FINANCE 361 – Topic 18 – Structured products and securitisation

Paul Geertsema

1
Contents

1 Readings 4

2 What are we doing today 5

3 Motivation (Why are we doing this?) 6

I Structured Products 8

4 Introduction 9

5 Generic Structure of a Structured Note 11

5.1 Constructing PEPPER . . . . . . . . . . . . . . . . . 14
5.2 Constructing PEPPER (2) . . . . . . . . . . . . . . . 15
5.3 PEPPER structure diagram . . . . . . . . . . . . . . . 16
2 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Contents (cont.)

6 Risk 17

7 Structure 21
7.1 Payoff structure . . . . . . . . . . . . . . . . . . . . . 22
7.2 Transaction structure . . . . . . . . . . . . . . . . . . 24

8 Structured Products Pros and Cons 27

II Securitisation 29

9 Introduction 30

10 Structure 34
10.1 Bankruptcy remote SPV . . . . . . . . . . . . . . . . 34
10.2 Tranched notes and cash flow waterfalls . . . . . . . . 37

3 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

1 Readings

• These notes

4 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

2 What are we doing today

• Structured products
• Securitisation

5 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

3 Motivation (Why are we doing this?)

• Why are we covering structured products and securitisation?

• Both are examples of financial engineering
• That is, building more complicated products using (relatively) simple
products
• The engineering characterisation is apt:
– In civil engineering, one starts with the basic properties of ma-
terials (concrete, steel, wood) and simple structures (beams,
arches, etc..)
– Ultimately, these are combined into more complicated structures
such as bridges

6 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Motivation (Why are we doing this?) (cont.)

• The same is true of financial engineering

– Basic products (zero coupon bonds, single stock call options,
currency swaps)
– When combined can be used to produce highly bespoke financial
instruments, e.g. credit range accrual notes or auto loan asset
backed securities
• This is the creative side of finance; believe me, it can be a lot of fun
- like playing Lego or Minecraft. It can also be dangerous, especially
if you do not understand the mechanics behind the gleaming façade
...
• That is where this lecture can help

7 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Motivation (Why are we doing this?) (cont.)

Part I

Structured Products

8 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

4 Introduction

• Different people have different definitions of structured products

• Is usually structured as a note (a type of bond); this distinguishes
it from derivatives
• Essentially “packages” one or more derivatives, assets and/or dy-
namic trading strategies into a bond format
• It is important to understand that structured notes are often ex-
posed (intentionally) to risks that has very little to do with normal
bond risk
• Be clear about the difference between legal form and economic
exposure

9 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Introduction (cont.)

• Any of the following can easily be packaged up as a note

– Gold (tracks the gold spot price total return)
– Profits from a pre-defined momentum trading strategy as ap-
plied to US large-caps
– Credit risk on a basket of sovereign bonds
– Equity stake in an unlisted firm
• Structured products is about taking some specific set of risk expos-
ures and embedding it into the legal form of a note

10 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

5 Generic Structure of a Structured Note

• There are endless variations in terms of how structured notes can

be assembled
• Let’s start with a simple made-up example: principal enhanced
protected participation equity referencer (PEPPER)
– It is important to have a catchy acronym for your note so sales
can easily refer to it; hopefully clients will like it too!

11 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Generic Structure of a Structured Note (cont.)

• PEPPER Term sheet (summary of basic terms of the note)

– Issuer: [Tropical Island SPV]
– Notional: USD 100mn (or as agreed)
– Maturity: 5 years
– Principal: Notional, guaranteed at maturity
– Rating: AA+ (Principal only)
– Coupon: Single coupon at maturity, equal to Notional x Coupon
Rate
– Coupon Rate: Participation Rate x (Notional / Initial Index
Level) x max(0, Final Index Level - Initial Index Level)
– Initial Index Level: [1875] (S&P 500 Index close as of [date])
– Final Index Level: S&P500 Index as of Maturity date, as de-
termined in accordance with note terms and conditions
– Participation Rate: [50%]

12 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Generic Structure of a Structured Note (cont.)

• Do you like PEPPER?

– Seems great
◦ Get 50% of any increase in S&P500 index
◦ With principal fully protected
– Now let me take you backstage...

13 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Generic Structure of a Structured Note (cont.)

5.1 Constructing PEPPER

14 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Generic Structure of a Structured Note (cont.)

5.2 Constructing PEPPER (2)

15 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Generic Structure of a Structured Note (cont.)

5.3 PEPPER structure diagram

16 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

6 Risk

• In the previous example the underlying risk was the S&P 500 equity
index, modified by a layer of call options, then packaged into a
structured note collateralised with AA+ government paper.
– Yes, this is how finance people talk...
• However, in principle, it could have been anything
• Anything, as long as there is
– A willing buyer of the structured note; and
– A seller that is either willing to take the other side of the risk;
or (more likely)
– A seller that can hedge (most of) the risk away
• Could one produce a “Global Warming Inverse Floater” note that
pays a coupon equal to (100 - x)/10 where x = average daily surface
temperature (in Celsius) in 20 selected cities?

17 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Risk (cont.)

• Sure.
– Would need to find a buyer
– Will need to hedge using
◦ Weather derivatives; or maybe
◦ Oil futures (air conditioning); or even
◦ Pub revenues (sell more beer when the sun is shining)
• What other underlying risks might we add to a structured note?

18 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Risk (cont.)

• Following the required reading, here is a list:

• Credit
– Single Name
– Portfolio
• Equity
– Index
– Single stock
• Currency
– Principal or coupon in alternative currency
– Linked to currency movements
• Commodity
– Oil
– Gold
19 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Risk (cont.)

– Soy bean
– Milk solids
◦ (perhaps issued by Fonterra? seem like a natural hedge for
them...)
• Other
– Internet Bandwidth
– Shipping cost
– Weather
– Catastrophe
◦ Earthquakes
◦ Hurricanes
◦ War
– Economic releases (US non-farm payroll, fed funds rate, etc..)

20 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

7 Structure

• We can conceive of two separate structural domains

– Payoff structure
– Transaction structure

21 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

7.1 Payoff structure

• How to transform one or more observable measures into a note

cash flow
– Let M be a set of N observable measures such as Libor, Gold
price, Nikkei index, etc..
– Then the payoff structure is a function that translates those
numbers into a real valued dollar amount
– F : {(m1, m2, ..., mN )} → R

22 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• In the PEPPER note example, M = {S&P 500Index} = {m}

and
N
F (m) = P articipationRate × ( ) × |max(0, m{z− Initial)}
| {z Initial }

= Number of call options × Payoff per call

• Other common payoffs
– Let m be the underlying measure (i.e. Libor, Gold price, NZX50)
– Range accrual
◦ Coupon level depends on measure m being in a certain range
– Inverse
◦ Pays c−m where c is some constant such that c > m usually
◦ Sometimes floored at zero, so max(0, c − m)
– Leveraged
◦ pays m ∗ l where l > 1 is a leverage factor
– Squared/Cubed
◦ m2 or m3 respectively
23 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Structure (cont.)

7.2 Transaction structure

• This is how the transaction is structured legally, in terms of the

parties to the transaction and securities created (in boxes) and the
obligations (flow of funds/securities) they have under the transac-
tion documents (as lines or arrows)
• Often communicated via a structure diagram
– See, for instance, the PEPPER transaction diagram earlier
– Here is another example (a real one, this time)
– (Sourced from http://investmentedge.files.wordpress.com/2010/05/fdic-
transaction-diagram.jpg)

24 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

25 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Stand-alone SPV vs bank issuer

– The PEPPER example note used an SPV
– So that note would have been OK, even if Megabank collapsed
– If instead PEPPER was issued directly by Megabank, then the
PEPPER note would have collapsed along with Megabank
– Bottom line: Unless it is structured through a stand-alone SPV,
you are exposed to counterparty risk from the bank that sold
you the note
◦ Remember Lehman Brothers? Investors in structured notes
issued by Lehman lost 100%, even when the underlying ex-
posure of the note was in the money

26 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

8 Structured Products Pros and Cons

• Pros
– Custom payoffs can be linked to just about any payoff on any
combination of risk that can be defined
◦ The “kitchen sink” trade
– Packaged in note form - legally, it is just a bond
– Issued when you want it, in the form you want it in, in the
amount you want
• Cons
– Since it is bespoke, it is very illiquid (like trying to sell a bespoke
suit)
– Bank counterparty risk (unless structured via an SPV)
– There won’t be any secondary market to speak off
◦ You are likely the only owner of this particular bond
27 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Structured Products Pros and Cons (cont.)

◦ But the bank that sold it to you might supply indicative marks
(prices) if you ask nicely
– The underlying mechanics might be quite involved, with several
layers of derivatives, hedge assets and/or trading strategies
◦ Which means it will be a nightmare to price independently
– The fees involved are likely to be substantial (and you might
not even know how much it is, since you can’t price it)
– In an efficient market, buying a structured note is NPV
negative

28 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structured Products Pros and Cons (cont.)

Part II

Securitisation

29 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

9 Introduction

• Securitisation is a financial technology that converts cash flow pro-

ducing assets into tradeable securities
• In other words it “securitises” the assets
– Common assets: Mortgages (about 2/3rds of total), consumer
loans, corporate loans, bonds
– Not-so-common: Pubs, diamonds, lottery profits, solar energy,
defaulted bank assets, service stations, tunnels, etc.
• There is clearly some overlap between the definitions of securitised
notes and structured products
• Total securitised assets in the US and Europe exceeds euro 10
trillion (as of 2011)

30 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Introduction (cont.)

• Source: OECD Journal: Financial Market Trends-Volume 2011 Is-

sue 1, retrieved from http://www.oecd.org/finance/financial-markets/48620405.p

31 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Introduction (cont.)

• Acronyms
– Europe/Rest of the World
◦ RMBS = Residential Mortgage Backed Securities
◦ ABS = Asset Backed Securities (e.g. Credit Card Debt, Auto
Loans, Student Loans, Receivables)
◦ CDO = Collateralised Debt Obligations(an ABS of Bonds)
◦ CMBS = Commercial Mortgage Backed Securities
– US
◦ Agency MBS = Mortgage Backed Securities issued by the
US government “agencies” (Fannie Mae, Freddie Mac, Ginnie
Mae)
◦ (The rest means the same as above)

32 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Introduction (cont.)

• In discussing securitisation, it is useful to make a distinction between

“structure” and “assets”
– “Assets” generate the cash. Since that is more straight-forward,
we won’t go into detail
– However, in real securitisation transactions, understanding the
drivers of asset performance is just as important as understand-
ing the structure; perhaps more so.
– “Structure” decides how the cash is allocated to different parties
in the transaction
• We’ll cover “Structure” next

33 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

10 Structure

10.1 Bankruptcy remote SPV

• In a typical securitisation, the assets are transferred (via a cash sale

or sometimes via a derivative transaction) to the SPV
• The SPV (short for “special purpose vehicle”) is often a trust (in
the US) or a special purpose company (Rest of the World)
• The SPV
– Holds the cash producing assets
– Funds the acquisition of the assets by issuing one or more se-
curitised bonds
– Engages in derivative transactions needed to hedge interest rate,
currency and other risks

34 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• The SPV operates like a pre-programmed robot; it is not like a

normal company where management has discretion
– Instead the SPV operates according to detailed instructions con-
tained in the transaction documents that covers all possible con-
tingencies
• The SPV is usually structured in such a way that it cannot be
declared bankrupt
– The bonds issued only promises to pay if money is available to
pay
– Hence by design a SPV cannot default
• SPVs are often incorporated in tax/regulatory advantaged jurisdic-
tions
– Cayman Islands, Bermuda (US transactions)
– British Virgin Islands (BVI), Ireland, Luxembourg (European/Chinese)
– Mauritius (Indian/African)

35 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Example transaction structure diagram (LBMC 2005-2)

• See http://www.derechos.org/nizkor/econ/crisis21.html for much more detail and background

36 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

10.2 Tranched notes and cash flow waterfalls

• A typical feature of securitisation is the issuance of multiple notes

with different risk profiles
• Known as “tranches” (after the French for “slice”)
• This allows for the creation of notes with different risk and return
profiles that can be targeted at different investors in order to achieve
the lowest “all-in” cost of funding for the SPV
• Tranched notes are often labelled “Class A”, “Class B”, “Class C”
and so on, with the senior Class A notes usually being safer and
offering lower yields than the more junior Class B notes
• The different risk and return profiles are achieved by allocating cash
flows and credit losses differentially to different tranches (= classes
of notes)
• The rules for allocating cash flows are known as the priority of
payments (PoP) or cash flow waterfall

37 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• There may be more than one cash flow waterfall - for instance, for
mortgage backed securities there may be one cash flow waterfall for
mortgage interest receipts and another one for mortgage principal
receipts
• As a general principle:
– Cash flows are allocated “top down” so the safer senior bonds
are first in line to make use of available cash with any residual
cash flowing on to the junior bonds
– Credit losses are allocated “bottom up” so any losses (due to
default on a mortgage, say) are allocated first to the most risky
junior bond (until wiped out) and then moves on the next most
junior bond
• Properly modelling these transactions requires careful reading of the
underlying transaction documents (which may consist of hundreds
of pages of legal definitions)
• See screen shots following...

38 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Legal docs: This is an extract from a credit card ABS offering cir-
cular (a summary of the transaction documents provided to buyers
of the bonds); this particular document consisted of 220 pages.
• Legally defined terms are always Capitalised and are often “Quoted”
and/or Bolded when first defined.

39 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Full cash flow model [In the pdf version you can zoom in...]

40 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Example waterfall schematic (LBMC 2005-2 again)

41 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• This is how a waterfall works

– At the top there is Available Funds - the accumulated cash
available on that particular date (monthly or quarterly)
– Then there is a list of things that needs to be paid along with
how much needs to be paid
◦ Class B Interest Required = Class B Note Balance
x Class B Interest Rate x Daycount Fraction
– The amount actually available to be allocated to the item is
calculated as min(Available Funds, Required Amount)
◦ Class B Interest Allocated = min(Available Funds,
Class B Interest Required)
– Now Available Funds is reduced by the amount allocated, and
the process moves on to the next item in the list...

42 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Implementation in Excel

43 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Structure (cont.)

• Credit support
– All sorts of mechanisms can be built into the transaction in order
to make some tranches safer
– Some of the common ones are
• Subordination: Including more junior tranches that bear losses first
• Over-collateralisation: The notional value of the assets exceeds the
notional value of the issued notes - that excess is available to bear
losses
• Excess spread: Structuring the transaction so that expected cash
flows exceeds the required payments - the excess cash flows are
typically directed at a privately held equity tranche or are simply
returned to the originator
• Guarantees/Letters of Credit (LOC): Not so common anymore
• Dynamic measures: Conditional spread trapping, re-routing cash
between different waterfalls in case of shortfalls, making up short-
falls from subsequent cash flows, etc.
44 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema