Wednesday, August 29, 2007

Securitization: The Tool of Financial Transformation

Two papers on Securitization and Collateralized Debt Obligations:

Securitization: The Tool of Financial Transformation

Fabozzi, Frank J. and Kothari, Vinod, Yale ICF Working Paper No. 07-07

Securitization as a financial instrument has had an extremely significant impact on the world's financial system. First, by integrating capital markets and the uses of resources - such as mortgage originators, finance companies, governments, etc. - it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient; evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them.

In its broadest sense, the term "securitization" implies a process by which a financial relationship is converted into a transaction. A financial transaction is the coming together of two or more entities; a financial relationship is their staying together. For example, a loan to a corporation is a financial relationship; once the loan is transformed into a tradable bond, it is a transaction. We find several examples in the history of the evolution of finance of relationships that have been converted into transactions. The creation of "stock," representing ownership in a corporation, is one of the earliest and most important examples of this process because of its impact on the growth of the corporate form of business organization. The process of converting loans to corporations of high credit quality corporate borrowers, and in the 1970s expanding that opportunity to speculative-grade corporate borrowers, into publicly traded bonds is another example of this. Commercial paper is another example of securitization of relationships as it securitizes a trade debt

Collateralized Debt Obligations and Credit Risk Transfer

Lucas, Douglas J., Goodman, Laurie and Fabozzi, Frank J., . Yale ICF Working Paper No. 07-06

Several studies have reported how new credit risk transfer vehicles have made it easier to reallocate large amounts of credit risk from the financial sector to the non-financial sector of the capital markets. In this article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation. Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer vehicle.

Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the borrower's inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade risks.

The most obvious way for a financial institution to transfer the credit risk of a loan it has originated is to sell it to another party. Loan covenants typically require that the obligor be informed of the sale. The drawback of a sale in the case of corporate loans is the potential impairment of the originating financial institution's relationship with the obligor of the loan sold. Syndicated loans overcome the drawback of an outright sale because banks in the syndicate may sell their loan shares in the secondary market. The sale may be through an assignment or through participation. While the former mechanism for a syndicated loan requires the approval of the obligor, the latter does not since the payments are merely passed through to the purchaser and therefore the obligor need not know about the sale.

Another form of credit risk transfer (CRT) vehicle developed in the 1980s is securitization [Fabozzi and Kothari (2007)]. In a securitization, a financial institution that originates loans pools them and sells them to a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities. Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow of the pool of loans. While the financial institution employing securitization retains some of the credit risk associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities issued by the SPE.

Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.

In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.

This entry has been added to Asset Class Reader: Nominal Bonds


Friday, August 17, 2007

Commercial equity real estate: A framework for analysis

Commercial equity real estate: A framework for analysis

Christopher B. Philips, CFA, Vanguard Investment Counseling & Research, 08/17/2007

Executive summary. The U.S. commercial real estate market has been estimated to be as large as $5.3 trillion.1 Historically, commercial real estate has provided competitive real returns and diversification opportunities for traditional portfolios. Yet an important question remains: Can an investment in commercial real estate actually deliver the characteristics and benefits of the broad real estate market? Indeed, investment vehicles such as real estate investment trusts or even limited partnerships or private investment pools can look quite different than the broad real estate market. The complexity of this question is a possible reason why institutional investors on average allocate only 2.5% to 4% of their portfolios to commercial equity real estate (Greenwich Associates, 2006, and Pension Real Estate Association, 2005). In fact, in contrast to
the $5.3 trillion investable market, as of December 2006 private real estate holdings were estimated at $310 billion (Chin, Topintzi, and Hobbs, 2007) and public REITs at $400 billion. This analysis evaluates the commercial real estate market and offers perspective regarding the various investment options. We contend that:
• Commercial real estate represents a unique and significant asset class.
• A real estate investment trust index serves as a long-term proxy for the commercial real estate market.
• Since REITs represent exposure to the commercial real estate asset class, a specific allocation to REITs may be based on a portfolio’s mandated objective; expected returns, risks, and covariance to the portfolio; or a unique circumstance.
• Because REITs are part of a broad-based U.S. equity portfolio, when determining an appropriate allocation to REITs, investors must factor in the exposure already contained within the active and indexed portions of the portfolio.

This entry has been added to Asset Class Reader: REITS

Thursday, August 02, 2007

Understanding alternative investments: The role of commodities in a portfolio

Understanding alternative investments: The role of commodities in a portfolio

Kimberly A. Stockton, Vanguard Investment Counseling & Research, (08/02/2007)

In recent years, a passive investment in commodities provided high, equity-like average returns, negative return correlations with traditional asset classes, and some protection against inflation. Augmenting a traditional portfolio with an allocation to commodity investments would have improved risk-adjusted portfolio returns. Consequently, interest in commodity investments has increased tremendously. This paper will describe the most popular means of passively investing in commodities—commodity futures indexes—and will discuss their role in a well-diversified portfolio. Although historical returns serve as a useful guide, long-term asset allocation decisions must be based on forward-looking expectations about commodity returns. Detailed analysis of commodity futures index returns will identify key drivers needed to form those expectations. Commodity futures index returns may be broken down into collateral return (U.S. Treasury bills), spot return (the return from changes in commodity prices) and roll return (the return associated with rolling a futures contract forward). Over long periods, the spot return is on average not much higher than inflation, so the roll return is an important contributor to the equity-like returns achieved by some commodity investments. Unfortunately, there is evidence that the roll return is declining or even disappearing in markets where it traditionally has been strongest (such as energy futures markets). So, although a small allocation to commodities may provide some diversification benefits, we caution against making an allocation to commodity investments based on extrapolations of historical returns.

Note: This post has been added to Asset Class Reader: Commodities