by Dave Sinclair and Direen Eraman, Debt Capital Markets team, Rand Merchant Bank
Securitisation is simply a form of secured financing; no dark arts, no magic.
Securitisation is an efficient technique for raising capital and transferring risk from originators of financial assets to the capital markets. Financial assets, such as individual loans, are pooled, repackaged and sold off as notes to investors. The process transforms a large pool of illiquid assets into tradeable, liquid securities allowing investors to purchase a small share of the larger asset pool. More importantly, it allows companies to free up their balance sheets by turning to the capital markets as a complementary source of funding, rather than relying solely on banks. Following the collapse of the American sub-prime mortgage market in 2007 and the ensuing global financial crisis, securitisation fell out of favour globally. However it is far too useful to be banished for good and, over the past year there has been a significant international revival. Fortunately lessons have been learned and unlike the complex and opaque structures pre-crisis, the securitisations of today are structured to be transparent, simple, easy to implement and used primarily for funding purposes. South Africa is no exception to the trend and securitisation represents a significant opportunity for companies looking for alternative sources of funding.
Over the past year there has been a significant international revival in securitisation.
The asset types that were historically pooled within a securitisation typically include residential and commercial mortgages, auto loans, credit card receivables and corporate loans. But why stop there? Provided that the underlying assets are ‘high quality’, a securitisation structure can be used to unlock funding and liquidity for a company by pooling a variety of assets. High quality assets must be clearly identifiable, have defined terms of repayment, legally transferable, quantifiable revenue streams and a transparent history of how the underlying assets have performed. Entities are able to securitise a number of different assets or income streams such as mobile handset receivables, operating lease charges, rental streams, insurance premiums, medical aid contributions, municipal rates payments, customs revenue streams and airline ticket sales. This allows a company to transform its balance sheet and create the funding and liquidity for much needed growth.
Benefits of securitisation
Banks have long dominated the funding for companies, but the implementation of Basel III regulation for banks has put pressure on their lending activities. Banks are required to hold more capital and liquidity buffers, which results in an increase in banking costs and a consequential increase in interest rates charged to borrowers.
Reduction in funding costs
By using a securitisation structure, to isolate a portfolio of high quality assets, a company may be able to lower its funding cost compared to that of traditional bank or vanilla capital market funding. A securitisation transfers the assets from the originator’s balance sheet into a ring-fenced, bankruptcy remote, separate legal entity or Special Purpose Vehicle (SPV). This reduces risk for both the originator and the investor. The originator is protected from claims from the investor as the originator no longer owns the assets or income stream as these have been legally sold to the SPV. The investor may only claim against the performance of the assets or income stream in the ring-fenced bankruptcy remote SPV. Investors benefit as they are not exposed to a possible default by the originator and have a direct claim on the assets housed in the SPV. By separating the assets from the originator, the investor is better able to evaluate the risks involved. This simpler, more transparent structure reduces the risk for the investor allowing the originator to raise funding at lower interest rates. Often the senior notes issued by the SPV have a higher credit rating than the originator.
Diversified funding base
Originators can gain access to alternative, complementary funding sources. Where companies have previously relied on banks and traditional financing facilities, they can now source funding directly from institutional investors and asset managers in the capital market. As the public place more of their savings in pension and life products than bank deposits, asset managers have a growing amount of funds that they need to invest. Asset managers seek alternative investment products that provide consistent, predetermined cash flows that are backed by the high quality assets that have the lowest possible risk. Securitisations provide this product to asset managers allowing a company to raise funding from non-bank sources. Instead of relying on a handful of banks, securitisations allow a company to access a broader universe of funding channels by tapping the large number of pension funds and life insurance companies in the South African financial sector.
This funding channel can also be used by banks. Banks can securitise their own illiquid assets by selling them to institutional investors, creating liquidity and funding capacity for new business origination.[[[PAGE]]]
Balance sheet optimisation
Securitisation converts illiquid high quality assets or future cash flows into available cash up-front. The cash can be used to pay back more expensive subordinated debt or utilised to grow the business and converted into new high quality assets from which additional income can be generated. By securitising assets and increasing funding and liquidity, the originators financial ratios can be improved, enhancing the return on capital, gearing ratios, liquidity, credit risk management and better comply with financial covenants in respect of its on-balance sheet borrowings.
Table 1 illustrates the impact of a securitisation on a typical corporate balance sheet.
South African securitisation market
The South African securitisation market in the late 1990s and early 2000s was extremely robust and, given its infancy, it was relatively illiquid. The assets underlying the issuances ranged from residential mortgages to auto loans and credit card receivables. However, the effects of the American sub-prime crisis and the ensuing effects on the world economy resulted in lower issuance volumes from 2007 onwards. Securitisations worldwide were painted with the same tarnished brush. The American structures were overly complex and the asset quality of the pooled assets was too low. In contrast, South African and European securitisations experienced extremely low default rates as the structures were relatively simpler with larger subordination and higher quality assets. Over the past decade, the default on European securitisation instruments has ranged between 0.6% and 1.5%. To date, there have been no defaults on South African securitisations, clearly illustrating the robustness provided by these structures to both investors and originators.
The resurgence of securitisations in the South African market from 2009 to 2012 can be attributed to growth in the South African economy in the years following the financial crisis. South African GDP grew from -1.5% in 2009 to 3.2% in 2011, before declining to 1.5% in 2014. Despite the poor economic growth in 2014 and 2015, the securitisation market in South Africa is set to grow primarily as a result of changes in banking regulation. Basel III regulations have been adopted by the South African banking sector, requiring banks to hold more capital and maintain different types of liquidity buffers. This will impact the securitisation market in two ways. Firstly, banks’ cost of funding will increase, causing companies to seek alternative sources of cheaper funding in the capital markets, and secondly, banks will securitise their own assets to take advantage of cheaper sources of funding and to make use of liquidity facilities provided by the South African Reserve Bank.
The regulations encourage banks to transform their balance sheets from illiquid, bespoke loans to more liquid, marketable securities. In addition to the impact of Basel III, the lack of securitised paper in the market over the last four years has led to a shortage of secured alternative investments for asset managers. The combination of increased regulation and market shortage creates a favourable environment for corporates to utilise securitisation structures to raise funding resulting in expected increased volumes going forward.
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Structuring considerations
A typical securitisation begins with the originator identifying high quality eligible assets that exhibit stable and predictable cash flows. The strength of the asset portfolio is then coupled with structured financial engineering to issue securities having a higher credit quality than the originators’ overall financial strength. The originator then establishes an SPV for the purposes of securitisation and appoints an arranger to structure and implement the transaction. The SPV is a newly established entity that has the legal form of a ring-fenced company or an inter vivos discretionary trust. One of the most important considerations with respect to the SPV is to ensure insolvency remoteness, as far as legally possible.
The SPV issues securities to capital market investors in order to fund the purchase of the high quality asset portfolio from the originator. The securities may be listed or unlisted, however, if they are publicly listed, the applicable exchange listing requirements must be complied with. In order to optimise the risk profile and maximise the range of investors, the securities are divided into different classes or tranches. These tranches have different priority with respect to payment of principal and interest. The more senior tranches have the right to priority of payment over more junior tranches.
Securitisation transactions can involve multiple structured tranches. As the sophistication of structured products, derivatives and securitisation structures increase, it has become possible for investors to specify the ideal characteristics of a tranche they would be willing to purchase. Arrangers would proactively structure the transaction accordingly to maximise the benefit to both the originator and investor.
An independent, external credit rating agency is often engaged to provide:
- a thorough analysis of the underlying asset portfolio;
- the transactions’ structural features (including credit enhancement mechanisms); and
- the priority of payments.
The rating agency will provide a rating for the securities upon issuance and will provide ongoing ratings throughout the life of the transaction. Using financial engineering techniques such as over-collateralisation, excess spread, subordination and insurance, the arranger can structure the securitisation to achieve a better credit rating than the originators’ credit rating.
International trends
The South African securitisation market tends to follow the developments in the European markets and have relatively similar regulations. The European Banking Authority, the Basel Committee on Banking Supervision and the other European regulators have published new rules to aid securitisation revival as part of a drive to create additional liquidity and funding for the European economy with a specific focus on small and medium-sized businesses. The proposed European framework is seen as supportive to creating investment in the economy by promoting simple, standardised and transparent securitisations. South African industry forums have undertaken to pursue similar rules for the local market. The key features include high quality underlying assets, standardised offering circulars and legal documentation, simplified, standardised structures with market observable interest rates and standardised quarterly reporting.
Conclusion
Simple, transparent securitisations backed by high quality assets are experiencing a revival in the European and South African financial markets, providing an alternate, complementary source of funding to companies and banks. As issuance volumes increase, the securitisation market will become more liquid with a more diversified investor base. This leads to increased competition and translates into lower funding costs for corporates. As increased regulation is placing pricing pressures on traditional bank funding, corporate treasurers should consider securitisation as part of the toolset for effective financial management. Securitisation is an asset class that may be too costly to ignore.
