Credit Risk: From Transaction to Portfolio Management

Smaller retentions result in relief equal to the difference between

8 per cent and the retainer.

There are other considerations, however including the cost of fund-

ing such an arrangement. If the bank accessed low cost financing then

the difference between the aggregate level achieved through the secur-

itization route is unattractive since even the most senior tranches are

typically sold at a premium to libor prevalent in the asset-backed

market. The alternative arrangement to participating loans is the syn-

thetic arrangement covered in great detail in Section 4.7.

4.11 Investor analysis

Construction of financial securities

We now drill down into the ‘profile’ and consider the assets that com-

prise the offering to the investors. A consideration of this base is vital to

originating the instruments and is another integral component of their

design. There is little benefit in promoting a particularly efficient struc-

ture which purportedly would enjoy a large valuation if the investor

demand for the individual components is low. To obviate the chances of

this, the structuring team would work closely with the organizations

origination and fixed-income sales team to understand the nature of the

investor marketplace and which instruments would appeal.

6

214 Credit risk: from transaction to portfolio management

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Date

Surplus liquidity

Figure 4.30 The liquidity within the structure.

6

We have described these entities as being an integral component of the bank. For

many commercial banks this is not the case and the service would be made available

from a partner bank.

The first instrument is a middle dated annuity. This is a class of

security which pays out a constant stream of income. Each payment

can be thought of as being comprised of both interest and principal; to

begin with most of the payment will be interest but as the time to matur-

ity increases then more will be comprised of nominal. There is a for-

mula to calculate its value; this is displayed in the equation below:

where P is the principal amount and r is the annuity rate lasting for n

years.

For example if we consider the first tranche, which has a common

annual payment of $115 000 000 lasting for 15 years, r  4%:

giving

This value is very approximate, and considerably overvalues, for reason

we postpone to a later discussion.

Annuities comprise two tranches of the structure. If we examine the

loan profile we can infer why this was the case. The shape can be

approximately described by two distinct patterns. The first part com-

prises payouts up to a maturity of about 2018; this is almost a hori-

zontal line. The second shape starts from 2018 and extends to 2023.

This is a downward sloping line and is caused by a heavy loan redemp-

tion schedule over this period.

As annuities produce a horizontal profile they are a natural candidate

for the securitization of the payments until 2018. The question then

arises as to whether there will be sufficient investor appetite for these

long dated instruments. The demand for the various tranches comes

from different sources of the investment community. Generally the prin-

cipal aim is to securitize as much as possible as high-investment grade.

This would then appeal to the large institutional investors who are usu-

ally only allowed through regulatory authorities to deal in such paper.

Further appeal would be anticipated from the retail marketplace.

The long dated annuities would be structured as investment grade

assets, and would find a natural home within the pension funds that

P $1278 614 560.

P $115 000 000

(1 0.04) 1

0.04 (1 0.04)

15

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rr

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,

Securitization 215