Correlation, price discovery and co-movement of ABS and equity

Asset-backed securitization (ABS) has become a viable and increasingly attractive risk management and refinancing method either as a standalone form of structured finance or as securitized debt in Collateralized Debt Obligations (CDO). However, the absence of industry standardization has prevented rising investment demand from translating into market liquidity comparable to traditional fixed income instruments, in all but a few selected market segments. Particularly low financial transparency and complex security designs inhibits profound analysis of secondary market pricing and how it relates to established forms of external finance. This paper represents the first attempt to measure the intertemporal, bivariate causal relationship between matched price series of equity and ABS issued by the same entity. In a two-dimensional linear system of simultaneous equations we investigate the short-term dynamics and long-term consistency of daily secondary market data from the U.K. Sterling ABS/MBS market and exchange traded shares between 1998 and 2004 with and without the presence of cointegration. Our causality framework delivers compelling empirical support for a strong co-movement between matched price series of ABS-equity pairs, where ABS markets seem to contribute more to price discovery over the long run. Controlling for cointegration, risk-free interest and average market risk of corporate debt hardly alters our results. However, once we qualify the magnitude and direction of price discovery on various security characteristics, such as the ABS asset class, we find that ABS-equity pairs with large-scale CMBS/RMBS and credit card/student loan ABS reveal stronger lead-lag relationships and joint price dynamics than whole business ABS. JEL Classifications: G10, G12, G2

Asset securitisation as a risk management and funding tool : what does it hold in store for SMES?

The following chapter critically surveys the attendant benefits and drawbacks of asset securitisation on both financial institutions and firms. It also elicits salient lessons to be learned about the securitisation of SME-related obligations from a cursory review of SME securitisation in Germany as a foray of asset securitisation in a bank-centred financial system paired with a strong presence of SMEs in industrial production. JEL Classification: D81, G15, M2

Collateralised loan obligations (CLOs) : a primer

The following descriptive paper surveys the various types of loan securitisation and provides a working definition of so-called collateralised loan obligations (CLOs). Free of the common rhetoric and slogans, which sometimes substitute for understanding of the complex nature of structured finance, this paper describes the theoretical foundations of this specialised form of loan securitisation. Not only the distinctive properties of CLOs, but also the information economics inherent in the transfer of credit risk will be considered, so that we can equally privilege the critical aspects of security design in the structuring of CLO transactions

Asset pricing and investor risk in subordinated asset securitisation

As a sign of ambivalence in the regulatory definition of capital adequacy for credit risk and the quest for more efficient refinancing sources collateral loan obligations (CLOs) have become a prominent securitisation mechanism. This paper presents a loss-based asset pricing model for the valuation of constituent tranches within a CLO-style security design. The model specifically examines how tranche subordination translates securitised credit risk into investment risk of issued tranches as beneficial interests on a designated loan pool typically underlying a CLO transaction. We obtain a tranchespecific term structure from an intensity-based simulation of defaults under both robust statistical analysis and extreme value theory (EVT). Loss sharing between issuers and investors according to a simplified subordination mechanism allows issuers to decompose securitised credit risk exposures into a collection of default sensitive debt securities with divergent risk profiles and expected investor returns. Our estimation results suggest a dichotomous effect of loss cascading, with the default term structure of the most junior tranche of CLO transactions (“first loss position”) being distinctly different from that of the remaining, more senior “investor tranches”. The first loss position carries large expected loss (with high investor return) and low leverage, whereas all other tranches mainly suffer from loss volatility (unexpected loss). These findings might explain why issuers retain the most junior tranche as credit enhancement to attenuate asymmetric information between issuers and investors. At the same time, the issuer discretion in the configuration of loss subordination within particular security design might give rise to implicit investment risk in senior tranches in the event of systemic shocks. JEL Classifications: C15, C22, D82, F34, G13, G18, G2

European Securitisation : a GARCH model of CDO, MBS and Pfandbrief spreads

Asset-backed securitisation (ABS) is an asset funding technique that involves the issuance of structured claims on the cash flow performance of a designated pool of underlying receivables. Efficient risk management and asset allocation in this growing segment of fixed income markets requires both investors and issuers to thoroughly understand the longitudinal properties of spread prices. We present a multi-factor GARCH process in order to model the heteroskedasticity of secondary market spreads for valuation and forecasting purposes. In particular, accounting for the variance of errors is instrumental in deriving more accurate estimators of time-varying forecast confidence intervals. On the basis of CDO, MBS and Pfandbrief transactions as the most important asset classes of off-balance sheet and on-balance sheet securitisation in Europe we find that expected spread changes for these asset classes tends to be level stationary with model estimates indicating asymmetric mean reversion. Furthermore, spread volatility (conditional variance) is found to follow an asymmetric stochastic process contingent on the value of past residuals. This ABS spread behaviour implies negative investor sentiment during cyclical downturns, which is likely to escape stationary approximation the longer this market situation lasts

The Basle securitisation framework explained: the regulatory treatment of asset securitisation : (forthcoming in Journal of Financial Regulation and Compliance, Vol. 13, No. 1)

The paper provides a comprehensive overview of the gradual evolution of the supervisory policy adopted by the Basle Committee for the regulatory treatment of asset securitisation. We carefully highlight the pathology of the new “securitisation framework” to facilitate a general understanding of what constitutes the current state of computing adequate capital requirements for securitised credit exposures. Although we incorporate a simplified sensitivity analysis of the varying levels of capital charges depending on the security design of asset securitisation transactions, we do not engage in a profound analysis of the benefits and drawbacks implicated in the new securitisation framework. JEL Klassifikation: E58, G21, G24, K23, L51. Forthcoming in Journal of Financial Regulation and Compliance, Vol. 13, No. 1

The Basle securitisation framework explained: the regulatory treatment of asset securitisation

The paper provides a comprehensive overview of the gradual evolution of the supervisory policy adopted by the Basle Committee for the regulatory treatment of asset securitisation. We carefully highlight the pathology of the new “securitisation framework” to facilitate a general understanding of what constitutes the current state of computing adequate capital requirements for securitised credit exposures. Although we incorporate a simplified sensitivity analysis of the varying levels of capital charges depending on the security design of asset securitisation transactions, we do not engage in a profound analysis of the benefits and drawbacks implicated in the new securitisation framework. JEL Klassifikation: E58, G21, G24, K23, L51. Forthcoming in Journal of Financial Regulation and Compliance, Vol. 13, No. 1

The pricing puzzle : the default term structure of collateralised loan obligations

Ambivalence in the regulatory definition of capital adequacy for credit risk has recently stirred the financial services industry to collateral loan obligations (CLOs) as an important balance sheet management tool. CLOs represent a specialised form of Asset-Backed Securitisation (ABS), with investors acquiring a structured claim on the interest proceeds generated from a portfolio of bank loans in the form of tranches with different seniority. By way of modelling Merton-type risk-neutral asset returns of contingent claims on a multi-asset portfolio of corporate loans in a CLO transaction, we analyse the optimal design of loan securitisation from the perspective of credit risk in potential collateral default. We propose a pricing model that draws on a careful simulation of expected loan loss based on parametric bootstrapping through extreme value theory (EVT). The analysis illustrates the dichotomous effect of loss cascading, as the most junior tranche of CLO transactions exhibits a distinctly different default tolerance compared to the remaining tranches. By solving the puzzling question of properly pricing the risk premium for expected credit loss, we explain the rationale of first loss retention as credit risk cover on the basis of our simulation results for pricing purposes under the impact of asymmetric information. Klassifikation: C15, C22, D82, F34, G13, G18, G2

Security issuance and investor information

Although the commoditisation of illiquid asset exposures through securitisation facilitates the disciplining effect of capital markets on the risk management, private information about securitised debt as well as complex transaction structures could possibly impair the fair market valuation. In a simple issue design model without intermediaries we maximise issuer proceeds over a positive measure of issue quality, where a direct revelation mechanism (DRM) by profitable informed investors engages endogenous price discovery through auction-style allocation preference as a continuous function of perceived issue quality. We derive an optimal allocation schedule for maximum issuer payoffs under different pricing regimes if asymmetric information requires underpricing. In particular, we study how the incidence of uninformed investors at varying levels of valuation uncertainty and their function of clearing the market effects profitable informed investment. We find that the issuer optimises own payoffs at each valuation irrespective of the applicable pricing mechanism by awarding informed investors the lowest possible allocation (and attendant underpricing) that still guarantees profitable informed investment. Under uniform pricing the composition of the investor pool ensures that informed investors appropriate higher profit than uninformed types. Any reservation utility by issuers lowers the probability of information disclosure by informed investors and the scope of issuers to curtail profitable informed investment. JEL Classifications: D82, G12, G14, G2

Securitisation and its impact on financial market stability

Ziel dieser Präsentation (anlässlich des Seminars „Die Auswirkungen von Asset Securitisation auf die Stabilität des Finanzmarktes“ Österreichische Nationalbank (ÖNB), Wien 1. Oktober 2003) ist es, eine Verbindung zwischen Verbriefung und Finanzmarkstabilität unter Berücksichtigung veränderter Finanzintermediation herzustellen. In der folgenden Abhandlung soll nun zunächst auf die Natur der Verbriefung per se eingegangen werden, um sodann anhand theoretischer Überlegungen und empirischer Beobachtungen mögliche Quelle systemischen Risikos in der Kreditverbriefung aufzuzeigen. In diesem Fall handelt es sich um die Informationsasymmetrien und die durch Handelbarkeit von Kreditrisiko bestimmte Transaktionsstruktur („security design“), die bei regulatorischer Nichtberücksichtigung eine destabilisierende Wirkung nicht nur im Bereich der Verbriefung, sondern auch hinsichtlich der gegenseitigen Zahlungsverpflichtungen von Finanzintermediären begründen könnte