Securitization in Financial Markets Development: An

Emerging Market Perspective

Dr. JAY SA-AADUChester A. Phillips Professor of

Finance and Real EstateUniversity of Iowa, U.S.A

African Capital Markets: The Next Investment Frontier

• Our Financial Field of Dreams– Develop new Financial Instruments– Develop deeper, more liquid , sounder and

more resilient capital markets– Raise capital more efficiently

• Remember the following two principles– Capital has no Conscience, and it is very more

mobile– Prosperity Makes Friends, adversity tries

Focus of My Talk

• Winds of Positive Change in Emerging Markets• The Financial Innovation of Structured Finance

and Securitization• Origin of the Sub-prime Mortgage (SPM) Debacle• Lessons from SPM Related Securitization• Using Securitization to Develop and Deepen

Domestic Bond Markets• Necessary Infrastructure Conditions• Areas of Focus and Potential benefits of

Securitization for African Capital Markets

Winds of Challenge: Perfect Alignment of Capital Market “gods”

• Capital Markets are springing up across the continent

• Spreads on emerging market bond index at historically low points

• Emerging market bonds constitute an important asset class

• International Investors starting to purchase local currency bonds

• African sovereign bond issues on the go• Critical vote of confidence in future financial and

economic stability

Appropriate Steps Taken to consolidate & enhance gains

• Enhanced macroeconomic performance– Better Monetary and Budget Policies– Currency stabilization and redenomination– Taming Inflation– Building Legal, accounting, regulatory infrastructures to

facilitate entry and exit all investors

• But much more needed to be done to reach potential– Outstanding emerging bond market only 40% of GDP,

compared to 140% for matured markets

The Innovation in Securitization: Don’t be Thirsty in the Middle of the River

• What is Structured Finance ?• What is Asset Backed Securitization ?

– Leveraging on good assets– Raise Capital at better terms– Manage Balance sheet– Risk Diversification– Transparency– Cash flows based solely on credit quality of underlying asset – Credit Enhancement Transfer asset risk to those best able to shoulder them

• The global outstanding ABS now in excess of US $10 trillion

Exhibit 1: The Basic structure of ABS

Sponsoring Company

•Assets

Special Purpose Vehicle

Sale orassignment

•Assets

The Separation of Two Business: Origination and Funding

IssuesAsset BackedCertificates

Servicing agreement

Asset securitization makes sense when the assets are worth more outside the company than within. But what makes them worth more?

Risk Transfer InstrumentsRisk Transfer Instruments

Traditional ProductsTraditional Products Capital Market Products**Capital Market Products**

SecuritizationSecuritization Credit DerivativesCredit Derivatives Other InstrumentsOther Instruments

Asset Backed Securities (ABS)Mortgage-Backed Securities (MBS)Collateralized Debt Obligations (CDO)

Credit Default Swaps (CDS)Total Return SwapsCredit Spread Options

Loan SalesBond TradingAsset Swaps

Credit InsuranceSyndicated LoansFinancial Guarantee

Collateralized Loan Obligations (CLO)Collateralized Bond Obligation (CBO)

Hybrid ProductsHybrid Products

“Synthetication”“Synthetication” “Pool of Pools- Hybrids”“Pool of Pools- Hybrids”

Credit-linked Notes (CLN)Synthetic CDOs

CDOs of CDOsCDOs of ABSs

Exhibit 2: Overview of Credit Risk Transfer (CRT) Instruments

Our focus

Primitive Assets/ReceivablesPrimitive Assets/Receivables

Basic Structured Finance (ABS)Basic Structured Finance (ABS)

Structured ABS with TranchingStructured ABS with Tranching

Synthetic CDO SecuritizationSynthetic CDO Securitization

Multiple Class of Tradable Derivative Securities(Structured Claims)

Single Class Tradable Derivative Security

Credit Risk transfer (CDS)Without Asset transfer

1ST Stage InnovationWhat is the innovation?

2nd Stage InnovationWhat is the innovation?

3rd StageInnovationWhat is theInnovation?

Mortgages, consumer credit (auto loans, credit card), equipment leasescommercial loans, student loans, aircraft lease, royalties, future flows, etc

Illiquid Assets (Primitive Asset)

Exhibit 3:Stages and Innovations Structured Finance (Securitization)

The Technology has Evolved Through Several Stages

Conventional CDOConventional CDO

Multiple Class TradableDerivative Securities Tranching & SubordinationOf Cash flows

4th Stage

Extensive use of Credit Derivatives

Originator(Asset Seller)

Special PurposeVehicle (SPV)

Investment Banks

Capital MarketInvestors

Sale of Asset Portfolio

Asset Cash Flows

Placement

PurchasePrice

Placement

PurchasePricePurchase Price

Obligors

Pla

cem

ent

PurchasePrice

Rating Agency •Debt Account•Collection of Principal & Interest

Trustee

•Paying office•Administration of transferred assets

Servicer Issued Securities•Single•Multiple•Equity (unrated)

CashFlow

Cash Flow

1ST Step: Sales of Assets to SPV 2nD Step: Issuance of Securities on the market

Other Keyparticipants

Credit Enhancement, Liquidity Support

Typically Provided byoriginator

Exhibit 4: Structural Characteristics of ABS Transaction

0

5

10

15

20

25

30

35

Default Frequency

1 2 3 4 5 6 7 8 9 10 11 12

Confidence Interval (99.5%)

Economic Risk Transfer

Before securitization

After Securitization

Expected Loss Unexpected Loss

Covered by economic capital

transferred risk exposure

Default Loss

Exhibit 5: Economic Risk Transfer to Capital Markets and Economic Capital Reduction

Before SecuritizationCovered by earned riskpremium and loan lossprovisionAfter Securitization

Retained risk exposure(First Loss Protection)

Origins of Subprime Mortgage Debacle: “Exuberant” Search for High Yields

• What are Subprime Mortgages?• Convergence of many factors -- 1997-2005

– Global Liquidity– Low Interest Rates– High Yield Securities -- MBS and CDO– Investment Banks– Growth and Stability– Subprime Mortgage Credit– Asset Price Bubble– Credit squeeze

• Bubble started to burst after 2Q 2006• The Rest is History• Question: Do you think SPM are bad and should be

banned?

Some Lessons from SPM Related Securitization

• Lesson #1: Real Business operations that create the assets and their credit quality are fundamental to financial and investment success of securitization

• Lesson #2: The complexity of some securitization structures may conceal the real risk of the new securities

• Lesson #3: Securitization may be susceptible to principal-agent problem

• Lesson #4: The value chain may only be as strong as its weakest link – systemic dependence or diffused responsibility

• Lesson #5: The prospect of the contagion – ability to provide liquidity support may diminish

Some More Lessons

• Lesson #6: Rating and Rating Agencies matter a lot for the well-functioning of markets for financial assets, especially, asset backed securities (ABS)

• Lesson #7: Back to Basic– Cash Flows come real business operation or LHS, not RHS of the balance sheet

• These are important lessons, BUT• Do not exaggerate or overreact

Mr. Chicken Little, Is the Sky of Securitization Falling?

• NO! Stay Calm, the Sky is Not Falling• The genie of financial innovation is already out of

the bottle, and is a good genie -- WHY?• Securitization has created dynamic & beneficial

relations between individual and business borrowers on one side, and the vast global capital markets that were previously non existent

• It has broadened access to credit for individuals and businesses at reasonable terms

How Does Securitization Create Value?

• Securitization creates value by rearranging the balance sheet to mitigate one or more markets imperfections– Information asymmetries– Incomplete Markets– Economic capital– Regulatory Capital– Taxes

• Translation: Capital Structure may not be irrelevant!

The Economics of Asset Securitization

“The Chicken Theory”

$6.99

Can you make money by cutting up the chicken? Where did Colonel Saunders get his idea from?

Whole chicken is worth $6.99

Incomplete market

$1.25

$2.95$1.40

$1.98

Cut and enhanced chicken $7.58Whole Chicken 6.99Economic Value Added $0.59

The Economics of Asset Securitization:

“The Chicken Theory”

How? “Go ask the Colonel for his secret recipe or you can homebrew your Own”

Should African Capital Markets “Enter the Kingdom of Securitization”?

• Emerging Economies of Africa should consider wading in the waters of the innovation of structured finance and securitization -- gradually– Several emerging markets have already embraced the

technology– Credit default swap (CDS) now constitute about 20% of

face value of emerging market debt– The World Food Program has sold futures on Ethiopian,

rains – Now that is EXOTIC– Argentine GDP-linked bonds

• Securitization may very well be a form of financial inoculation for African Capital Markets

What Should be the Priority Objective?

• Development of more inclusive and flexible debt market, characterized by efficient risk transfer , sound risk management , lower cost of capital, with all the necessary shock absorbers

• Complete Markets• Well-functioning capital markets will make

crucial contribution to growth and stability

The Necessary Conditions

• Uphold and protect the sanctity of property rights• Improve the legal environment to foster the use of

financial innovation• Strong standard for investor protection• Protection and enforcement of creditor rights• Prudent (not excessive) regulation and

supervision, by central banks an other regulatory bodies

• Subscribe to the maintenance of stable macroeconomic framework -- value proposition

The Necessary Conditions

• Overall improvement of financial infrastructure• Improve financial architecture• Appropriate governance and transparency• Clear and transparent bankruptcy code• Appropriate yield curves across all maturity

spectrum• Effective underwriting and hard-nosed auditing of

assets -- Where are the rating agencies?• Most of all financial transparency and honesty

What Do African Capital Markets Get for This Tall Order? -- The Benefits

• Inclusive and Flexible Capital Markets• Securitization of Future Flows to accelerate economic

growth• Access to capital markets for SMEs• Long Term Financing for Housing and Infrastructure• Transparency in risk pricing, mitigation and transfer• Capital Markets Integration• Lower cost of capital • Broader access to capital markets• More efficient capital utilization

Concluding Remarks

• I WOULD LIKE TO READ THIS