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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-n-
roll 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-a-
kind.
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
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
Scheduled Principal
Interest (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 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
Buy Lease
Firm U buys asset and uses Firm U leases asset from lessor;
asset; financing raised by the lessor owns the asset
debt and equity
Manufacturer Manufacturer
of asset of asset
Firm U buys asset
Lessor buys asset
from manufacturer
Firm U Lessor Lessee (Firm U)
Firm U
1. Uses asset 1. Owns asset 1. Uses asset
leases asset
2. Owns asset 2. Does not use 2. Does not own
from lessor
asset asset
Creditors and
shareholders supply
financing to lessor
Equity
Creditors
shareholders Equity
Creditors
shareholders
Buying versus leasing
Synthetic Leases
Loan to
Use of finance
asset asset
Company Trust Investors
Lessor
Wholly owned
subsidiary of
Lease payments; diff between Company Interest
ending asset value and face Owns asset and payments
value of loan =(final depreciates it
guaranteed payment +
unguaranteed portion);
amount of final guaranteed
payment satisfies FASB 13:
PV(min lease payments)
0.9(initial fair value of asset).
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 $400m. of
insurance risk. It sold a structured note split into
two classes.
Tranche A2 of $313m., paying LIBOR+5.76% is
fully at risk if insurance losses go above $1b.
Tranche A1 of $163m., paying LIBOR+ 2.73%, has
its principal protected (a portion of the tranche is
placed in escrow to be paid to A1 investors).
In effect, USAA does not have to pay $313m. of
insurance losses, if total losses go above $1b.
Equivalently, it can put $313m. worth of insurance
contingent on total losses going above $1b.
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.
Issues
Firm equity SPV Issues debt Investors
Synthetic IPO
Owned by Formula One
FO Holdings Administration
Formula One
Borrows
Holdings
money from
FO Finance
Investors
SLEC sells FO
Mgmt shares to
FO Holdings Formula One Issues bonds
Finance backed by int.
SLEC payments on
Owned by loan to FO
SLEC Adm
Formula One Management;
directs FO business; sells
broadcast rights to TV cos.,
employs people who run
operation
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 non-
parallel 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 non-
investment grade by Moody's Investors
Service and Standard & Poor's Inc.
Structure of a Trust Preferred
Wells Fargo Company (Parent)
Tax-Deductible Interest Loan Proceeds of $300
Payments at 8.13% Million
Wells Fargo Capital A
(Special Purpose Trust)
Dividend Payments at Cash Proceeds of $300
8.13% Million from TPS Issuance
Trust Preferred Security
Investors
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.
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