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Innovations in Corporate Finance
Innovations in Corporate Finance
Securitizing future cash flow This is the purpose of standard bonds. However, they draw upon the general cashflows of a company. Project financing channels pre-specified subsets of a company’s cashflows to bondholders. More specialized “projects” like rock-nroll bonds.
Rock-n-Roll bonds David Bowie, issued February 1997, raised $55 m. by selling securities. Backed solely by expected royalites from future sales of his first 25 albums. 7. 9% coupon, 15 yr maturity, 10 yr. av. maturity. Investment banker on the deal was David Pullman at Gruntal & Co. Prudential Insurance Co. is purchaser. Bonds guaranteed by EMI Group Plc.
Rock-n-Roll bonds Ethan Penner, in Sept. 1997, set up Nomura Capital Entertainment Finance to be sole investor in making $1 billion in loans to musicians, actors and studio executives. Bear Stearns is interested in securitizing the expected cash flows of existing and soon-to-be-released films. Target: Insurance companies looking for diversification.
Problems/Questions What is the purpose of the loan for the issuer? Consumption Diversification Artists might want to repurchase artistic works that they were forced to sell earlier in their careers. To buy other artists’ intellectual properties. Tax reasons What about the issue of Moral hazard?
Valuation of Rock-n-Roll Bonds Actuarial approach is not possible. One-of-akind. The riskiness of cashflows from the asset itself as opposed to the issuer (e. g. if Citibank securitizes its credit card receivables) Collection of cashflows (from the entertainment industry) will have to be more scientific and specialized. How to evaluate cashflows that are projected to grow, rather than depreciate? (Lengthens the life of the asset. )
Rock-n-Roll Bonds Possible solutions: Diversification of trust issuing the security. This is the Penner strategy. Securitize cashflows from known artists and/or known works with a history. Credit Enhancement
Corporate Bonds which Securitize Insurance Risks Catastrophe or Act-of-God Bonds Weather Bonds
Issues Insurance companies can go bankrupt; traditional insurance requires a very large amount of capital. Insurance companies are locked into the deal for a long time. Investors in capital markets are more willing to hold these risks, because they can sell them off.
Catastrophe Bonds Oriental Land Company placed two $100 million catastrophe bonds with special purpose reinsurers to protect against earthquakes. First bond has a five-year maturity. Payment depends upon magnitude, location and depth of earthquake, regardless of actual property damage. (Why? Auditing problems? ) Second provides post-earthquake financing: Oriental Land will ussue a $100 million 5 -yr bond to the reinsurer with no interest for the first three years. (Put like? )
Weather Bonds In Oct. 1999, Koch Ind. , of Wichita and Enron Corp, of Houston issued $200 m. of weather bonds. The interest on the Koch bonds depends on the weather in the 19 cities in which Koch operates. If temperatures are similar to historical levels, the coupon is 10. 5%. If temps are colder (warmer) by ¼ degree on average, the coupon is 10% (11%). Koch’s objective: Hedging Value for investors: Diversification
Alternatives to Securitization of Insurance Risks Catastrophe Insurance Catastrophe Derivatives Pros and Cons: Information Costs versus Basis Risk
Securitization The repackaging of receivables in a tradable form. SEC definition: "the creation of securities that are primarily serviced by the cashflows of a discrete pool of receivables or other assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holder
Securitization: Purposes The goal is to sever the risk of originator insolvency from the risk of asset performance: the investor can rely on asset risk rather than the general corporate credit of the originator. Increase the clientele for the company’s liabilities and thus decrease the cost of financing.
Earliest examples: The market for home mortgages Banks provided loans for the purchase of homes. Government agencies, such as the Government National Mortgage Association (GNMA), and the FHLMC (Freddie Mac); and private corporations, such as the Federal National Mortgage Association (FNMA) were charged with providing broader and more stable sources of capital to the residential mortgage market.
Mortgage Backed Securities These agencies started securitizing mortgages by purchasing home mortgage loans from local lenders and guaranteeing securities backed by pools of residential mortgages. Result: Volume of funds available for housing expanded. Redistribution of mortgage funds from capital-surplus to capital-deficit regions.
An example: GNMA pass-throughs were issued by mortgage bankers and were backed by pools of newly issued FHA/VA single-family mortgages (i. e. loans guaranteed by the Farmers Home Administration or the Veterans Administration). GNMA guaranteed the timely payment of scheduled monthly principal and interest. These guarantees represent full faith and credit obligations of the US Government.
Structure of a GNMA Pass-through Homeowners Interest Scheduled Principal (Amortization) Prepayments Servicing Fee/ Guarantee Fee Originator/Servicer Delinquencies Defaults Investors
Credit Enhancements The purpose is to improve the quality of the asset External Enhancements Corporate Guarantee Letter of Credit Pool Insurance Bond Insurance
Credit Enhancements Internal Credit Enhancements: Reserve Funds Cash Reserves Excess Servicing Spread Accounts Overcollateralization Establishing a pool of assets with principal amount of the securities issued. Senior/Subordinated Structure The subordinated class absorbs all losses on the underlying collateral, protecting the senior class. A Shifting Interest Structure redirects prepayments disproportionately from the subordinated class to the senior class according to a pre-specified schedule.
Collateralized Mortgage Obligations CMOs are bond classes (tranches) created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk. Sequential Pay tranches: Principal payments are directed to the seniormost tranche until it is paid off, then to the next senior tranche, etc. Accrual bond/tranche: The interest for this tranche accrues until more senior tranches are paid off.
Automobile ABS Traditional Auto ABSs price up to 10 bp wider than credit card ABSs because auto deals have amortizing tranches that depend on prepayments. In Aug. 99, GMAC securitized a pool of amortizing auto loans and created bullet maturity structures by having all the amortization that occurs between bullet payments get absorbed by a variable funding certificate. This structure matches corporate bonds and makes it easier to construct swaps.
Sport Securitization Formula One, the British company that manages the international car-racing championship has issued $1. 4 b. in bonds securitized by all assets of Formula One’s business, including its TV and promotional contracts. Shows that intangible assets and intellectual property rights can be the basis for securitization.
Standard Lease vs. Purchase
Synthetic Lease Company can use the depreciation on the asset. The lease and the asset do not show up on the balance-sheet of the company: the lease structure allows classification as operating lease. The company obtains operating control of the asset, unlike in a traditional operating lease. Payments to investors can be structured to resemble a bullet loan. The lenders do not have to bear all the risk of the asset’s end-value, as in a bullet loan, because of the final guaranteed payment.
Catastrophe Bond w/ Synthetic Put USAA, in 1998, wanted to cede $400 m. of insurance risk. It sold a structured note split into two classes. Tranche A 2 of $313 m. , paying LIBOR+5. 76% is fully at risk if insurance losses go above $1 b. Tranche A 1 of $163 m. , paying LIBOR+ 2. 73%, has its principal protected (a portion of the tranche is placed in escrow to be paid to A 1 investors). In effect, USAA does not have to pay $313 m. of insurance losses, if total losses go above $1 b. Equivalently, it can put $313 m. worth of insurance contingent on total losses going above $1 b.
Synthetic IPO Allows issuers to sell shares, but investors purchase bonds. Issuer raises non-recourse financing, but holds on to a 100% shareholding in company.
Synthetic IPO SLEC is a holding company that owns Formula One (FO) Management that owns the assets. FO Finance, a SPV, lends money to FO Administration, another SPV, to buy FO Management shares from SLEC. These funds are raised by a loan issue made by FO Finance. After the share purchase, FO Administration buys assets from FO Mgmt. SLEC, which owns the SPVs, gets the money from the bond issue, and retains control.
Synthetic IPO Ecclestone, the owner of FO does not want to issue an IPO currently because it currently has stable earnings, which is not attractive to investors. Ecclestone believes that in the near future, FO will have explosive growth. At that time, he will want to issue stock. Since investors already know FO, the stock issue will be easier then. FO does not have to provide the disclosure that a standard IPO would require.
J. P. Morgan ARPPS Corporate treasurers have to decide how to invest short-term funds. Preferred Stock is attractive because of the tax preference on dividends received. 70% of intercorporate dividends are deductible for tax purposes.
Disadvantages for Investing Corporations Issues for the Corporate Treasurer: Safety Short-term liquidity
Floating versus Fixed rate securities Fixed Rate securities are riskier for investors with a short-term horizon. Floating rate securities are less desirable for issuers because of refinancing risk Cost of refinancing
Compromise: ARPPS Long-lived security with a floating rate: reduce refinancing costs. Limits on coupon payments: reduce refinancing risk for issuer. Offsetting characteristic: The benchmark rate is the max of three rates: T-bill rate The 10 -year constant maturity rate The 20 -year constant maturity rate
Investor Risk Reduced risk protection due to collar. The floating rate structure reduces price risk. The benchmarking of the coupon to the max of three rates makes the security more desirable. The 4. 875% penalty is the premium for the option implied by the benchmarking criterion.
Investor Risk Investor not protected against nonparallel term structure changes: If the yield-curve flattens, the investor would be getting less value for the 4. 875% implied option premium. If interest rates become less volatile, the fixed 4. 875% option premium would become too high.
Alternatives to ARPPS CAPS: Convertible Adjustable Preferred Stock These securities were convertible at any time into as many common shares as it took to obtain a market value equal to the CAPS par value. This was supposed to reduce fluctuations in their market value, which was a problem with the ARPPS. What is the advantage of making the CAPS convertible into stock? Why not make it puttable? Would there be any reason for CAPS not to trade at par?
Alternatives to ARPPS PARPS: Price Adjusted Rate Preferred Stocks The dividend on the PARP stock was inversely proportional to the observed trading price of the security in a specified two-week period. In other words, the sum of the capital gain and the cash payout was to be kept as stable as possible. Can you think of any problems with the price stability of PARPS?
Alternatives to ARPPS MMP: Money Market Preferred Stocks Every 49 days, the yield on the MMP security would be reset through a Dutch Auction. All winners of the auction would receive the same dividend rate in the future 49 -day period, equal to the highest bid (dividend rate) that cleared the market. In theory, this would clear the market at a price equal to par (since the winning bidder would be willing to pay par by definition). DARTs was the name given to comparable securities issued by Salomon Brothers.
Alternatives to ARPPS Municipalities issued similarly structured debt instruments that were also designed to maintain their value. Since these were munis, they were free of federal tax liability. At the same time, the municipalities did not need the equity classification of the Floating Rate Adjustable equity securities discussed above.
Trust Preferreds A recent alternative to ARPPS? Similar to ARPPS, these securities are also structured to be carry tax advantages to investors and desirable balance sheet/tax characteristics to issuers. Riggs National Corp. of Washington, sold $200 million of floating-rate trust- preferred securities in July 1999. The issue has been rated on the borderline between investment grade and noninvestment grade by Moody's Investors Service and Standard & Poor's Inc.
Structure of a Trust Preferred
Trust Preferreds Also used as a way to manage reporting requirements because they are not treated as debt for reporting purposes. For financial reporting purposes, the loan from the subsidiary to the parent is eliminated, leaving only the preferred stock issued to outside investors in the balance sheet. This need not be shown as debt. However, because the trust is structured to qualify for tax purposes as a partnership, it does not have to be consolidated for tax purposes, and the interest paid by the parent is tax-deductible.