ABS- Structures, Markets, Threats and Opportunities

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Table of Contents

TABLE OF  CONTENTS  I

  LIST OF ABBREVIATIONS  IV

  LIST OF FIGURES  VI

  LIST OF TABLES  VII

1  INTRODUCTION  1

1.1  Preface  1

1.2  Research Objective  1

1.3  Research Methodology  2

1.4  Organization of the Thesis  2

2  PORTFOLIO THEORY BY HARRY M. MARKOWITZ  4

2.1  Definition of a Portfolio  4

2.2  Portfolio Analysis  4

2.3  Uncertainty within a Portfolio  4

2.4  Relation of Securities within a Portfolio  5

2.5  Objectives of Markowitz’ Portfolio Analysis  6

2.6  Further Portfolio Theories  6

2.6.1  Capital Asset Pricing Model (CAPM)  6

2.6.2  Arbitrage Pricing Theory (APT)  7

2.7  Critical Appraisal  8

3  ASSET-BACKED SECURITIES  10

3.1  Definition of Asset Backed Securities as a Term  10

3.2  Historical Development of ABS as a Financial Tool  10

3.3  Basic Structure of an ABS Transaction  12

3.4  Asset-Backed Commercial Paper (ABCP) Program  14

3.5  Types of ABS  16

3.5.1  Mortgage-Backed Securities  16

3.5.2  Collateralized Debt Obligations  17

3.5.3  Borrowers Characteristics  18

3.6  Cash Flow Structures  19

3.6.1  Pass-Through Structure  19

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3.6.2  Pay-Through Structure  20

3.7  Importance of Rating  21

3.7.1  Definition of Rating  21

3.7.2  Function of Rating for Investors  22

3.7.3  Rating- Systems and -Symbols  23

3.8  Credit Risks while Investing in ABS  24

3.8.1  Asset Risks  25

3.8.2  Structural Risks  26

3.9  Credit Enhancement Methods  27

3.9.1  Internal Enhancement  28

3.9.1.1  Subordination  28

3.9.1.2  Overcollateralization  29

3.9.1.3  Spread Accounts  29

3.9.2  External Enhancement  30

3.9.2.1  Pool Insurance  30

3.9.2.2  Letters of Credit  31

3.9.2.3  Liquidity Facilities  31

3.10  Critical Appraisal  32

4  US SUBPRIME CRISIS  34

4.1  History of the Subprime Market  34

4.2  History of the Subprime Crisis  35

4.3  Reasons for the US Subprime Crisis  39

4.3.1  Factors in the US  40

4.3.2  Factors beyond the US Boundaries  41

4.3.3  Rating Agencies as a Further Factor  42

4.4  Regulations for German Banks Concerning the Subprime Crisis  44

4.5  Effects on Further ABS Vehicles  46

4.6  Critical Appraisal  49

5  DEUTSCHE INDUSTRIEBANK AG (IKB)  51

5.1  About IKB  51

5.2  History and Development of Deutsche Industriebank AG  51

5.2.1  Bank for Industry Obligations (Bafio)  51

5.2.2  Reorganization of Bafio  52

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5.2.3  Deutsche Industriebank  52

5.2.4  Industriekreditbank AG (IKB)  53

5.2.5  Deutsche Industriebank AG  53

5.3  Influence of the Subprime Crisis on IKB  53

5.3.1  Overview on IKB’s Crisis  55

5.3.2  IKB’s Management Failures  57

5.3.3  IKB and Rhineland Funding  59

5.3.4  Effects on IKB’s Customers  62

5.3.5  Reorientation for IKB  63

5.3.6  Current Developments for IKB  64

6  CONCLUSION  67

6.1  Findings  67

6.2  Recommendation and Outlook  68

  BIBLIOGRAPHY  VIII

List of Abbreviations

AAA The highest rating symbol ABS Asset-Backed Securities APT Arbitrage-Pricing-Theory BaFin Bundesanstalt für Finanzdienstleistungsaufsicht Bafio Bank für deutsche Industrieobligationen BAKred Bundesaufsichtsamt für das Kreditwesen CAPM Capital-Asset-Pricing-Model CEO Chief Executive Officer Cf. Confer to; Compare CMO Collateralized Mortgage Obligations EBIT Earnings before Interest and Taxes etc. Et cetera; and other similar things ; and so on EUR Euro FDIC Federal Deposit Insurance Corporation FHA The Federal Housing Administration GNMA Government National Mortgage Association i.e. Id est. (lat.); that means IKB Deutsche Industriebank AG IOSCO International Organization of Securities Commissions KfW Kreditanstalt für Wiederaufbau KWG Kreditwesengesetz MBS Mortgage Backed Securities p. Page pp. Pages PwC Pricewaterhouse Coopers S&P Standard & Poor’s SIV Structured Investment Vehicle SPV Special Purpose Vehicle URL uniform resource locator USA United States of America USD United-States-Dollar VA The Veterans Administration

- V -vs. Versus w.p. without page w.y. without year

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  List of Figures  

  Figure 1: Basic Structure of an ABS Transaction  

  Figure 2: Basic Structure of an ABCP Program  

  Figure 3: Calculation of the Excess Spread  

  Figure 4: Announced and Estimated Losses of Banks  

  Figure 5: An Overview of the IKB Crisis  

  Figure 6: Strategy of Rhineland Funding  

  Figure 7: IKB’s Shareholder’s Structure  

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  List of Tables  

Table 1:  Comparison of the Rating Symbols of the Well-Known Rating Agencies  23

Table 2:  Example for Credit Enhancement by Subordination  29

Table 3:  Contingent Liabilities of IKB  61

Table 4:  Liabilities of IKB  61

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1 Introduction

1.1 Preface

The general view once was that the financial system has become more stable because risks mainly lay not within the banks balance sheets, but with the investors and further parties involved when structuring and selling structured products such as asset-backed securities. ¹ As a result of the re-evaluation of subprime loans and other asset-backed

securities structures as the speculative bubble busted in summer 2007, a clear increase in the risk aversion has been observable during the past few months. This, in turn, has caused problems in the interbank market since refinancing costs have increased enormously, so that not only banks are being affected by the breakdown in the US subprime mortgages. 2

In addition, it can be assumed that due to the subprime market breakdown and loans given to hedge funds plus their own investments in credit products, risks have found their way back in the banks balance sheets. Recently, there has been talk of an upcoming recession. ³ Only time will tell how the financial markets will continue to

react on the consequences of the subprime crisis.

1.2 Research Objective

Basically asset-backed securities were thought to carry little or almost no risk while simultaneously bringing in a high return. They were supposed to transform risky assets into riskless ones without minimizing the return. 4

In connection with high ratings there may be the question of which risks should actually be considered when investing in asset-backed securities. Furthermore, it needs to be discovered how possible problems can affect the economic performance of a company.

The objective of this paper is to reveal the difficulties in evaluating and handling the investments in asset-backed securities of German financial institutes, using the example

¹ Cf. Brost, M. et al. (2007), p. 19.

² Cf. Fischermann, T. et al. (2007), p. 27.

³ Cf. Gerth, M. (2007), p. 86.

⁴ Cf. Gundlach, M., Lehrbass, F. (2004), p. 311.

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of the Deutsche Industriebank AG. In order to achieve this aim, the following questions will be dealt with:

What kind of problems in understanding and evaluating asset-backed securities can arise?

What kinds of dependencies occur when investing in asset-backed securities? How can problems emerge for banks investing in asset-backed securities?

1.3 Research Methodology

This thesis about asset-backed securities using the example of the Deutsche Industriebank AG (IKB) contains information from sources such as books, newspapers and the Internet.

Please note that due to the fact that the consequences of the subprime crisis and the developments concerning IKB are still a main issue in the daily news. Moreover, as the number of pages of this thesis is limited, not every statement about further new consequences for the financial market and financial institutes will be discussed. The author focuses mainly on news which was issued up to the 1 ^st of February 2008, with the exception of news about the Deutsche Industriebank AG, which includes information from the news up until the 15 ^th of February 2008. Furthermore, it should be noted that the author only covers those topics which are the most important for finding out why IKB and other German banks failed while investing in asset-backed securities.

1.4 Organization of the Thesis

This study is structured as follows: first, the author begins by providing information on the portfolio-selection theory by Markowitz in chapter 2, introducing two further theories known as the Capital Asset Pricing Model and the Arbitrage Pricing Theory in section 2.6. While the Capital Asset Pricing Model in 2.6.1 is based on the portfolio theory of Markowitz, the Arbitrage Pricing Theory in 2.6.2 takes a different approach. These theories provide a smooth transition to the theoretical part of asset-backed securities in chapter 3. Chapter 3 deals with the complex structure of asset-backed securities as a financial tool. Starting with a general introduction of ABS, including its definition and historical background, the author will offer an overview of the parties

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involved within a basic asset-backed securities transaction in chapter 3.3. Next the author provides information about a further transaction type, namely the asset-backed commercial paper program, in chapter 3.4. An overview of the types of ABS follows. Subsequently the various existing cash flow structures within an ABS transaction are outlined. Chapter 3.7 gives an overview of the importance and functionality of ratings for ABS for all financial market parties. An overview of the risks which can occur within an ABS transaction and how they can be minimized by credit enhancements follows. The chapter ends with a critical look at the complex structure of asset-backed securities.

Chapter 4 includes information on the subprime crisis in the financial markets. After providing information on the history of the subprime market, the author outlines the development of the crisis briefly. Next, the reasons for the crisis within and beyond the USA are analyzed, taking the rating agencies into account as a further factor. The rules and regulations for German banks will be outlined before the effects on further ABS vehicles and the current development of the crisis are discussed. The chapter concludes with a critical assessment of the subprime crisis.

Chapter 5 focuses on the example of the Deutsche Industriebank AG. After a look at IKB’s history, the consequences for the bank concerning the subprime crisis are outlined. Furthermore IKB’s conduit Rhineland Funding and its SIV Rhinebridge are introduced, followed by some details about how those vehicles contributed to the problems of the Deutsche Industriebank AG. Subsequently, the author discusses the effects on IKB’s customers and the management failures. The chapter closes with the plan to reorganize IKB in the future and an overview of the current developments of this financial institute.

Finally, chapter 6 presents the author’s findings as well as a recommendation and outlook.

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2 Portfolio Theory by Harry M. Markowitz

2.1 Definition of a Portfolio

A portfolio is a combination of the assets of an individual, an institution or a national budget. It has the purpose of a calculated summary, display and control of financial characteristics of the portfolio and its components. The investor’s desired criteria concerning collateral, rate of return and liquidity should come together in a portfolio in total. The simultaneous inspection of the individual assets as a portfolio is the basis for the decision for its contents. 5

2.2 Portfolio Analysis

Portfolio analysis as defined by Markowitz is based on portfolios which include a great quantity of securities. In his opinion a good portfolio is not just a list of stocks and bonds. An investor should build up their portfolio with attributes which best fits them. In order to find portfolios which are most suitable to the investor’s objective it is essential to carry out a portfolio analysis. The analysis’ purpose is to draw conclusions concerning the portfolio as a whole by collecting information on the single assets. Information like the past performance of single securities and further several types of information represent the raw data of the analysis. The belief of one or more analyst regarding the future performance of single securities represents a further source of information. Using information on the past performances of securities as an input leads to an output of portfolios displayed which had a good performance. The same happens with using the opinions of analysts as an input. The output of the analysis will be the reflections of those beliefs concerning portfolios being better or worse. 6

2.3 Uncertainty within a Portfolio

The reason why uncertainty is a salient feature within a portfolio is the lack of understanding those economic forces which can lead to improper predictions concerning error or doubt. In addition to those economic influences there are also non-economic effects which can decide over a portfolio’s profit or loss of one or many securities. An example of a non-economic influence can be a very dry summer which leads to a poor

⁵ Cf. Spremann, K. (2006), p. 5.

⁶ Cf. Markowitz, H. M. (1970), p. 3.

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harvest and therefore high prices for harvest goods or perhaps the success of a new product that exceeds the management’s expectations. However, the appearance of uncertainty does not imply that a good analysis is worthless. Since it is nearly impossible to predict with certainty it is of high importance to build judgments by experts and with great care. 7

2.4 Relation of Securities within a Portfolio

Securities bear the disadvantage that they tend to highly correlate in terms of returns within one asset class. This development is characteristic for an economic quantity and leads to the fact that they are most likely to go up and down at the same time, which is not satisfying concerning an entire portfolio. 8

Markowitz uses the example of flipping a coin. He sets up the theory that one is not able to predict which side of the coin will appear when flipping one coin once. But he continues with the thought that if one uses many coins to flip that either head or tail will appear probably on one half of the tossed coins. Comparing the correlation of those coins to securities it can be said that once the securities reacted like those coins, which highly correlate, it would be possible to reduce risk via diversification. But if one flipped a hundred coins and every coin fell like the first one, eliminating or reducing risk by diversification would be impossible. This is because of the perfect correlation of those coins. 9

In the process of portfolio allocation it is necessary to compose a portfolio which includes securities not perfectly correlated with each other. It is to be expected that a security of the same industry will correlate more than ones of unrelated industries. This leads to a higher effect of diversification once similarity between asset classes is low. Portfolios can provide an improvement in performance once the assets do not correlate perfectly on one hundred percent with each other. This is important to reduce risk, since once securities are rising and falling at the same time the portfolio does not offer protection. 10

⁷ Cf. Markowitz, H. M. (1970), p. 4.

⁸ Cf. Markowitz, H. M. (1970), p. 5.

⁹ Cf. Markowitz, H. M. (1970), p. 5.

¹⁰ Cf. Markowitz, H. M. (1970), p. 5.

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2.5 Objectives of Markowitz’ Portfolio Analysis

It seems that it is nearly impossible to obtain every conclusion which is important for a portfolio. Therefore it is necessary to break the basis of a portfolio analysis down into important and unimportant criteria. The decision whether criteria are relevant or irrelevant depends on the investor’s personality. Some investors may consider the relationship between the cost of living and the returns on a portfolio important while other investors would not. But there are two objectives which fit every investor. Every investor desires a high return, even though investors mostly define this return differently. ¹¹ The term return itself has different definitions depending on the context of the analysis. ¹² Nevertheless it can be said that return in the common sense is what you

receive in comparison to what an investor invests. It is the change in the investment’s market price plus the income received over a certain period. 13

Investors would like this return to be stable, dependable and definitely not uncertain. Therefore Markowitz has developed the theory of efficient portfolios. This means that there is no portfolio with a higher possible return by constant risk. Secondly there is no portfolio which has the same return by lower risk. And finally there is no portfolio with a higher return by lower risk. Choosing efficient portfolios depends on the investor’s ability and willingness to accept risk. It is important that the investor chooses portfolios which best fit his requirements, meaning choosing a portfolio providing the best combination of return and risk to the investor. 14

2.6 Further Portfolio Theories

2.6.1 Capital Asset Pricing Model (CAPM)

In 1958 James Tobin provided an amendment to Markowitz’ theory of portfolio selection. He recognized that once a certain number and certain securities were given it is wise, not depending on the individual investor’s risk aversion, to invest in a so called “tangential portfolio’’. The risk addiction of an investor is only important for the allocation of assets on risk or risk-free securities should look like. Tobin’s contribution

¹¹ Cf. Markowitz, H. M. (1970), p. 6.

¹² Cf. Guilding, C. (2002), p. 70.

¹³ Cf. Morris, V. B., Morris, K. M. (2005), p. 50.

¹⁴ Cf. Markowitz, H. M. (1970), p. 6.

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is called the “separation theorem’’. On the basis of Markowitz’ theory of portfolio selection and on Tobin’s expansion of the same Sharpe, Lintner and Mossin developed a Capital Asset Pricing Model (CAPM) in 1964. ¹⁵ Their theory was one of the capital market equibilirium. According to this theory the capital market of securities which are fraught with risk is balanced once there is no surplus of supply and demand. Every available security is held by investors with everyone holding a part of the entire market portfolio. ¹⁶ This means all available securities are held in proportion to their market values. ¹⁷ The risk aversion of a single investor is only shown in how he combines his portfolio with risk-free securities. ¹⁸ This is the idea taken up from Tobin. Sharpe supports the same idea of eliminating risks via diversification. The only question which was left unanswered was which part of risk can not be eliminated by diversification. 19

2.6.2 Arbitrage Pricing Theory (APT)

The reason why the Arbitrage Pricing Theory was developed is because CAPM limited its statements concerning returns only to the factors risk and return. ²⁰ In contrast to the CAPM the arbitrage pricing theory (APT) by Stephen Ross does not consider whether a portfolio is efficient or not. The theory is an alternative to the theory of return and risk. It assumes that every return of a stock is influenced by interactive macroeconomic events or “noise’’ and “factors’’ of incidents which are unique to a company. There can be factors such as inflation, interest rate etc., but the theory does not name the factors. Each stock will be more sensitive to certain factors then others. There is the example of Exxon Mobil which would be more sensitive to an oil factor than Coca Cola. ²¹ The main conclusion of the APT is that firstly arbitrage processes lead to balanced securities which are always evaluated correctly. Secondly it is said that it is not necessary to have further knowledge about the market theory. Furthermore the securities’ returns depend on many risk factors either macro- or microeconomic. And finally that the return consists of a risk-free part and various risk premiums. 22

¹⁵ Cf. Sharpe, W. F. (1964), p. 425 ff.; Lintner, J. (1965), p. 13 ff.; Mossin, J. (1966), p. 768 ff.

¹⁶ Cf. Natter, A. (2002), p. 31.

¹⁷ Cf. Merton, R. C. (1990), p. 43.

¹⁸ Cf. Natter, A. (2002), p. 31.

¹⁹ Cf. Steiner, M., Bruns, C. (2000), p. 21.

²⁰ Cf. Ross, S. A. (1976), p. 341 ff.

²¹ Cf. Brealey, R. A. et al. (2006), p. 199 ff.

²² Cf. Steiner, M., Bruns, C. (2000), p. 30.

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2.7 Critical Appraisal

The portfolio selection model (portfolio theory) by Harry M. Markowitz is based on the idea of diversifying investment capital into different asset classes within a portfolio. This has the function of minimizing risk. ²³ Therefore Markowitz arrives at the

conclusion that the number of securities in a portfolio is less important than the correlation of the securities with each other. ²⁴ Securities of unrelated industries are

considered to not perfectly correlate with each other, which leads to a better portfolio performance. ²⁵ It is a fact that the correlation of assets does not remain constant but

varies from time to time. This volatility is based on supply and demand and also possibly on different economic cycles. This is a normal development in the financial markets but therefore it is necessary to verify the correlations constantly. 26

During the 1990’s different asset classes showed different performances, creating an ideal situation for establishing a new portfolio with rather low potential risks combined with an optimized return. However, the past two years have demonstrated that the situation of different securities not perfectly correlating has changed. It has been observed that the development of different assets classes in the financial market assimilates. The reason for this situation can be explained by a global financial system which has become highly complex with ever increasing dependencies. ²⁷ Furthermore,

upon the creation of the Euro, exchange rates and interest rates were fixed in the Euroarea. 28

Because of this development new securities emerge on an almost daily basis. Those products are said to have perfect possibilities for diversification but at the same time investors and banks have to judge critically whether those instruments include the desired diversification and return. ²⁹ The importance of traditional banking activities has

declined in most countries because of open competition and therefore price pressures among lenders from the non-bank financial sector such as venture capital and private

²³ Cf. Steiner, M., Bruns, C. (2000), p. 13 f.

²⁴ Cf. Markowitz, H. M. (1952), p. 89.

²⁵ Cf. Markowitz, H. M. (1970), p. 5.

²⁶ Cf. Wilhelm von Finck AG (2007), p. 108 ff.

²⁷ Cf. Wilhelm von Finck AG (2007), p. 108 ff.

²⁸ Cf. European Central Bank (2003), p. 29f.

²⁹ Cf. Wilhelm von Finck AG (2007), p. 108 f.

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equity. Therefore banks have expanded to non traditional sectors such as loan securitization in order to generate fees. Asset-backed securities are said to be such an alternative product and will be introduced and discussed by the author in the following chapters. 30

³⁰ Cf. International Monetary Fund (2006), p. 107 ff.

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3 Asset-Backed Securities

3.1 Definition of Asset Backed Securities as a Term

The term asset-backed securities (ABS) encompasses every bond that is able to act as a financial tool and cover all varieties of assets. Therefore asset-backed securities is an umbrella term for several varieties which will be described by the author in chapter 2.4. ³¹ Assets can be securitized once they are able to generate a predictable cash flow stream. ³² This type of securities are carefully structured products in a structured process whereby loans, bonds, etc. are packaged, underwritten and sold in the form of ABS. 33

Therefore the securitized loans have to be relatively homogenous in terms of rates, collateral and terms. ³⁴ The goal of an asset-backed securities transaction is to convert illiquid assets into liquid securities. ³⁵ This takes place by selling selected assets without

recourse to entities, which are founded only for this transaction and which is called special purpose vehicle (SPV). The SPV finances the purchase price by issuing securities which are secured (backed up) with assets. ³⁶ All required payments to the

investors are derived from the cash flow from these assets. This procedure leads to a low priced refunding, which results from the separated rating of the issue and the rating of the receivable seller. 37

3.2 Historical Development of ABS as a Financial Tool

Asset-backed securities as a financial vehicle originated in the United States in the 1970s. ³⁸ The separate banking system, which is considered to be to some extent

inefficient, caused an imbalance among mortgages during that time. It was impossible to create capital compensation among the US states with a funds surplus and those with funds shortfalls. This situation was additionally made worse by economic factors and a high volatility in interest rates. Because of those difficult basic conditions for the American banks, the US Government decided to create a secondary market for

³¹ Cf. Achleitner, A. -K. (2002), p. 419.

³² Cf. Glantz, M. (2003), p. 76.

³³ Cf. Rosenthal, J. A., Ocampo, J. M. (1998) p. 3.

³⁴ Cf. Glantz, M. (2003), p. 444.

³⁵ Cf. Kuhn, R. L. (1990), p. 345.

³⁶ Cf. Gruber, J. et al. (2005), p. 63; Ergenzinger, T. (2003), p. 311.

³⁷ Cf. Achleitner, A. -K. (2002), p. 420.

³⁸ Cf. Böhmer, M. (1996) p. 19.