Structured Finance Transactions Research Articles

A comparative analysis of ex ante credit spreads: Structured finance versus straight debt finance

This paper examines the pricing of structured finance (SF) – asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt obligations (CDO) – and straight debt finance transactions. Using a cross-section of 24,525 European bonds issued by financial and nonfinancial firms in the 2000–2016 period, we show that although ratings are the most important pricing determinant for SF and corporate bonds (CB) at issuance, investors rely on other contractual, macroeconomic, and firms’ characteristics beyond these ratings. We find that CDO tranches have, on average, higher credit spreads than similarly rated CB, while investors are not compensated for facing higher systematic risk components in relation to investment-grade ABS and MBS. Our results also support the hypothesis of SF transactions as mechanisms of reducing funding costs: SF transactions’ weighted average spread is lower than that of comparable CB and originating firms’ creditworthiness does not deteriorate when compared to a sample of matched firms.

Filling the Accountability Gap in Structured Finance Transactions: The Case for a Broader Fiduciary Obligation

This article examines the regime of legal liabilities designed to protect investors in complex structured finance transactions, notably collateralised debt obligations (CDO). In reviewing the duties and liabilities of the main actors involved in these transactions – namely directors, trustees and asset managers – the article critically assesses whether the existing law is adequate to hold them to account. It also explores more specific avenues to establish accountability, namely the law of misrepresentation and fiduciary law. The analysis shows that in the context of structured transactions there remains an accountability problem due to the extent of the applicable duties, the nature of the conflicts of interest, the problematic disclosure (misrepresentation) of the transactions’ risks. The article contends that the complexity of the legal relationships underpinning CDOs and the resulting asymmetry of information between financial institutions on the one hand and investors on the other pushes for either a broader application of fiduciary obligations or alternatively a statutory redefinition of structured transactions.

Beyond Auto Leasing: The Use of Titling Trusts in Structured Finance Transactions

A primary feature of most structured finance transactions is the initial transfer of the assets being financed. The time, effort, and expenses of an asset transfer may be an impediment to the execution of a successful transaction. For decades, auto lease transactions have mitigated this impediment through the use of titling trusts, which allow for the transfer of the beneficial and economic ownership of an asset without the necessity of transferring legal title. Auto lease titling trusts have gained broad acceptance in the structured finance markets, including supporting securitizations receiving the highest structured finance credit ratings. Recently, structured finance transactions involving real estate have begun to adopt the use of the titling trust to achieve the same viability, scalability, and efficiency found in auto lease transactions. Key Findings • The time, effort, and expense associated with transferring real estate can be a barrier to including real estate in structured finance transactions. • Real estate titling trusts can streamline the transfer process required to include real estate in structured finance transactions. • Although there are some challenges associated with real estate titling trusts, they are gaining acceptance in the market and at some point soon will be as widely accepted as auto lease titling trusts in structured finance transactions. TOPIC:Fixed income and structured finance

Cayman Islands Corporate Law as a Tool for Innovative CLO Warehouse Structuring

The Cayman Islands is well known to be the jurisdiction of choice for structured finance transactions due to its robust legislation and judicial framework, its creditor friendly nature, its familiarity to market participants (in particular, rating agencies), and the list goes on. What is less obvious, and arguably more intriguing, is the increased reliance on basic features of Cayman Islands corporate law to facilitate innovative structuring, particularly at the warehouse stage of a collateralized loan obligation transaction, and create greater efficiencies in transaction execution. The existence of these features is not novel; however, their increased adoption is. In this article, the authors explore the most commonly utilized features and the ways in which they support transaction innovation. <b>TOPICS:</b>CLOs, CDOs, and other structured credit; legal and regulatory issues for structured finance <b>Key Findings</b> • The flexibility of the Cayman Islands corporate regime allows for bespoke structuring. • There is an ever-increasing reliance on basic corporate law features to support transaction innovation. • Cayman as a jurisdiction is commercially responsive, facilitating efficient transaction execution through a robust statutory framework and evolving market practices.

Document Analysis Streamlined by Structure, Tagging, and Artificial Intelligence

Systems for creating and attaching metadata tags to document segments in structured finance transactions can allow for faster, more efficient, and less expensive review, analysis, and processing of those documents. Those systems can facilitate both the initial marketing of transactions and secondary trading. Metadata tags can be created and applied either manually or using artificial intelligence technology. In either case, once the tags have been applied, they can help every subsequent user of a document to understand its content more quickly and more thoroughly. Ultimately, open-access libraries of tagged documents may allow investors and other market participants to perform comparisons and cross-sectional analyses of deal attributes across whole categories of structured finance transactions. This has the potential to improve transparency while preserving a main benefit of securitization: providing creative and flexible solutions to turn relatively illiquid assets into tradable securities. <b>TOPICS:</b>Fixed income and structured finance, quantitative methods

Oversight and Due Diligence: Independent Credit Risk Managers and Trust Oversight in RMBS Transactions

In structured finance transactions, a trustee works collaboratively with the issuer and servicer to protect the financial interest of the investors. Large investors have been lobbying for residential mortgage-backed securities (RMBS) trustees to take on a more direct role to ensure that initial collateral conforms to the representations and warranties, put-back rights under the securitization’s reps and warranties are exercised properly, all loan documentation is properly executed and transferred, servicers are performing their duties, and adequate transparency is provided to the investors. RMBS trustees, however, are not currently equipped to handle any of these functions. Given the market and technical expertise required in the mortgage securitization arena, trustees could benefit from partnering with or retaining the services of an independent credit risk manager (CRM) steeped in a high degree of domain knowledge related to evaluation, modeling, stress testing, regulatory reporting, and complex asset credit underwriting. This article seeks to explain the role an independent CRM can provide in securitization of residential mortgages, with a specific focus on governance. <b>TOPICS:</b>MBS and residential mortgage loans, legal/regulatory/public policy, credit risk management

Too Complex to Perceive? Drafting Cash Distribution Waterfalls Directly as Code to Reduce Complexity and Legal Risk in Structured Finance, Master Limited Partnership, and Private Equity Transactions

This Article proposes that complex structured finance transactions involving sophisticated investors should adopt an analogous solution to the home construction agreements’ strategy of contracting by reference to blueprints. First, dealmakers should, preferably by choice, place as much of their waterfall distribution specification and related inputs as possible into automated, programmatic representations that will be used to make the actual distribution. In many cases, these agreements already have programmatic representations, so this change should pose relatively few practical challenges logistically. Second, they should, like their counterparts in construction contracts, define the terms of those waterfalls by reference to their functional representations. The contract should be depicted by the same code that will decide the actual distribution, and that coded depiction should be the legally binding contract. By unifying the functional and legal realities of the structured finance products, dealmakers will avoid wasting resources on creating unnecessary and inaccurate legal depictions, and will also reduce the legal and financial risk created by the imprecision and inaccuracy of perception those poor depictions create.

The path to impairment: do credit-rating agencies anticipate default events of structured finance transactions?

The global financial crisis (GFC) has led to a general discussion of the accuracy and declining standards of credit-rating agency ratings. Substantial criticism has been directed towards the securitisation market, which has been identified as one of the main sources of the crisis. This study focuses on the ability of rating agencies to adjust their ratings prior to impairments of structured finance transactions. We develop a new measure that quantifies a rating agency's performance in advance of defaults. By analysing a large number of impaired transactions rated by Moody's Investors Service, we find that rating quality deteriorated during the GFC. Furthermore, we identify tranche-specific and macroeconomic factors that explain differences in Moody's performance.

Improving Issuer–Investor Communication in U.S. Securitization Transactions

The U.S. securitization market has been addressing many of the lessons learned from the financial crisis in an effort to rebuild the market in a more sustainable and sound fashion. One theme recognized by an increasing number of market participants concerns improving the communication process between issuers and investors in structured finance transactions. As the private ABS market emerged in the mid-1980s and shifted the source of much of consumer finance from banks, as lenders, to capital markets investors, the fundamental relationship between lender and borrower changed, as the authority of the lenders was distributed across multiple investors. Under this model, efficient communication between issuers (i.e., lenders) and investors is important, especially in the context of amendments, waivers, and consents (AWCs). Moreover, the way in which issuers communicate with investors in the securitization market underwent a significant change with the adoption of Rule 144A, as private placement transactions took on many features of the public bond market, including the use of book-entry securities. Issuing securities in book-entry form creates a separation of legal and beneficial ownership of the underlying securities, which has visible implications for investor communication in the ABS market. This article looks at the way that issuers currently communicate with investors in the U.S. ABS market when looking to effectuate AWCs. It also examines some steps the market is taking to improve this process, including a solution that utilizes the distributive power of Bloomberg to deliver AWC notifications directly to end investors.

The Governance of SPVs in Structured Transactions - Is the Law Fit for the Purpose?

The paper investigates the operational and legal frameworks governing special purpose vehicles in the context of structured finance transactions. It seeks to assess whether the existing applicable law governing parties’ duties and liabilities in this very delicate area of finance is sound and fit for the purpose, and in highlighting its shortcomings, a number of proposals are presented.

Systemic operational risk: smoke and mirrors

Christmas 2009 did not bring much festive cheer to the shareholders of Australia's largest banks. On December 23, the so-called four pillars announced simultaneously that their subsidiaries in New Zealand had settled with the New Zealand Inland Revenue Department (IRD) in respect of long-running litigation that resulted in payments of unpaid tax and interest totaling some NZ$2.2 billion. The settlement followed a finding in October 2009, in the High Court of New Zealand, in favor of the local tax authorities regarding a series of "structured finance transactions", which the IRD claimed were specifically designed to avoid paying tax in New Zealand. The transactions in dispute, which numbered only around thirty across the four banks, were, at face value, highly complex and intricate, but, when stripped of the "smoke and mirrors" were little more than standard commercial loans. The profitability, or otherwise, of these disputed transactions depended very much on how profits, losses and tax were accounted for. Because of various tax treaties between New Zealand and Australia, the Australian parents of New Zealand banks are able, under certain circumstances, to offset operating losses against profits being repatriated from New Zealand. This, in effect, could turn a loss-making transaction into a powerful device for shielding profits from tax. The Inland Revenue argued that this tax benefit was, in fact, the "tax tail that wagged the commercial dog" in such transactions. New Zealand courts at various levels agreed with this interpretation and unanimously found that the banks concerned were using these transactions to avoid paying tax. This paper argues that the losses to the Australian banks incurred as a result of the New Zealand tax scandal were, for the most part, a result of systemic operational risk, and, in particular, legal risk. Using examples from published court cases, the paper identifies some of the legal risk that arose using these transactions. The paper then suggests proactive approaches to systemic risk management that should help detect and minimize the impact of similar scandals in future.

Independent Film Funding: A Structured Approach

Although the sale of film assets to investors on a portfolio basis is not a new idea, the mechanics and reasoning behind the vast majority of past deals would hardly qualify them to be true structured finance transactions. The combined effects of global recession and economic turmoil have forced many industries to explore new forms of structured financing. But the film industry has been extraordinarily resistant to applying any major form of statistical and predictive modeling. Many in the film industry are convinced that the wide range of variables related to movies is incapable of being successfully quantified in any significant manner. A viable means of doing such quantification for low-budget independent filmmaking exists, however, as does the application of this technique to the creation of a portfolio of films that is capable of achieving a reasonably precise overall predictive structure for the financial management of that portfolio. The authors believe the structure presented in this article can provide efficient, long-term, and flexible funding to independent films and introduce to the indie community an entirely new suite of capital management techniques. As a byproduct, it goes a long way toward the creation of an essentially new asset class with previously unseen and yet to be explored correlation properties. <b>TOPICS:</b>Portfolio theory, other real assets

Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study

The major cause of the financial crisis in the U.S. was the collapse of housing and mortgage markets resulting from an accumulation of an unprecedented number of weak and risky Non-Traditional Mortgages (NTMs). These NTMs began to default en mass beginning in 2006, triggering the collapse of the worldwide market for mortgage backed securities (MBS) and in turn triggering the instability and insolvency of financial institutions that we call the financial crisis. Government policies forced a systematic industry-wide loosening of underwriting standards in an effort to promote affordable housing. This paper documents how policies over a period of decades were responsible for causing a material increase in homeowner leverage through the use of low or no down payments, increased debt ratios, no loan amortization, low credit scores and other weakened underwriting standards associated with NTMs. These policies were legislated by Congress, promoted by HUD and other regulators responsible for their enforcement, and broadly adopted by Fannie Mae and Freddie Mac (the GSEs) and the much of the rest mortgage finance industry by the early 2000s. Federal policies also promoted the growth of over-leveraged loan funding institutions, led by the GSEs, along with highly leveraged private mortgage backed securities and structured finance transactions. HUD’s policy of continually and disproportionately increasing the GSEs’ goals for low- and very-low income borrowers led to further loosening of lending standards causing most industry participants to reach further down the demand curve and originate even more NTMs. As prices rose at a faster pace, an affordability gap developed, leading to further increases in leverage and home prices. Once the price boom slowed, loan defaults on NTMs quickly increased leading to a freeze-up of the private MBS market. A broad collapse of home prices followed.

Trustee Representation in Structured Finance Transactions

Certain fundamental trustee issues arise in virtually all financings involving a trust structure. Significant concerns for trustees include capacity, indemnification, direction, and limited responsibility. It is vitally important that counsel and other deal parties distinguish between the trust and the individual and trustee capacities of the trustee, and also that they take particular care to limit the power and authority of the trustee such that the trustee’s risk (and associated fee structure) remains low, while allowing the parties with a material interest in the transaction to retain control. A comprehensive understanding of these matters by counsel and other deal parties is critical to ensure an efficient closing. <b>TOPICS:</b>Currency, portfolio construction, portfolio theory

Trustee Representation in Structured Finance Transactions

Trustee Representation in Structured Finance Transactions

Are Credit Enhancements Risk-Sensitive? A New Technique for Evaluating Structured Finance Ratings Performance

This article looks at the relationship between credit enhancements supporting structured finance transactions and the realized credit performance of the underlying pool of collateral assets. Based on samples of structured finance transactions across U.S. commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), credit card asset-backed securities (ABS), and auto loan ABS, the study finds a positive correlation between the size of enhancement levels (at a given rating category) and statistical measures of realized collateral performance, encompassing a broad range of vintages. More specifically, higher enhancement levels are generally associated with weaker collateral performance; however, the correlation and statistical robustness of this relationship vary across asset classes and rating levels. As a measure of structured finance ratings performance, this technique has the advantage of explicitly analyzing both enhancements and collateral and helps to provide insight into the sensitivity of enhancements to differences in risk profiles of pools of collateral assets. <b>TOPICS:</b>MBS and residential mortgage loans, CMBS and commercial mortgage loans, asset-backed securities (ABS)

Off-Balance-Sheet Transactions: The Changing Landscape

The balance sheets of lenders, sponsors, servicers, managers, and investors in structured finance transactions are likely to change as a result of the accounting amendments recently issued by the Financial Accounting Standards Board (FASB). FASB Statement 167 (FAS 167) will affect who consolidates entities known as Variable Interest Entities (VIEs). VIEs are entities in which the equity holders may not be the controlling parties; therefore, a consolidation model is provided to identify the controlling party. The new guidance in FAS 167 redefines the entities that must be evaluated under this model, the consolidation model itself, when the assessment must be performed, and the related financial statement presentation and disclosures. It also increases the degree of judgment that will be required in the process. FAS 166 and FAS 167 also bring the United States closer to convergence with International Financial Reporting Standards (IFRS), which many believe will become the single set of high-quality accounting standards used globally. The elimination of the Qualifying Special-Purpose Entity (QSPE) and the move to a qualitative consolidation model based on control (with regard to both power and benefits) is closely aligned with the requirements of IFRS. And further amendments are possible as the FASB and IASB move forward with the current consolidation project. <b>TOPICS:</b>Other real assets, credit default swaps

How Robust Is Your Structured Finance Transaction?

Structured finance transactions are increasingly under scrutiny by tax authorities. They are suspicious that the driving motivation behind such transactions is tax avoidance. This places all structured finance transactions in a spotlight of tax uncertainty and makes them a source of potential disclosures under Section 404 of the U.S. Sarbanes-Oxley Act of 2002 (SOX 404) and the Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48) (Accounting for Uncertainty in Income Taxes).This paper sets out principles successfully implemented in South Africa to overcome and decrease risk exposure on structured finance transactions. The South African tax authority (South African Revenue Service or SARS) aggressively pursues and investigates structured finance transactions, causing turmoil in the financial services sector. The principles applied may also be applicable in other jurisdictions around the world.

Rating Performance and Agency Incentives of Structured Finance Transactions

The mismatch between credit ratings o fstructured finance transactions and their true risks has been a source of the Global Financial Crisis which manifested in criticism of models and techniques applied by credit rating agencies (CRA). This paper provides an empirical study which assesses the historical performance of credit ratings for structured finance transactions and finds that CRAs do not include all factors explaining securitization impairment risk. In addition, CRA ratings for selected asset categories underestimate risk in origination years when the fee revenue is high.

What was Wrong with Credit Ratings for Securitizations? - Evidence from ABS, CDO and MBS Markets

This paper compares and analyzes cross-sectional and time-series characteristics of credit rating agency (CRA) ratings, implied impairment rate estimates and realized impairment rates of asset portfolio securitizations. This is of highest importance as past shortcomings may have been instrumental to past, current and possibly future loss rates of financial institutions in relation to securitizations. The disappointment of investors manifested in the criticism of models applied by CRAs. Examples are VECTOR from Fitch, CDOROM from Moody's and CDO Evaluator from Standard and Poor's. Our most substantial finding is that rating agencies do not include all factors explaining securitization impairment risk. In particular, the state of the economy is not addressed as CRAs average over the business cycle. The results are threefold. Firstly, CRA ratings are unable to predict impairment risk. Secondly, CRA ratings over-predict impairment risk in boom years and under-predict impairment risk during economic downturns. Thirdly, the recent deterioration CRA rating standards can not be confirmed and may be a result of an economic downturn which was not predicted by CRA ratings. Additional results are that CRA ratings for securitizations do not fully account for the average credit quality in asset portfolios and do not fully account for structural elements of structured finance transactions. Such elements include the subordination level, the resecuritization status and principal payment years. The inclusion of missing information, in particular the impact of the economy, is paramount to a sound measurement and management of impairment risk. Transparency may increase with the accurate econometric forecasting of such risk. Credibility in internal and external models may not be restored otherwise.