The Economics Of Structured Finance

Pratik Killa
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THE ECONOMICS OF STRUCTURED FINANCE

A PROJECT REPORT
Submitted By PRATIK KILLA

In partial fulfillment for the award of the Degree Of BACHELOR OF COMMERCE ROLL NO 31 ROOM NO - 06 ST. XAVIERS COLLEGE (AUTONOMOUS) DEEMED UNDER UNIVERSITY OF CALCUTTA APRIL 2011

ACKNOWLEDGEMENT
To begin with this project undertaken by me was an extremely rewarding experience for me in terms of learning and exposure. I have tried to keep the project as simple as possible so as to impart a better understanding of the content and to demonstrate exactly what I am trying to bring to the fore through this project. I would like to extend my deep gratitude towards the Department of Commerce, St.Xaviers College, for designing a curriculum which inculcates research and project work.

I would like to extend my deepest gratitude to my research guide, Prof. Soummya Banerjee, Senior lecturer, Dept. of Commerce, who gave his valuable time and guidance in every step of my project. Sir has always helped me out with valuable information and has contributed immensely towards the successful completion of this project. Apart from the above, I would like to thank all my peers and colleagues for their contribution in this project of mine. I would also like to thank my family who kept motivating me and suggested me in the content of my work.

PRATIK KILLA

TABLE OF CONTENTS
1. INTRODUCTION DEFINITION OF STRUCTURED FINANCE OBLECTIVE OF THE STUDY LITERATURE REVIER METHODOLOGY 2. OVERVIEW OF STRUCTURED FINANCE MARKETS & TRENDS A SPECIFIC NOTE ON EMERGING MARKETS INDIAN STRUCTURED FINANCE EVOLUTION CURRENT STATE OF SF IN INDIA FUTURE PROSPECTS FOR INDIA 3. RATINGS IN STRUCTURED FINANCE: WHAT WENT WRONG?? ISSUES ASSOCIATED WITH RATING SF TRANSACTIONS THE LESSONS WE LEARNT RECOMMENDATIONS 4. CASE STUDY: HOW ENRON HAS AFFECTED THE BOUNDARIES OF SF BACKGROUND EFFECT ON TRADITIONAL PROJECT FINANCE STRUCTURED PROJECT FINANCE SPECIAL PURPOSE ENTITIES SOURCES OF FREE CASH FLOW SECURITY INTERESTS HOW COMPANIES HAVE RESPONDED INCREASED TRANSPERANCY AND DISCLOSURES REGULATORY ISSUES OTHER LESSONS LEARNED 5. CONCLUSIONS, LIMITATIONS AND RECOMMENDATIONS 6. BIBLIOGRAPHY 06 06 09 10 12 13 16 19 19 22 23 24 28 33 35 36 36 38 38 39 39 40 41 42 42 44 48

ABSTRACT
The financial crisis that began in late July 2007 represented the first test of the new complex structured finance products, markets, and business models that have developed over the past decade.1 The crisis has been both deep and protracted: one-month and three-month interbank interest rates remain elevated despite coordinated central bank operations and rate cuts; there is significant uncertainty about the valuations and disclosures of structured instruments; counterparty risk remains a concern; and the balance sheets of financial institutions have been weakened. As a result, important questions are being asked about whether structured finance products provided the intended benefits, the extent to which these products increased the risk of a crisis and exacerbated its consequences, and the need for both the official and private sectors to address systemic weaknesses. The conclusion of this research project is that, although structured finance can be beneficial by allowing risks to be diversified, some complex and multi-layered products added little economic value to the financial system. Further, they likely exacerbated the depth and duration of the crisis by adding uncertainty relating to their valuation as the underlying fundamentals deteriorated. The recovery of the structured market will likely entail more standardized products, at least for some time to come, and better disclosure both at origination and subsequently. To this end, policy measures should aim to strengthen design and market weaknesses and to close the regulatory gaps in structured finance, without impeding innovation.

CHAPTER chapter

INTRODUCTION

In the wake of the financial crisis, many once-esoteric investment terms have
become a familiar part of our vocabulary. The role of structured finance securities such as collateralized debt obligations (CDOs), for example, and the part played by ratings agencies in legitimizing these products, has become all too clear. The pooling and repackaging of economic assets such as loans, bonds, and mortgages resulted in enormous yields for many investorsuntil, one day, they didn't.

DEFINITION OF STRUCTURED FINANCE

There is no universal definition of Structured Finance. It is apparent from the way that Structured Finance teams are organized in banks that the term covers a wide range of financial market activity. The following can be viewed as a good working definition of structured finance: . . . Techniques employed whenever the requirements of the originator or owner of the asset, be they concerned with funding, liquidity, risk transfer, or other need, cannot be met by an existing off the shelf product or instrument. Hence, to meet this requirement, existing products and techniques must be engineered into a tailor made product or process. Thus structured finance is a flexible financial engineering tool.

The following elements can be enumerated as characterizing a structured finance transaction: A complex financial transaction that may involve actual or synthetic transfer of assets or risk exposure, aimed at achieving certain accounting, regulatory and/or tax objectives; A transaction ring-fenced in its own special purpose vehicle; A bond issue that is asset-backed and/or external reference index-linked; A combination of interest-rate and credit derivatives; A transaction employed by banks, other financial institutions, and corporations as a source of funding and/or favorable capital, tax and accounting treatment; and Disintermediation between banks and other corporate entities. As we just noted, there are alternative definitions of structured finance. Some of them proposed by practitioners and regulators have been identified in the next section. As will be seen, the working definition above, as well as the elements of structured finance given above, tie together many of the alternative definitions identified in the next section.

SF involves tailoring a product to the risk-return profile and maturity requirements of the borrower. Usually improvised over traditional loan financing products, it refers to such financing structures wherein the lender does not look at the entity as a risk but tries to align the financing to specific cash accruals of the borrower. It encompasses all advanced private and public financial arrangements that efficiently refinance and hedge any profitable economic activity beyond the scope of conventional forms of on-balance sheet securities (debt, bonds, equity) in the effort to lower cost of capital and to mitigate agency costs of market impediments on liquidity

Source: Committee on the Global Financial System (2005), The role of ratings in Structured Finance: issues and Implications, cited in Structured Finance: Complexity and Uses of Rating, BIS Quarterly Review, June 2005

As it is highlighted in this chapter Structured Finance is a term that covers a very wide range of financial market transactions and products. While a common definition of it seems to center on securitization, structured financial products also include complex instruments such as bonds with embedded options and transactions such as project financing and leveraged leasing. It is thus suggested that securitization and the employment of SPV entities is a subset of structured finance, albeit a large subset. In conclusion, it is probably best to say that there is no one definition of structured finance, and that the term can be used to describe any financial transaction or instrument that is not plain vanilla.

OBJECTIVES OF THE STUDY

1. To have an overview of the structured product market and the trend. 2. To analyze the role of credit rating agencies in the issuance of structured
financial products. 3. To track the evolution of structured finance in the Indian financial market. 4. Analyze the views of how the Enron debacle affected project finance and the broader realm of structured finance.

LITERATURE REVIEW
One obvious way to define structured finance is to rely on already published definitions. Here are three examples. Here are three examples. In a recent report, the Bank for International Settlements (BIS) defines Structured Finance in this way: Structured finance can be defined through three key characteristics: (1) pooling of assets (either cash based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differentiates structured finance from traditional pass through securitizations; (3) delinking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through use of a finite lived, standalone Special Purpose Vehicle (SPV). A 1995 report written by the Committee on Bankruptcy and Corporate Reorganizations of the Associations of the Bar of the city of New York, entitled New Developments in Structured Finance, defines structured financing and parties involved as follows: Structured Financings are based on one central, core principle: a defined group of assets can be structurally isolated and thus serve as the basis of a financing that is independent from the bankruptcy risk from the originator of the assets. By isolating the assets, an originator obtains easier access to the Capital Markets by generating note proceeds at a lower cost of funds than it otherwise might if it issued notes directly to the investors. One of the principal benefits from structured financings is the reduction in the cost of financing (e.g., through lower yield on issued debt). The parties involved in a structured financing typically include many, if not all, of the following entities (of which there may be more than one): the originator of the assets; a special purpose vehicle; credit enhancers (i.e., financial guarantors); the servicer (who makes collection on the receivables, directs cash-flow allocation, and otherwise acts as agent for the bondholders); a liquidity provider (letter of credit bank); a trustee or collateral agent; a securities underwriter or placement agent, and a rating agency.

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Andrew Silver of Moodys Investors Service defines Structured Financing as follows: Structured Finance is a term that evolved in the 1980s to refer to a wide variety of debt and related securities whose promise to repay investors is backed by (1) the value of some form of financial asset or (2) the credit support from a third party to the transaction. Very often, both types of backing are used to achieve a desired credit rating. Structured Financings are offshoots of traditional secured debt instruments, whose credit standing is supported by a lien on specific assets, by a defeasance provision or by other forms of enhancement. With conventional secured issues, however it s generally the issuers earning power that remains the primary source of repayment. With structured financings, by contrast, the burden of repayment on a specific security is shifted away from the issuer to a pool of assets or to a third party. Securities supported wholly or mainly by pools of assets are generally referred to as either mortgage-backed securities (mortgages were the first types of assets to be widely securitized) or asset-backed securities, whose collateral backing may include virtually any other asset with a relatively predictable payment stream, ranging from credit card receivables or insurance policies to speculative grade bonds or even stock. Outside the United States both types of structured financing are often referred to as simply Asset-Based Securities.

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METHODOLOGY
The project undertaken by me is of Descriptive and Exploratory in nature.

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CHAPTER

OVERVIEW OF STRUCTURED FINANCE MARKETS AND TRENDS

The easiest way to highlight the development of the structured finance market is to quantify its new issuance volume. That volume has been steadily climbing all over the world, with U.S. leading, followed closely by Europe, and Japan and Australia a distant third and fourth. The rest of the world is now awakening to the opportunities offered by structured credit products to both issuers and investors and gearing up for a strong future growth. In that respect, it is worth mentioning Mexico, which is leading the way in Latin America; South Korea and Republic of China lead in continental Asia and Turkey in for the Middle East and Eastern Europe. It is only a matter of time before Central and Eastern Europe and China and India spring into action, and the Middle East launches its own version of securitization. The data shown in Tables 1.1 to 1.4 are based on publicly available information about deals executed on each market. Such data is believed to seriously understate the size of the respective markets due to several factors: The availability of private placement markets in many countries, the data for which are not widely available; The execution of numerous transactions executed for a specific client, known as bespoke or custom tailored deals, especially in the area of synthetic collateralized debt obligations and synthetic risk transfers. The exclusion from the count of many transactions based on synthetic indices, such as iTraxx and CDX, ABX, etc, whereby structured products are created using Tranches from these indices

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That being said, the publicly visible size of the markets and their growth rates are sufficient to attract investors, issuers and regulators. The structured finance market growth also stands out against the background of declining bond issuance volumes by corporates and the rising issuance volumes of covered bonds, which in turn are increasingly becoming more structured in nature. The markets of United States, Australia, and Europe can be viewed as international markets, i.e., providing supply to both domestic and foreign investors on a regular basis and in significant amounts, whereas the other securitization markets remain predominantly domestic in their focus. The international or domestic nature of a given market is not only related to where the securities are sold and who the investors are, but also to the level of disclosure, availability of information and, subsequently, the level of quantification (as opposed to qualification) of the risks involved, in particular structured finance securities and underlying pools. If we were to rank the markets by the level of disclosure of information about the structured finance securities and their related asset pools, we should consider the U.S. market as the leader by far in terms of breadth, depth, and quality of the information providedbeing the oldest structured finance market helps, but it is not the only reason: investor sophistication, type of instruments used (those subject to high convexity risk, for example), bigger share of lower credit quality securitization pools, higher trading intensity with related desire to find and explore pricing inefficiencies, etc. are all contributing factors. Other structured finance markets, however, are making strides in that direction as well. Some of the reasons are associated with the type of instruments used: say, convexity-heavy-Japanese mortgages, refinancing-driven UK subprime, defaultand correlation-dependent collateralized debt obligations (CDO) structures, etc. The existence of repeat issuers with large issuance programs and pools of information also helps. However, outside the United States, another major change is quietly driving toward more quantitative work: the need to quantify risks in structured finance bonds is moving from the esoteric (for many) area of backoffice risk management to front-office investment decision making based on economic and regulatory capital considerations, under the new regulatory guidelines of BIS2 (Basel 2 Banking Regulation) and Solvency 2 (Regulation of Insurance Companies

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TABLE 1.1 US STRUCTURED PRODUCT NEW ISSUANCE VOLUME, 2000-2005

AUTO CRCARDS HEL MH EQUIP STLOANS OTHER OTHER ABS

2000 64.72 2001 68.96 2002 93.08 2003 85.49 2004 77.02 2005 99.54

50.45 58.47 70.04 66.55 50.36 67.51

55.73 9.13 71.79 6.27 148.14 4.30 214.99 0.44 320.11 0.50 493.20 NA

9.56 7.40 6.54 10.09 5.92 7.93

12.42 9.94 20.18 39.96 44.99 70.36

16.90 24.14 12.41 16.67 6.73 14.93

38.89 41.48 39.14 66.71 57.64 93.23

Abbreviations: SF CBO = Structured Finance Collateralized Bond Obligation; HY CLO = High Yield Collateralized Loan Obligation; TruPS = Trust Preferred Securities; HY CBO = High Yield Collateralized Bond Obligation; IG CBO = Investment Grade Collateralized Bond Obligation; MV = Market Value Collateralized Debt Obligation. Source: Merrill Lynch.

TABLE 1. 2 U.S. CDO NEW ISSUANCE BY CDO TYPE, 20002005 2000 2001 2002 2003 2004 SF CBO 10.3 13.5 25.2 26.2 56.8 HY CLO 16.8 11.5 14.7 16.7 30.2 TruPS 0.3 2.2 4.3 6.5 7.5 HY CBO 17.5 15.2 1.5 0.8 0.6 IG CBO 13.1 5.2 4.4 0.0 0.0 Other 10.2 5.4 3.2 4.6 3.9 MV 0.2 0.0 0.0 0.0 0.9 Total 68.5 53.0 53.3 54.9 99.9 Synthetic 5.5 6.0 11.0 6.2 Total 68.5 58.5 59.3 65.9 106.1
Abbreviations: ABS = asset backed securitizations; CDO = collateral debt obligations; CMBS = commercial mortgage backed securitizations; CORP = Corporate Securitization; RMBS = Residential Mortgage Backed Securitization. Source: Merrill Lynch.

2005 69.9 50.5 9.0 0.0 0.0 25.4 154.8 29.7 184.5

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Source: JPMorgan SF Research cited in BIS Quarterly Review, June 2005

The United States is the largest, deepest and widest securitization market in the world.13 Australia has a market size of A$10bn. and is dominated by residential mortgages and commercial property leases. In Japan, securitization is largely undeveloped with transactions confined to about US$4.8bn In Asia, assets worth only US$2bn. has been securitized, half of which were in Hong Kong. India, Indonesia, and Thailand are the future markets on horizon with a few deals of low volume having been concluded in each country. In Latin America, securitization transactions were up from about US$3.67bn. in 1995 to 10.3bn in 1996. In South Africa, very few transactions have taken place although the Government has enacted a special law in 1992.

A SPECIAL NOTE ON EMERGING MARKETS

Emerging Markets have high costs of raising funds and look for alternative sources for raising funds at cheaper sources. FIs in Asia have large illiquid debt to get rid off. These countries have the potential to benefit from securitization as soon as the situation improves in South East Asia. Some of the countries in Emerging Markets have introduced specific securitization laws. Eastern Europe offers good scope with the growth of consumer assets; export credit for traditional markets is

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growing in countries like Poland, Czech Republic, Hungary, and Slovakia. After the success of securitization of credit cards and workers remittances in Turkey, other markets in the region like Israel, Lebanon, and Egypt are ready for consumer type securitization. Latin America is already on the path of active securitization and is well ahead of the other EMs.

After having evolved rapidly as a risk transfer and refinancing tool in developed economies, asset securitization has also assumed a vital role for private sector financing in Emerging Market countries. Since the end of the 1980s, large and highly-rated corporates and banks in developing economies have successfully sold receivables from future claims against obligors. Such future flow securitization involves the origination of foreign currency denominated debt secured by future export receivables (e.g. oil and steel) and financial flows from either credit card merchant vouchers or other payment rights in a move to vault the low sovereign ceiling of Emerging Market county ratings and borrow at lesser cost than under conventional funding methods. In light of the importance of financial liberalization in improving the efficiency of capital markets, several Emerging Market countries have developed the legal and financial infrastructure necessary to strengthen their local securitization markets. This has allowed the securitization of existing assets in local currencies in domestic capital markets or even abroad via cross-border ABS transactions (CBEAs) (despite the currency mismatch between securities denominated in foreign currency and underlying assets generated in local currency).

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Also the public sector in many emerging market countries has embraced securitization as an expedient means to foster favorable external debt dynamics (i.e. lower debt service relative to current account receipts), greater fiscal consolidation (i.e. lower public debt relative to GDP), and a more balanced amortization profile of public debt. With the development of a strong local institutional investor base amid regulatory, tax, and legal reforms, asset securitization has become an attractive funding solution for the public assetliability management. The securitization by sub national authorities is particularly prominent. Over the recent past, federal, state and local authorities (municipalities and provinces) as well as government agencies in various emerging market countries have securitized future revenues to domestic and/or retail investors. In most cases, public sector agencies have enlisted securitization in order to monetize tax receivables (federal tax participations), deferred sales tax revenue, oil and gas royalties, future water receivables, toll road revenues, sovereign lease receivables, government loans, housing loan receivables, and performing bank assets from state deposit insurance schemes. Resource-rich countries, such as Brazil and Venezuela, have recorded securitization mostly on future oil export receivables sponsored by governmentcontrolled entities. In Brazil, government controlled Petrleo Brasileiro S/A (Petrobas) issued future flow ABS on U.S.$1.5bn and 200m (U.S.$257m) of future oil export receivables by from 2001-2003. In Venezuela, government controlled Petrleos de Venezuela (PDVSA) raised U.S.$2.5bn and 200m (U.S.$257m) from future flow ABS on oil export receivables from 1998 to 2001.

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INDIAN STRUCTURED FINANCE EVOLUTION

Securitization is a relatively new concept in India but is gaining ground quite rapidly. One of the earliest structured financing deals in India was the India Infrastructure Developer issue on BOLT structure to institutional investors. Global Telesystems also used the SPV structure to raise capital on its telecom future receivables. ICICI and DOT did one of the first deals for securitizing receivables. TELCO did a hire-purchase deal, where the future receivables from truck sales, along with the ownership of assets, were assigned to investors directly without an SPV. CRISIL rated the first securitization program in India in 1991 when Citibank securitized a pool from its auto loan portfolio and placed the paper with GIC Mutual Fund. While some of the securitization transactions which took place earlier involved sale of hire purchase or loan receivables of NBFCs arising out of auto-finance activity, many manufacturing and service companies are now increasingly looking towards securitizing their deferred receivables and future flows also.

CURRENT STATE OF SF IN INDIA

In FY2005, the market for SF transactions grew by 121%-y-o-y in value terms. The number of transactions increased only by 41%, pointing to a significant rise in average deal size. Within the SF domain, the ABS market showed maximum growth. This was largely due to strong increase in retail lending by banks and NBFCs. The SF scenario is largely based on ABS, accounting for 72% of the SF market in 2005, covering a variety of asset classes like cars, commercial vehicles, construction equipment, two-wheelers and personal loans.

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NOTABLE SHIFTS
In ABS:
ABS is the dominant type of instrument in the Indian SF market. The growth of ABS issuances in recent years has been due to a continued increase in disbursements by key retail asset financiers, investors familiarity with the underlying asset class, relatively shorter average tenure of issuances and stability in the performance of a growing number of past pool

FY2005 saw relatively newer asset classes such as loans for financing used cars, three wheelers and two-wheelers which were securitized in a significant way. The average ABS deal size almost doubled y-o-y to Rs. 2.9billion in FY2005, mainly due to large pools securitized by leading vehicle financiers like ICICI Bank and HDFC Bank. There is a growing preference for floating-rate yields, given the volatile interest rate conditions. Time-tranching is increasingly becoming the norm: during FY2005, 64% of ABS issuances involved multiple tranches with different tenures.

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Source: ICRA

In MBS: The largest ever MBS transaction in India, a RS. 12billion mortgage-backed
pool of ICICI Bank happened in FY2005. MBS has the potential for maximum growth, given the significant expansion in the underlying housing finance business underway. However, the long tenure of MBS papers and the lack of secondary market liquidity still deter investors.

In CDO:

Investment decisions influenced by the rating of the underlying corporate exposures in a CDO pool (and not purely the rating of the instrument) have impeded the growth of CDO in India. Corporate loan securitization has been far lower than that in retail securitization.

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FUTURE PROSPECTS FOR INDIA

Securitization will grow in future for two significant reasons: (a) securitized paper is rated more creditworthy than the FI itself and (b) strict capital requirements are imposed on the FIs. Moreover, the opening of the insurance sector for privatization can create demand for securitized paper. The extent of securitization in relation to incremental retail loan disbursements remains low at less than 10% estimated) in India. Going forward, ICRA believes that there is potential for ABS and RMBS volumes to grow, with Originators scaling up their lending volumes and with investor confidence returning. Funding needs together with regulatory prescriptionsuch as priority sector lending guidelinesare likely to remain the key factors prompting lenders to securitize. Higher activity may be expected in the second half of the current year (FY2011), as has been the case in the past, with banks keen to meet their annual PSL requirements. While the various hindrances to RMBS continue to play their part, the recently stated intention of the National Housing Bank (NHB) to revive the market for RMBS appears encouraging. Convergence with International Financial Reporting Standards (IFRS) is expected to impact ABS and MBS, as asset de-recognition is a challenge for transactions wherein the Originator provides credit enhancement. Nevertheless, the deferment of IFRS implementation to 2013-14 for most banks (and to 2014-15 for most NBFCs) could provide some relief for the time being. The final Judgment of the Supreme Court on the issue of trading in loans by banks can also have a crucial bearing on securitization volumes in India. In the light of the RBIs recent draft guidelines on MHP and MRR, the prospects are dim for LSOs. The applicability of these guidelines to securitization (and bilateral loan pool assignments) by NBFCs will have a crucial bearing on ABS and RMBS activity in India, going forward.

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CHAPTER

RATING IN STRUCTURED FINANCE: WHAT WENT WRONG???

The problems in Structured Finance markets that emerged in mid-2007 have revealed weaknesses in risk management. Given the important role of ratings in the investment and risk management processes, and in regulation, the turmoil has also raised questions about the effectiveness of Credit Rating Agencies (CRAs) assessment of risks in rating complex financial products. This chapter focuses on the use of rating information on Structured Financial products by different investor groups, including the hard- wiring of ratings in structured investment vehicles (SIVs) and the role of monolines in providing credit enhancements to Structured Finance product ratings, and discusses opportunities to broaden the scope, information content and reliability of SF ratings.

One lesson from the recent market turmoil is that investors risk management and stress- testing systems need to be updated to account better for the key differences in risk characteristics between structured finance and traditional corporate debt securities. A number of initiatives are already under way to improve the information content and to explore the usefulness of complementary risk measures for Structured Finance ratings by CRAs, in consultation with investors. The chapter supports these efforts by proposing four ways in which CRAs should improve the information on SF products:

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 First, by enhancing the clarity and accessibility of existing rating information and documentation on SF products. Second, by improving the information available to investors on the key risk factors that drive SF ratings, in particular on model risk and the sensitivity of ratings to assumptions about macroeconomic and sectoral developments. Third, through periodic provision of information on the robustness of a CRAs ratings criteria for classes of SF instruments to changes in systemwide market developments Fourth, by expanding the ratings framework for SF products to include information on the risk properties of individual issues and their rated tranches.

ISSUES ASSOCIATED WITH RATING SF TRANSACTIONS

During the second half of 2007, the deterioration in the performance of subprime loans in the United States resulted in a broad re-pricing of asset-backed securities (ABS) and collateralized debt obligations (CDOs), many of which were backed by subprime mortgages and in a loss of confidence in SF products more generally. The ongoing re-pricing undercut investors confidence in the ratings of existing SF products backed by subprime mortgages and, to a lesser degree, those backed by other assets. Indeed, rating revisions and frequency of multi-notch rating downgrades on SF products far exceeded those on corporate securities in 2007 Rating migration characteristics of corporate and SF Securities
Relative stability of SF and corporate debt rating
100

frequency of more than one notch downgrades

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90 80 2007 structured finance 2007 global corporate 19782007 structured finance 19842007 corporate

12 8

70 60

4 0

AAA

AA

BBB

BB

AAA

AA

BBB

BB

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This section highlights the factors that are likely to have contributed to the poor rating performance of the US subprime mortgages included in pools of residential mortgage-backed securities (RMBS), and consequently those of SF products backed by them. In particular, the underlying risks associated with those mortgages were obscured, and the impact of resulting losses was amplified, through the resecuritization of subprime RMBS in the form of CDOs of ABS. The complexity and underlying leverage of these instruments may not have been apparent to many investors who placed undue reliance on the ratings. 1. CRAS UNDERESTIMATED THE SEVERITY OF THE HOUSING MARKET DOWNTURN: The accuracy of SF credit ratings depends crucially on the precision of the CRAs economic forecast. The pooling of assets reduces idiosyncratic risk, but increases exposure to systematic risk. Hence, losses in a mortgage pool are driven by changes in economic conditions, and especially in house prices. In contrast, a corporate credit rating relies on the CRAs assessment of the likelihood that a firm will default during neutral economic conditions (i.e. full employment at the national and industry level). If one were to fix the level of economic activity for example at full employment and zero home price appreciation (HPA) the level of losses in the RMBS pool is determined and, according to the model, the probability of default is either zero or one. It follows that the credit rating on an RMBS tranche is the agencys assessment that economic conditions will deteriorate to the point where losses on the underlying mortgage pool exceed the tranches credit enhancement. However, the failure of CRAs to spot early enough a deterioration in underwriting standard led to a significant underestimation of both the level and the correlation of defaults. As a result, it does not appear that the agencies fully anticipated the severity of the housing market downturn. Economic projections remain an important factor in subprime RMBS surveillance, and the CRAs have changed their outlook for the housing market dramatically over the last year. Broadly speaking, whereas in January 2007 they expected zero nationwide HPA during the housing market downturn, by July they had revised their expectation to price in declines of about 10% and by January 2008 to falls of 20%.

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2. LIMITED HISTORICAL DATA ADDED TO RATING MODEL RISK: RMBS ratings rely more heavily on quantitative models while corporate debt ratings are more dependent on analyst judgment but a long historical record. In particular, corporate credit ratings require the separation of a firms long-run condition and competitiveness from the business cycle, the evaluation of whether or not an industry downturn is cyclical or permanent, and an assessment about whether or not a firm could actually survive a prolonged transitory downturn. In contrast, RMBS credit ratings rely crucially on the ability of the rating agency to predict how the level of losses for a particular loan pool will respond to a number of different economic scenarios. Errors in the CRAs model of the relationship between losses and economic conditions create an additional source of uncertainty in the performance of RMBS credit ratings. The lack of comprehensive historical data is likely to have added to model risk during the current turmoil. Historical data on US subprime loans are largely confined to a relatively benign economic environment, with very little data on periods of significant declines in house prices. Given the importance of refinancing to the performance of subprime loans, and the inherent non-linearities in the payoff of the refinancing option, this could be an important source of model error as the limited historical data will provide inadequate information on the underlying risks. Fitch has recently noted that the increased willingness of borrowers to simply walk away from mortgage debt has contributed to extraordinary levels of early default. The lack of historical data arguably added to difficulties in correctly assessing correlations, and the degree of diversification achieved through a pooling of subprime loans. In particular, the assumption that geographical diversification exists turned out to be incorrect.

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3. CRAS UNDERESTIMATED THE ORIGINATOR RISK FACTOR: While there is typically diversification across borrowers within a mortgage pool, there is not similar diversification across originators, issuers or servicers. This leaves SF investors vulnerable to correlated risk, introducing additional risk factors which need to be addressed. In the case of RMBS, the performance of mortgage loans depends in part on the state of refinancing conditions. The level of interest rates, credit spreads, and the general level of underwriting standards each have important effects on the performance of mortgage loans. Since all of the loans in a pool are serviced by the same firm, and are originated by at most a few firms, there is correlated risk across the loans related to servicer and/or originator quality. The CRAs have noted that servicer quality has a dramatic impact on the loss distribution, and publish servicer quality ratings in order to minimize this source of uncertainty. However, the CRAs do not deal with differences in originator quality with the same amount of analytical rigour. The July 2007 subprime RMBS downgrades were concentrated in the issues of four firms, suggesting that there were important unobserved differences in underwriting standards across originators. Some weakly capitalized originators may have taken advantage of transparent rating agency criteria, enabling borrowers to misrepresent occupancy, income, down payment source and/or property appraisals. A recent report by Fitch observes that, for a significant fraction of early payment defaults, there were clear signs of fraud in the loan files that were ignored in the underwriting process. To deal with this problem, Moodys changed its surveillance criteria in October 2007, splitting originators into three tiers, with loss expectations increasing significantly from the highest to the lowest tier.

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THE LESSONS WE LEARNT!!

1. Credit rating information should support, not replace, investor due diligence : Recent events have shown that many investors failed to incorporate adequately the risk characteristics of SF securities into their portfolio allocation and risk management systems. Several factors probably contributed to this failure, including a search for yield in an environment where credit spreads were being progressively squeezed, combined with a lack of experience with, and understanding of, the risk characteristics of structured credit products. That said, credit ratings on SF products have played an important role in portfolio allocation and risk management processes. Some investors whose investment mandates and asset preferences are significantly governed by minimum external rating requirements have been attracted to highly rated SF securities. In part, this has happened because such securities, given their apparently well diversified collateral and perceived low default risk, appeared to offer better value than highly rated corporate or sovereign bonds, or non-structured, pass-through securitizations Investors with relatively long holding periods were also attracted by high spreads, which they may have assessed as reflecting liquidity rather than credit risk given the high CRA ratings attached to the securities. And many investors have probably read far more into ratings than the CRAs have ever claimed for them. The responsibility of investors for risk assessment and stress testing of any investment product must be strengthened going forward. In particular, trustees of investment funds and investment managers should review their internal procedures and guidelines concerning how ratings information on SF products is used in their investment mandates and decisions. At the same time, rating information is likely to remain a key input to asset allocation and risk management processes. Moreover, credit ratings also serve as an input for determining banks regulatory capital under the Basel II framework, as well in other areas of non-bank financial regulation. In fact, many of the investors with exposures to structured finance

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securities have been supervised institutions, and some of the largest losses have been sustained by firms active in the design and marketing of these structures. Against this background, we expect the CRAs to continue to play an important role by conveying rating information in a way that supports risk analysis and investor due diligence. It is apparent from the responses of the CRAs to recent criticism that they recognize that more should have been done to alert users to the limitations of their rating models and their own scrutiny of the quality of underlying asset pools, as well as the sensitivity of their ratings to any divergence from the key central assumptions upon which their analysis rested. Against this backdrop, while it is important for public authorities to identify clearly areas where improvement is needed and to suggest alternatives as to how such improvement could be achieved, the group believes that it is the responsibility of CRAs and users of ratings to collaborate on developing specific solutions. The consultation processes initiated by various CRAs and industry organizations serve this purpose. 2. CRAS SHOULD ENHANCE THE INFORMATION UNDERLYING SF RATINGS: CRAs do already provide a large amount of information on SF products. Currently CRAs provide a view on an SF transaction, in the form of a pre-sale report which includes indicative tranche ratings. The models on which their ratings are based are available to investors, along with defaults and transition studies. Once a deal has been completed, CRAs process information from the trustee report in standardized format (like other private vendors) and show the remaining level of the credit enhancement. However, such post-deal monitoring, including the processing of trustee reports, has not always been timely. Information provided by CRAs should be presented in a way that facilitates comparisons of risk within and across classes of different SF products. For instance, standardization of pre-sale and post-sale performance reports would support monitoring. This would apply particularly to re-securitization products, where relatively little performance information is currently provided. Information should be provided on the timing and completion of post-issuance reviews by CRAs, and whether an existing rating has been reassessed in the light of changes to

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modeling assumptions. Finally, more user-friendly access to CRA SF models and their documentation should be provided. The Group recognizes that responsibility for improving the transparency of SF markets does not, of course, rest solely with the CRAs. At present, the initial information provided by issuers is often regulated, as it supports the sale of the products. Public data on collateral pool asset performance are very fragmented among a large number of commercial data vendors who specialize in different asset classes, and none is able to provide market-wide data. Competitiveness concerns are usually the reason put forward by sponsors to explain these shortcomings. However, in the changed market conditions this reticence may disappear. 3. BETTER INFORMATION ON KEY RISK FACTORS OF SF RATINGS IS NEEDED: The massive rating downgrades in 2007 dramatically illustrated the risk properties of SF instruments that arise from the tranching of claims against an underlying portfolio of collateral assets. These differences manifest themselves in the stability characteristics of ratings. Over a long period and at an aggregate level, highly rated SF securities have shown greater ratings stability than corporate bonds. This longrun historical experience is reflected in the lower risk to highly rated SF securities of a single-notch downgrade, but this disguises the higher risk of multi-notch downgrades that can follow a more pessimistic reappraisal of the prospective performance of the underlying collateral. Usually this risk will be small, but where projected losses on the pool are subject to a significant adverse and correlated change, sharp downgrades can ensue. CRAs should provide more information about their assumptions on the key risk factors that influence ratings of SF securities. These include: Model risk: CRAs should document the sensitivity of SF tranche ratings to changes in their central assumptions regarding default rates, recovery rates and correlations. Limitations to the historical data on underlying pools, for instance if they cover only a short time period, apply only to similar rather

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than identical contracts, or where the characteristics of underlying assets have changed significantly, should be clearly disclosed as a risk to the rating, as should any adjustment made to mitigate this risk. CRAs should give greater emphasis to stress tests by providing such analysis in their publications or by facilitating what if? scenario analysis by users. Macroeconomic forecast error. CRAs should clearly and regularly disclose to investors their economic assumptions underlying the rating of SF products, and document how they expect each rated tranche of a structured finance transaction to perform under different economic scenarios. CRAs should document the type of scenario that would lead to a severe impairment of a tranche. Related to the above, CRAs could indicate the extent to which ratings based on historical default experience have been modified by their assumptions about the macroeconomic outlook. Other risk factors. The rating agencies should take effective steps to ensure that information from issuers and originators is trustworthy, and monitor more intensively the performance of the various agents in the securitization process. One key practical proposal would be that the agencies should rate mortgage originators, as they do servicers. The rating would focus on reducing uncertainty created by the originator risk factor. Hence, it might look at factors such as underwriting standards rather than the originators debt.

4. CRAS SHOULD TAKE SYSTEM-WIDE RISK INTO ACCOUNT: CRAs should periodically consider the wider systemic implications of a rapid growth of similar instruments or vehicles, or of new business undertaken by existing vehicles, for the continued robustness of their original ratings criteria. Such growth may lead to a concentration of market and other risks that may not have been anticipated at the time the CRAs minimum requirements were formulated. As illustrated by the recent experience of SIVs, the consequences of exposure to a common shock can be amplified when several vehicles sharing common ratings rules are simultaneously affected. This is particularly the case when market-based triggers are incorporated in the rating.

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Such a review, perhaps conducted on an annual basis (and made available to investors), may lead to a tightening of ratings criteria and possibly to downgrades if existing structures are unable to adapt quickly. Moreover, anticipatory adjustments, if carried out in calmer times, are likely to be less disruptive to financial markets. Among other issues, this raises the question of the potential system-wide implications of rating structured products and vehicles, whose ratings themselves are sensitive to market value changes and/or to the ratings of their collateral assets. Similar effects may arise from ratings being embedded in financial regulation.

5. SF RATINGS SHOULD MORE CLEARLY BE DIFFERENTIATED FROM SINGLE-NAME CREDIT RATINGS: Considering ways to distinguish clearly between the rating information on structured and other securities appears important for certain groups of investors. In the course of rating SF instruments, CRAs collect and process large amounts of information, much of which might be useful to investors who devote substantial resources to risk assessment and management. These users may well communicate with CRAs on their own initiative to solicit additional information. However, ratings are extensively used, and will continue to be used, as rough standalone measures of overall credit risk by a number of participants: investors who have limited access to analytical resources; private principals (such as pension fund trustees) that wish to provide straightforward and easily verifiable risk guidelines to managers to whom they have delegated investment decisions; and public regulators. Several options are available for incorporating different risk characteristics into the ratings framework, which can be broadly classified under one-, two- or multidimensional measures of risk. For example, lower ratings can be assigned to structures with high model uncertainty, a practice referred to as notching, than might otherwise be warranted by the central (but highly uncertain) estimates of key parameters such as correlation, default probabilities and recovery rates. Alternatively, different loss characteristics of SF instruments could also be conveyed using a separate rating scale.

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RECOMMENDATIONS
1. Investment fund trustees and managers should review their internal procedures and guidelines concerning how ratings information on SF products is used in their investment mandates and decisions. 2. Rating reports should be presented in a way that facilitates comparisons of risk within and across classes of different SF products. For instance, presale and post-sale performance reports should be standardized. This would particularly be important for re-securitization products, where relatively little performance information is currently provided. 3. Rating agencies should provide clearer information on the frequency of rating updates. For instance, CRAs should disclose the timing and completion of post-issuance reviews by CRAs, and disclose whether an existing rating has been reassessed in the light of changes to modeling assumptions. 4. More user-friendly access to CRA SF models and their documentation should be provided. Rating models made available by CRAs should facilitate the conducting of what if? analysis or stress tests by users on key model parameters. 5. CRAs should document the sensitivity of SF tranche ratings to changes in their central assumptions regarding default rates, recovery rates and correlations. For instance, how would ratings of different tranches change if the recovery rate assumption were altered? 6. CRAs should clearly and regularly disclose to investors their economic assumptions underlying the rating of SF products. This includes documenting how they expect each rated tranche of an SF transaction to perform under different economic scenarios, as well as the type of scenario that would lead to severe impairment of a tranche. CRAs could also indicate the extent to which ratings based on historical default experience have been modified by their assumptions about the macroeconomic outlook.

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7. Limited historical data on underlying asset pools should be clearly disclosed as adding to model risk, as should any adjustment made to mitigate this risk. For instance, CRAs should state in reports that they cannot attach the same degree of confidence to the quality and stability of the products rating as would be the case with more established products. 8. CRAs should monitor more intensively the performance of the various agents involved in the securitization process, particularly where potential incentive misalignments and poor quality data inputs can undermine the presumed quality of the underlying assets. One key practical proposal would be that the agencies should assign ratings to mortgage originators loan approval processes and controls. 9. CRAs should periodically consider the wider systemic implications of a rapid growth of similar instruments or vehicles, or of new business undertaken by existing vehicles, for the continued robustness of their original ratings criteria. 10.CRAs should consider how to incorporate additional information on the risk properties of SF products into the rating framework. CRAs should, in the next few months, explore with market participants and regulators ways to indicate rating risk for SF instruments in a summary form. For instance, could a simple rating risk suffix, stating rating volatility or uncertainty, increase investor risk awareness without further increasing reliance on ratings? CRAs should provide an analysis of the reliability with which risk suffixes could be calculated. Regulators will also need to consider how additional dimensions of rating risk could be taken into account in determining regulatory capital.

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CHAPTER

CASE STUDY: HOW ENRON HAS AFFECTED THE BOUNDARIES OF SF

In the spring of 2002, the Journal of Structured and Project Finance surveyed nine frequent contributor and leading experts to hear their views of how the Enron debacle affected project finance and the broader realm of structured finance. Their general view is that the Enron bankruptcy and related events have changed neither the nature nor the usefulness of traditional project finance but they have led to a slowing down of some of the more innovative forms of structured and project finance. Among the other direct and indirect effects of Enron have been increased caution among lenders and investors toward the energy and power sectors; increased scrutiny of off balance-sheet transactions; increased emphasis on counterparty credit risk, particularly with regard to companies involved in merchant power and trading; and deeper analysis of how companies generate recurring free cash flow. There is increased emphasis on transparency and disclosure, even though disclosure in traditional project finance has been more robust than in most types of corporate finance. In the recent market environment, for reasons that extend beyond Enron, some power companies have been canceling projects and selling assets to reduce leverage and resorting to on-balance-sheet financing to fortify liquidity.

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BACKGROUND

The immediate cause of the Enron bankruptcy was a loss of confidence among investors caused by that companys restatement of earnings and inadequate, misleading disclosure of off-balance-sheet entities and related debt. There were also secondary causes related more to conditions in the energy and power business than to structured finance, including (1) the California power crisis in 2001; (2) the related Pacific Gas & Electric bankruptcy; (3) falling spot power prices, caused largely by recent over-building of power plants; (4) increasing perception by investors, lenders, and rating agencies of the risk related to independent power producers; and (5) increasing skepticism of the energy trading business, including suspicion that some parties were manipulating their earnings through the marking to market of power contracts and off-balance-sheet vehicles.

EFFECT ON TRADITIONAL PROJECT FINANCE

Traditional project finance is cash-flow-based, asset-based finance that has little in common with Enrons heavily criticized off-balance-sheet partnerships. According to Roger Feldman, Partner of Bingham McCutchen, the historic elements of project finance are firmness of cash flow, counterparty creditworthiness, and ability to deal over a long timeframe, and confidence in the legal system. Barry Gold, Managing Director of The Carlyle Group, points out that project finance is a method for

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monetizing cash flows, providing security, and sharing or transferring risks. The Enron transactions had none of these characteristics. They were an attempt to arbitrage accounting, taxes, and disclosure. Traditional project finance is based on transparency, as opposed to the Enron partnerships, where outside investors did not have the opportunity to do the due diligence upon which any competent project finance investor or lender would have insisted. Those parties are interested in all the details that give rise to cash flows. As a result, there is a lot more disclosure in project finance than there is in most corporate deals. In traditional project finance, analysts and rating agencies do not have a problem with current disclosure standards; it is not hidden and it never has been. First, they know project financing is either with or without recourse and either on or off the balance sheet. For example, in the case of a joint venture where a company owns 50% of a project or less, the equity method of accounting is used. On the companys income statement, the companys share of earnings from the project are included below the line in the equity investment in unconsolidated subsidiaries and, on the balance sheet, its investment is included in equity investment in unconsolidated subsidiaries. The point to remember is that whether a project is financed on or off the balance sheet, analysts know where to look. Off-balance-sheet treatment may not be the principal reason for most project financing. It usually is motivated more by considerations such as risk transfer or providing a way for parties with different credit ratings to jointly finance a projectwhereas if all of those parties provided the financing on their own balance sheets, they would be providing unequal amounts of capital by virtue of their different borrowing costs. None of these considerations have anything to do with the Enron partnerships, where a 3% equity participation from a financial player with nothing at risk was used as a gimmick to get assets and related debt off the balance sheet.

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STRUCTURED PROJECT FINANCE

Even though pure project finance has not been affected very much by Enron, some slowing of activity in the more innovative types of structured finance such as synthetic leasing, structured partnerships, and equity share trusts can be seen. Synthetic leases are a mature product, understood by rating agencies and accountants, in which billions of dollars of deals have been done. But the problem is headline risk. Since the Enron debacle, numerous other companies have had disclosure issues. Even though synthetic leases are transparent and well understood by financial experts, they have an off-balance-sheet element that is not understood by everyone in the market at large. But Christopher Dymond of Greengate LLC cautions that the investor market has overreacted to anything that sounds like Enron. Structured and project financial techniques have been developed for sound risk management reasons and, in his opinion, must be defended vigorously on those grounds. He believes a prejudice against complexity in financial structures could have a real economic and financial cost. Most sponsors and investors are sophisticated enough to make these distinctions. However, if sponsors fear that the wider market will punish them for using complex structures, they will stop using them. After the Enron crisis, several companies made public vows not to use any off-balance-sheet structures. But, rather than pandering to uninformed sentiment, Dymond believes that companies should make greater efforts to clearly delineate the difference between legitimate nonrecourse debt and the Enron structures.

SPECIAL PURPOSE ENTITIES

By using corporate stock as collateral and by creating conicts of interest, Feldman of Bingham McCutchen believes that Enron undermined the pristine nature of the special purpose, nonrecourse entity and caused all such structures to look suspect in some peoples eyes. He stresses that in traditional project nance, a special purpose, nonrecourse entity must be clean and fully focused on the transaction concerned. In the aftermath of the Enron bankruptcy, project sponsors and the bankers and lawyers who support them have had to make special efforts to explain the legitimate business reasons for these entities.

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SOURCES OF FREE CASH FLOW

William Chew, Managing Director of Standard & Poors recalls that immediately after Enron filed for bankruptcy protection, some questioned whether project and structured finance would survive in their current form. And indeed, some corporations with large amounts of off-balance-sheet financing and inadequate disclosure were subjected to increased scrutiny and sharply reduced valuations for both their equity and their debt. In response, a number of those companies expanded their liquidity and reduced their debt to the extent possible. But Chew believes that, as time progresses, that the main fallout from Enron and the other recent market shocks may be not so much a turning away from project finance but rather a greater stress on bottom-up evaluation of how companies generate recurring free cash flow and what might affect it over time. In this process, Chew believes that project finance and other types of structured finance probably will continue to play an important role. The change, in his view, is that the focus will be on not only the project structures, but also on how they may affect corporate- level cash flow and credit profilesfor example, through springing guarantees and potential debt acceleration, through contingent indemnification and performance guarantees, through negative pledges and their limits at both the project and the corporate holding company level, and through the potential for joint-venture and partnership dissolutions to create sudden changes in cash flows. Standard & Poors reminds us in its project as well as its corporate credit analysis that there can be a big difference between generally accepted accounting principles (GAAP) and cash flow analysis.

SECURITY INTERESTS
The power business, in part, has shifted from a contract business to a trading, cash flow kind of business where the counterparty becomes critical to the viability of a transaction. The security in the transaction is less the asset itself and more what the trading counterparty does with the asset. That asset has an option value in the hands of counterparty, but a far different value if a bank has to foreclose on ita value you would rather not find out.

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Enrons alleged tendency to set its own rules for marking gas, electricity, and various other newer, thinly traded derivative contracts to market raises some interesting questions about collateral and security. Historically, the security in a power plant financing has consisted of contracts, counterparty arrangements, and assets. But if a lenders security depends on marking certain contracts to market, and there is some question as to the objectivity of the counterparty that is marking them to market, that raises additional questions as to what is an adequate sale, what is adequate collateral, how a lender takes an adequate security interest, how a lender monitors the value of its security interest, and what a lender needs to do to establish a sufficient prior lien in the cash flow associated with the transaction. In the case of a structured finance transaction, the key question remains just as it always has been: whether the security is real and whether you can get your hands on it.

HOW COMPANIES HAVE RESPONDED

The affected companies have responded to the post-Enron market environment rapidly and decisively to strengthen their liquidity through issuing new equity, canceling projects, selling assets, either unwinding structured finance deals or putting them on the balance sheet, and increased transparency and disclosure. Even though traditional project finance has little to do with the off-balance-sheet entities that brought Enron down, Dino Barajas of Paul, Hastings, Janovsky, and Walker, LLP fears a backlash that could affect project finance in the event of a credit crunch. If that happens, one possible solution could be, simply, to finance more projects on the corporate balance sheet. Some power companies have set up massive credit facilities for doing so based on their overall corporate cash flow and creditworthiness. Another option for a company is to borrow against a basket of power projects, allowing the lenders to diversify their risks, although such a facility is still largely based on the credit fundamentals of the corporation. But project nancing on an individual plant basis can be preferable to either of these approaches for both project sponsors and lenders. For example, say a company is nancing 10 projects

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and three run into trouble. The company can make a rational economic decision as to which of those projects are salvageable and which ones do not merit throwing in good money after bad. It might let one go into foreclosure and be restructured and sold. But if a company is financing ten projects together, its management may feel compelled to artificially bolster some of its projects so that the failure of one project does not bring the entire credit facility down. Making such an uneconomic decision for the near term would not be in the companys long-term interests.

INCREASED TRANSPARENCY AND DISCLOSURE

It was observed that after Enron major players started to release much more information than before about their businesses and financing arrangements. Similarly an overriding aura of conservatism was seen in disclosures, for example, in conference room discussions while drafting prospectuses for project finance deals. Bankers were making extra efforts to confirm that deals are being disclosed and explained the right way. Going forward, strong management actions are needed to restore belief in honesty of numbers. A companys management needs to demonstrate the same passion for integrity as it had for growth in the past. It needs to get rid of gimmicks and consistently communicate and execute a simple, clear strategic vision. This involves cleaning up the balance sheet. Transactions that have significant recourse to the sponsor should be put back on the balance sheet. Only true nonrecourse deals should be left off the balance sheet. To convey an accurate, fair picture of the business, companies need to communicateto the point of obsession information and assumptions about how earnings are recognized, including markto-market transactions. Managing earnings is out and managing cash flow is in and, as Chew of Standard & Poors noted earlier, that is what the rating agencies are looking at anyway.

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REGULATORY ISSUES
One of the reasons Enron was left to its own devices in valuing gas, electricity, and other types of contracts was that it became, in effect, the largest unregulated bank in the world. It was able to avoid regulation of its trading activities by the Commodity Futures Trading Commission (CFTC), partly as a result of its own lobbying efforts, and the Federal Energy Regulatory Commission (FERC) declined to get involved as well. Therefore, it was able to duck some of the scrutiny that regulators have directed toward commercial and investment banks dealing in derivatives. Of course, securities analysis had long complained about Enrons opaque financial reporting, only to be told in return that they just did not understand the business.

OTHER LESSONS LEARNED

Some general lessons from Enron in the field of Structured Finance: The transfer of assets, intangible and otherwise, into non consolidating vehicles controlled by a sponsor may mislead investors as to the extent of nonrecurring earnings or deferred losses, even in the absence of fraud. There is a risk of low recovery rates on structured transactions secured by intangible assets (investments, contracts, company stock) or by tangible assets whose values are not established on an arms-length basis. Having been badly burned by the Enron bankruptcy, banks and investors involved in structured and project nancings, and in the energy sector generally, will be especially conservative, and this will limit credit and capital access for many clients in the sector, creating a general liquidity issue for these customers. An effort must be made by all in the project finance industry (and investor relations) to underscore the distinction between true nonrecourse structures and Enrons activities.

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 The terms nonrecourse and off-balance-sheet should remain synonyms. Liabilities that truly have no recourse to a companys shareholders can justly be treated as off-balance-sheet. Enron appears to have violated this principle since the undisclosed liabilities in the off-balance sheet partnerships actually had significant recourse to Enron shareholders through share remarketing mechanisms Many project finance structures are limited recourse rather than non recourse, and thus there is a potential gray area in which accounting rules allow off-balance sheet treatment but there is nonetheless some contingent liability to the parent companys shareholders. Full (footnote) disclosure of any potential shareholder recourse was advisable pre-Enron, and is absolutely necessary now. To conclude, project finance today is alive and well as a form of structured finance. We may just need to remind some people of its basic fundamentals. Neither project finance nor sensible innovations in structured finance with sound, well explained business reasons have been shaken by Enron. The principal lessons learned from the Enron debacle have to do with transparency and disclosure. When some of our businesses or our financing structures become hard to explain, we may begin to question whether they make sense in the first place.

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CHAPTER

CONCLUSIONS, LIMITATIONS & RECOMMENDATIONS

The financial turmoil of 2007-2008 has revealed substantial transparency and information shortcomings due to the increasing opaqueness and complexity of the global financial system. This has in particular been evidenced by uncertainty on the size and distribution of the losses resulting from the subprime crisis and on the valuation and related ratings of structured finance products. The aim of this paper has been to present an overview of the fundamental characteristics of the main instruments of structured finance and their role in the financial turmoil. Against the background of rising regulatory unease about the evolution of derivative markets, it is argued that a clear-cut definition of structured finance helps substantiate more viable debate about the resilience of credit risk transfer to financial shocks. Structured finance encompasses all advanced private and public financial arrangements that serve to efficiently refinance and hedge any profitable economic activity beyond the scope of conventional forms of on-balance sheet securities (debt, bonds and equity) in the effort to lower cost of capital and to mitigate agency costs of market impediments on liquidity. Especially, the distinction of the various methods of credit risk transfer through credit derivatives in a wider and narrower sense as well as securitization transactions illustrates the need for more comprehensive and creative regulatory considerations that take on board the heterogeneity of institutions, markets, and infrastructure.

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From an investor perspective, structured finance has allowed for a more widely diversified population of investment alternatives from which to choose, with varying degrees of credit, interest rate, or prepayment risks from which to choose. In short, when properly structured, these are legitimate transactions meeting important business and economic needs. The Enron transactions were secular, unusual transactions designed to take risk rather than ameliorate it, entirely unlike the vast majority of legitimate structured finance solutions. The structured finance market can be complicated. Investors need to be aware that there are multiple layers of risk, including the unique risks for each segment of the market, risk of the underlying assets in the pool, structural risk, and risks associated with the servicer and issuer of the transaction. Much of the market is subject to interest rate and prepayment risk. Potential investors will want to consider investment managers with a long track record in the asset class. Since detailed due diligence needs to be performed at each level, a robust research organization should also support the investment management process. Similar to the corporate credit market, fundamental and quantitative analysis must focus on early detection of credit deterioration. Rotation among the various segments of the market is critical, so managers with broad access to the market, the ability to source new deals, and research capabilities to uncover potential credit problems and perform relative value analysis should be given extra consideration. The structured finance market in the U.S. continues to evolve. The developments of the subordinated sector and the ABCDS market have increased the opportunity set for investors in the market. The asset class has historically shown rating stability and good relative value when compared to other sectors in the fixed income market. The single-A to triple-B or subordinated component of the market represented about 0.6% of the LB Aggregate Bond Index as of December 31, 2005. We believe investors largely overlook this component of the market, but with prudent investment management it has the potential to provide excess returns to an investors fixed income allocation. Based on this, investors searching for alpha might want to take a deeper look at the structured finance market.

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LIMITATIONS OF THE STUDY

The calculations for the industry wide data for various factors taken into consideration are based on all the players aggregate data. As we are aware that as of now only few players have significant market share. So the data for the insignificant issuing companies will act as outliers thus skewing the result and hence the conclusions as well. The collection of primary data was not possible given the time constraints and the volume of data associated with the same. Thus the accuracy of the data is contingent. Proxy variables are used for some of the factors for calculation purpose. The conclusion depends on the correctness of the assumptions made about the proxy variables. Not all data were readily available and hence certain assumptions were made about the data used for calculations. The accuracy of the conclusions depends on the assumptions made about the data used

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RECOMMENDATION

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CHAPTER

BIBLIOGRAPHY
BOOKS Structured Finance: Techniques, Products and Markets; Edited by Caselli, Stefano and Gatti, Stefano; 2005; Springer Berlin Heidelberg; Germany A Primer on Securitization; Edited by Kendall, Leon T. and Fishman, Michael, J.; 1998; Massachusetts Institute of Technology Press; Cambridge, USA Kat, Harry M.; Structured Equity Derivatives: The Definitive Guide to Exotic Options and Structured Notes; 2001; John Wiley & Sons, Ltd; West Sussex; England Davidson, Andrew; Sanders, Anthony; Wolff, Lan-ling; Ching, Anne; Securitization: Structuring and Investment Analysis; 2003; John Wiley & Sons, Inc.; New Jersey; USA JOURNALS Welsher, Ellen and Penrose, James; Securitization of New Asset Classes: A rating approach; The Journal of Structured Finance, Summer 2004, Vol. 10, No. 2, pp. 20-23 Belmontes R., Manuela; Using the Cayman Islands and other offshore jurisdictions for securitization transactions, The Journal of Structured Finance, Summer 2004, Vol. 10, No. 2, pp. 36-41

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Erturk, Erkan and Gillis, Thomas G.; Default behavior of global structured finance securities; The Journal of structured finance, Fall 2004, Vol. 10, No. 3, pp. 48-55 Humphreys, Peter; Structured Finance Challenges for New Issuers and New Assets: an overview, The Journal of structured finance, Fall 2004, Vol. 10, No. 3, pp. 56-61 Kavanagh, Barbara T.; The Uses and Abuses of Structured Finance; Policy st Analysis, No. 479; 31 July, 2003; Cato Institute Lipton, Joshua; The Silent Scream; The American Lawyer; July 2006 Booth, Laurence; Aivazian, Varouj; Demirguc-Kunt, Asli; Maksimovic, Vojislav; Capital Structure in Developing Countries; The Journal of Finance; Vol.56, No.1, pp. 87-130; Feb 2001 Frankel, Tamar; Cross-Border Securitization: Without Law, But Not Lawless; th Duke Journal of Comparative & International Law; Vol. 8:255, pp. 255-282; 16 Dec 1998; 12:26 pm Baker, Malcolm; Wurgler, Jeffrey; Market Timing and Capital Structure; The Journal of Finance; Vol. 57, No.1, pp. 1-32; Feb 2002 Strassberg, Richard M., Esq.; Falvey, John J., Jr., Esq.; Farley, John O., Esq.; The Pendulum Swings Back; White-Collar Crime, Vol. 20, Issue 8; May 2006; Thomson West PAPER, PRESENTATIONS & REPORTS Gada, Kalpesh; Inamdar, Rohit; Update on Indian Structured Finance Market; ICRA Rating Feature; July 2005 Report of the In-house Working Group on Asset Securitisation; Dec 1999, Reserve Bank of India, Mumbai

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Kamesam, Vepa; Deputy Governor, Reserve Bank of India; Indian Banking of Tomorrow Cowan, Cameron L.; Hearing on Protecting Homeowners: Preventing Abusive th Lending While Preserving Access to Credit; 5 Nov, 2003; American Securitization Forum; Orrick, Herrington, and Sutcliffe, LLP Skarabot, Jure; Asset Securitization and Optimal Asset Structure of the Firm; 21 Mar, 2001 Kohn, Meir; The Capital Market Before 1600; Working Paper 99-06; Feb 1999; Department of Economics; Dartmouth College Horsewood, Rachael; BIS Stress Tests Structured Finance; International st Securitisation Report; 1 Mar, 2005; from http://www.tavakolistructuredfinance.com/isr1.html Giddy, Ian; Presentation on Structured Finance; NYU Stern School of Business, 2006 Subramanyam, Pratap G.; Presentation on Structured Financing and Advisory Services Jobst, Andrea A.; What is Structured Finance?; Working paper; Sep 2005
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WEBSITES Wayman, Rick; Off-Balance-Sheet Entities: The Good, The Bad and The Ugly; 20 Feb, 2002 from http://www.investopedia.com/printable.asp?a=/articles/analyst/022002.asp Securitization; Wikipedia, the free encyclopedia; from http://en.wikipedia.org/wiki/Securitization
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