Banking Law notes recently updated for exams at top-tier British Universities. These notes, written at King's College London, cover all the LLB banking law cases and so are perfect for anyone doing an LLB in the UK or a great supplement for those doing LLBs abroad, whether that be in Ireland, Hong Kong or Malaysia (University of London). These were the best Banking Law notes the director of Oxbridge Notes (an Oxford law graduate) could find after combing through over a hundred LLB samples from ou...
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How to reduce risk:
Sharing amongst many through loan syndication and bond issue.
Getting security
Transferring to others through securitisation (to be covered now)
Hedging
Monitoring and influencing the borrower’s behaviour
Getting a better ranking than other creditors through subordination.
Overview:
What is asset securitisation?
Asset-backed securities
Collateralised debt obligations
Policy considerations
What is securitisation?
Definition:
Illiquid loan obligations (e.g. residential and commercial mortgages credit card receivables, commercial loans, et cetera) are pooled and repackaged as highly liquid and tradable debt securities that are supported by the underlying loan portfolio.
Purposes:
Risky loans are removed from the originator's balance sheet;
Reduced regulatory capital requirements;
Debt securities are more highly rated;
Lower cost of capital due to bankruptcy remoteness;
Spreading of risk;
Structured finance: Tranches with optimum risk attributes; and
Capital can be raised more widely.
Originate-and-distribute:
Originator has granted loans to B1 and B2 of 1000 each.
Assume that each loan carries a 10% risk of total default.
What is the expected value of each loan? How much would a risk-averse buyer be willing to pay?
Expected value = 900 each
Price that the risk-averse buyer will pay = Less than 900, because the risk-averse will “price in” the risk.
This give the originator an incentive to securitise rather than selling the loans directly on the markets.
B1 and B2 loans are sold (through an assignment of debt receivables) to an SPV.
This has to be a true sale.
This means that the SPV must be entirely separate from the originator (and definitely cannot be a subsidiary of the originator); if there is such a link, the loans will not disappear from the originator’s balance sheets because the balance sheets will still have to be consolidated in the end.
The loans are combined into a single pool.
The equity in the SPV is held by a charitable or purpose trust.
The SPV issues two tranches of debt securities.
Tranche 1: Receives the first 1000 coming in.
Tranche 2: Receives whatever else comes in.
The SPV pays the sale price of the loans to the originator through the proceeds of the issue of debt securities.
Financial Alchemy (1):
B1 and B2: 10% of default each
Tranche 1: 1% probability of default
Default only if both B1 and B2 default, and 10% x 10% = 1%
AAA credit rating (which is higher than the rating for B1 and B2 loans)
Higher yield than that for other AAA-rated instruments
Tranche 2: 19% probability of default
Fully paid only if B1 and B2 do not default (90% x 90% = 81%)
19% probability of default
This gives it high-yield (i.e. “junk”) status
But the market premium on T1 is large enough to offset the discount on T2.
Financial Alchemy (2): Collateralised Debt Obligations
T2 bonds of different securitisations are pooled
Special Investment Vehicle (“SIV”) issues two tranches
Senior: The first 1000 coming in
Junior: Whatever else comes in
Tranche 2: Bonds A and B have a 19% probability of default each
Senior tranche: A 3.6% probability of default
Default only if T2Aand T2B both default (19% x 19% = 3.6%)
AAB credit rating (higher than the rating of T2A or T2B)
Yield higher than that for other AAB rated instruments
Junior tranche: 34.4 probability of default
Fully paid only if T2A and T2B both do not default (81% x 81% = 65.6%)
34.4% probability of default
This gives it high-yield (i.e. “junk”) status
Two risky assets have been transformed into a safe asset and a very risky asset
Repeating the above: CDO-squared
Junior notes of different CDOs are pooled.
The SIV issues two tranches again.
Senior tranche: A 11.8% probability of default.
Junior tranche: A 57% probability of default.
Next step: CDO-cubed
Synthetic CDO
The swap counterparty does not have any real exposure to the reference portfolio or the different reference entities.
Nothing of any real value is being created here.
Fees are charged on all sides, and this is therefore an inefficient form of risk transfer between the parties.
Policy considerations
Advantages:
Lower cost of capital through risk reduction:
Risk transfer can be used to limit the lender’s exposure to particular borrowers, asset classes, or regions.
Diversification of funding sources:
Through financial alchemy (see above), the originator can reduce the riskiness of (certain tranches of) the bonds, and the AAA tranches can then be used to access investors that the originator would not otherwise be able to reach.
These investors include regulated financial institutions such as pension funds, trusts, and insurance companies.
These financial institutions also need not maintain as much capital (as against the bonds that they have invested in).
This is because capital adequacy requirements are measured against the riskiness of...
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Banking Law notes recently updated for exams at top-tier British Universities. These notes, written at King's College London, cover all the LLB banking law cases and so are perfect for anyone doing an LLB in the UK or a great supplement for those doing LLBs abroad, whether that be in Ireland, Hong Kong or Malaysia (University of London). These were the best Banking Law notes the director of Oxbridge Notes (an Oxford law graduate) could find after combing through over a hundred LLB samples from ou...
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