A primer on structured finance
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Jobst, A. (2006a) ‘Sovereign Securitization in emerging markets’, Journal of Structured Finance, Vol. 12, No. 3, pp. 2–13.
Derivatives help “discover” the fair market price (spot and future) of certain assets or risks in instances of high transaction costs, poor liquidity due to the dispersion of markets, limited asset supply or the conglomeration of many risks into one whole asset.
In a cash-settled CDS, the protection seller is required to make a settlement payment in the amount of the difference between the notional principal and the market price of the underlying bond or the reduced recovery value of the defaulted bank credit. Alternatively, in what has increasingly become the market norm, physical settlement CDSs oblige the protection seller to accept the reference asset (or any other eligible collateral asset, such as cheapest-to-deliver (CTD) bonds) against payment of their par value. Unlike credit insurance contracts, credit derivatives are negotiable and attract large secondary trading.
Micu, M. and Upper, C. (2006) ‘Derivative Markets’, BIS Quarterly Review, Bank for International Settlements (BIS), 47.
Jobst, A. (2006b) ‘Correlation, price discovery and co-movement of ABS and equity’, Derivatives Use, Trading & Regulation, Vol. 12, No. 1–2, pp. 60–101.
Effenberger, D. (2003) ‘Frankfurt Voice: Credit Derivatives — Implications for Credit Markets’, Deutsche Bank Research.
This feature does not apply to plain vanilla asset-backed securities (ABS) and mortgage-backed securities (MBS).
Although the transformation and fragmentation of credit risk through securitisation brings greater diversification within the financial system, the structural complexity arising from multi-layered security designs, diverse amortisation schedules and the state-contingent funding of synthetic credit risk transfer might obfuscate actual riskiness of these investments and inhibit provident investment. The tradability of credit risk facilitates the synthetic assembly and dynamic adjustment of credit portfolios via secondary markets, but numerous counterparty links established in the commoditisation of securitised asset risk and wads of derivative claims also create systemic dependence susceptible to contagion on the risk of heightened aggregate moral hazard. This prospect of leveraged investment in synthetic structures seems to be particularly troubling when investors take on more risks for yield during times of compressed spreads and rising default rates when credit cycles approach their turning-point. Moreover, the contingent liability of credit derivatives as credit protection of securitised assets requires the protection seller to put up liquidity only if a credit event occurs.
‘Market developments testify to “structural substitution” in complex hybrid CDOs. After CDO-squareds (“CDOs of CDOs”) led to the narrowing of mezzanine spreads in the CDO market, leveraged super-senior tranches (SS) with marked-to-market (MTM) loss- and spread-based triggers emerged in a significant number of synthetic CDOs. Most recently, investment banks with significant mezzanine ABS inventory also began to employ leveraged super-senior (LSS) tranches in synthetic CDOs as an alternative method of hedging specific — and not diversified — mezzanine tranche exposure by offloading senior risk instead of selling credit protection or delta hedging. With the leveraged super-senior concept becoming exhausted, CDO managers are now introducing overlay structures that bring in other sources of risk, such as foreign exchange rates, inflation and commodity price linkages in order to juice up investor yields.’7Super-senior tranches themselves are usually secured by a CDS as a means of improving the marketability of issued claims.
Jobst, A. (2005) ‘Risk Management of CDOs During Times of Stress’, Derivatives Week, Euromoney, London, 28 November.
Both the Dow Jones iTraxx® Europe index of credit default swap (CDS) contracts and the iBoxx® index of collateralised (fixed-rate) debt obligations have inaugurated the first round of emerging standardisation. A recent survey paper by Cousseran and Rahmouni12 states that the development of liquid pricing benchmarks has greatly contributed to the maturity of the market for collateralised debt obligations (CDOs) as regards ‘an improvement in the transparency of the market, as tranche prices are continuously quoted; a significant increase in market liquidity […], allowing protection to be bought and sold at a lower cost […], an improvement in the management of market participants’ risk, as they now have access to daily valuations from which they can obtain […] levels of implied correlation […], [and] a broadening of the investor base to new market participants such as hedge funds, which use these instruments for their sophisticated trading strategies (correlation trading).’ Large parts of the ABS market in Europe have, however, shed little of their frequently deplored opacity. Market observers do not find a dramatic change in market transparency due to standardisation as much as they acknowledge changing hedging patterns of ABS issues in its wake.13 For instance, CDOs are generally structured to meet specific investor needs. In the past, issuers would hedge unbalanced positions of customised CDOs through complex subordinated, multi-tranche structures (‘transaction-based’), whose complexity inhibited transparent asset pricing. When the Dow Jones iTraxx® Europe index was created in June 2004 from the merger between two existing CDS indices, large issuers began to offer standard (single) CDO tranches on the iTraxx® index, which replicate the behaviour of synthetic CDO claims on constituent names of the Dow Jones iTraxx® index. These standardised (synthetic) CDO claims on liquid indices now offer a base correlation measure (‘CDO delta’) with the actual equity prices of (underlying) reference assets and constitute a dynamic ‘market-based’ hedge for issuers of bespoke and mostly privately transacted single-tranche transactions (arranged for single investors). Most recently, issuers also began to offer multi-tranche transactions with mezzanine tranches indexed to equity prices and tranche-specific CDS contracts on any retained CDO interest.
Cousseran, O. and Rahmouni, I. (2005) ‘The CDO Market — Functioning and Implications in Terms of Financial Stability’, Banque de France Financial Stability Review, No. 6, pp. 43–62.
Tsui, E. (2005) ‘Asia Poised for Take-Off in CDOs’, Financial Times, Capital Markets, 15 July.
The introduction of CDS indices contributed to hedging patterns thanks to greater standardisation. In the past, issuers would hedge unbalanced positions of customised CDOs through complex subordinated, multi-tranche structures (‘transaction-based’), whose complexity inhibited transparent asset pricing. When the Dow Jones iTraxx® Europe index was created in June 2004 from the merger between two existing CDS indices, large issuers began to offer standard (single) CDO tranches on the iTraxx® index, which replicate the behaviour of synthetic CDO claims on constituent names of the Dow Jones iTraxx® index. These standardised (synthetic) CDO claims on liquid indices now offer a base correlation measure (‘CDO delta’) with the actual equity prices of (underlying) reference assets and constitute a dynamic ‘market-based’ hedge for issuers of bespoke and mostly privately transacted single-tranche transactions (arranged for single investors). Most recently, issuers also began to offer multi-tranche transactions with mezzanine tranches indexed to equity prices and tranche-specific CDS contracts on any retained CDO interest.
The annual issuance volume worldwide has grown more than fourfold from US$ 48.1 billion in 1997 to US$ 193.5 billion by the end of 2004. In 2004, one out of four new CDO deals was synthetic (US$ 143.7 billion cash CDOs vs US$ 49.8 billion funded synthetic CDOs), up from one out of 20 in 1997 (US$ 45.5 billion cash CDOs vs US$ 2.7 billion funded synthetic CDOs). With new asset classes being securitised in CDO transactions, the market size of outstanding CDO tranches has reached an estimated US$ 800 billion by the end of 2004, which does not include privately placed transactions and unreported unsold tranches of bespoke, single-tranche synthetic CDOs.
Jobst, A. (2005) ‘Tranche pricing in subordinated loan securitization’, Journal of Structured Finance, Vol. 11, No. 2, pp. 64–96.
Jobst, A. (2005) ‘Need for Vigilance by CDO Investors’, Financial Times, Comments & Letters, 4 November.
Jobst, A. (2005) ‘Investors Must Heeds Those CDO Risks’, Financial Times, Comments & Letters, 19 April.
Although investors should expect the same returns for CDOs as for similar credit risk exposure in plain vanilla debt, their risk profile of CLOs tranches varies dramatically in response to changes in the valuation of the underlying (reference) asset.
Also Spain, Denmark and Sweden have established a long track record in the issuance of Pfandbrief-style investment products.
Skarabot, J. (2002) ‘Securitization and Special Purpose Vehicle Structures’, Working Paper, Haas School of Business, University of California at Berkeley. April.
The first ABS issue in its modern form was completed by Sperry Corporation, which issued computer lease-backed notes in 1985 (Kendall and Fishman, 1996).
Mastroeni, O. (2005) ‘Pfandbrief-Style Products in Europe’, Occasional Papers Series, European Central Bank, Frankfurt/Main.
Jobst, A. (2006c) ‘European securitization: A GARCH model of secondary market spreads’, Journal of Structured Finance, Vol. 12, No. 1, pp. 55–80.
Thus, synthetic arrangements effectively sidestep possible legal constraints associated with different loan characteristics and jurisdictions, mainly because most or all of the securitised assets are never sold to capital market investors.
Other, less relevant sinful activity under Islamic law in this context include hoarding, miserliness and extravagance.
These distinctive features derive from two religious sources, which aim at an equitable system of distributive justice: (i) the sharia’ah (or shariah), which comprises the qur’an (literally, ‘the way’) and the sayings and actions of the prophet Mohammed recorded in a collection of books know as the sahih hadith, and (ii) the figh, which represents Islamic jurisprudence based on a body of laws deducted from the shariah by Islamic scholars.
While the elimination of interest is fundamental to Islamic finance, shariah-compliant investment behaviour also aims to eliminate exploitation pursuant to Islamic law. Note also that Islamic law does not object to payment for the use of an asset. In fact, the earning of profits or returns from assets is encouraged.
See Archer and Karim27 as well as Iqbal and Llewellyn28 for an in-depth analysis.
Archer, S. and Karim, R.A., (eds.) (2002) ‘Islamic Finance: Growth and Innovation’, Euromoney Books, London.
Iqbal, M. and Llewellyn, D., (eds.) (2002) ‘Islamic Banking and Finance: New Perspective on Profit-Sharing and Risk’, Edward Elgar Publishing, Ltd, Cheltenham/UK.
Islamic debt instruments come in the form of murabaha (or murabahah) (cost-plus sale), salam (deferred delivery sale), bai bithaman ajil (BBA) (deferred payment sale), istina (or istisna) (pre-delivery, project finance) and quard al-hasan (benevolent loan) contracts, which create borrower indebtedness from the purchase and resale contract of an asset in lieu of interest payments. Interest payments are implicit in an installment sale with instantaneous or future title transfer for promised payment of agreed sales price in the future.
In Islamic asset or quasi-debt instruments (al-ijarah leasing notes) the lender leases an asset to the borrower for a specified rent and term. The lessor (ie financier) acquires the asset either from the borrower or a third party (at the request of the borrower) and leases it to the borrower for an agreed sum of rental payable in installments according to an agreed schedule. The legal title of the asset remains with the financier throughout the tenure of the transaction, who bears all the risk associated with the ownership of the asset. The asset is returned to the borrower for the original sale price or the negotiated market price unless otherwise agreed (as opposed to debt-based contracts, which require a higher re-purchase price inclusive of quasi-interest payments). If the lessee does not exercise the option to buy the assets a pre-determined price at maturity, the lender will dispose of it in order to realise the salvage value.
In Islamic profit-sharing contracts (mudharaba and musharaka), lenders and borrowers agree to share any gains of profitable projects based on the degree of funding or ownership of the asset by each party.
In a debt-based synthetic loan, the borrower repurchase the assets from the lender at a higher price than the original sales price, whereas borrowers under a lease-back agreement repurchase the assets at the same price at the end of the transaction and pay quasi-interest in the form of leasing fees for the duration of the loan.
El Qorchi, M. (2005) ‘Islamic Finance Gears Up’, Finance and Development (December), International Monetary Fund (IMF), Vol. 42, No. 4, pp. 46–49.
The underlying asset transfer of Islamic lending arrangements provides collateralisation until the lender relinquishes ownership at the maturity date. In equity-based Islamic investments lenders do not have any recourse unless pre-mature termination enables the lender to recover some investment funds from the salvage value of project assets.
The relationship between the put and call values of a European option on a nondividend paying stock of a traded firm can be expressed as PV(E)+C=S+P. PV(E) denotes the present value of a risky debt with a face value equal to exercise price E, which is continuously discounted by exp(−rT) at an interest rate r over T number of years. In our case of a lending transaction, the share price S represents the asset value of the funded investment available for the repayment of the debt obligation at future value E.
The lease payments by the borrower are received wash out in this representation.
The call option is extendible in that the borrower has the right to renew the option to eventually acquire the asset by making the required rental payments or retiring any upcoming obligation according to the investment contract. The borrower pays a periodic premium for the call option to compensate the lender for the short position on the underlying asset until final repayment at maturity. The put option +P(E) represents a series of cash-neutral, risk-free hedges of the lender's credit risk exposure. In corporate finance, borrowers (ie managers) would pay debt investors (ie lenders) a spread over the risk-free return (implied in the coupon yield) as option premium of their put on default risk if the asset value is insufficient to existing debt E (strike price). As opposed to holders of risky corporate debt with payoff PV(E)−P(E), financiers of such lending transactions own the underlying asset and hold a long put position on the firm value, which reflects the lender's full recourse for each installment repayment during the term of the transaction if the asset value S falls below the promised repayment level E.