I. Introduction.

In the lexicon of previous decades financial intermediation occurred when banks and non-bank financial institutions, such as insurance companies, accepted funds from depositors or other investors and channelled these funds at some margin to businesses and households by means of lending. Originators of loans used to hold such loans on the books until these asset claims matured, rolled over or terminated once debtors went insolvent. The corresponding credit risk was the prime focus of banks and non-banks, which applied forecasting models to estimate the probability of incurring bad debt, whereas interest rate risk could be managed by ensuring that the contractual interest rate on the loan varied with the cost of funds.

Over the last two decades, however, non-bank financial service providers, such as investment banks, captive finance companies and insurance firms have posed a formidable challenge as contenders in the intermediation process, employing the same technological advances as banks. Since the 1980s important technological changes have been taking place in the "old-fashioned" business of financial intermediation. Chief among the innovations introduced at major banks has been securitisation, which--in a general sense--reflects the substitution of credit finance by capital market-based finance. Generally, securitisation represents a structured finance transaction, where receivables from a designated asset portfolio are sold as contingent claims on cash flows from repayment in the bid to increase the issuer's liquidity position and to support a broadening of lending business (refinancing) without increasing the capital base (funding motive). Aside from being a funding instrument, securitisation also serves (i) to reduce both economic cost of capital and regulatory minimum capital requirements as a balance sheet restructuring tool (regulatory and economic motive), (ii) to diversify asset exposures (especially interest rate risk and currency risk) as issuers repackage receivables into securitisable asset pools (collateral) underlying the so-called asset-backed securitisation (ABS) transactions (hedging motive).

Much attention has especially been devoted to asset-backed securitisation (ABS), i.e. the mechanism by which individual, illiquid financial assets are converted into tradable capital market debt instruments (The Bond Market Association, 2001). Asset-backed securitisation (ABS)--usually backed by a portfolio of a large number of homogenous receivables in terms of seasoning, nominal value and remaining maturity (sec Appendix 3 for a specific break-down of the securitisation process and its characteristics)--is an asset funding tool for financial institutions as a surrogate of deposit-based refinancing as well as a modern form of corporate finance as a substitute for classical credit. Particularly banks have embraced a new form of ABS, the collateralised loan obligation (CLO), as a means to curb credit risk by outright selling portions of a large loan portfolios to investors. In the conventional type of such transactions a portfolio of pre-selected loans is transferred from the balance sheet of the originator to a special purpose vehicle (SPV) (1), which refinances itself by issuing securities on this reference portfolio to capital markets at a margin (Burghardt, 2001) (2). Typically institutional investors are the prime investor group for such transactions. Besides the obvious benefit of improved credit risk management, CLOs enable issuers to achieve a broad range of financial goals, which include the off-balance sheet treatment of securitised loans, reduced minimum regulatory capital requirements and access to alternative sources for asset funding of lending activities and liquidity support.

The move towards such capital market-based investment funding is reducible to various causes. (3) First, recent financial crises have led to a general shortage of investment funds and heightened competition for low-risk borrowers. Second, the deregulation and liberalisation of international financial markets as well as technological advances have elevated market efficiency to a level amenable to two strands of asset securitisation. On the one hand, the issuing of debt securities by banks and non-bank financial institutions as well as corporations has posed a formidable challenge to traditional channels of asset funding through bank-based external finance and deposit business. On the other hand, securitisation of balance-sheet assets has also drawn in banks and financial service companies alike as rising sophistication in credit risk management have facilitated continuous innovation in structured finance products and derivative instruments (Eichholz, 2000).

Since financial markets have displayed a remarkable shift towards the substitution of securitisation of bank assets for traditional loan finance, the issue of debt securities, collateralised by an underlying portfolio, as a form of structured finance holds the prospect of completely transforming the traditional paradigm of intermediation. In securitisation asset risk is transferred to capital market investors in return for cash flows generated from an asset portfolio (reference portfolio), whose repayment risk is sliced into tranches, with the most junior tranche typically bearing any initial losses (first loss position) according to a subordination routine of loss allocation. (4)

For the securitisation process (see Exhibits 34-37 in Appendix 3) allows issuers to lower their cost of investment funding by segregating assets in terms of risk, securitisation is understood as an important risk reduction tool in the spirit of Skarabot (2002) as well as Rosenthal and Ocampo (1988). (5) The Bond Market Association (2001) considers securitisation "an increasingly important and widely-used method of business financing throughout the world, [given that its] continued growth and expansion ... [generates] significant benefits and efficiencies for issuers, investors, securities dealers, sovereign governments and the general public." Both mounting competitive pressure over client deposits and a notorious squeeze on interest spreads have led banks to the employ securitisation as a vehicle for balance sheet management. Frequently, this involves more complicated financial structures of packaging the risk of bank assets. The complexity of these structures is rooted in regulatory requirements for insulating investors against a multiplicity of impending risks arising from credit default (credit risk), an adverse movement of market prices (market risk) and the inability of the issuer of the security to honour scheduled payment obligations to investors (liquidity risk) in the wake of a securitisation transaction. By convention, these risks are managed by the originating institution on an institutional basis with the backing of the institution's equity base. However, as financial institutions have faced additional complexity in securitised asset pools with few uniform characteristics, maintaining investor confidence is rendered difficult in the quest for external funds, as banks operations need to cater to various stakeholder interests in financial intermediation at the same time. Doing so will become imperative if banks can use securitisation as a prime asset funding tool to reduce both risk and regulatory capital requirements.

Generally, mortgages and receivables are the most common asset classes issuers transfer to special purpose vehicles (which issue securities to refinance the purchase). Although securitisation has been traditionally used by commercial banks to finance these simple, self-liquidating assets such as mortgages, bank loans and consumer loan receivables, it is now also used for infrastructure and project finance. Besides securitising a wide variety of bank loans, including short-term commercial loans, trade and credit card receivables, auto loans, first and second mortgages, commercial mortgages and lease receivables, banks have also turned to small business loans and middle-market commercial loans as suitable for securitisable reference portfolios (see Exhibit 3). The evolution ofsecuritisation has produced two prime asset classes that serve as underlying collateral. Apart from structured leasing and project finance, alternative means of external investment finance (6) vie for the attention of firms, whose credit standing influences their mode of funding, such as small and medium-sized companies (SMEs). (7) Whereas the securitisation of corporate and sovereign loans, auto loans, credit card receivables, project finance or individualised lending agreements and alike (Investment Dealer's Digest, 1997; Standard & Poor's, 1996) are categorised as asset-backed securities (which is also the generic term for securitised assets irrespective of their type), private and commercial mortgages are called mortgage-backed securities (MBS). (8)

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A. Definition of Asset-Backed Securities (ABS)

Over the last 20 years the market for asset-backed securities has been growing steadily, swelled by many new heterogeneous issuers. (9) In contrast to the U.S., where the market for ABS has had a longstanding tradition since the first half of the 1980s (10) (Klotter, 2000), European ABS only began to display dynamic growth since the mid-1990s. Nonetheless, Pfandbrief structures ("on-balance sheet" mortgage-backed securities mostly by German issuers) (11) have been an established method of securitising a homogenous reference portfolio for more than two centuries. (12) Actually, the Pfandbrief market has developed into one of the largest fixed income markets in Europe. Especially since 1995 asset-backed securitisation (ABS) has been used by many in the financial service sector as well as corporations as a preferred asset funding technique to achieve a more efficient use of capital and return on equity (Bar, 1997; Laternser, 1997). Recently, the issue volume of both mortgage-backed securities (MBS) and collateralised debt obligations (CDO) has surged at an impressive scale despite depressed expectations from interest-based income and the search for alternative sources of asset funding. Both types of ABS transactions have become an important segment of the European bond market as banks, non-bank financial intermediaries (NBFIs) and corporations favour more flexible funding mechanisms. Hence, ABS issues have caught up with Pfandbrief transactions as one of the largest (by outstanding volume) fixed income markets in Europe. By the end of 2000 the ABS market had grown six times its size in 1997 (Walter, 2000), which reflected the growing wish of issuers to parcel assets into portfolios to structure stratified debt claims issued to capital market investors.

The strong increase in issuance and trading of ABS are often attributed to three causes, i.e. issuer's desire to manage risk beyond what would be possible through portfolio diversification, balance sheet restructuring (i.e. to shore up the quality of the balance sheet) and regulatory capital relief; particularly against the backdrop of weak equity markets and stronger performance of fixed income markets (Burghardt, 2001). (13) By the end of 2001 bank-sponsored loan securitisation alone involved over U.S.$200 billion in outstanding securities worldwide, (14) whose volume accounts for roughly 20 percent of the aggregate credit activities of their sponsors.

As ABS transactions help issuers to improve their returns through off-balance-sheet financing and longer-term securities (Bhattacharya and Fabozzi, 2001; Fabozzi, 1996), this type of securitisation has been and continues to be a popular funding source for many financial institutions and corporations. ABS is particularly appealing to firms who have failed to receive an investment-grade rating or no rating at all, as a securitisation of future cash flows is covered by various structural provisions for the issuer to receive an investment-grade rating on the transaction. Securitisation enables issuers with a sufficiently high level of balance-sheet assets to transfer future cash flows generated from operations to a special purpose vehicle (SPV), which refinances this acquisition of assets by means of issuing debt securities to capital market investors (Andersen Consulting, 2001). (15)

Under an ABS transaction selected receivables (assets) are packaged together into a pool and sold by the originator to a special purpose vehicle (SPV). The SPV refinances the pool by issuing tradable commercial paper as debt interest secured by the assets (Bayerische Landesbank, 2000). The ABS structure allocates proceeds generated from an underlying collateral (reference portfolio) of receivables (asset claims) to a prioritised collection of securities issued to capital market investors in the form of so-called tranches. This allocation of proceeds from a reference portfolio as a means of asset funding also extends to the distribution of losses, which the issuer of a securitisation may incur until the transaction reaches the designated maturity date. Individual security mechanisms, so-called liquidity and/ or credit support, offer protection against bad debt loss. Asset-backed securities with first class ratings are particularly marketable.

Financial institutions resort to ABS primarily to increase the issuer's liquidity position and to support a broadening of lending business without increasing the capital base. Besides being a source of more competitive total weighted funding costs, ABS is not only used as a funding instrument. Corporate and banks, the two most important types of ABS issuers, often manage their balance sheets and diversify their assets by repackaging the cash flows of their asset portfolios in ABS transactions (Schwarz, 1997).

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Over the years general financial innovation and the flexible security design of asset-backed securitisation has encouraged issuers to consider a variety of asset types in underlying reference portfolios (see Exhibit 3), where mortgage-backed securities (MBS), real estate and non-real estate asset-backed securities (ABS) and collateralised debt obligations (CDO), form the three main categories of ABS (in a broader sense). The worldwide breakdown of outstanding ABS issues until 2002 is illustrated in Exhibit 4 above (J.P. Morgan, 2003).

B. Definition of Collateralised Debt Obligations (CDOs)

As a result of recent favourable regulatory changes, structured finance has evolved into a viable and rapidly advancing sector especially in Europe. One type of asset-backed security especially has put securitisation on the agenda of banks and other financial service providers across the world-collateralised debt obligation (CDO). In a collateralised debt obligation (CDO) structure (Fabozzi and Goodman, 2001), the issuer repackages (corporate or sovereign) debt securities or bank loans into a reference portfolio (the collateral), whose proceeds are subsequently sold to investors in the form of debt securities with various levels of senior claim on this collateral. The issued securities are structured in so-called senioritised credit tranches, which denote a particular class of debt security investors may acquire when they invest in a CDO transaction. The tranching can be done by means of various structural provisions governing the participation of investors in the proceeds and losses stemming from the collateral. Subordination is one of the most convenient vehicles for attaching different levels of seniority to categories of issued securities, so that losses are allocated to the lowest subordinated tranches before the mezzanine and the senior tranches are considered. This process of filling up the tranches with periodic losses bottom-up results in a cascading effect, which conversely applies in the distribution of payments from collateral by the issuer. Both interest and losses are allotted according to investor seniority. So the prioritisation of claims and losses from the reference portfolio guarantees that senior tranches carry a high investment-grade rating (triple-A or double-A rating), provided sufficient volume of junior tranches have been issued to shield more senior tranches from credit losses. (16)

A broad categorisation of CDO deal structures has been proposed by Herrmann and Tierney (1999) as well as by Duffle and Garleanu (2001). The classification of CDOs depends on possible variability in the valuation of the collateral ex post the issuance of securities. In market value CDOs (see Exhibit 5 below) the allocation of payments to the various tranches depends on the marked-to-market returns on the reference portfolio underlying the transaction. Hence, the performance of this type of CDOs is strongly influenced by the trading acumen of asset managers, who are required to maintain an equity cushion between the market value of the reference portfolio ("the collateral") and the face amount of the outstanding debt securities backed by the underlying collateral.

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Once the reference portfolio falls in value below an agreed trigger point, asset managers are obliged to pay down any liabilities by means of an early settlement of collateral assets. Asset managers have considerable discretion in actively trading the collateral both to take advantage of relative value opportunities and to realise capital gains in reaction to an evolving credit outlook of the collateral portfolio. This trading-based early amortisation feature of market value CDOs represents a form of essential credit enhancement, i.e. the discretion of active trading does mitigate possible default risk borne by investors. The market value form of CDOs is generally applied in cases of a distressed reference portfolio (collateral) of bonds or loans such that the credit and trading expertise of the originator of these assets might provide grounds for arbitrage gains (see arbitrage CDOs below) from the differences in prices between the distressed assets on the bank books and their aggregate valuation when bundled in a reference portfolio underlying the securitisation.

As opposed to market value CDOs, cash flow CDOs (see Exhibit 5) represent a more common form of structured finance in this area, where the value of issued debt securities (various prioritised tranches) and their settlement are contingent on collateral distress only, i.e. expected and unexpected losses from the reference portfolio. By definition, proceeds generated from the reference portfolio are sufficient to service liabilities, i.e. debt securities backed by the assets, over the life of the transaction. These payment liabilities to investors are exposed to default risk resulting not only from the amount and timing of default but also from the degree of prepayments or early amortisation of assets in the underlying reference portfolio, which impose uncertainty on expected investor returns (Paul, 1994). Fluctuations in the market value of the collateral pool do not affect the valuation of the transaction and the payment mechanism as the collateral assets of cash flow CDOs tend to be relatively static (Fabozzi and Goodman, 2001), i.e. assets are acquired or held, and issuers have little discretion in trading these assets.

Cash flow CDOs are usually repaid by way of bullet payments (see Appendix 2--ABS payment structures), which require a reinvestment period for cash collected from the underlying reference portfolio. Moreover, as commercial bank loans are not regularly repaid, e.g. mortgage loans or auto loans, there is no question of regular retirement of CDOs like in pass-through structures in the mortgage market. According to the J.P. Morgan Handbook (2002) the funded volume of CDO transactions between 1997 and 2001 worldwide breaks down as follows: 52% synthetic or traditional. (17) (true sale/cash) cash flow, arbitrage CDOs, 6% traditional, market value CDOs and 41% synthetic or traditional (true sale/cash) cash flow, balance sheet CDOs, with the remaining 1% unclassified private placements. Since most CDOs (93%) are cash flow deals, the following analysis of the CDO market will concentrate on this type of CDO funding structure, where any trading behaviour of issuers (as it would apply in arbitrage CDOs) does not apply.

Exhibit 4. Global market breakdown of asset-backed securitisation (ABS)

Lease             2%
Credit Card       4%
Consumer Loans    5%
Whole Business    6%
Auto Loans        7%
Sovereign         7%
CMB               8%
CDO              14%
RMBS              3%
Other            44%

Note: Table made from pie chart.

Andreas A. Jobst

London School of Economics and Political Science (LSE) and J.W. Goethe Universitat Frankfurt am Main