Learning the Basics, Issuers Prepare for Securitization

2001/01/11

The thick of the 1995 Mexican peso crisis, when investors were frantically bailing out of emerging markets, was not an ideal time for a Latin American company to tap the international capital markets. On top of that, presidential elections in Argentina, the headquarters of crude oil and natural gas producer YPF S.A., made the situation even more uncertain. Nevertheless, YPF managed to raise US$800 million through the securitization of future crude oil export receivables.

"The critical issue in securitization is identification of the risks involved," said Carlos Felices, YPF's chief financial officer. "You look at your company and say these are our activities and you start to classify them in terms of their different risks. Then, you transfer to the investor the risk that he wants to buy."

At that time, YPF was a noninvestment-grade company located in an emerging market looking for access to investment grade financing costs and the ability to issue at any time, regardless of market jitters. In the past five years, YPF has issued two other securitized transactions totaling more than US$700 million, and each deal has been increasingly sophisticated.

"We have been making the transactions better and better, incorporating different elements like puts or calls or some other type of protection that gives the investors comfort and reduces our costs," Mr. Felices said. "And we have used monoline insurance companies that wrapped our paper and gave us access to the market with a better rating. In some cases, we have issued paper with 'AAA' ratings."

Examining the Options
For many years, securitization was a hard sell to companies outside the U.S., who saw it as a relative of factoring, a process by which a company sold its receivables at a discount. It was generally viewed as the last resort of economically disadvantaged operators. However, recent history has shown that securitization can be an appealing option for financially healthy asset originators as much as it is for capital-constrained ones. Furthermore, its resemblance to factoring is only skin-deep.

Securitization allows companies to diversify their funding sources and access lower costs of funds. They may also gain access to longer term funds and obtain higher ratings on their securitized debt than their own corporate credit ratings.

Securitization also benefits lending institutions by permitting them to originate new business without directly financing the assets on their balance sheets which, in turn, allows them to expand their customer bases. This may prompt some to provide loans to borrowers they would not otherwise be willing to work with because of funding constraints and regulatory capital reserve requirements.

Structuring a Transaction
Regardless of a company's reasons for pursuing this financing method, there are myriad conditions that must be met in order for it to be successful. "I'm pretty black and white about it," said Jorge Calderon, cohead of the asset finance group at Deutsche Bank's New York branch, when he is approached by companies eager to do their first structured finance deals.

In order to respond realistically to their aspirations, he asks some pointed questions: How long have you been in business? What is the size of the pool you want to securitize? How long has the pool been around? What is the quality of the obligors? How did you underwrite them? What are your loss and delinquency histories?

But the strength of the assets is often not enough to allow the transaction to succeed. So Mr. Calderon measures the issuer's information against the sovereign rating of the country in which it is located, and then he is able to tell issuers, in rough terms, the pricing, tenor, and ratings they should expect.

Developing Pools for Securitization
Residential mortgages are often the first assets to be securitized in countries with developed capital markets because they generally comprise almost homogeneous pools that were underwritten in a relatively standardized manner. As a rule, they also have predictable and steady income streams. These factors make RMBS attractive to investors because it is easier for them to analyze the loans' performances.

For instance, once it understood the importance of consistent underwriting and pool performance tracking, the Argentine government developed an MBS program that requires participants to use uniform loan documentation, said Diane Audino, a director in Standard & Poor's Latin America Structured Finance Ratings group in New York.

In most developed countries, residential mortgages may have extensive performance histories. Therefore, it is important for a residential mortgage loan originator to retain records of the assets' performances-something it may not have done because it was not necessarily considering pursuing a securitization. Investors typically like to know the track records of the assets they are investing in because uncertain or unpredictable loan performances and cash flows will cause fluctuations in their investment portfolios. This will likely cause them to demand higher pricing on the securities.

In some developing countries without sizable primary mortgage markets or consumer loan products in general, companies, such as YPF, instead securitize future receivables of export sales.

Also contributing to the success of a securitization is its perceived liquidity. Companies are more likely to achieve attractive financing rates if they are regular, repeat issuers or, in some cases, if they sell particularly large pools of assets, because investors believe those securities will be more liquid.

Weighing the Benefits
Securitization can be an expensive process, particularly with first-time issuers, untested assets, or new jurisdictions. Investment bankers, lawyers, accountants, and rating agencies must all be paid for their services. Therefore, except when securitization is the only option, an issuer should assess whether the costs can be justified by the savings or advantages that securitization will provide.

Nevertheless, the ability to borrow capital from international investors can be important for companies in developing countries, or in comparatively small markets that may not be able to absorb a large volume of securitizations.

The Australian securitization market continues to grow, with US$40 billion in outstandings. The market is dominated by prime RMBS that benefit from 100% primary mortgage insurance. These issues comprise around 60% of Australia's total term structured finance market. But increasingly, the largest and most frequent RMBS issuers are tapping into the European and U.S. markets, driven by the local market's limited ability to absorb large issues at an attractive price due to its size, said Fabienne Michaux, director of Standard & Poor's Structured Finance Ratings group in Melbourne. Offshore markets are receptive to Australian RMBS due to their strong track records and their relative values compared with other investment alternatives, as well as investors' growing familiarity with the product through good access to research and performance data.

Regulatory capital pressure convinced the management of Frankfurt's Rheinische Hypothekenbank AG, known as Rheinhyp, to pursue its first securitization-a transaction that stands as one of the most innovative CMBS offerings in Europe. Rheinhyp sold its Europa One Ltd. in March 2000; it consisted of euro (Eur) 1.345 billion floating-rate, amortizing, credit-linked notes.

"The international business of the bank is growing at a phenomenal rate. That puts a lot of strain on the capital base of the bank," said George Ruchti, head of structured finance and portfolio management at Rheinhyp. "Rather than asking our major shareholder for more equity, we thought we might transfer this risk off balance sheet."

Preparing for Market
With a generic corporate bond offering, the issuer provides regular financial statements. With a securized offering, the issuer must be able to provide reports showing the performance of the asset pool. Therefore, even before the transaction has been structured, the issuer must pull together various parts of its organization, including the underwriting, servicing, information systems, and treasury departments, to prepare itself to produce these specialized reports.

Further, payment and collection procedures, known as servicing, may have to be tightened. Lenders with lax attitudes toward delinquent payments will find it necessary to become more diligent. "As you have more sophisticated lending taking place, you are going to need more sophisticated servicing," noted George von Liphart, a managing director at GMAC Commercial Mortgage Japan K.K., in Tokyo.