Giddy/ABS

ABS and Swaps/1

Asset-Backed Securities: Managing the Risks Asset-Backed Securities

l l

Asset-Backed Securities: Managing the Cash Flow Risks with Swaps

Identifying the risks Restructuring the cash flows with swaps and other techniques uInterest-rate uCurrency

Prof. Ian Giddy

l

Stern School of Business New York University

swaps swaps

Reallocation of cash flows

Copyright ©1998 Ian H. Giddy

Using Swaps: Interest-Rate Swap

Swaps and Cash Flow Reallocation l

ABS and Swaps 3

Restructuring the cash flows with swaps and other techniques swaps uCurrency swaps uReallocation of cash flows

Fixed rate interest

uInterest-rate

Floating rate interest

Special Purpose Vehicle

Servicer

Fixed rate interest

Investors

Floating rate interest

Swap counterparty

Copyright ©1998 Ian H. Giddy

ABS and Swaps 4

Using Swaps: Currency Swap

Copyright ©1998 Ian H. Giddy

ABS and Swaps 5

Swaps: Mechanics and Valuation Fixed ECU 7%

Servicer

Fixed rate, interest and principal in Currency A

Floating rate, interest and principal in Currency B

Special Purpose Vehicle

Fixed rate, interest and principal in Currency A

IC&Tel IC&Tel Investors

Periodic exchanges of interest payments are made during the life of the swap. Remember that the principal amount is not exchanged

Floating rate, interest and principal in Currency B

Swap counterparty

Copyright ©1998 Ian H. Giddy

CIBC CIBC Floating ECU Libor

ABS and Swaps 6

Copyright ©1998 Ian H. Giddy

ABS and Swaps 7

Giddy/ABS

ABS and Swaps/2

Interest-Rate Swap Example

Interest-Rate Swap Example Exchange of Interest Payments Every 6 Mo

Payments to Capital Markets

Payments to Capital Markets

Floating 6-Month LIBOR + 25

IC&Tel

CIBC

BBB

AA

Payments to Capital Markets

IC&Tel Fixed 5.00%

Copyright ©1998 Ian H. Giddy

ABS and Swaps 8

Interest-Rate Swap Example

Floating 6-Month LIBOR + 25

Floating 6-Month LIBOR + 25

BBB

Floating 6-Month LIBOR Flat

Copyright ©1998 Ian H. Giddy

ABS and Swaps 9

Fixed RM 8%

CCM CCM

Payments to Capital Markets

UMBC UMBC Floating KLibor

CIBC AA

Floating 6-Month LIBOR Flat

Cost of Funds After Swap:

Fixed 5.00%

l l

Cost of Funds After Swap:

- Pay fixed 5.50% - Receive LIBOR Flat - Pay LIBOR + 25 - Net Cost: 5.75% Fixed

Fixed 5.00%

AA

Swaps: Applications of Valuation

Fixed 5.50%

IC&Tel

CIBC

BBB

Exchange of Interest Payments Every 6 Mo Payments to Capital Markets

Payments to Capital Markets

Fixed 5.50%

l

- Pay 5.00% fixed - Receive 5.50% fixed - Pay 6-month LIBOR Flat - Net Cost: 6-month LIBOR - 50

l l

Copyright ©1998 Ian H. Giddy

ABS and Swaps 10

Valuation Off-market swaps Cancellation Counterparty exposure Hedging swap positions

FRN B O N D

Copyright ©1998 Ian H. Giddy

ABS and Swaps 13

Valuation of an Interest Rate Swap

Swap Valuation

Valuation of the swap is based on discounting the cash flows over its life.

The value of a swap equals the "net worth" of the swap cash flows expressed as a balance sheet

A RECEIVE-FIXED, PAY-FLOATING SWAP: Fixed USD 9% VALUE OF INTEREST RATE SWAP

Copyright ©1998 Ian H. Giddy

=

PRICE OF BOND WITH N YEARS TO RUN

-

PRICE OF MONEY MARKET INSTRUMENT WITH M DAYS TO RUN

ABS and Swaps 14

Labatt’s Labatt’s Labatt’s swap: Receive floating, pay fixed

Bank Bank Floating USD Libor s.a.

“ASSETS”

“ LIABILITIES”

Receiving floating 6-mo US$ Libor Semi-annual for 5 years Principal US$100m Like a 5-year US$ FRN

Paying fixed 9% Annual for 5 years Principal US$100m Like a 5-year bond

Copyright ©1998 Ian H. Giddy

ABS and Swaps 15

Giddy/ABS

ABS and Swaps/3

At Inception, Standard Swap is Worth Zero

Two Years Later, Rates Have Fallen... Labatt’s swap: Receive floating, pay fixed

Labatt’s swap: Receive floating, pay fixed “ASSETS”

”LIABILITIES”

“ASSETS”

”LIABILITIES”

Receiving floating 6-mo US$ Libor Semi-annual for 5 years Principal US$100m Like a 5-year US$ FRN

Paying fixed 9% Annual for 5 years Principal US$100m Like a 5-year bond

Receiving floating 6-mo US$ Libor Semi-annual for 3 years Principal US$100m Like a 3-year US$ FRN

Paying fixed 9% Annual for 3 years Principal US$100m Like a 3-year bond

Value=$100m

Value=$100m

Value still $100m

Copyright ©1998 Ian H. Giddy

ABS and Swaps 16

Termination of Swaps

Copyright ©1998 Ian H. Giddy

ABS and Swaps 17

Default Risk in Swaps

Basic principle: cancel or neutralize all future swap cash flows l What are the alternative ways in which this can be done? l

uOffsetting

swap with same counterparty swap with new counterparty uCancel swap uReassign swap. uOffsetting

Copyright ©1998 Ian H. Giddy

ABS and Swaps 18

How Swaps are Quoted

In-the-money swaps entail credit risk—the value of the swap is the amount owed l At initiation, credit risk exposure is based on the potential value of the swap, which depends on potential changes in interest rates and currencies l Credit risk can be mitigated by collateralization and by netting of bilateral exposure. l

Copyright ©1998 Ian H. Giddy

ABS and Swaps 19

Example

US$ INTEREST RATE SWAPS CURRENCY SWAPS Years Treasury Curve Spread [b.p.] DEM/USD JPY/USD Benchmark to AA Annual Annual Semi-Annual Counterparties Yields 2 3 4 5 7 10

8.02 8.01 8.01 8.02 8.13 8.14

Years

CHF/USD Annual

2 3 4 5 7 10

6.60-6.70 6.20-6.30 6.05-6.10 6.00-6.10 5.95-6.05 5.95-6.05

Copyright ©1998 Ian H. Giddy

62-66 70-75 72-76 78-81 77-81 78-81

7.00-7.10 7.00-7.10 7.00-7.10 7.00-7.10 7.02-7.12 7.02-7.12

CURRENCY SWAPS GBP/USD ECU/USD Annual Annual 12.80-12.90 12.35-12.45 11.90-12.00 11.75-11.85 11.50-11.60 11.26-11.36

Swap rate = 6% Value=$108m

9.20-9.30 9.15-9.25 9.10-9.20 9.05-9.15 9.05-9.15 9.05-9.15

5.35-5.45 5.35-5.45 5.35-5.45 5.35-5.45 5.40-5.50 5.45-5.53

AUD/USD Annual

Fixed USD 5yr T+.78%

Fixed USD 8.50%

15.65-15.80 15.25-15.40 15.1515.30 14.78-15.13 NA NA ABS and Swaps 20

Petronas Petronas

HSBC HSBC

Floating USD Libor s.a.

Copyright ©1998 Ian H. Giddy

ABS and Swaps 21

Giddy/ABS

ABS and Swaps/4

Asset Swaps l l

Asset Swaps

Investor buys cheap fixed-rate bond But wants a floating-rate note.

Fixed GBP 12.73% Fixed GBP 12%

Fixed GBP 12.73%

INVESTOR INVESTOR

Fixed GBP 12.73%

INVESTOR INVESTOR

BANK BANK Floating USD Libor s.a.

Floating USD Libor s.a. +0.75% Copyright ©1998 Ian H. Giddy

ABS and Swaps 22

Asset Swaps: Default

Copyright ©1998 Ian H. Giddy

ABS and Swaps 23

Default

Bank Bank

Fixed GBP 12.73% Perjawa Perjawa Steel Steel Co. Co.

MAYMAYBANK BANK

CURRENCY SWAP

Floating USD Libor s.a. +0.75% Copyright ©1998 Ian H. Giddy

ABS and Swaps 24

Default

Copyright ©1998 Ian H. Giddy

ABS and Swaps 25

Asset-Swapping an ABS l Bank Bank

To get a spread over Libor: uFloating uFloating

ABS: L+Spread ABS with Cap: Buy ABS & buy

cap CURRENCY SWAP

uFixed

ABS: Buy ABS & do fixed-floating

swap l

INTEREST RATE SWAP

Considerations uCredit

risk of swap

uIlliquidity Copyright ©1998 Ian H. Giddy

ABS and Swaps 26

Copyright ©1998 Ian H. Giddy

ABS and Swaps 27

Giddy/ABS

ABS and Swaps/5

Swaps and ABS: Case Studies

Using Swaps: Cremonini Case Study Sale of Receivables Cremonini Group

Cremonini l Dragon MBS l Hong Kong Cards l Thai Cars l

Purchaser SPC

Subordinated Lender

Purchase 98% Goods & Services

Receivables Italian Obligors

Receivables & Contract Rights

Purchase Price & fee 98%

Issuer Crystal Castle (SPC)

ter. %in e 16 Lir

te No ted ina ord Sub

Spread Account

Lire 2% interest

US Dollars 84%

FX and Interest Rate Swap Swiss Bank

Lire

Pledges: SPC’s stock, receivables, contract rights

Guaranty of SPC’s Lire Obligation

Dollars 84%

Investors Senior Euronotes

FSA Guaranty of Euronotes Copyright ©1998 Ian H. Giddy

ABS and Swaps 28

Mortgage Securitization: Dragon MBS

Copyright ©1998 Ian H. Giddy

ABS and Swaps 29

Dragon MBS: The Swap

Merrill Lynch (swap counterparty) US$ interest and principal

HK$ interest (based on HK$ prime rate) and principal

Brilliant Oscar Ltd. (servicer)

HK$ interest and principal

US$ Principal+interest

Class A1 US$32M

1 month US$ LIBOR + 0.9%

Servicer

Fixed rate, interest and principal in Currency A

Dragon MBS Ltd. US$ Interest

HK$ interest and principal

Special Purpose Vehicle

Fixed rate, interest and principal in Currency A

1 month US$ LIBOR + 1.35%

Class A2 US$17.6M

Floating rate, interest and principal in Currency B

Investors

Floating rate, interest and principal in Currency B

US$ Principal (after Class A1 completely redeemed)

Swap counterparty

Floating-rate residential mortgages (Tin Shui Wai ,Hong Kong)

HK$ Interest

HK$ Prime rate + 0.5%

HK$ Principal (after Class A2 completely redeemed)

Class A3 HK$131.7M

Copyright ©1998 Ian H. Giddy

ABS and Swaps 30

Chase Manhattan Hong Kong

Copyright ©1998 Ian H. Giddy

ABS and Swaps 31

Thai Cars: Dual Swap

Hong Kong Credit Card Obligors

Swap US$/Yen

Swap Baht/Yen

Bankers Trust

Bankers Trust

Credit Card Payments (HK$) Manhattan Card Co.Ltd. (Servicer) Excess Spread (HK$) after losses

Credit Card Payments (HK$)

Amount in US$ equal to the principal and interest to be paid on the notes (LIBOR+0.22%)

Manhattan Card Funding Corp. (Seller/Cayman Island SPV) Excess Spread (HK$) Spread Account

HK$ Payments

Hong Kong Card Trust (US Based Issuer)

Amount in Yen equal to the principal and interest on the Yen Loan (?%)

Amount in Yen equal to the principal and interest to be paid on the Yen Loan

HK$ Swap Payments

Chase Manhattan Bank

Dollar principal and interest

US$ Swap Payments US$ Principal/Interest Payments

LIBOR+0.22%

Thai Cars Ltd (Issuer)

Amount in Baht equal to the principal and interest on the Baht Notes/Loan (weekly payment date) 9.25%

Yen principal and interest

TruLease Lease Tru

Investors Copyright ©1998 Ian H. Giddy

ABS and Swaps 32

Copyright ©1998 Ian H. Giddy

ABS and Swaps 33

Giddy/ABS

ABS and Swaps/6

Swap Must Have Declining Balance

Hedging an ABS Currency Swap Must hedge principal as well as interest Principal timing uncertain l Amount and level of interest rate to hedge depends on prepayment rates l

Principal Balance on HP Loans

l

$250,000 $200,000

PRINCIPAL BALANCE WITH PREPAYMENTS

$150,000 $100,000

Principal Balance on HP Loans

$50,000

SCHEDULED PRINCIPAL BALANCE

$250,000 $200,000

S1

$150,000 $100,000

10

8

6

4

2

$-

$50,000

ABS and Swaps 34

Hedging an ABS Currency Swap l l

8

S1 10

4

2 Copyright ©1998 Ian H. Giddy

6

$-

Copyright ©1998 Ian H. Giddy

ABS and Swaps 35

Counterparty Exposure

Quanto hedging instuments Dynamic hedging: adjust amount of hedge to changing principal values

CURRENCY SWAP: INCREASING EXPOSURE ON A DECLINING PRINCIPAL

Principal Balance on HP Loans $250,000 $200,000 $150,000 $100,000 $50,000 S1 10

6

8

2

4

$-

Copyright ©1998 Ian H. Giddy

ABS and Swaps 36

Cash-Flow Reallocation Pay-through obligation

ABS and Swaps 37

Case Study: Thai Cars Different tranches

Pool of mortgage loans Pass-through obligation CMO (or REMIC or FASIT)

Copyright ©1998 Ian H. Giddy

PAC (planned aamortization class)

How was the transfer of assets and funds structured? l Where is the SPV, and what are its assets and liabilities? l Show how the swaps worked. l

TAC (targeted amortization plan)

Group work

IO/PO strips Copyright ©1998 Ian H. Giddy

ABS and Swaps 38

Copyright ©1998 Ian H. Giddy

ABS and Swaps 39

Giddy/ABS

ABS and Swaps/7

Case Study: Hong Kong Card Master Trust

Ian H. Giddy

What is the relationship among the parties in this deal? (Draw a diagram) l How are investors protected? And FSA? l How are the interest rate and currency risks managed? l Can you quantify the costs and benefits to Chase? l

Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0332; Fax 630-604-7413 [email protected] http://giddy.org

Group work Copyright ©1998 Ian H. Giddy

ABS and Swaps 40

Copyright ©1998 Ian H. Giddy

ABS and Swaps 43