CAIA L2 - 9.3 - Complexity and Structured Products

Question 1

Define

• Risk
• Knightian uncertainty
• Ambiguity
• Opacity

9.3 - Complexity and Structured Products

Answer 1

• Risk event with
  => known probabilities of outcomes
  => unknown outcome
• Knightian uncertainty
  => unknown probabilities of outcomes
  => unknown outcome
• Ambiguity
  => similar to Knightian uncertainty
  => unknown future returns and their associated probabilities of a financial asset.
  => Knightian uncertainty = key driver of risk premiums for financial assets
• Opacity
  => The extent to which an asset’s risks and characteristics are not clear
  => Opacity can result from principal-agent conflicts in portfolio management and the natural incentive for managers to conceal their sources of return variability in order to avoid being labeled as unskilled
  => Managers of opaque investments can charge higher fees because investors do not have the needed transparency to evaluate the appropriateness of the fees charged
  => Financially engineered complexity can also be beneficial because it can be viewed as providing assets to meet demand from investors, which works toward completing the market

9.3 - Complexity and Structured Products

Question 2

Define

Complexity crashes

9.3 - Complexity and Structured Products

Answer 2

In a severe market crisis
=> Investors may need to sell complex securities at deep discounts
=> leading to large losses in value,
=> resulting in complexity crashes
(similar to momentum crashes)

9.3 - Complexity and Structured Products

Question 3

Describe

Complexity risk premium

9.3 - Complexity and Structured Products

Answer 3

additional return that accrues to investors
to compensate them for the risk of loss
associated with less transparent investments
and for the higher cost of analyzing complex securities

General complexity risk premium across asset classes is supported by some evidence

9.3 - Complexity and Structured Products

Question 4

Interpret

Complexity as a return characteristic or factor and the 4 criteria for complexity to be viewed as a market-wide return factor

9.3 - Complexity and Structured Products

Answer 4

Complexity premiums
might be characteristics and not risk factors

Because > complexity meet 1 and 2:
1. The asset must have a return history of unfavorable (bad) periods.
2. The complexity factor should be implementable.
3. Any risk premium needs to be confirmed empirically.
4. Any risk premium should be persistent over time.

9.3 - Complexity and Structured Products

Question 5

Demonstrate

Knowledge of cases involving complexity
and perverse incentives
1. Treasury strips in the 1980s
2. Collateralized mortgage obligations in the 1990s
3. Residential mortgage-backed securities in the 2000s

and
Key Takeaways from the cases

9.3 - Complexity and Structured Products

Answer 5

1. Treasury strips in the 1980s
   => created by dividing each bond into its separate principal and coupon components (i.e., strips)
   => they added complexities to retail investor
   => Brokers charged high fees and encouraged rolling the strips at very large bid-ask spreads at lower rates, reducing returns to investors
2. CMO - Collateralized mortgage obligations in the 1990s
   => CMOs broke up mortgages into baskets organized around targeted maturity dates
   => ’90s - CMOs became more complex and opaque. Were financially engineered to provide attractive returns and pass interest rate risk stress testing, and had enormously risky features that helped them avoid normal methods of risk detection
   An increase in interest rates resulted in those CMOs with the greatest extension risk to suffer significant market value losses.
3. RMBS - Residential mortgage-backed securities in the 2000s
   => The complexity and opacity of those products did not allow investors to fully understand the nature of the risks in the underlying assets, which included risky subprime mortgages.
   => Even credit rating agencies assigned AAA-ratings to many of the tranches

Key takeaways
* Despite their risks, those fixed-income instruments provide investors with a wider array of choices for cash flow matching and enhanced loan access for some qualified homebuyers.
* Complexity may be a necessary byproduct of financial engineering.
* Complexity often leads to opacity and that can be intentional.
* Complexity and opacity have the potential to cause adverse outcomes for investors and financial markets.
* Principal-agent conflicts between managers and clients or sell-side institutions and investors can lead to the intentional use of complexity primarily to create opacity.

9.3 - Complexity and Structured Products

Question 6

List

7 Characteristics
of an Asset-Based Borrower
(in a ABL)

9.3 - Complexity and Structured Products

Answer 6

1. Most ABL borrowers are small- or medium-sized firms.
2. ABL loans tend to range from $10 million to $50 million, but some loans are larger.
3. Retail, distribution, wholesale, manufacturing, and services firms are common ABL borrowers.
4. Borrowers usually have an asset-rich balance sheet with at least 50% of assets in working capital (inventory and accounts receivable).
5. A proven management team capable of dealing with complex securities with an established history of strong debt management.
6. ABL borrowers usually have strong controls for financial accounting and IT systems.
7. ABL loans are typically not rated by credit rating agencies, and because loans are secured and therefore lower risk, borrowers are typically the equivalent of noninvestment grade borrowers.

9.3 - Complexity and Structured Products

Question 7

Define

collateral amount
borrowing base
advance rate

9.3 - Complexity and Structured Products

Answer 7

• collateral amount = sum of available assets to support a loan
• borrowing base = reduced amount lended (comparing with collateral)
• advance rate = credit / collateral

advance rate x collateral amount = borrowing base

Example:
a borrower with $200 million in collateral might be able to access credit up to $150 million using a 75% advance rate.

Alternatively, the scenario represents a 25% discount. The discount rate and the advance rate both relate to the same concept.

9.3 - Complexity and Structured Products

Question 8

Define

seasonal overadvance
and
traditional overadvance

9.3 - Complexity and Structured Products

Answer 8

seasonal overadvance
temporary increase in the advance rate to allow for seasonal financing needs, including borrowers’ needs to purchase more goods (e.g. retailers in December)
‘–
traditional overadvance
primarily used during corporate transactions (e.g., acquisition or leveraged buyout funding) and the incremental borrowing is then amortized or added to an existing loan

9.3 - Complexity and Structured Products

Question 9

List

4 primary categories
of assets used as collateral
+
discount rates
(in an ABL loan)

9.3 - Complexity and Structured Products

Answer 9

1. Accounts receivable (AR) collateral.
   The collateral is evaluated using client diversification, the length of term, standard collection periods, and dilution in determining the advance rate. The advance rate typically ranges from 70% to 85% but can go as high as 90% if the borrower purchases credit insurance.
2. Inventory collateral.
   Inventory collateral is evaluated by the type of inventory and the expected ease of liquidation. Inventory value is typically evaluated by a third-party appraiser and is set at 80% to 90% of liquidation value. Important considerations include the ease of converting inventory into merchandise, profit margin, and the type and mix of inventory. For commodity inventory, the advance rate could be as high as 80%.
3. Equipment and 4. real estate collateral.
   They are based on the estimated liquidity of each asset and the availability of interested buyers.

9.3 - Complexity and Structured Products

Question 10

Define

Revolving line of credit (revolver)
and
term loan
(components of ABLs - Asset backed loans)

9.3 - Complexity and Structured Products

Answer 10

• Revolving line of credit (revolver)
  => credit line that is available for a specific time period with a preapproved limit
  => is usually shorter-term in nature and is used to fund working capital needs
• Term loan
  => is a loan with an amortizing or a bullet structure with a specific maturity
  => Term loans usually have maturities of three to five years and comprise up to one-third of the ABL facility
  => typically longer term in nature because they are used to fund capital expenditures
  Assets such as real estate and equipment are used to support the term loan.

9.3 - Complexity and Structured Products

Question 11

Contast

Covenants of
Asset-based lending (ABL)
and
Cash flow-based lending

9.3 - Complexity and Structured Products

Answer 11

ABL - Asset-based lending
* typically does not include leverage covenants
and tends to focus on collateral and borrowers liquidity
* fixed charge coverage ratio = [ (EBIT + fixed charge) / (fixed charge + interest) ]

’–
Cash flow-based lending
* net leverage covenant = ND/EBITDA (=maximum amount of total (or senior) debt, net of cash, relative to EBITDA
* negative covenants (prohibit certain actions of borrowers - e.g. special dividend)

9.3 - Complexity and Structured Products

Question 12

Define

attachment of security
and
Perfecting the security interest

9.3 - Complexity and Structured Products

Answer 12

Attachment of security
* process to ensure that a lender has the right to take possession of collateral should a borrower default

Perfecting the security interest
* occurs when a lender, who is trying to assume ownership of collateral, ensures that no other creditor has a right to the same collateral

9.3 - Complexity and Structured Products

Question 13

List and explain

risks characteritics
involved in
asset-based loans (ABL)

9.3 - Complexity and Structured Products

Answer 13

1. Collateral Valuation Risk (=> operational risk)
   value of the collateral can change on a daily basis (monitoring is vital)
2. Risk relative to the process of gathering collateral monitoring data and having the right people to analyze the data.
3. Hedging Risks (=> Basis risk)
   => ABL is usually a long-only strategy on small-medium sized firms
   => hard to hedge (only large bond issuers usually available)
   => Introduces basis risk
4. Legal risks
   => attachment of security
   => perfecting the security interest)
5. Exit Timing Risks
   => Market conditions could change rapidly
   => Risk of collateral loss of value

Credit Risk and Interest Risk are not primary concern!!

9.3 - Complexity and Structured Products

Question 14

Contrast

Senior tranche (A)
vs
Junior tranches (B and C)

9.3 - Complexity and Structured Products

Answer 14

Senior tranche (A)
* Credit rating: Highest
* Expected return: Lowest
* Credit event (Default): Absorbs last
* Payments / prepayments: Receives first
* Interest: Receives together

Junior tranches (B and C)
* Credit ratings: Lower (or may not be rated)
* Expected return: Higher due to the assumption of higher risk.
* Credit event (Default): Absorbs first
* Payments / prepayments: Receives last
* Interest: Receives together

9.3 - Complexity and Structured Products

Question 15

Define and give examples

Recourse loans
and
Nonrecourse loans

9.3 - Complexity and Structured Products

Answer 15

Recourse loans
* borrower is personally liable for the loan and for repaying any outstanding balance
* lenders can garnish wages or levy accounts
* Example: auto and credit card loans
Prepayments increase when interest rates fall, but not a significant concern because they have short maturities

Nonrecourse loans
* no claim to other assets or income of the borrower

9.3 - Complexity and Structured Products

Question 16

List

7 Credit Enhancements
for
Credit Card Receivables

9.3 - Complexity and Structured Products

Answer 16

The four most common internal enhancements are the following:

1. Senior/subordinated structure
   CCRs segment credit risk through subordination, where subordinated tranches absorb losses first and reduce the credit risk of more senior tranches.
2. Spread accounts
   If performance falls below a threshold, excess spread earned on the collateral will be retained in an account for the benefit of CCR investors.
3. Excess finance charges (spread)
   Any excess between the gross yield on the securitized receivables and the cost of financing them will reduce credit risk.
4. Overcollateralization
   Credit risk can be further reduced by the CCR holding a quantity of receivables that is greater than the sum of the nonequity tranches.

The three most common external enhancements are the following:

1. Cash collateral accounts
   It is a special (securitization) trust account that can be used to fund CCR principal and interest expenses and trust expenses when the excess spread becomes negative.
2. Letters of credit
   A third-party can provide a letter offering a financial backstop in the event of a default.
3. Collateral invested amounts (CIAs).
   They are privately-placed ownership interests in the securitization trust. Payment rights are subordinated to CCR owners.

9.3 - Complexity and Structured Products

Question 17

Describe a springing covenant

Answer 17

A springing covenant is often used to protect a lender against potential cash flow issues should the borrower’s unused portion of the ABL facility fall below a certain percentage (usually below 10% to 20%).
When the springing covenant is activated, it typically triggers a fixed-charge coverage covenant, which measures whether the firm is generating enough cash to pay for its fixed costs.

LO 9.3.4