An entity may issue bonds to investors collateralized by the future profits expected to be derived from a portion of its existing life insurance business.
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When a pool of financial assets (such as auto financing, home or commercial mortgages, corporate loans, royalties, leases, nonperforming receivables, and contractually pledged operating income) is structured and transferred to a “special purpose vehicle or entity” (SPV or SPE), it is called a securitization transaction.
Generally, most securitization transactions are two-step transactions in which the originator of the assets being securitized transfers those assets to a wholly owned SPV.
In the SPV transfers or pledges those assets to another entity that issues rated securities in the capital markets backed by such investments.
This second-tier entity may be another SPV or a multi-seller commercial paper conduit and may provide financing through the issuance of medium-term notes or commercial paper.
Types of securitization transactions
In securitization transactions, the transfer of rights to assets can generally take two main forms, true sale or synthetic securitization.
1. True sale securitization
In a true sale securitization, the originator (e.g., a bank selling mortgages) sells the assets to the issuer. The assets are serviced by the servicer, who happens to be the originator, with respect to the mortgages sold to the issuer (i.e., the originator) and the originator continues to collect principal and interest from borrowers on behalf of the issuer for such mortgages and also takes care of any defaulting mortgages.
The significance of a true sale is that the first priority sale of assets from the originator to the SPV is structured as a “true sale” so that the assets are removed from the bankruptcy or insolvency estate of the originator and cannot be recaptured by any trustee.
Thus, the issuers are generally registered as bankruptcy remote entities; and may not engage in transactions other than those necessary to effectuate the securitization, which is referred to as a “limited purpose” structure, under which the SPV is not permitted to issue additional debt or enter into mergers or similar transactions.
Transactions may be conducted as conduits, whereby the buyer purchases and securitizes assets from a number of different originators. This is done through refinancing by issuing commercial paper to the capital markets.
Banks typically operate conduits by arranging securitization for their clients, or stand-alone where the buyer only purchases assets and issues them as asset-backed securities in a single securitization transaction. No commercial paper is issued.
It must be said here that the legal characteristics and economic substance of the transfer will be the primary determining factors, such as whether the transaction is a true sale and not a loan.
2. Synthetic securitization
In a synthetic securitization transaction, the originator does not sell any assets to the issuer and therefore does not receive any funding or liquidity under the transaction.
The originator enters into a credit swap with the issuer with respect to an asset or pool of assets and transfers the originator’s risk to the issuers. Under this agreement, the issuer pays the originator an amount equal to any credit losses incurred with respect to such asset or pool of assets.
The income streams of the issuer (SPV) in a synthetic transaction are the fixed amounts paid by the originator under the credit default swap and the interest amounts received on the collateral. These transactions are typically undertaken to transfer credit risk and reduce regulatory capital requirements.
3. Whole-business securitization
Apart from the two primary forms mentioned above, whole company securitization is sometimes used to finance participation in private or management buyouts of the originator. This type of securitization originated in the United Kingdom.
It involves the provision of a secured loan from an SPV to the originator in question. The SPV issues bonds in the capital markets and lends the proceeds to the originator. The originator services its obligations under the loan through the profits generated by its business.
The originator grants security over most of its assets for the benefit of investors. In terms of cash flow, there are three most common types of securitization transactions:
Collateralized Debt – This is similar to traditional asset-based borrowing. The debt instrument does not have to match the cash flow ratio of the pledged assets.
Pass-Through-This is the simplest way to securitize assets with a reg-by selling the interest in the pool of assets, i.e., an interest in the underlying assets so that principal and interest in the underlying assets are delivered to the security holders;
Pay-through debt instrument – this is a debt instrument and not a participant. Investors in a pay-through bond are not direct owners of the underlying assets, they are simply investors.
One important thing with SPVs is that unlike ordinary operating companies, whose charters typically provide maximum flexibility, the charters of SPVs provide that the company has only the powers necessary to fulfill the purpose of the securitization transaction.
Thus, in securitization, the SPV has only the authority to acquire the particular receivables contemplated by the transaction, issue the related capital market securities and make payments thereon, and so forth.
It is assumed that the reason for these restrictions is to minimize the risks of the SPV’s own insolvency: The smaller the scale of the company’s activities, the lower the risk of bankruptcy.
Securitization is based on the underlying assets being securitized. Rating agencies take a lot of time to assess the credit risk for all underlying assets in securitization transactions. Other risks considered are prepayment risks.
The risk is that a portion of the assets in the underlying pool may be repaid early. Payments and settlements in Ghana are considered good. Prepayments can reduce the weighted average life of the pool and, as a result, expose investors to significant uncertainty about future cash flows. This can be mitigated by separating the payment of principal and interest or converting fixed-rate returns to floating-rate returns.
Third-party risk
Collateral is not the only important factor in structured finance transactions. Servicer risk would be particularly high in Ghana. This is the case where the collection of payments, distribution to investors, and performance tracking fail. This is because credit ratings are not popular in Ghana.
A securitization or structured finance transaction involves many third parties who must meet their various responsibilities to make the transaction successful.” Time is money,” they say. Other third-party risks include fiduciary management of succession in the event of servicer default, notifying investors and rating agencies of breaches and defaults, and holding cash to prevent misuse of cash flows by servicers; manager responsible for balancing competing interests within a transaction.
Financial risks (interest rate risk, foreign exchange risk, devaluation risk).
Financial risks usually include interest rates, exchange rates, availabilities, currency, and inflation risks. Inflation really affects the originator of a securitization transaction for reasons such as increasing the cost of the transaction, which can delay its closing.
Some governments are also skeptical of foreign investment in their country and sometimes prevent the repatriation of funds by foreigners abroad. Devaluation and interest rates can have a negative impact on securitization, as can inflation, especially if not foreseen in the transaction deal.
Russia is a good example. International funds are often cheaper than local ones, but given that payment on receivables is sold locally and paid in local currency, the use of foreign loans creates the risk of currency devaluation.
Political Risk
Because cross-border transactions are conducted in such a way that assets generate cash flows in local currency while the securities backed by those assets are denominated in foreign currency, there is a risk that the issuer will default on payment regardless of the credit strength of the underlying assets. The following relevant known political risks are identified:
Expropriation risk:
The act of taking something from its owner for public use. This includes the act of a government taking assets or accounts of local parties in the event of a financial crisis.
Nationalization:
Transfer of businesses from private to government ownership. This is not usually experienced in the West as it is in South America and Africa. In terms of Ghana’s political situation, this is not envisioned.
Convertibility risk:
This is the risk that the government could impose a moratorium on all foreign currency debt in a national crisis due to a financial crisis in the country.
Change in Law:
The ruling government can change laws overnight, which can affect structured finance. Sometimes for business and political reasons, tax laws are enacted that may not be to the originator’s advantage in terms of increasing costs on certain elements that may increase the purchase price of the product at closing and jeopardize the securitization transaction, which must be made cheaper if it is to be successful. For example, an increase in fuel tax may impact the entire transaction, as tax neutrality is paramount to the securitization transaction.
Legal & Documentation Risks
Following the legislative change in political risk discussed above, potential legal risks to a securitization transaction include an inadequate legal, legislative and regulatory framework for tax, finance, money markets, and securities.
Sometimes the case and administrative laws are not developed in the country concerned. These issues are of great concern to investors and, moreover, the originator will have to deal with this risk.
However, for asset-backed securities (ABS), the legal and documentation risks include uncertainty related to the transfer of assets from the seller/originator to the SPV (i.e., “true sale”), the need to ensure that ABS holders maintain full control over the underlying assets; the bankruptcy segregation of the issuing SPV.
This means reviewing all obligations related to the separation of the SPV from the seller; the legal roles of the trustee and service provider in all relevant jurisdictions, including Ghana, in order to mitigate operational and execution risks associated with the payment and receipt of transactions.
Due to the changes in deal structures and taking into account Ghana’s legal and financial environment, legal and documentation risks will be very high.
Regulatory Risk
The risk is that originators and other lenders are not treated fairly. There should be a defined profit sharing regime, regulations on the instruments being valued, and most importantly the structure of the SPV issuing the securities.
Liability structure risk
This risk is the issues associated with the tranche or split of securities that involve conflicting interests that, if left unchecked, can disrupt the appropriate distribution of claims to end investors.
The key to structured finance transactions is the payment waterfall, which establishes covenants for the payment of interest and principal and the allocation of losses among investors.
This can be addressed with over-collateralization tests to ensure that there is sufficient collateral in the underlying pool of assets to cover principal payments, and interest coverage tests to ensure that there are sufficient interest proceeds to cover interest payments to bondholders.
Level of risk
Rating agencies would typically need to evaluate the totality of risks contemplated in each transaction before assigning a rating to the security. Hence, the potential for any bad debts and the appropriateness of any credit enhancement to ensure that the right level of default risk is assigned to the end investors.
Cross-border transactions, for example, require a specific analysis of the potential limitations that could apply to the rating of the debt securities due to the potential default of a government and the possible application of a moratorium by a government in times of crisis.
Advantages of securitization
The use of securitization is not limited to a specific asset or revenue stream. The application goes beyond existing bank financing products and equity financing arrangements. The challenge is the approach used to consider securitization and the ability to measure its impact on the future of the business. This is due to the fact that securitization is focused on cash flow rather than profit improvement.
In general, securitization can provide the following benefits, and we would later analyze whether it would benefit Ghana.
Efficient access to capital markets: For most liabilities, for example, if transactions are structured with ratings from a recognized rating agency, pricing is not tied to the creditworthiness of the originator. This is very important if the originator is not creditworthy.
The constraint on the issuer-specific entity’s ability to raise capital is reduced: securitizations can minimize an entity’s inability to raise capital because the capital raised in the securitization becomes a function of terms, credit quality or rating, prepayment assumptions, and prevailing market conditions.
Illiquid assets are converted into cash: Securitization facilitates combining assets that could not otherwise be sold on their own to create a diversified collateral pool against which debt instruments can be issued.
Raise capital to generate additional assets: capital can be raised quickly, such as releasing long-term capital for all permissible purposes, such as completing a capital project and purchasing additional assets.
Match assets and liabilities to minimize risk: A well-structured securitization transaction could result in a near-perfect match of maturity and cash flow, which includes an interest rate differential between the interest rate earned on assets and the interest rate paid on debt.
This means that Ghanaian companies can raise sufficient funds due to the risk transfer without necessarily providing collateral for the security.
Raising capital without prospectus disclosure: A conduit securitization transaction allows capital to be raised without disclosing sensitive information of any kind; in fact, information is kept confidential.
Complete mergers and acquisitions and divestitures more efficiently: assets can be efficiently combined or sold in a securitization transaction.
By splitting assets into smaller pieces against which debt is issued, it may become possible to eliminate other business units that are no longer profitable.
Transfer risk to third parties: Some of the financial risks from loans and other contractual obligations from customers can be transferred to investors through securitization.
More refinancing beyond bank loans: A structured securitization transaction allows the originator to raise refinancing while retaining the right to profit on the receivables.
However, these funds are not linked to their creditworthiness; instead, the creditworthiness relates to the special purpose entity created for the securitization transaction. By creating an offshore SPE, many companies in Ghana with poor credit ratings could potentially raise funds for any purpose.
The overall effect of securitization of bank loans and credit aggregates is likely to be a reduction in lending by the money sector and a reduction in M3 of a similar magnitude.
That is, the banking sector closes its balance sheet by offsetting some loans against some M3 deposits. However, the original borrowers still have obligations, but vis-à-vis the SNI, no bank and institutional investors still hold assets that are now tradable securities and not M3 deposits.
Structure of Ghana’s Financial System
The financial system consists of Bank of Ghana
I. Savings and Loan Bank
II. discount houses
III. Financial houses
IV. Leasing companies
V. Forex Office
Securities and exchange commission
I. Stock Exchange
II. brokerage firms
III. capital management companies
IV. Trustees and custodians
National insurance commission
I. Insurance companies
II. Insurance brokers
III. reinsurance companies
The banking system in Ghana is structured to serve the needs of all citizens as much as possible. At the end of 2005, the banking sector consisted of commercial banks, universal banks, commercial banks, development banks, ARB Apex banks, and rural banks; with total asset growth of 17.62%.
The Non-Banking Financial Institutions (NBFI) sector consists of savings and loan companies, discount stores, finance companies, and leasing companies. Total assets of non-banking financial institutions also grew by 47.98%, which was mainly triggered by loans, investments, other assets, and fixed assets. Discount houses hold 82.61% of the total investments in the NBFI sector.
The new banking law, Act 673, which came into effect in 2005 with its higher capital adequacy ratio requirements, new sanctions regime, and higher governance standards, ensuring that banks generally met regulatory and supervisory requirements.
The Securities Market in Ghana
African stock exchanges face a number of challenges before they can enter a new phase of rapid growth. The most critical issue is the removal of existing barriers to institutional development. These include wider dissemination of information in these markets, the introduction of robust electronic trading systems, and the adoption of central depository systems. Ghana has since established a central depository system in November 2004.
Ghana’s securities market is regulated by the SEC. The Ghana Stock Exchange is underdeveloped relative to exchanges in the U.S., Europe, and even South Africa. South Africa, for example, has a market capitalization of $180 billion, one of the largest in the world with Ghana’s market capitalization at $11 billion.
Considering that Ghana has only one securitization transaction – structured finance – without records for research and the position of Ghana’s macroeconomic situation, it was deemed appropriate to consider the securitization transaction in South Africa.
Although still at an early stage of development, the securitization transaction in South Africa has grown rapidly in recent years and would be an appropriate “yardstick” by which to carve Ghana’s securitization transaction.
According to the information available, the first securitization in South Africa was aimed at securitizing mortgages; development was very slow over the 11 years. In 1992, securitization was applied to the leasing and rental of business equipment until the 1997s to 2000s with the securitization of trade receivables, real estate, future rebate flows, future cross-border flows and CLOs.
South Africa’s motive for the securitization transaction was to benefit from more efficient financing and profit maximization; improved balance sheet structure and funding ratios; improved risk management; and lower economic and regulatory capital requirements, among others.
Although securitization transactions are still in their infancy in South Africa, available records show that issuance by domestic banks in South Africa (i.e., private banks) has increased from 250 million rands in 1989 to a whopping 26 billion rand at the end of October 2005.
Based on a recent study conducted in the U.K. market, which suggests that securitization offers investors the opportunity to earn a higher after-tax return compared to the after-tax returns generated by equity-related real estate investments, securitization in South Africa is used as an acquisition tool in the purchase of real estate and as portfolio optimization and value enhancement tool.
Securitization regulations in South Africa compare favorably with international regulatory practices similar to those in the United States of America and govern the manner in which securitization assets and income streams are transferred from the originator to the SPV, as well as operational aspects and efficiencies of the SPV.
In the South African market, there are differing opinions on how to comply with the securitization prescription. One focuses on the use of specific words “bank or deposit-taking institution” that only South African banks can originate from a securitization. The other opinion refers to non-compliance when a company or entity other than a bank originates a securitization.
The task is that securitization transactions are also referred to in the regulation as an activity that is not limited to the business of a bank under certain conditions; In this way, entities that are not banks can initiate a securitization transaction.
The 2004 Annual Report of the Ghana Securities Exchange Commission does not mince words about the state of the Ghanaian securities market. It reported that “despite the slight decline in percentage index performance, the GSE maintained its position as one of the best performing stock exchanges in the world for the second consecutive year in 2004.”
The market capitalization of listed companies on the Ghana Stock Exchange increased by 84.90 trillion cedis from just 12.6 trillion cedis to 97.61 trillion cedis. In dollar terms, market capitalization increased by 654.0% from US$1.43 billion at the beginning of 2004 to US$10.8 billion at the end of 2004.
Unlike the stock market, the bond market was relatively low in 2004, posing “a serious market development challenge for the Commission.” The turnover value of listed corporate bonds fell to $73,414 in 2004 from $606,600 in 2003, a decline of 87%, while government bonds also fell 71%. The value of listed corporate bonds was $6.79 million in 2004, down from $8.98 million in 2003.
The corporate bond market remained relatively quiet. However, U.S. dollar-denominated corporate bonds traded in the market increased by $41,783 to $115,200.
The Government of Ghana is committed to using municipal, corporate, government, and agency bonds to improve activity in the primary market. As a result, in 2005, the Bank increased its accountability and transparency in line with International Financial Reporting Standards (IFRS) best practices in its financial reporting and disclosures.
In conjunction, other relevant government measures were strengthened to revive revenues and consolidate public spending aimed at reducing the domestic debt-to-GDP ratio. As a result, the government launched a program to reduce the domestic debt-to-GDP ratio to enable the private sector to access credit and lead the growth process.
The importance of the Bank of Ghana in the financial system is that the Verbotk provides technical assistance in the legal and regulatory reform of the financial system to minimize risks and ensure legal certainty, especially in electronic transactions; and also monitors various financial laws at various stages of development.
There is no doubt that people learn from the experiences of others, just as nations learn about the successes and failures of other nations, especially with regard to something new and complex like the concept of securitization transactions. It is recommended that securitization in Ghana be based on the experience of South Africa’s securitization transactions, with some changes in the legislation to suit the situation in Ghana.
Ghana’s private sector undoubtedly faces many constraints, but the other side is that there are so many opportunities, either untapped or unidentified comparable, as well as other natural and mineral resources that already exist in large quantities.
There is potential for more effective use of these endowments. But the country’s continued reliance on a few commodities with low prices and wages, facing fierce international competition in slow global markets, has left it vulnerable to hardship. These products could be structured and securitized.
Training of securitization transaction stakeholders such as originators, service providers, legal counsel, accounting advisors, tax advisors, and others must be continuous from now until the launch of the technical details of the securitization transaction. There should be no mediocrity, as are the characteristics of government and government agencies.
Investors and potential originators also need to be educated on the benefits of securitization as an alternative to traditional capital formation in addition to equity and debt, which are common in the Ghanaian business environment. Provide a better understanding of the cash flow drivers behind securitization transactions, rating agencies, and also credit enhancement issues. This would create a strong desire for this form of capital formation to bring Ghanaian companies into the race to compete well on the international stage.
The technicalities of capturing the intrinsic techniques to properly analyze the segregation of assets and income streams from the company that owns them to the SPV that is supposed to control the assets for the benefit of the investors need to be well understood by the investment community.
A lack of true understanding of the drivers behind a securitization transaction, the ability to measure the impact on future operations as well as the initial costs associated with the securitization, leads to difficulties in clearly defining the true incentives for South African companies to engage in securitization. Therefore, a comprehensive understanding of this nature among Ghanaian companies will boost the securitization transaction.
One issue that needs to be addressed very well is the tax laws to make the securitization transaction work. Ghana operates a free zone program that can be expanded to encourage securitization transactions. Certain areas within the country could be allocated as a “free zone for securitization” and “used as a tax haven” to cultivate and nurture securitization in Ghana.
The regulatory environment in which securitization is conducted, in conjunction with the capital market infrastructure to support appropriate pricing of all risks associated with all forms of securitization transactions, synthetic or “whole business transactions.”
Finally, it is recommended that research into the legal framework for bankruptcy, tax, and commercial law in relation to structured finance and securitization be encouraged, particularly among Ghanaian academia.
Ghana indeed has a favorable environment conducive to securitization transactions. Key issues that can drive this includes, as mentioned above, the extension of existing laws such as tax, bankruptcy, and commercial laws to deal with securitization transactions.
Ghanaians are strong-willed, energetic, and patient. If the expertise for securitization is acquired with the training of the above stakeholders, the good governance of the other key government policies such as MIDR and Strategy for 2004-2008, and the improvement of Ghana School Financing activities, they will serve as a catalyst for securitization.
Given South Africa’s experience over the past decade, the developed economies’ experience with securitization transactions and the macroeconomic and investment climate over the next 10 years will not stray too far from participation in securitization transactions, if it is not already there.
Reference:
- “Securitization in South Africa-a revolution for local funding,” by Bagley et al(2003) Fitch Ratings avaiLable online accessed 20/07/2007.
- “Securitization: a public instrument?” Treasury working paper, by Davis,N, available online treasury.govt.nz/workingpapers/ retrieved on 20/07/2007.
3.’ Securitization.’ Wikipedia, the free encyclopedia. Reference.com Retrieved February 25, 2007.
4.’Consider Securitisation to improve liquidity in the South African property market’ by Eugene G van den Berg, retrieved on vinodkothari.com retrieved on 04/08/07.
- “Note on the impact of securitization transaction on credit extension by banks” in the December 2005 Quarterly Report by N. Gumata and J . Mokoena
- “The awakening of securitization in South Africa”, by Van Vuuren available online vinodkothari.com/secafric.htm
- Africa – Ghana organizing in the informal sector (online) Available at oecd.org/dataoecd/html (accessed April 29, 2006).
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Wendy is now a financial analyst and writer. Wendy has been writing about finance and personal finance since she was a sophomore in high school. She has also been writing for several online publications and published in The Huffington Post, and Forbes Woman.
Wendy is a credentialed financial analyst and has experience working with financial institutions and businesses. Wendy is also a certified financial planner. When Wendy's not writing, she enjoys tending to her many plants, watching TV, and spending time with her family.
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