Presentation

Christopher Laursen

Senior Consultant

Structured Finance in Post-Bubble Markets

PRMIA Washington, DC Meeting

Market and Liquidity Risk for Financial Institutions

May 4, 2009

Structured Finance: Background

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Structured finance encompasses all public and private financial arrangements that serve to refinance and hedge any profitable economic opportunity beyond the scope of traditional on-balance sheet securities (debt, bonds, equity) in the effort to lower cost of capital and to mitigate agency costs of market impediments on liquidity.

Structured Finance Defined

Source: Andreas A. Jobst, “What is Structured Finance,” IMF Working Paper (September 2005).

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Structured Finance Defined for the Masses

Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However, it arguably contributed to the degradation in underwriting standards for these financial assets, which helped give rise to both the credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2008

Source: Wikipedia

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Securitization Rates:Q1 1980 – Q4 2008

Sec

uri

tiza

tio

n R

ate

Home Mortgages Multifamily Mortgages Commercial MortgagesFarm Mortgages Commercial and Industrial Loans Consumer Credit Loans

Notes and Sources: Data from the Federal Reserve's U.S. Flows of Funds Accounts (Table L2, L125, L126) for the period 1Q 1980 through 4Q 2008.Share securitized is calculated as the percentage of loans securitized outstanding over total loans outstanding.

0%

10%

20%

30%

40%

50%

60%

1Q 1980

1Q 1982

1Q 1984

1Q 1986

1Q 1988

1Q 1990

1Q 1992

1Q 1964

1Q 1996

1Q 1998

1Q 2000

1Q 2002

1Q 2004

1Q 2006

1Q 2008

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ABS Issuance by Type:1990 – 2009

Global ABS Issuance by Type 1990 - 2009

0

100

200

300

400

500

600

700

800

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Issu

ance

(B

illi

ons

$)

Auto Credit Cards Equipment Home Equity Manufactured Housing Student Loans Other

Notes and Sources: Data from SIFMA. 2009 data is as of the end of Q1 2009.

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CDO Issuance by Type:Q1 2005 – Q1 2009

0

20

40

60

80

100

120

140

160

180

200

2005Q1

2005Q2

2005Q3

2005Q4

2006Q1

2006Q2

2006Q3

2006Q4

2007Q1

2007Q2

2007Q3

2007Q4

2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

Issu

ance

(Bill

ions

$)

HY Bonds HY Loans IG Bonds Mixed Collateral Other Other Swaps Securitizations

Source: SIFMA.

Structured Finance Demand: End-Investors

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End-investors - Who are they?

– Traditional money managers

– Pension funds, insurance companies, trusts

– Sovereign wealth funds

There remains natural demand for structured finance from end-investors who seek to maintain a diversified portfolio with a specified risk profile

Structured finance allows investors, whether slightly or highly risk averse, to invest in a diverse variety of asset classes that would otherwise be unavailable

– Risk tranching

– Subordination

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AAA

AAA

BBBBBB

Unrated

Collateral Senior Class

Mezzanine Classes

First-Loss Piece

Credit Tranching

Tranched securitizations can provide desired credit risk profile, derived from otherwise unavailable asset classes

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True diversification is still better than concentration, though standard deviation is only one estimate of “risk”

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Did “Diversified” Securitization Portfolios Reduce Risk as Expected?

Maybe not…

– In portfolios that diversified by holding Florida, Nevada, and California residential real-estate exposure

– For structured securities derived from mostly high-risk/subprime underlyings (which are highly correlated in a system downturn)

– Within a highly leveraged and interconnected system

– In the short-term, within panicked markets under mark-to-market accounting

– With a conflicted rating agency/origination model and end-investors who were too accepting

Many of these issues equate to faux-diversification, or uncertainty around underlying risk and diversification

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AAA

AAA

BBBBBB

Unrated

AAA

AAA

BBBBBB

Unrated

AAA

AAA

BBBBBB

Unrated

In Systemic Downturn, Are Varied Subprime Assets Diversified?

AAA

AAA

BBBBBB

Unrated

Senior Class

Mezzanine Classes

First-Loss Piece

Credit TranchingSubprimeCollateral

SubprimeCollateral

PrimeCollateral

CDOCDO

BBB

AA

BB

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Diversification with Subordination

Diversification: Portfolio of diversified cars; drive each of them into a wall at 60mph

Subordination: If 50% survive, all principal and interest returned

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Post-Bubble Market: End-Investors

Increased transparency of positions

Less (unnecessary) complexity

Better due-diligence and analysis

Markets/regulators make adjustments to reduce interconnectedness

Expansion of available structured finance products that provide better diversification opportunities

– Mortality/longevity

– Intellectual property rights

Structured Finance Need: Intermediaries

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Financial intermediaries have large interest in maintaining robust structured finance market

Originate-to-Distribute (OTD) has become buzzword in recent years, in reference to securitization/structured finance

CFOs and students of corporate finance think of OTD as “asset turnover”

Finance’s DuPont equation illustrates importance of turnover to the value of a financial institution, and the financial sector as a whole

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Corporate Finance:

– Corporations seek to maximize shareholder wealth

– Interpreted as maintaining stable (i.e., non-volatile) and growing Return on Equity (ROE)

– ROE components broken out by DuPont Equation:

ROE = Net Profit/Sales x Sales/Assets x Assets/Equity

re-written as:

ROE = Net Profit Margin x Asset Turnover x Leverage

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Traditional Banking Model

Traditional Banking Model

– Take short-term deposits (liabilities) and lend long-term (assets)

Works reasonably well with:

– Upward sloping yield curve

– FDIC deposit protection and regulatory oversight

– Satisfactory ratings (credit and regulatory)

– Management/staff that understands credit risk and bank operations

Traditional banking example: Auto Loans

– Bank earns: 6.0% on a 5-year car loan

– Pays: 1% p.a. on deposits

– Costs: 2.0% p.a. on operating costs, credit losses

– Net Profit Margin = 3%

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Traditional Banking Model ROE Results


– Net Profit Margin: 3%

– Asset Turnover (annual): 1x

– Leverage ($10 deposit/$1 capital): 10x

ROE = .03 x 1 x 10 = 30%

When regulators increase capital requirements and leverage declines…

ROE = .03 x 1 x 7 = 21%

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Originate-to-Distribute Model

Pure OTD Model

– Distribute (without recourse) all positions originated

OTD Example: ABS Auto Securitization

– Same level of average assets leverage as traditional bank

– Bank earns: 3% in fees and net interest for originating and warehousing car loans,

creating/tranching securitization, and distributing

– Costs: 2% for operations, legal fees, and funding

– Net profit margin = 1%

– Average time from loan funding to distribution: 2 months

– Turnover = 6x

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OTD Model ROE Results


– Net Profit Margin: 1%

– Asset Turnover: 6x

– Leverage ($10 Deposits/$1 Capital): 10x

ROE = .01 x 6 x 10 = 60%

When regulators increase capital requirements and leverage declines…

ROE = .01 x 6 x 7 = 42%

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When traditional bankers learned DuPont:

– Reduced balance sheets

– Increased fee-based income

DuPont does not have many factors to adjust:

– Leverage Regulators are increasing capital requirementsFAS 140 brings positions on-balance sheet

– Margins Funding costs cannot go below zero;Borrowers cannot afford credit above certain rates;Operational efficiency has limits;

– Asset Turnover: Still available….

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Two possible results from sustained reductions in financial institution leverage and asset turnover:

– Significant sustained loss of market value in financial sector

– Increased borrowing costs with commensurate slower economic growth

Oliver Wyman estimates that the market capitalization of the banking industry will stabilize at 30% lower than its peak in 2006

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Post-Bubble Market: Intermediaries

Less competition

Lack of public trust

Lack of pre-bubble leverage available to drive turnover

Injections of government leverage and “support”

Better underlying data collection and transmission

Objective and qualified credit-rating paradigm

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The World without Structured Finance

Less efficient capital allocation

– Increases borrowing costs

– Reduces potential economic growth

Contact Us

Christopher Laursen

Senior ConsultantWashington, [email protected]

© Copyright 2009National Economic Research Associates, Inc.

All rights reserved.

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Distinguished Panelists

Kyle Bass

– Managing Partner, Hayman Advisers LP

Robert Burns

– Chief, Exam Support & Analysis Section, FDIC

Phoebe Moreo

– Partner, Deloitte & Touche Securitization Transactions Team

Sylvain Raynes

– Managing Director, RR Consulting

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