Seminar in Project Financing

January 1-5, 2006 Tehran

Project Financing: The Case for Securitization in the Electric Utility Industry in the Islamic

Republic of Iran

Securitization Manual: Structure, Analysis, and Implementation*

By

Ghassem A. Homaifar

Professor of Financial Economics

Middle Tennessee State University, Murfreesboro TN 37132 USA

I would like to thank Mostafa Beheshtirouy Deputy Managing Director of the Parsian Bank for his insight on various issues relevant to this project that substantially improved my understanding of the microeconomics of securitization process in Iran. The author also expresses gratitude to Reuben Kyle, Jim Feller, Stephanie Wright, Carol White, Frank Michello, Bichaka Fayissa and Mahmod Haddad for reading and suggesting revisions that improved the clarity of my presentations. As always the author remains solely responsible for any remaining errors.

Acknowledgement

Is the firm facing higher funding cost?

The lender is likely to securitize its loan assets when removing assets than when keeping them on balance sheet creates more value.

Firms rated ‘AAA’ can secure credit in the market at a substantially lower cost than their counterparts with low ratings and with higher funding cost.

Securitize or not securitize

Does the firm need cash to grow and expand its existing operation,

To retire maturing debt, or buy back firm’s own stocks?

What are the alternatives cost of funding?

Alternative Funding

First alternative: The firm can borrow $25 million by issuing 7-year unsecured debt at all-in-cost of 7.25 percent from its bank.

Second alternative: Secured debt can be issued by pledging mortgage loan assets as collateral at all-in-cost of 6.75 percent.

Both funding scenarios are achieved by increasing assets and liabilities on balance sheet

Panel A Balance Sheet of Company A as of 01/02/XXXX in (000) Cash 2,000 Short term notes 1,000 Receivables 15,000 Senior notes 29,000 Residential mortgages 25,000 Sub-debts 20,000 Other 18,000 Equity capital 10,000

Panel B Balance Sheet of Company A as of 01/02/XXXX in (000) Cash 27,000 Short term notes 1,000 Receivables 15,000 Senior notes 29,000 Residential mortgages 25,000 Sub-debts 45,000 Other 18,000 Equity capital 10,000

Panel C Balance Sheet of Company A as of 01/02/XXXX in (000) Cash 25,750 Short term notes 1,000 Receivables 15,000 Senior notes 29,000 Investment in mortgages 1,250 Sub-debts 20,000 Other 18,000 Equity capital 10,000

The process of transforming relatively homogenous illiquid assets (receivables: current or future) off-balance sheet, through assignment or “true sale”, into heterogeneous asset-backed marketable securities for sale to third party investors is known as securitization.

What is Securitization?

Loan Originator (Sponsor) Third Party Guarantor (Credit enhancer) Rating Agency Special Purpose Vehicle SPV Arranger (underwriter) Liquidity Enhancer (secondary market

provider) Swap Counterparty Investors

Major Players

Intermediation

Banks and Savings &Loans were largely responsible to perform all functions of:

originating, servicing, credit risk taking and managing it, and investing in a typical mortgage loan.

Disintermediation

Disintermediation has shuffled various functions into different entities that specialized to perform. For example, an originator does not need to use its own funds to finance a mortgage.

Rather, using the capital markets to acquire funds cheaply has created thousands of mortgage companies, thereby:

Increased price and rate competition, and the range of available products.

The volume of securitized instruments speaks loudly of the success.

Obligors

Originator/Sponsor

SPV

Arranger/Underwriter

Investors

Liquidity Enhancer

Credit EnhancerRating

Agency

Swap Counterparty

Figure 1.1: Basic Structure of Creating Asset Backed Securities

Financial Engineering Process Securitization is financial engineering in a classic sense. The process

of financial engineering is as follows:

Diagnosis: is the firm facing high funding cost? Analysis: Are the assets suitable for securitization? Production: Repackaging and unbundling the pool into marketable

securities (underwriting) Pricing: The structure of securities created from the pool. What is the

Risk/return profile of new securities and types of credit enhancement attached to them?

Customization: Tailoring the new product to the specific needs of customers

Legal Framework: The law governing securitization in the country of issuance.

Diagnosis

Analysis

Production

Underwriting

Legal framework

Process

Structure of typical securitization

Receivables:

Current or future

Receivables:

Current or

future

Issues securities backed by the pool of receivables

Sponsor/originator Balance sheet

Special Purpose Vehicle Balance sheet

Tranche 1: L-risk

Tranche 2: Mezzanine M-risk

Tranche 3: 5% F-loss H-risk

Credit enhancement

Rating Agency’s Functions

Analyzes individual assets in the pool, compares them to the historical performance of assets in its data bank, and subjects the pool to stress tests based on severe market conditions.

Looks at the seasoning of the pool, as mortgages are more likely to default in the first four years.

Evaluates geographic diversification of the loans. Projects the amount of credit enhancement needed based on

the worst-case scenario. Secures legal certification that assets transferred to the SPV are

“true sale”, and thus legally isolated from the reach of originator.

Internal Credit Enhancements

These come in several different forms and are custom designed to enhance the quality of the underlying pool of the collateral. They possibly may alter characteristics of the cash flow of the securitized products. They can be classified as follows:

Over-collateralization Senior/subordinate structure Reserve funds Excess spread

Shift to Securitization in 1980

Deterioration of the credit quality of the major banks portfolio as a result of less developing countries’ LDC debt crisis of 1982.

Mushrooming innovative products induced by liberalization of regulatory landscape that transferred risk from banks & other intermediaries to ultimate investors.

Return to a more favorable macro-economic conditions, i.e., reappearance of positive real interest rates and upward sloping yield curves

Disintermediation of credits induced through securitization

Asset on Balance Sheet

Illiquid and non-tradable Not transparent Valued by originator Risk assessed by originator Originator has high cost of funding Have lower ratings Concentration risk is high Market is local Limited in terms, rates, duration, convexity, etc.

Asset backed securities ABS off-balance sheet

Highly liquid and tradable Transparent Value is determined in the market daily Risk assessed by rating agencies Originator has low cost of funding Credit enhanced with higher ratings Diversified Market is national and global Offers investors/borrowers variety of options

Summary of the basic requirements for Securitization

Standardization of contracts Standardization of underwriting and appraisal process Actuarial analysis of risk Standardization of governing laws Historical data base for estimation of default and delinquencies Reliable secondary market players Reliable supply of third party guarantor Reliable management information system

The keys for the success

securitization in the United States is related to the following phenomena:

Attracting private capital to the housing sector by meeting investors needs.

Providing lower cost financing for home ownership through increased price and rate competition among various lenders in a securitization process.

Reducing overall riskiness of the pool of mortgages through diversification,

To increase income stability and enhance the management of risks inherent in mortgage products.

Access to competitive rates and terms Access to cheaper financing Availability of array of financing alternatives Funding availability for all types of borrowers Reduced processing time Benefits to originators Reduce funding cost Improve profit margin on asset and equity Removing illiquid assets off-balance sheet Improve asset/liability management Reduce concentration risk

Benefits to borrowers/consumers

Increased product lines and fees Increased opportunities to expand operation nationally

and globally Increased trading volume and profit Improved efficiency and specialization Benefits to investors Attractive yields on rated securities Diversification of risk Improved liquidity Availability of vast array of products that meet their

desire in terms of duration, convexity, etc.

Benefits to arranger/investment bankers

May be attributed to several reasons: Homogeneity of the residential mortgages in terms of underwriting

standards encouraged by federal government involvement to promote home ownership that helps to increase job creation in a labor intensive sector of the U.S. economy.

Mitigation of default risk on the RMBS due to the existence of government or private insurers in this market.

Availability of large historical data base reflecting performance of the pool of mortgages in terms of delinquencies, default rates, payments, and prepayments that helped the investors to price various risks in determination of the fair market value of these asset backed derivative instruments.

Government and quasi government agencies created through congress various Acts is to be credited for establishing infrastructures i.e., active secondary markets (needed for providing liquidity), and the legal frameworks that encourage securitization.

The growth in securitization of RMBS

The need is the mother of all inventions. To manage and mitigate imbalance in duration of the assets and liabilities of the depository institutions, new innovative asset backed securities needed to improve asset/liability management.

Passage of the 1986 Tax Reform Act that permitted real estate mortgage investment conduits REMICS to be tax exempt entities as well as allowing REITs to invest in mortgages and their derivatives MBS products fueling growth of the securitization.

Last but not least was the profitability of these instruments as the proceeds from the sale of the pool was greater than the amount the pool paid to investors in the ABS credit enhanced by the originator or third party guarantor, thereby improving ratings beyond the rating of the sponsor or originator allowing the new securities to be sold to the ultimate investors at a premium.

Legal and Structural Issues

Revolving Credits Achieving Capital Relief Moral Hazard Problem Relationship Banking Cherry Picking & Lemon Selling Liquidity Facilities and Large Exposure Which Regulator?

There are three basic principles that ensure that an originator has surrendered control of financial assets and can legally record a sale of the assets:

- Asset isolation, - Originator or SPV control, - Originator or seller non-control.

The emerging market economies are faced with few problems in securitization, which include:

1. Country’s legal issues as to whether assets can be assigned to an SPV,

2. Limits imposed by rating agencies (sovereign ratings ceilings),

3. Local customs, such as whether direct debits (automatic/electronic payment of debt servicing obligation by a financial institution on behalf of an obligor or borrower) may be used for receivables and thereby qualify for securitization,

4. Lack of availability of currency swaps if receivables are denominated in the local currency.

The transfer of assets from the originator to SPV has to be a “true sale” which satisfies the following criteria:

(a) Intent of both parties as to sale/assignment of the assets.

(b) Asset isolation (perfection), that is legal. (c) Pricing. Assets are priced for transfer to SPV at fair

market value. (d) Repurchase. Right of repurchase agreement with

originator may lead into classification of transfer as a secured loan subjecting this to recourse by other creditors in the event of the bankruptcy of the originator as opposed to true sale.

Future Flow Securitization

This transaction involves the borrowing entity to sell future receivables that would have been generated by selling future products directly or indirectly to an off-shore facility known as special purpose entity (SPE).

Originator

Designated Foreign Obligors

Sells goods & services

Pays for goods by hard currency

Special Purpose Vehicle

Proceeds

INVESTORS

Pay for ABS

Receive coupon and principal

Offshore Trust

Structure of typical corporate future Flow-backed securitization

Offshore

Proceeds & excess spread

Heavy crude oil receivables Airline ticket receivables, telephone receivables,

credit card receivables, and electronic remittances

Oil and gas royalties, export receivables Paper remittances Tax revenue receivables Source: Standard & Poor’s (1999b), Fitch

(2000b)

Hierarchy in future flow-Backed Transactions

Bank in Emerging market

Country

Merchants in Emerging market country

Foreign Business and Tourist

Submit credit card vouchers

Pays for vouchers in local currency

Sells goods & services

Pays for goods by credit cards

Special Purpose Vehicle

Proceeds

Right to collect future receivables

INVESTORS

Pay for ABS

Receive coupon and principal

Offshore Trust

Sell Voucher

Pay Voucher

Structure of typical future Flow securitization

Offshore

Spreads of Pemex Finance Ltd. Securitized Debt and UMS* Versus US Treasuries

  Rating** $US million Average life (year)

Final life (year)

Spread over US

Treasuries

Coupon % Issue date

Pemex Finance A

AAA 500 3 5 125 5.72 12/4/1998

Pemex Finance A

BBB 350 7 8.5 350 7 12/4/1998

Pemex Finance A

AAA 400 10 11.5 175 6.3 12/4/1998

Pemex Finance A

BBB 250 18 20 412.5 9.15 12/4/1998

Pemex Sr. Unsecured

BB 600   10 462.5 9.375 12/2/1998

UMS* BB 1500   10 571 9.875 12/4/1998

Various risks Involved in Future Flow Securitization are:

Sovereign risk: will the originator government take steps to disrupt the payment arrangement set out in the structured transaction?

Performance risk: will the originator have the ability and willingness to produce and deliver the product?

Product risk: will there be sufficient demand for the product at a stable price and will the buyer meet his payment obligation?

Diversion risk: can the product or the receivable be diverted to customers other than designated customers?

Various types of Risks

Future Flow Securitization by Sector

  $ million Share of total dollar volume %

No. of transactions

Oil and gas receivables 16,362 45 25

Non-oil export receivables

7,537 20.7 40

Credit card receivables 4,314 11.8 37

Project finance 2,467 6.8 6

Telephone receivables 2,519 6.9 15

Remittances 1,731 4.8 14

Other receivables 1,443 4 11

  36,372 100 148

Source: Fitch, Moodys and S&P

Four-Tranche Sequential-Pay Structure*

Par amount

Coupon Rate Maturity in

Months

Principal Pay-down Window In Months*

Average Life**

Tranche A 21,500,000,000 0.174 36 36 1.625 year Tranche B 21,500,000,000 0.181 64 29 4.4 years Tranche C 21,500,000,000 0.190 85 22 6.36 years Tranche D 21,500,000,000 0.215 102 18 7.84 years

Total collateral

IR850 billion

Pass-through Rate

0.190

4.96 years

WAC of Collateral

0.2052

WAMof Collateral

102 Months

Four-Tranche Sequential-Pay Structure*

  Par amount

Coupon RateMaturity in

Months

Principal Pay-down Window In Months*

Average Life**

In year

Tranche A 21,500,000,000 0.174 24 23 1.04

Tranche B 21,500,000,000 0.181 43 20 2.82

Tranche C 21,500,000,000 0.19 61 18 4.4

Z Bonds 21,500,000,000 0.215      

Total collateral

IR850 billion 

     

Pass-through Rate

 0.19

102   4.96 years

WAC of Collateral

 

0.2052

     

WAMof Collateral

 102 Months

     

International Balance of Payments: Current Account

  1978 1979 1980 1981 1982

Total OECD* 12.2 -27.7 -69.1 -31 -26.4

Non-OPEC Developing

-24 -39 -63 -73 -60

OPEC 4.5 62 115 67 -5

Other Countries**

-9 -4 -11 -10 3

* Major Industrialized Countries

** Including Sino-Soviet area

Source: National Westminster Bank

Summary Statistics of Pemex 7-year and 18-year oil-backed papers and UMS 2026 (Unsecured)

  Pemex 7-years Pemex 18-years UMS 2026

Mean 309 356 372

Range 205 202 324

Standard deviation 63 62 79

Source: Basel Committee on Bank Supervision, Bank for International Settlements

Source: Islamic Republic of Iran Central Bank DAY 1381

Source: Islamic Republic of Iran Central Bank DAY 1381