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I posted this question this morning and it seems like it was deleted & I didn’t receive any reason or notification. I’ll try again.
My questions are regarding the following ACCA support article:
https://www.accaglobal.com/ca/en/student/exam-support-resources/professional-exams-study-resources/p4/technical-articles/toxic-assets.html1) What amount does the bank receive? Does it get the full $350m or only 85%?
2) What would the bank’s cost of capital be for the funds received?
3) I know this last question isn’t in the syllabus but I am asking for my own interest to complete my learning – what is the accounting treatment for the bank?Thanks!
1. Assuming the non of the loans default then they will received the full $350M – it is only the income that is being distributed.
2, I have no idea what the cost of capital is for the bank because we are not told how the bank is financed. It is of no relevance anyway – the securitisation is simply determining how the income is distributed.
3. I have no idea what the accounting treatment is (because, as you state, it is not relevant for Paper AFM). If it interests you then you are going to have ask in the Paper SBR forum 🙂 )
Thanks for the reply.
I am still very confused about question 1:
1) If they are selling just the income, why would the investors pay $350m? For example the tranche A cash flow to investors each year is $13.4m and this accounts for 75% of the collateral value. The mortgages have a 10-year maturity, so there is no way they make 75% of $350m if that was the amount they were to invest?
2) What happens with non-interest-only mortgages?
Sorry, I misunderstood your question 1. I thought you were meaning how much would the bank be receiving from the mortgages ultimately.
As far as the securitisation is concerned they will be receiving 85% of the amount.
2. If there was no interest then there would be no income to securitise.
Just to clarify,
the general order of events is:
(1) Bank lends money in the form of mortgages to customers. The total principal lent out totaling $350m.
(2) At some point in the future the bank either
i) is unhappy with the risk/return of the mortgages & feels the need to diversify this risk completely, or
ii) need to quickly liquidate funds for higher NPV investments
(3) At this point in time the average term left on the mortgages is 10 years and the average yearly yield is 6%.
(4) The bank proceeds with the securitization of the mortgages as detailed in the article. In this process, they receive $297.5m (0.85 x $350m) from selling CDOs to investors.Hopefully, I have understood the above events correctly?
The big question for me is – WHY? the bank gives away $350m and gets back only 85% and no longer has a claim to any of the yield? What was the point in making loans in the first place then? This would obviously be a huge loss for the bank?
Am I correct in (2) as being possible explanations for this?
Following on from (4)
(5) the SPV now owns the $350m of mortgages (100%), and the bank has none left. the buyers of the CDOs own the SPV and have claim to the rewards through the tranche system. If a mortgage holder defaults, that would lower the return on investment for the investors – starting from tranche 3, and the bank would have no impact.
(6) At the end of the 10 year period, the investors get their initial capital back along with that year’s yield. The safety of this return depends on whether or not customers default on their mortgages or not.What happens to the 15% – the investors only paid 85% right? At least in the article where it does the return on high-risk investment calculation it uses $350m x 85% x 10% = $29.75m as the amount invested.
The whole point of securitisation is to convert a future income stream into a ‘lump-sum’ receipt now.
A practical example was a singer called David Bowie. He was earning royalties every year from all his past music, but what he did was issue bonds and the bond holders paid him for the bonds. In return, instead of getting interest on the bonds they shared in the future royalties.
He converted an uncertain future income stream (uncertain because the royalties depended on record sales) into a certain lump sum immediate receipt.
This is effectively the same as is described in the article (although the article is unnecessarily complicated – it was written at the time of the banking crisis when it was much more topical).
The reason that the article uses a bank as the example is that this is what happened in the banking crisis – the banks securitised the future income stream because they knew that they had lent out mortgages to people too easily and without proper checks and that a substantial number of them would not be able to keep up with their payments. It was very risky lending, but by securitising them, the risk was being passed to others.Much better than the article is to work through one or both of the only two questions (and answers) that have ever been asked on this in the exam. One is Moonstar Co (from the December 2015 exam) and the other is GoSlo Motor Corporation (from the June 2010 exam).
I do not know which Revision Kit you are using, but Moonstar is in the BPP Revision Kit (but not GoSlo, which was very similar). I do not have the Kaplan Kit and so I don’t know if they have either of them.
Not only do the examiners answers to these questions give a much better understanding than does the article, but also they are indicative of the level of understanding that would be required were it to ever be asked again.
Hi John, thanks for the reply.
So, am I correct in my understanding of events 1 – 4? In the case of a bank, the incentive is to rectify risky lending made in the past, at a loss? For Moonstar, the incentive is to raise funds at a “lower cost of capital”.
I went through Moonstar a few days before reading the article. In Moonstar, it clearly states that the process is transferring the rights to the rental income. Also, when you look at the total gains for the investors, it exceeds the amount invested as expected. eg. Tranche B receives $3.24m per year for 10 years on an investment of $27m (0.9 x $200m x 15%). Therefore making a non-discounted profit of $5.4m ($32.4m-27m).
However, in the article, this is not the case. If we are saying that it is only the risks and rewards of the interest income that has been transferred then: Tranche A receives $13.4m per year for 10 years ($134m total) on an investment of $223.13m (0.85 x $350m x 75%).
There is clearly a missing element here? Perhaps these are two different types of arrangements?
And again with Moonstar, the investors are only paying for 90% of the collateral of the investment right? So the total funds that they would raise would be $180m less costs associated with setting up the arrangement / attracting investors? However, the investment requires $200m and there is no mention of the remaining $20m anywhere.
The first sentence to the answer to part b) of the question says: “the finance costs of the securitization may be lower than the finance costs of ordinary loan capital”. In the question it says: “Moonstar Co has had some difficulties over the last few years … the company has at times struggled to pay its finance costs. As a result Moonstar Co’s credit rating has been lowered, affecting the terms it can obtain for bank finance.” In the question, the finance costs of $200k are not coming out of Moonstar’s pocket but are being deducted from the cash received in the SPV & thus reducing the return to investors. So what are Moonstar’s finance costs?
You are quite right about the ‘missing’ $20m. Presumably that will be financed out of the company’s existing cash reserves or by conventional borrowing. However it is odd to distribute all of the income to the investors providing only part of the finance needed. Fortunately that does not cause a problem with regard to the arithmetic required (because the instructions are clear) although it is strange that the examiner does not mention this in the written parts of his answer.
With regard to the finance costs, it is true that the $200k is effectively being paid out the money going to the subordinated certificates but this is provided that the income is at least $200k of the total invoice is remaining after paying out the fixed rate loans.
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