CHAPTER 1 1 Introduction he deNnition of structured Nnance is broad, and not everyone agrees on exactly what it is. This introductory chapter begins with our working deNnition of structured Nnance and then follows with views and opinions from a variety of experts. It concludes with a case study of how the boundaries of structured Nnance were tested by the Enron debacle.
DEFINITION OF STRUCTURED FINANCE There is no universal deNnition of structure Nnance. It is apparent from the way that structured Nnance teams are organized in banks that the term covers a wide range of Nnancial market activity. We believe a good working deNnition for structured Nnance is the following: .
. . techniques employed whenever the requirements of the originator or owner of an asset, be they concerned with funding, liquidity, risk transfer, or other need, cannot be met by an existing, off-the-shelf product or instrument.
Hence, to meet this requirement, existing products and techniques must be engineered into a tailor-made product or process. Thus, structured Nnance is a Oexible Nnancial engineering tool. We believe one or more of following elements generally characterize a structured Nnance transaction: T 1-Intro Page 1 Thursday, August 24, 2006 2:35 PM COPYRIGHTED MATERIAL 2 INTRODUCTION ... more. less.
TO STRUCTURED FINANCE a complex Nnancial transaction that may involve actual or synthetic transfer of assets or risk exposure, aimed at achieving certain account- ing, regulatory, and/or tax objectives; a transaction ring-fenced in its own special purpose vehicle; a bond issue that is asset-backed and/or external reference index- linked; a combination of interest-rate and credit derivatives; a transaction employed by banks, other Nnancial institutions, and cor- porations as a source of funding and/or favorable capital, tax, and accounting treatment; and disintermediation between banks and other corporate entities.<br><br> As we just noted, there are alternative deNnitions of structured Nnance and we will identify in the next section some deNnitions proposed by practitioners and regulators. As will be seen, the working deNnition above, as well as the elements of structured Nnance given above, tie together many of the alternative deNnitions identiNed in the next section. OTHER DEFINITIONS OF STRUCTURED FINANCE One obvious way to deNne structured Nnance is to rely on already-pub- lished deNnitions.<br><br> Here are three examples. In a recent report, the Bank for International Settlements (BIS) deNnes structured Nnance in this way: Structured Nnance instruments can be deNned through three key characteristics: (1) pooling of assets (either cash- based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differenti- ates structured Nnance from traditional cpass-through d securitizations); (3) de-linking of the credit risk of the col- lateral asset pool from the credit risk of the originator, usually through use of a Nnite-lived, standalone special purpose vehicle (SPV). 1 A 1995 report written by the Committee on Bankruptcy and Corpo- rate Reorganizations of the Association of the Bar of the City of New York, entitled cNew Developments in Structured Finance, d deNnes structured Nnancing and the parties involved as follows: 1 cThe Role of Ratings in Structured Finance: Issues and Implications, d Committee on the Global Financial System, Bank for International Settlements, 2005.<br><br> 1-Intro Page 2 Thursday, August 24, 2006 2:35 PM Introduction 3 Structured Nnancings are based on one central, core princi- ple: a deNned group of assets can be structurally isolated and thus serve as the basis of a Nnancing that is indepen- dent from the bankruptcy risks of the originator of the assets. By isolating the assets, an originator obtains easier access to the capital markets by generating note proceeds at a lower cost of funds than it otherwise might if it issued notes directly to investors. One of the principal beneNts from structured Nnancings is a reduction in the cost of Nnancing (e.g., through lower yield on issued debt).<br><br> The parties involved in a structured Nnancing typi- cally include many, if not all, of the following entities (of which there may be more than one): the originator of the assets; a cspecial purpose vehicle; d credit enhancers (i.e., Nnancial guarantors); the servicer (who makes collections on the receivables, directs cash-Oow allocation, and oth- erwise acts as agent for the bondholders); a liquidity pro- vider (letter of credit bank); a trustee or collateral agent; a securities underwriter or placement agent; and a rating agency. 2 Andrew Silver of Moody 9s Investors Service deNnes structured Nnance as: Structured Nnance is a term that evolved in the 1980s to refer to a wide variety of debt and related securities whose promise to repay investors is backed by (1) the value of some form of Nnancial asset or (2) the credit support from a third party to the transaction. Very often, both types of backing are used to achieve a desired credit rating.<br><br> Structured Nnancings are offshoots of traditional secured debt instruments, whose credit standing is sup- ported by a lien on speciNc assets, by a defeasance provi- sion, or by other forms of enhancement. With conventional secured issues, however, it is generally the issuer's earning power that remains the primary source of repayment. With structured Nnancings, by contrast, the burden of repay- ment on a speciNc security is shifted away from the issuer to a pool of assets or to a third party.<br><br> 2 Committee on Bankruptcy and Corporate Reorganizations of the Association of the Bar of the City of New York, cNew Developments in Structured Finance, d Re- port 56, Business Lawyer 95, 2000 32001. 1-Intro Page 3 Thursday, August 24, 2006 2:35 PM 4 INTRODUCTION TO STRUCTURED FINANCE Securities supported wholly or mainly by pools of assets are generally referred to as either mortgage-backed securities (mortgages were the Nrst types of assets to be widely securitized) or asset-backed securities, whose col- lateral backing may include virtually any other asset with a relatively predictable payment stream, ranging from credit card receivables or insurance policies to speculative- grade bonds or even stock. Outside the United States, both types of structured Nnancing are often referred to simply as casset-backed securities, d which is the convention that we will employ here.<br><br> 3 The problem with the three deNnitions above is that they focus only on one area of what many market participants might view as structured Nnance: securitization. Our view is that securitization is a subset of structured Nnance. In 2005 the Editor and the Editorial Board of the Journal of Struc- tured Finance recognized the elusive deNnition of structured Nnance as a challenge.<br><br> They considered it important to get their arms around the full range of views concerning how structured Nnance should be deNned in today 9s Nnancial markets. They thought that the best source of those views would be expert contributors to the journal. They sent question- naires to 53 people and received responses from 25.<br><br> 4 Some replied indi- vidually while others participated in group responses from their Nrms. 5 The survey asked the experts two basic questions: 3 Andrew A. Silver, cRating Structured Securities, d Chapter 1 in Frank J.<br><br> Fabozzi (ed.), Issuer Perspectives on Securitization (Hoboken, NJ: John Wiley & Sons, 1998). 4 Survey respondents were: Phil Adams, Barclays Capital; Mark H. Adelson, Nomu- ra Securities International; Beth Bartlett, Nomura Securities International; Terry Benzschawel, Citigroup; Ronald Borod, Brown Rudnick; Moorad Choudhry, KBC Financial Products; Edward DeSear, McKee Nelson LLP; Frank J.<br><br> Fabozzi, Yale Uni- versity School of Management; J. Paul Forrester, Mayer, Brown, Rowe & Maw LLP; Edward Gainor, McKee Nelson LLP; Brian P. Gallogy, Brown Rudnick; Stav Gaon, Citigroup; Paul Geertsema, Barclays Capital; Barry P.<br><br> Gold, Citigroup; Jeffrey J. Griffiths, Columbia University/Bear Stearns; Andreas Jobst, International Monetary Fund; Jason Kravitt, Mayer, Brown, Rowe & Maw LLP; Douglas Lucas, UBS; Jef- frey Prince, Citigroup; Madeleine M. L.<br><br> Tan, Brown Rudnick; Janet Tavakoli, Tava- koli Structured Finance, Inc.; Jon Van Gorp, Mayer, Brown, Rowe & Maw LLP; Lawrence E. Uchill, Brown Rudnick; Hans Vrensen, Barclays Capital; Jacob J. Worenklein, U.S.<br><br> Power Generating Company; and Boris Ziser, Brown Rudnick. 5 One survey respondent offered a humorous definition of structured finance: cA complicated transaction that results in large legal fees. d 1-Intro Page 4 Thursday, August 24, 2006 2:35 PM Introduction 5 What is your deNnition of structured Nnance? Where do you think the boundaries are?<br><br> Survey recipients were also asked to cite some borderline cases they thought were just inside or outside the boundaries. As expected, the deNnitions received ranged from narrow to broad. In this section, we discuss those deNnitions based on: basic conceptual deNnitions; instruments and techniques; when or where structured Nnance is used; beneNts provided by structured Nnance; and emphasis on securitization.<br><br> Even the above deNnitions do not fully cover the diverse range of struc- tured Nnance activity in the market. Exhibit 1.1 describes more esoteric transactions that also fall into the universe of structured Nnance as sug- gested by respondents. Basic Conceptual Definitions It is apparent from the survey responses that cstructured Nnance d cov- ers a wide range of activities and products.<br><br> We present here a number of conceptual deNnitions from respondents that help us to see the different nuances by the variety of terminology used. Structured Nnance has been deNned as: A synthetic transaction that transfers risk; such a transaction may or may not involve raising capital. A complex Nnancial transaction involving the transfer of assets to raise cash, frequently with the additional goal of achieving certain account- ing, regulatory, and/or tax treatment.<br><br> Such a transaction may or may not involve a securities offering. The monetization of any rights to payments by a party having the legal right to transfer those payments to others. A Nnancing transaction where legal structures are used to isolate asset or entity risk, resulting in decreased risk for the originator.<br><br> The identiNcation and isolation of inherent risk in a particular asset (or liability) or portfolio of assets (or liabilities) and the Nnancing of such asset or assets (or liability or liabilities) in an economically efNcient manner using speciNc risk transfer mechanisms when justiNed. The process whereby cash Oows from cash-generating assets are molded into legal and Nnancial structures designed to insulate those cash Oows from insolvency risk and to invest those cash Oows with greater predictability than they would be in their natural state. 1-Intro Page 5 Thursday, August 24, 2006 2:35 PM 6 INTRODUCTION TO STRUCTURED FINANCE EXHIBIT 1.1 Borderline Cases and Boundaries This exhibit identiNes some survey responses on structured Nnance that encom- passes a wider range of transactions.<br><br> Respondents had numerous ideas about the borderline between what should and should not be considered structured Nnance and also about how the boundaries of structured Nnance are expanding in the course of continued product innovation. There is general agreement that ABS, CMBS, RMBS, and CDOs fall squarely within the realm of structured Nnance. Borderline cases cited by respondents include credit opportunity funds, project Nnance loans, other tranched loans, credit default swaps (CDS), and hedge funds.<br><br> For example, most respondents as well as the authors of this book consider project Nnance loans and CDS to be part of structured Nnance but some do not. In one respondent 9s opinion, pure credit derivatives are examples of struc- tured products for credit risk transfer that allow very speciNc, capital-market- priced credit risk transfer. That is why they should be considered part of structured Nnance.<br><br> Credit insurance and syndicated loans share the same Nnancial objective; however, they do not constitute arrangements to create new risk-return proNles from existing reference assets. Another respondent considers structured Nnance to include any Nnancial trans- action that is not standard, or in market jargon, cplain vanilla d in terms and conditions. In this respondent 9s view, structured transactions add nonstandard terms, conditions, and other characteristics to create additional economic value for the principal, the agent, or both.<br><br> So plain vanilla transactions such as syndi- cated loans, straight equity offerings (including preferred), and straight debt offerings would be outside the boundaries of structured Nnance. All of these types of Nnancings are relatively commoditized in nature, meaning that there are very standard terms and conditions that govern the vast majority of simple cap- ital-raising activities. In this respondent 9s view, we enter the realm of structured Nnance when we add bells and whistles to these straight, standard capital-rais- ing activities.<br><br> Structured Nnance can include straight equity and debt offerings that incorporate complex structures to provide some additional economic value to all transaction parties. Examples of features that can be added to plain vanilla capital offerings to make them cstructured d include the creation of offshore, special-purpose vehicles; interest rate and currency swaps; embedded options; forward sales; and any other exotic derivatives. Also included under this respon- dent 9s deNnition of structured Nnance would be chybrid d debt or equity securi- ties such as trust preferred securities, warrants, and convertible bonds.<br><br> There are differing opinions as to whether we should categorize the derivatives market and derivative securities as cstructured Nnance. d We might consider derivative securities to be the elements that can cause certain plain vanilla transactions to become cstructured. d Although derivative securities are highly structured products within themselves, some believe structured Nnance pertains mostly to capital-raising transactions that have nonstandard elements attached to them. But others point to numerous derivatives-based synthetic transactions that are designed not to raise capital but merely to transfer risk. Those transac- tions are becoming an increasingly important part of structured Nnance.<br><br> 1-Intro Page 6 Thursday, August 24, 2006 2:35 PM Introduction 7 EXHIBIT 1.1 (Continued) The boundaries of structured Nnance, in terms of the assets that can be securi- tized on a repeated basis, are continuing to expand with the inclusion of intel- lectual property, time-share loans, tobacco legal fees, and life settlements. Other assets that may soon be added to this category are renewable energy project cash Oows and greenhouse gas emission credits. The boundary between structured Nnance and project Nnance is steadily blurring, as ABS technology is applied to cash Oows (e.g., wind power) that previously were Nnanced exclusively through the traditional project Nnance paradigm.<br><br> Another respondent addresses the expanding boundaries of structured Nnance with two questions: (1) How speciNc and identiNable are the assets? In a lot of transactions the borrower has Oexibility within certain covenants and can bring in new assets as well as take out existing assets. But as assets become less speciNc and identiNable, it may become more difNcult to design structured Nnance transactions around them.<br><br> (2) How exactly does the security work? In a lot of transactions there are no registered mortgages on day one, but regis- tration is triggered by certain events. In other words, structured Nnance is being applied to cassets to come d as well as assets already securely in place.<br><br> One who sees no limit to the boundaries cites future-Oow credit card securiti- zations originated by banks that have higher credit ratings than their native countries, for example Argentina and Turkey. Whereas assets are isolated from the credit risk of the originator in most securitizations, in this case the transaction is actually enhanced by the originating bank 9s credit rating. The continuing Oow of credit card payments underlying the securitization depends on the creditworthiness of the bank.<br><br> Weather-related securities are another deNnition-stressing example of securiti- zation. Investors pay money into an account where it is invested in money- market-type instruments. The negative arbitrage (the difference between the low reinvestment rate on the escrowed proceeds and the signiNcantly higher interest payable to the investors in the weather-related securities) is made up by a reinsurance premium paid by the U.S.<br><br> property and casualty insurance company buying this capital-markets-provided reinsurance. The assets being securitized are the escrow investments and the future reinsurance payments from the single obligor. A bank may offer a savings product that pays a return linked to an index, but with a minimum guaranteed return as well.<br><br> To hedge this product, the bank may buy a combined exotic option (an Asian option linked to the index) from an options market maker as well as a zero-coupon bond. The options product will pay what the bank is obliged to pay on its savings product. This combi- nation of a vanilla product, a zero-coupon bond, and an exotic option linked to an index is another example of structured Nnance.<br><br> 1-Intro Page 7 Thursday, August 24, 2006 2:35 PM 8 INTRODUCTION TO STRUCTURED FINANCE EXHIBIT 1.1 (Continued) A method of raising capital that involves the monetization of a cash Oow stream, either due currently or to become due in the future, utiliz- ing nonrecourse Nnancing techniques to achieve a lower cost of funds, while enabling the borrower to meet its other operational objectives. A way of reorganizing an illiquid asset or group of assets for them to become liquid; a way to pool assets together for securities/certiNcates/ Some aspects of Islamic Nnance also may fall within the realm of structured Nnance. For example, an Islamic loan becomes a structured Nnance instru- ment whenever its formation through replication of conventional asset classes involves a contingent claim.<br><br> In Islamic Nnance, traditional Nxed income instruments are replicated via more complex arrangements in order to establish (1) compliance with the religious prohibition on both interest earnings ( riba ); (2) the exchange of money for debt without an underlying asset transfer; and (3) nonentrepreneurial investment. Structured Nnance redresses these moral impediments to conventional forms of external Nnance. For instance, Islamic banks create synthetic loans for debt-based bond Nnance, where the borrower repurchases, or acquires the option to repurchase, its own assets at a markup in a sell-and-buyback transaction.<br><br> That might entail a cost-plus sale of existing assets ( murabahah ) or project Nnancing for future assets ( istina) . The lender can reNnance the selling price and/or the indebtedness of the borrower via the issuance of commercial paper. Alternatively, the ijarah principle prescribes an asset-based version of reNnancing a synthetic loan, where the lender securitizes the receivables from a temporary lease-back agreement as quasi-interest income.<br><br> The debt transaction underlying each of these forms of reNnancing reOects a put-call, parity-based replication of interest income, where the lender holds stock ownership of the notional loan amount and writes a call option to the bor- rower, who thereby has a put option to acquire these funds at an agreed pre- mium payment subject to the promise of full payment of principal and markup after time. Both options have a strike price equal to the markup and the notional loan amount. So the lender 9s position at the time the synthetic loan is made is the value of the stock ownership minus the value of the call option plus the value of the put option, which equals the present value of principal and interest repayment of a conventional loan.<br><br> A respondent believes the boundaries of structured Nnance will be set by investors, who will weigh the beneNts of a particular transaction against the risk that the investment entails, and by public opinion and the legal system, as with Enron and Orange County, California. The Enron deals that used structured Nnance techniques are a difNcult gray area. The securitization industry tried hard to distinguish its deals from the ones that Enron did.<br><br> In the end, however, the main difference was simply that Enron was crooked and deceitful, in this respondent 9s opinion. 1-Intro Page 8 Thursday, August 24, 2006 2:35 PM Introduction 9 notes to be sold to investors, who otherwise would not want to pur- chase the underlying assets; a way to allocate risk by isolating some assets from other assets owned by the originator of the assets or the issuer of the securities; a way to create an efNcient market in an asset initially unsuitable for investment and then trade the resulting invest- ment instrument based on current market conditions. The art or business of partitioning the risk of an investment (security) or investments (securities) into three or more unique securities 4none being identical 4that derive their value from the initial investment(s).<br><br> Encompasses all advanced private and public Nnancial arrangements that serve to efNciently reNnance and hedge any proNtable economic activity beyond the scope of conventional forms of on-balance-sheet securities (debt, bonds, equity) in the effort to lower cost of capital and to mitigate agency costs of asymmetric information and/or market impediments to liquidity. In particular, most structured Nnancings (1) combine traditional asset classes with contingent claims, such as risk transfer derivatives and/or derivative claims on commodities, curren- cies, or receivables from other reference assets; or (2) replicate tradi- tional asset classes through synthetication. In essence, the last deNnition here is probably the closest to what we believe the concept to be.<br><br> Clearly structured Nnance encompasses more than simply securitization, although that is a popular deNnition for it. Instruments and Techniques Some survey respondents 9 deNnitions emphasize the instruments and techniques used in structured Nnance: A term used in two different ways: (1) asset-backed securities (ABS), residential mortgage-backed securities (RMBS), commercial mort- gage-backed securities (CMBS), and collateralized debt obligations (CDOs); and (2) credit derivatives on corporate names. This respon- dent puts asset-backed securities credit default swaps (ABS CDS) in both categories.<br><br> 6 Involves some or all of the following components: derivatives, securiti- zations, and/or special purpose entities. A structured Nnancing can be as simple as a callable bond with an embedded option or as compli- cated as a cross-border, tax-advantaged securitization. Any transaction that is speciNcally structured using a special-purpose vehicle (removed from the corporation and bankruptcy remote), issues 6 The instruments cited here are described in later chapters.<br><br> 1-Intro Page 9 Thursday, August 24, 2006 2:35 PM 10 INTRODUCTION TO STRUCTURED FINANCE bonds listed with an exchange, and is secured by ring-fenced assets pro- ducing cash Oows solely for supporting the transaction. These elements allow the issuer to obtain better credit ratings and/or more leverage than it would by issuing senior unsecured debt. Incorporates the use of securitization techniques, leasing structures, tax credits, derivatives, and Nnancial and regulatory arbitrage with respect to taxes, securities and related laws, regulatory requirements, and accounting issues.<br><br> A method of providing Nnancing that attempts to maximize proceeds that can be funded to an issuer through the use of various techniques that attract investors to provide such Nnancing, including: (1) the use of special-purpose, bankruptcy-remote entities that function in the roles of borrowers or holders relative to such loans; (2) the use of pass- through entities to avoid cdouble d taxation entities that function in the roles of borrowers or holders relative to such loans; (3) the use of tech- niques to mitigate risks that, if they occurred, would divert or eliminate cash Oow necessary to pay debt service; and (4) the use of techniques to maximize tax advantages for the issuer. Includes Nnancial instruments such as credit derivatives that isolate and transfer credit risk. 7 As a common working principle, credit derivatives involve the sale of contingent credit protection for predeNned credit events of lending transactions.<br><br> In their basic concept, credit derivatives sever the link between the loan origination and associated credit risk, but leave the original borrower-creditor relationship intact. The protec- tion buyer of a credit derivative hedges speciNc credit risk in return for periodic premium payments to the protection seller, who assumes the credit exposure of a Nnancial contract isolated from the underlying transaction. The signiNcance of credit derivatives lies in their ability to supplement traditional ways of hedging credit risk through the transfer of credit-related exposures to a third party.<br><br> Pure credit derivatives are clear examples of structured products for credit risk transfer that allow very speciNc, capital-market-priced risk transfer. Other noncredit- 7 If one agrees with this definition, then one must, logically, include interest-rate de- rivatives such as swaps and describe them as structured finance products as well. A plain vanilla credit derivative such as a credit default swap consists of fixed and float- ing cash flows (the cfloating d cash flow is the payment on occurrence of a terminat- ing credit event), the value of both of which are linked to the credit quality of the underlying reference.<br><br> Replace ccredit quality d with cinterest rate level d and we have described an interest-rate swap. The authors do not extend the definition of struc- tured finance to include plain vanilla credit or interest-rate derivatives themselves, but indeed the use of those instruments may put an otherwise conventional financing into the structured category. 1-Intro Page 10 Thursday, August 24, 2006 2:35 PM Introduction 11 derivative based forms of credit risk transfer include credit insurance, syndicated loans, loan sales, bond trading, and asset swaps.<br><br> Those instruments share the same Nnancial objectives as credit derivatives, but they do not constitute arrangements to create new risk-return pro- Nles from reference assets. This respondent distinguishes between credit derivatives in the narrower and in a wider sense. The latter classiNcation includes pure credit derivatives, such as credit default swaps (CDSs), total return swaps, and credit spread options, as well as securitization products with signiNcant contributions by credit-derivative elements, such as collateralized debt obligations (CDOs).<br><br> Some unfunded/partially funded structured Nnance transactions, such as credit-linked notes (CLNs) and synthetic CDOs contain both securitization and credit derivative elements by providing reNnancing through cash Oow restructuring and tranche-speciNc credit risk transfer (which does not apply to fully funded asset-backed securities (ABS) and mortgage- backed securities (MBS)). These hybrid products, which are consid- ered credit derivatives in a wider sense, usually condition the repay- ment of securitized debt on the nonoccurrence of a deNned credit event (in the case of CLNs), the premium income generated from credit pro- tection sold on reference assets (in the case of synthetic CDOs), or the returns from investment in securitization transactions as reference assets ( cpools of pools d). CDOs have been the fastest growing area of structured Nnance.<br><br> Generally, a CDO represents a form of asset-backed securitization (ABS), which converts a large, diversiNed pool of exposures into trad- able capital market debt instruments (tranches). In a CDO structure, asset managers can increase assets under management while locking in committed funds and achieving some protection from market-value volatility. While cash CDOs are backed by the collateral of actual bonds and loans as reference assets, whose legal title is transferred to the purchaser, issuers of synthetic CDOs enlist large amounts of credit derivatives and various third-party guarantees to create partially funded and highly leveraged investments from synthetic claims on the performance of designated credit exposures.<br><br> CDOs involve either cash Oow or arbitrage mechanisms to fund either expected principal and interest payments or expected trading and sales activity. CDOs enable issuers to achieve a broad range of Nnancial goals that include the off- balance-sheet treatment of securitized exposures, reduced regulatory capital requirements, and access to alternative sources for asset funding and liquidity support. The conventional security design of CDOs assumes a typical three-tier securitization structure of junior, mezza- nine, and senior tranches.<br><br> Expected losses are concentrated in a small 1-Intro Page 11 Thursday, August 24, 2006 2:35 PM 12 INTRODUCTION TO STRUCTURED FINANCE Nrst-loss position as equity claim, which bears the majority of the credit exposure and is frequently covered by a junior CDS, shifting most unexpected risk to larger, more senior tranches, which display dis- tinctly different risk proNles. This risk-sharing arrangement induces a leverage effect on constituent tranches, whose distinct risk-return pro- Nles can be tailored to speciNc investment preferences. When or Where Structured Finance is Used Some of the survey respondents emphasized when or where structured Nnance is used: Employed by Nnancial and nonNnancial institutions in both banking and capital markets if (1) established forms of external Nnance are either unavailable or depleted for a particular Nnancing need, or (2) traditional sources of funds are too expensive.<br><br> Used wherever there is a reliable cash Oow stream that should continue to exist over the maturity of the loan, which the owner wants to utilize to obtain a sizable cash payment from the Nnancing proceeds, in a situ- ation where the owner would like to retain ownership of, and manage, that cash stream. Could be utilized in connection with a variety of cash streams such as proceeds from power purchase agreements, rents from real estate assets, credit card revenues, toll revenues, payments in lieu of taxes, patent revenues, and the like. Seeks to substitute capital-market-based Nnance for credit Nnance through disintermediation, that is, sponsoring Nnancial relationships outside the lending and deposit-taking capabilities of banks.<br><br> The issuer raises funds by issuing certiNcates of ownership as pledges against existing or future cash Oows from an investment pool of Nnan- cial assets in a bid to increase the issuer 9s liquidity position without increasing the capital base or by selling these reference assets to a spe- cial-purpose vehicle, which subsequently issues debt to investors to fund the purchase. Benefits of Structured Finance Other deNnitions emphasize the beneNts provided by structured Nnance: Enables the Nnancing of a unique asset class that (1) previously may have been Nnanced only by traditional borrowing methods or (2) could not be Nnanced at all without structured Nnance. Offers issuers Oexibility in terms of maturity structure, security design, and asset types, which in turn allows issuers to provide enhanced 1-Intro Page 12 Thursday, August 24, 2006 2:35 PM Introduction 13 return and a customized degree of diversiNcation commensurate with investors 9 appetite for risk.<br><br> Contributes to a more complete capital market by offering a trade off along the efNcient frontier of optimal diversiNcation at minimum trans- action cost. Allows the issuer to obtain better credit ratings and/or more leverage compared to senior unsecured debt issuance. May reduce borrowing costs; often captive Nnance companies and independent companies can obtain capital at rates better than those obtainable for the originator of the securitized assets.<br><br> May provide funding and liquidity by converting illiquid assets into cash. May transfer the risk of assets or liabilities to allow a bank originator to do additional business without ballooning its balance sheet. May enable a Nnancial institution to exploit regulatory capital arbi- trage, for example through securitization of assets that offer a low return on regulatory capital.<br><br> Can be used to shelter corporations from potential operating liabili- ties. Securitization A large part of what is considered to be structured Nnance in today 9s markets involves securitization, as can be seen from the three published deNnitions provided earlier. Some respondents provided us with their deNnitions of securitization as well.<br><br> Those deNnitions included the fol- lowing: The use of superior information on how given assets will perform, or given risks will occur, in a way that such assets will be Nnanced, or such risks allocated, more efNciently, usually by some means of structuring to isolate such assets or risks, and most commonly through offerings into the capital markets. An alternative means of raising money through the transfer of Nnancial assets to a special-purpose entity that issues securities, payments on which are based on collections on the Nnancial assets to investors in a transaction in which the Nnancial assets are isolated from the credit risks of the originator/sponsor. Some people think that single assets can be csecuritized. d In this respect, bonds are securities that could be considered the securitization of a promise to pay, a stream of cash, or the value of assets.<br><br> One respondent describes securitization as a close cousin to tradi- tional secured debt. Securitizations are intended to provide a lender or 1-Intro Page 13 Thursday, August 24, 2006 2:35 PM 14 INTRODUCTION TO STRUCTURED FINANCE investor with greater protection against the corporate credit risk of the originator of the assets than with traditional secured debt. In princi- ple, a securitization lender/investor is a kind of csuper-secured credi- tor, d with rights that surpass those of a traditional secured lender.<br><br> Securitization employs the notion that the subject assets have been csold d by the originator and, therefore, will not become entangled in bankruptcy proceedings if the originator Nles for protection under the bankruptcy code. This respondent goes on to provide a working, functional deNni- tion of securitization. In a securitization, a company raises money by issuing securities that are backed by speciNc assets.<br><br> In most cases, the underlying assets are loans, such as mortgage loans or auto loans. The cash Oow from the underlying assets usually is the source of funds for the borrower/issuer to make payments on the securities. Securitization products generally are viewed as including the following: ABS, RMBS, CMBS, CDOs, and asset-backed commercial paper.<br><br> Accomplishing a csale d of the securitized assets often requires the use of a special-purpose entity (SPE). A typical securitization is struc- tured as a two-step transaction. In the Nrst step, the originator trans- fers the subject assets to an SPE in a transfer designed to constitute a ctrue sale. d In the second step, the SPE issues securities backed by the assets.<br><br> The SPE uses the proceeds from selling the securities to pay the originator for the assets. In addition, part of the cconsideration d that the originator receives for transferring the assets to the SPE is its own- ership of the SPE. In some securitizations, the originator does not receive the equity in the SPE.<br><br> Instead, the originator may retain the subordinate or equity position in the securitized assets through other means, such as a variable fee structure. Aside from being a Oexible and efNcient source of funding, the off-bal- ance-sheet treatment of securitization serves (1) to reduce both the eco- nomic cost of capital and regulatory minimum capital requirements as a balance sheet restructuring tool and (2) to diversify asset exposures (especially interest rate risk and currency risk), says another respon- dent. The generation of securitized cash Oows from a diversiNed asset portfo- lio represents an effective method of redistributing asset risks to inves- tors and broader capital markets; it amounts to a transformation and fragmentation of asset exposures.<br><br> As opposed to ordinary debt, a secu- ritized contingent claim on a promised portfolio performance allows investors at low transaction costs to quickly adjust their investment holdings in response to changes in personal risk sensitivity, market sen- timent, and/or consumption preferences. 1-Intro Page 14 Thursday, August 24, 2006 2:35 PM Introduction 15 Arguments for Broader Definitions One respondent favors a broad deNnition that would include project Nnance, leveraged leasing, securitization, structured risk transfer (catas- trophe and other insurance-linked securities and embedded-value securi- tization), and various other applications of derivatives. Indeed, most of the conceptual deNnitions appearing earlier in this article would apply to all aspects of structured Nnance under such a broad deNnition.<br><br> In this respondent 9s view, one of the most interesting attributes of structured Nnance is that it may defy deNnition. That very hard-to-deNne attribute may help preserve its creativity, vibrancy, and Oexibility and generally contribute to the success of structured Nnance in the face of repeated challenges by accountants, regulators, and others. Another respondent recommends that we err on the side of inclu- siveness, even for gray areas such as project Nnance and equipment trust certiNcates.<br><br> In a similar vein, another respondent believes that in today 9s market, structured Nnance simply refers to more sophisticated, complex transactions. It is no surprise that the market has not standardized these distinctions because, as we know, the Neld of Nnance is extremely dynamic and constantly changing. What was complex and structured today may become plain vanilla and standard tomorrow.<br><br> This leads the respondent to conclude that the market really does not need a clear def- inition for structured Nnance. And a consultant in the Neld agrees, say- ing, cIt is to my advantage to leave the deNnition ambiguous. d The overall tone of the responses and the opinions strongly support the our notion that we should take a broad, inclusive view of structured Nnance. Thus in this book, we cover not only securitization, but other transactions that we believe should be viewed as structured Nnancing.<br><br> CASE STUDY: HOW ENRON HAS AFFECTED THE BOUNDARIES OF STRUCTURED FINANCE One of the respondents to our survey cautions that the increasing com- plexity of the structured Nnance market and the ever growing range of products being made available to investors are invariably creating chal- lenges in terms of efNcient information assembly, management, and dis- semination. Another warns that structured Nnance and securitization create Oexibility, but also can be vehicles for manipulating accounting statements and committing fraud, but these applications ultimately tend to work to the detriment of the deal sponsor. And in the course of pro- viding us their deNnitions, several respondents mentioned Enron as pushing beyond the legal and ethical boundaries of structured Nnance.<br><br> 1-Intro Page 15 Thursday, August 24, 2006 2:35 PM 16 INTRODUCTION TO STRUCTURED FINANCE In the spring of 2002, the Journal of Structured and Project Finance surveyed nine frequent contributors and leading experts to hear their views of how the Enron debacle affected project Nnance and the broader realm of structured Nnance. 8 Their general view is that the Enron bank- ruptcy and related events have changed neither the nature nor the useful- ness of traditional project Nnance but they have led to a slowing down of some of the more innovative forms of structured and project Nnance. Among the other direct and indirect effects of Enron have been increased caution among lenders and investors toward the energy and power sectors; increased scrutiny of off-balance-sheet transactions; increased emphasis on counterparty credit risk, particularly with regard to companies involved in merchant power and trading; and deeper analysis of how companies gen- erate recurring free cash Oow.<br><br> There is increased emphasis on transparency and disclosure, even though disclosure in traditional project Nnance has been more robust than in most types of corporate Nnance. In the recent market environment, for reasons that extend beyond Enron, some power companies have been canceling projects and selling assets to reduce lever- age and resorting to on-balance-sheet Nnancing to fortify liquidity. Background The immediate cause of the Enron bankruptcy was a loss of conNdence among investors caused by that company 9s restatement of earnings and inadequate, misleading disclosure of off-balance-sheet entities and related debt.<br><br> There were also secondary causes related more to conditions in the energy and power business than to structured Nnance, including (1) the California power crisis in 2001; (2) the related PaciNc Gas & Electric bankruptcy; (3) falling spot power prices, caused largely by recent over- building of power plants; (4) increasing perception by investors, lenders, and rating agencies of the risk related to independent power producers; and (5) increasing skepticism of the energy trading business, including suspicion that some parties were manipulating their earnings through the marking to market of power contracts and off-balance-sheet vehicles. Effect on Traditional Project Finance Jonathan Lindenberg, Managing Director of Citigroup, reminds us that traditional project Nnance is cash-Oow-based, asset-based Nnance that has little in common with Enron 9s heavily criticized off-balance-sheet partner- ships. According to Roger Feldman, Partner of Bingham McCutchen, the historic elements of project Nnance are Nrmness of cash Oow, counterparty 8 Henry A.<br><br> Davis, cHow Enron Has Affected Project Finance, d Journal of Structured and Project Finance 8 (Spring 2002), pp. 19 326. 1-Intro Page 16 Thursday, August 24, 2006 2:35 PM Introduction 17 creditworthiness, ability to deal over a long timeframe, and conNdence in the legal system.<br><br> Barry Gold, Managing Director of The Carlyle Group, points out that project Nnance is a method for monetizing cash Oows, pro- viding security, and sharing or transferring risks. The Enron transactions had none of these characteristics. They were an attempt to arbitrage accounting, taxes, and disclosure.<br><br> In Lindenberg 9s view, traditional project Nnance is based on transpar- ency, as opposed to the Enron partnerships, where outside investors did not have the opportunity to do the due diligence upon which any competent project Nnance investor or lender would have insisted. Those parties are interested in all the details that give rise to cash Oows. As a result, there is a lot more disclosure in project Nnance than there is in most corporate deals.<br><br> Gold points out that, in traditional project Nnance, analysts and rating agencies do not have a problem with current disclosure standards; it is not hidden and it never has been. First, they know project Nnancing is either with or without recourse and either on or off the balance sheet. For exam- ple, in the case of a joint venture where a company owns 50% of a project or less, the equity method of accounting is used.<br><br> On the company 9s income statement, the company 9s share of earnings from the project are included below the line in the equity investment in unconsolidated subsidiaries and, on the balance sheet, its investment is included in equity investment in unconsolidated subsidiaries. The point to remember is that whether a project is Nnanced on or off the balance sheet, analysts know where to look. Lindenberg explains that off-balance-sheet treatment may not be the principal reason for most project Nnancing.<br><br> It usually is motivated more by considerations such as risk transfer or providing a way for parties with differ- ent credit ratings to jointly Nnance a project 4whereas if all of those parties provided the Nnancing on their own balance sheets, they would be providing unequal amounts of capital by virtue of their different borrowing costs. None of these considerations have anything to do with the Enron partnerships, where a 3% equity participation from a Nnancial player with nothing at risk was used as a gimmick to get assets and related debt off the balance sheet. Structured Project Finance Even though pure project Nnance has not been affected very much by Enron, Lindenberg and Worenklein see some slowing of activity in the more innovative types of structured Nnance such as synthetic leasing, structured partnerships, and equity share trusts.<br><br> 9 9 See Glenn McIsaac, Chris Beale, and Jonathan Lindenberg, cFinancing in the New Merchant Power Generation Business, d Journal of Project Finance 6 (Spring 2000), pp. 13 319, and David Fowkes and Nasir Kahn with Don Armstrong, cLeasing in Project Financing, d Journal of Project Finance 6 (Spring 2000), pp. 21 332.<br><br> 1-Intro Page 17 Thursday, August 24, 2006 2:35 PM 18 INTRODUCTION TO STRUCTURED FINANCE Lindenberg notes that synthetic leases are a mature product, under- stood by rating agencies and accountants, in which billions of dollars of deals have been done. But the problem is cheadline risk. d Since the Enron debacle, numerous other companies have had disclosure issues. Even though synthetic leases are transparent and well understood by Nnancial experts, they have an off-balance-sheet element that is not understood by everyone in the market at large.<br><br> But Christoper Dymond of Greengate LLC cautions that the inves- tor market has overreacted to anything that sounds clike Enron. d Struc- tured and project Nnancing techniques have been developed for sound risk management reasons and, in his opinion, must be defended vigor- ously on those grounds. He believes a prejudice against ccomplexity d in Nnancial structures could have a real economic and Nnancial cost. Most sponsors and investors are sophisticated enough to make these distinc- tions.<br><br> However, if sponsors fear that the wider market will punish them for using complex structures, they will stop using them. After the Enron crisis, several companies made public vows not to use any off-balance- sheet structures. But, rather than pandering to uninformed sentiment, Dymond believes that companies should make greater efforts to clearly delineate the difference between legitimate nonrecourse debt and the Enron structures.<br><br> Special Purpose Entities By using corporate stock as collateral and by creating conOicts of inter- est, Feldman of Bingham McCutchen believes that Enron undermined the pristine nature of the special purpose, nonrecourse entity and caused all such structures to look suspect in some people 9s eyes. He stresses that in traditional project Nnance, a special purpose, nonrecourse entity must be clean and fully focused on the transaction concerned. In the after- math of the Enron bankruptcy, project sponsors and the bankers and lawyers who support them have had to make special efforts to explain the legitimate business reasons for these entities.<br><br> Sources of Free Cash Flow William Chew, Managing Director of Standard & Poor 9s recalls that immediately after Enron Nled for bankruptcy protection, some ques- tioned whether project and structured Nnance would survive in their current form. And indeed, some corporations with large amounts of off- balance-sheet Nnancing and inadequate disclosure were subjected to increased scrutiny and sharply reduced valuations for both their equity and their debt. In response, a number of those companies expanded their liquidity and reduced their debt to the extent possible.<br><br> But Chew 1-Intro Page 18 Thursday, August 24, 2006 2:35 PM Introduction 19 believes that, as time progresses, that the main fallout from Enron and the other recent market shocks may be not so much a turning away from project Nnance but rather a greater stress on bottom-up evaluation of how companies generate recurring free cash Oow and what might affect it over time. In this process, Chew believes that project Nnance and other types of structured Nnance probably will continue to play an important role. The change, in his view, is that the focus will be on not only the project structures, but also on how they may affect corporate- level cash Oow and credit proNles 4for example, through springing guarantees and potential debt acceleration, through contingent indemni- Ncation and performance guarantees, through negative pledges and their limits at both the project and the corporate holding company level, and through the potential for joint-venture and partnership dissolutions to create sudden changes in cash Oows.<br><br> Standard & Poor 9s reminds us in its project as well as its corporate credit analysis that there can be a big dif- ference between generally accepted accounting principles (GAAP) and cash Oow analysis. Security Interests Feldman notes that the power business, in part, has shifted from a con- tract business to a trading, cash Oow kind of business where the coun- terparty becomes critical to the viability of a transaction. The security in the transaction is less the asset itself and more what the trading counter- party does with the asset.<br><br> That asset has an option value in the hands of a counterparty, but a far different value if a bank has to foreclose on it 4a value you would rather not Nnd out. In Feldman 9s opinion, Enron 9s alleged tendency to set its own rules for marking gas, electricity, and various other newer, thinly traded derivative contracts to market raises some interesting questions about collateral and security. Historically, the security in a power plant Nnanc- ing has consisted of contracts, counterparty arrangements, and assets.<br><br> But if a lender 9s security depends on marking certain contracts to mar- ket, and there is some question as to the objectivity of the counterparty that is marking them to market, that raises additional questions as to what is an adequate sale, what is adequate collateral, how a lender takes an adequate security interest, how a lender monitors the value of its security interest, and what a lender needs to do to establish a sufNcient prior lien in the cash Oow associated with the transaction. In the case of a structured Nnance transaction, Mr. Feldman believes the key question remains just as it always has been: whether the security is real and whether you can get your hands on it.<br><br> 1-Intro Page 19 Thursday, August 24, 2006 2:35 PM 20 INTRODUCTION TO STRUCTURED FINANCE How Companies Have Responded Jacob Worenklein of U.S. Power Generating Company has seen affected companies respond to the post-Enron market environment rapidly and decisively to strengthen their liquidity through issuing new equity, cancel- ing projects, selling assets, either unwinding structured Nnance deals or putting them on the balance sheet, and increased transparency and disclo- sure. Even though traditional project Nnance has little to do with the off- balance-sheet entities that brought Enron down, Dino Barajas of Paul, Hastings, Janovsky, and Walker, LLP fears a backlash that could affect project Nnance in the event of a credit crunch.<br><br> If that happens, one possible solution could be, simply, to Nnance more projects on the corporate bal- ance sheet. Some power companies have set up massive credit facilities for doing so based on their overall corporate cash Oow and creditworthiness. Another option for a company is to borrow against a basket of power projects, allowing the lenders to diversify their risks, although such a facility is still largely based on the credit fundamentals of the corporation.<br><br> But Barajas believes that project Nnancing on an individual plant basis can be preferable to either of these approaches for both project sponsors and lenders. For example, say a company is Nnancing 10 projects and three run into trouble. The company can make a rational economic deci- sion as to which of those projects are salvageable and which ones do not merit throwing in good money after bad.<br><br> It might let one go into foreclo- sure and be restructured and sold. But if a company is Nnancing ten projects together, its management may feel compelled to artiNcially bol- ster some of its projects so that the failure of one project does not bring the entire credit facility down. Making such an uneconomic decision for the near term would not be in the company 9s long-term interests.<br><br> Increased Transparency and Disclosure Worenklein observes that after Enron major players started to release much more information than before about their businesses and Nnancing arrangements. Similarly, Gold of The Carlyle Group saw an overriding aura of conservatism in disclosure, for example, in conference room dis- cussions while drafting prospectuses for project Nnance deals. Bankers were making extra efforts to conNrm that deals are being disclosed and explained the right way.<br><br> Going forward, Worenklein believes that strong management actions are needed to restore belief in honesty of numbers. A company 9s management needs to demonstrate the same passion for integrity as it had for growth in the past. It needs to get rid of gimmicks and consis- tently communicate and execute a simple, clear strategic vision.<br><br> This involves cleaning up the balance sheet. Transactions that have signiN- 1-Intro Page 20 Thursday, August 24, 2006 2:35 PM Introduction 21 cant recourse to the sponsor should be put back on the balance sheet. Only true nonrecourse deals should be left off the balance sheet.<br><br> To con- vey an accurate, fair picture of the business, companies need to commu- nicate 4to the point of obsession 4information and assumptions about how earnings are recognized, including mark-to-market transactions. In Worenklein 9s view, managing earnings is out and managing cash Oow is in 4and, as Chew of Standard & Poor 9s noted earlier, that is what the rating agencies are looking at anyway. Regulatory Issues Feldman of Bingham McCutchen brings up some regulatory issues.<br><br> One of the reasons Enron was left to its own devices in valuing gas, electricity, and other types of contracts was that it became, in effect, the largest unregulated bank in the world. It was able to avoid regulation of its trad- ing activities by the Commodity Futures Trading Commission (CFTC), partly as a result of its own lobbying efforts, and the Federal Energy Reg- ulatory Commission (FERC) declined to get involved as well. Therefore, it was able to duck some of the scrutiny that regulators have directed toward commercial and investment banks dealing in derivatives.<br><br> Of course, securities analysis had long complained about Enron 9s opaque Nnancial reporting, only to be told in return that they just did not under- stand the business. Other Lessons Learned James Guidera of Calyon sees some general lessons from Enron in the Neld of structured Nnance: The transfer of assets, intangible and otherwise, into nonconsolidating vehicles controlled by a sponsor may mislead investors as to the extent of nonrecurring earnings or deferred losses, even in the absence of fraud. There is a risk of low recovery rates on structured transactions secured by intangible assets (investments, contracts, company stock) or by tan- gible assets whose values are not established on an arms-length basis.<br><br> Having been badly burned by the Enron bankruptcy, banks and inves- tors involved in structured and project Nnancings, and in the energy sector generally, will be especially conservative, and this will limit credit and capital access for many clients in the sector, creating a gen- eral liquidity issue for these customers. Dymond of Greengate LLC has several recommendations concern- ing accounting treatment and disclosure: 1-Intro Page 21 Thursday, August 24, 2006 2:35 PM 22 INTRODUCTION TO STRUCTURED FINANCE An effort must be made by all in the project Nnance industry (and investor relations) to underscore the distinction between true nonre- course structures and Enron 9s activities. The terms nonrecourse and off-balance-sheet should remain synonyms.<br><br> Liabilities that truly have no recourse to a company 9s shareholders can justly be treated as off-balance-sheet. Enron appears to have violated this principle since the undisclosed liabilities in the off-balance sheet partnerships actually had signiNcant recourse to Enron shareholders through share remarketing mechanisms. Many project Nnance structures are climited d recourse rather than cnon d recourse, and thus there is a potential gray area in which accounting rules allow off-balance sheet treatment but there is none- theless some contingent liability to the parent company 9s shareholders.<br><br> Full (footnote) disclosure of any potential shareholder recourse was advisable pre-Enron, and is absolutely necessary now. To conclude, project Nnance today is alive and well as a form of structured Nnance. We may just need to remind some people of its basic fundamen- tals.<br><br> Neither project Nnance nor sensible innovations in structured Nnance with sound, well explained business reasons have been shaken by Enron. The principal lessons learned from the Enron debacle have to do with transparency and disclosure. When some of your businesses or your Nnancing structures become hard to explain, you may begin to question whether they make sense in the Nrst place.<br><br> CONCLUSIONS As we have highlighted in this chapter, structured Nnance is a term that covers a very wide range of Nnancial market transactions and products. While a common deNnition of it seems to center on securitization, struc- tured Nnancial products also include complex instruments such as bonds with embedded exotic options and transactions such as project Nnanc- ing and leveraged leasing. We would suggest that securitization and the employment of SPV entities is a subset of structured Nnance, albeit a large subset.<br><br> In conclusion, it is probably best to say that there is no one deNni- tion of structured Nnance, and that the term can be used to describe any Nnancial transaction or instrument that is not plain vanilla. 1-Intro Page 22 Thursday, August 24, 2006 2:35 PM