Gerling Global Financial Products Pricing Structured Finance, Project Finance and Credit Enhancement Paul R. Hussian, FCAS Seminar on Reinsurance June 15, 2000
Dec 21, 2015
Gerling Global Financial Products
Pricing Structured Finance, Project Financeand Credit Enhancement
Paul R. Hussian, FCAS
Seminar on Reinsurance
June 15, 2000
Gerling Global Financial Products
Transaction Examples
• Trade Receivables
• Debt pools: Bonds (CBO), Bank Loans (CLO)
• Entertainment: Film Receivables
• Real estate finance: Commercial and residential mortgages (MBS)
• ...
Gerling Global Financial Products
Corporate Debt Ratings
Moody's S&P
Aaa AAAAa1 AA+Aa2 AAAa3 AA-A1 A+A2 AA3 A-
Baa1 BBB+Baa2 BBBBaa3 BBB-Ba1 BB+Ba2 BBBa3 BB-B1 B+B2 BB3 B-
Caa CCC
* Ratings reflect both frequency and severity of default
Gerling Global Financial Products
Structure
Assets(Collateral)
Receivables
Bonds,Corp Loans,Mortgages
Films
Real Estate
CashFlow
Aaa
Tranches
Senior 1
Senior 2
Mezzanine
Equity
Ba3
NR
Aa2
(Insurer)
Pari Passu
Equity
Unwrapped Notes
Insurer
Aa2 Aa2
NR
Structure 1 Structure 2
Gerling Global Financial Products
Two Pricing Perspectives
• Actuarial/Insurance
– premium
• Capital Markets
– yield spread: over Treasuries/LIBOR
Gerling Global Financial Products
Actuarial/Insurance Pricing
• Identify assets/cash flows
• Identify risk(s)
• Gather data
• Build cash flow model
• Run cash flows through deal structure
• Determine Premium, Profit, ROE
Gerling Global Financial Products
Assets / Cash Flows
• Receivables Collection cycle
• CBO/CLO Pools of debt (bonds, bank loans)
• Entertainment Film receipts
• Real estate Commercial/residential property
Gerling Global Financial Products
Risks (Quantitative)
• Receivables Credit defaults, price/volume
• CBO/CLO Bond/loan defaults, interest rates
• Entertainment Film performance
• Real estate Property value, rent income
• All transactions Correlation to economy
Gerling Global Financial Products
Data Sources
• Commodities Commodities futures exchange, Bloomberg,
company
• CBO/CLO Moody’s, S&P, sponsoring bank/company
• Entertainment MPAA, company
• Real estate Company, FHA, FDIC, private industry study
• All transactions Offering Memorandum
Gerling Global Financial Products
Cash Flow Modeling – Common Challenges
• Company’s business model / economics of industry
• Stochastic modeling / simulation– mean, standard deviation, distribution of key variable(s)
• Scenario testing– stress tests; where is deal’s “break point”?
– effect of recession
• Correlations– between variables
– between assets/cash flows
– to economy (cyclical, counter-cyclical, recession-proof)
Gerling Global Financial Products
Receivables - Cash Flows
• Credit defaults on receivables
– historical ratio: defaults receivables
– strength of obligors
• Price/volume of commodity being produced
– range of price fluctuation
– effect of recession on price, volume
– obligor concentration risk
Gerling Global Financial Products
Sample Receivables Loss Data
1.0
2.0
3.0
4.0
5.0
Pool Origination Date
% T
ota
l Lif
eti
me
Lo
ss
es
Historically 3%, stable
Historically 3%,
volatile
Increasing Loss
Trend
Gerling Global Financial Products
Receivables – Sample Average Monthly Price Data (Heavy Crude Oil)
$5
$10
$15
$20
$25
Jan-
91
Jul-9
1
Jan-
92
Jul-9
2
Jan-
93
Jul-9
3
Jan-
94
Jul-9
4
Jan-
95
Jul-9
5
Jan-
96
Jul-9
6
Jan-
97
Jul-9
7
Jan-
98
Jul-9
8
Jan-
99
Jul-9
9
US
$/ba
rrel
Gerling Global Financial Products
CBO/CLO – Cash Flows(Default Rates)
• Default Rate (frequency) = % of bonds/loans defaulting
– Annual, multi-year
• Moody’s/S&P credit ratings of bonds/loans in portfolio (Aaa, Aa1, …)
• Correlation between bonds/loans
– Diversity Score: translate portfolio into homogeneous, independent debt
securities
• Binomial distribution
Gerling Global Financial Products
CBO/CLO – Cash Flows (Severity)
• Severity = 1 - Recovery Rate
• Recovery Rate = post-default market value par value
• Moody’s/S&P credit ratings of portfolio notes (Aaa, Aa1, …)
• Normal, Lognormal distribution
• Correlation between frequency, severity
• Loss rate = Default rate x Severity
Gerling Global Financial Products
One-Year Default Rates by Year and Rating
Aaa
Aa
A
Baa
Ba
B
0.00
5.00
10.00
15.00
20.00
25.00
Defa
ult
Rate
%
Year
Gerling Global Financial Products
Average Cumulative Default Rates by Rating
1 4 7
10
13
16
19
Aaa
Aa
A
BaaBa
B
0.00
10.00
20.00
30.00
40.00
50.00
60.00
Defa
ult
Rate
%
Age in Years
Gerling Global Financial Products
CBO/CLO –Historical Recovery Rates 1977-98
Seniority and Security AverageStandard Deviation
Senior Secured Bank Loans 70.26% 21.33%Equipment Trust 65.93% 28.55%Senior Secured Public Debt 55.15% 24.31%Senior Unsecured Public Debt 51.31% 26.30%Senior Subordinated Public Debt 39.05% 24.39%Subordinated Public Debt 31.66% 20.58%Junior Subordinated Public Debt 20.39% 15.36%All Subordinated Public Debt 34.12% 22.35%All Public Debt 45.02% 26.77%
Gerling Global Financial Products
CBO/CLO – Moody’s Diversity Score
• Avg default rate = p, Diversity score = n, Recovery rate = r– p = weighted avg of individual bond default rates
• n selected to equate loss variance
• Decreasing n increasing volatility & correlation– binomial C.V. =
– n depends on industry concentration
• S&P method: increase p with industry concentration, assume independence
np
p1
Gerling Global Financial Products
CBO/CLO - Example
# bonds = 5par value = 60,000,000
p = 5.0%n = 3 r = 50%
# of BinomialDefaults Prob Loss
0 85.7375% - 1 13.5375% 10,000,000 2 0.7125% 20,000,000 3 0.0125% 30,000,000
Expec Loss = 1,500,000 Loss Rate = 2.5%
Gerling Global Financial Products
Entertainment – Cash Flows (Film Co.)
• Coverage ratio = film revenue production cost– mean
– standard deviation
• Box office, licensing, pay-per-view, international
• Film revenue stream
• Correlation between films
Gerling Global Financial Products
Real Estate – Cash Flows
• Occupancy rates
• Average rents
• Capital structure (debt, equity)
• Property value
– cash flow discount rate
• Mortgages unrated, use industry data (FHA, FDIC)
• Strong correlation to economy
Gerling Global Financial Products
Modeling Deal Structure
• Tranched (layered) vs Syndicated (pari passu) securities
• Cash flow waterfall
• Equity, subordination structure
• Early amortization triggers
• Indemnification provisions
• Floating rates
• Impact on insurer’s profit & risk
Gerling Global Financial Products
Capital Markets Pricing
• Premium vs. yield spread between unwrapped notes and insurer credit rating
• Insurance vs. levered investment in unwrapped securities
(insurer = investor)
Gerling Global Financial Products
Current Spreads Over Treasuries (Financials)
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
Aaa
Aa1
Aa2
Aa3 A1 A2 A3
Baa1
Baa2
Baa3 Ba
1
Ba2
Ba3 B1 B2 B3 C
aa
3-yr
5-yr
10-yr
Investment Grade
Sub-Inv Grade
Gerling Global Financial Products
Example
5-yr bond: par value = $100M
insurer rating = Aa1 145 b.p. over T
unwrapped notes = Ba3 415 b.p.
over T
insurer premium = (415 – 145) b.p. x $100M =
$2.7M/yr
present value = $10.1M
Gerling Global Financial Products
Example
Levered Investment: Insurance:(1) (2) (3) (4)=(2)-(3) (1) (2) (3) (4)=(2)+(3)
(Ba3) (Aa1) (Aa1) (Ba3)Bond Insurer BondO/S Paid to Debt Insurer O/S Paid to Insurer Total
Year Principal Bond Service Profit Year Principal Bond Premium Paid0 100 0 1001 100 4.15 1.45 2.70 1 100 1.45 2.70 4.152 100 4.15 1.45 2.70 2 100 1.45 2.70 4.153 100 4.15 1.45 2.70 3 100 1.45 2.70 4.154 100 4.15 1.45 2.70 4 100 1.45 2.70 4.155 0 4.15 1.45 2.70 5 0 1.45 2.70 4.15
PV Profit--> $10.07 PV Profit--> $10.07
Aa1 spread = 1.45%Ba3 spread = 4.15%T = 6.50%
In $ millions
Gerling Global Financial Products
Model Metrics
• Debt service coverage ratios = cash flow / debt service
• Balance sheet: equity, debt– % collateralization (value of collateral / full limits loss)– CBO collateral/CBO principal– loan/value (real estate, mortgages)
• Default probability & Loss rate (principal, interest, premium) – compare to Moody’s ratings
• Transaction break point
• Insurer present value profit/(loss)
• Relative risk/reward of tranches (IRR)
Gerling Global Financial Products
CBO Example
p = 24.5% T = 6.5%r = 50.0% Expenses = 1.00%s.d. (r) = 25.6% Insurer Prem = 2.25%Maturity = 5 yrs Insurer Rating = Aa2
CashFlow
Aaa
Senior
CBO
3.50% + T
0.60% + T
$385 mm
$65 mm
$50 mmEquity
NR
Mezzanine(Insurer)
Ba2
Assets(Collateral)
50 Hi-Yield Bonds"Junk"
Avg Rating =
B1
Yield =4.10% + T
Par =$500 mm
Diversity = 30
Gerling Global Financial Products
Model Output
AllSenior Mezz Equity Tranches
Loss Rate 0.002% 4.238% 46.486% 10.179%
Insurer Expec Profit NA $2,789 $2,770 ($15,161)
Insurer ROE NA 18.0% 35.5% -17.4%
Insurer Loss Prob NA 16.5% 41.0% 77.4%
Rating Aaa Ba2 NR B1
Offered Spreads 0.60% 3.50% - 4.10%
Market Spreads 0.30%-0.60% 4.50%-5.00% - 4.00%-6.00%
All figures on present value basis.Results from 5000 iterations.In $000s.