Perhaps a more intuitive way of thinking about the conversion pre- mium is to break it down into its constituent pieces. We have done this in the equation below:
This shows the value of the bond to the investor can be thought of in terms of what is received, that is the coupon, but the dividend is for- gone, because we have not yet converted, that is why it is subtracted in the equation. The other piece is the value of the embedded option.
The clearest way of illustrating how these components change with share price is with reference to Figure 1.20.
We can see from this chart that there are two main regions. We have the region to the right where the bond follows the share price and is said to be ‘in the money’. The premium in this region is very small because there is no longer any upside potential within the bond. The region to the left is where the current share price is below the conver- sion value and here the premium will be appreciable in anticipation of the share price rising.
within the US back in 1970 and indeed the North American market is still the largest.
The seeds of securitization were sewn by the Government National Mortgage Association (or GNMA). This government sponsored agency began issuing so-called mortgage pass through certificates. This is an asset-backed security representing participation in a pool of mortgages.
The mechanism works through each of the residential mortgage owners paying their monthly interest and sometimes redemption pay- ment into a central vehicle. A number of securities will subsequently be issued into the marketplace and purchased by investors. If we follow the path of an individual monthly mortgage interest payment it will not always go to the same security. Indeed sometimes it may represent a very small component of the coupon for the first asset issued and sometimes it may be a small component of the redemption payment for the second issue. The point is that the investor has absolutely no inter- est in the dynamics of a single person’s mortgage actions, however pooled together into many thousands it will be a relatively stable asset base which grows in a fairly predictable manner. It is the stable char- acteristics that the investor is buying into.
Implicit within the last paragraph, is the mechanism of securitiza- tion. This is virtually synonymous with asset-backed securities. We have described a pass through arrangement whereby the investor bears all the risks associated with the collateral. These risks can be rather unpalatable and consequently the arrangement as it stands might not be able to successfully issue the proposed securities into the marketplace. To avoid this possibility the backing may be consolidated.
This is typically known as credit enhancement because the risk is typically credit in nature. For example in our pool of mortgages some of the lenders may default. (However the mechanism could also mitigate pre-payment risk; some property holders may redeem early causing the investor a headache because instead of receiving a large coupon on a 10 year bond, for example, unexpectedly receives his capital in an unfavourable yield environment. The objective of enhancement is to mitigate this type of scenario, which has nothing to do with credit.)
So far we have discussed asset-backed securities purely from the investor’s perspective we wish to complement this with the motiv- ations for the issuer.
If an issuer has made a number of commercial loans, the bulk of which are financed at libor plus a credit related spread. The repack- aged loans can occasionally be funded at a lower rate because of their enhanced credit worthiness. This allows the package to be sold off at a comparable value to that derived at origination. The benefit then is
a transformed capital position, enhanced liquidity and perhaps most importantly less dependency on its traditional revenue stream.
Securitization can be represented as transference of risk to the cap- ital markets. The implication here is that the organization originating the collateral upon which the obligations are made has moved capital and its associated risk off the balance sheet. We draw a distinction between a true sale, whereby assets are physically transferred and risk transfer which is more common in Europe, this is not accompanied by any movement of capital – these are commonly referred to as synthetic.
This is key to understanding what has developed into a fairly disparate activity predominant within the European marketplace.
Everyone knows the example of the release of regulatory capital is a major motivation for banks to engage in securitization, but other busi- nesses adopt the method in order to target a lower cost of funding and ultimately an increase on shareholder return on equity (Table 1.3).
The company can also change its debt/equity ratio (or leverage) through these means. We illustrate how it is possible to achieve this in Table 1.3, depicting the reduction of debt on the balance sheet and the resulting saving in regulatory capital. (Applied at 8%.)
One question that may have occurred to the reader is where does the burden of credit analysis now lie? As you know, a commercial bank systematically evaluates the credit risk associated with the bor- rower prior to making a lending decision. In the landscape of asset- backed securities the lending is effectively advanced by the issuing entity through the sale of the asset-backed structure into the capital markets. The bank receives the proceeds upon transferring these assets into the entity (in the case of a true sale). It is the job of the rating agencies to subsequently evaluate the credit worthiness of both the collective pool of receivables and the resulting structure.
All public mortgage and asset-backed securities are rated by one or both of the large credit rating agencies such as Moody’s, and Stand- ard and Poor’s. This is now a specialist service, distinct from their stand- ard business of providing measures of company credit worthiness.
Table 1.3 The balance sheet pre- and post-securitization.
Holding Value (€M) Capital requirement (€M)
Initial portfolio 5000 400
Securitized amount 500 40 (on balance sheet)
Senior securities 400 None
Junior securtiites 100 None
Final portfolio 4500 360
Within a securitization structure it is normal for the issued secur- ities to be of good to high-investment grade (many issues launched in Europe are rated AAA/Aaa). The focus of the agencies is to evaluate both the resulting security structure and the characteristics of the asset backing. Usually a pass through arrangement will not provide sufficient protection to the investor and evaluation will be performed on the additional enhancement.
The amount of additional enhancement is determined by establish- ing the risk present within the collateral through stress testing which quantifies the effects of various loss scenarios, driven by either credit or market related events.
Once additional enhancement is required the question arises as to what forms are available. We refer you to Section 4.9 in Chapter 4.
In order to further discuss we need a diagram of the common elem- ents within a securitization structure. We refer you to Figure 1.21.
With reference to Figure 1.21 the original assets are sourced through the originator/servicer. The risks are transferred (or sometimes sold) to a special independent legal entity which can either have trust or company status. The main feature of the vehicle that comes into exist- ence is the enjoyment of a completely different credit character dis- tinct from the originating company. This is the so-called the SPV or special purpose vehicle.
The SPV being a separate legal concern, can now issue securities into the marketplace, which are evaluated by the rating agencies. We also see in this diagram an external credit enhancer. This can take the form of a cash collateral account segregated for the benefit of the company or trust. It is set up at the time of issue and used on the occasions when there are insufficient receipts within the pool to cover the required out- goings. The funds within the account are usually borrowed from a third party bank and will be returned once the issues have been repaid.
On this theme another mechanism is the so-called ‘collateral invested’ account representing an ownership interest in the trust. This works in the same way as the cash collateral account and makes up
Credit enhancer Securities issuer
Servicer Investor
Figure 1.21 The main elements of an asset-backed structure.
any shortfall needed to pay the investors. If funds are drawn down during a particular period they will usually be repaid later if the spread recovers.
Further reserve funds can be built up into separate ways. Either a portion of the profits upon issuance is placed on deposit, or the excess servicing spread is pooled (if any). These represent proceeds generated from the difference between the incoming payments and the debt ser- vicing payments.