7. Fnancial Innovation

Question 1

Q: What are different types of financial innovation?

Answer 1

a) Institutional innovation
Creation of new financial firms.

b) Product innovation
New products such as derivatives, securitized assets, foreign currency mortgages and so on. Are introduced to respond better to changes in market demand or to improve market efficiency.

c) Process innovation
New ways of doing financial business including online banking, phone banking and new ways of implementing IT-technology and so on

Question 2

Q: Examples of financial innovations?

Answer 2

a) ATM
b) Credit and Debit cards
c) Online payment systems like Paypal

Question 3

Q: Example of a bad financial innovation that was popular until 2008?

Answer 3

a) Collateralized Debt Obligations (CDOs):
Pool together various types of debt, such as mortgages, loans, or bonds, into a single investment vehicle. Divided into tranches that investors can buy.

b) Structured Investment Vehicles (SIVs):
Off-balance-sheet entities created by financial institutions, like banks. Designed to generate profit by borrowing money at a low short-term interest rate and investing those funds in longer term, higher yielding assets.

c) Credit Default Swap (CDSs):
Derivatives contracts that provide insurance-like protection against the default or credit risk of a particular debt instrument, like a bond or loan. Lets say you give a loan to a company. To protect yourself from the risk of default, you buy a CDS. You pay regular premiums to the seller of a CDS, and the seller promises to compensate you if a specific credit event occurs

Question 4

Q: Why did Collateralized Debt Obligations (CDOs), Structured Investment Vehicles (SIVs), and Credit Default Swaps (CDSs) fail during the 2008 crisis?

Answer 4

a) Collateralized Debt Obligations (CDOs):
Many of them were backed by mortgage-related assets, particularly subprime loans.

b) Structured Investment Vehicles (SIVs):
Failed due to the heavy reliance on short-term borrowing to finance long-term investments. When the crisis hit, the market for short-term debt froze. As a result, they faced liquidity problems, and many SIVs were unable to meet their debt obligations. The decline in the value of the underlying assets, particularly mortgage-related securities, further exacerbated their financial distress.

c) Credit Default Swap (CDSs):
Many financial institutions and investors bought and sold CDSs as a form of insurance against default risk. Problem arose when CDS market became highly speculative. Investors betting on failure of certain companies. Failure of one major institution triggered a chain reaction of CDS payouts, causing further financial instability

Question 5

Q: What is a CDS?

Answer 5

a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults.

Question 6

Q: What is Securitization?

Answer 6

Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.

Question 7

Q: What is Mortgage-backed securities (MBS)?

Answer 7

Securitization. Combines mortgages into one large pool, then divides the large pool into smaller pieces based on each individual mortgage’s inherent risk of default and then sell those smaller pieces to investors.

Question 8

Q: How does Mortgage-backed securities (MBS) create liquidity?

Answer 8

The process create liquidity by enabling smaller investors to purchase shares in a larger asset pool.

Question 9

Q: Economic benefits of Mortgage-Backed Securities?

Answer 9

“originate and distribute” - spreading out credit exposures, thereby spreading risk concentrations and reducing systemic vulnerabilities

Question 10

Q: What is Asset-backed Securities (ABS)?

Answer 10

Asset-backed securities (ABS) are securities backed by the cash flows of a pool of assets. The process involves transfering the ownership of the underlying assets to a special purpose vehicle (SPV) or a trust. The SPV then issues securities backed by the cash flows generated from the underlying assets. Investors can purchase these ABS, which represent a share in the cash flows generated by the underlying assets.

Question 11

Q: Benefits of Asset-backed securities (ABS)?

Answer 11

a) Allow financial institutions to convert illiquid assets, such as individual loans, into marketable securities
b) Provide diversification for investors by allowing them to gain exposure to a pool of assets rather than holding individual loans directly.

Question 12

Q: Give an overview of the securitization market

Answer 12

a) Mortgage-backed securities (MBS)
b) Asset-backed securities (ABS)
c) HELOANs are home equity loans;
d) HELOCs are home equity lines of credit;
e) CMBS are commercial mortgage-backed securities;
f) CDOs are collateralized debt obligations

Question 13

Q: What are the options of a company to raise new capital? And what are their cons?

Answer 13

a) Loan
Often very expensive due to credit rating of company and the associated rise in interest rates
b) Bond issue:
Often very expensive due to credit rating of company and the associated rise in interest rates
c) Issuance of stock:
Dilute the ownership and control of company

Question 14

Q: Explain the process of pooling and transfer from a company’s standpoint

Answer 14

1. The originator:
   Company wants to raise capital. Loan, bond issue or issuance of new stocks are not preferred.
2. Revenue-generating assets:
   Company has a constantly revenue-generating part. This part might be more worth than the company as a whole
3. Transform future cash flows:
   Sells the rights to the cash flows to someone else. Hence, transfers the income stream to a lump sum today.
4. Creating a special purpose vehicle (SPV):
   To facilitate the transaction, the company creates a special purpose vehicle (SPV). The company then transfer some of its assets to the SPV.
5. Originator loses claim:
   Once they are here, the company (originator) doesn’t have control or claim over them anymore. Company cant use it to pay its debts.
6. Involvement of an investment bank:
   The originator often seeks the assistance of an investment bank, known as the arranger, to help structure and set up the transaction.

Question 15

Q: The Process of Securitization (short):

Answer 15

1. Pooling and transfer
2. Issuance
3. Credit enhancement and tranching
4. Servicing
5. Repayment structures

Question 16

Q: The Process of Securitization: Pooling and transfer

Answer 16

1. Originator aims to raise capital.
2. Traditional capital-raising options like loans, bonds, or stock issuance may not be ideal.
3. Revenue-generating assets with a higher credit rating than the company as a whole are identified.
4. Selling the rights to future cash flows from these assets can provide upfront capital.
5. For originators subject to capital adequacy requirements, a separate company called a special purpose vehicle (SPV) is often created.
6. The assets are pooled and transferred to the SPV, which is formed specifically to fund those assets.
7. Once transferred, there is usually no recourse to the originator, and the SPV is “bankruptcy remote,” protecting the assets from the originator’s creditors.
8. The originator may seek the assistance of an investment bank (arranger) to structure the transaction.

Question 17

Q: The Process of Securitization: Issuance

Answer 17

1. To buy the assets from the originator, the SPV issues tradable securities to fund the purchase.
2. Investors purchase these securities through private offerings or on the open market.
3. Credit rating agencies rate the securities, providing an external perspective on the risk.
4. The performance of the securities is directly linked to the performance of the assets.

Question 18

Q: The Process of Securitization: Credit enhancement and tranching

Answer 18

1. Securities in securitization deals are “credit enhanced” to have higher credit quality than the originator’s debt.
2. External credit enhancements, such as surety bonds or parental guarantees, may be used.
3. Securities are split into tranches with varying degrees of credit protection or risk exposure.
4. Tranches have a cash flow waterfall arrangement, with senior classes being paid first and junior classes receiving repayment after.
5. Senior classes typically have higher credit ratings, while lower-credit quality subordinated classes have lower ratings.

Question 19

Q: The Process of Securitization: Servicing

Answer 19

1. A servicer collects payments and monitors the assets in the structured financial deal.
2. The servicer’s collection policy influences cash flows to investors.
3. Any remaining income after payments and expenses is usually accumulated in a reserve or spread account.
4. Bond rating agencies provide ratings based on collateral performance and credit enhancements.
5. The trustee, as part of the SPV, has a fiduciary duty to protect the assets and investors.

Question 20

Q: The Process of Securitization: Repayment structures

Answer 20

1. Most securitizations are amortized, with gradual principal repayment.
2. Prepayment models and controlled amortization structures help define repayment schedules.
3. Bullet structures involve single payments, with soft bullets being more common and hard bullets guaranteeing principal payment.
4. Securitizations can be sequential pay bonds (paid based on maturity) or pro rata bond structures (proportionate share of principal throughout the life of the security).

Question 21

Q: What is “credit enhanced”?

Answer 21

It means that measures are taken to improve the credit quality or reduce the credit risk associated with those securities. Credit enhancement techniques are used to make the securities more attractive to investors.

Question 22

Q: What are the key advantages of securitization to the issuer?

Answer 22

1. Reduce funding costs
   Can get cheaper loans
2. Reduce asset-liability mismatch
   Reduce risk of imbalance between assets and liabilities
3. Lower capital requirements
   Gets to remove assets from balance sheet while maintaining the “earning power” of the assets.
4. Locking in profits
   Predictable profit
5. Transfer risks
6. Off Balance sheet
   Securitization allows certain assets or financial instruments to be moved off the balance sheet.
7. Liquidity
   Assets securitized and sold. Now gets liquidity.

Question 23

Q: Key advantages of securitization to the issuer: Reduce funding costs:

Answer 23

Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. Can have big impact on borrowing costs

Question 24

Q: Key advantages of securitization to the issuer: Reduce asset-liability mismatch:

Answer 24

Securitization allows banks and finance companies to match their assets (such as loans or mortgages) with a corresponding funding source, reducing the risk of imbalances between the assets they hold and the funding they rely on. This can lead to more efficient and self-funded operations.

Question 25

Q: Key advantages of securitization to the issuer: Lower capital requirements

Answer 25

Some firms have a limit on how much debt they can have. By securitizing assets, which is considered a sale for accounting purposes, these firms can remove the assets from their balance sheets while still benefiting from the earnings generated by those assets. This can help them stay within their allowable leverage limits.

Question 26

Q: Key advantages of securitization to the issuer: Locking in profits

Answer 26

The profits associated with the asset becomes fixed and predictable. This reduces the uncertainty of future profits and allows the company to have a clearer financial outlook.

Question 27

Q: Key advantages of securitization to the issuer: Transfer risks:

Answer 27

Securitization enables the transfer of risks from one entity to another. For example, a company can transfer credit, liquidity, prepayment, reinvestment, or asset concentration risks to another party that is willing to bear those risks. This helps the company mitigate its exposure to potential losses or concentrate on more profitable business opportunities.

Question 28

Q: Key advantages of securitization to the issuer: Off Balance sheet

Answer 28

Securitization allows certain assets or financial instruments to be moved off the balance sheet. While there has been a trend toward recording derivatives on the balance sheet, securitization can still provide an avenue for off-balance-sheet treatment, freeing up capital and reducing the impact on the company’s financial statements.

Question 29

Q: Key advantages of securitization to the issuer: Liquidity:

Answer 29

When assets are securitized, the future cash flows associated with those assets become immediately available for spending or investment. This provides liquidity, allowing the company to access cash that was previously tied up in future cash flows. It also creates opportunities for reinvestment at potentially better rates.

Question 30

Q: What is amortization?

Answer 30

Amortization refers to the gradual repayment of a debt or loan over a specified period. In securitization, most securities are structured with an amortizing repayment structure.

Question 31

Q: What are the disadvantages of securitization to the issuer?

Answer 31

1. May reduce portfolio quality:
   The safest and highest quality assets often gets securitized first. Typically AAA ratings
2. Costs:
   Securitizations can be expensive for the issuer due to various costs involved, such as management and system costs, legal fees, underwriting fees, rating fees, and ongoing administration.
3. Size limitations
   The process of securitization can be complex and expensive. Might be more suitable for bigger businesses. For smaller or medium-sized transactions, costs may outweigh the potential benefits.
4. Risks
   a) Prepayment risk
   b) Credit Risk
   c) Retained Strips risk

Question 32

Q: What can be different costs related to securitization?

Answer 32

a) Management and system costs
b) Legal fees
c) Underwriting fees
d) Rating fees
e) Ongoing administration

Question 33

Q: What is “retained strips” in securitization?

Answer 33

Sometimes the issuer keeps a portion of the securities rather then selling them all. This is called a “retained strip”.

Question 34

Q: Explain the different risks associated with securitization

Answer 34

1. Prepayment Risk:
   There is a chance that borrowers may repay their loans earlier than expected. This can affect the expected cash flows
2. Credit Risk
   The underlying assets in the pool of securitization defaults or performs badly. Issuer might not receive full repayment
3. Retained Strips Risk:
   If the assets behind the securities perform poorly, the value of the retained strips held by the issuer can decline

Question 35

Q: What are the advantages of securitization to the investors?

Answer 35

1. Opportunity to potentially earn higher rate of return
2. Access to high-quality assets:
   Securitization allows for the creation of bonds with high credit ratings, such as AAA, AA, or A ratings.
3. Portfolio diversification
4. Isolation of credit risk:
   When assets are securitized, they are separated from the originating entity’s other assets. This separation allows the securitization to have a different credit risk profile than the parent entity. As a result, the securitization can potentially receive a higher credit rating than the parent entity, offering better terms and potentially lower interest rates.

Question 36

Q: What are the risks of securitization for the investors?

Answer 36

1. Liquidity Risk
   Borrowers not being able to meet their payment obligations.
2. Event Risk (Prepayment/reinvestment/early amortization)
   Event risk relates to factors that can cause the security to be paid off prematurely. This can include insufficient payments from borrowers, a rise in defaults, or a decrease in credit enhancements. Fluctuations in currency and interest rates can also impact ABS prices, with fixed-rate ABS being more affected by interest rate changes
3. Contractual agreements
   a) Moral Hazard:
   If deal manager earn fees based on performance, there may be a temptation to mark up the prices of the portfolio assets
   b) Servicer Risk:
   If the one collecting payments from borrowers and transferring them becomes insolvent. This is mitigated by having a backup servicer.