s ratin+ a+encies or
third:*arty +uarantors to validate the ori+inatin+ and under'ritin+ decisions in a
successful securiti-ation.
The e.am*les of asset classes financial, cor*orate, and future flo' that have een
securiti-ed, aleit not limited to the follo'in+ finite set as mar(ets continue to innovate
ne' instruments as yet to e securiti-ed in the future com*lement of financial en+ineers
around the +loe5
%7
#inancial Assets
: Mort+a+e loans
: 3redit card receivales
: Auto loans
: 3ommercial loans
: Aircraft lease finance receivales
: !on:*erformin+ loans
: Students loans
: Har+e and small usiness loans
: Preferred em*loyee loans
: Mar+in lendin+ *ortfolios
: 3atastro*he loans
&orporate assets Bcas( 3lo5sC
: Trade and e.*ort receivales
: Pro*erty rental cash flo's
: &nstallment sale contracts receivales
: Healthcare receivales
: Time sharin+ cash flo's
: Franchise *ayments
: /ecord and film royalties
: Utility receivales
#uture #lo5 Securitization
: 8il and +as e.*ort receivales
: Pro,ect finance
: !on:oil e.*ort
: 3redit card receivales
: Tele*hone receivales Ainternational callsC
: /emittances
: 8ther receivales
The innovations accordin+ to Ban( for &nternational Settlements B&S have to e classified
'ith res*ect to the ty*e of intermediation function *erformed. B&S have identified four
ty*es of innovations in the financial mar(ets.
$$

&nnovations transferrin+ A*rice and creditC ris(
&nnovations enhancin+ li;uidity
&nnovations +eneratin+ det ca*ital
&nnovations +eneratin+ e;uity ca*ital
Most of the +ro'th in derivatives transactions such as o*tions, futures, s'a*s, and
for'ard contracts can e attriuted to their valuale function of transferrin+ ris( in the
ca*ital mar(et.
1III.0. Structure o3 t(e Assets &reated in a Securitization
1. esidential Mort!a!e :ac8ed Securities M:S
$$
See B&S A$6E7C /ecent &nnovations in &nternational Ban(in+ ABasle5 Ban( for &nternational SettlementsC.
%#
Mort+a+es 'ere first securiti-ed in the United States in the early $6#=s ecause they 'ere
easily standardi-ed. The securiti-ation in the U.S. mort+a+es mar(et 'as heavily
influenced y creation of +overnment and ;uasi +overnment institutions, *rovidin+
li;uidity in the secondary mar(ets to the *artici*ants in the ca*ital mar(et. The !ational
Housin+ Act of $6"K can e considered as a catalyst for *romotin+ home o'nershi* and
securiti-ation of mort+a+es. As a result of this Act, the Federal Housin+ Administration
AFHAC 'as formed to insure loans made y *rivate lenders so as to ma(e them less ris(y
and attract *rivate ca*ital to the housin+ sector.
&n order to attract more ca*ital to housin+ sector FHA created secondary mar(et for
mort+a+e dets, the Federal !ational Mort+a+e Associations AF!MA or Fannie MaeC in
$6"E, to uy and sell federally insured mort+a+es. The mar(et did not develo* until the
late $67=s, 'hen con+ress s*lit the F!MA into t'o cor*orations in $67E5 a *rivately:
o'ned federally:chartered F!MA, and Government !ational Mort+a+e Association
G!MA AGinnie:MaeC as a federal a+ency.
F!MA<s role in the secondary mar(et continued to e.*and over time, and included
uyin+ FHA, and Beteran Administration ABAC +uaranteed loans, as 'ell as uyin+
conventional non:+uaranteed loans in $6#=. Since $6E=, F!MA has e+un +uaranteein+
*rinci*al and timely *ayments of interest on the *ass:throu+h certificates ac(ed y
secondary securiti-ation of the seasoned conventional lon+:term loans.
To *romote and e.*and an affordale housin+ *ro+ram for the lo'er, middle class
*o*ulation in the country, and *articularly in the Sunelt States, G!MA is authori-ed to
+uarantee interest and *rinci*al *ayments on *rivately issued loans ac(ed y BA, FHA,
and Farmers Home Administration mort+a+es. G!MA ac(in+ carries the full faith and
credit of the United States +overnment ma(in+ these securities free of ris( of defaultI this
fuelled the +ro'th and e.*ansion of the other more so*histicated o*tion emedded credit
derivatives for securiti-ation of the credit. The Federal Home Hoan Mort+a+e
3or*oration FHHM3 AFreddie MacC 'as chartered y con+ress in $6#= to uy uninsured
and *rivately insured conventional mort+a+es.
That charterin+ further fuelled and revived the +ro'th in the securiti-ation *rocess
throu+h the e.*ansion of the secondary mar(et.
To securiti-e a lar+e *ool of homo+enous fi.ed rate residential mort+a+e:ac(ed
securities /MBS for the FHAFBA +uaranteed loans 'ith a minimum denomination of
>$==,=== 'ere sold to a small numer of investors y Ginnie Mae in $67E. The *ool of
loans +radually e.*anded y ;uasi:+overnment secondary mar(et institutions such as
Fannie Mae and Freddie Mac, to include *rivately issued su:*rime loans Alo'er ;ualityC
y conduits, Q1umo< loans Alar+eC 'ith varyin+ de+ree of diversity in terms of si-e, ty*es,
rates, maturity, and date of issue. From the *ool of the mort+a+es standardi-ed Q*ass:
throu+h< certificates issued to the investors that entitled them to a *ro*ortional interest,
*rinci*al, and *re*ayments Aless cost of securiti-ation, fi.ed and variale, cost of credit
enhancementC +uaranteed y the federal +overnment, *rivate insurers and or ori+inators.
The *ool of investors continued to +ro' that included, an(s, insurance com*anies,
mutual funds, real estate investment trust /E&Ts and individuals.
The +ro'th in securiti-ation of /MBS may e attriuted to several reasons.
$%

$%
See 0erry Bandell., ?Securiti-ation of the U.S. Mort+a+e Mar(et5 Pro+ress and Pitfalls, 'ith lessons for
1a*an,@ The Seventh &nternational Hand *olicy Forum, 8ctoer "$, %===.
%E
Homo+eneity of the residential mort+a+es in terms of under'ritin+ standards
encoura+ed y federal +overnment involvement to *romote home o'nershi* that
hel*s to increase ,o creation in a laor intensive sector of the U.S. economy.
Miti+ation of default ris( on the /MBS due to the e.istence of +overnment or
*rivate insurers in this mar(et.
Availaility of a lar+e historical data ase reflectin+ *erformance of the *ool of
mort+a+es in terms of delin;uencies, default rates, *ayments, and *re*ayments
that hel*ed the investors to *rice various ris(s in determination of the fair mar(et
value of these asset ac(ed derivative instruments.
Government and ;uasi +overnment a+encies created throu+h 3on+ress<s various
Acts is to e credited for estalishin+ infrastructures i.e., active secondary
mar(ets Aneeded for *rovidin+ li;uidityC, and the le+al frame'or(s that
encoura+e securiti-ation.
The need is the mother of all inventions. To mana+e and miti+ate imalance in
duration of the assets and liailities of the de*ository institutions, ne' innovative
asset ac(ed securities needed to im*rove assetFliaility mana+ement.
Passa+e of the $6E7 Ta. /eform Act that *ermitted real estate mort+a+e
investment conduits /EM&3S to e ta. e.em*t entities as 'ell as allo'in+ /E&Ts
to invest in mort+a+es and their derivatives MBS *roducts fuelin+ +ro'th of the
securiti-ation.
Hast ut not least 'as the *rofitaility of these instruments as the *roceeds from
the sale of the *ool 'as +reater than the amount the *ool *aid to investors in the
ABS credit enhanced y the ori+inator or third *arty +uarantor, therey
im*rovin+ ratin+s eyond the ratin+ of the s*onsor or ori+inator allo'in+ the ne'
securities to e sold to the ultimate investors at a *remium.
More than $F" of the all asset classes securiti-ed in the United States 'ere mort+a+e:
ac(ed securities.
2. &ommercial Mort!a!e :ac8ed Securities &M:S
Fe' events 'ith unintended conse;uences have had enormous influence in the
securiti-ation of the commercial mort+a+es in the United States. The real estate crisis
associated 'ith the insolvency of the Savin+s and Hoans Association SGH of the late
$6E=s and early $66=s, and the creation of the /esolution Trust 3or*oration /T3 y
con+ress in $6E6 are t'o such related events. The /T3 had several mandates5 to mana+e
li;uidation of the *erformin+ and non:*erformin+ residential and commercial mort+a+es
ori+inated y SGH s at a minimum cost to ta. *ayersI minimi-e the im*act of real estate
crisis on the financial mar(et and the economyI and to *reserve affordale housin+. These
mandates *roved to e the catalyst to ,um* start securiti-ation in this sector of the U.S.
economy.
$"
The /T3 has ta(en over more than #9= failed SGH 'ith more than >K7= illion oo(
value of assets y $66K. The /T3 has recovered >"9E illion out of >"66 illion assets
Aoo( valueC collected from the failed SGHs, 'hich is a recovery rate of 6= *ercent.
$"
See 1un+man, %===, A Primer on Securiti-ation M&T Press.
%6
Furthermore, the /T3 has *rovided *rotection to over %% million insured de*ositors 'ith
an avera+e alance of >6,===.== that fre;uently 'as called a ailout:nearly >"== illion
dollar ailout s*ent in *rotectin+ de*ositors 'ithout *ayin+ a dime to o'ners,
stoc(holders, or o*erators of the failed savin+s and loans association.
$K

The first +eneration of the multi:family Arental *ro*ertyC 'as securiti-ed y Ginnie
Mae in $6#= y issuin+ FHA insured *ass:throu+h. Fannie Mae and Freddie Mac e+an
issuin+ multifamily conventional mort+a+e *ass:throu+hs in late $6#=s. Penn Mutual Hife
&nsurance 3om*any securiti-ed office:uildin+ mort+a+es in $6EK.
$9

The /T3<s attem*t to li;uidate non:*erformin+ loans throu+h sale of individual or
*ortfolios of 'hole loans *roved inefficient, costly, and unsuccessful from the ta.*ayers<
*ers*ective, therey forcin+ /T3 to securiti-e commercial mort+a+es as an economically
viale alternative for resale to institutional investors in the early $66=s. To remove hu+e
amount of assets of the failed SGH held y /T3 'ithout *uttin+ undue do'n'ard
*ressure in the real estate mar(et, access to the mort+a+e:ac(ed securities mar(et *roved
to e essential. Had the /T3 attem*ted to sell 'hole loans in the mar(et, it 'ould have
de*ressed the real estate mar(et. To access the ca*ital mar(et ;uic(ly and conveniently
the /T3 filed a shelf re+istration statement 'ith the Securities and E.chan+e
3ommission SE3 in March $66$ to offer mort+a+e:ac(ed securities to investors.
Securiti-ation 'as desi+ned to offer investors standardi-ed investment *roducts that offer
investors more hi+her yield than a com*arale rated securities 'ithout e.*osin+ them to a
hi+her ris(. The securiti-ation achieved several o,ectives, e.+. e.*edited asset sales and
increased recovery values.
Based on /T3 estimates, the securiti-ation *rocess *roduced a**ro.imately >".K illion
additional *roceeds as com*ared to sales of 'hole loans.
$7
Most of the enefits achieved
in the securiti-ation of multi:familyFcommercial mort+a+es 'ere due to si+nificant
dis*arities in *ricin+ 'ith securiti-ation as o**osed to 'hole loan sales. The /T3
contriuted to the securiti-ation *rocess5 y develo*in+ sustantial investor ase for
commercial mort+a+es y emeddin+ o*tions to its securiti-ed instruments that a**ealed
to roader classes of investorsI *rovidin+ +reater de+ree of li;uidity that 'as *articularly
asent in the commercial mort+a+e mar(etI y allo'in+ various mar(et *artici*ants such
as ori+inators, arran+ersFunder'riters, investment an(ers, and ratin+ a+encies to develo*
necessary analytical tools for analysis of com*le. investment *roducts at +overnment
e.*ense. &nvestors 'ere enticed y additional yields 'ithout ein+ e.*osed to e.cessive
credit ris( associated 'ith 3MBS.
The commercial real estate securiti-ation re;uired +reater de+ree of due dili+ence for
analy-in+ individual *ro*erties in the *ortfolio *ertainin+ to the earnin+ *o'er of the
*ro*erties, det service covera+e ratios, *hysical ins*ection of the *ro*erties, and ta*e:to:
file chec(in+ to verify that the information aout the *ro*erty on the loan file matches
that on the same *ro*erty on the com*uter file. The underlyin+ assets are either alloon
ty*e or fully amorti-ed, fi.ed or ad,ustale rate mort+a+es, ori+inated y many different
ori+inators across the United States, serviced y many different servicers. The ratin+
a+encies re;uire ins*ection of the *ro*erties a+ainst environmental ha-ards, 'hich may
su,ect the security holders to losses stemmin+ from environmental la's. The loans in the
$K
&id.
$9
&id.
$7
&id.
"=
*ool are multi:family *ro*erties, office uildin+s, retail *ro*erties, and other *ro*erties
s*read over many different +eo+ra*hic re+ion of the country.
The 3ommercial real estate securiti-ation differs from the residential mort+a+es as
related to the servicin+ involvin+ foreclosure for the defaulted loans. &n the event of
homeo'ner defaults, foreclosure immediately is follo'ed y the sale of the residential
*ro*erty, for the commercial *ro*erty the foreclosure may not e an o*timal course of
action, as it is *ossile to restructure the loan 'ith the o'ner or o*erator to ensure +reater
revenue in the future. Most loans in the *ortfolio of commercial *ro*erties are alloon
ty*es. For e.am*le, a *ortfolio of seasoned commercial *ro*erties may have 'ei+hted
avera+e maturity of $K years, 'hile the *ass:throu+hs issued have thirty years to maturity,
'hich should *ermit the servicer to roll over at the end of the alloon *eriod u* to the full
term of the securities issued to investors.
By $669, res*ectively 7N and $KN of the commercial mort+a+es and multi:family
*ro*erties in the U.S. 'ere securiti-ed. Mar(ets for 3MBS *roducts e+an to +et
acce*tance y institutional investor as familiarity 'ith these instruments increased and
the *ool of investors +re' that included an(s, insurers, *ension funds, and individuals as
they assumed e.*osure to these ty*es of securities throu+h mort+a+e /E&Ts.
The *ace of securiti-ation for 3MBS mar(et did not develo* as ;uic(ly as their
residential counter*art for the follo'in+ reasons5
Hetero+eneity of commercial mort+a+es in terms of ty*es, maturity, rates, and
under'ritin+ standards.
Asence of commercial mort+a+e insurance that could miti+ate default ris(.
Ho'ever, develo*ment of ratin+ system y ratin+ a+encies in $6E9, and senior:
suordination of the derivative *roducts have miti+ated default ris( to some e.tent
y shiftin+ and transferrin+ ris( from senior class to suordinated and unrated
residual class.
Asence of historical data on the *erformance of the commercial mort+a+es in
terms of *re*ayments, *ayments, default, and delin;uencies made it difficult if not
im*ossile to *rice these ris(s into determination of the fair mar(et value of these
instruments in the mar(et.
Asence of secondary mar(et *layers such as Ginnie Mae, Fannie Mae, or Freddie
Mac to uy commercial mort+a+es for securiti-ation. The /T3 came to life to
create secondary mar(et for this ty*e of mort+a+es in the late $6E=s and early $66=s
and dissolved in $667 havin+ accom*lished its intended *ur*oses.
There 'as disincentive to hold 'hole loan commercial mort+a+es in a an( or
insurance com*any<s *ortfolio, as it 'as costly to (ee* these loans in the alance
sheet 'ith the re+ulatory ca*ital reserve re;uirement of $== *ercent of E *ercent. As
the reserve re;uirement 'as reduced to 9= *ercent for securities ac(ed y
commercial mort+a+es Aas o**osed to 'hole loans classified as $== *ercent ris(
ased assetC after the *assa+e of the Financial &nstitution /eform, /ecovery, and
Enhancement Act of $6E6 AF&//EAC, and !ational Association of &nsurance
3ommissioners A!A&3C action *rovided incentives for the an(s and insurance
com*anies to invest in 3MBS.
8ther re+ulatory reforms, such as e.tension of Em*loyee /etirement &ncome
Security Act AE/&SAC that *ermitted *ension funds to invest in the 3MBS,
roadened the a**eal of these instruments in the mar(et.
"$
The 3MBS *roducts evolution from fairly un(no'n to an acce*tale one to hold in
most *ortfolios did not ha**en overni+ht. First5 re+ulatory chan+es made it
attractive to hold these securities in the investors< *ortfolio. Second5 *rofit mar+ins
im*roved as various ris(s are correctly *riced in determination of the fair mar(et
value. Third5 ris( ased ca*ital 'as reduced ma(in+ it less costly to hold these
securities in the *ortfolio *articularly for an(s and insurance com*anies. Fourth5
investors +ained acce*tance as their understandin+ of these *roducts im*roved
overtime. Fifth5 +reater standardi-ation and lar+er *ool si-e reduced the cost and
*rovided economies of scale in securiti-ation of this class of loans.
The level of credit enhancement *rovided for the residential and commercial mort+a+es
are a**ro.imately e;ual to E and K9 *ercent of *rinci*al res*ectively. An E *ercent credit
su**ort as a *ercenta+e of the *rinci*al is considered as a si-ale amount to secure a
tri*le:A ratin+ for the residential mort+a+e ac(ed securities, ho'ever, to secure the same
ratin+ for the 3MBS, ratin+ a+encies re;uire K= to 9= *ercent credit su**ort that is
usually invested in the Treasury securities.
The Asset ac(ed securities usually trade at %= to "= asis *oints over the same rated
cor*orate onds. The 3MBS traded at %== to "== asis *oints over com*araly rated
cor*orate dets in $66". The s*read has narro'ed to under $== asis *oints. The
investor<s interest in the real estate mort+a+e *roducts is driven not only y the *romise
of hi+her yield, ut also y the lo'er ca*ital re;uirements in the securiti-ed instrument.
For e.am*le, insurance com*anies must maintain " *ercent ca*ital for havin+ a *iece of
real estate *ro*erty in their oo(, 'hile holdin+ tri*le:B rated 3MBS re;uires only ."
*ercent re+ulatory ca*ital. Therefore, for the same re+ulatory ca*ital insurer can maintain
$= fold securiti-ed instruments in their alance sheet.
0. Pass<t(rou!( &erti3icates P&
This certificate entitles the investors to a *ro*ortional share of the cash flo's Athe
cou*on, *rinci*al, and *re*aymentsC of the *ool of underlyin+ mort+a+es Aresidential or
commercialC less the administrative cost, default and foreclosure in the individual
com*onents of the *ool, and the cost of under'ritin+ and credit enhancement. The
investors share on a *ro rata asis the ris( and return in the *ass:throu+hs across all
mort+a+es ori+inated in different +eo+ra*hic re+ions and over time. The first
conventional mort+a+e *ass:throu+h security 'as issued y Ban( of America, and
under'ritten y Salomon Brothers, in $6##. The ;uality of mort+a+e:ac(ed *ass:
throu+h, unli(e cor*orate loans, im*roves over time as the mort+a+e loan is amorti-ed
and loan to value HTB ratio declines. Furthermore, risin+ inflation and a concurrent rise
in the *rice of real estate also leads to im*rovement in the ;uality of the underlyin+ *ool
of mort+a+es as HTB ratio declines ma(in+ this class of asset safer than other assets in
investors< *ortfolio.
3onsider a *ortfolio of $= 'hole loans each 'orth >$==,=== are *ooled y an
ori+inator or s*onsor, from 'hich *ass:throu+hs or *artici*ation certificates P3s 'ith
denomination of >$,===.== are issued to investors as sho'n in the Fi+ure $.E. Each P3
re*resents a *ro*ortional o'nershi* interest in the underlyin+ *ool of mort+a+es
A*rinci*al, cou*on, and *re*aymentC net of costs. The cou*on interest on the *ass:throu+h
"%
is smaller than the cou*on of the underlyin+ *ool of mort+a+es y an amount that is e;ual
to the administrative, servicin+, and cost of credit enhancement.
The cash flo' of a *ass:throu+h security is un(no'n as the *re*ayments y the
underlyin+ *ool of mort+a+es are su,ect to the chan+es in various micro and macro
economic conditions to 'hich 'e return later. Ginnie Mae, Fannie Mae, and Freddie Mac
issued *ass:throu+hs res*ectively +uaranteed y the federal +overnment, Federal !ational
Mort+a+e Association, and Federal Home Hoan Mort+a+e 3or*oration that came to e
(no'n as a+ency *ass:throu+hs. These +uarantees im*roved the ;uality of the *ass:
throu+hs ma(in+ them a close sustitute to U.S. Treasury securities. Ho'ever, *ass:
throu+h securities *ossessed characteristics in terms of duration, conve.ity, *re*ayments,
and default similar to that of the underlyin+ mort+a+es.
Private conduits, an(s and other financial institutions *urchased a *ool of
nonconformin+ mort+a+es and issued *ass:throu+h securities that came to e (no'n as
issue non:a+ency *ass:throu+hs. The *ass:throu+hs are ac(ed y the underlyin+
mort+a+es and credit enhanced y third *arty *rivate +uarantors 'ithout any +uarantee y
the federal +overnment or any of its a+encies. These securities are re+istered y the
Securities and E.chan+e 3ommission and are rated y four ratin+ a+encies in the United
States that im*roved mar(et acce*tance and a**eal of these instruments.
Ho'ever, a+ency and non:a+ency *ass:throu+hs, similar to all mort+a+e loans, are
callale, thus ma(in+ them *articularly unattractive to uy:and:hold classes of investors.
The call feature emedded in this instrument allo's the issuer to call the ond 'hen and
if the issuer desires to do so. 2hen rates fall the *rice of mort+a+e det is not li(ely to +o
u*, as com*ared to non:callale onds, since the u*side *otential is severely limited y
the *ros*ect of call.
$#
Ho'ever, 'hen rates increase, the *rice of callale onds is
e.*ected to decline more than its non:callale counter*art.
$E
This *rice ehavior is
attriuted to the *resence of negative convexity on this ty*e of det instruments. Those
*ass:throu+hs 'hose *rice ehavior mimics that of an underlyin+ *ool of mort+a+es
*rone to *rice com*ression Au*side *rice is truncated due to the emedded call o*tionC
'hen rates fall and do'nside ris( is +reater as rates +o u*, are also callaleI *re*ayment
slo's, as mort+a+ors are not li(ely to *re*ay at times of risin+ interest rates.
The mar(et needs innovative *roducts that differ in terms of duration, conve.ity,
*re*ayment, and default. Early MBS, such as the P3, 'ere destined for modification,
'ith cash flo's sliced vertically to miti+ate *re*ayment ris(, and hori-ontally to limit
default and interest rate ris(. To a**eal to a roader +rou* of investors in the mar(et,
senior and suordinate classes 'ere created.

$#
This is due to contraction ris(, as the life of the det instrument is li(ely to e shortened due to callaility
of this instrument y the issuer.
$E
This is due to e.tension ris(, as the life of the det instrument is li(ely to increase as *re*ayments slo'.
""
7. &M,s
The first +eneration of derivative mort+a+e:ac(ed securities 'as collaterali-ed
mort+a+e oli+ations A3M8sC issued y Freddie Mac in 1une $6E".
$6
The 3M8s 'ere
$6
See iid.
1,000 P&s
Issued to
in-estors
PP3UPPP
Hoan %5 >$==,===
PP3PPP
Hoan "5 >$==,===
PP3PPP
Hoan K5 >$==,===
PP3PPP
Hoan 95 >$==,===
PP3PPP
Hoan 75 >$==,===
PP3PPP
Hoan $=5 >$==,===
PP3PPP
Hoan 65 >$==,===
PP3PPP
Hoan #5 >$==,===
PP3PPP
Hoan E5 >$==,===
PP3PPP
Hoan $5 >$==,===
PP3PPP
He+end5 PV*rinci*al, 3V cou*on, PPV *re*ayment, 3UV cou*on of *ass:throu+h
#i!ure 1.+: &reation o3 P&s 3rom A(ole =oans in a Securitization Structure
"K
desi+ned to shift *re*ayment ris( from some of the classes to another class y
redistriutin+ *re*ayments of *rinci*al y rules other than *ro*ortional allocation. &n this
*rocess of redirectin+ the allocation of cash flo's, neither *re*ayment ris( nor default
ris( is reducedI ris( is sim*ly reshuffled and redistriuted amon+ different classes of
investors.
For e.am*le, 3M8 structure allocates cash flo's into different tranches 'ith different
*riorities on the *re*ayment and scheduled *rinci*al *ayment, as 'ell as senior
suordination of the cash flo's to miti+ate default ris( for senior class at the e.*ense of
suordinate class. An accrual or a W class is also included in some of the 3M8 structuresI
interest *ayments accrue and are deferred until all other classes are *aid off in full efore
*ayin+ interest and *rinci*al to this class, 'ith relatively hi+her duration and conve.ity as
com*ared to other classes. This structure a**eals to lon+:term investors, such as
insurance com*anies, 'ho uy and hold the W class until its maturity and are averse to
reinvestment rate ris(.
Another class of derivative *roducts sliced the cash flo's hori-ontally y allocatin+
dis*ro*ortionate amount of interest and *rinci*al to different classes of investors. For
e.am*le, interest only &8 and *rinci*al only P8 securities allocated $== *ercent of
interest to &8 class and -ero *ercent to P8 class, 'hile allocatin+ -ero *ercent of
*rinci*al to &8 class and $== *ercent of *rinci*al to P8 class.
To miti+ate *re*ayment ris( a ne' class of derivative MBS 'ere created to *rovide
investors *rotection a+ainst oth contraction and e.tension ris(. The Planned
Amortization &lass APA3C and $ar!eted Amortization &lass ATA3C re*resent financial
en+ineerin+ desi+ned to reshuffle the *re*ayment ris( to the com*anion class. To address
the interest rate ris( concern of some of the investors, a floater 'as carved out of the
underlyin+ *ool of fi.ed rate mort+a+es collateral, alon+ 'ith an inverse floater 'hose
cou*on is inversely related to the *revailin+ mar(et interest rates inde. such as H&B8/ or
the *rime rate.
The financial mar(ets continue to create ne' *roducts that can miti+ate *rice ris( and
transfer ris(, enhance li;uidity, +enerate det or e;uity, transform one form of income
into another for ta. *ur*oses, and create future *roducts for currently un*erceived ris(s.
&n this *rocess of financial en+ineerin+ some of the *roducts 'ill fail to s*ur interest and
demand to survive the test of time, 'hile others 'ill flourish as they create value,
increase trans*arency and im*rove efficiency, and therey lo'er the cost of ca*ital in the
residential and commercial mort+a+e or other mar(ets, im*rove *rofit mar+in, increase
availaility and roaden the *ool of investors and the *ool of orro'ers in the mar(et
*lace.
Gro'th in securiti-ation can e attriuted to the follo'in+ factors5
#irst, the im*osition of an E *ercent minimum ca*ital reserve y the B&S has increased
the safety of the financial intermediaries, and increased *ulic 'illin+ness to invest in the
securities issued y these institutions. &n search of hi+her yields, and to defray the cost of
re+ulatory restrictions, an(s and other non:an( finance com*anies find securiti-ation of
assets a ne' means of financin+ for ori+ination of hi+her yieldin+ assets. By removin+
illi;uid assets from alance sheets, securiti-ation allo's the financial institutions to serve
a lar+er customer ase 'ithout havin+ to raise ne' funds in the form of det or e;uity
ca*ital.
"9
Second, as the +loal cost of ca*ital increases due to risin+ ris( *remium and +loal
inflation, securiti-ation of current and or future receivales hel*s an(s and non:an(
institutions to raise chea*er ca*ital for their usinesses at the asset level instead of the
cor*orate enter*rise level.
$(ird, as the 'orld economies move in the direction of +reater inte+ration of financial
mar(ets due to removal of arriers, and as these institutions com*ete for the same ca*ital,
it ecomes im*erative to secure an efficient and lo' cost financin+ vehicle.
#ourt(, vast im*rovements in com*uter technolo+y have reduced the cost of *rocessin+
information for the ma,or *layers in the financial mar(et, enalin+ them to identify and
isolate certain self:li;uidatin+ assets such as mort+a+e loans and other receivales 'ith
the o,ective of removin+ them from alance sheets and lo'erin+ the cost of fundin+.
Assets off a alance sheet at times are 'orth more than on it. &t is very li(ely that the SPB
'ill secure hi+her ratin+s for the assets removed from the alance sheets of an ori+inator
than the ori+inator could command in the mar(et, therey reducin+ cost of fundin+.
The first issue in the +ro'th of securiti-ation is related to the ;uestion of 'hy an(s and
finance com*anies ori+inate loans and suse;uently try to securiti-e them. Ban(s see(
usiness relationshi* 'ith cor*orate clients, some of 'hom can access ond mar(ets on
their o'n +iven the introduction of ,un( ond mar(ets and the increasin+ numer of
*rivately *laced det issues. &n this environment an(s analy-e mar+inal enefitsFcosts of
maintainin+Fseverin+ relationshi*s 'ith cor*orate clients 'ith the mar+inal enefits of
securiti-ation5 reduced fundin+ costs, increases in return on e;uity, and access to roader
sources of fundin+. Maintainin+ this delicate alance et'een relationshi* an(in+,
et'een orro'er and lender, and securiti-ation is essential for the lon+ run *rofitaility
of these institutions.
%=
1IIII. e!ulatory &apital e6uirements
The Basle committee on an( su*ervision A$6EEC, under the aus*ices of the an( for
&nternational Settlement AB&SC and senior memers of G:$= central an(s, estalished
common criteria for the measurement of an( ca*ital and a methodolo+y for 'ei+hin+
and classification of ris(:ased assets for ris(:ased ca*ital.
%$
Based on the Basle Accord,
an(s and their holdin+ com*anies are re;uired to maintain an ei+ht *ercent ca*ital
reserve for their ris(:'ei+hted value of assets. The Basle Accord classifies an( ca*ital
into three Tiers5 Tier $ ca*ital is related to common stoc(s, non:cumulative *er*etual
*referred stoc(s, and disclosed reservesI
%%
Tier % ca*ital re*resents dets 'ith fi.ed or
cumulative costs, such as cumulative *referred stoc(s, convertile dets, redeemale
*referred shares, suordinated dets, and +eneral *rovisionsI and, Tier " ca*ital
re*resents short:dated suordinated deentures retained to su**ort the tradin+ des( and
mar(et ris(s associated 'ith derivatives transactions.
The Basle Accord further im*oses limits on the amount of ;ualifyin+ ca*ital for the
an(s, i.e., for e.am*le, Tier % ca*ital may not e.ceed $== *ercent of Tier $ ca*ital,
%"
and
%=
See Alri+ht .T and Smith. S, A%==KC ?3or*orate Hoan Securiti-ation5 Selected He+al and /e+ulatory
&ssues,@ )u(e 1. of 3om*. G &nt<l Ha'. P K$$:K"E.
%$
Basle committee on an(in+ su*ervision consists of G:$= 3entral an(ers that include Bel+ium, France,
3anada, Germany, &taly, Hu.emour+, !etherlands, 1a*an, the United 0in+dom, and the United States.
%%
See Ban( for &nternational Settlement, Pro*osal for &nternational 3onver+ence of 3a*ital Measurement
and 3a*ital Standards, A$6EEC, hereafter Basle Accord.
%"
See Basle Accord, su*ra note ", *ara. KK.
"7
suordinated det may not amount to more than 7= *ercent of Tier $ ca*ital.
%K
Tier "
ca*ital that is retained to su**ort the mar(et ris( associated 'ith tradin+ des( may not
e.ceed %9= *ercent of a an(<s tier $ ca*ital.
%9
Furthermore, +eneral *rovisions included
in Tier % ca*ital should not e +reater than $.%9 *ercent of ris( 'ei+hted assets.
%7

A an(<s ca*ital ade;uacy re;uirement for the assets held in the an( oo( is
estimated y the ratio of total ;ualifyin+ Tier $ and Tier % ca*ital over the ris(:'ei+hted
value of assets, oth on and off:alance sheet.
%#
The ris(:'ei+hted value of the an(
assets is calculated as the *roduct of the *rinci*al amount of the asset 'ei+hted y the
ris( 'ei+htin+ of an associated counter*arty.
%E
Based on the Basle Accord, an(s are
re;uired to maintain a minimum ca*italFris( asset ratio of ei+ht *ercent.
%6
/e+ulatory
a+encies may re;uire hi+her rates if they see the assets structure of the an( *ortfolio are
deterioratin+.
For e.am*le, dets issued y the countries that are memers of the 8r+ani-ation of
Economic 3oo*eration and )evelo*ment A8E3)C are assumed free of ris( of default,
and therefore are -ero ris(:'ei+hted. )ets issued y +overnment a+encies such, as
Federal Home Hoan Mort+a+e, and Federal !ational Mort+a+e Association are %= *ercent
ris( 'ei+hted. /esidential mort+a+es are ris( 'ei+hted y 9= *ercent.
"=
3or*orate loans
are ris( 'ei+hted $== *ercent of ei+ht *ercent, re+ardless of 'hether the counter*arty to
the ori+inatin+ an( is an SGP 9== firm or a small *rivately held HH3.
"$
Therefore, from the ori+inatin+ an(<s *ers*ective, cor*orate loans are more
e.*ensive to hold on a an( alance sheet than, for e.am*le, residential mort+a+es Aris(:
'ei+hted 9= *ercentC, 'hich has een securiti-ed since the $6#=s in the United States.
"%

Ban(s are findin+ it increasin+ly difficult to reduce their overall cost of ca*ital and to
im*rove /8E 'ithout restructurin+ the asset side of the alance sheets throu+h
securiti-ation of cor*orate loans.
1IIII.1 =e!al and Structural Issues
He+al and structural issues arisin+ in securiti-ation of credits has to address re+ulatory
concerns as follo's5
""
/evolvin+ 3redits
Achievin+ 3a*ital /elief
Moral Ha-ard Prolem
/elationshi* Ban(in+
3herry Pic(in+ G Hemon Sellin+
Hi;uidity Facilities and Har+e E.*osure
2hich /e+ulator4
%K
See Basle Accord, su*ra note ", *ara. %".
%9
See 3a*ital Accord Amendment, su*ra, note E, *ara.$.
%7
See Basle Accord, su*ra note ", *ara. %$.
%#
See Basle Accord, su*ra note ", *ara. KK.
%E
See &id.
%6
See &id.
"=
See Basle Accord, su*ra note ", *ara. K$ and Anne. %.
"$
See Basle Accord, su*ra note ", *ara. %E
"%
See &id.
""
See Alercht G Smith A%==KC for detailed revie'.
"#
Fully dra'n term loans are easy to securiti-e asent of *rovisions to rene' or e.tend a
revolving credit facility to the ori+inator. Ho'ever, revolving lines of credit *ose
com*lications for the SPB, as it is difficult to foresee fundin+ re;uirements of the
ori+inator. &n this scenario, if an SPB assumes a commitment to lend and finds it difficult
to secure credit in a timely fashion, it o*ens itself u* for a reach of contract la'suit. For
a financial institution that has *rovided a committed line of credit to a counter*arty 'ith a
commitment *eriod e.ceedin+ "79 days, this commitment 'ill e ris(:'ei+hted off:
alance sheet.
"K
&n the event the SPB assumes the commitment to fund the facility,
'ithout *rovidin+ cash collateral for its oli+ation, the ori+inator may e oli+ated to
assi+n a ris( 'ei+htin+ of $== *ercent to the commitment of the SPB.
"9
To *revent
ne+ative carry the SPB may not issue dets for the *ar amount of committed lines of
credit that is fundin+ for the ori+inator, ecause the undra'n *ortion of the det is li(ely
not to earn a rate of return commensurate 'ith the SPB<s fundin+ cost.
8nce the assets are removed from the alance sheet of the ori+inatin+ an( in a
securiti-ation *rocess, *ursuant to Financial Accountin+ Standard Boards FASB $%9, the
ori+inator 'ill reali-e capital relief from the ori+inal ca*ital re;uirement associated 'ith
those assets.
"7
Strictly s*ea(in+, no asset sale 'ill relieve the ca*ital re;uirement unless it
com*lies 'ith FASB $%9, *rovided that the ori+inatin+ institution has retained no
recourse 'hatsoever to the assets transferred to the SPB.
"#

FASB $K= is the e.tension of FASB $%9, 'here the ne' statement a**lies to the
transfer of ne' financial assets occurrin+ after March "$, %==$. Some of the more
si+nificant *rovisions of FASB $K= affectin+ securiti-ation transactions are noted elo'.
The assets and liailities of a Rualifyin+ S*ecial Pur*ose Entity RSPE 'ill not e
consolidated 'ith the financial statement of the ori+inator As*onsorC, the transferor.
Statement $K= is *la+ued 'ith a loo*hole as follo's5 Even if the transferor retains $==
*ercent of the residual or e;uity class of the ABS or MBS issued y the SPE in ali+nin+
its interest 'ith the investors, and the issuer of the ABS fails to ;ualify as a RSPE, a third
*arty investors must ma(e e;uity investment of Ae.+., more than three *ercent of the
mar(et value of the assetsC, controllin+ Amore than 9= *ercent of the votin+ ri+htC, and
ear the ris( of first loss, the financial statements of the third *arty 'ill not e
consolidated 'ith that of the transferor, other'ise transferor and issuer consolidates.
FASB $K= si+nificantly eefs u* disclosure re;uirements for securiti-ation
transactions and residual interests. These disclosures include A$C the assets *ool *ro,ected
and actual lossesI A%C stress test sho'in+ adverse im*act on the fair value of retained
interests resultin+ from the chan+es in *re*ayments, losses and discount ratesI A"C
sho'in+ all cash flo's e.chan+ed et'een SPE and the transferorI and AKC delin;uencies
and net credit losses for oth on and off:alance sheet assets under transferor control.
An ori+inatin+ an( may transfer its ris( to a *ortfolio of credits, ut retains the ri+ht
to service those loans and continue its association 'ith ori+inal orro'ers 'hose loans
have een assi+ned, 'ithout orro'ers ein+ a'are of such transfer to an SPB. This
creates moral hazard *rolem for the ori+inatin+ an( that re+ulatory authorities around
the 'orld are concerned 'ith in a securiti-ation *rocess. For e.am*le, a orro'er 'hose
loan has een securiti-ed may defaultI to *reserve future customer relationshi*s, the
"K
See Basle Accord, su*ra note ", Anne. ".
"9
See Basle Accord, su*ra note ".
"7
See Federal Financial &nstitutions E.amination 3ouncil Press /elease, !ov. ", $669
"#
See The 3om*troller of 3urrency, su*ra note "E.
"E
ori+inator may e tem*ted to re*urchase the defaulted asset, instead of leavin+ it to the
SPB to see( its o'n solution. All an( re+ulatory authorities in the U.S. and Euro*e,
includin+ the 833, the Ban( of En+land, the )utch, and the )eutsche Ban( insist on
ensurin+ that the ori+inatin+ an(s have com*letely divorced themselves of the assets
transferred to the SPBs.
"E
Furthermore, ori+inatin+ an(s are *rohiited from o'nin+ any
shares or ca*ital interests in the SPBs, and an( re+ulators restrict the ty*e of facility an
ori+inator may *rovide to an SPB for credit enhancement of suordinated dets
suscried for at the issuance of securities.
"6

Money mar(et lines or overdraft facilities andFor short:term undra'n lines of credit
ta(e on *articular im*ortance as far as the baner!customer relationshi* and the ensuin+
moral ha-ard in re+ulatory treatment of securiti-ation of uncommitted lines of credit.
/e+ulatory treatment of securiti-ation of uncommitted lines of credit, for commitments
'ith a tenor of "79 days or less, are -ero ris(:'ei+hted, and therefore incur no ca*ital
cost.
K=
8n the other hand, once dra'n, the loan 'ill e ris(:'ei+hted $== *ercent::similar
to any other cor*orate loans.
Ty*es of assets chosen for securiti-ation *ose a serious concern for re+ulatory
authorities as it is *ossile that the ori+inatin+ institution involves in cherry picing and
lemon selling. &t is li(ely that the ori+inatin+ an( cherry picing *ortfolio of its loans for
securiti-ation, leavin+ *ortfolio of loans in the alance sheet that may not e hi+h ;uality
assets. &n this scenario, the ori+inatin+ an(<s attem*t to securiti-e +ood credits leads to
the deterioration of the remainin+ assets in the *ortfolio. This is li(ely to increase
ori+inator<s ca*italFris(:asset ratio, as the remainin+ assets in the *ortfolio are hi+her ris(:
'ei+hted as *erceived credit ris( increases. Furthermore, if assets in the ori+inator oo(
start to default, the ori+inator is li(ely to set additional *rovisions that do not count as
Tier $ ca*ital. This is counter:*roductive and defeats the *ur*ose for a an( involved in
securiti-ation, as the ca*italFris(:asset ratio is risin+ and the an(<s ;ualifyin+ ca*ital is
fallin+. Finally, the an(<s *rofit mar+in may e adversely affected from the retention of
*oorly *erformin+ assets.
K$
8n the other hand, lemon selling of the loans for
securiti-ation may lead to im*rovement in the credit ;uality of the loans in the an(
*ortfolio.
Based on the Basle Accord, an(s need to lessen their e.*osure to credit ris( throu+h
diversification of their overall *ortfolios y5 industry, economic sector, country of the
orro'er, and ty*es of orro'er and credit facility. Asent of this diversification,
minimum ca*ital ade;uacy re;uirement 'ould e +reater than ei+ht *ercent. Assets
chosen for securiti-ation, therefore need to e randomly selected as there a**ears to e no
strict criteria from the Ban( of En+land or 833.
K%
The ori+inatin+ an( must maintain a
delicate alance et'een the loan assets (e*t in its *ortfolio::'ithout *rovo(in+ a
re+ulatory ac(lash, and the ;uality of assets removed from its oo( to access chea*er
sources of fundin+ in the ca*ital mar(et throu+h the issuance of asset ac(ed securities y
the SPB to the investors.
"i#uidity facilities in the form of committed lines of credit +ranted for su**ort of asset
ac(ed commercial *a*ers AB3P, are usually short dated 'ith tenor of "7K days or less,
"E
See Ban( of En+land !otices, su*ra note K7.
"6
See Ban( of En+land !otice BS)F$6E6F$, su*ra note K7, *ara. $K.
K=
See Basle Accord, su*ra note ", *ar. K%AdC and Anne. ".
K$
See iid.
K%
See Ban( of En+land !otice SGSF$667FE, su*ra note K7, *ara.$$.
"6
therefore are -ero ris(:'ei+hed and incur no ca*ital cost.
K"
Furthermore, the *roviders of
the facility are not *rovidin+ de facto credit enhancement.
KK
Ban(s *rovidin+ such
facilities should ensure that the facility +ranted does not reach other re+ulatory
re;uirements, such as e.*osure limit to a *articular counter*arty not to e.ceed $= *ercent
of ;ualifyin+ Tier $ and Tier % ca*ital.
K9
Ban(s securiti-in+ lon+ dated loan assets y
sellin+ it to SPBs, 'hich in turn have issued AB3P, therey aritra+in+ et'een the
lo'er rates *ayale to AB3P investors and the hi+her rates earned on the lon+ dated
assets. The SPBs in the aove scenario have hi+h duration assets and lo' duration
liailities, such as "=, 7=, 6=, or $E= days commercial *a*er, creatin+ mismatch et'een
assets and liailities. To *rotect the AB3P investors and miti+ate SPBs e.*osure to
structural mismatch, the ori+inator *rovides standy li;uidity facilities to the SPB, in the
amount not to e.ceed the a++re+ate amount of AB3P *lus any accrued interest or
accreted discount.
$hich regulator4 &n a cross:order securiti-ation, the ;uestion arises as to 'hich
re+ulatory rules the ori+inator is ound4 &n +eneral, an ori+inatin+ an( has to com*ly
'ith the le+al, accountin+, and ta. la's of its o'n ,urisdiction of incor*oration. Ho'ever,
*rudence re;uires that the local as 'ell as home country ,urisdiction e satisfied.
K7

Forei+n an(s that do not ta(e de*osits in the United States, and are not su,ect to
Federal )e*osit &nsurance 3or*oration F)&3, may a**ly the le+al re;uirements of their
home country ,urisdiction.
A securiti-ation structure is accounted for as a sale, as neit(er a sale nor a 3inancin!, as
a 3inancin!, or as a partial sale de*endin+ on the terms of the deal5
As a sale 'hen the transferor has surrendered control over the transferred assets for
cash and some residual interests, 'here cash fundin+ is considered as off:alance sheet
and residual interests are oo(ed as on:alance sheet assets of transferor.
As a 3inancin! 'hen transfer violates one or more of FASB $K= criteria for sale
accountin+.
As neit(er a sale nor 3inancin!I as in a s'a* of mort+a+e loans for mort+a+e ac(ed
securities A'hen no *roceeds are raised other than interests in transferred assetsC.
As a partial sale, 'hen the transferor retains the ri+ht to service the assets transferred
'ith some residual e;uity interests and FASB $K= sale criteria are met for the assets sold
to securiti-ation vehicles. Most securiti-ations are considered in this cate+ory.
1IIII.2: Sale Accountin!
3ontrol is surrendered for the transferred assets, 'hen the follo'in+ three criteria are
met in a securiti-ation transaction5
?$. The transferred assets have een isolated from the transferor: *ut eyond the reach of the transferor,
or any consolidated affiliate of the transferor, and their creditors Aeither y a sin+le transaction or a series of
transactions ta(en as a 'holeC even in the event of an(ru*tcy or receivershi* of the transferor or any
consolidated affiliate.
K#

K"
See Basle Accord, su*ra note ", Anne. ".
KK
See iid.
K9
See 3ouncil )irective 6%F$%$FEE3.
K7
See iid.
K#
See FASB $K=, Para. 6a and %#
K=
%. The transferee Aor, in a t'o:tier structureC is a RSPE and each holder of its eneficial interests
Aincludin+ oth det and e;uity securitiesC has the ri+ht to *led+e, or the ri+ht to e.chan+e its interests. &f
the issuin+ vehicle is not a RSPE, then the sale accountin+ is only *ermitted if the issuin+ vehicle itself has
the ri+ht to *led+e or the ri+ht to e.chan+e the transferred assets.
KE
".The transferor does not effectively maintain control over the transferred assets either throu+h5 AaC an
assi+nment that calls for the transferor to re*urchase the transferred assets Aor to uy ac( securities of a
RSPE held y a third *arty investorsC efore their maturity Ain other 'ords, the a+reement oth entitles and
oli+ates the transferor to re*urchase as 'ould, for e.am*le, a for'ard contract or a re*oI or
AC the aility to unilaterally cause the SPE or RSPE to turn s*ecific assets, other than throu+h a clean
call.@


1IIII.05 Sales o3 =oan
Under the e.istin+ common la' re+ardin+ ?true sales@ there are three methods y 'hich
a loan sale y the an( ori+inator can achieve relieve of re+ulatory ca*ital. These
methods are novation, assignment, and participation.
!ovation, involves transfer of an asset from the ori+inator to the SPB 'ith the consent of
the oli+or AdetorC of the underlyin+ loan asset that is ein+ securiti-ed. &n this tri:*arty
arran+ement, the ori+inator and oli+or ,ointly a+ree to transfer the assetAsC to third *arty
the SPB, 'ith ori+inator unconditional a+reement to terminate all of his security interest
to the assetAsC, and SPB assumes all ri+hts and oli+ations to the transferred assetAsC.
&ase Study*5 Su**ose a re+ional an( in mid:'est is a**roached y an arran+er an(
for sellin+ a *ortfolio of >9= million car loans 'ith a 'ei+hted:avera+e cou*on of #.9
*ercent and 'ei+hted:avera+e maturity of K.%9 years at *ar throu+h its s*ecial *ur*ose
vehicle. The ori+inatin+ an( Aarran+erC 'ishes to retain %9 *ercent of the loans or >$%.9
million in its oo( and continue to service the remainin+ alance securiti-ed under
novation. The ori+inal orro'ers have consented to the assi+nment of the loans to a third
*arty SPB, and the ori+inal lender has terminated its security interest in the loan assets
'ithout any recourse in the event of an(ru*tcy to the sold assets. The aove *rocess
assumin+ the arran+er syndicated the remainin+ alance to three other re+ional an(s in
+eo+ra*hically different areas is illustrated in Fi+ure $.6.
This case 'as contriuted y 1onathan Adon+o, a Ph.) student in Financial
Econmics at Middle Tennessee State University.
#i!ure 1.9: Securitization $(rou!( @o-ation Process

3lean salesFno recourse *roceeds

KE
See FASB $K=, Para. 6 and %6.
Post !ovation5 /e+ional an( sells >9= million
loans to SPB
SPB
K$
Arran+er fee
Servicer fee
Hi;uidity fee
XX


The re+ional an( sellin+ >9= million loans removes >9= million *ortfolio of car loans
from its alance sheet, reali-in+ ca*ital relief of >K million AE *ercent of >9= millionC.
Ban( securiti-in+ *ortfolio of its loans achieves amon+ other thin+s5
Impro-ed return on assets and return on e;uity y increasin+ velocity of the money
flo'in+ throu+h the an(. 8nce illi;uid assets are removed from alance sheet as most
commercial loans are due to asence of secondary mar(ets, li#uidity is enhanced, as
an(s are ale to ad,ust to chan+in+ mar(et conditions and chan+es in interest rates
throu+h securiti-ation of credits.
&redit ris8 is reduced as securiti-ation s*reads the ris( amon+ the ma,or *layers i.e.,
ori+inator, arran+er, and *roviders of ca*ital AinvestorsC.
Interest rate ris8 is miti+ated as securiti-ation of the assets im*roves asset liaility
mana+ement, as an(s and other financial institutions are *rone to this ris(. Most of the
an(<s assets are usually fi.ed rate, 'here an(s are fi.ed rate receiver and floatin+ rate
*ayer on the fundin+ side of the alance sheet. The an( can structure securiti-ation
throu+h its SPB y issuin+ asset ac(ed securities 'ith fi.ed and or floatin+ interest rates
to miti+ate its interest rates e.*osure.
&oncentration ris8 to *articular oli+orAsC and or industry is miti+ated throu+h
securiti-ation as an(s attem*t to off:load credits to achieve re+ulatory com*liance.
Strictly s*ea(in+, no-ation re*resents the cleanest form of transfer from a le+al
stand*ointI ho'ever it is rarely used in securiti-ation *rocess for a numer of reasons.
#irst, an(s are un'illin+ to inform their clients that their loans are ein+ sold,
,eo*ardi-in+ the an(Ycustomer relationshi*. Second, if the underlyin+ loan is secured y
collateral, the novation terminates the ori+inal contract et'een the ori+inator and the
oli+or, 'hich must e re*laced and *erfected 'ith additional filin+s y a ne' contract
et'een the oli+or and the SPB.
1III.7: Assi!nment
Under the 3ommon Ha', assets can e assi+ned throu+h legal assignment and e#uitable
assignment.
K6
An assi+nment is a le+al assi+nment that satisfies four criteria of the section
$"7 of the $6%9 of the Ha' of Pro*erty Act, that the assi+nment is AaC an asolute
K6
See Mea+her et al., E;uity5 )octrines and /emedies "7:K$A"d ed. $66%C.
S*onsor Ban(
Arran!er
>$%.9 million
Hender A
>$%.9 million
Hender B
>$%.9 million
Hender 3
>$%.9 million
K%
assi+nment, AC in 'ritin+, AcC of the full amount of det, and AdC notified in 'ritin+ to the
underlyin+ det oli+or. &n the event any of the four criteria is not satisfied, the
assi+nment is termed as an e#uitable assignment. The method of assi+nment in transfer of
assets to SPB in a securiti-ation is throu+h an e;uitale assi+nment, as the ori+inator is
un'illin+ to inform the customers that their assets are ein+ sold.
1IIII.9: Participation
This is an a+reement 'here the ori+inatin+ an( AsellerC transfers to investors the ri+ht to
a *ro rata share of interest and *rinci*al from the orro'er. Partici*ation does not transfer
votin+ ri+hts and does not re;uire the consent of the orro'er. &t im*oses limits on the
aility of the ori+inatin+ an( to the chan+es in interest rates, *rinci*al, scheduled
*ayments, +uarantor, and collateral 'ithout a**roval of the uyers AinvestorsC.
')ample5 3onsider a multinational cor*oration 'ho 'ishes to orro' a >$.%9 illion
,umo loan in the Eurodollar mar(et at H&B8/ *lus $.%9 *ercent over a #:year *eriod
'ith an u*:front fee of $.%9 *ercent. The lead arran+er an( retains >%9= million in its
oo( and s*reads the ris( and re'ard *ro*ortionally amon+ the su:*artici*ants as
illustrated in Fi+ure $.6. The arran+er an( oo(s >K.%%9 million arran+er fee of the total
u*:front fee of >$9.7%9 million collected from the orro'er as sho'n in Tale ".
$a/le 05 Participation and Su/<Participation
Ban(s fee Amount of
ca*ital funded
Fee income
$% su:
*artici*ants
.=$ >7== million >7,===,===
$= su:
*artici*ants
.=$ >"== million >",===,===
$% su:
*artici*ants
.=$ >%K= million >%,K==,===
Arran+er .="EK=6 >$$= million >K,%%9,===
total $.%9 N >$.%9 illion >$9,7%9,===
#i!ure 1.9: $(e Participation Process


Arran+er fee
Servicer fee

S*onsor Ban(
Arran!es D1.29 /illion =oan
/etains >$$= million
Borro'er
>$.%9 illion
K"



Under U.S. la', *artici*ations have different le+al ramifications from su:*artici*ations
in En+lish la'. A su:*artici*ation in En+lish la' is defined as a contractual fundin+
arran+ement, 'here a su:*artici*ant a+rees to fund the loan of another *arty, the
?seller@, 'hich may ta(e t'o forms5 funded su:*artici*ation and unfunded su:
*artici*ation. &n a funded su:*artici*ation, as a claim collaterali-ed y cash, the su:
*artici*ant de*osits cash 'ith the counter*arty, the seller, 'hich is only re*aid 'hen the
underlyin+ assets *ay interest or *rinci*al. 8n the other hand, in an unfunded su:
*artici*ation, the su:*artici*ant *ays no money u*front, and only *ays 'hen the loan is
dra'n do'n, or the underlyin+ asset defaults, in 'hich case ein+ as a +uarantor. The
funded su:*artici*ation is -ero ris(:'ei+hted, as it is cash collaterali-ed. The unfunded
su:*artici*ation is 9= *ercent ris(:'ei+hted if the su:*artici*ation is related to an
undra'n commitment 'ith a commitment *eriod more than "79 daysI ho'ever, if the
undra'n commitment *eriod is for less than "79 days, then it 'ill e -ero ris(:'ei+hted.
The le+al status of the SPB has a earin+ in securiti-ation *rocess as licensin+
re;uirements increase the cost of securiti-in+ loan assets. As the cost of com*liance 'ith
re+ulatory re;uirements increases fundin+ costs, securiti-ation ecomes economically
unfeasile. Since an SPB does not ta(e de*osits, it therefore is not su,ect to licensin+
re;uirements of the de*osit:ta(in+ financial institutions im*osed y federal entities such
as the F)&3. The SPB<s unlicensed status ma(es interest *ayments to non:an(s in some
,urisdiction su,ect to 'ithholdin+ ta..
9=

>: =e!al #rame5or8
&ommon la5 +overns the *rocess of securiti-ation in the United States, United
0in+dom and Australia.
&i-il =a5 is the +overnin+ *rinci*le in the most other nations in a securiti-ation *rocess.
3ivil la' restricts the assi+nment or transfer of assets Aremovin+ assets from alance
sheet as true sale 'ithout recourse y the ori+inator or oli+orC. Also, insolvency la's
dictate that the ori+inal oli+or is to +ive its e.*ress consent or e notified in advance of
the transfer or assi+nment of loan. 8ther'ise, the transfer 'ould not constitute a true
sale.
&n the United States, Financial Accountin+ Standards Board AFASBC Statement !o. $%9
and FASB !o. $K= +overn the securiti-ation of current and future receivales or other
9=
See &ncome and 3or*oration Ta.es Act, $6EE, 3h. $ Z "K6 A%C
$% Su:*artici*ants
>9= million each
$= Su:*artici*ants
>"= million each
$% Su:*artici*ants
>%= million each
KK
financial assets. The SPB is also isolated le+ally from a an(ru*tcy of the ori+inator
Asometimes this may e referred to as an(ru*tcy remoteC, and this re;uires that the
transfer of assets e a true sale.
There are three asic *rinci*les that ensure that an ori+inator has surrendered control of
financial assets and can le+ally record a sale of the assets5
: Asset isolation,
: 8ri+inator or SPB control,
: 8ri+inator or seller non:control.

The *ur*ose is to ensure that the SPB has le+ally *erfected its interest in the assets
ein+ securiti-ed from any com*etin+ claims that mi+ht arise if the oli+or or ori+inator
ecomes su,ect to an(ru*tcy *roceedin+s.
The cost to *erfect a true sale ecomes *rohiitive unless certain le+al remedies are made
in the la', as 'as done in several Hatin American countries *rior to %==$.
The emer+in+ mar(et economies are faced 'ith fe' *rolems in securiti-ation, 'hich
include5
$. 3ountry le+al issues as to 'hether assets can e assi+ned to an SPB,
%. Himits im*osed y ratin+ a+encies Asoverei+n ratin+s ceilin+sC,
". Hocal customs, such as 'hether direct deits AautomaticFelectronic *ayment of det
servicin+ oli+ation y a financial institution on ehalf of an oli+or or orro'erC may e
used for receivales and therey ;ualify for securiti-ation,
K. Hac( of availaility of currency s'a*s if receivales are denominated in the local
currency.
>I: Macro 'conomics o3 Securitization
The 'orld financial mar(et havin+ asored the oil *rice shoc(s and volatile e.chan+e
rate re+ime of $6#=s 'hich caused massive imalance for the im*ortin+ countries and
concurrent sur*luses for the 8PE3 countries as is evidenced in Tale K e+an a shift to
securiti-ation in the $6E=s.
9$
The shift to a *redominantly securiti-ed international
financial mar(et in the early $6E=s is attriuted to a numer of factors5
$a/le 7: International :alance o3 Payments: &urrent Account
$6#E $6#6 $6E= $6E$ $6E%
Total 8E3)U $%.% :%#.# :76.$ :"$ :%7.K
!on:8PE3 )evelo*in+ :%K :"6 :7" :#" :7=
8PE3 K.9 7% $$9 7# :9
8ther 3ountriesUU :6 :K :$$ :$= "
U Ma,or &ndustriali-ed 3ountries
UU &ncludin+ Sino:Soviet area
Source5 !ational 2estminster Ban(

)eterioration of the credit ;uality of the ma,or an(s *ortfolio as a result of less
develo*in+ countries< H)3 det crisis of $6E%.
9$
See Paul Feeney, ?Securiti-ation5 /edefinin+ the Ban(,@ St. Martin Press $669.
K9

Mushroomin+ innovative *roducts induced y lierali-ation of re+ulatory landsca*e

that transferred ris( from an(s G other intermediaries to ultimate investors.

/eturn to a more favorale macro:economic conditions, i.e., rea**earance of *ositive

real interest rates and u*'ard slo*in+ yield curves.
9%

)isintermediation of credits induced throu+h securiti-ation.

A fallin+ term structure of interest rates, such as the one oserved on the last usiness day
of Au+ust $6E$, indicates that the mar(et e.*ects fallin+ for'ard interest rates due to
dam*enin+ inflationary e.*ectations in the near future that 'ill *roduce an inverted yield
curve. As lon+ term:rates command a *remium for the hi+her interest rate ris( associated
'ith lon+ term det, as 'ell as a hi+her *remium for future inflation, a normal mar(et
condition evolvesI the yield curve is u*'ard slo*in+, as is evidenced in 8ctoer $6E% for
U.S. Treasury securities.
As an(s< alance sheets deteriorate, so do their ratin+s. For e.am*le, in $6E= Standard
G Poor<s rated lon+:term senior det of $" ma,or an(s as QAAA<. 2ith the e.ce*tion of
9%
See Ghassem Homaifar, ?Mana+in+ Gloal Financial and Forei+n E.chan+e rate /is(,@ 1ohn 2iley G
Sons !e' Mor( 1anuary %==K PP $K6:$9=.
Source5 Ghassem A. Homaifar, ?Mana+in+ Gloal financial and
Forei+n E.chan+e rate /is(,@ 1ohn 2iley G Sons !e' Mor( %==K.
Source5 &id
K7
one an(, all of the other an(s sa' their senior det do'n:+raded y $6E#.
9"
As a result
of *erceived risin+ an(s< ris(, investors ris( aversion, mismatches of assets and
liailities, and investors< *reference for hi+her yields *rom*ted fli+ht of ca*ital from an(
de*osits and into hi+her yieldin+ short, medium, and lon+:term floatin+ rate notes AF/!sC
securities. The H)3 det crisis can e considered as a turnin+ *oint for the restructurin+
of the ma,or an(s alance sheets non:*erformin+ loans A!PHsC, and the securiti-ation of
these loans into asset:ac(ed mar(etale securities as a catalyst to remedy the *rolem.
The +ro'th of the securiti-ation can e attriuted to the increased a**lication of this
vehicle as a chea*er source of fundin+ for an(s and other non:an(s institutions relative
to an( orro'in+, and term loans. Ban(s also started to loo( into other avenues for
increasin+ their /8E y *rovidin+ li;uidity facilities to the securiti-ation *rocess as
arran+er, servicer, and +uarantor. For e.am*le, commercial an(in+ re:emer+ed in the
$6E=s as an(s started to oo( illions of dollars of li;uidity su**ort for the revolvin+
under'ritin+ facilities A/UFsC and note issuance facilities A!&FsC in su**ort of
securiti-ation 'here *rovision of direct credits y issuance of medium term securities is
ac(ed y a li;uidity facility such as a standy letter of credit. These li;uidity
commitment fees oo(ed y an(s off:alance sheets *roved to e a valuale source of
revenue as an(s tried to im*rove earnin+s 'ithout raisin+ their e.*osure to mar(et ris(.
The develo*ment of /UFs and euro:commercial *a*er AE3PC as a *rimary
securiti-ation vehicle Ashort termC can e attriuted to cost:conscious an(s in ac;uisition
of medium term loans su**orted y se;uence of *ortfolio of lo' cost short term
revolvin+ for'ard notes in the Euro:credit mar(ets as a sustitute for the hi+her cost
revolvin+ syndicated medium term loans. For e.am*le, &BM can +et a medium term loan
funded in 'hich the issuer sells short term euro:notes on a revolvin+ asis under'ritten
y a +rou* of an(s, +uaranteein+ the availaility of the funds to the orro'er. The
under'riters oo( an arran+er and commitment fees from the issuer and as a ris( ased
asset in its alance sheet receives a *referential treatment from the an( re+ulator as
*rovision of this facility is 9= *ercent ris(:'ei+hted as o**osed to direct loans 'hich is
$== *ercent ris( 'ei+hted.
From the *ers*ective of the orro'ers /UFs offer the same advanta+e as a revolvin+
loan facility, ho'ever various functions5 arran+in+, under'ritin+, fundin+, and
transformin+ short notes to medium term in a se;uence of short:term orro'in+ are
unundled and therefore are *erformed y different financial institutions at relatively
lo'er cost to the issuer. The /UFs can e considered as a multi o*tion facility M8F in
'hich issuer has a ri+ht to issue a se;uence of short term dets 'hen and if desired, has
the ri+ht to *ut unsold issues ac( to the under'riter and terminate the facility 'ithout
ever usin+ it as demonstrated in fi+ure $.$=. These o*tions are not free and effectively
raise the cost of orro'in+s.
#i!ure 1.10: Structure o3 Multi ,ption #acility 4#
9"
See iid.
Head
Arran+er
K#



The structure in aove e.hiit miti+ates rollover ris( for the issuin+ com*any as the
com*any is ale to ta* into a medium term fundin+ source in the ca*ital mar(et y
issuin+ a series of short:term three to si. month euro:notes ac(ed y a medium:term
li;uidity facility *rovided y an( under'riters for a fee. This under'ritin+ facility is
oo(ed off:alance sheet of the an( and receives *referential treatment for ca*ital
reserve re;uirements from su*ervisory authority.
2hile securiti-ation has evolved over hundreds of years, its *ace has ;uic(ened in the
last t'enty years. Hi(e other innovations there are learnin+ costs that *arties to a
securiti-ation transaction incur that is unevenly distriuted amon+ ori+inators, arran+ers,
and ultimate investors in the ca*ital mar(et. The B&S ar+ues that the learnin+ costs 'ith
ne' financial technolo+y and mar(ets is li(ely to manifest itself in the form of under:
*riced transactions, in 'hich short or lon+ term losses could e +enerated5
9K
?&t seems *lausile that the mar(et for ne' instruments must in +eneral e less efficient than mature
ones, sim*ly ecause there must e some cost of ac;uirin+ the (no'led+e and e.*erience re;uired for
efficient *ricin+. The learnin+ costs may a**ear in the form of under:*ricin+ transactions, 'hich could
+enerate either near:term or future losses. Such *rolems 'ould seem most li(ely to occur in ra*idly
+ro'in+ ne' mar(ets Asuch as securiti-ed mar(etsC.
Under:*ricin+ of the financial instrument is not inconsistent 'ith the mar(et efficiency, in
'hich all availale information is reflected in the *rice. 8n the other hand over*ricin+
+enerally is corrected, as it is not sustainale in a fairly com*etitive mar(et. Ho'ever, if
an(s and other financial institutions under:*rice loan assets, 'hich is the case in the
&ranian ca*ital mar(ets, this could dilute the ca*ital ase of these institutions and raise the
e.*osure of the financial system in +eneral and threaten the solvency of the *rivate an(s
in *articular. 4nder pricin! of loans is *revalent in the entire &ranian ca*ital mar(et
A+overnment o'ned as 'ell as *rivate an(sC as the monthly *ayments Ain mort+a+e
9K
Ban( for &nternational Settlements A$6E7C, /ecent &nnovations in &nternational Ban(in+ A Basle5 Ban( for
&nternational SettlementsC.
Borro'er
Mid:term
under'ritin+
commitement
Placement
a+ent
&ssues short
term euronotes
3a*ital mar(et investors
!on:an(
investors
/UF
A+reement
Under'riters
Unsold
notes
KE
dets, auto loans, e;ui*ment lease financin+, and othersC are determined usin+ a
fundamentally fla'ed linear al+orithm that favors the orro'ers.
99

The B&S has alluded to its concern re+ardin+ the under:*ricin+ *henomenon for ne'
financial instruments, aleit not related to a *articular country or a *articular asset classes
as follo's5
97
?The ;uestion of 'hether ne' financial instruments Asuch as securiti-ed instrumentsC contriute to an
increase in systematic ris( de*ends in *art on 'hether the various ris(s inherent in them are a**ro*riately
*riced. That is, 'hether they *roduce sufficient *rofit mar+ins on avera+e to cover *otential losses from
mar(ets, credit or other ris(s, oth in the short and lon+ run.@
Systematic ris8 refers to a *ossile incidence of financial crisis that is li(ely to e
associated 'ith fallin+ asset *rices and ensuin+ insolvency amon+ detors and creditors,
'hich may s*read throu+h the financial mar(ets, disru*tin+ and disturin+ the function of
the ca*ital mar(et in allocatin+ ca*ital. The +reater use of off:alance sheet hi+hly
levera+ed transactions such as s'a*s, o*tions or futures, as 'ell as e.*onential +ro'th of
alance sheet and synthetic securiti-ation of credit ma(e it more difficult for re+ulatory
oversi+ht to accurately determine the ris( e.*osure of financial and non:financial
cor*orations.
Securiti-ation enales mar(et *artici*ants to restructure their alance sheets and ad,ust
their ris( *rofiles more efficiently than is *ossile under traditional an( intermediation.
The *rocess of unundlin+ various functions of credit intermediation enales credit to e
channeled from lenders to orro'ers 'hile se*aratin+ and distriutin+ different ris(s
associated 'ith such *rocesses amon+ ori+inators, arran+ers, and investors in the ca*ital
mar(et. To the e.tent securiti-ation increases trans*arency and creates value for issuers,
investors, and consumers, then mar(et forces in favor of more efficient allocation of
scarce ca*ital 'ill rea( do'n Qconstrainin+ factors<.
Securiti-ation has also een em*loyed as a financin+ tool in mer+ers and ac;uisitions
AMGAC in 1a*an. For e.am*le, Aiful 3or*oration, a consumer finance com*any, ac;uired
a an(ru*t com*etitor, Hife 3or*oration y securiti-in+ a *ortfolio of *erformin+
receivales to *ay for the ac;uisition.
&ase Study5 A $=:year fully amorti-ed mort+a+e *riced at %# *ercent interest rate on a
notional *rinci*al of &/ 9==,===,=== has monthly *ayment of &/6,E"E,9K$.77 that
includes interest and *rinci*al, accordin+ to an internal Parsian Ban( rochure. The
monthly installment is estimated 'ith a fundamentally fla'ed linear formula used in the
99
The author accidentally discovered under:*ricin+ of loans from a *rivate an( internal rochure on
)ecemer %==".
97
See iid P. $66C.
K6
entire an(in+ system in &ran.
9#
Fi+ure $.$$ *resents under:*ricin+ of this loan for varyin+
maturities ran+in+ from three to "= years.
#i!ure 1.11: Mont(ly Payments and 'rror ates 3or 90 million BtomanC loans o3
1aryin! Maturities
Principal
Interest rate
% Interest b
Install!ent
S d
Install!ent
Scienti"ic #
$nderesti!ation
%rror %rror rate
&''''''' () *+ (',-(&'' -.+)'-*/,,. 0(1'2-1(+'/)+ 30)21(2+/,)4 5'/'*+
&''''''' () +' *2*-(&'' -2'&(',/*** 0-1&(+1)++/*) 30-(-1&&,/'24 5'/').
&''''''' () -(' +,'+(&'' .,*,&2/-++) 0-1(',1+.,/., 30((21,22/,-4 5'/-,+
&''''''' () -,' -'-,-(&'' ,2*2'(/))), 0-1-2&1,,'/&) 30*'(12))/).4 5'/(+*
&''''''' () (2' -*&&+(&'' ))*-))/',** 0-1-*'12('/&+ 30*&)1(2*/2,4 5'/*-+
&''''''' () *'' -+.*-(&'' )*-'2-/+++) 0-1-(+12(-/*) 30*.&1*)./)'4 5'/*&-
&''''''' () *+' ('*'+(&'' )'(.&-/*,,. 0-1-(&1*)*/+, 302((12((/(.4 5'/*)&
. &nterest amount is estimated accordin+ to the formula in footnote #=.
d. Monthly *ayment is estimated accordin+ to the formula in footnote #=.
;. Monthly *ayment is estimated usin+ the standard formula used all over the 'orld 'ith the e.ce*tion of
&ran as follo's5
AF V [A$ P /FMC \ !M :$]F [A$ P /FMC \ !M U /FM]
MP V PFAF
2here, AF is an annuity factor for an !:year loan 'ith M *ayments *er year. / is the annual interest rate
and P is the *rinci*al of the loan, and PM is the monthly installment.
The faled formula underestimates the monthly *ayments in Fi+ure $.$$ for all
maturities. Ho'ever, the lon+er the maturity of the loan the +reater is the estimation error.
For e.am*le, monthly error rate as a *ercenta+e of the actual monthly *ayment is :".7
*ercent for a "7 month mort+a+e, 'hile the error rate increases y $= folds for a "=:year
mort+a+e to "#.9 *ercent all else remainin+ the same. The faled formula favors the
orro'ers as the rate im*lied from the monthly installment for a ":year mort+a+e is
estimated to e e;ual to %K.% *ercent 'ith %# *ercent ;uoted interest rate, 'hile for a $=
:year mort+a+e the standard mort+a+e ori+inated y an(s in &ran the actual im*lied rate
is e;ual to %=.9% *ercent as is sho'n in Fi+ure $.$%.
#i!ure 1.12: $(e Actual Implied ate 3or a 2* Percent Mort!a!e in Iran
6 o"
Periods
Interest
rate
Actual
I!plied
Rate
$nderesti!ation
%rror
*+ '/() '/(2('22 '/'().&+
+' '/() '/((,2. '/'2-&-
-(' '/() '/('&(,( '/'+2)-,
-,' '/() '/-.'&*, '/').2+(
(2' '/() '/-,'*.& '/',.+'&
*'' '/() '/-)*'&, '/'.+.2(
9#
&VAAPCUA/CUA!P$CCFAA$%CUA%CC
&V &nterest Amount over the life of the loan,
PVPrinci*al Amount,
/V Annual &nterest /ate Percenta+e,
!V !umer of &nstallments
PMV &nstallment Payments
PMVAPP&CF!,
9=
*+' '/() '/-+)&+( '/-'(2*,
Accordin+ to Fi+ure $.$% the orro'er actually *ays $7.#9 *ercent interest rate for a "=:
year mort+a+e 'ith %# *ercent interest rate used to estimate the monthly installment
*ayment of #=%,69$."E ATomanC usin+ the linear fla'ed formula. Assumin+ the an(
funds the mort+a+e over the life of the loan at an avera+e rate of %= *ercent, the loan
asset has ne+ative carry of :".%9 *ercent erodin+ an( ca*ital that cannot e sustained
indefinitely.
The *rivate an(ers in &ranian ca*ital mar(et are in the *rocess of activatin+ the correct
formula for estimatin+ monthly installment.
9$
>II: Implications
For an(s in the &ranian ca*ital mar(et the assets in alance sheet are 'orth more than
off:alance sheet. This is in shar* contrast to other an(s in the rest of the 'orld as assets
are 'orth more off:alance sheet than on it throu+h securiti-ation. The a**lication of the
fla'ed formula has rendered all e.istin+ assets in the &ranian an(in+ system overvalued
i.e. far more than they are actually 'orth. The de+ree to 'hich assets are overvalued is
related directly to the maturity of the loan assets. The lon+er the maturity of the assets
and the +reater its duration the lar+er is the amount of over:valuation. For e.am*le, a
ty*ical %# *ercent auto loan has a maturity of three years and an im*lied rate of %K.%
*ercentI therefore, this asset class is overvalued in the an( alance sheet y
a**ro.imately three *ercentI on the other hand, a ten year mort+a+e is overvalued y
a**ro.imately 7.9 *ercent:the difference et'een the rate in the le+al loan documentation
of %# *ercent and the rate of %=.9% *ercent im*lied from the installment *ayment:as can
e verified in Fi+ure $.$9.
The hi+h de*osit rate in e.cess of %= *ercent in the *rivate an(in+ system in &ran can
e attriuted to hi+h inflation as 'ell as the a**lication of the incorrect al+orithm
conveyin+ faulty information to avera+e de*ositors and orro'ers in the &ranian ca*ital
mar(et. /emoval of such an al+orithm from the an(in+ system 'hile informin+ the
*otential ne' and seasoned orro'ers and savers 'ill +o a lon+ 'ay in *avin+ the 'ay
for fallin+ lon+ term mort+a+e interest rates in &ran. The orro'ers have the im*ression
that they *ay %# *ercent, 'hile this rate is illusory and needs to e communicated to
seasoned orro'ers.
3onsider securiti-ation of the home loan currently in the Parsian Ban( alance sheet.
The avera+e cou*on of the $=:year loan is %# *ercent in the le+al document si+ned y
oth *arties. Ho'ever, the underlyin+ collateral *ays an avera+e cou*on of no more than
%=.9%E *ercent accordin+ to fi+ure $.$9. Also consider *ortfolio of $,#== loans 'ith an
avera+e *rinci*al of &/9==,===,===.== and 'ei+hted avera+e maturity of E.9 years.
>II.1: &onstruction o3 Mont(ly &as( #lo5 3or Pass<t(rou!( Securities
2e 'ill demonstrate construction of monthly cash flo' of for a hy*othetical *ass:
throu+h, assumin+ the underlyin+ mort+a+es have 2A3 of %=.9% *ercent and 2AM of
$=% months and *ass:throu+h rate of $6 *ercent. The distriution of the cash flo' from
the underlyin+ collateral is *resented in Fi+ure $.$".

&olumn 1. This is the month in 'hich cash flo' is the *ass:throu+h distriuted.
&olumn 2. This is the outstandin+ *rinci*al alance at the e+innin+ of the month, 'hich
is e;ual to the *rinci*al alance in the *recedin+ month less total *rinci*al *ayment in the
*revious month
&olumn 0. This column dis*lays sin+le monthly mortality SMM for a *ass:throu+h
security that has een seasoned for $E months 'ith -ero *re*ayment in the first $E
months. Ho'ever, a conditional *re*ayment rate 3P/ of three *ercent is assumed
thereafterI " out of every $== mort+a+ors *re*ay every year. To estimate cash flo' of
9%
*ass:throu+h security, 'e are re;uired to ma(e an assum*tion that some of the underlyin+
mort+a+es collateral *re*ay. Althou+h *re*ayment is asent in the &ranian ca*ital mar(et
for the time ein+ due to hi+h nominal interest rates, 'e e.*ect it 'ill a**ear in the future
as interest rates decline. The conditional *re*ayment rate 3P/ is an annual rate and has
to e ad,usted to monthly *re*ayment rate (no'n as SMM. The SMM is estimated from
the 3P/ in e;uation $.$ as follo's.
SMM V $: A$:3P/C\$F$% 1.1
Assumin+ 3P/ of " *ercent, the SMM can e estimated to e e;ual to5
SMM V $: A$:.="C\$F$%
V $:A.6#C\.=E""""
V=.==%9"9=K6
Pre*ayment for month t V SMM . Ae+innin+ mort+a+e alance for month t Y Scheduled
*rinci*al *ayment for month tC 1.2

For e.am*le, the *re*ayment for month "= is e;ual to the mort+a+e alance of
7E,$9",K%#,%E9 less the scheduled *rinci*al *ayment of K#7,$=","#7 times the SMM of .
==%9"9=K6. That is the estimated *re*ayment for month "= is estimated usin+ the
e;uation $.%.
.==%9"9=K6A7E,$9",K%#,%E9 : K#7,$=","#7C V$#$,979,""%.%6
&olumn 7. This column *rovides the monthly installment *ayment for month t assumin+
2A3 of the underlyin+ collateral is %=.9% *ercent and 2AM of $=% for the first month
only. The monthly installment *ayment continues to decline over time as *re*ayment and
scheduled *rinci*al *ayment reduce the mort+a+e alance. The monthly *ayment for
month t is estimated usin+ e;uation $.".
Princi*al alance at time t F AFt 1.0
AFt V [A$P rF$%C\An:tP$C :$]F [A$P rF$%C\An:tP$C U rF$%]

2here AFt is the annuity factor at time t for t e;ual to $ throu+h "7= for a thirty year
mort+a+e and n is the maturity of the loan in months.
&olumn 9. Monthly interest *aid to *ass:throu+h investors is sho'n in this column. The
*ass:throu+h interest *ayment to investors is estimated y e;uation $.K.
&nterest Payment to P3s at time t V Ae+innin+ *rinci*al alance at time tCU A/* F$%C 1.7

2here /* is the *ass:throu+h rate.
&olumn %. Provides the estimate of the re+ularly scheduled *rinci*al re*ayment, 'hich
is calculated as the difference et'een column K Athe monthly mort+a+e *ayment at time
9"
tC and the +ross cou*on interest that is estimated at 2A3 of the underlyin+ collateral of
%=.9% *ercent in our e.am*le. The +ross cou*on interest is estimated y the *roduct of
the outstandin+ mort+a+e alance at the e+innin+ of the month and 2A3 of the
collateral, and then divided y $%.
&olumn *. The amount of *re*ayment for month t is estimated usin+ e;uation $.%. For
e.am*le, in month "=, the e+innin+ mort+a+e alance is e;ual to 7E,$9",K%#,%E9 and
the scheduled *rinci*al *ayment is K#7,$=","#7. Given SMM rate of .==%9"9=K6,
therefore the *re*ayment for month "= is
.==%9"9=K6A7E,$9",K%#,%E9:K#7,$=","#7C V $#$,979,""%.%6
&olumn +. Total *rinci*al *ayment is sho'n in this column, 'hich is found y addin+
column 7 and # Athe scheduled *rinci*al *ayment and *re*ayment for the month tC.
&olumn 9. Provides the monthly cash flo' for the *ass:throu+h Asum of columns 9, 7,
and #C, 'hich is e;ual to monthly interest *ayment to *ass:throu+h investors, the
re+ularly scheduled *rinci*al *ayment, and *re*ayment.
#i!ure 1.10: Mont(ly &as( #lo5 3or a I+90 /illion 19E Pass<t(rou!( rate 5it( a AA& o3
20.92E and AAM o3 102 Mont(s Assumin! 0E Prepayment
Cash flow for Pass-through Investors
Pass-Through
Rate
WAC WAM Months
19.00% 20.52% 102 12
1 2 3 4 5 6 7 ! 1"
Mont
h
Pr#n$#%al &alan$e 'MM
Mortgage
Pa()ent
Interest
'$he*ule*
Pr#n$#%al
Pa()ent
Pre%a()ent Total Pr#n$#%al Cash +low Average ,#fe
0
1 $85,000,000,000.00 0.00253505 $1,766,917,754.56 $1,345,833,333.33 $313,417,754.56 $214,684,602.93 $528,102,357.49 $1,873,935,690.83 $528,102,357.49
2 $84,471,897,642.51 0.00253505 $1,762,438,532.16 $1,337,471,712.67 $317,969,082.47 $213,334,299.95 $531,303,382.41 $1,868,775,095.09 $1,062,606,764.83
3 $83,940,594,260.09 0.00253505 $1,757,970,664.80 $1,329,059,409.12 $322,586,502.95 $211,975,714.66 $534,562,217.61 $1,863,621,626.73 $1,603,686,652.82
4 $83,406,032,042.48 0.00253505 $1,753,514,123.70 $1,320,595,507.34 $327,270,975.78 $210,608,698.08 $537,879,673.86 $1,858,475,181.20 $2,151,518,695.43
9K
5 $82,868,152,368.63 0.00253505 $1,749,068,880.15 $1,312,079,079.17 $332,023,474.65 $209,233,099.14 $541,256,573.79 $1,853,335,652.96 $2,706,282,868.97
6 $82,326,895,794.83 0.00253505 $1,744,634,905.51 $1,303,509,183.42 $336,844,987.42 $207,848,764.65 $544,693,752.07 $1,848,202,935.49 $3,268,162,512.41
7 $81,782,202,042.77 0.00253505 $1,740,212,171.21 $1,294,884,865.68 $341,736,516.28 $206,455,539.24 $548,192,055.53 $1,843,076,921.20 $3,837,344,388.68
8 $81,234,009,987.24 0.00253505 $1,735,800,648.76 $1,286,205,158.13 $346,699,077.98 $205,053,265.40 $551,752,343.38 $1,837,957,501.51 $4,414,018,747.02
9 $80,682,257,643.86 0.00253505 $1,731,400,309.73 $1,277,469,079.36 $351,733,704.02 $203,641,783.36 $555,375,487.39 $1,832,844,566.75 $4,998,379,386.47
10 $80,126,882,156.48 0.00253505 $1,727,011,125.78 $1,268,675,634.14 $356,841,440.90 $202,220,931.14 $559,062,372.04 $1,827,738,006.19 $5,590,623,720.44
11 $79,567,819,784.43 0.00253505 $1,722,633,068.62 $1,259,823,813.25 $362,023,350.30 $200,790,544.46 $562,813,894.76 $1,822,637,708.02 $6,190,952,842.38
12 $79,005,005,889.67 0.00253505 $1,718,266,110.04 $1,250,912,593.25 $367,280,509.33 $199,350,456.72 $566,630,966.05 $1,817,543,559.31 $6,799,571,592.62
13 $78,438,374,923.62 0.00253505 $1,713,910,221.92 $1,241,940,936.29 $372,614,010.73 $197,900,498.99 $570,514,509.72 $1,812,455,446.01 $7,416,688,626.37
14 $77,867,860,413.90 0.00253505 $1,709,565,376.19 $1,232,907,789.89 $378,024,963.11 $196,440,499.95 $574,465,463.06 $1,807,373,252.95 $8,042,516,482.84
15 $77,293,394,950.84 0.00253505 $1,705,231,544.85 $1,223,812,086.72 $383,514,491.20 $194,970,285.85 $578,484,777.04 $1,802,296,863.77 $8,677,271,655.67
16 $76,714,910,173.79 0.00253505 $1,700,908,699.99 $1,214,652,744.42 $389,083,736.02 $193,489,680.51 $582,573,416.53 $1,797,226,160.95 $9,321,174,664.48
17 $76,132,336,757.26 0.00253505 $1,696,596,813.75 $1,205,428,665.32 $394,733,855.20 $191,998,505.25 $586,732,360.45 $1,792,161,025.77 $9,974,450,127.67
18 $75,545,604,396.81 0.00253505 $1,692,295,858.35 $1,196,138,736.28 $400,466,023.16 $190,496,578.87 $590,962,602.03 $1,787,101,338.32 $10,637,326,836.59
19 $74,954,641,794.78 0.00253505 $1,688,005,806.08 $1,186,781,828.42 $406,281,431.39 $188,983,717.60 $595,265,148.99 $1,782,046,977.41 $11,310,037,830.81
20 $74,359,376,645.79 0.00253505 $1,683,726,629.30 $1,177,356,796.89 $412,181,288.66 $187,459,735.09 $599,641,023.74 $1,776,997,820.63 $11,992,820,474.86
21 $73,759,735,622.05 0.00253505 $1,679,458,300.44 $1,167,862,480.68 $418,166,821.30 $185,924,442.32 $604,091,263.63 $1,771,953,744.31 $12,685,916,536.21
22 $73,155,644,358.42 0.00253505 $1,675,200,792.00 $1,158,297,702.34 $424,239,273.48 $184,377,647.64 $608,616,921.12 $1,766,914,623.46 $13,389,572,264.61
23 $72,547,027,437.30 0.00253505 $1,670,954,076.56 $1,148,661,267.76 $430,399,907.38 $182,819,156.65 $613,219,064.04 $1,761,880,331.79 $14,104,038,472.81
24 $71,933,808,373.26 0.00253505 $1,666,718,126.74 $1,138,951,965.91 $436,650,003.56 $181,248,772.22 $617,898,775.78 $1,756,850,741.69 $14,829,570,618.69
25 $71,315,909,597.49 0.00253505 $1,662,492,915.27 $1,129,168,568.63 $442,990,861.15 $179,666,294.40 $622,657,155.55 $1,751,825,724.18 $15,566,428,888.76
26 $70,693,252,441.94 0.00253505 $1,658,278,414.91 $1,119,309,830.33 $449,423,798.15 $178,071,520.43 $627,495,318.58 $1,746,805,148.91 $16,314,878,283.16
27 $70,065,757,123.35 0.00253505 $1,654,074,598.51 $1,109,374,487.79 $455,950,151.70 $176,464,244.67 $632,414,396.37 $1,741,788,884.16 $17,075,188,702.06
28 $69,433,342,726.98 0.00253505 $1,649,881,438.99 $1,099,361,259.84 $462,571,278.36 $174,844,258.56 $637,415,536.92 $1,736,776,796.76 $17,847,635,033.64
29 $68,795,927,190.06 0.00253505 $1,645,698,909.34 $1,089,268,847.18 $469,288,554.39 $173,211,350.56 $642,499,904.95 $1,731,768,752.12 $18,632,497,243.47
30 $68,153,427,285.12 0.00253505 $1,641,526,982.60 $1,079,095,932.01 $476,103,376.02 $171,565,306.16 $647,668,682.19 $1,726,764,614.20 $19,430,060,465.57
31 $67,505,758,602.93 0.00253505 $1,637,365,631.90 $1,068,841,177.88 $483,017,159.79 $169,905,907.79 $652,923,067.58 $1,721,764,245.46 $20,240,615,094.86
32 $66,852,835,535.36 0.00253505 $1,633,214,830.42 $1,058,503,229.31 $490,031,342.77 $168,232,934.78 $658,264,277.54 $1,716,767,506.85 $21,064,456,881.41
33 $66,194,571,257.81 0.00253505 $1,629,074,551.43 $1,048,080,711.58 $497,147,382.92 $166,546,163.33 $663,693,546.25 $1,711,774,257.83 $21,901,887,026.12
34 $65,530,877,711.57 0.00253505 $1,624,944,768.24 $1,037,572,230.43 $504,366,759.38 $164,845,366.45 $669,212,125.83 $1,706,784,356.26 $22,753,212,278.17
35 $64,861,665,585.74 0.00253505 $1,620,825,454.26 $1,026,976,371.77 $511,690,972.75 $163,130,313.94 $674,821,286.69 $1,701,797,658.46 $23,618,745,034.12
36 $64,186,844,299.05 0.00253505 $1,616,716,582.94 $1,016,291,701.40 $519,121,545.43 $161,400,772.31 $680,522,317.74 $1,696,814,019.14 $24,498,803,438.64
37 $63,506,321,981.31 0.00253505 $1,612,618,127.81 $1,005,516,764.70 $526,660,021.93 $159,656,504.75 $686,316,526.68 $1,691,833,291.38 $25,393,711,487.09
38 $62,820,005,454.63 0.00253505 $1,608,530,062.46 $994,650,086.36 $534,307,969.18 $157,897,271.07 $692,205,240.26 $1,686,855,326.62 $26,303,799,129.77
39 $62,127,800,214.37 0.00253505 $1,604,452,360.55 $983,690,170.06 $542,066,976.89 $156,122,827.68 $698,189,804.56 $1,681,879,974.62 $27,229,402,377.99
40 $61,429,610,409.81 0.00253505 $1,600,384,995.82 $972,635,498.16 $549,938,657.81 $154,332,927.49 $704,271,585.30 $1,676,907,083.45 $28,170,863,411.97
41 $60,725,338,824.51 0.00253505 $1,596,327,942.06 $961,484,531.39 $557,924,648.16 $152,527,319.91 $710,451,968.06 $1,671,936,499.45 $29,128,530,690.57
42 $60,014,886,856.45 0.00253505 $1,592,281,173.12 $950,235,708.56 $566,026,607.87 $150,705,750.77 $716,732,358.64 $1,666,968,067.20 $30,102,759,062.93
43 $59,298,154,497.81 0.00253505 $1,588,244,662.94 $938,887,446.22 $574,246,221.03 $148,867,962.28 $723,114,183.30 $1,662,001,629.52 $31,093,909,881.99
44 $58,575,040,314.50 0.00253505 $1,584,218,385.51 $927,438,138.31 $582,585,196.13 $147,013,692.96 $729,598,889.09 $1,657,037,027.40 $32,102,351,119.96
45 $57,845,441,425.41 0.00253505 $1,580,202,314.88 $915,886,155.90 $591,045,266.51 $145,142,677.62 $736,187,944.13 $1,652,074,100.03 $33,128,457,485.81
46 $57,109,253,481.28 0.00253505 $1,576,196,425.20 $904,229,846.79 $599,628,190.67 $143,254,647.26 $742,882,837.93 $1,647,112,684.72 $34,172,610,544.71
47 $56,366,370,643.36 0.00253505 $1,572,200,690.63 $892,467,535.19 $608,335,752.63 $141,349,329.06 $749,685,081.69 $1,642,152,616.88 $35,235,198,839.56
48 $55,616,685,561.66 0.00253505 $1,568,215,085.45 $880,597,521.39 $617,169,762.35 $139,426,446.29 $756,596,208.64 $1,637,193,730.03 $36,316,618,014.58
49 $54,860,089,353.03 0.00253505 $1,564,239,583.97 $868,618,081.42 $626,132,056.04 $137,485,718.27 $763,617,774.31 $1,632,235,855.73 $37,417,270,941.00
50 $54,096,471,578.72 0.00253505 $1,560,274,160.59 $856,527,466.66 $635,224,496.59 $135,526,860.31 $770,751,356.90 $1,627,278,823.56 $38,537,567,844.93
51 $53,325,720,221.82 0.00253505 $1,556,318,789.74 $844,323,903.51 $644,448,973.94 $133,549,583.65 $777,998,557.60 $1,622,322,461.11 $39,677,926,437.40
52 $52,547,721,664.23 0.00253505 $1,552,373,445.95 $832,005,593.02 $653,807,405.49 $131,553,595.41 $785,361,000.90 $1,617,366,593.91 $40,838,772,046.61
53 $51,762,360,663.33 0.00253505 $1,548,438,103.79 $819,570,710.50 $663,301,736.45 $129,538,598.50 $792,840,334.95 $1,612,411,045.45 $42,020,537,752.47
54 $50,969,520,328.38 0.00253505 $1,544,512,737.93 $807,017,405.20 $672,933,940.31 $127,504,291.60 $800,438,231.91 $1,607,455,637.11 $43,223,664,523.36
99
55 $50,169,082,096.46 0.00253505 $1,540,597,323.05 $794,343,799.86 $682,706,019.20 $125,450,369.08 $808,156,388.28 $1,602,500,188.14 $44,448,601,355.36
56 $49,360,925,708.18 0.00253505 $1,536,691,833.94 $781,547,990.38 $692,620,004.33 $123,376,520.91 $815,996,525.24 $1,597,544,515.62 $45,695,805,413.68
57 $48,544,929,182.94 0.00253505 $1,532,796,245.44 $768,628,045.40 $702,677,956.41 $121,282,432.65 $823,960,389.06 $1,592,588,434.46 $46,965,742,176.69
58 $47,720,968,793.87 0.00253505 $1,528,910,532.44 $755,582,005.90 $712,881,966.07 $119,167,785.35 $832,049,751.42 $1,587,631,757.32 $48,258,885,582.24
59 $46,888,919,042.46 0.00253505 $1,525,034,669.92 $742,407,884.84 $723,234,154.29 $117,032,255.48 $840,266,409.77 $1,582,674,294.61 $49,575,718,176.53
60 $46,048,652,632.68 0.00253505 $1,521,168,632.89 $729,103,666.68 $733,736,672.87 $114,875,514.89 $848,612,187.76 $1,577,715,854.44 $50,916,731,265.62
61 $45,200,040,444.92 0.00253505 $1,517,312,396.45 $715,667,307.04 $744,391,704.85 $112,697,230.72 $857,088,935.56 $1,572,756,242.61 $52,282,425,069.31
62 $44,342,951,509.36 0.00253505 $1,513,465,935.77 $702,096,732.23 $755,201,464.96 $110,497,065.33 $865,698,530.29 $1,567,795,262.52 $53,673,308,877.84
63 $43,477,252,979.07 0.00253505 $1,509,629,226.05 $688,389,838.84 $766,168,200.10 $108,274,676.26 $874,442,876.37 $1,562,832,715.20 $55,089,901,211.14
64 $42,602,810,102.71 0.00253505 $1,505,802,242.57 $674,544,493.29 $777,294,189.81 $106,029,716.14 $883,323,905.95 $1,557,868,399.24 $56,532,729,980.79
65 $41,719,486,196.76 0.00253505 $1,501,984,960.68 $660,558,531.45 $788,581,746.72 $103,761,832.59 $892,343,579.31 $1,552,902,110.75 $58,002,332,654.83
66 $40,827,142,617.45 0.00253505 $1,498,177,355.79 $646,429,758.11 $800,033,217.03 $101,470,668.20 $901,503,885.23 $1,547,933,643.34 $59,499,256,425.23
67 $39,925,638,732.22 0.00253505 $1,494,379,403.36 $632,155,946.59 $811,650,981.04 $99,155,860.43 $910,806,841.47 $1,542,962,788.06 $61,024,058,378.36
68 $39,014,831,890.75 0.00253505 $1,490,591,078.92 $617,734,838.27 $823,437,453.59 $96,817,041.53 $920,254,495.12 $1,537,989,333.39 $62,577,305,668.18
69 $38,094,577,395.63 0.00253505 $1,486,812,358.08 $603,164,142.10 $835,395,084.61 $94,453,838.47 $929,848,923.08 $1,533,013,065.18 $64,159,575,692.53
70 $37,164,728,472.55 0.00253505 $1,483,043,216.47 $588,441,534.15 $847,526,359.59 $92,065,872.87 $939,592,232.46 $1,528,033,766.61 $65,771,456,272.35
71 $36,225,136,240.09 0.00253505 $1,479,283,629.82 $573,564,657.13 $859,833,800.11 $89,652,760.93 $949,486,561.04 $1,523,051,218.18 $67,413,545,833.88
72 $35,275,649,679.05 0.00253505 $1,475,533,573.90 $558,531,119.92 $872,319,964.39 $87,214,113.30 $959,534,077.70 $1,518,065,197.61 $69,086,453,594.06
73 $34,316,115,601.35 0.00253505 $1,471,793,024.56 $543,338,497.02 $884,987,447.78 $84,749,535.08 $969,736,982.86 $1,513,075,479.88 $70,790,799,748.99
74 $33,346,378,618.49 0.00253505 $1,468,061,957.69 $527,984,328.13 $897,838,883.32 $82,258,625.68 $980,097,509.00 $1,508,081,837.12 $72,527,215,665.63
75 $32,366,281,109.50 0.00253505 $1,464,340,349.26 $512,466,117.57 $910,876,942.29 $79,740,978.73 $990,617,921.02 $1,503,084,038.59 $74,296,344,076.73
76 $31,375,663,188.47 0.00253505 $1,460,628,175.29 $496,781,333.82 $924,104,334.77 $77,196,182.06 $1,001,300,516.83 $1,498,081,850.65 $76,098,839,279.04
77 $30,374,362,671.64 0.00253505 $1,456,925,411.86 $480,927,408.97 $937,523,810.17 $74,623,817.55 $1,012,147,627.73 $1,493,075,036.69 $77,935,367,334.93
78 $29,362,215,043.92 0.00253505 $1,453,232,035.11 $464,901,738.20 $951,138,157.86 $72,023,461.08 $1,023,161,618.94 $1,488,063,357.14 $79,806,606,277.38
79 $28,339,053,424.98 0.00253505 $1,449,548,021.26 $448,701,679.23 $964,950,207.69 $69,394,682.42 $1,034,344,890.11 $1,483,046,569.34 $81,713,246,318.44
80 $27,304,708,534.87 0.00253505 $1,445,873,346.56 $432,324,551.80 $978,962,830.61 $66,737,045.16 $1,045,699,875.77 $1,478,024,427.57 $83,655,990,061.24
81 $26,259,008,659.10 0.00253505 $1,442,207,987.33 $415,767,637.10 $993,178,939.26 $64,050,106.61 $1,057,229,045.87 $1,472,996,682.97 $85,635,552,715.56
82 $25,201,779,613.23 0.00253505 $1,438,551,919.97 $399,028,177.21 $1,007,601,488.59 $61,333,417.72 $1,068,934,906.31 $1,467,963,083.51 $87,652,662,317.04
83 $24,132,844,706.93 0.00253505 $1,434,905,120.92 $382,103,374.53 $1,022,233,476.43 $58,586,522.96 $1,080,819,999.40 $1,462,923,373.93 $89,708,059,950.16
84 $23,052,024,707.53 0.00253505 $1,431,267,566.69 $364,990,391.20 $1,037,077,944.19 $55,808,960.28 $1,092,886,904.46 $1,457,877,295.67 $91,802,499,974.87
85 $21,959,137,803.07 0.00253505 $1,427,639,233.82 $347,686,348.55 $1,052,137,977.39 $53,000,260.93 $1,105,138,238.32 $1,452,824,586.87 $93,936,750,257.17
86 $20,853,999,564.75 0.00253505 $1,424,020,098.96 $330,188,326.44 $1,067,416,706.41 $50,159,949.45 $1,117,576,655.85 $1,447,764,982.30 $96,111,592,403.46
87 $19,736,422,908.89 0.00253505 $1,420,410,138.79 $312,493,362.72 $1,082,917,307.04 $47,287,543.52 $1,130,204,850.56 $1,442,698,213.29 $98,327,821,998.97
88 $18,606,218,058.33 0.00253505 $1,416,809,330.03 $294,598,452.59 $1,098,643,001.23 $44,382,553.88 $1,143,025,555.12 $1,437,624,007.71 $100,586,248,850.12
89 $17,463,192,503.21 0.00253505 $1,413,217,649.50 $276,500,547.97 $1,114,597,057.70 $41,444,484.22 $1,156,041,541.92 $1,432,542,089.89 $102,887,697,231.02
90 $16,307,150,961.29 0.00253505 $1,409,635,074.06 $258,196,556.89 $1,130,782,792.62 $38,472,831.09 $1,169,255,623.71 $1,427,452,180.60 $105,233,006,134.05
91 $15,137,895,337.58 0.00253505 $1,406,061,580.62 $239,683,342.85 $1,147,203,570.35 $35,467,083.77 $1,182,670,654.12 $1,422,353,996.96 $107,623,029,524.81
92 $13,955,224,683.46 0.00253505 $1,402,497,146.16 $220,957,724.15 $1,163,862,804.07 $32,426,724.20 $1,196,289,528.27 $1,417,247,252.43 $110,058,636,601.17
93 $12,758,935,155.19 0.00253505 $1,398,941,747.71 $202,016,473.29 $1,180,763,956.56 $29,351,226.85 $1,210,115,183.41 $1,412,131,656.70 $112,540,712,056.86
94 $11,548,819,971.78 0.00253505 $1,395,395,362.37 $182,856,316.22 $1,197,910,540.86 $26,240,058.60 $1,224,150,599.46 $1,407,006,915.68 $115,070,156,349.43
95 $10,324,669,372.32 0.00253505 $1,391,857,967.30 $163,473,931.73 $1,215,306,121.03 $23,092,678.68 $1,238,398,799.71 $1,401,872,731.44 $117,647,885,972.64
96 $9,086,270,572.61 0.00253505 $1,388,329,539.68 $143,865,950.73 $1,232,954,312.89 $19,908,538.50 $1,252,862,851.39 $1,396,728,802.12 $120,274,833,733.58
97 $7,833,407,721.22 0.00253505 $1,384,810,056.81 $124,028,955.59 $1,250,858,784.78 $16,687,081.56 $1,267,545,866.33 $1,391,574,821.92 $122,951,949,034.37
98 $6,565,861,854.88 0.00253505 $1,381,299,495.99 $103,959,479.37 $1,269,023,258.28 $13,427,743.34 $1,282,451,001.62 $1,386,410,480.99 $125,680,198,158.60
99 $5,283,410,853.26 0.00253505 $1,377,797,834.62 $83,654,005.18 $1,287,451,509.03 $10,129,951.20 $1,297,581,460.23 $1,381,235,465.40 $128,460,564,562.56
100 $3,985,829,393.04 0.00253505 $1,374,305,050.13 $63,108,965.39 $1,306,147,367.51 $6,793,124.20 $1,312,940,491.71 $1,376,049,457.10 $131,294,049,171.48
101 $2,672,888,901.32 0.00253505 $1,370,821,120.02 $42,320,740.94 $1,325,114,719.81 $3,416,673.07 $1,328,531,392.88 $1,370,852,133.81 $134,181,670,680.58
102 $1,344,357,508.44 0.00253505 $1,367,346,021.84 $21,285,660.55 $1,344,357,508.44 $0.00 $1,344,357,508.44 $1,365,643,168.99 $137,124,465,861.34
Average ,#fe 4.967803217
97
>II.2: Multi &lass Se6uential<Pay Pass<t(rou!(
Pass:throu+hs 'ith varyin+ maturity classes can e created from the *ool of 'hole loans
y reshufflin+ cash flo's from the underlyin+ collateral so as to a**eal to investors 'ith
different investment hori-ons. For e.am*le, consider construction of four tranches of
*ass:throu+h securities that retires the various classes of onds se;uentially as sho'n in
fi+ure $.$E. The se;uential:*ay structure in Fi+ure $.$K distriutes cou*on interest to all
four tranches ased on the *rinci*al alance at the e+innin+ of the month for each
tranche at the res*ective cou*on interest rate a**licale to the tranche. Ho'ever, total
*rinci*al *ayment Ascheduled *rinci*al *ayment *lus *re*aymentC 'ill accrue to tranche
A until it is com*letely *aid off, follo'ed se;uentially to tranche B, tranche 3, and finally
the retirement of tranche ) until it is com*letely *aid off. For e.am*le, investors in
tranche A, B, 3, and ) 'ill res*ectively receive cou*on interest income of "=E,$%9,===I
"%=,9%=,E""."I ""7,K9E,"""." and "E=,#%6,$77.# at the end of the first month.
#i!ure 1.17: #our<$ranc(e Se6uential<Pay Structure*
Four:tranche *ass:throu+hs created from the underlyin+ collateral 'ith 2A3 of .%=9%,
2AM of $=% months, and a 'ei+hted avera+e *ass:throu+h rate of $6 *ercent Assumin+
" *ercent *re*ayment after $E months for a $=:year residential mort+a+es in &ran
Par A!ount
Coupon Rate
7aturit8 in
7onths
Principal
Pa85do9n
:indo9 In
7onths;
Avera+e
HifeUU
<ranche A
(-1(&'1'''1'''
'/-)2 *+ *+ $.7%9 year
<ranche B
(-1(&'1'''1'''
'/-,- +2 (. K.K years
<ranche C
(-1(&'1'''1'''
'/-.' ,& (( 7."7 years
<ranche =
(-1(&'1'''1'''
'/(-& -'( -, #.EK years
Total
collateral
IR850 billion
Pass5through
Rate '/-.'
K.67 years
:AC o"
Collateral '/('&(
9#
:A7 o"
Collateral -'( 7onths
UThis is the time *eriod et'een the e+innin+ and the end of total *rinci*al *ayments to
a tranche.
UUThis is the avera+e time to recei*t of *rinci*al amounts Ascheduled *rinci*al *ayment
and *ro,ected *re*aymentsC, 'ei+hted y the amount of e.*ected *rinci*al.
ules 3or distri/ution o3 cas( 3lo5s5
1. Periodic cou*on interest5 )isurse cou*on interest to all four:tranches ased on the
*rinci*al alance at the e+innin+ of the month for each tranche at the res*ective cou*on
interest rate a**licale to the tranche.
2. Princi*al Payment5 )isurse scheduled *rinci*al *ayment *lus *re*ayment of the
entire *ool of collateral to tranche A until it is com*letely *aid off, follo'ed se;uentially
to tranche B, tranche 3, and finally the retirement of tranche ).
Tranche A 'ill receive all *rinci*al *ayments Ascheduled *rinci*al *ayment and any
*re*aymentC from the underlyin+ *ool of the collateral until all *rinci*al of
%$,9==,===,=== o'ed to this class of ondholders is com*letely *aid off. Thereafter,
tranche B starts to receive *rinci*al *ayments from the *ool until this class of
ondholders is com*letely *aid off. This *rocess continues se;uentially until tranche )
ondholders are com*letely *aid off. &n our *rototy*e se;uential:*ay structure, at the end
of "7 monthsI of the total *rinci*al *ayments of 7E=,9%%,""".$, K"7,EK",K%6."$ are used
to retire tranche A ondholders, the remainin+ alance of %K",7#E,6=".#6 is used to *ay
do'n the *rinci*al alance of tranche B. After 7K months, of the total *rinci*al *ayments
of EE","%",6==.97 of the entire *ool of the collateral $=%,E=6,=7".7% is used to
com*letely *ay off ondholders in tranche B, the remainin+ alance of #E=,9$K,E"7.6K is
a**lied to *ay do'n the *rinci*al alance of tranche 3. Tranche 3 is com*letely *aid off
after E9 months. At the end of the E9 months of the total *rinci*al *ayments of
$,$=9,$"E,%$=.K9, #=6,$"#,=EE.69 is used to *ay off creditors of tranche 3, the remainin+
*rinci*al alance of "67,==$,$%$.9= is used to *ay do'n tranche ). Tranche ) is
com*letely *aid off at the end of $=% months y ma(in+ a final *ayment of
$,"KK,"9#,K99.EE to'ard the *rinci*al and interest *ayment of %K,=E7,K=K.K% that
com*letely retires ondholders of tranche ).
Given that the rules estalished for disursement of interest and *rinci*al are (no'n
in advance, the e.act amount of total *rinci*al *ayment is not (no'n, that de*ends on the
cash flo' of the *ool of the collateral 'hich in turn de*ends on the actual *re*ayment not
the assumed one in our analysis.
As sho'n in fi+ure $.$E, tranche A, B, 3, and ) are res*ectively *aid off com*letely y
month "7, 7K, E9, and $=% 'hich 'ill e the maturity of each class of ond in the *ool.
There are fe' other essential statistics, 'hich 'ill e discussed shortly.
The principal pay<do5n 5indo5 is the time from the e+innin+ to the end of the
*rinci*al *ayment to a *articular tranche that effectively retires that class of ond. For
e.am*le, tranche A is *aid do'n in "7 months. Tranche B e+ins receivin+ *rinci*al
*ayment in month "7 until month 7K, for a total of %6 months until it is com*letely *aid
off. The tranche 3 ondholders start to receive *rinci*al *ayment in month 7K, until it is
*aid off entirely after %% months in months E9. Finally, tranche ) e+ins receivin+
*rinci*al in month E9, until it is *aid off in month $=% in $E months as the *ay:do'n
'indo' for this class.
9E
A-era!e =i3e
The avera+e life of a *ass:throu+h is estimated y the sums of each *rinci*al amount
received Ascheduled *ayment *lus *re*aymentC 'ei+hted y the time at 'hich cash flo'
from the underlyin+ collateral accrues to *ass:throu+h investors at month t divided y the
*roduct of total *rinci*al times $% usin+ e;uation $.K as follo's5
Avera+e life V

=
T
t $
t x principal received at time t / 12 (total principal 1-4
The avera+e life of the *ass:throu+h of the underlyin+ collateral is estimated to e K.67
years as sho'n in the fi+ure $.$K. Ho'ever, the four tranches of se;uential:*ay *ass:
throu+hs have an avera+e life shorter or lon+er than that of the underlyin+ *ass:throu+h.
For e.am*le, tranches A and B have avera+e life of $.7%9 and K.K years shorter than that
of the underlyin+ *ass:throu+h of K.67 years. 8n the other hand tranches 3 and ) have an
avera+e life of 7."7 and #.EK years, res*ectively, that is +reater than that of the underlyin+
*ass:throu+h life of K.67 years. Throu+h *rioriti-in+ cash flo's of the underlyin+
collateral, 'e have created four different classes of securities that could a**eal to
investors 'ith si+nificantly different investment hori-on. The avera+e life a statistic can
e inter*reted as a ;uasi Macaulay duration, 'hich is the *resent value of the cash flo's
'ei+hted y the time in 'hich they accrue to investors. The cash flo's accruin+ to
various tranches are *resented in A**endi. $.
>III: #loater
The se;uential:*ay structure 'ill e far more a**ealin+ *rovided that investors desire for
various maturities, ratesI fi.ed or floatin+ are accommodated in the financial mar(ets. For
e.am*le, an(s< liailities are mostly floatin+ rate and they find floatin+ rate assets in
their alance sheet attractive for mana+in+ interest rate ris(. 3onsider secondary
securiti-ation of tranche ) in our *revious hy*othetical e.am*le into t'o classes of
3loater G in-erse 3loater. 2e demonstrate creation of floatin+ rate tranches of floater
and inverse floater from the underlyin+ fi.ed rate collateral usin+ tranche ) in our
se;uential:*ay structure.
The *ar value of the floatin+ rate A%f C and inverse floater A%i f C 'ill e e;ual to the *ar
value of the underlyin+ tranche ) collateral APc C of %$.9 illion.
BPc C F BPf C G BPi f C
There are infinite 'ays to s*lit the underlyin+ collateral into distinctly t'o different
securities. Ho'ever, the investors< desire 'ill effectively dictate as to the amount of
floater and inverse floater. From the collateral, t'o distinct securities are created5 a
floater 'ith mar(et value of $7.$%9 illion, and inverse floater 'ith mar(et value of
9."#9 illion. The cou*on rate on the floater is set at a s*read over a 'idely used inde. of
interest rates such as U.S. treasuries, H&B8/, Eurodollar, Eurior, or say 7:month Tehran
inter:an( offer rate T&B8/ in &ran.
9E
Su**ose the cou*on on the floater is set at 7:month
9E
This rate is not yet availale in the &ran ca*ital mar(etI ho'ever, it is conceivale to estalish such an
inde. as the sim*le 'ei+hted avera+e of rates at 'hich *rivate an(s are 'illin+ to e.tend credit to their
96
T&B8/ *lus K *ercent, therefore the cou*on of the floater 'ill e e;ual to %% *ercent if
the 7:month T&B8/ is e;ual to $E *ercent at the scheduled reset date. There is a
'ides*read misconce*tion aout duration of the floater. The duration of a floater amon+
other thin+s de*ends on its time to reset, chan+in+ s*reads in the mar(et, and 'hether the
ca* is reached. For e.am*le, a monthly reset floater 'ill have duration close to -ero if the
ca* is not reached or if the s*read in the mar(et does not chan+e. &t doesnSt ma(e a
difference if it is a floater 'ith a $= or "= years maturity.
&oupon o3 #loater F %<mont( $I:, G 7E
>III.1: I@1'S' #=,A$'
The inverse floater is a derivative security synthetically created from the fi.ed rate det
instrument as the underlyin+ collateral. The many variations of inverse floaters are (no'n
as reverse floaters, ull floaters, yield curve notes, and ma.imum rate notes. They 'ere
created in $6E7. The incentive to create synthetic security is to create value and reduce
ris(. The floater cou*on is ca**ed and -ero floors are im*osed on the cou*on of the
inverse floater to *revent this ond from havin+ a ne+ative cou*on. The cou*on of
inverse floater is set to ta(e into account the amount of floater relative to an inverse
floater (no'n as levera+e factor AHC as follo's5
&oupon o3 in-erse 3loater F 6 H = B$I:,C
2here ; is a constant to e determined and levera+e factor H is e;ual to $7.$%9F9."#9, or
" as there is >" of floater for every >$ of inverse floater in the underlyin+ collateral. The
hi+her the levera+e factor the +reater is the *rice sensitivity of the inverse floater. The
+ross cou*on of the collateral is e;ual to %$.9 *ercent, 'hile the 'ei+hted avera+e of the
cou*on of floater and inverse floater is e;ual to $6 *ercent. A ca* in the floater is
determined y settin+ the cou*on on the floater e;ual to $6 *ercent assumin+ the inverse
floater cou*on is -ero.
AA& F .*9 * I$I:, G7EJ G .29*I6 H 0*B$I:,CJ
.19 F .*9 * I$I:, G7EJ $I:,F.21000

The relationshi* e.*ressed aove assumin+ 2A3 of $6 *ercent does not have a solution,
as there is one e;uation 'ith t'o un(no'nsI therefore, 'e need to im*ose a minimum
cou*on of -ero on the inverse floater to solve the ca* rate on the floater. &t turned out that
the ca* rate on the 7:month T&B8/ has to e e;ual to %$."" *ercent. The constant term ;
on the inverse floater is determined y settin+ the cou*on for the inverse floater e;ual to
-ero 'hen the inde. is at the ma.imum ca* rate of %$."" *ercent in our e.am*le.
6< 0*B.2100C F 0 6 F .%099
The *rice of the floater 'ill trade close to *ar as lon+ as the s*read that de*ends on the
credit ;uality of the issuer remains the same and neither the floor nor the ca* is activated.
*rime customers.
7=
The *rinci*al alance on the floater declines over time as *rinci*al *ayments Ascheduled
*ayment *lus *re*aymentsC are made. The *rice of the inverse, ho'ever, is inversely
related to the interest rate. 2hen rates fall, the floater 'ill +et a smaller share of the
cou*on interest rate, and the inverse floater 'ill receive the lar+er share of the fi.ed
cou*on interest underlyin+ the collateral. The *rice sensitivity of the floater and the
inverse floater can e analy-ed assumin+ the interest rate scenarios sho'n in the fi+ure
$.$9.
#i!ure 1.195 Share of Floater and &nverse Floater 3ou*on &nterest from the $6 *ercent
fi.ed cou*on of 3ollateral under various interest rates.

$I:, =.=9 =.$ =.$% =.$K =.$7 =.$E =.% 0.2100
"loater '/'+)& '/-'& '/-( '/-*& '/-& '/-+& '/-, '/-,..)&
inverse "loater '/-((2, '/',2.)& '/'+..)& '/'&2.)& '/'*..)& '/'(2.)& '/''..)& 0
:AC o"
collateral '/-,..)& '/-,..)& '/-,..)& '/-,..)& '/-,..)& '/-,..)& '/-,..)& '/-,..)&
As interest rates fall, the floater is receivin+ a smaller share of the $6 *ercent cou*on
underlyin+ the collateralI the inverse floater is receivin+ the lion<s share of the cou*on,
not *ro*ortional to its share. The floater is e.*ected to trade elo' its *ar 'hile the
inverse is e.*ected to trade at *remium. Ho'ever, as interest rates rise, the inverse floater
'ill receive a smaller share of the cou*on. At the limit, 'hen the T&B8/ reaches the ca*
rate of %$."" *ercent, all of the cou*on 'ill accrue to the floater and the investors 'ith
the inverse floater 'ill +et nothin+. 2hen the T&B8/ reaches $9 *ercent, the floater and
inverse floater *rice are at *ar, ecause oth det instruments are receivin+ their
*ro*ortional share of the underlyin+ collateral. The inverse floater is receivin+ %9 *ercent
of the $6 *ercent cou*on, or K.#9 *ercent, and the floater is +arnerin+ the remainin+
$K.%9 *ercent, 'hich is #9 *ercent of the cou*on underlyin+ collateral of $6 *ercent.
&n our e.am*le cou*on levera+e is e;ual to ", indicatin+ that for every PF: $ *ercent
chan+e in the 7:month T&B8/ the inverse floater cou*on is e.*ected to chan+e y PF: "
*ercent. The mar(et convention in the U.S. defines various cou*on levera+es as follo's5
3ou*on levera+e /an(
.9= to %.$ Ho'
^%.$to _ K.9 Medium
^ K.9 Hi+h
>III.2: Accrual :onds
&n order to s*eed u* *ayments to some classes of onds at the e.*ense of another class,
'e need to structure a class of ond 'here the monthly interest *ayment for this class is
used to *ay off earlier classes. Therefore, the class of ond that monthly interest *ayment
is *ost*oned, and the *roceeds are used to *ay off earlier classes is (no'n as accrual
class or K /onds. To see 'hat ha**ens to other classes of onds 'hen a W onds re*laces
tranche ). 3onsider four tranches of onds in Fi+ure $.$K, 'e have re:estimated all the
7$
relevant statistics and they are *rovided in Fi+ure $.$7. &n Fi+ure $.$7 the maturities of
tranche A, B, and 3 are res*ectively reduced to %K, K", and 7$ months as com*ared to the
same tranche in Fi+ure $.$K. Tranche A and B are *rotected a+ainst e.tension ris( y
tranche 3 and tranche W. The tranche 3 and W are *rotected a+ainst contraction ris( y
tranche A and B in Fi+ure $.$7.
#i!ure 1.1%: #our<$ranc(e Se6uential<Pay Structure*
Four:tranche *ass:throu+hs created from the underlyin+ collateral 'ith 2A3 of .%=9%,
2AM of $=% months, and 'ei+hted avera+e *ass:throu+h rate of $6 *ercent Assumin+ "
*ercent *re*ayment after $E months for $=:year residential mort+a+es in &ran
Par A!ount
Coupon Rate
7aturit8 in
7onths
Principal
Pa85do9n
:indo9 In
7onths;
Avera+e
HifeUU
&n year
<ranche A
(-1(&'1'''1'''
'/-)2 (2 (* $.=K
<ranche B
(-1(&'1'''1'''
'/-,- 2* (' %.E%
<ranche C
(-1(&'1'''1'''
'/-.' +- -, K.K=
> Bonds
(-1(&'1'''1'''
'/(-&
Total
collateral
IR850 billion
Pass5through
Rate '/-.'
$=% K.67 years
:AC o"
Collateral '/('&(
:A7 o"
Collateral -'( 7onths
UThis is the time *eriod et'een the e+innin+ and the end of total *rinci*al *ayments to
a tranche.
UUThis is the avera+e time to recei*t of *rinci*al amounts Ascheduled *rinci*al *ayment
and *ro,ected *re*aymentsC, 'ei+hted y the amount of e.*ected *rinci*al.
ules 3or distri/ution o3 cas( 3lo5s5
1. Periodic cou*on interest5 )isurse cou*on interest to tranche A, B, and 3 ased on the
*rinci*al alance at the e+innin+ of the month for each tranche at the res*ective cou*on
interest rate a**licale to the tranche. For tranche W, use the cou*on interest for this
tranche as *rinci*al *ay:do'n for earlier tranches. The *rinci*al alance of the tranche W
is increased y the accrued interest for the *recedin+ month as sums of *rinci*al *lus
accrued interest.
2. Princi*al Payment5 )isurse scheduled *rinci*al *ayment *lus *re*ayment of the
entire *ool of collateral to tranche A until it is com*letely *aid off, follo'ed se;uentially
to tranche B, tranche 3, and finally disurse *rinci*al *ayments *lus accrued interest to
tranche W until it is com*letely *aid off. The cash flo's accruin+ to the ondholders in
tranche A and B are *resented in the A**endi. %.
>I1: &ross :order Securitization
Accordin+ to a recent re*ort, Shinhan Ban( of 0orea ori+inated the first cross:order
asset:ac(ed securiti-ation of 02E== illion of its consumer loan receivales, 'ith
Merrill Hynch as a lead arran+er and s'a* counter*arty to a currency s'a* of U.S. dollar
7%
for the 0orean 2on, as illustrated in Fi+ure $.9.
96
The Shinhan Ban( removed 02E==
illion fi.ed:rate consumer loans from its alance sheet to an SPB, 'hich in turn issued
asset:ac(ed securities denominated in floatin+:rate US dollars. The Ban( achieved
re+ulatory ca*ital relief of 027K illion, as consumer loans are $== *ercent ris(:
'ei+hted A$== *ercent of E *ercentC, ased on the Basle Accord. Shinhan Ban( 'as ale
to reali-e an aritra+e *rofit from the difference on the lo'er cost of fundin+ in the
floatin+:rate Eurodollar mar(et and its hi+her yieldin+ consumer loans. Furthermore,
02E== illion ca*itals tied u* in consumer loans 'as freed to allo' the an( to ori+inate
other loans in the 0orean ca*ital mar(et. The currency and interest rate ris(s e.*osure to
the floatin+ rate dollar denominated securities issued in the cross:order asset ac(ed
securiti-ation 'as miti+ated y enterin+ into a currency and interest rate s'a*s 'ith
Merrill Hynch, as sho'n in Fi+ure $.$#.



Risk Management: Currency &
Interest rate swaps
&n the aove structure Shinhan Ban(<s SPB *ays a US dollar floatin+:rate to Merrill
Hynch and receives fi.ed:rate 02, therey miti+atin+ its e.*osure to forei+n e.chan+e
and interest rate ris(s. At the ince*tion of the s'a* Merrill Hynch and Shinhan Ban(<s
SPB s'a* the *rinci*al amounts, thereafter e.chan+in+ *eriodic cash flo's over the
tenor of the s'a*. The counter*arties e.chan+e the *rinci*al amount of the s'a* in dollar
and 02 at the maturity of the currency s'a*.
Hyundai Motor 3om*any<s susidiary, Hyundai 3a*ital, securiti-ed its fi.ed:rate
automoile loans in a cross:currency securiti-ation 'ith Standard 3hartered Ban( as a
lead arran+er and currency and interest rate s'a*s counter*arty to US>%%E million asset:
ac(ed securiti-ation. This structure 'as very similar to the deal structured et'een
Shinhan Ban( and Merrill Hynch, 'ith the e.ce*tion that the floatin+:rate dollar:
denominated securities issued y the SPB 'ere rated Aa" y Moody<s &nvestors Service,
'ith a t'o year revolvin+ *eriod follo'ed y a %#:month amorti-ation *eriod.
7=

>I1.1: ?apanese Securitization o3 @P=s
96
See 2orld Trade E.ecutive, 1anuary $9, %==K., P E.
7=
See iid.
Shinhan
Ban( 0orea
SPB
&ssues Asset
ac(ed securities
Senior:
&nvestor E=N
Merrill Hynch
Arran+er
3redit Enhancement
collaterali-ation
Su: $= N
Senior
3lass
>99$.#%Km
illion
9 N First
Hoss
9 N First
Hoss
02 E== illion
Proceeds Proceeds
Fixed Floating
KW $
&ross :order Securitization o3 & in Sout( Lorea
7"
Securiti-ation made a late start in Asia, includin+ 1a*an. But havin+ done so, it is
+ro'in+ at a very fast *ace. &n 1a*an, securiti-ation +re' almost $==N in $666, for the
third successive year. &n the rest of Asia, a si+nificant momentum for securiti-ation
transactions is already seen, 'ith several transactions re*orted from Hon+ 0on+,
Sin+a*ore, Malaysia, 0orea, &ndia, etc. Ho'ever, securiti-ation can still e re+arded as
develo*in+ in Asia. /e+ulations, *rudential +uidelines and la's in most Asian mar(ets
are yet to e defined to *romote or re+ulate securiti-ation. There is no accountin+
standard as yet from any of the Asian countries. 1a*anese financial institutions, havin+
nearly >$ trillion of non:*erformin+ loans !PHs on their alance sheets, can ta(e
advanta+e of an im*roved re+ulatory environment for securiti-in+ these assets.
7$

The advanta+e of securiti-ation rests on the aility of the an(s to remove the non:
*erformin+ assets from their alance sheet, relievin+ the re;uired ca*ital reserve used for
the *otential loss on the non:*erformin+ loans. The an(s 'ill reali-e ta. enefits, 'hich
may not e availale under the current 1a*anese la's for 'ritin+:off the loans.
7%

Ban(s in 1a*an have smaller ase of e;uity ca*ital, as com*ared to their counter*arts
in the United States, to asor lar+e losses, therefore the an(s< un'illin+ness to 'rite off
!PHs are due to the comination of insufficient ca*ital and re+ulatory constraints
emedded in the ta. la's. The Ban( of 1a*an half:heartedly has addressed the issue of
relatively hi+h levera+e Alo' e;uity ca*italC of the 1a*anese an(: 'ith a "= to $ e;uity
multi*lier as com*ared to $9 to $ for the U.S. an(s:: y infusin+ *ulic funds into the
an(in+ sector, as 'ell as y increasin+ the money su**ly in $669 to lo'er interest
rates::a move that increases the net interest mar+in of the an(s, due to lar+er s*reads on
loans.
&n e.chan+e for infusion of *ulic funds >7$ illion distriuted to $9 ma,or an(s on
March E, $666, and over >%== illion later, the +overnment 'ill receive *referred stoc(s
of the an(s in *ro*ortion to the amount of *ulic funds. The *referred stoc(s can e
converted to shares of common stoc(s after a *eriod of " months to # O years de*endin+
on the an(.
7"
Private fundin+ in the Euro:credit mar(et, +iven the enormous a**etite for
o'nershi* of 1a*anese an( stoc(s, may *rovide sufficient ca*ital to im*rove an(s<
alance sheets and lift *oor ratin+s of 1a*anese an(s *la+ued y !PHs.
Firms consider securiti-ation of asset as a means of reducin+ fundin+ cost and
miti+atin+ e.*osure to a *articular asset classes or oli+ors. 1a*anese an(s *la+ued y
!PHs can stren+then their alance sheets y meetin+ Ban( for &nternational Settlement
B&S ca*ital ade;uacy re;uirements. 2hen loans are held in the an( *ortfolio and not
securiti-ed, an(s must maintain ca*ital reserves of ei+ht *ercent of the outstandin+
*ortfolio alance. 8nce !PHs are removed from the an( alance sheet throu+h
securiti-ation, the ca*ital re;uirement falls to the level of e;uity the an( retains in the
securiti-ed assets.
7K
For e.am*le, if a an( retains say 9 *ercent e;uity interest in the
*ortfolio of !PHs as a first loss in ali+nin+ its interest 'ith the ,unior and senior tranches,
then the an( needs to maintain five *ercent ca*ital A$==N of 9NC instead of the EN
re;uired y B&S standards. This relieves the ca*ital for de*loyment in other *rofitale
7$
San+er, )avid. ? Bad det held y 1a*an<s Ban(s no' estimated near >$ trillion ? The !e' Mor( Times,
1uly "=. $66E.
7%
1a*anese ta. system does not *ermit ta. deductions for 'rite:offs.
7"
?Finance and Economics5 ?Money for !othin+ The Economist@. March $", $666, * E#:EE
7K
/yan, 1erome. ? S*ea(in+ of Securiti-ation5 1a*anese Securiti-ation@ )eloitte G Touche A*ril %%, %==%.
7K
ventures and or ori+ination of loans to non:an( finance com*anies de*rived of credit, y
an(<s increasin+ ris( aversion.
Securiti-ed det instruments are usually rated hi+her than the ori+inator<s o'n ratin+,
resultin+ in reduced fundin+ cost. Securiti-ation also transfers the ris( of default of
underlyin+ credits to the ca*ital mar(et as ris( is transferred from the ori+inator As*onsorC
to the investor, limitin+ the loss of ori+inator to the 9 N e;uity retained as 'ell as the cost
of credit enhancement as sho'n in Fi+ure $.$E.
#i!ure 1.1+: Securitization

?True Sale@
Proceeds
Proceeds


Risk Management: Interest rate &
Currency swap


The SPB havin+ ta(en a five *ercent first loss on the underlyin+ securities issued to
ca*ital mar(et *asses the loss to the ori+inator As*onsorC. The SPB havin+ issued
securities in domestic or forei+n currency Across:order securiti-ationC at H&B8/ *lus a
s*read reflectin+ the credit ris( of the underlyin+ *ool of assets, can miti+ate its e.*osure
to interest rate and or currency ris( y en+a+in+ in s'a* transactions that transform the
oli+ation of the SPB into fi.ed or floatin+ ratesF and or the desired currency of the
ori+inator As*onsorC.
Securiti-ation of credit card receivales, auto loans, leases, and other assets has een
oomin+ in 1a*an. Ho'ever, des*ite its attractive nature for an(s and other finance
com*anies and *romotion y such an(s as Fu,i Ban( and Sumitomo, the numer of
deals remains fairly lo' as com*ared to !orth America and Euro*e. 3ultural and
relationshi* an(in+ is at odds 'ith the securiti-ation *rinci*le as to the assi+nment of
the loan to a third *artyI le+al, ta., and other restrictions remain to e resolved.
S*onsor
8ri+inator
SPB
&ssues Asset
ac(ed securities
&nterest rate s'a*
3urrency s'a*
3redit Enhancement
collaterali-ation
In-estors
SeniorFSu
3lasses
9 N First
Hoss
9 N First
Hoss
79
&n 8ctoer $66E, an assi+nment that allo's *erfection 'ithout notice or consent of
orro'ers 'as introduced into a la', su*ersedin+ Section %K.% of the Money lender<s
la', 'hich re;uired M8F:re+ulated an(s and other financial institutions to notify all
oli+ors via re+istered letter of their intention to sell or assi+n assets.
79
Ho'ever, other
re+ulatory reform such as re+ulation effective March "$, $66E have eroded the
attractiveness of collaterali-ed loan oli+ations 3H8s ac(ed y 1a*anese cor*orate
loans. Althou+h these re+ulations are intended to *romote trans*arency and are similar to
U.S. accountin+ and re+ulatory rules, they re;uire an(s to maintain EN ca*ital reserve
for the face value of senior dets securiti-ed if the *ro*ortion of the suordinated *osition
e.ceeds EN of that face value.
77

Another im*ediment for securiti-ation in 1a*an is related to the difficulty of
foreclosin+ ad loans. 2hile in the U.S. trouled firms can see( an(ru*tcy *rotection
under 3ha*ter $$ of Ban(ru*tcy 3ode, a similar measure is not availale for 1a*anese
firms. Under the current 1a*anese la's, if the *re:fillin+ mana+ement remains in *lace
after fillin+, secured lenders can sei-e the collateral underlyin+ the loanI unless an
automatic stay e.ists, this dictates that a trustee must a**oint the ne' mana+ement.
7#

Ta. la's also com*licate the *rocess of securiti-ation in 1a*an. For e.am*le, in a
cross:order securiti-ation, the ori+inator As*onsorC must ensure that the securities issued
are onds, not loans. Bonds 'ill e treated as loans if held only y a fe' investors or a
fe' investors hold sustantial amount of *rinci*al under article $7$ and %$%, of &ncome
Ta. Ha'I in this case su,ectin+ forei+n investors to 1a*anese 'ithholdin+ ta..
7E
The transfer of assets from the ori+inator to SPB has to e a ?true sale@ 'hich satisfies
the follo'in+ criteria5
AaC &ntent of oth *arties as to saleFassi+nment of the assets.
AC Asset isolation A*erfectionC, that is le+al.
AcC Pricin+. Assets are *riced for transfer to SPB at fair mar(et value.
AdC /e*urchase. /i+ht of re*urchase a+reement 'ith ori+inator may lead into
classification of transfer as a secured loan su,ectin+ this to recourse y other creditors in
the event of the an(ru*tcy of the ori+inator as o**osed to true sale.
He+al sale GAAP Sale
FASB $%9
&n the aove structure the sale from the ori+inator to its o'n susidiary re*resent a le+al
sale and SPB is the susidiary of the ori+inator and is li(ely to e consolidated 'ith the
ori+inator. The second sale from SPB to the trust com*letely isolates the securiti-ed
assets from the ori+inator, therey ma(in+ it acce*tale to the FASB $%9 re;uirements
and an off:alance sheet treatment of the transferred assets.

79
Herr, E. 0 and Miya-a(i, G, ?A Pro*osal for the 1a*anese !on:Performin+ Hoans Prolems5
Securiti-ation as a Solution,@ &n Ban(ru*tcy and /eor+ani-ation, y Ed'ard Atman, A*ril $666.
77
?The Hottest !e' Game in To'n.@ Euro'ee(. Au+ust $66E, P %9:"%.
7#
2hitman, M. ?8ther Boices5 1a*an should 'rite a !e' 3ha*ter.@ Barron<s. 8ctoer $6, $66E, P 97.
7E
Moost, et al. ?Securin+ Success in 1a*an. @&nternational Ta. /evie'.@ Hondon5 8ctoer $66E, P
$#:%%.
8ri+inator SPB Trust In-estors
77
Scenario5 3onsider Ban( A 'ith >9= million !PH in its *ortfolio 'ith mar(et value of
>%= million. Ban( A estalishes an SPB in a lo' ta. environment such as 3hannel
&slands. Ban( A sells the assets at the fair mar(et value for >%= million and receives the
*roceeds from the SPB. The enefits of securiti-ation are that it5
/elieves the an( from holdin+ >K million ca*ital reserves AEN of >9= millionCI
Enales the an( to remove the non:*erformin+ assets from its alance sheetsI
Enales Ban( A 'ith a ta. relief Ain some ,urisdictions sim*ly 'ritin+:off the loans
'ill not *rovide ta. enefitsCI
An alternative scenario for Ban( A is to estalish the SPB in a lo':ta. environment and
have the SPB rated y the ratin+ a+encies. !e.t, Ban( A ori+inates a ne' loan as a
creditor to the SPB, and SPB as a detor and simultaneously sells the loan as illustrated in
the Fi+ure $.$6.
#i!ure 1.19: :an8 A ,ri!inates and Sells =oans to SP1
8ld Hoan BB >9= M

MB >%= M



Ban( A, havin+ *laced the old loan 'ith fair collateral value of >%= million and oo(
value of >9= million 'ith the SPB, ori+inates a ne' loan and e.tends it to the SPB, 'hile
simultaneously sellin+ the ne' loan for >%= million cash. The ori+inatin+ an( 'rites off
a >"= million loss and reco+ni-es ta. enefits at the time of sale. The ta. enefits of the
aove scenario accrue immediately to the ori+inatin+ an( at the time of sale, 'ithout
'aitin+ for the SPB to issue asset:ac(ed securities. The SPB, havin+ *ooled assets in its
*ortfolio, issues asset:ac(ed securities AABSC, as individual ris(s of the com*onents of
the *ortfolio are diversified and overall ris( is reduced.
>1: #uture #lo5 Securitization
This transaction involves the orro'in+ entity to sell future receivales that 'ould have
een +enerated y sellin+ future *roducts directly or indirectly to an off:shore facility
(no'n as s*ecial *ur*ose entity ASPEC. The SPE sells asset:ac(ed securities in the
+loal financial mar(ets and channels the funds +enerated from the sale of securities ac(
to the ori+inatin+ firm. The essence of these transactions is to ca*ture cash flo's
+enerated y a soverei+n or *rivate com*any y *lacin+ forei+n investors on the
Ban( A SPB
8ri+inate >%=
million !e' Hoan
Sell ne' loan to SPB
for >%= million
7#
underlyin+ *ool of collaterals in a senior *osition, le+ally and *ractically as sho'n in
Fi+ure $.%=.

Furthermore, future flo' securiti-ations miti+ate many of the common elements of
soverei+n ris(s associated 'ith an emer+in+:mar(et orro'er. The ori+inatin+ entity
directs its overseas customers Aim*ortersC to *ay for the e.*ort *roducts Afrom the
ori+inatin+ firmC to the off:shore facility mana+ed y a trust. The trust uses *roceeds
from the sale of the securities to *ay to ori+inatin+ entity 'hile servicin+ the interest and
*rinci*al to domestic and forei+n investors y collectin+ *ayments from the sale of future
*roducts to domestic and forei+n clients. Any e.cess collection 'ill e channeled to the
ori+inatin+ firm less servicin+, administrative, and cost of under'ritin+ and credit
enhancement.
The aove transaction allo's credit'orthy and investment +rade firms in develo*in+
economies to ta* into a chea*er source of financin+ y accessin+ 'ider classes of
investors Adomestic and forei+nC y *iercin+ the soverei+n credit rate ceilin+ throu+h
over:collaterali-ation and a**ro*riate credit enhancement of securiti-ed dets in order to
secure etter credit terms and lon+er maturity for fundin+ ca*ital as the securiti-ed
instruments are rated as investment +rade y ma,or ratin+ a+encies. Future flo':ac(ed
securiti-ation miti+ates soverei+n ris(, therey allo'in+ a credit ratin+ fe' notches aove
that of the soverei+n ceilin+. Furthermore, once credit history is estalished for a firm,
the cost of future ca*ital is e.*ected to e si+nificantly lo'er for the orro'in+ firm in
the future.

>1.1: &(aracteristics o3 #uture #lo5 Securitization

Fi+ure $.%=5 Structure of 3or*orate Future Flo' Securiti-ation
7E
Securiti-ation of the future flo':ac(ed receivales is a ne' *henomenon in
develo*in+ economies. The first transaction involved securiti-ation of tele*hone
receivales due to Me.ico<s Telme. in $6E#. Ma,or ratin+ a+encies in the United States
such as Fitch, )uff and Phel*s AFitchC, Moodys and Standard G Poor<s ASGPC have rated
assets in over %== securiti-ations, 'ith an a++re+ate *rinci*al amount of >#%." illion y
%==%. 8ver the *ast $= years, future flo' AFFC securiti-ation has +ro'n in emer+in+
mar(ets in res*onse to findin+ lo'er cost fundin+ instrument y investment +rade firms
in the emer+in+ mar(et economies 'here their ailities 'ere ham*ered y soverei+n rate
ceilin+. 2hile many of these com*anies historically relied on an( loans, or strai+ht dets
syndicated y ma,or forei+n an(s in the *ast, risin+ volatility of interest rates and
forei+n e.chan+e rates as 'ell as reduced ris( tolerance of ma,or lenders have *ushed
these institutions Asoverei+n and *rivate com*aniesC to'ard an alternative vehicle such as
future flo' securiti-ations. Future flo's, have successfully miti+ated a variety of the
ris(s associated 'ith emer+in+:mar(et investments, and consistently remained the most
viale ty*e of rated transactions for fundin+ in emer+in+:mar(et countries over the last $=
years as seen in E.hiit$.$.
')(i/it1.1: 'mer!in! Mar8et Issuance 1991< 2002
Source5 Fitch May %#, %=="
Me.ico has dominated FF securiti-ation since the Me.ican Peso crisis of $66K:69, 'hen
soverei+n ratin+s 'ere do'n+raded and orro'in+ costs increased in ma,or Hatin
American economies. Me.ican firms have raised over US>$E illion since $6E# due, in
lar+e *art, to the various issuances y Me.ico<s Telme. securiti-ation of tele*hone
receivales in $6E#, Peme.<s securiti-ation of US>7.= illion oil e.*ort receivales, and
Baname.<s securiti-ation of residential mort+a+es. There has also een a si+nificant
amount of future flo' securiti-ation in other countries, includin+ the Bra-ilian mar(et at
US>9.K illion and Bene-uela at US>".9 illion, as sho'n in the follo'in+ e.hiit. The
Bene-uelan issuance stems almost com*letely from the e.*ort receivales transaction.
Tur(ey<s issuance totaled US>".7 illion, 'hile Ar+entina follo's at US>".$ illion. The
most common flo' ein+ securiti-ed has een from e.*ort receivales as sho'n in
E.hiit $.%.
76
The cash flo's from future flo' transactions come from a variety of sources to an off
shore facility, includin+ forei+n im*orters ma(in+ *ayments on receivales, international
credit card com*anies such as Bisa, Master 3ard, American E.*ress and other s*ecialty
cards y ma(in+ settlement *ayments to local an(s and international an(s ma(in+
remittance transfers to local an(s. Future flo' transaction structures miti+ates many of
the elements of soverei+n ris( y (ee*in+ the cash flo's offshore until the investors< in
the future flo':ac(ed securities are *aid.
')(i/it 1.2: #uture #lo5 Issuance /y &ountry
Asset classes suitale for future flo' securiti-ation are5 future oil and +as
receivales, minerals, a+ricultural *roducts, credit card vouchers, and tele*hone
receivales in dollars from ATGT, M3&, and S*rint and others. The aility to e.*loit
future flo' securiti-ation in develo*in+ economies is constrained y elo':investment:
+rade ratin+s of soverei+n nations, as 'ell as y the lac( of a uniform standard for
securiti-ation transactions, *articularly in the la's concernin+ an(ru*tcies. The ratin+
a+encies have develo*ed a hierarchy of future flo' transactions that are *erceived to e
the most secure to those that are assumed to e the least secure as sho'n in Tale 9.
$a/le 9: ;ierarc(y in 3uture 3lo5<:ac8ed $ransactions
$. Heavy crude oil receivales
%. Airline tic(et receivales, tele*hone receivales, credit
card receivales, and electronic remittances
". 8il and +as royalties, e.*ort receivales
K. Pa*er remittances
9. Ta. revenue receivales
#=
Source5 Standard G Poor<s A$666C, Fitch A%===C
Accordin+ to the ratin+ a+encies, Standard G Poor<s and Fitch, securiti-ation of crude
oil is considered to e the most secure and that of the ta. revenue receivales is elieved
to e least secure. 3rude oil is y far the most li;uid and +ood collateral 'ith the
follo'in+ attriutes. The stoc( of crude oil is fairly 'ell (no'n for a *articular country or
re+ion for that matter. &t is hi+hly li;uid 'ith enormous demand from ma,or industriali-ed
economies and others, *articularly 3hina. Unli(e any other commodities in the 'orld
mar(et, crude oil is a hi+hly li;uid asset 'ith an estalished +loal mar(et ac(ed y a
cartel of the 8r+ani-ation of Petroleum E.*ortin+ 3ountries A8PE3C. Therefore, crude oil
is *erfectly suited as a safe future flo':ac(ed securiti-ation. The 8PE3 countries can
ta(e advanta+e of this asset class in securin+ various lon+ and short term fundin+ for their
*ro,ects Amanufacturin+, infrastructure, and othersC at a relatively lo'er cost y accessin+
+loal financial mar(ets via future flo':ac(ed securiti-ation of crude oil *articularly at
times of li;uidity crisis. 8n the other hand, to secure investment +rade ratin+ underlyin+
collateral in the lo' end of the hierarchy, ratin+ a+encies re;uire si+nificantly more over
collaterali-ation and other forms of credit enhancement.
For e.am*le, Tur(ey<s forei+n currency:denominated onds are rated B$in E.hiit $.".
The soverei+n rate ceilin+ of B$ for forei+n currency denominated onds for Tur(ey can
e *ierced via future flo':ac(ed securiti-ation, throu+h over:collaterali-ation and credit
enhancement of the underlyin+ *ool of collateral. The amount of hard currency raised in
the +loal financial mar(ets throu+h future flo':ac(ed securiti-ation as a *ro*ortion of
total Ae.istin+ and future flo'C has een a**ro.imately ## *ercent accordin+ to ma,or
ratin+ a+encies, as sho'n in Fi+ure $.%$.
76

76
Amount of hard currency raised in US> 'ith e.istin+ and future flo' securiti-ation over $6E#: $666
*eriod is res*ectively >$=.6 illion and >"7.K illion accordin+ to Fitch, Moodys and Standard G Poor<s.
#$
#i!ure 1.21: #uture #lo5 and ')istin! Assets
Source5 Fitch, Moody<s, and SGP

Future flo' securiti-ations are of t'o ty*es5 3inancial 3uture 3lo5s are ty*ically issued
y an(s and secured y the offshore cash flo's +enerated throu+h the an(s< various
lines of usiness, includin+ credit card vouchers, electronic and *a*er remittances.
')(i/it 1.0 :
#%
&orporate<related transactions involvin+ airline tic(et receivales, tele*hone net
settlements and, e.*ort receivales transactions, includin+ oil, +as, steel, iron ore,
soyean, *a*er, aluminum, coffee and chemicals.
&n an electronic remittance securiti-ation, the future cash flo's re*resent *ayments
sent y individuals and entities from forei+n countries to eneficiaries in an emer+in+
mar(et country. 8ver K9 *ercent of all future flo' securiti-ations are ac(ed y oil and
+as e.*ort receivales durin+ $6E#:$666 *eriods, 'hich are considered y ratin+
a+encies as +ood collateral. !on:oil e.*ort Airon, coo*er, aluminum, coffee, soy and
oran+e ,uiceC ma(es u* over %= *ercent, follo'ed y credit card receivales at $$.E
*ercent as sho'n in Tale 7.

$a/le %: #uture #lo5 Securitization /y Sector
> million Share of total dollar
volume N
!o. of
transactions
8il and +as
receivales
$7,"7% K9 %9
!on:oil e.*ort
receivales
#,9"# %=.# K=
3redit card receivales K,"$K $$.E "#
Pro,ect finance %,K7# 7.E 7
Tele*hone receivales %,9$6 7.6 $9
/emittances $,#"$ K.E $K
8ther receivales $,KK" K.= $$
"7,"#% $== $KE
Source5 Fitch, Moody<s and SGP
8il and +as deals are relatively much lar+er in si-e as com*ared to non:oil transactions
due to the homo+eneous nature of oil. As a 'ell:develo*ed *roduct in hu+e demand from
various oli+ors around the 'orld, oil ma(es u* only $% *ercent of all transactions 'ith
over K9 *ercent of the share of entire securiti-ed deals. The choice of collateral is
considered to e very si+nificant in securin+ a ratin+ aove that of the soverei+n as the
underlyin+ collateral may have hi+h or lo' correlation 'ith that of the economy of the
soverei+n. For e.am*le, if there is a hi+h correlation AcovarianceC et'een the value of
the collateral and economic cycles, the underlyin+ collateral is considered as *oor ris(,
other thin+s remainin+ the same. For instance, durin+ an economic crisis the value of
collateral may fall sustantially, therey ma(in+ it harder to use such collateral for
securin+ fundin+. &t has een sho'n that the correlation et'een the value of collateral
and economic cycle is asymmetric, i.e. the loss of value durin+ crisis is +reater than the
+ain in value durin+ times of *ros*erity.
#=

Fitch considers soverei+n ris(, *erformance ris(, *roduct ris(, diversion ris(, as 'ell as
credit ;uality and, thus, the local currency ratin+ as im*ortant *arts of the future
*erformance of a com*any.
3redit card receivales are most susce*tile to soverei+n ris( as turmoil in the local
soverei+n environment, leads to dro* in tourism and usiness:related flo's due to civil
#=
See &-;uierdo A%===C, ?3redit 3onstraints, and the Asymmetric Behavior of Asset Prices and 8ut*ut
Under E.ternal Shoc(s,@ The 2orld Ban(. Mimeo, 1une.
#"
unrest or deterioration in economic and *olitical conditions. Furthermore, as *urchases
are made onshore and +oods and services are *riced in local currency, su,ectin+ the
receivales to devaluation of local currency.
>1.2: Miti!atin! is8 in #uture #lo5 Securitization $ransactions
Future flo' securiti-ations are structured det offerin+s y an offshore trust s*onsored y
a forei+n ori+inator ASPBC and secured y underlyin+ collateral that can e the ri+ht to
receive future receivales from the e.*ort, credit card vouchers, etc. as sho'n in the
Fi+ure $.%%. For e.am*le, in a ty*ical securiti-ation of credit card receivales, the
ori+inatin+ an( in an emer+in+ mar(et sells credit card vouchers to a SPB, 'hich in turn
directs the vouchers to an offshore trust, 'hich issues future flo':ac(ed securities credit
enhanced y a third *arty +uarantor to forei+n investors. The *roceeds from the sale of
securities in hard currency as 'ell as any e.cess s*read is channeled ac( to the
ori+inatin+ an( in emer+in+ mar(ets.
The transaction<s structure determines ho' various ris(s 'ill e covered.
#$
&nvestors in
the aove structure are *rotected from soverei+n ris( as related to the ris(s of transfer and
convertiility *rotection as defined in follo'in+ e.hiitI *ayments for the *roducts are
made to an offshore entity Anot to the home country entityC that is created to service the
#$
This section has enefited from S G P<s *ulication, ?Hessons from the *ast a**ly to future securiti-ation
in Emer+in+ Mar(et,C G )uff and Phel*<s ?Methodolo+y for ratin+ future flo' securiti-ation,@ .
#i!ure 1.22: Structure o3 #inancial
#lo5 Securitization
#K
det for the enefits of investors. Furthermore, the structure is also an(ru*tcy:remote, as
the SPB has no other creditors and is le+ally isolated from the reach of an ori+inator 'ho
may +o an(ru*t. Ho'ever, +iven the asence of an(ru*tcy la's *ertainin+ to
securiti-ed instrument, creditors may continue to have access to collateral *led+ed 'hen
and if an(ru*tcy *etition is filed y the ori+inator in the develo*in+ economies.
#%

Asence of le+al clarity on an(ru*tcy *rocedures in the develo*in+ economies does
constraint the aility of the issuer to utili-e securiti-ation as an efficient fundin+ vehicle.
Furthermore, *olicy ma(ers in some cases are not familiar 'ith this *rocess. &ssuers find
the urden of full disclosure of information in a timely fashion in structured finance as
urdensome.
1arious types o3 is8s In-ol-ed in #uture #lo5 Securitization
So-erei!n ris8: 5ill t(e ori!inator !o-ernment ta8e steps to disrupt t(e payment arran!ement set
out in t(e structured transactionM
Per3ormance ris8: 5ill t(e ori!inator (a-e t(e a/ility and 5illin!ness to produce and deli-er t(e
productM
Product ris8: 5ill t(ere /e su33icient demand 3or t(e product at a sta/le price and 5ill t(e /uyer
meet (is payment o/li!ationM
2i-ersion ris8: can t(e product or t(e recei-a/le /e di-erted to customers ot(er t(an desi!nated
customersM
Additionally, t(ere is currency de-aluation ris8, /an8ruptcy ris8 and political ris8, 5(ic( are
related to so-erei!n ris8. $(e usual trans3er and con-erti/ility ris8s are su/stantially miti!ated
5(en (ard currency 3uture 3lo5 recei-a/les are securitized -ia an SP1 structure. B#or a detailed
discussion o3 -arious ris8s and (o5 t(ese can /e miti!ated t(rou!( securitized structure, see 2u33
N P(elps B1999aC and Standard N Poor"s Structured #inance: 'mer!in! Mar8et &riteria.C

Ho'ever, other ris(s such as *erformance ris(, *roduct ris(, and diversion ris( remain
that can not e diversified a'ay.
>1.2.1: Per3ormance ris85 is related to the aility and the 'illin+ness of the ori+inator
As*onsorC to *roduce and deliver the *roduct to the desi+nated *arty in a timely fashion.
This ris( is usually ca*tured in the domestic currency ratin+ of the ori+inator. For
e.am*le, Fitch uses +oin+ concern, 'hile SGP em*loys the ?survival@ assessment of
ori+inator to rate future flo':ac(ed transaction a fe' notches hi+her than the issuer<s
local currency ratin+. This is *articularly a**licale 'hen the ori+inator is a soverei+n or
#%
Section 99% of the U.S. Ban(ru*tcy 3ode does not *rovide creditors access to the security Asuch as FF
receivalesC in the event a an(ru*tcy *etition is filed. Ho'ever, le+al *rovisions in most develo*in+
countries are ami+uous, to *ermit ?true sale@ o*inion.
#9
an a+ency of the soverei+n that may e ale to +enerate receivales ca*tured y an
offshore trust 'hile it is in financial default.
#"

A com*any could e in default on its det ut continue to o*erate and +enerate
receivales from its *rofitale lines of usiness, and the structure of the securiti-ation
deal could le+ally *rotect investors< interest in cash flo's. Fitch uses the +oin+ concern
assessment AG3AC 'hen assessin+ the *erformance ris( of an entity. Accordin+ to Fitch,
there have een a numer of cases 'here com*anies defaulted on their dets yet
continued to o*erate s*ecific, securiti-ed usiness lines. Similar to U.S. an(ru*tcy
decisions, the ori+inatin+ firm as a +oin+ concern mi+ht e 'orth more than in
an(ru*tcy *roceedin+s. E.am*le of com*anies that have continued o*eratin+ after a
default are com*anies 'ith mono*oly status, ma,or an(s, state:run com*anies, ca*ital:
intensive com*anies andFor com*anies o*eratin+ in a 'ea( an(ru*tcy environment 'ith
limited creditor ri+hts.
>1.2.2: Product ris85 factors such as *rice, volatility of *rice and ;uantity of demand,
li(elihood of su**ly disru*tion, as 'ell as ori+inator com*etitive cost advanta+e or lac(
of it determines *roduct ris(. For e.am*le, *roduct ris( 'ill e lo'er if there is a stale
lon+:term demand for the *roduct 'ith a (no'n and credit'orthy oli+or AcustomerC.
Furthermore, *roduct ris( is lo'er 'hen the volatility of the *roduct is relatively lo' and
the ori+inator is in a *osition to miti+ate *roduct volatility 'ith over: collaterali-ation
andFor a for'ard or s'a* contract, assumin+ these contracts are availale from a hi+hly
rated uncorrelated counter*arty. 8il and +as, minerals and metals are +ood ;uality
collateral 'here *roduct ris( can e miti+ated as demands for the *roducts are derived
from diverse +rou* of oli+ors.
Some e.*ort:+enerated receivales have delivery ris(I there is a ris( that 'hile the
com*any continues to *roduce the *roduct, it may sto* e.*ortin+ the *roduct due to the
chan+es in su**ly and demand conditions, 'or( sto**a+e in the ori+inatin+ local mar(et,
and or soverei+n interference throu+h soverei+n diversion of the *roduct to other *arties
not desi+nated in the contract. History has sho'n that +overnments, durin+ *eriods of
li;uidity crisis, soverei+n stress, and or defaultI may ta(e actions that may include
free-in+ an( de*osits, limitin+ savin+s de*osit 'ithdra'als, institutin+ an( holidays,
and confiscatin+ de*osits and savin+s accounts throu+h forced conversion into ne'
+overnment securities. These actions are intended to *revent the loss of confidence in a
an(in+ system and suse;uent colla*se of the *ayment mechanism that a run on a
an(in+ system mi+ht entail.
#K
>1.2.0: So-erei!n ris85 some of the as*ects of soverei+n ris( such as transfer G
convertiility are miti+ated in a structured deal 'here forei+n oli+ors are directed to *ay
for the *roduct to an offshore facility. Ho'ever, other as*ects of soverei+n ris(, such as
severe devaluation of the soverei+n currency durin+ *eriods of li;uidity crisis, and the
ensuin+ ram*ant inflation, may force the soverei+n to im*ose *rice controls on certain
commodities. The effect of devaluation 'ill e unevenly distriuted in an economy. For
e.am*le, e.*orters 'ith si+nificant overseas usiness fare etter than others as their
revenue denominated in hard currencies such as U.S. dollar or Euros increases, 'hile
#"
See Fitch A%===a, %===C and Standard G Poor<s A%===C.
#K
See ?Ar+entina defaults on >K= illion loans@ 2all Street 1ournal 1anuary $$, %==%.
#7
their cost is li(ely to fall in real terms as the cost of servicin+ dets denominated in local
currency is reduced in an inflationary environment relative to the their hard currency
denominated cash flo's.
#9
Accordin+ to Fitch, e.*orters are relatively insulated from
+overnmentI therefore their local currency ratin+s can e.ceed the local currency ratin+ of
the soverei+n y $to 7 notches.
2hile over:collaterali-ation miti+ates volume and *rice ris(, det service covera+e of
the ori+inator is an im*ortant element for miti+atin+ the incentive for +overnment to
interfere in a structured transaction. For e.am*le, if a transaction has det service
covera+e of $= times, then only $=N of the forei+n e.chan+e is ein+ collected offshore,
and the rest is returned to the ori+inatin+ com*any. 8n the other hand, if an ori+inatin+
entity has det service covera+e of only $.%9 times, then E=N of the cash flo' is
collected offshore. Therefore, even if *rice and volume ris(s 'ere removed, additional
covera+e is needed to decrease a soverei+n<s incentives to interfere in the transaction.
#7
>1.2.7: 2i-ersion ris85 A soverei+n or com*any<s aility to redirect *roceeds from the
e.*orts to entities other than the desi+nated offshore trust is classified as diversion ris(.
The contract should clearly and roadly identify the receivales so that there is no dout
the customers< *ay for the *urchased +oods from the ori+inator in a future flo':ac(ed
securiti-ation to a desi+nated offshore collection facility. The desi+nated customer is
re;uired to si+n a indin+ contract (no'n as notice and ac(no'led+ement !GA
a+reement, so that she 'ill *ay to the offshore facility therefore, miti+atin+ +overnment
diversion and or transfer and convertiility ris(. Structured transactions are much more
susce*tile to diversion ris( 'hen the ori+inatin+ entity is a state o'ned enter*rise.
Ho'ever, !GA le+al indin+ contracts et'een the ori+inator and oli+ors directin+
them to *ayFdeliver to a desi+nated offshore collection a+encyFoli+ors 'ith recourse to
the oli+orsFori+inator can effectively miti+ate diversion ris(.
>1I: ')ternal #actors
8ther e.ternal factors +reatly ham*erin+ the aility of the orro'ers to service their loans
could include, amon+ others5
$. Fro-en an( accounts
%. Hi;uidity crisis
". Hi+h inflation
K. Host *urchasin+ *o'er
9. Shar* currency de*reciation
7. Hoan *erformance deterioration.
>1I.1: #rozen :an8 Accounts
2hen a country is faced 'ith li;uidity and insolvency crisis, +overnment may
tem*orarily close do'n the an(in+ system to *revent run. This action is often ta(en to
minimi-e a run on the an(s and to *revent a colla*se of the an(in+ system. 8nce the
an(s are reo*ened the +overnment may free-e an( accounts or convert monies 'ithin
into lon+:term securities. &n March $666, Ecuador shut do'n its financial mar(ets y
#9
See Standard and Poor<s Structured Finance Emer+in+ Mar(et 3riteria for details.
#7
See Fitch A%=== and %===C for details.
##
closin+ the an(s for $= days. 8nce the an(s reo*ened, savin+s and chec(in+ accounts
'ere *artially fro-en. Ban( customers could only 'ithdra' aout half of their money to
uy food and *ay ills. Amounts in dollar savin+s accounts e.ceedin+ >9== have een
fro-en for one year. &n $6E6, Ar+entina<s +overnment fro-e monies in e.cess of >$,=== in
certain an( accounts and converted this e.cess into $=:year securities (no'n as Bone..
2hen an( accounts are fro-en the orro'ers< aility and 'illin+ness to service their
oli+ations are reduced.

>1I.2: =i6uidity &risis
&n an economic crisis, the li;uidity of the financial system is severely drained. )e*osits
are usually fro-en and future de*osits y individuals and cor*orations are reduced as
investors attem*t to find safe haven in such instruments as *recious metals, +overnment
onds, and even in mattresses. This fli+ht to ;uality causes a halt in lendin+ and rationin+
of ca*ital. Borro'ers see(in+ to refinance loans or rollover may face difficulty from their
lenders. Under this environment the aility to re*ay dets A*ersonal, mort+a+es or auto
loansC ecomes very difficult as consumers o*t for cash to *ay for asic necessities such
as food and utilities. Securiti-ed transactions ac(ed y these loans 'ould e, in turn,
severely affected.
>1I.0: ;i!( In3lation
E.cessive inflation is usually associated 'ith severe economic crisis as +overnments
shar*ly raise short:term interest rates to stren+then their currency. Ar+entina e.*erienced
hy*erinflation of a**ro.imately 9,=== *ercent in $6E6. 2hen the /eal Plan 'as
im*lemented in Bra-il in $66K, the annual inflation rate reached over 6== *ercent. Hi+h
interest rates follo'in+ the Me.ican Peso crisis of $66K caused floatin+ rate mort+a+e
rates to reach $== *ercent, leadin+ mort+a+ors to default on their loans.
>1I.7: =ost Purc(asin! Po5er
Hi+h inflation and interest rates cause a si+nificant dro* in consumers< *urchasin+ *o'er.
Erosion of *urchasin+ *o'er leads to default y orro'ers, as consumers must use
money to uy asic necessities. For e.am*le, current real 'a+es in Me.ico are aout "9
*ercent lo'er than they 'ere $= years a+o. As +overnment attem*ts to cur inflation
throu+h 'a+e and *rice control, further reducin+ *urchasin+ *o'er. Moreover, in an
effort to increase revenues or satisfy austerity *ro+rams im*osed y the &MF, or the
2orld Ban( 'ho have *rovided financial aid, soverei+ns often increase ta.es on income
and services that further reduces dis*osale income for the *o*ulation.
>1I.9: S(arp &urrency 2epreciation
Hard currency:denominated orro'ers< aility to service their dets 'ill e +reatly
reduced due to severe devaluation of home currency, as orro'ers need more domestic
currency to service their forei+n:denominated oli+ations. For e.am*le, Me.ico, Bra-il,
and Ar+entina e.*erienced a shar* devaluation in their currencies. Me.ican Pesos
devalued nearly #$ *ercent in $66K ecause of the ?Te;uila@ crisis. The Bra-ilian /eal
dro**ed y "9 *ercent from 1anuary to March due to the comined effects of Asian and
/ussian crises in $66E. Prior to this, Ar+entina defaulted on its local currency dets in
#E
$6E6I seventeen australes Athe local currencyC 'ere 'orth one U.S. dollar. &t too( $=,===
australes y the end of $66= to uy one dollar.
>1I.%: =oan Per3ormance 2eterioration
As economies fall into hard times induced y severe recessionI hi+h unem*loyment rates,
la++in+ 'a+es, currency devaluation, and loss of *urchasin+ *o'er are factors
res*onsile for increasin+ default rates and deterioration of the loan assets in the an(in+
system *ortfolios. As *ro*erty values dro* the incentive to ma(e loan *ayments is +reatly
reduced. Under such conditions loan to value ratio increases leavin+ many mort+a+ors
'ith loan values +reater than their houses. For e.am*le, aout #9 *ercent of all
residential mort+a+es in Me.ico 'ere in default or seriously delin;uent in *ayment. )ue
to the restructurin+ of many loans in the mid $66=s, the avera+e default rate dro**ed to
aout %9 *ercent, 'hich is still an e.cessive level.
2hen ratin+ a security ac(ed y mort+a+e or consumer loans, it is very im*ortant to
e ale to estimate the *otential for recovery on defaultin+ loans. This determination
'ould e very difficult 'hen loan restructurin+ and forearance can alter 'hat can
usually e a *redictale outcome. Also, orro'ers may try to set loan oli+ations off
a+ainst fro-en an( accounts at their lender.
>1II: Ad-anta!es o3 #uture #lo5</ac8ed Securitization
8ne of the main a**eals of securiti-ation is that this vehicle 'as created to address
fundin+ shorta+es for a firm, an industry, and or soverei+n country 'hose cost of fundin+
is relatively very hi+h due to *oor credit ratin+s, therefore is unale to secure loans
*articularly durin+ time of stress and li;uidity crunch. Securiti-ed det is rated y ma,or
ratin+ a+encies and credit:enhanced y a third *arty +uarantor, *rovidin+ uy:and:hold
investors such as insurance com*anies an o**ortunity to ac;uire these asset:ac(ed
instruments for their *ortfolio. The *erformance of these securities and their trac( records
over +ood and ad economic times have *rovided investors 'ith an array of investment
*roducts 'ith +reater li;uidity, etter *erformance, and enhanced yields and increased
diversification of ris(.
The cost savin+ to issuers of the asset:ac(ed securities comes in the form of +ettin+ a
ratin+ over an aove that of a soverei+n rate ceilin+, that allo's an other'ise viale firm
'ith solid financials to avoid the misdeeds of the soverei+n state. Therefore, the cost
savin+s associated 'ith issuin+ asset:ac(ed securities can e as hi+h as +ettin+ $:7
notches aove the ratin+ of the soverei+n and de*ends also on the time and the
*sycholo+y of the mar(et condition at the time of issue. 3onsider the case of Me.ico<s
Peme., a state o'ned enter*rise that is one of the ma,or oil and +as com*anies in the
'orld, as sho'n in Tale #.
$a/le *: Spreads o3 Peme) #inance =td. Securitized 2e/t and 4MS* 1ersus 4S
$reasuries
/atin+UU >US
million
Avera+e
life
AyearsC
Final life
AyearsC
S*read
over US
Treasuries
A*sC
3ou*on
N
&ssue date
#6
Peme.
Finance A
AAA 9== " 9 $%9 9.#% $%FKF6E
Peme.
Finance A
BBB "9= # E.9 "9= #.== $%FKF6E
Peme.
Finance A
AAA K== $= $$.9 $#9 7."= $%FKF6E
Peme.
Finance A
BBB %9= $E %= K$%.9 6.$9 $%FKF6E
Peme. Sr.
Unsecured
BB 7== $= K7%.9 6."#9 $%F%F6E
UMSU BB $9== $= 9#$ 6.E#9 $%FKF6E
UUTranches rated AAA are *rotected y ond insurance.
U United Me.ican States %==# issued in $66# had a ratin+ of BB. The s*read is from the
yield on "=:year U.S. Treasury ond maturin+ in %==#. Source5 SGP
The s*read on the emer+in+ mar(et onds inde. EMB& as Ameasured y 1.P Mor+an<s
EMB&P inde.C soared from EKK *s to $999 *s in March $669, follo'in+ the Me.ican
Peso crisis of )ecemer $66K. Peme. Finance Htd issued series of future flo' oil:ac(ed
securities in late $66E, 'hich 'as rated y Fitch AAA and BBB and sold to investors at
s*reads ran+in+ $%9 to K$%.9 *s over the U.S. Treasuries. Peme. unsecured det 'as
sold at a s*read of K7%.9 *sI the 9= *s difference et'een the unsecured dets rated BB
and securiti-ed det rated BBB is the savin+s associated 'ith the asset:ac(ed securities,
other thin+s remainin+ the same.
##
The Peme. savin+s over its unsecured det ran+es as
lo' as 9= *s to as hi+h as ""#.9 *s on its senior AAA rated tranche. The savin+s are
even +reater 'hen com*ared a+ainst UMS that ran+es as lo' as $=E.9 *s to as hi+h as
KK7 *s.
A financial crisis in one *art of the 'orld has conta+ion effects on other *arts of the
'orld. For e.am*le, Me.ican *eso crisis had an adverse effect on Ar+entina and Bra-il
soverei+n aility to raise ca*ital similar in terms to the *re:crisis *eriod. The cost of
ac;uirin+ credit in oth countries increased *ost:crisis reflectin+ mar(et nervousness and
increased volatility of the interest and e.chan+e rates.
Asset ac(ed securities are structured so that the avera+e life of collateral is +reater and
smaller than that of the various tranches of securiti-ed instruments. Therefore they can
a**eal to 'ider se+ment of investors 'ith varyin+ maturity *references, thus *rovidin+
investors 'ith a vehicle to mana+e alance sheet mismatch as 'ell as im*rove return on
e;uity.
&nvestors find investment:+rade ratin+s of the future flo':ac(ed securiti-ed
instruments alon+ 'ith their +ood *erformance in +ood and ad economic times very
attractive. Ho'ever, asence of an efficient secondary mar(et for these *roducts alon+
'ith infre;uent tradin+ ma(es it difficult to +au+e *rices, yield, and s*read on these
securities. Met, mar(et *erce*tions su++est that the securiti-ed dets to have relatively
smaller volatility in *rice, yield, and s*read as com*ared to unsecured dets from
emer+in+ mar(et economies. S*reads of Peme. # and $E years oil:ac(ed notes a+ainst
##
The *resent value of interest savin+s of 9= asis *oints on the >%9= million securiti-ed BBB rated dets
over the life of the issue is e;ual to >%%,96#,%#K.#6 assumin+ the "=:year U.S. Treasury rate of 9.$%9
*ercent as of $%FKF6E.
E=
same maturity notes issued y the United Me.ican States reveal smaller mean and
standard deviation, as sho'n in Tale E.
$a/le +: Summary Statistics o3 Peme) *<year and 1+<year oil</ac8ed papers and
4MS 202% B4nsecuredC
Peme.
#:years
Peme.
$E:years
UMS
%=%7
Mean "=6 "97 "#%
/an+e %=9 %=% "%K
Standard deviation 7" 7% #6

Finally, the securiti-ed future flo':ac(ed instruments have endured the test of time in
+ood and ad times. For e.am*le, there have een no defaults in these asset classes
des*ite numerous crises of li;uidity andFor duress and insolvency of the soverei+n
unsecured dets. Therefore, future flo':ac(ed instruments have *roven the test of stress
in the mar(et as attriuted to that of the Me.ican Peso crisis of $66K:69, Asian currency
crisis of $66# and ensuin+ li;uidity crisis of $66#:6E, /ussian and Ecuadorian det
defaults of $66E and $666, and Ar+entina<s det default of %==%.
The Pa(istan<s Telecommunication 3om*any Htd APT3HC future flo' securities
ac(ed y tele*hone settlements receivales from ma,or international carriers did not
default des*ite default and soverei+n det reschedulin+ of Pa(istan in 1une $666.
Althou+h, the securiti-ed dets 'ere do'n+raded 'ith the deterioration of economic
fundamentals in Pa(istan follo'in+ detonation of nuclear devices in May $6EE and
im*osition of trade sanction and the free-in+ of >$" illion in forei+n currency de*osits,
they continued to e resilient in the *resence of severe economic conditions and default
of the soverei+n det as sho'n in the follo'in+ e.hiit documented y Standard G
Poor<s. 8nly time 'ill tell as to ho' future flo' securiti-ation 'ill *erform under
different scenarios and different conditions *revailin+ in the financial mar(et of the
soverei+n.
The mar(et for future flo' securiti-ation in develo*in+ economies is currently in an
e.*erimental sta+e. He+al frame'or(s, institutional chan+es, la's +overnin+ foreclosure
and *ro*erty ri+hts, and le+al codes as related to transfer and assi+nment of the *ro*erty
and an(ru*tcy code has to e standardi-ed for the enefits of all *arties in a
securiti-ation structure. These reforms are Qmandates< that +loal ca*ital mar(et investors
demand for su**lyin+ much needed hard currency and for ta(in+ credit in the
international ca*ital mar(et. Ho'ever, there is no +uarantee that any structured
transaction can miti+ate all elements of soverei+n ris(. Ho'ever, at the end of the day it
is the soverei+n 'ho can save the day y not *oolin+ all dets in the same as(et for
some form of reschedulin+ and restructurin+ of dets as 'e have 'itnessed in the case of
Pa(istan<s PT3H securiti-ed dets.

Pa(istan Telecommunication 3om*any APT3HC
!o defaults on asset:ac(ed *a*ers even in the face of selective default on soverei+n det
&n $66#, the Pa(istan Telecommunication Himited APT3HC issued >%9= million in onds ac(ed y future
tele*hone settlement receivales from ATGT, M3&, S*rint, British Telecom, Mercury Telecommunication
and )eutsche Tele(om. Even thou+h PT3H is o'ned EE *ercent y the Government of Pa(istan, this
issue 'as rated BBB: y SGP, four notches hi+her than the BP soverei+n ratin+.
Follo'in+ the detonation of nuclear devices in May $66E, Pa(istan<s economy and credit'orthiness
deteriorated ra*idly. &nvestors ecame concerned that faced 'ith increasin+ official demands for e;ual
urden sharin+, the +overnment mi+ht *lace the future flo' receivales:ac(ed securities in a sin+le
as(et 'ith all other soverei+n det and interfere 'ith PT3H<s det servicin+. The Government of
Pa(istan rescheduled its Paris 3lu det oli+ations on 1anuary "=, $666 and si+ned a *reliminary
Hondon 3lu a+reement on 1uly 7, $666 to reschedule >E## million of soverei+n commercial loan
arrears. But PT3H<s future flo' net receivales ac(ed onds 'ere not su,ected to any reschedulin+ or
restructurin+, althou+h their ratin+ 'as do'n+raded several times durin+ $66#:6E Asee tale elo'C.
Partly, this 'as ecause the amount re;uired to service these oli+ations made u* only "= *ercent of the
total net tele*hone receivales of the com*any. The main reason 'as that there 'as a stron+ incentive on
the soverei+n<s *art to (ee* servicin+ the onds and not ,eo*ardi-e the o*eration of the local tele*hone
net'or( and even more im*ortantly ris( severin+ Pa(istan<s telecommunication lin( to the rest of the
'orld.
History of PT3H 3redit /atin+

)ate Pa(istan PT3H /atin+ 3omment
Soverei+n
/atin+
Au+ust 6# BP BBB: At issuance due to its structure
1une EE B: BBPF: follo'in+ the detonation of nuclear device
outloo( 'hich led to im*osition of trade sanctions
and the free-in+ of >$" illion in forei+n
currency de*osits
1ul 6E 333 B: follo'in+ Pa(istan<s do'n+rade from B: to
333
)ec 6E 33 333P follo'in+ a tentative a+reement 'ith &MF
2hich o*ened the 'ay for restructurin+
1une 66 S) 333P follo'in+ the restructurin+ of US >676
Million of commercial loans in default since
$66E.
)ec 66 B` 333P E.*ected to e u*+raded to BB.
Source5 SGP
E$

&apital &(ar!es 3or Securitized Assets under @e5 :asel Accord
>1III: &apital &(ar!es 3or Securitized 2e/ts @e5 :asel Accord
The !e' Basel 3ommittee<s o,ective in develo*in+ a ne' ca*ital char+e frame'or( is
to etter ali+n re+ulatory ca*ital 'ith economic ris( and address the shortcomin+s of the
$6EE Accord. The ne' Accord *ro*oses three a**roaches for the ca*ital treatment of
securiti-ation tranches. The ratin+s:ased a**roach A/BAC and the su*ervisory formula
a**roach ASFAC L are for an(s usin+ the internal ratin+ ase &/B credit ris( frame'or(.
E%
)e*endin+ on a numer of factors, oth a**roaches may e re;uired for calculatin+ the
re;uired re+ulatory ca*ital on a +iven *ool of securiti-ed assets. A third securiti-ation
a**roach is *ro*osed for an(s usin+ the revised, standardi-ed, credit ris( frame'or(.
For e.am*le, ca*ital char+es increases to %E *ercent on the BBP tranche of securiti-ed
*ortfolio as com*ared to E *ercent in the same rated cor*orate e.*osure as sho'n in the
E.hiit $.K.
Source5 Basel 3ommittee on Ban( Su*ervision, Ban( for &nternational Settlements
Ho'ever, assi+nin+ hi+her ca*ital char+es to lo'er level suordinated tranches of
securiti-ed *ortfolio than to similarly rated cor*orate e.*osures should e ca*ital neutral.
&t is im*erative to ensure that the allocation of ca*ital across securiti-ation tranches is
ca*ital neutral relative to the underlyin+ *ool of collateral assets. That is, 'hen the ca*ital
char+es on individual tranches are ris(: ased, 'ei+hted under the current Basel &/B
securiti-ation *ro*osals, it results in more ca*ital ein+ re;uired Aunless a ca* is im*osed
that limits the ca*ital char+es to no more than ei+ht *ercentC than the amount of ca*ital
that 'ould have een re;uired had the *ortfolio not een securiti-ed. The driver of this
*remium on securiti-ation is the level of ca*ital assi+ned to the more suordinate
tranches. This su++ests that the 'ei+htin+ develo*ed y the Basel 3ommittee is too harsh
for suordinate tranches and is li(ely to result in a misallocation of ca*ital relative to
underlyin+ ris(, as 'ell as unintended ehavioral effects, as sho'n in the follo'in+
e.hiit. For e.am*le, the amount of ca*ital chares for BBP under %==% &/B rulin+ is %=
*ercent, 'hile same rate cor*orate e.*osure as 7.6% *ercent ca*ital char+es. The
*ercenta+e difference is $E6 *ercent hi+her ca*ital char+es for securiti-ed instrument as
o**osed to same rated cor*orate e.*osure as sho'n in the E.hiit $.9.
')(i/it 1.7:
')(i/it 1.95
E"
Source5 Basel 3ommittee on Ban( Su*ervision, Ban( for &nternational Settlements
The %==% Basel securiti-ation rules outlines the ca*ital aritra+e under the $6EE Basel
3a*ital Accord Athe $6EE AccordC, 'here as an(s are ale to decrease their re+ulatory
ca*ital re;uirements via a securiti-ation *ro+ram 'ithout lo'erin+ the economic ris( on a
*ortfolio. This is accom*lished throu+h im*osition of much hi+her ca*ital char+es on
QBBB< and lo'er rated securiti-ation tranches than on similarly rated cor*orate
e.*osures. Ho'ever, the Basel rules seem to overchar+e L 'hen 'ei+hted avera+e of
re+ulatory ca*ital for all tranches of a +iven *ool of securiti-ed assets are added to+ether,
the overall re+ulatory ca*ital re;uirement is 'ell in e.cess of 'hat 'ould have een
re;uired had the underlyin+ *ortfolio not een securiti-ed Aunless a ca* is a**liedC. The
main cul*rit of this rulin+ is the ca*ital char+e on QBBB< and lo'er rated tranches.
Accordin+ to Fitch the char+es on lo'er rated securiti-ation tranches may e overly
e.cessive and, even if a ca* is a**lied to limit the ca*ital re;uirement to that of the non:
securiti-ed *ortfolio, ca*ital could e misallocated across tranches, 'hich could lead to
ne' aritra+e o**ortunities et'een an(s and non:an(s.
#E

&f an ori+inatin+ an( retains first loss on a securiti-ed asset, the severity of loss can
e sustantial. &t is thereforeI im*erative to see( relatively hi+her ca*ital char+es for the
suordinated tranches, as com*ared to similarly rated cor*orate e.*osures, to miti+ate
+reater e.*osure on a relatively small *ro*ortion of assets. 3a*ital char+es in the ne' and
the old accord fail to allo' for the effects of diversification5 for instance ca*ital char+es
are the same for a sin+le >$== million and for a hundred >$ million loans.
>1IIII: Potential 3or #uture #lo5 ecei-a/le Securitization in Islamic epu/lic o3
Iran
#E
See Fitch &B3A, )uff G Phel*s, %===a. ?/atin+ Securities ac(ed y Future Flo' 3ash Flo's,@
Se*temer %9. '''.fitchratin+.com
EK
&n a future flo' transaction an issuer is ale to *led+e receivales over a numer of years
and therefore, ma(e it *ossile to raise ca*ital that is a multi*le of a +iven year<s
receivales. The asset classes that are suitale for future flo':ac(ed securiti-ation
amon+ other thin+s include5 8il and +as, minerals, tele*hone receivales from ma,or
international carriers in the 'orld, credit card vouchers receivales, 'or(er remittances,
and a+ricultural *roducts and ra' materials. The amount of &ran<s total e.*ort 'as
US>%E.$E7 illion in the year $"E$, of 'hich oil and +as e.*ort made u* >%%.E=# illion
and non:oil e.*ort com*risin+ >9."#6 illion.
#6
Assumin+ a conservative over:
collaterali-ation of five to one, >K.9#K illion of future oil and +as receivales can e
securiti-ed. Similarly >$.=# illion non:oil e.*ort future flo' asset ac(ed securities may
e issued that 'ill e rated hi+her than that of the soverei+n y fe' notches, aleit
de*endin+ on the ;uality of the underlyin+ collateral, as discussed in the earlier section.
Funds are channeled y +overnment o'ned an(s to non:*ulic sectors of the
economy to achieve certain o,ectives 'ithin a *articular sector as 'ell as the strate+ic
im*ortance of that sector to the overall 'ell ein+ of the economy. For e.am*le,
manufacturin+, a+ricultural, and housin+ sector res*ectively received "", %9, and %=
*ercent of overall an(in+ facilities in year %==% 'ithout re+ard to the overall rate of
return on such facilities. For e.am*le, the housin+ sector received %= *ercent of the
overall an( facility 'ith a rate of return of $9 *ercent, 'ith the a+ricultural sector
receivin+ a lion share of the funds 'ith rate of return of $".9 *ercent. The most *rofitale
sector from the *ers*ective of the an(s i.e., e.*ort, domestic trade, services and
miscellaneous received $".9 *ercent of the an(s fund 'hile *rovidin+ the hi+hest rate of
return of %$ *ercent as sho'n in the E.hiit $.7 ta(en from the &/ 3entral Ban(.
Source5 &slamic /e*ulic of &ran 3entral Ban( )AM $"E$.
Ban(s< avera+e de*osit and lendin+ rate are *rovided in the E.hiit $.#. The s*read is
#6
These statistics are derived from the &/ 3entral Ban( )ay $"E%.
')(i/it 1.*:
')(i/it 1.%:
E9
Source5 &slamic /e*ulic of &ran 3entral Ban( )AM $"E$.
a**ro.imately e;ual to four *ercent over $"#= to $"E$, aleit the actual s*read is much
ti+hter as nominal lendin+ rate is much +reater than the effective rate orro'ers *ay
rooted in the fla'ed linear al+orithm em*loyed in the &ranian an(in+ system, that favors
the orro'er as discussed earlier in this manuscri*t.
E=
>>: Synt(etic Securitization
Synthetic securiti-ation *rovides an(s the o**ortunity to achieve amon+ other thin+s5
reduced re+ulatory ca*ital re;uirements, increased li;uidity, access to an efficient fundin+
for lendin+ and assumin+ e.*osure to other issuers, reduced concentration ris( and off:
alance sheet accountin+ treatment. The synthetic collaterali-ed loan oli+ation A3H8C
emulates the cash 3H8 y transferrin+ credit ris( of the reference assets to the ca*ital
mar(et throu+h credit derivatives such as credit:lin(ed notes, credit default s'a*, and
total return s'a* 'ithout actually transferrin+ the o'nershi* of the assets to the
an(ru*tcy:remote SPB trust. The an(s therefore are ale to *reserve the an(Fclient
relationshi* in issues arisin+ from loan assi+nment, loan transfer and client
confidentiality.
E$
>>.1. &redit<=in8ed @otes
3redit lin(ed notes A3H!sC are created as a hed+in+ instrument for direct loans to
cor*orations in 'hich the lender Ae.+., 3iti+rou*C e.tends a 9:year loan to a cor*oration
Ae.+., EnronC and simultaneously sets u* a trust 'here the trust issues 9:year notes lin(ed
to the default of Enron onds to investors. The trust invests the *roceeds of the loan in
an(ru*tcy:distant near money mar(et det. &n the event the orro'er AEnronC defaults
the investors receives the *roceeds of the det issued y the failed cor*oration, ho'ever
if Enron does not default 3iti+rou* is oli+ated to *ay the *rinci*al and interest in notes
issued y the trust.
The 3H!s notes en,oy hi+h ratin+s ecause of the e.istence of the trust, as the note
holders receive the *rinci*al and interest PG& in the event the 3iti+rou* defaults. The
credit ris( of the orro'er determines the interest rates on the 3H!s des*ite the fact that
it is essentially issued y the 3iti+rou* trust. Fi+ure $.%" demonstrates the creation of the
3H!s.
E=
Avera+e de*osit rate is much hi+her for the *rivate an(s and other thrifts. Private Ban(s *ay
a**ro.imately over %= *ercent on the five:year de*osit to attract ca*ital.
E$
This section dra's from the author<s 3ha*ter $$, ?Mana+in+ Gloal Financial and Forei+n E.chan+e
/ate /is(,@ 1ohn 2iley G Sons !e' Mor(, 1anuary %==K.
E7
#i!ure 1.20: &redit =in8ed @otes

D1.1 /illion 9<year =oan
9<year &=@s
D1.1 /illion Proceeds
/eturn of PG&
&nitial Hoan
After e.tendin+ over >$ illion in loans to Enron in %=== and %==$ and hed+in+ its
e.*osure to Enron credit ris( y issuin+ 3H!s, 3iti+rou*, throu+h its trust, avoided lar+e
losses 'hen Enron colla*sed: as the second lar+est an(ru*tcy filin+ in the United States
late %==$.
E%
The structure of the 3H!s is similar to the catastro*he ond as the *rinci*al
and cou*on interest *ayment is lin(ed to the occurrence and severity of the tri++er event
as the investors ear some of the losses in the form of for+iveness of the interest and
some, or all, of the *rinci*al.
E"

1.P. Mor+an issued >96K million 3H!s throu+h its trust tied to the s*read of 2al:Mart,
an Aa: rated firm ori+inally *riced at 79 asis *oints over a $=:year Treasury note in
Se*temer $667. Mor+an emedded a materiality clause in the issuance of the note 'hich
*rovided for a default tri++er of $9= asis *oints over Treasury to tri++er the default. &n
such events investors +et the recovery values of the defaulted ond, identified y *ollin+
five leadin+ mar(et ma(ers every t'o 'ee(s over a *eriod of three months. 3H!s
*rovide investors 'ith relatively hi+her returns as 'ell as hi+her ris(, as 2al:Mart<s
com*arale det *riced at a s*read of K= to K9 asis *oints over Treasuries.
>>.2. Synt(etic &ollateralized =oan ,/li!ations
A collaterali-ed loan oli+ations A3H8C is an asset:ac(ed det instrument that is
su**orted y assets such as commercial or mort+a+e dets and revolvin+ credit facilities,
E%
See )aniel Altman A%==%C, ? Ho' 3iti+rou* Hed+ed Bets on Enron@ !e' Mor( Times, P. 3$, Fe, E, =%.
E"
An e.am*le of this ty*e of issue is the To(yo )isneyland ond issued y 8riental Hand 3o the o*erator
of the theme *ar(s in 1a*an to raise >$== million at H&B8/ *lus "$= *s in May $666 to mana+e
earth;ua(e e.*osure.
3iti+rou*
Trust
Enron
&nvestors
E#
and is usually ac(ed y a variety of credit enhancement *roducts such as letters of
credit, senior Fsuordinated structure, cash reserve funds and e.cess servicin+ s*read.
Ban(s and other financial institution use the 3H8s and their synthetic variants to mana+e
and transfer credit ris( to the ca*ital mar(ets. Ban(s transfer assets and loans to a s*ecial
*ur*ose vehicle ASPBC trust, 'hich in turn issues asset ac(ed securities consistin+ of
classes of dets referred to as ?tranches@ and residual e;uity. The 'ei+hted avera+e
cou*ons of various tranches includin+ the so called residual, su**ort or W:onds 'ill e
less than the avera+e cou*on of the underlyin+ loan y an amount e;ual to the service,
administrative and +uarantee fee. The various tranches of dets 'ith varyin+ ris(:return
characteristics a**eal to a roader ran+e of investors in the mar(et.
The Basle committee on an(in+ su*ervision in $6EE set an ei+ht *ercent minimum
ca*ital re;uirement for the an(s on their ris(:ased ca*ital.
EK
The ei+ht *ercent ca*ital
re;uirement a**lies to any ris(:ased asset classesI that includes all commercial loans,
and reduces the relative attractiveness of these assets in a an( *ortfolio, +iven the small
mar+ins an(s en,oy in these loans in a hi+hly com*etitive environment.
E9
Therefore,
throu+h 3H8s an(s are ale to securiti-e AsellC some of their *ortfolio and free u*
si+nificant amount of ca*ital for rede*loyment *rofitaly in hi+her yieldin+ assets,
diversification of its overall ris(, increased li;uidity, ma(in+ an ac;uisition, or ori+ination
of other loans results in ori+ination fees.
&n a traditional 3H8 structures, the assets are transferred into an SPB trust that fully
funds the *urchase of the assets throu+h the issuance of securities Ai.e., senior,
suordinated and unrated classes desi+ned to enhance the rated notes as sho'n in Fi+ure
$$.KC. For e.am*le, a an( that 'ishes to securiti-e a >9 illion *ortfolio of its loans, can
free u* >K== million A.=E times >9 illionC re+ulatory ca*ital throu+h 3H8 transaction y
sellin+ the loans to the SPB to su**ort ori+ination or *urchase of >$= illion residential
mort+a+e dets 'ith 9= *ercent ris(:'ei+ht or ori+ination and the *urchase of >%9
illion, %= *ercent ris(:'ei+ht assets such as det issued y F!MA or FHHM3.
The ris(:ased ca*ital enefits of the 3H8 hin+es u*on the s*onsorin+ an( ta(in+ no
e;uity or suordinated interest in the det issues of the SPB. Assumin+ the an( retains
some suordinated issue in its oo(, the an( under the so:called ?lo' level recourse
rule@ must maintain ca*ital on a dollar for dollar asis.
E7
For e.am*le, if the an( in the
earlier e.am*le holds >"== million of the suordinated or e;uity issue, it 'ill e re;uired
to maintain a >"== million reserve ca*ital and can only free u* >$== million in the 3H8
EK
The Basle 3ommittee on Ban(in+ Su*ervision consists of senior memers of the G:$= 3entral Ban(ers
that includes, Bel+ium, France, 3anada, Germany, &taly, Hu.emour+, !etherlands, 1a*an, United
0in+dom, and the United States.
E9
Based on the Basle Accord the an(s and their holdin+ com*anies are re;uired to maintain E *ercent
ca*ital a+ainst their ris(:'ei+hted assets. For e.am*le some less ris(y assets such as, +overnment and
+overnment a+ency s*onsored issues are ris(:'ei+hted y 9= N, %=N, $=N, or = *ercent of their face
amount. 3ommercial loans are ris(:'ei+hted y $==N and therefore re;uire an E *ercent ca*ital. Mort+a+e
dets are 9= *ercent ris(:'ei+hted, and assets issued y +overnment a+encies Federal !ational Mort+a+e
Association AF!MAC and Federal Home Hoan Mort+a+e 3or*orations AFHHM3C securities are assi+ned %=
*ercent ris(:'ei+ht. 3ash and near cash such as Treasury ills are assi+ned = *ercent ris(.
E7
Ban(s under the @lo' level recourse rule@ *ursuant to $% U.S.3. KE=E, the ca*ital re;uirement for
recourse can not e.ceed the amount contractually oli+ated to fund.
EE
transaction in order to su**ort ori+ination or *urchase of >$==F.=E, >$.%9 illion 'orth of
securities ris(:'ei+hted $== *ercent. The structure of the fully funded 3H8 is sho'n in
fi+ure $.%K.
#i!ure 1.275 #ully #unded Securitization

Senior !otes
Hoans
*roceeds
$== N Proceeds Su:!otes

Proceeds

>>.0. ,/jecti-es o3 Structurin! &=,
8nce the loans are securiti-ed throu+h a 3H8 the an( can use the *roceeds to reinvest in
other hi+her yieldin+ instruments and in diversifyin+ its loan *ortfolio. A 3H8 enales an
other'ise lo':rated an( to restructure its loan *ortfolio y raisin+ the ratin+s of its
senior det issues to e si+nificant *ro*ortion of its loan *ortfolio alance. Some of the
enefits of the structurin+ 3H8 are5
: A an( throu+h a 3H8 transaction can reduce its liailitiesI im*rove on its hi+her
rated lo'er yieldin+ assets therey increasin+ return on assets and return on e;uity.
: /educe concentration ris(5 3H8 enales a an( to transfer its credit e.*osure to a
*articular orro'er and a *articular industry to the ca*ital mar(et fairly efficiently.
The an( in the *rocess of securiti-ation assumes other credit ris( to 'hich it 'ishes
to have +reater e.*osure.
: Ban( can e ale to mana+e its li;uidity, credit s*read and concentration of assets
tied to floatin+ rate inde. such as H&B8/ throu+h its 3H8 transaction therey
im*rovin+ assetFliaility mana+ement.
: Preservin+ an(:clientele relationshi* as the 3H8 enales the an( to sell its loan
'ithout dama+in+ relationshi* 'ith its customer, since the s*onsor and the *ortfolio
mana+er of the SPB trust is the affiliate of the an( and there is no need to notify the
client in sellin+ or assi+nin+ of the loans as is the case in sellin+ loans on a 'hole
loan asis.
XX.4: Synthetic CLO
Synthetic 3H8 emulates the cash 3H8 y transferrin+ credit ris( of the reference assets
to the ca*ital mar(et throu+h credit derivatives such as total return s'a*, credit default
s'a* or throu+h issuin+ credit:lin(ed notes 'ithout actually transferrin+ the o'nershi*
of the assets to the an(ru*tcy:remote SPB trust. The an(s therefore are ale to
*reserve the an(Fclient relationshi* in issues arisin+ from loan assi+nment, loan transfer
and client confidentiality. Synthetic securiti-ation that transfers the *ortfolio ris( throu+h
Ban(
SPB
Senior !otes

Suordinated !otes
&nvestors
8ther
Ban(s
E6
credit default *rotection can e unfunded, *artially funded or fully funded. The synthetic
*artially funded 3H8 is illustrated in fi+ure $.%9.
#i!ure 1.295 Synt(etic Partially #unded &=,

Premium
1.P. Mor+an
*roceeds
)

The first synthetic 3H8 issued in $66#, 'here the trust created y the issuer of the 3H8
issues the same dollar amount of credit:lin(ed notes to investorsI and the trust invests the
*roceeds of the issue that is Ae;ual to the outstandin+ 3H8s the issuer 'as hed+in+ in its
alance sheetC in a an(ru*tcy:remote det instrument. &n a synthetic 3H8, the
s*onsorin+ an( uses credit default s'a*s or credit:lin(ed notes to transfer the e.*osure
of its *ortfolio of loans to the ca*ital mar(et, therey allocatin+ economic ca*ital more
efficiently y reducin+ re+ulatory ca*ital re;uirements.
For e.am*le, 3iti+rou* miti+ated its e.*osure to the Enron loan throu+h the issuance
of 3H!s that transferred the credit ris( of its loan to Enron to the ca*ital mar(et. To the
e.tent the Enron loan in the 3iti+rou* oo( is fully collaterali-ed y cash, to e assi+ned
the -ero ris( 'ei+ht cate+ories for re+ulatory ca*ital re;uirements.
There are t'o ty*es of synthetic 3H8s, arbitrage and balance sheet. &n the aritra+e
3H8, usually underta(en y insurance com*anies, asset mana+ement and investment
an(in+ firms to e.*loits yield mismatch As*readC on the underlyin+ *ool of assets and
the lo'er cost of servicin+ 3H8 liailities.
The alance sheet 3H8s are em*loyed y an(s to miti+ate and mana+e re+ulatory and
ris(:ased ca*ital. Synthetic 3H8s are more efficient in transferrin+ ris( and less costly,
since the amount of the issuance is usually small relative to the reference *ortfolio and
less urdensome to administer as com*ared to cash 3H8s in transferrin+ *artial claims on
a *articular credit. Synthetic 3H8s allo' an(s to ac;uire e.*osure to a *articular asset
that may e difficult to ac;uire in the cash mar(et throu+h 3)s. The an( that 'ishes to
ta(e credit e.*osure on a *articular firm can sell *rotection on the reference asset of the
entity. 8n the other hand, a an( can uy *rotection and therefore synthetically short the
credit ris( of the reference entity. Furthermore the synthetic structure allo's an( to
transfer the alance sheet ris( su,ect to a +iven threshold, over a +iven interval.
E#
E#
See for details Fitch structured finance, Feruary, 7, %==$.
Ban( loan
Portfolio
Senior
Tranche

Suordinated
Tranche
SPB Trust
Senior !otes
Ban(ru*tcy:
remote assets Su:!otes
&nvestors
Ban(
)efault *rotection
Premium
)efault
*rotection on
su:tranche
Proceeds
Su:!otes
6=
The cash 3H8 on cor*orate e.*osure is $== *ercent ris(:'ei+hted, 'hile for synthetic
3H8s, the ris(:'ei+htin+s are much less, reflectin+ the funded *ortion of the structure
that is ac(ed y +overnment securities that are -ero ris(:'ei+hted. The aove
*henomenon has *rom*ted Euro*ean an(s to issue synthetic 3H8 y ta(in+ advanta+e
of the fact that ca*ital ade;uacy re;uirements Aei+ht *ercent minimum ca*ital on
cor*orate e.*osureC do not differentiate et'een various levels of o*eratin+, mar(et and
credit ris(s.
>>.9: Synt(etic Ar/itra!e &=,
This structure re*licates a hi+hly levera+ed e.*osure to a *ortfolio of syndicated loans
and onds. An SPB trust in a ty*ical structure enters into total return s'a* AT/SC on the
*ortfolio of credits that is ram*ed u* at the ori+ination. &t *ays H&B8/ *lus a s*read
normally e;uivalent to the an(<s fundin+Fadministrative costs to the s*onsorin+ an(
and receives total returns from the referenced *ortfolio. The trust issues a series of dets
'ith a seniorFsuordinated structure and uses the *roceeds to invest in a hi+h
;ualityFli;uid instrument that earns a return a**ro.imatin+ H&B8/, 'hich defrays the
cou*on on the referenced notes and funds the first loss e.*osure to the referenced
*ortfolio. Ty*ical 'ith any s'a*, the T/S is mar(ed to mar(et *eriodically, and may e
su,ect to mar(et value tri++ers, as outlined in the confirmation master a+reement of the
s'a*. E.am*les of these synthetic transactions, 'here the ris( of the referenced *ortfolio
is transferred to the ca*ital mar(et via credit default s'a*, total return s'a* and credit:
lin(ed notes are5 1.P. Mor+an B&ST/8, 3itian( E3H&PSE, Ban( of America SE/BES,
3has<s 3SHT, and 1.P. Mor+an SERU&HSFM&!3S.
1.P. Mor+an B&ST/8 is the synthetic securiti-ation of ris( achieved throu+h a credit
default s'a*, 'here an ori+inatin+ an( uys credit *rotection on *ortfolio of e.*osed
credit from 1.P. Mor+an via a *ortfolio of credit default s'a*, and 1.P Mor+an
simultaneously uys credit *rotection from a B&ST/8 SPB Trust. The ori+inatin+ an(
usually ta(es a 9 *ercent first loss that is e;uivalent of ta(in+ %=.$ levera+e *osition in
the referenced *ortfolio in ali+nin+ its interest 'ith that of the note holders. This levera+e
*osition has the *otential to increase and or decrease the return y a levera+e factor of %=,
as a sin+le default on the referenced *ortfolio increases the severity of loss y levera+e
factor of %=.
The SPB issues tranches of notes, that is, credit:lin(ed notes at s*read over H&B8/
'here the returnFris( to the note holders is au+mented y the *remium of the 3)S as 'ell
as the losses arisin+ from actual default and recovery value of dets accordin+ to the
*riority of their det. The *roceeds of the notes are invested in hi+h li;uid +overnment
det instruments in collaterali-in+ notes and *led+ed first to the s*onsorin+ an( in
satisfyin+ default in 3)S transaction on the first loss, and second to the re*ayment of
*rinci*al to the note holders.
Har+e an(s usually uy 'hole loans from smaller an(s and re*ac(a+e and securiti-e
them, therey earnin+ an aritra+e *rofit in the *rocess. Motivations for structurin+
synthetic 3H8F3B8 could e5
e!ulatory &apital relie3
is8 trans3er
6$
Ar/itra!e pro3it
estructurin! /alance s(eet
The synthetic aritra+e 3H8 is created 'hen the SPB enters into total return s'a*s 'ith
the s*onsorin+ an( on the referenced *ortfolio of loans, *ayin+ H&B8/ *lus s*read and
receivin+ total returns from the referenced *ortfolio. The SPB invests the collateral loans
in an(ru*tcy:remote det instruments and issues layers of securities to investors, as
sho'n in Fi+ure $.%7.
#i!ure 1.2%: Synt(etic Ar/itra!e &=, O$otal eturn S5aps

H&B8/ P S*read Proceeds of !otes
Total /eturns H&B8/ P s*read
H&B8/

Proceeds from the !otes
&n a synthetic 3H8 the an( or its affiliate (ee*s the assets in its /oo8s, 'hile
securiti-in+ the ris( y transferrin+ it to an SPBI ultimately the SPB transfers the
credit ris( to investors in the ca*ital mar(et throu+h credit:lin(ed notes, credit
default s'a*s or total return s'a*s, therey reali-in+ re+ulatory ca*ital relief. The
synthetic 3H8 does not *rovide any enefit to the s*onsorin+ an( for the *ur*ose
of calculatin+ its Tier $ ca*ital, ecause the reference assets remain on the an(<s
oo(. &n a cash 3H8 the loansFonds are p(ysically remo-ed from the an(<s
alance sheet, allo'in+ the an( to reduce its ris(:ased ca*ital, and +ivin+ it the
aility to ori+inate and *urchase other loans *roducin+ ori+ination fee for the
s*onsorin+ an(.

>>.%: Synt(etic :alance S(eet &=,
Ban(s use synthetic alance sheet 3H8s to transfer the credit ris( to the ca*ital mar(et
and im*rove the ris(Freturn *rofile on its *ortfolio of re+ulatory ca*ital. A synthetic 3H8
can e structured y AaC issuin+ a credit:lin(ed note throu+h the s*onsorin+ an( or its
affiliate SPB, or AC 'ritin+ a credit default s'a* y an( or SPB affiliate for a *remium,
therey *rovidin+ the s*onsor the o**ortunity to achieve re+ulatory ca*ital relief at lo'er
all:in cost fundin+, as com*ared to cash 3H8s. This is demonstrated in Fi+ure $.%#.
Ban( SPB
&nvestors
3ollateral
Securities
6%
#i!ure 1.2*: Synt(etic :alance S(eet &=,

Premium !otes

)efault *rotection Proceeds



/eference Portfolio
3)S: credit default s'a*, SPB: s*ecial *ur*ose vehicle
The s*onsorin+ an( usually ta(es the first loss on the oli+or<s underlyin+ reference
commitment, 'hich re*resents the credit enhancement of the remainin+ issues in the
synthetic 3H8.
>>.*: &apital Ade6uacy e6uirements
The B&S ca*ital ade;uacy re;uirements allo' an(s to estimate the minimum ca*ital for
off:alance sheet derivative transactions usin+ t'o methods5 the ori+inal e.*osure
method, and the current e.*osure method. The ori+inal e.*osure method is *resented in
Fi+ure $.%E.
As sho'n in fi+ure $.%E, the B&S re;uirements for ris(:ased off:alance sheet s'a*s
assi+n a ris( 'ei+ht of =, %= and 9= *ercent de*endin+ on the relative ris(iness of the
counter*arty to the s'a* transaction. The B&S ca*ital re;uirements for various classes of
dets for on:alance sheet re;uirements are as follo's5

: The soverei+n +overnment det of the memer of the 8r+ani-ation of Economic
3oo*eration and )evelo*ment A8E3)C is assi+ned -ero B&S ris( 'ei+ht, these dets are
treated as ris( free and an(s are not re;uired to hold any reserve ca*ital a+ainst them.
: The senior dets of the an(s from 8E3) are assi+ned %= *ercent B&S ris( 'ei+htI
the an(s are re;uired to hold $.7 *ercent A.%= ..=EC of reserve ca*ital for this ty*e of
dets. For e.am*le, a an( has to hold >"%=,=== in reserve ca*ital A.%= . .=E .
>%==,===,===C for >%== million investment in a Me.ican an( note.
#i!ure 1.2+: :IS &apital Ade6uacy e6uirement ,ri!inal ')posure Met(od
&on-ersion #actor
Maturity &nterest /ate S'a*s Forei+n E.chan+e S'a*s
Hess than $ year .9N %.=N
Ban(
3)S
3ounter*arty
SPB 3redit:lin(ed !otes
&ssued to investors
3ollateral
Securities
6"
8ne year G less than t'o
years
$N 9N
For each additional year $N "N
&apital re6uirements V !otional value of s'a* . conversion factor . ris( 'ei+ht
E.am*les of ca*ital re;uirements5
A. Five year &nterest rate s'a*s5 >%== million notional *rinci*al, counter*arty 8E3)
Ban(.
%==,===,=== . .=9 . .%=V >%,===,===
B. ":year interest rate s'a*s5 >%= million notional *rinci*al, counter*arty AAA rated
manufacturin+ firm.
%=,===,=== . .=" . .9= V >"==,===
3. ":year currency s'a*5 >$== million notional *rinci*al, counter*arty GM.
$==,===,=== . .=E . .9=V >9,===,===
Source5 Basle 3ommittee on Ban( Su*ervision, Treatment of Potential E.*osure for 8ff:alance Sheet
&tems ABasle, S'it-erland, B&S, A*ril, $669C.

: Unfunded cor*orate revolvin+ credits is assi+ned a 9= *ercent ris( 'ei+ht, the an(
is re;uired to hold a K *ercent A.9= . .=EC reserve ca*ital.
: For all others, includin+ cor*orate dets, funded revolvin+ credit, non:8E3)
soverei+n dets $== *ercent B&S ris( 'ei+ht is assi+ned, re;uirin+ financial institutions to
hold ei+ht *ercent reserve ca*ital a+ainst ris( ased assets.
The ca*ital ade;uacy re;uirement distin+uishes credit derivatives from other derivatives
and 'hether or not the derivative transaction is oo(ed in the tradin+ des( of the an( or
oo(ed in the an( alance sheet. The Federal /eserve and Ban( of En+land in $66#
allo'ed an(s to oo( credit default s'a*s and o*tions similar to total return s'a*s in
the an( tradin+:des(, thus re;uirin+ smaller ris( 'ei+htin+ than the ei+ht *ercent
re;uired ca*ital, had the an( oo(ed it in its alance sheet.
2hen there is a asis ris(, and most hed+es do have asis ris(, the hed+e is not *erfect
in miti+atin+ the e.*osure of the underlyin+ instrument 'ith credit derivatives. The
an( may e char+ed ca*ital not only for the counter*arty ris(, ut also for the reference
asset ein+ hed+ed, therey increasin+ ca*ital re;uirements. This can reduce the relative
attractiveness of the deal.
>>.+: &redit ')posure Met(od
This method is estimated y mar(in+ to mar(et the value of the s'a*, *lus *otential
e.*osure as determined y add<on 3actor, for s'a*s 'ith *ositive, ne+ative, or -ero
mar(:to:mar(et value. The method is illustrated in Fi+ure $.%6. 3a*ital re;uirement
under this method is estimated as the *roduct of the credit e.*osure and ris( 'ei+ht
a**licale to the counter*arty.
#i!ure 1.295 :IS &apital Ade6uacy e6uirement &urrent ')posure Met(od
6K

Add<on #actor 3or
Maturity &nterest /ate S'a*s Forei+n e.chan+e rate
s'a*s
Hess than one year =N $N
8ne to five years .9N 9N
Five years or more $.9N #.9N

3a*ital re;uirement5 3redit E.*osure . /is(:'ei+ht
E.am*le
$. ":year, >%9 million interest rate s'a*, counter *arty is Microsoft, assumin+ the
s'a* is in the money y >"7=,===.==
3urrent e.*osure V Ma. A"7=,===.==C V >"7=,===
Potential e.*osureV >%9,===,=== . .==9V >$%9,===
3a*ital re;uirementV A"7=,=== P $%9,===C . .9=V >%K%,9==

%. 9:year currency s'a*s >F Euro >%=million notional *rinci*al, assumin+ the s'a* is
out of money y :"==,==.
3urrent e.*osure V ma. A:"==,==,=C V =
Potential e.*osure V %=,===,=== . .=#9 V >$,9==,===
3a*ital re;uirement V A$,9==,===P =C . .9= V >#9=,===
Source5 Basle 3ommittee on Ban( Su*ervision, Treatment of Potential E.*osure for 8ff:alance Sheet
&tems ABasle, S'it-erland, B&S, A*ril, $669C.
The B&S ca*ital ade;uacy re;uirements continue to evolve as ne' instruments emer+e in
the ca*ital mar(et and associated ris(s to 'hich the financial institutions are e.*osed also
chan+e. The re+ulatory a+ency on an( su*ervision has mandated the minimum ca*ital
for an(s on their derivative transactions to e " times the $=:day value at ris( ABA/C
'ith a 66 *ercent confidence interval. The B&S ca*ital re;uirements do not distin+uish
et'een t'o:currency s'a*s denominated in t'o currencies 'ith si+nificantly different
amount of volatilities. The B&S ca*ital ade;uacy re;uirements fail to ta(e into account the
volatility of the interest and e.chan+e rates, 'hich needs to e addressed in the near
future.
>>.9: $otal eturn S5aps
Total return s'a*s AT/SC are an on off:alance sheet transaction for the *arty 'ho *ays
total returns com*osed of ca*ital +ains or losses *lus the ordinary cou*on or dividend,
and receives H&B8/ *lus s*read related to the counter*arty<s credit ris(iness on a +iven
notional *rinci*al. The an( *ayin+ total returns is effectively 'arehousin+, rentin+ out
its alance sheet 'hile transferrin+ economic -alue and ris8 to *referaly an
uncorrelated counter*arty to the referenced assets. For e.am*le, it ma(es little sense for
a an( to lay off its e.*osure to a *ortfolio of credits in Sin+a*ore rated Baa 'ith a
counter*arty an( in Sin+a*ore rated A.
There is a stron+ correlation et'een the referenced det and the counter*arty, as the
fortunes of oth are directly related to that of the Sin+a*ore economy. The counter*arty in
69
another *art of the 'orld, say !e' Wealand, 'hose *erformance is unaffected y the
an(in+ crisis in Sin+a*ore is said to e an uncorrelated *arty.
i
The an( *ays all the cash
flo's from the loansI cou*ons, commitment fee and may e some of the ori+ination fee
as 'ell as any *ositive increase in the value of the underlyin+ det to the counter*arty,
'hile receivin+ floatin+ rate H&B8/ *lus s*read that defrays its fundin+ cost, as 'ell as
receivin+ any decrease in the value of the referenced assets from the counter*arty.
T/S is a hi+hly le-era!ed transaction AHHTC that motivates the receiver to ta(e on the
credit ris( of referenced assets 'hich are not actually o'ned. The an( 'hich is tryin+ to
reduce its concentration ris( to a *articular entity and free u* re+ulatory ca*ital may enter
into T/S 'ith a hed+e fund 'hich is 'illin+ to *ost five, ten or t'enty *ercent collateral
andFor mar(:to:mar(et the *osition fre;uently to miti+ate counter*arty ris( to the an( on
the notional *rinci*al of, for e.am*le, >9= million. The an( can free u* >".% million of
ris( ca*ital as the ris( 'ei+ht is reduced from $== *ercent to %= *ercent A.=E ca*ital
re;uirement . $== *ercent ris( 'ei+ht for ris(y det . >9= millionC y transferrin+ the
total returns Acou*on of H&B8/P "==*sC, as 'ell as +ains or losses due to ris( of default
of the referenced ond, to the hed+e fund in return for H&B8/ *lus #9 asis *oints. This
is sho'n in Fi+ure $."=.
$(e /an8"s moti-ations are different from that of the hed+e fund, and may include
reducin! its e.*osure 'ithout sellin+ the reference asset, se-erin! an(in+ relationshi*s
'ith the client 'hose det is ein+ securiti-ed y the an(, re!ulatory capital relie3 to
free u* ca*ital, /alance s(eet mana!ement to ori+inate other loans and earn ori+ination
fees, deferrin+ unreco+ni-ed +ainsFlosses on the referenced assets y *ayin+ total returns
and receivin+ floatin+ rate, and di-ersi3ication of its ris(.
#i!ure 1.00: $otal eturn S5ap
H&B8/P"== *s P a MB
H&B/8/P#9 *s
The det underlyin+ the reference asset is a *ar ond rated BBB 'ith cou*on e;ual to
H&B8/ *lus "== *sI the hed+e fund<s fundin+ cost is assumed to e at the s*read of $==
*s over H&B8/. Su**ose H&B8/ is e;ual to 9 *ercent. The return received y the hed+e
fund is *redicated on the amount of the chan+e in the mar(et value AMBC of the asset net
of cou*on AdividendC, levered y the amount of collateral *osted y the hed+e fund. The
levera+e cuts oth 'ays. Assumin+ the underlyin+ det *rice a**reciates, then the return
'ill e ma+nified y the levera+e factor. 8n the other hand, if the det *rice falls o'in+
to risin+ interest rates or to a do'n+rade of the issuer, the levera+e factor 'ill have a
devastatin+ ne+ative im*act on the return reali-ed y hed+e fund.
The amount of the collateral *osted de*ends on the e.tent of an(<s desire to securiti-e
the credit ris( of the referenced asset. A an( may enter into T/S 'ith a hed+e fund
*ostin+ five *ercent collateral that to some de+ree miti+ates the counter*arty ris(, 'hile a
conservative an( may re;uire lar+er ten, $9 or %= *ercent collateral. 2here the
counter*arty is hi+hly:rated entity there 'ill e no re;uirement for *ostin+ collateral. For
e.am*le, assume that 3/EF is the counter*arty to the aove s'a* as the receiver of T/S.
Ban(
Buyer of
*rotection
Hed+e Fund
Seller of
Protection
67
The 3/EF, as a AAA rated *ension fund, 'ill e e.*ected to *ost no collateral as the
lar+est *ension fund man+er for hi+her education *rofessionals, therey reali-in+ the
enefitsF'oes of the hi+hly levera+ed transaction HHT in T/S. The ottom line is that a
s'a* allo's the economic use of ca*ital 'ithout tyin+ u* $== *ercent of the ca*ital in a
transaction for the *arties involved. The im*act of levera+e on the T/S reali-ed return for
the hed+e fund as a receiver and the an( as a *ayer, assumin+ the fund 'ill *ost 9 or $=
*ercent collateral, is illustrated in Fi+ure $."$.

#i!ure 1.01: $otal eturn S5ap Payo33 to t(e ecei-er Assumin! 9 to 10 percent
&ollateral Posted /y ;ed!e #und on @otional Principal o3 D90 million
Bond *rice 3a*ital Gain 3ou*on &nterest &nterest /eturn /eturn
in one year Hoss !et on 9 N on $= N reali-ed /eali-ed
P%%9 *s 3ollateralU 3ollateralU 9 N $= N
3ollateral 3ollateral
$=" $,9==,=== $,$%9,=== $%9,=== %9=,=== $$= N 7= N
$== = $,$%9,=== $%9,=== %9=,=== 9= %#.9=
6# :$,9==,=== $,$%9,=== $%9,=== %9=,=== :$= :%.9
69 :%,9==,=== $,$%9,=== $%9,=== %9=,=== :9= :%%.9=
6% :K,===,=== $,$%9,=== $%9,=== %9=,=== :$$= :9%.9=
UAssumin+ 9 *ercent interest is earned.
As e.*ected, the return reali-ed y the receiver 'ho is ta(in+ on the credit ris( Aris( of
defaultC, the mar(et ris( Ainterest rate ris( due to risin+ interest rateC, as 'ell as the uni;ue
ris( A*ossile do'n+rade of the det issueC of the underlyin+ det instrument as a an(
lays off all the ris(s to the receiver y *ayin+ total return 'hile receivin+ H&B8/ *lus
s*read is e.tremely sensitive to the amount of collateral *osted. For e.am*le the receiver,
the hed+e fund ,'ill reali-e return of 7= to $$= *ercent, assumin+ the amount of collateral
*osted is res*ectively ten and five *ercent of the notional *rinci*al of >9= million and the
underlyin+ det instrument only a**reciates y three *ercent over the one:year *eriod.
8n the other hand, assumin+ the underlyin+ det o'ned y the an( dro*s to 6%, the
hed+e fund res*ectively 'ill reali-e returns of Y9%.9= to Y $$= *ercent 'here the levera+e
factor is $= and %= to $.
The an( in the aove e.am*le, y *ayin+ total returns, is essentially uyin+ *rotection
in order to lay off ris( and reali-e economic relief of ris(y ca*ital as it no lon+er needs to
hold a re;uired reserve for the ris(:ased ca*ital. The receiver of the total return is
sellin+ *rotection for the reference assets it does not o'n, ut are financed y the an(
for the receiver, 'ho *osts some a+reed amount of collateral.
>>.10: Moti-ations o3 t(e ecei-er o3 $S
The receiver is li(ely to have a host of reasons to enter into this HHT, for e.am*le5
: Financin+ hu+e transaction 'ith limited ca*ital
: E.*loitin+ the levera+e as the returnFris( can e ma+nified
: Aritra+e *rofit
: Access to ca*ital mar(ets not *reviously availale
: Sectoral aritra+e of credit ris( in the hi+h yield mar(et
6#
3onsider Goldman Sachs AGSC and Ban( of America that entered into a T/S, 'here the
an( *ays total returns on the *ortfolio of syndicated soverei+n det 'ith avera+e cou*on
of H&B8/P%#9 *s and receives the yield on a %= year Treasury ond. The an( elieves
that the total return on the *ortfolio is e.*ected to fall over the ne.t three years, as some
of the issues may e do'n+raded, 'hile GS elieves that this HHT 'ill e a oon for the
investment an(in+ firm as the s*read is li(ely to ti+hten et'een the t'o issues over the
s'a* hori-on of three years, +iven a ;uarterly reset date and notional *rinci*al of >%9=
million, as sho'n in Fi+ure $$.E. Su**ose the total return in the aove s'a* is ca**ed at
the ma.imum rate of 6 *ercent 'hile a minimum floor of 9.9 *ercent is im*osed on the
%=:year yield on the Treasury to *rovide *rotections for oth *arties, as sho'n in Fi+ure
$."%.
#i!ure 1.02: $S 5it( &ap and #loor
[7:month H&B8/P %#9 *s P a MB] ca**ed at 6 N
%=:year T:ond
9.9 N yield
'ith floors
The an( achieves re+ulatory ca*ital relief as B&S ris( 'ei+ht of the assets on its oo(
is reduced from $== to %= *ercent, y layin+ off the credit ris( of the *ortfolio to GS. The
*rotection seller GS has access to hi+h ;uality soverei+n ris( 'ith attractive yield levered
y the nature of the s'a*. The an( reali-es >$7 million ca*ital reliefI .E= . .=E . >%9=
million, as the *ayer of the total returns e.*ectin+ a 5idenin! of the yield et'een the
referenced assets versus T:onds. The receiver of total returns, e.*ectin+ a ti!(tenin! of
the yield on the referenced assets versus T:onds, ta(es on the credit ris(, as 'ell as
mar(et ris( of the *ortfolio of credits it does not o'n, 'ith the u*side *otential limited y
a ca* of nine *ercent, *rovidin+ do'nside *rotection to the receiver of the T:ond yield at
the floor rate of 9.9 *ercent.
The an(, in order to minimi-e the counter*arty ris( and its credit e.*osure, may
re;uire *eriodic mar(:to:mar(et in the T/S. The increase in the fre;uency of the mar(:
to:mar(et is intended to mimic the treatment of the derivatives transaction in the
or+ani-ed e.chan+e in miti+atin+ mar(et ris(5 *rice ris(, s*ecific ris(, and the ,oint
*roaility of default in the HHT.
>>.11: =e-era!e Impact o3 &apital Structure on :an8 :alance S(eet
The im*act of ca*ital structure on the an( alance sheet has een a source of on:+oin+
concern for decades, s*ecifically relatin+ to det and the e;uali-ation of ca*ital on ris(:
ased assets. Ban(s in the United States, on avera+e, have assets:over:e;uity ratios
Ae;uity multi*lierC of $9 times, 'hile 1a*anese an(s are levera+ed nearly t'ice as much
'ith assets:over:e;uity of "= times. Ban(s in 1a*an, therefore, can *rice a loan to earn,
say, one *ercent return on assetsI that translates to a thirty *ercent return on e;uity
A/8EC. U.S. an(s, on the other hand, can earn an /8E of $9 *ercent, *rovided that their
BA3
Buyer of
*rotection
Goldman Sachs
Seller of
Protection
6E
return on assets is one *ercent. Ban(s in 1a*an have a com*etitive advanta+e over their
U.S. counter*arts in *ricin+ loans, as they are not re;uired to hold as much e;uity ca*ital.
To ma(e the *layin+ field even, ca*ital e;uali-ation across the Pacific 'ould e a ste* in
the ri+ht direction to stren+then the +loal an(in+ system. To ma(e the matter 'orse,
B&S ca*ital re;uirements add insult to in,ury, as demonstrated in the follo'in+ e.am*le.
3onsider a an( that 'ishes to ac;uire e.*osure to the follo'in+ t'o classes of dets,
B&S ris(:'ei+hted res*ectively y %= and $== *ercent. The %= *ercent ris( 'ei+ht is a
senior det of an 8E3) an( 'ith a cou*on of H&B8/ *lus 79 *s. A Ford Motor senior
det also has a cou*on of H&B8/ *lus 79 *s. The relative ris(iness of oth issues is
identical. Ho'ever, the B&S ca*ital re;uirement s(e's the relative attractiveness of the
one issue over the other as the return on e;uity ca*ital 'ill e a multi*le of the levera+e
in a det B&S ris(:'ei+hted %= *ercent Afive timesC that of det B&S ris( 'ei+hted $==
*ercent. This is sho'n in the Fi+ure $."".
#i!ure 1.00: $S and =e-era!e
H&B8/P$=*s
T/
$==N B&S ris( 'ei+ht
3ou*on5 H&B8/P79

H&B8/P$=*s
T/
%=N B&S ris( 'ei+ht
3ou*on5 H&B8/P79
The *rotection seller has the fundin+ cost of H&B8/ *lus $= asis *oints. Assumin+ no
default and no adverse *rice movement in the reference assets, the an( Athe *rotection
sellerC earns 99 asis *oints on oth transactions. Ho'ever, return on ca*ital is levered
five times for the assets B&S ris(:'ei+hted y %= *ercent, as sho'n in Fi+ure $."K.
#i!ure 1.07: =e-era!e Impact on eturn on &apital

$== N B&S %= N B&S
!otional >"= million >"= million
Ban(
Seller of
Protection
Buyer
of
Protection
Ban(
Seller of
Protection
Buyer
of
Protection
66
/eserve .=E .=E
/is( 'ei+ht $==N %= N
3a*ital
/e;uired .=E . $==N . >"= M .=E . %=N . >"= M
S*read earned 99 *s 99 *s
&ncome >$79,=== >$79,===
/eturn on 3a*ital 7.E#9N "K."#9 N
The an( havin+ e.*osure to $== *ercent B&S ris( 'ei+ht is li(ely to lay off its e.*osure
throu+h *ayin+ total returns in the T/S or uyin+ a credit default s'a* in order to reali-e
ca*ital relief for ori+inatin+ loans that are ris(:'ei+hted t'enty *ercent, as sho'n in
Fi+ure $."K.

e3erences5
Altman E. A%==%C, Ban(ru*tcy, 3redit /is(, and Hi+h Mield 1un( Bonds Blac('ell.
Anand 0. Bhattacharya AEditorC, Fran( 1. Fao--i AEditorC 1uly A%==$C ?Asset:Bac(ed
Securities,@ 1. 2iley GSon !e' Mor(
3alomiris, 3harles 2., 1ose*h /. Mason, %==", ?3redit 3ard Securiti-ation and
/e+ulatory Aritra+e,@ Federal /eserve Ban( of Philadel*hia, 'or(in+ *a*er.
3arlstrom, 3harles T., 0atherine A. Samoly(, $669 ?Hoan sales as a res*onse to mar(et:
ased ca*ital constraints,@ &ournal of Baning ' Finance $6, ",K 7%#:799.
Moorad 3houdhry ?Ban( Asset G Hiaility Mana+ement,@ Se*temer A%==K C 1. 2iley
GSon !e' Mor(.
$==
)adush, Uri, and ). )as+u*ta. $666. ?Benefits and /is(s of 3a*ital Account
lierali-ation,@ The 2orld an(,. Processed.
Andre' )avidson, Anthony Sanders, Han:Hin+ 2olff, Anne 3hin+, Se*temer A%=="C,
?@Securiti-ation5 Structurin+ and &nvestment Analysis,@ 1. 2iley GSon !e' Mor(.
1. )ermine M. F. Bissada B%==%C Asset and Hiaility Mana+ement5 A Guide to Balue
3reation and /is( 3ontrol Prentice Hall.)uffie, ) A$666C5 ? 3redit s'a* valuation@,
Financial Analyst 1ournal, ** #":E#.
Elul, /onel, %==9, ?The Economics of Asset Securiti-ation,@ Business (evie) $7 R", $7:
%9.
E3B A%===C5 ?The information content of interest rates and their derivatives for monetary
*olicy@, E3B Monthly Bulletin, ** "#: K7, May.
Fitch &B3A, )uff G Phel*s. $666a. ?Future Flo' Securiti-ation /atin+ Methodolo+y,@
Fitch &B3A, )uff G Phel*s.
Fitch &B3A, )uff G Phel*s. $666c.@Under Pressure5 Structured Transactions in
Emer+in+ Mar(et Stress,@ Fitch &B3A, )uff G Phel*s.
Gertler, M and 3 S Ho'n A%===C5 ?The information in the hi+h yield ond s*read for the
usiness cycle5 evidence and some im*lications@, !BE/ Pa*er no #9K6.&nternational
Monetary Fund. Balance of Payments Statistics, Barious issues.
Ha(hir Hayre AEditorC, November (%==%C ?Salomon Smith Barney Guide to Mort+a+e:
Bac(ed and Asset:Bac(ed Securities@ Salomon Smith Barney !e' Mor(.
3aro', 0enneth A., Gayle /. Er'in, and 1ohn 1. Mc3onnell, $666, ?A Survey of US
3or*orate Financin+ &nnovation5 $6#=:$66#,@&ournal of Applied Corporate Finance *+
A!o. $, S*rin+C, 99:76.
3hen, Andre' H. and 1ohn 2. 0ensin+er, $6EE, ? Puttale Stoc(5 A !e' &nnovation in
E;uity Financin+,@ Financial ,anagement *- A!o. $ S*rin+C, %#:"#.
Fran( 1. Fao--i AEditorC A%==$C, ?Accessin+ 3a*ital Mar(ets throu+h Securiti-ation,@
1. 2iley GSon !e' Mor(.
Fao--i, F. 1. Handoo( of Structured Financial Products. Fran( 1. Fao--i Associates,
$66E.
Fao--i, F., 3. /amsey. 3ollaterali-ed Mort+a+e 8li+ations5 Structure and Analysis, "
rd

ed. A!e' Ho*e, PA, $66%.
Fao--i, Fran( 1., bBaluation of Fi.ed &ncome Securities and )erivatives,b Third Edition
A!e' PA5Fran( 1. Fao--i Associates, $66EC, *. 9".
Fao--i, F.1., Fi.ed &ncome Mathematics5 Analytical and Statistical Techni;ues. 3hica+o5
Prous, $66".
Fran( 1. Fao--, ed., Advances and &nnovations in the Bond and Mort+a+e Mar(ets,
3hica+o, &H, Prous, K$#:K"7.
Finnerty, 1ohn ) and )ou+lass Emery. ?3or*orate Securities &nnovations5 An U*date,
1ournal of A**lied Finance, S*rin+FSummer %==%, PP %$:K#.
Homaifar, Ghassem, %==K, ?Mana+in+ Gloal Financial and Forei+n E.chan+e /ate
/is(,@ 1ohn 2iley G Sons !e' Mor( 1anuary.
1affee, )'i+ht and 0enneth T. /osen, $66=, ?Mort+a+e Securiti-ation Trends,@ &ournal
of .ousing (esearch $, $$#:$"E.
1affee, )'i+ht and Bertrand /enaud, $669, ?Securiti-ation in Euro*ean Mort+a+e
Mar(ets,@ *a*er for First &nternational /eal Estate 3onference.
$=$
Hi*in, S., A$66%C, ?1. P. Mor+an Had >9= million Hosses in Tradin+ Mort+a+e:ac(ed
Securities,@ 2all Street 1ournal, AMarch $=C, AK.
Houts(ina, Elena, %==9, ?)oes Securiti-ation Affect Ban( Hendin+4 Evidence from Ban(
/es*onses to Fundin+ Shoc(s,@ EFA %==9 Mosco' Meetin+s, 'or(in+ *a*er,
forthcomin+ availale at SS/!5 htt*5FFssrn.comFastractV7##==$
Mar(ose, Sheri and Man )on+, %==9, ?8*timal Securiti-ation in Ban(s,@ 'or(in+ *a*er.
Mor+an Stanley )ean 2itter, %===, ?Peme. Finance Htd. 8fferin+ Memorandum,@
Feruary.
8<hara, Maureen, $6E", ?A )ynamic Theory of the Ban(in+ Firm,@ &ournal of Finance
"E, $, $%#:$K=.
8+den, 1ose*h P., $6E#, ?An Analysis of Mield 3urve !otes,@ &ournal of Finance K%
A!o.$, MarchC, 66:$$=.
Perlman, S.)., A$6E6C, ?3ollaterali-ed Mort+a+e 8li+ations5 The &m*act of Structure on
Balue, ?in Bodnar, G.M., Hayt, G.S., and Marston, /.3., $66E, b$66E 2harton Survey of
Financial /is( Mana+ement y U.S. !on:Financial Firms.b Financial ,anagement,
%#AKC, #=:6$.
1ames A. /osenthal, 1uan M. 8cam*o 1. Securiti-ation of 3redit5 &nside the !e'
Technolo+y of Finance 1. 2iley GSon !e' Mor( 1uly $6EE
Standard G Poor<s. $666a. ?Securiti-ation in Hatin America $666,@ Structured Finance at
Standard G Poor<s.
Standard G Poor<s, $666,@Hesson from the Past A**lies to Securiti-ation in Emer+in+
Mar(ets,@ 1uly.
Standard G Poor<s. Structured Finance5 Emer+in+ Mar(et 3riteria.
Steven Sch'arc- A$66"C ?Structured finance5 A +uide to the *rinci*les of asset
securiti-ation,@ Practising Law Institute; 2nd ed edition.
Smith, )onald 1., $6E6, ?The Arithmetic of Financial En+ineerin+,@ &ournal of Applied
Corporate Finance * A!o. K, 2interC, K6:9E.
Tufano, Peters, $669, ?Securities &nnovation5 A Historical and Functional Pers*ective,@
&ournal of Applied Corporate Finance - A !o.K, 2interC,6=:$=".
2orld Ban(.%===. Gloal )evelo*ment Finance.
Tranche A
Total Collateral Coupon Rate
0
,&1'''1'''1'''/'' -)/2'%


Month alance !rincipal !ay"ent Intere#t
!ayo$$ Ti"e
%"onth#&
A'era(e Li$e
$=%
'
0
(-1(&'1'''1'''/''
-
0
(-1(&'1'''1'''/''
0
&(,1-'(1*&)/2. 0 *',1-(&1'''/'' 0 &(,1-'(1*&)/2.
(
0
('1)(-1,.)1+2(/&-
0
&*-1*'*1*,(/2- 0 *''12+)1&-&/,( 0 -1'+(1+'+1)+2/,*
*
0
('1-.'1&.21(+'/'.
0
&*21&+(1(-)/+- 0 (.(1)+*1+-+/)) 0 -1+'*1+,+1+&(/,(
2
0
-.1+&+1'*(1'2(/2,
0
&*)1,).1+)*/,+ 0 (,&1'-(12+2/+( 0 (1-&-1&-,1+.&/2*
& 0 -.1--,1-&(1*+,/+*
0
&2-1(&+1&)*/). 0 ())1(-*1('./*& 0 (1)'+1(,(1,+,/.)
+
0
-,1&)+1,.&1).2/,*
0
&221+.*1)&(/') 0 (+.1*+21.,./'* 0 *1(+,1-+(1&-(/2-
)
0
-,1'*(1('(1'2(/))
0
&2,1-.(1'&&/&* 0 (+-12++1.(./+( 0 *1,*)1*221*,,/+,
,
0
-)12,21''.1.,)/(2
0
&&-1)&(1*2*/*, 0 (&*1&-,1-22/,- 0 212-21'-,1)2)/'(
.
0
-+1.*(1(&)1+2*/,+
0
&&&1*)&12,)/*. 0 (2&1&-)1)*&/,2 0 21..,1*).1*,+/2)
-'
0
-+1*)+1,,(1-&+/2,
0
&&.1'+(1*)(/'2 0 (*)12+21).-/() 0 &1&.'1+(*1)('/22
--
0
-&1,-)1,-.1),2/2*
0
&+(1,-*1,.2/)+ 0 ((.1*&,1*,+/,) 0 +1-.'1.&(1,2(/*,
-(
0
-&1(&&1''&1,,./+)
0
&++1+*'1.++/'& 0 ((-1-.)1&,&/2' 0 +1)..1&)-1&.(/+(
-*
0
-21+,,1*)21.(*/+(
0
&)'1&-21&'./)( 0 (-(1.,-12*+/*. 0 )12-+1+,,1+(+/*)
-2 0 -21--)1,+'12-*/.'
0
&)212+&12+*/'+ 0 ('21)',1.)+/'' 0 ,1'2(1&-+12,(/,2
-&
0
-*1&2*1*.21.&'/,2
0
&),12,21)))/'2 0 -.+1*).1((+/). 0 ,1+))1()-1+&&/+)
-+
0
-(1.+21.-'1-)*/).
0
&,(1&)*12-+/&* 0 -,)1..-1-.)/&( 0 .1*(-1-)21++2/2,
-)
0
-(1*,(1**+1)&)/(+
0
&,+1)*(1*+'/2& 0 -).1&2*1,,(/., 0 .1.)212&'1-()/+)
-, 0 --1).&1+'21*.+/,-
0
&.'1.+(1+'(/'* 0 -)-1'*+1(+*/)& 0 -'1+*)1*(+1,*+/&.
-. 0 --1('21+2-1).2/),
0
&.&1(+&1-2,/.. 0 -+(12+)1*'+/'( 0 --1*-'1'*)1,*'/,-
('
0
-'1+'.1*)+1+2&/).
0
&..1+2-1'(*/)2 0 -&*1,*&1.+-/*+ 0 --1..(1,('12)2/,+
(-
0
-'1''.1)*&1+((/'&
0
+'21'.-1(+*/+* 0 -2&1-2-1-++/&( 0 -(1+,&1.-+1&*+/(-
((
0
.12'&1+221*&,/2(
0
+',1+-+1.(-/-( 0 -*+1*,-1,2*/(' 0 -*1*,.1&)(1(+2/+-
(*
0
,1).)1'()12*)/*'
0
+-*1(-.1'+2/'2 0 -()1&&+1,.)/,2 0 -21-'21'*,12)(/,-
(2
0
,1-,*1,',1*)*/(+
0
+-)1,.,1))&/), 0 --,1++&1((-/2- 0 -21,(.1&)'1+-,/+.
(&
0
)1&+&1.'.1&.)/2.
0
+((1+&)1-&&/&& 0 -'.1)'&1+,./-+ 0 -&1&++12(,1,,,/)+
(+
0
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Appendi) 2: $ranc(e A5
Month alance !rincipal !ay"ent Intere#t
' (-1(&'1'''1'''/''
- (-1(&'1'''1'''/'' .',1,*-1&&+/,+ *',1-(&1'''/''
( ('1*2-1-+,122*/-2 .-(1'*(1&,-/*) (.21.2+1.2(/2*
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2 -,1&-*1,22122&/+- .-,1+',1,)-/., (+,12&'1)22/2+
& -)1&.&1(*&1&)*/+* .(-1.,&1))-/2. (&&1-*'1.-&/,(
+ -+1+)*1(2.1,'(/-2 .(&12((1.2./*2 (2-1)+(1-((/-*
) -&1)2)1,(+1,&(/,' .(,1.(-1(&(/*) ((,1*2*12,./*)
, -21,-,1.'&1+''/2* .*(12,-1&*./), (-21,)21-*-/(-
. -*1,,+12(21'+'/+2 .*+1-'21+,*/*& ('-1*&*1-2,/,,
-' -(1.&'1*-.1*))/(. .*.1).-1&+)/&) -,)1)).1+*'/.)
-- -(1'-'1&()1,'./)( .2*1&2*1',./,2 -)21-&(1+&*/(2
-( --1'++1.,21)-./,. .2)1*+'1-+'/+) -+'12)-1(),/22
-* -'1--.1+(21&&./(( .&-1(2*1)'*/,, -2+1)*21&&+/--
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-+ )1(&*1.)(1((,/*' .+*1*'(1+'./(. -'&1-,(1&.)/*-
-) +1(.'1++.1+-./'- .+)12+-1&&(/)* .-1(-21)'./2,
-, &1*(*1(',1'++/(, .)-1+.-1).*/,* ))1-,+1&-+/.+
-. 21*&-1&-+1()(/2& .)&1..21*2'/*' +*1'.+1.,&/.&
(' *1*)&1&(-1.*(/-& .,'1*)'1(-2/&& 2,1.2&1'+,/'(
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(( -12-'1**-1(+*/++ .,.1*2+1--'/.( ('122.1,'*/*(
(* 2('1.,&1-&(/)2 2('1.,&1-&(/)2 +1-'21(,2/)-
$ranc(e :
alance
!rincipal
!ay"ent Intere#t
!ayo$$ Ti"e
%"onth#&
$$%
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