Structured finance designates all specialized finance where credit risk is entirely dependent on a structure resiliency, the ability of this dedicated entity to sustain stressed conditions, rather than on the credit standing of a firm. The lender is not at risk with a counterparty that is a firm, as usual, but with an entity that […]
There is no need to stick to cash exposures with credit derivatives. By unbundling the credit risk component from the cash transactions, market players can create synthetic exposures that are not available in the cash market.
The rationale of securitizations is very simple. The first motivation is arbitraging the cost of funding in the market with funding on-balance sheet, for a bank or a corporate entity. The second motivation is off-loading credit risk to free capital for new operations or to modify the risk-return profile of the loan portfolio of banks.
The issue, when off-loading risks, is whether freeing up capital in this way is economically acceptable. The solution lies in finding out whether this makes the risk-return profile of the banking portfolio more efficient (higher return for the same risk or lower risk for the same return).
The analysis below uses an example. Its purpose is to determine the costs and benefits of the transaction and to assess the impact on return on capital. There are three steps: the description of the original situation before securitization; the calculation of the funding cost for the originating bank; the funding cost through securitization. The […]
In our example, the influence on the equity return results from both the lower level of equity and the reduced cost of funding through securitization. The gain value is either a present value or an improvement of yearly margins averaged over the life of the transaction. The capital saving is a preset forfeit percentage, used […]
Under a forfeit valuation of capital as a function of the amount securitized, it is relatively easy to determine whether the securitization enhances the ROE, by how much, and what are the limitations. Under full economic capital analysis, the capital results from a direct calculation with a portfolio model pre- and post-securitization.
