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Financial Services
Simply Securitisation
Connectingthe process
Series 1/2006
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While all reasonable care has been taken in the preparation of this publication, it should not be considered as a substitute for professional
advice. The issues contained herein have been described in general terms and it is recommended that readers seek professional advice
regarding their specific circumstances.
Table of Contents
1. Introduction ........................................................................ 1
2. The securitisation process ................................................. 2
3. The securitisation components .......................................... 3
3.1. Asset classes .................................................................. 3
3.2. Credit enhancement ...................................................... 3
3.3. Liquidity facilities ........................................................... 5
3.4. Owner trust ................................................................... 5
3.5. Rating ............................................................................ 5
4. The effects of accounting treatment,
taxation and regulation on securitisation ....................... 6
4.1. Accounting .................................................................... 6
4.2. Taxation ......................................................................... 6
4.3. Regulation ..................................................................... 7
Key Contacts ............................................................................ 8
Glossary ................................................................................... 9
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Securitisation provides local institutions with additional
flexibility in managing credit, liquidity and other risks
involved in originating and funding assets. Depending on
the particular structures utilised, these risks can be eitherretained by an originating institution or passed on to
investors and others involved in the schemes.
The securitisation market in South Africa continues
to grow in both size and innovation. This publication
therefore does not attempt to cover each possibility arising
from any individual securitisation transaction, but to
provide readers with a basic explanation of securitisation
and the benefits thereof.
It has been widely observed that securitisation offers
tremendous opportunities and potential benefits to issuers
and investors. Securitisation also provides companies with
access to an alternative funding source compared to the
traditional funding mechanisms available in South Africa.
For issuers, securitisation provides a vehicle that can
be used to transform non-liquid financial assets into
tradable capital markets instruments. It offers an efficient,
diversified source of financing, often at lower execution
cost than is available through traditional bank loans, debt
or equity financing.
Securitisation can potentially also facilitate the removal of
assets from company balance sheets. The proceeds from
the transfer of the assets can be invested in other assets
with a better return.
This process also transfers the risk of exposure to one asset
type to investors and the capital markets in general.
For investors, securities issued by a securitisation
vehicle generally offer an attractive return compared
to a government security with similar credit quality and
maturity. The securitisation sector permits investors to
diversify their investment portfolios and corresponding
risks, while offering a significant variety and flexibility
of credit, maturity and payment structures and terms,
attributes that may be tailored to meet specific investor
needs.
In its simplest form, securitisation is a method of funding receivables (assets), such as mortgage debts,
leases, loans or credit card balances, through creating freely tradable securities backed by these assets.
1. Introduction
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A company may have assets on its balance sheet that
are producing a return, normally in the form of interest.
These assets usually also have a funding cost attached
to them, even if it is the cost of internal cash resourcesof the company that may be more profitably employed
elsewhere. The assets are grouped into a homogenous
set (e.g. all mortgage loans where the customer meets a
specified list of criteria such as loan to value ratio, credit
rating, geographic location, etc).
This set of pooled assets is then sold to a special purpose
vehicle (SPV) set up specifically for the securitisation
transaction i.e. the SPV does not own any other assets.
The SPV then issues securities (e.g. bonds or commercial
paper) to investors. The balance sheet of the SPV reflects
assets (a pool of mortgage loans) and liabilities (bonds or
commercial paper). The cash received from the investors
is used to pay off the liability the SPV has for the purchase
price of the asset pool it acquired.
The income statement of the SPV reflects interest income
on the mortgage bonds and interest expense on the bonds
or commercial paper issued. As cash is received from
bondholders in the form of their monthly instalments,comprising interest and capital, this cash is used to settle
the interest obligation to the investors and to either
redeem the notes issued, or to acquire further mortgage
assets.
The investors, for the most part, decide whether to invest
in the securities based on the quality of the underlying
assets in the SPV. This is where the term Asset-Backed
Securities (ABS) comes from.
The company that sold the pool of assets primarily decides
whether to participate based on the amount and cost of
funding it can generate from the securitisation transaction.
The end result is that the assets are converted into
securities that can be traded in the capital markets.
In a securitisation transaction, the securitised assets are transferred to a special purpose vehicle created for
the limited purpose of entering into the securitisation transaction.
2. The securitisation process
Figure 2.1: An illustration of a typical securitisation transaction
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3.1. Asset classes
A wide range of assets could be securitised,
including the following:
3.1.1. Asset-Backed Securities (ABS)
A pool of assets consisting of credit card
receivables, vehicle loans or leases, other types
of consumer loans, equipment leases, trade
receivables, etc.
3.1.2. Residential mortgage-backed securities
(RMBS)
A pool of assets consisting of residential
mortgage loans.
3.1.3. Commercial mortgage-backed securities
(CMBS)
A pool of assets consisting of commercial
mortgages that may consist of a single property or
a group of properties financed by a single borrower,
or a pool of assets that combines numerous
loans from different borrowers secured by diverse
commercial properties.
3.1.4. Collateralised debt obligations (CDOs)
A pool of assets such as commercial loans to
corporates or small and medium-sized enterprises
(SMEs).
3.1.5. Future flow securitisationsThe future cash flows from a pool of physical assets
such as export receivables and airline receivables
or flows from financial assets such as credit card
voucher processing receivables, trade payments
rights or worker remittances.
A variety of assets, including those discussed above,
can also be funded by securitisation programmes
that issue short-term paper through Asset-Backed
Commercial Paper (ABCP) conduits.
There has also been an increase in the use of
synthetic securitisation structures that rely on the
credit derivative market to allow for risk-based, as
opposed to asset-based, structures.
3.2. Credit enhancement
Securitisation transactions rely on the credit quality
of the pool of assets in the SPV as opposed to the
credit quality of the company that originated the
assets. Despite the fact that the credit quality of
a portfolio of diverse assets can be very high, it is
unusual that the credit quality of those assets is
sufficient on its own to support the credit quality
of the highly rated securities (bonds or commercial
paper) issued by the SPV.
Therefore, in most securitisation transactions, it is
essential to design the legal and financial structure
of the SPV to accommodate additional financial
support to the transaction. This financial support
is usually referred to as credit enhancement.
Credit enhancement can be provided in many
different ways but always with the same goal. It is
not uncommon for a securitisation transaction to
have more than one form of credit enhancement
in order to secure the required rating of the senior
securities. Some examples of the types of credit
enhancement are as follows:
3.2.1. Over collateralisationThis is similar to calculating the loan to value ratio
in a mortgage loan i.e. more assets are included in
the pool than are required to back the securities
issued by the SPV. The effect of this method is that,
if there are some assets that default against the
cash they are intended to generate, then there are
surplus assets in the pool to make up for the
asset that have defaulted.
In South Africa, a typical securitisation transaction involves several components, each with their own
specific purpose. These components can be structured in various ways to suit the individual transaction.
3. The securitisation components
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3.2.2. Reserve funds
This method simply means that the SPV
accumulates and maintains additional cash on its
balance sheet to cater for instances when one ofthe assets in the pool goes into default. This cash is
accumulated by paying out less cash than it collects
in the early part of the transaction. In South Africa
the reserve fund is often provided by means of a
subordinated loan from the originator at inception
of the transaction (please also refer to 3.2.3 dealing
with excess spread).
3.2.3. Excess spread
Spread refers to the difference between the
amount of interest received on the assets and the
amount of interest to be paid on the securities
that have been issued by the SPV. If there is
excess spread, i.e. more net interest income than
is required to meet expenses of the SPV, then an
element of reserve funds begins to accumulate.
These reserve funds can be used in the event of
default by one of the assets in the pool.
3.2.4. Guarantees or standby letters of credit
Similar to the concept of reserve funds,
guarantees or letters of credit can be obtained by
the SPV from a suitable institution that ensures cash
will become available if one of the assets in the
pool goes into default i.e. no cash is maintained on
the balance sheet. Should the SPV need to call on
the guarantee or letter of credit then the companyissuing the guarantee will provide the necessary
amount of cash. Using a guarantee or letter of
credit does not provide the same level of credit
enhancement as cash collateral because there is
the potential risk that the institution issuing the
guarantee or letter of credit could default if called
on to provide the necessary cash.
3.2.5. Hierarchy of securities based on the
securitisation structure adopted
A securitisation transaction can be structured to
provide credit enhancement based purely on thestructure adopted. This type of structure requires
that at least two classes of securities are created
based on the priority of payment to each class. In
South Africa it is common for the number of classes
to be limited to three or four.
The first class will be the senior class, which is
generally highly rated (AAA or AA) and has
the priority of payment for interest and principal
over the second or subordinate class. This means
that different classes of securities can be issued
all the way down the credit curve in a single
securitisation transaction. The subordinate class
is also referred to as the first-loss piece because
any losses arising from defaults are first allocated
to the subordinate class. Because of the priority
of distributions over the subordinate class and the
loss protection provided by the subordinate class,
the senior class receives a high credit rating. The
subordinate class is typically purchased by the
originator of the assets.
In South Africa, the originator is usually also the
servicer and therefore they also carry the credit risk
through the subordinate class. This provides the
originator with an added incentive to service the
book properly and ensure that the losses are keptto a minimum, thus providing further protection
to the senior class. The quality of the underlying
assets sets the precedence for a credit rating. The
subordination provides protection in addition to the
natural protection against losses provided by the
good quality of the assets in the pool.
3. The securitisation components
(continued)
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3.3. Liquidity facilities
A liquidity facility, as distinct from a credit
enhancement facility, is provided to the SPV by abank to cover the potential mismatch arising from
delays in payment from the assets in the pool. A
liquidity facility refers to delay and not default.
Therefore, the liquidity facility is provided to ensure
payments are maintained to the investors in the
SPV, despite differences in timing between when
cash is received from the assets and when cash is
due to be paid to investors.
Detailed rules exist in most regulatory regimes
regarding the extent of capital required to be
maintained by a bank that issues a liquidity facility
to a securitisation transaction. In most cases, the
regulatory treatment is attractive to the bank,
provided that it can be proven that the liquidity
facility is structured so that it does not cover losses
arising from the potential default of the assets
in the pool. If the liquidity facility is structured
incorrectly, it potentially could be seen as a credit
enhancement facility because it absorbs losses
from the underlying assets. In general, a credit
enhancement facility attracts a higher regulatory
capital charge than a liquidity facility.
3.4. Owner trust
An inter vivos trust established in terms of a trust
deed with the purpose of owning all the issuedequity shares of the SPV. The beneficiary of the
trust is normally a charitable organisation. A
fundamental element of a securitisation transaction
is to have the assets isolated from the originator
so that the cash flow associated with the assets is
available to make principal and interest payments
to investors. The inclusion of the owner trust in
the securitisation structure ensures that the SPV is
insolvency remote. The effect of this is that the SPV
is not owned by the originator and therefore, the
assets of the originator could not be attached in
the event of an insolvency proceeding. The owner
trust does not own any assets other than the equity
shares of the SPV.
3.5. Rating
Securitisation transactions are usually rated by a
recognised rating agency. The purpose for rating
the transaction is to increase the ability to attract
investors. A rating for the transaction also assists
in determining the interest rate to be paid on
the notes issued to investors i.e. a highly rated
deal will close at a lower interest rate because
the assumption is that the risk is lower. A rating
is not a guarantee by the rating agency butrather a grading system that is intended to reflect
the likelihood of being paid the full amount of
principal.
3. The securitisation components
(continued)
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4.1. Accounting
The accounting treatment for a securitisation
transaction can be a challenging process but theaim remains to provide the users with information
that is understandable, relevant and reliable.
There are two main considerations regarding the
accounting treatment:
4.1.1. Derecognition
The first is the ability to derecognise the assets
from the balance sheet of the originator i.e.
meeting the requirements of IAS 39 (AC 133) for
transfer of risk and rewards as well as the extent of
control of the asset.
4.1.2. Consolidation
The second consideration is whether the asset
would have to be recognised on consolidation,
even if the requirements for derecognition from
the balance sheet of the originator have been
met i.e. SIC 12 (AC 412) requires an SPV to
be consolidated by the originator when the
substance of the transaction indicates that the
SPV is controlled by the originator. The extent
of equity invested by the originator in the SPV is
not conclusive in terms of deciding the extent of
control.
4.2. Taxation
Taxation is a key component in any financial
transaction, including both direct and indirecttaxation. The issue of taxation is a significant
consideration in structuring a securitisation
transaction. The types of taxes that come into
play include; income tax, value added tax and
capital gains tax.
The following three points on Accounting, Taxation and Regulation are the topics of further publications in
this series on securitisation. They are mentioned briefly in this publication as an indication of some of the
technical aspects that are required to be considered in a securitisation transaction.
4. The effects of accountingtreatment, taxation and
regulation on securitisation
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4. The effects of accountingtreatment, taxation and
regulation on securitisation(continued)
4.3. Regulation
The financial regulators, including the Basel
Committee on Banking Supervision, havedeveloped complicated rules to apply to
securitisation structures.
In South Africa, securitisation transactions
are currently regulated by the South African
Government Notice R. 681, Designation of an
activity not falling within the meaning of the
business of a bank (securitisation exemption
notice). This securitisation exemption notice
was issued to both authorise and to regulate
securitisation transactions i.e. an SPV accepting
funds from the general public against the issue of
commercial paper. Ordinarily, the acceptance of
funds from the general public would fall within the
definition of the business of a bank, and therefore
be limited by the Banks Act, 1990 to institutions
with a banking licence. In essence, a securitisation
transaction is exempt from the definition of a
business of a bank provided that it complies with
the conditions of the securitisation exemption
notice, and it therefore does not have to comply
with the requirements of the Banks Act, 1990 and
Regulations thereto. A bank that participates in asecuritisation transaction would have to comply
with both the requirements of the Banks Act, 1990
and the securitisation exemption notice. A corporate
entity that participates in a securitisation transaction
only has to comply with certain defined sections of
the securitisation exemption notice.
The International Convergence of Capital
Measurement and Capital Standards was published
by the Bank for International Settlements (BIS)
in June 2004 and then updated in June 2006.
This document, published by the BIS, is commonly
known as Basel II and supersedes the original 1988
Basel I Accord. Basel II includes a specific section
referred to as the Securitisation Framework that
deals with the various approaches for calculating
the capital requirement as a result of credit risk
to a bank from participating in a securitisation
transaction.
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Key Contacts
Andr Pottas
Partner Financial Services Team:Debt Origination and Securitisation
Services Group
Andr is the lead partner responsiblefor the debt origination and assetsecuritisation services group of DeloitteSouth Africa. He is on the ExecutiveCommittee of the South AfricanSecuritisation Forum. He has beenpublished on current trends in thesecuritisation industry in South Africaand on the impact of IAS 39 (AC133) on securitisation structures, andhas consulted and spoken widely onsecuritisation structures and compliancewith the Banks Act Securitisation
Regulations.
Riaan Eksteen
Partner Financial Services Team:Assurance Services
Riaan is responsible for assuranceservices to a large number ofsecuritisation structures and relatedvehicles. In addition to the statutoryaudit of securitisation structures, hisresponsibilities include the assessmentand reporting of compliance in termsof securitisation agreements, whichrepresents an integral part of the overall
securitisation governance process.
Grant Fowlds
Partner Financial Services Team:Advisory Services
Grant has provided specialisedaccounting services to a numberof securitisation structures to date,including advice and technical opinionson the impact of IAS 39 (AC 133) andSIC 12 (AC 412), and valuation offinancial instruments.
Nazrien Kader
Partner Tax:Corporate Tax Services
Nazrien is responsible for the provisionof taxation services to large and mediumsized corporate entities. She hasconsulted on both the direct and indirecttaxation implications to originators andSpecial Purpose Vehicles in securitisationstructures.
Chris Beneke
Director Tax:Specialist Financial Services
Chris is responsible for the provision ofspecialist taxation services to financial
services institutions, including a focus onsecuritisation, and has consulted on awide range of tax issues in the financialservices sector.
Andrew Huntley
Senior Manager Financial Services Team:Advisory Services
Andrew has worked on assuranceengagements relating to varioussecuritisation structures in Australiaand South Africa and completedseveral due diligence reviews specific
to securitisation. He providesadvisory services to financial servicesinstitutions on the impact of the Basel IISecuritisation Framework.
Preparation of this publication was performed by Andr
Pottas and Andrew Huntley. For any queries regardingthis publication, or in respect of the securitisation servicesoffered by Deloitte, please contact:
Andr Pottas [email protected]+27 (0)31 560 7206
Andrew Huntley [email protected]+27 (0)11 806 5732
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Arranger
This is the company that handles all aspects of establishing
a securitisation transaction and takes the deal to market. In
South Africa, this role is normally fulfilled by a bank.
Asset
The receivable (obligation from debtor to creditor) to be
securitised (e.g. mortgage loans or vehicle loans) that the
company has on its balance sheet and that will be sold to
the SPV.
Asset-Backed Securities (ABS)
The securities (bonds or commercial paper) that are issued
as part of the securitisation transaction by the SPV.
Investor
The entity that buys the securities (bonds or commercial
paper) issued by the SPV. These investors are normally
entities such as collective investment schemes, life insurers,
pension funds or other companies.
Issuer
The SPV that buys the assets from the originator and issues
securities backed by those assets in order to acquire the
cash to settle the purchase price of the assets acquired.
Multi-seller conduit
An SPV that issues securities backed by numerous different
asset classes or a pool of smaller securitisation transactions
based on assets it has purchased from a variety of
companies over time.
Originator
The company that has the assets on its balance sheet and
sells them to the SPV.
Physical (Traditional or Cash) securitisation
In a physical securitisation, the assets are sold and
physically transferred off the balance sheet of the
originator and the issuer becomes the new legal owner.
Priority of payments
All payments to investors and other creditors are made
in terms of an agreed order of priority i.e. in the event
that there is insufficient cash in the bank account whenpayments are due, then there is a pre-determined order
in which payments will be made. The ranking or order
in which payment will be made is normally detailed in
the securitisation documentation and any party to those
documents agrees to be paid in terms of the priority of
payments listed.
Rating
The grade assigned, by a rating agency (e.g. Moodys,
Standard & Poors or Fitch), to the securities issued by
the issuer. There could be different classes of securities
issued by the issuer for one securitisation transaction
and each class would be assigned its own rating. The
different classes are often called tranches of a securitisation
issue. One of the conditions of a properly structured
securitisation is the isolation of assets from the creditors of
the company. Separation of good quality assets, in terms
of their credit quality, from a companys core risky business
will likely result in an enhanced rating for the securities
issued by the SPV when compared to the rating of the
originating entity.
Single-seller conduit
An SPV that issues securities backed by a single asset class
purchased over time from a s ingle originator. The assets are
usually short-term receivables and the proceeds on receipt
of payments from the obligors are utilised to purchase newreceivables (e.g. In-store credit card receivables from large
retailers).
Synthetic securitisation
In a synthetic securitisation, the underlying credit risk of
owning the asset is transferred from the originator to the
issuer through the use of derivative instruments; the assets
themselves are not physically sold. The economic rights of
ownership embodied in the assets are owned by the issuer
and therefore ultimately by the investors.
The following are some key terms used in this publication:
Glossary
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ABOUT DELOITTE
Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, its member firms, and their respectivesubsidiaries and affiliates. Deloitte Touche Tohmatsu is an organisation of member firms around the world devotedto excellence in providing professional services and advice, focused on client service through a global strategy
executed locally in nearly 140 countries. With access to the deep intellectual capital of approximately 135,000people worldwide, Deloitte delivers services in four professional areas - audit, tax, consulting and financial advisoryservices - and serves more than 80 percent of the worlds largest companies, as well as large national enterprises,public institutions, locally important clients, and successful, fast-growing global growth companies. Services are notprovided by the Deloitte Touche Tohmatsu Verein, and, for regulatory and other reasons, certain member firms donot provide services in all four professional areas.
As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms has any liability foreach others acts or omissions. Each of the member firms is a separate and independent legal entity operating underthe names Deloitte, Deloitte & Touche, Deloitte Touche Tohmatsu, or other related names.
In Southern Africa, Deloitte & Touche is the member firm of Deloitte Touche Tohmatsu, and services are provided byDeloitte & Touche and its subsidiaries. Deloitte & Touche is among the nations leading professional services firms,providing audit, tax, consulting, and financial advisory services through nearly 3600 partners and staff in more than16 offices in Southern Africa. Known as an employer of choice for innovative human resources programme, it isdedicated to helping its clients and its people excel. For more information, please visit Southern Africas website atwww.deloitte.com/za
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