1.1 SETTING THE SCENE: ABOUT THIS BOOK

First of all—and before I forget: Thank you for buying this book.—I much appreciate your interest and curiosity.

As the subtitle of this book implies, we will be taking a close look at a securitization and structured finance “deal”. But, hang on a minute, there are so many different deals out there, spanning across many different asset classes as well as jurisdictions, so why are we looking at one “deal”?

The answer is simple: Our starting point for this journey is a generic deal, with no particular focus on asset class, deal structure, or jurisdiction. Based on the generics, I will guide you through along the way and would hope to develop your understanding so that you are equipped with the right tools, are able to ask the right questions, and consequently receive the appropriate answers.

Thinking about this introduction, I realized that there is really no such structured finance or securitization “college” or “university” course out there that would equip practitioners with the necessary tools and skills to just go away and structure or manage a deal throughout the transaction’s lifecycle for their firms. Clearly, there are many independent providers of courses (including more recently the rating agencies themselves), but with those courses being more theoretical in nature and typically only lasting a short duration (i.e., 2 to 5 days), don’t expect to walk away as a qualified structurer, underwriter, rating agency analyst, or securitization lawyer from such seminars.

Furthermore, a lot—if not most—of the practical knowledge and skills that are needed for these kinds of fairly complex activities are typically acquired over a long period of time on the job and by working with more experienced colleagues. However, as a direct consequence of the credit crisis, many banks and other financial institutions were forced to wind down some—if not the majority—of their structured finance-related business areas leading directly to a huge drain on experienced resource.

The knowledge in this book has been accumulated over at least 10 years including the “good” years, when this was a highly buoyant market as well as the four solid years of the 2007–2010 credit crisis—which many commentators referred to as the worst one of the last century. I am very grateful and indeed feel privileged to have been able to see both sides of the coin and to have been able to learn from both of them.

Whilst I can understand that some people may wish they could turn the clocks back pre crisis, when many institutions as well as individuals were doing very well, I can also understand an adjustment was probably overdue and with the crisis the pendulum had overswung. What we have seen since are many serious attempts to restore some kind of equilibrium. The danger here is of course that the securitization and structured finance market will be hit too hard with new regulatory requirements and essentially become prohibitively regulated.

Structuring a transaction can take anything from 2 to 6 months whereas the resulting structured finance deal is likely to be around for much longer—anything from 5 to 25 years, in extreme cases even considerably longer (usually due to specific legal or other requirements in certain jurisdictions).

The book’s key aims are twofold:

• To provide a solidly grounded back-to-basics approach that allows you to gain a quick understanding of the underlying key principles and sound practices for conducting these types of transactions.

• To give you a tried and tested set of tools to get you started in the structured finance market.

Please note, however, that the market itself has always been—and continues to be—in constant flux and, more recently, it has become increasingly difficult—if not at times impossible—to keep up with global developments. This leads to a higher level of uncertainty in terms of the form and shape the future market will actually evolve into. Taking a more generic deal view helps here in ensuring that most of this will be applicable to you in one way or another, no matter whether you are based in Europe, the U.S., or Asia—as I take a global view here.

I personally hope that you get value out of the book. If you have any comments—good or critical—please feel free to send them to me via the book’s companion website www.structuredfinanceguide.com or contact me at www.markuskrebsz.info

1.2 DIAGRAMMATICAL OVERVIEW OF DEAL LIFECYCLE STAGES

The following section provides a diagrammatical overview of deal lifecycle stages for a generic structured finance transaction. I emphasize the focus on generic as there may be slightly different steps depending on the asset class and jurisdiction that are involved. Figure 1.1 gives you a general overview of these deal lifecycle stages and also provide a roadmap to the book.

Following this overview you will find a more detailed roadmap (Chapter 2) dependent on the particular role you may currently be playing in the market (i.e., originator, issuer, deal structurer, arranger, lawyer, rating agency analyst, investor, portfolio manager, researcher, regulator, financial journalist, or other interested parties).

1.3 ROLE-BASED ROADMAP TO THE BOOK

Assuming that you are currently playing a particular role in the structured finance market, you would typically be more interested in certain areas and chapters more than others. Hence, I hope that you will find the following guidance with a focus on your particular area useful.

1.3.1 Originator, issuer, deal structurer, arranger

If you look at these roles logically, you may see that most of the chapters covering pre-close and at-close lifecycle stages are likely to be of most interest to these types of market players.

1.3.2 Investor, portfolio manager, asset manager

Equally, from an investor’s, portfolio manager’s, and asset manager’s perspective anything post close of a transaction’s lifecycle is likely to be most interesting for the analysis of transactions. However, in light of recent regulatory changes (e.g., requiring investors to undertake their own due diligence), some chapters on asset readiness are likely to be of interest to these roles too.

Figure 1.1. Generic deal life cycle stages

1.3.3 Lawyers, rating agency analysts, researchers, regulators, financial journalists and others that do not fit any of these categories

For the remaining readers, I’m afraid it pretty much depends what in particular you are after, so you are best advised to take a look in the table of contents as well as the comprehensive index at the back of the book to see if this helps.

Part I

The credit crisis and beyond

Looking back: What went wrong?

2.1 OVERVIEW

To answer the question, “Looking back: What went wrong?”, the answer can be succinctly given as “Quite a few things actually.”

But in all fairness, each of the following sore points on their own would probably not have led to the spectacular collapse of the structured finance market, in particular, and the global financial markets, in general. The combination of them, however, within the framework of globally operating and highly interconnected capital markets led to the chain of events that unfolded into the financial crisis 2007 to 2010.

This was then further exacerbated by a panicked reaction of the global financial regulators as well as market participants. For instance, the decision to withdraw formal support for Lehman Brothers in September 2008: I remember working for one of my clients who was at that time holding one of the largest portfolios of structured finance bonds—approximately 1,100 bonds worth around £45bn at the time—and many of these bonds were in one way or another exposed to Lehman credit risk as counterparties. The impact of Lehman’s bankruptcy on those bonds as well as countless transactions where it acted as credit default swap (CDS) or interest rate swap (IRS) counterparty was almost impossible to assess—you can imagine the tension in the air; something I will never forget.

Some call this “the law of unintended consequences” and I guess they are right. These panicky decisions were taken in a matter of days—sometimes hours—and the only people involved were usually senior government officials, central bankers, and the CEOs of all the big banks affected—not necessarily best placed though to understand the potential impact of their decisions on the market, particularly the structured finance market.

I don’t blame them: it’s just the way things were in those days in many institutions: information would be filtered before it actually hit the top level and in many cases senior management would only get to see part of the picture—not always able to properly understand the implications of what they did get to see. Another example was a client who was sitting on a sizable structured finance portfolio for years with senior management blissfully unaware of what “assets” were sitting in its books.

In order to develop best practice principles for the market post credit crunch it is important to understand what went wrong and why? Once the shortcomings have been identified, we will be able to look ahead and understand the requisites so that a better and more robust market develops.

Before we delve deeper into this in Section 2.2, please note that we will be taking a closer view at areas that are of particular importance for securitization and structured finance only. If you are after additional sources and reports covering the whole financial market and not only this subsector, then please refer to this book’s bibliography. Alternatively, search for “Financial crisis of 2007–2010” on Google which will help you identify the comprehensive coverage and the underlying problems that led to the credit crunch.

2.2 DATA, DISCLOSURE, AND STANDARDIZATION

When you as an individual are borrowing a substantial sum (e.g., for a mortgage) from your bank, the lender would like to become fairly comfortable that you will be able to repay the mortgage over the agreed period as well as ensuring that you have a sufficient regular income to service the interest payments for the term of the mortgage. You may call this process of gathering data and answers to relevant questions “due diligence”.

In order to support such due diligence activities as well as subsequent risk analysis your lender will typically request a considerable amount of information (i.e., data) so that he can support his decision and justify whether or not you have the creditworthiness and financial standing to service your principal as well as interest payments.

Some of the data used by lenders would be information about your financial history and possibly the use of a “credit score” of some kind, which simply puts you into one of various categories which expresses your presumed current credibility based on your past financial performance. This credit score would then be used as a measure to forecast and predict whether or not you may be able to repay the mortgage over the term of the loan.

You would expect the same lender to be even more prudent when using substantially larger amounts of (not quite his own money) to purchase, say, AAA-rated prime U.S. RMBS tranches. Amazingly, this was not always the case with structured finance investments as many investors turned to the credit rating agencies for such assessment instead.

For starters, rating agencies would typically receive larger amounts of data which enables them to undertake detailed analysis. Some of these data would have been treated almost as proprietary by the originators of such instruments and hence they would not offer the same level of information to investors of their structured finance bonds. Furthermore, rating agencies would also request considerable amounts of historical data in order to model the future expected (rating) performance of these structured finance bonds. The difficulty here though is that it is fairly difficult—in fact, almost impossible—to model future performance based on historical information because

• A rating model will always be a “model” and never be able to reflect true reality. In fact, as my dear friend Nassim Taleb would put it: “Models are always wrong, but some are harmful.” So please keep this in mind.

• People in the investment funds business know and understand this truth—hence they include a disclaimer in their prospectuses which states that “Past performance is no indication of future returns” which is not just a legal clause but a fundamental investment principle that should never be ignored.

Once the deals have been structured and issued to the market, there would be—depending on the asset class—considerable amounts of performance-related data (e.g., trustee, servicer, cash manager reports, etc.) available to investors. However, from an investor’s perspective, it can be a lengthy and tedious process to lift this information from these reports and change it into a comparable, digestible, and easy-to-process format to support the investor’s surveillance, performance, and risk analysis.

Even back in 2006 at the height of the market prior to its collapse there was a considerable amount of structured finance bond issuance in some asset classes which would report either in paper or near paper electronic format.

2.3 PAPER REPORTS

Paper reports can be sent by post or alternatively distributed as telefax. Paper reports do not generally provide an easy means of entering the information into a bank’s or financial institution’s proprietary performance analytics systems. You would literally need a team of “performance data coordinators” or similar who would lift (i.e., physically read) the information of these paper-bound reports and then enter them into the relevant systems. Even some of the rating agencies’ surveillance teams would process paper reports in such a fashion. You can imagine that this is not the most efficient process and in some case it can take considerable time from the receipt of those reports until they finally appear (e.g., on the rating agencies’ websites). Furthermore, if your institution has a file retention policy which, depending on the jurisdiction you are operating in, can be anything from 5 to 10 years after a transaction has matured (and some have maturity dates of 25 years or even longer), you will appreciate that the collection of various monthly investor reports for one single transaction can consume considerable storage space over the deal’s life. Let alone if you have several dozen of these transactions in your portfolio. Fortunately, the parties involved have recognized these issues and electronic reports are becoming much more common.

2.4 ELECTRONIC REPORTS

Reports in electronic format are considerably easier to distribute and store, but it depends a lot on the format of these files whether they are actually easier to use than paper files.

The most common electronic file formats are portable document format (PDF) and tagged image file format (TIFF) files. TIFF is used to store images and in this context are in essence scanned paper documents which are easy to distribute, but are similarly annoying to paper reports when processing them, as they are typically not searchable. Assume you have a 250-page portfolio manager’s report as a TIFF file and you are looking for certain key performance indicators: you will most likely have to flick through the pages on your screen to see whether you can find the data points you are after. Depending on the file format, you may be able to use optical character recognition (OCR) software in order to transpose such reports into an electronically readable format; but OCR software is usually not part of the standard desktop setup in a bank or financial institution.

Portable document files (PDF), on the other hand, are easily readable and electronically searchable and hence represent much better usability.

Both TIFF and PDF files have one major constraint: the data in these file formats are not easily exportable into Excel or similar programs and hence do not facilitate detailed analysis. Of course, you could use conversion software which transposes the information from PDF into Excel. In my experience, whilst such software may work with simple embedded PDF tables, it is not always possible to get the data into Excel without manual intervention.

Issuers of ABS deals are currently required to file their registration statements, current reports, and periodic reports in ASCII (American standard code for information interchange) or HTML (hypertext markup language). The SEC has in its proposed new ruling for ABSs (Release No. 33-197; 34-61858; File No. S7-08-10) suggested introducing a filing requirement in XML (extensible markup language) as an asset data file. XML is a machine-readable language and the SEC expects, by proposing this new disclosure requirement, that users of these data (such as investors) will be able to download this information directly into their proprietary spreadsheets and databases. As XML follows an openformat data structure, investors will be able to use off-the-shelf commercial software solutions to analyze it further or indeed are able to build their own analytical tools.

A key advantage of data in XML format is that the information can be processed automatically, without any great manual intervention. Further, it can also be “tagged” ensuring consistent structure of context and identity, which helps recognition and processing by a variety of analytical software.

2.5 DATA FEEDS

As an alternative to collecting individual files, and in particular if you are holding a large number of bonds (say > 500) and only have a limited amount of staff resources to look after the performance of such a portfolio, you may wish to consider a third-party vendor solution such as an automated data feed. Of course, such a service will usually come at considerable cost, but clearly can have additional advantages. These feeds can either come in the shape of an XML file which may be provided to you via FTP (e.g., ABSNet’s “scheduled export”) or you may be able to source the information directly into your proprietary applications via an application-programming interface (API), such as Bloomberg’s desktop and/or server API. Alternatively, you may be able to download specific performance information in a digestible and easily processable data format (e.g., Excel or CSV) from the credit rating agencies; this could either relate to individual deals you hold or you may also be able to source benchmark information (e.g., Fitch’s and S&P’s credit card index data) so that you can compare the performance of your deal(s) against the performance of the whole market sector by benchmarking your transaction(s).