Conventional versus Synthetic Securitisation - Securitization.Net

Conventional versus Synthetic Securitisation
– Trends in the German ABS Market
Contributing Authors:
Dr. Martin Böhringer
Ulrich Lotz
Christian Solbach
Jochen Wentzler
Edited by:
Deloitte & Touche Germany
Düsseldorf
May 2001

Contents
Introduction
Asset-Backed Securitisation
1
– Development of the ABS Market
Conventional Collateralised Loan Obligation (CLO)
3
– Structure and Process
Synthetic Conventional Collateralised Loan Obligation (CLO)
10
– Utilising Credit Derivatives 22
Case Study 33
German Tax Treatment of Synthetic Securitisation 53
Regulatory Environment 63
Outlook and Conclusion 73
Appendix 78
List of figures 81
List of tables 82
Index 83
Bibliography 86
Contacts 90
About Deloitte & Touche 91
I

INTRODUCTION
The securitisation of numerous types of assets has been a very successful
way of generating funds on the capital market. Funding of
future business activities and optimising balance sheet ratios have
been the main motivations for securitisation transactions in the past.
For corporates it is furthermore important to have a tool to manage
the financial statements, an indirect access to the capital market
and an alternative to existing creditors.
During the last few years the growing importance of transferring
credit risks and managing regulatory capital has fostered the development
of credit derivatives.
Conventional asset securitisation can combine the above-mentioned
objectives: funding of future business,transferring of credit risks,
achieving a capital market access and influencing the balance sheet.
However, the credit protection costs using conventional securitisation
exceed the costs of comparable unfunded credit derivatives.
Synthetic securitisation transactions combine the advantages of
credit derivatives and conventional asset securitisations in order
to circumvent the disadvantages of conventional securitisations.
In Germany the first synthetic securitisation was closed in 1999.
The transaction was called CAST 1999-1.The issuer was Deutsche
Bank AG, Frankfurt. The securitised portfolio consists of corporate
loans. Deloitte & Touche participated as one of the advisors of
Deutsche Bank London, the arranger, and is still acting as collateral
and noteholder trustee.
Over the last year synthetic securitisation has grown faster than
conventional securitisation, especially in Germany. This was due
to some changes in tax treatments of local tax authorities, which
have confused the market in respect to conventional transactions.
1

These changes in the securitisation market were the reason for
Christian Solbach to make some evaluations about the differences
between synthetic and conventional collateral loan obligations
(CLOs).CLOs have been one of the fastest growing products
in the securitisation market over the last 2 years.
Christian’s analysis was part of his master degree at the University
of Southampton. During this time Christian was a probationer
at Deloitte & Touche in Düsseldorf, the national competence
centre of Securitisation Services. Now he is a member of our professional
Securitisation Service Group.
In addition to the above-mentioned analysis of conventional and
synthetic transaction this publication will try to identify the rationale
of the rapid growth of synthetic securitisation.Professionals of our
German Securitisation Group have also outlined some significant
tax and regulatory issues in Germany.
While Deloitte & Touche’s first publication ‘Asset Securitisation in
Deutschland’gives a general overview of the market,structure and
process of securitisation transactions as well as an introduction to
German and international regulations, this publication should be
used as a guideline for synthetic securitisation transactions and
should highlight the differences of synthetic and conventional securitisation,
using two case studies. It is based on numerous experiences
in due diligence, legal and economical structuring, tax
and accounting opinion,cash flow modelling and trustee services.
Grateful thanks to the team of authors, Dipl.-Ök. Ulrich Lotz
(WP/StB/CPA), Dr. Martin Böhringer (StB, LL.M) and MSc Christian
Solbach, and to the securitisation professionals who completed
the survey and particularly those who gave up their valuable
time for interviews.
Düsseldorf, May 2001. Jochen Wentzler
Head of German Securitisation Services
2

ASSET-BACKED SECURITISATION
– DEVELOPMENT OF THE ABS MARKET
Christian Solbach
1. History of ABS
Mortgage-backed securities were being issued by the Prussians about
200 years ago,giving an historical reference.The modern form
of ABS, like so many financial innovations in this century, originated
in the US during the 1950s. In the 1970s the US government
supported mortgage-backed securities (MBS) issued by “Ginnie
Mae” (Government National Mortgage Association),“Fannie Mae”
(Federal National Mortgage Association) and “Freddie Mac”(Federal
Home Loan Mortgage Corporation). Even today they play an important
role on the financial market: On August 1,2000 Fannie Mae
issued a record-sized transaction of USD11.5bn 1 .
‘Although little has been written about what is perhaps one of the
most important innovations to emerge in financial markets since
the 1930’s, (asset) securitisation has revolutionised the way that
the borrowing needs of consumers and businesses are met. Today,
(in the US) for example, over two-thirds of all home loans are
being securitised, along with substantial percentages of auto loans
and credit card receivables, and the process continues to expand
into new fields’ 2 .
Norton et al (1995) describe asset-backed securitisation (ABS) as
the process of converting receivables and other assets that are not
readily marketable into securities that can be placed and traded
in the capital markets.
1 Financial Times, 03.08.2000
2 Kendall, L./Fishman, M., A Primer on Securitisation, 1996
3

It was not until the mid 1980s that financial institutions started
to securitise assets other than mortgages. The first non-mortgage
public securitisation occurred in March 1985 with a
USD192m offering of lease-backed notes for Sperry Lease Finance.
In the 1990s asset-backed securitisation established itself in
Europe as an active balance sheet and risk management instrument.
Nowadays there seem to be very few assets which can not
be securitised such as the royalties of David Bowie and Rod Stewart,
the funds collected from individuals travelling to the Isle of
Wight or films revenues such as a USD325m deal in December
1997 which securitised the film rights and future revenues from
a series of action films produced by DreamWorks.
2. Development of the European ABS market
The European ABS market has grown substantially. The key figures
for the European ABS market in 2000 were 3 :
� Total new ABS issuance €85.4bn (+37%)
� Total new ABS issuance including Credit Default Swaps €127bn
(+39%)
� Number of deals 160
� Unfunded portion of Collateralised Loan Obligations (CLOs) was
90%
� AAA rated classes made up 78%
� Since 1989,the annual default rate for ABS globally,rated by Fitch,
is 0,01%
3 Dresdner Kleinwort Wasserstein (DKWR), Securitisation market overview 2000, 2001
4

Due to an increasing influence of credit derivatives the unfunded
portion of securitisation transactions has grown much faster than
predicted.
Figure 1: New European ABS Note issuance and total
securitisation
140
120
100
80
60
40
20
0
Jan
Feb
Source: DKWR
March
April
May
Jun
As depicted above the portion of the underlying portfolio, which
is not refinanced by a note issuance, but covered by a credit default
swap, has grown constantly. This is due to the fact that the
originators are mostly interested in reducing the risk protection
costs and not in refinancing the portfolio.
Commercial and mortgage banks followed by corporates and
mortgage lenders were the main European ABS issuers in the year
2000 (see figure 2). According to DKWR most of the securitised
assets were originated from the UK (43%) followed by Italy (10%),
Spain (9%), the Netherlands (8%) and Germany (7%).
Jul
Note issuance in 2000
Size of the underlying portfolio in 2000
Aug
Sep
Oct
Nov
Dec
5

Figure 2: New issuance in 2000 (by originator type)
Source: DKWR
In the year 2000 numerous asset classes were securitised. However
the securitisation market was dominated by securitisation of
portfolios which are comprised of mortgages and of collateralised
debts (see figure 4). Mortgages can be divided into commercial
mortgages (CMBS) and residential mortgages (RMBS).Collateralised
debts (CDO) can be divided into collateralised
loans (CLO) and collateralised bonds (CBO). According to the
underlying asset class the securitisation transactions are categorised
as illustrated in the following figure:
6
Mortgage Bank
22%
Insurance
Company
2%
Government
6% Fund
Manager
1%
Mortgage Lender
11%
Finance
Company
1%
Consumer
Finance
6%
Corporate
14%
Commercial Bank
37%

Figure 3: Types of asset securitisation
Source: Deloitte & Touche
Collateralised Loan Obligations (CLO) are one of the fastest growing
products in the ABS market. However, though the number of
deals has increased the volume has decreased. The main reason is
the growing use of synthetic structures (partly unfunded transactions).
Figure 4: Asset type distribution in 2000 (all currencies)
Source: DKWR
ABS in a
narrower
sense
ABS in a
broader
sense
MBS CDO
ABCP
Others, e.g.
Automobile Loan-BS,
Credit Card-BS
Trade Receivables BS,
Lease-BS
RMBS CMBS CLO CBO
€m Number
40.000
60
35.000
30.000
Asset class distribution
No. of deals 00
50
50
25.000
40
20.000
30
15.000
10.000
20
20
5.000
0 1
4
7
1
10 10
5 4
1
4 5
2
4 4 4
7
12
10
1
0
Aircraft Lease receivables
Arbitrage CBO/CDOs
Auto Lease Receivables
Catastrophe
CLO
Commercial Mortgages
Consumer Loans
Credit Card Receivables
Equipment/Real Estate Leases
Fixed Asset Leases
Loans for Social housing institutions
Non-performing mortgage loans
Nursing home lease receivables
PFI (Private Finance Initiative)
Pub Revenues
Residential Mortgages
State related
Static CBO/CDOs
Subprime Mortgages
Trade receivables
7

The European asset-backed market has always been smaller than
its American counterpart. However, over the past two years, the
European market has expanded and closed the gap. In 1999 the
American market was about four times the size of the European.
As a result of the immense growth in Europe over the last two years
the American market is now only three times the size of the
European (see figure 5). The gap narrows even more if the unfunded
portions are taken into account.
Figure 5: US vs. European ABS issuance
Source: DKWR, ABA
3. Development of the German ABS Market
The German ABS market was based on transactions of major banks
and multiseller conduits for short-term receivables especially
trade receivables. Banks are one of the major players in this market
for both investing and issuing, especially mortgages and corporate
loans, and sponsoring of multiseller conduits which issue
Asset-Backed Commercial Paper Programs (ABCP).
8
US$ bn
300
250
200
150
100
50
0
US
Europe
US
1999 2000
Europe

In the year 2000 there were 11 multiseller conduits in Germany
which had an outstanding volume of USD25 billion which is an
increase of approximately 14% to 1999. The German market (excluding
ABCP) also consisted of 15 ABS transactions whereas 14
were synthetic.The volume (defined as the amount of risk transferred)
according to Moody’s amounts to USD 23.6 billion, which
is an increase of over 70% to 1999 as, illustrated in the following
figure.
Figure 6: German term structured finance market since 1995
2000
1999
1998
1997
1996
1995
0 5000 10000 15000
€ m
20000 25000 30000
Source: Moody’s
Funded Synthetic
The growth of the German market has been based on a high-unfunded
portion of about USD 16,3 billion. As a result some statistics
show a small German market share.
9

CONVENTIONAL COLLATERALISED
LOAN OBLIGATION (CLO)
– STRUCTURE AND PROCESS
Christian Solbach
1. Introduction
‘CLOs are securities backed or collateralised by a diversified pool
of corporate loans’ 4 .In a conventional CLO process there is an originator
(bank) which pools together a number of illiquid assets,
such as corporate loans, that have relatively stable and predictable
cash flows.These are sold to a special purpose vehicle (SPV),
a bankruptcy remote entity. The SPV is bankruptcy remote in relation
to the originator and to the investor.
The originator receives cash in exchange for the transfer of the
assets.To fund this acquisition the SPV issues asset-backed notes.
These are normally divided into different classes and the classes
are further subdivided into different tranches. There are normally
three classes: senior, mezzanine and junior. The risk is allocated
from the junior to the senior class. The notes are rated by
rating agencies.In order to achieve high credit ratings the SPV initiates
various types of credit enhancement techniques.
Other parties involved in the securitisation process are the trustee
whose main duties could include: monitoring the servicer, holding
the collateral on behalf of the noteholders and supervision of principal
and interest payments to the noteholders.
4 Standard & Poor’s Structured Finance, Global CBO/CLO Criteria, 1999, p. 3
10

The servicer runs the reference pool on behalf of the SPV. In most
cases the bank continues to service the reference pool (i.e. is responsible
for the collection of principal, interest and other relevant
payments from the obligor).
In a conventional CLO transaction the originator tries to establish
a true sale for regulatory, tax, legal and accounting purposes. In
order to achieve this the reference pool has to be rightfully transferred
to the SPV, meaning a change of ownership.As a result, the
notes are de-linked from the risk of the originator’s bankruptcy.
Therefore, the notes’ credit rating can exceed the originator’s.
The investor can buy notes from the various tranches with both
different risk and return allocation. For instance, the junior class,
discarding any credit enhancement techniques, has both the
highest return and risk because the losses are allocated from the
junior to the senior tranche. A conventional CLO structure is illustrated
in figure 7:
Figure 7: Conventional CLO Structure
Servicer
Originator
Bank
Obligator
Corporate
Loans
Administration
Asset Portfolio
Cash Payment
Interest and
Principal Payment
Source: Deloitte & Touche
Credit
Enhancement
Trustee
Monitoring
Special
Purpose
Vehicle (SPV)
Credit
Enhancer
Cash
Proceeds
Senior
Notes
Mezzanine
Notes
Junior
Notes
Rating
Rating
Agencies
Capital
Markets
Investors
11

2. Investor’s Risks
There are various risk categories related to ABS/CLO transactions:
Credit risk
The most obvious risk attached to an ABS/CLO transaction is the
credit risk: the probability that a number of obligators default. In
case of corporates the portion of additional collateral is often
quite low. The credit risk depends on the viability of the companies
business.
Currency risk/Exchange rate risk
Currency risk arises if the obligor is permitted to borrow in currencies
other than the base currency.
Liquidity risk
Liquidity risk is the fear that the SPV will run out of cash in order
to pay the security holders. This could occur if the obligors cannot
fulfil their obligations on time.
Pre-payment risk
The lending agreement may include a pre-payment option for the
obligor.Therefore the principal payments on the notes might be
made ahead of the expected maturity date.
Reinvestment risk
This risk occurs only if there is a pass-through structure.There could
be a mismatch between the incoming and the outgoing cash
flows.For instance, the SPV receives monthly repayments from the
obligor and has to pay the securities holder every three months.
The monthly payments will be reinvested by the SPV until the payment
date occurs. During this time there is reinvestment risk.
Depending on the investment strategy interest rate and exchange
rate risk can also occur.
12

3. Credit Enhancement
In order to achieve a high credit rating on the asset-backed
notes issued into the capital market internal and external credit
enhancements play an essential role. They try to mitigate the
above-mentioned risks.
Internal Credit Enhancement
Yield spread (Excess servicing)/Spread account
The interest rate on the receivables frequently exceeds the payments
made to the investor. The difference between the two
rates, which would normally be returned to the originator, is paid
into an account that can be used if there are any defaults or
liquidity problems.
Senior/Subordinated structure (tranches)
The SPV may issue different asset-backed note tranches.The first,
the most senior tranch, is superior in payment of principal and interest
to all the other classes and therefore, has the highest credit
rating and consequently the lowest risk premium.The risk premium
increases the more junior the tranches become as the
losses are allocated from the junior to the senior tranche.
Overcollateralisation
The total value of the underlying assets exceeds the total value
of the securities issued.Meaning the incoming cash flows are greater
than the outgoing. As a result a buffer is created which acts
against losses.
External credit enhancements
Guaranteed investment contract (GIC)
Traditionally a bank or an insurance company guarantees a fixed
return on the underlying asset.
13

Cash collateral account
An account is created through a loan normally given by the originator,
which is used as a buffer in the case of financial difficulties.
Currency exchange agreement
The originator or third parties agree to a cross currency swap at
a pre-determined rate.
Recourse/Direct credit substitution (DCS)
The responsibility of the originator could either be the reimbursement
of the SPV up to a specified amount of losses or the
exchange of underperforming or non-eligible assets of the underlying
asset portfolio with new ones to maintain the asset pool
quality.However,the exchange of underperforming assets can endanger
a true sale.
Letter of credit
Typically a highly rated bank promises to pay a specified sum if
a certain event occurs.
Swap arrangements
They can be used to reduce currency risks as mentioned above
or to transform fixed into floating interest rates.
4. Pass-through/Pay-through structures
The two most common structures are pass-through and paythrough
structures.The main difference between these two structures
is the point of time when the cash inflow of the asset pool
is paid to the investor. In a pass-through structure the cash flows
generated by the asset pool are directly distributed to the investors.
For instance, if there are monthly payment dates the inves-
14

tors also get paid on a monthly basis. Whereas in a pay-through
structure there is a mismatch between the generated cash flows
and the payment date. For instance, the asset pool generates a
monthly cash flow but the payment dates only occur every three
months, therefore there is reinvestment risk.
5. Originators’ advantages
There are several advantages for a bank to engage in a conventional
CLO.The most important advantages are discussed below:
Management of regulatory capital
Banks are required to hold risk-based capital of 8% (see chapter
regulatory environment).The impact securitisation (true sale) can
have on regulatory capital is best illustrated by an example:
‘A bank with a USD1 billion portfolio of corporate loans is required
to maintain risk-based capital of 8%, or USD80 million,
against that portfolio.If the bank is able to complete a CLO transaction
in which it is able to sell all of the debt and equity securities
of the CLO for cash on a break-even basis, the bank will
free up USD80 million of regulatory capital that can be used
for other corporate purposes or to support the origination or
purchase of another USD1 billion portfolio of commercial
loans, or the origination or purchase of USD2 billion of 50% riskweighted
assets (such as residential mortgage loans), or USD5
billion of 20% risk-weighted assets (such as FNMA or FHLMC
securities)’ 5 .
5 Kenneth E. Kohler, Collateralized Loan Obligations: A Powerful New Portfolio Management
Tool for Banks, 1998, p. 8
15

Management of the capital ratio
Securitisation can be a tool to increase the capital ratio. By using
the cash proceeds, generated by securitising assets, to shrink the
balance sheet, the capital ratio can be improved. The process is
illustrated in figure 8.
Figure 8: Management of the Capital Ratio
Source: Deloitte & Touche
Attractive/reliable funding source
For companies with a low credit rating or with barely any contact
to the capital market, securitisation can be a way of achieving funding
in the capital markets at rates and maturities that otherwise
would not be obtainable.The main reason for this is that investors
purchase notes where the credit quality is based primarily
on the underlying asset, the securitised asset pool. Another
possible reason for attractive rates could be the tapping of a new
16
Before securitising assets
Assets Liability
Fixed
and
Current
Assets
Equity
Liabilities
After securitising assets
Using the cash proceeds to
shrink the balance sheet
Assets Liability Assets Liability
Fixed
and
Current
Assets
Cash
Proceeds
Equity
Liabilities
Fixed
and
Current
Assets
Equity
Liabilities
Increased Capital Ratio

market, diversifying the funding and possibly broadening the investor
base. As a result the company’s funding flexibility and independence
is increased.
Companies with a high credit rating utilise securitisation as a funding
source as it diversifies the funding and the issued notes are
a very reliable funding source at a relatively stable cost.According
to Tamara Adler, head of Deutsche Bank’s European securitisation
group in London,‘the issued notes don’t have the event risk
associated with sovereigns and corporates – and in Europe, at the
worst point of the Russian crisis 1998, spreads on triple A securitisations
only widened by a couple of basis points, and double-B
tranches went out by 40bp or 50bp’.
Improvement of return on equity (RoE)
One reason to achieve a high RoE is the growing importance of
the shareholder value concept. Shareholders have started to focus
on RoE and especially European banks still have a very low
RoE compared to American banks.Securitisation is seen as a possible
way of increasing the RoE and to catch up with the US banks,
which have been much more involved in the securitisation market.
The possible impact of securitisation is illustrated below.
17

Table 1: Illustration of the Benefits of Issuing CLOs
18
Balance Sheet of a bank
Assets USDm Margin Liabilities USDm Margin
Corporate Loans 50 0.75% Customer Deposits 50 1.00%
Retail Loans 50 1.50% Interbank 42 0.00%
Equity 8
Total Assets 100 Total Liabilities 100
P&L
Net Income $1.625m
RoE 20.3%
RoA 1.6%
Balance Sheet of a bank after securitising $25m
retail loans and generating new ones
Assets USDm Margin Liabilities USDm Margin
Corporate Loans 50 0.75% Customer Deposits 50 1.00%
Retail Loans 50 1.50% Interbank 42 0.00%
Equity 8
Total Assets 100 Total Liabilities 100
P&L
Net Income $1.875 Notes: Lost margin of 50 basis points
RoE 23.4% when selling retail loans. Balance sheet
RoA 1.9% remains the same ($25m retail loans sold
Source: Wolfe
and $25m new retail loans generated).
As depicted in the above example, by securitising USD25m retail
loans and using the cash proceeds from the securitisation process
to generate USD25m new retail loans the balance sheet does not
change. However, the net income, RoE and RoA increase. Further
it would have been possible to invest the cash proceeds in
higher yielding or more diversified assets.

Improvement of the risk adjusted performance
The risk adjusted performance of a bank is becoming more and
more important in the times of shareholder value. By securitising
assets a bank is able to improve its risk adjusted performance.Risk
adjusted return on capital (RAROC) ratio can be used as an indicator.
The following example illustrates the possibility of improving
RAROC by securitising corporate loans.
Table 2: Example of CLOs in facilitating a higher RAROC on investment-grade
Assets
Assumptions
Amount of Loans in CLO $1 Billion
Loan Portfolio Yield LIBOR + 50 basis points (bp)
Bank Funding Costs LIBOR – 10 bp
CLO Funding Costs LIBOR + 24 bp
Bank Retains 1% Reserve Fund $ 10 million
Before CLO
Yield Less Funding Cost (L + 50) less (L-10) = 60bp
Net Spread Earned 0.006 x $1bn = $6 million
Risk-Based Capital Requirements (8% on $1bn) = $80 million
RAROC $6 million/$80 million = 7.5%
After CLO
Yield Less Funding Cost (L + 50) less (L + 24) = 26bp
Net Spread Earned 0.0026 x $1bn = $2.6 million
Risk-Based Capital Requirements (100% of Reserve Fund) = $10 million
RAROC $2.6 million/$10 million = 26%
Source: Bear Stearns & Co. Inc.
19

Management of other balance sheet characteristics
Securitising assets that are over represented and purchasing assets,which
are under represented,can influence numerous balance
sheet characteristics. In short securitisation allows a bank to adjust
the financial profile of the balance sheet.
Credit limit management/risk management
A bank may be exposed to loan concentrations in a certain industry
or a geographic area and further credits would exceed the credit
limit and lead to extensive risks. Securitisation can free up credit
lines by securitising assets of concentrated industries. An active
risk management is attainable by securitising risky assets and using
the cash proceeds to acquire assets with a lower risk exposure and
therefore remove credit risk.
6. Disadvantages of conventional CLOs
There can be some disadvantages involved with conventional
ABS/CLOs:
The synchronisation of the interest generated by the pool and the
interest paid to the noteholders is a very arduous and tedious process.
The transfer of corporate loans may be difficult for legal, regulatory
or tax reasons. On the one hand it is necessary to achieve
a true sale under different regulations: local tax treatments, national
and international accounting standards and local legal
framework, which are based on different objectives.On the other
hand the transactions have to satisfy the requirements of regulatory
authorities. Further in some jurisdictions the banking secrecy
laws can be an obstacle.
20

Traditional ways of funding may be more economical for a bank,
especially for banks with a high credit rating as the market requires
a higher spread for new products, asset classes or participants.
The complexity of the transaction requires a very highly sophisticated
documentation, which covers every potential risk.The numerous
participants and opinions as well as the voluminous documentation
are very time consuming and costly.
21

SYNTHETIC COLLATERALISED LOAN
OBLIGATION (CLO)
– UTILISING CREDIT DERIVATIVES
Christian Solbach
1. Introduction
‘Credit Derivatives are bilateral financial contracts that isolate specific
aspects of credit risk from an underlying instrument and transfer
that risk between two parties’ 6 . By using credit derivatives it
is feasible to decrease credit risk exposure without removing the
assets from the balance sheet.The growing importance of credit
risk management fostered the growth of credit derivatives as outlined
in figure 9.
Figure 9: Outstanding Volume of Credit Derivatives (in bn)
$800
$700
$600
$500
$400
$300
$200
$100
$0
Source: British Bankers’ Association
22
1996 1997 1998 2000
(estimated)
6 The J. P. Morgan Guide to Credit Derivatives, September 1999, p. 10

According to British Banker’s Association (BBA), banks are the major
participants of the credit derivatives market representing 63%
of the buy side and 47% of the sell side in 1999. However, they
predict that over the next few years the market share of banks will
decline. Especially insurance companies will increase their participation
from 10% in 1997/98 to 26% by 2002.
In 1999, the International Swap and Derivatives Association
(ISDA) published the ISDA standard credit derivatives confirmation
and a revised credit swap documentation.Both helped to standardise
credit derivative contracts and were important steps for
the further growth of the market because to a great extent legal
uncertainty was eliminated. It is typical for credit derivatives that
at the beginning of a transaction the counterparties define the
periodic fee, a contingent payment and the credit events. There
is no standard definition for a credit event.The most common definitions
for a credit event are repudiation, bankruptcy, insolvency
and failure to meet payment obligations when due.
The costs for the risk protection depend on the kind of credit
derivative. They are lower in case of an unfunded credit default
swap and difficult to calculate in case of a total return swap.
2. Variations of Credit Derivatives
There are unlimited possible variations of credit derivatives.‘The
only true limitation to the parameters of a credit swap is the
willingness of the counterparties to act on a credit view’ 7 . Some
of the most common credit derivatives are: credit (default) swaps,
credit spread products, total return swaps, credit-linked notes and
repackaged notes. The market share of credit derivatives is illustrated
in table 3.
7 The J. P. Morgan Guide to Credit Derivatives, September 1999, p. 16
23

Table 3: Market share of credit derivatives
24
1996 1997 2000 (estimated)
Credit Default Swaps 35% 52% 38%
Credit Spread Products 15% 16% 13%
Total Return Swaps 17% 14% 17%
Credit-Linked Notes 27% 13% 21%
Repackaged Notes 6% 5% 11%
Source: British Bankers’ Association
In connection with synthetic securitisation the most important
credit derivatives are credit default swaps (CDS) and credit-linked
notes (CLN). Both will be explained below.
Credit Default Swap (CDS)
‘The credit default swap (or credit swap) is a bilateral financial contract
in which one counterparty (the protection buyer) pays a periodic
fee, typically expressed in basis points (bp) per annum, paid
on the notional amount, in return for a contingent payment by
the protection seller following a credit event with respect to a reference
entity’ 8 .
By engaging in a CDS the protection buyer wants to reduce its
credit risk exposure. In case of a credit event the protection seller
agrees to make a contingent payment to the protection buyer.The
two most common contingent payments are: first, delivery
of the reference entity to the protection seller for the original
amount, second, the protection buyer obtains the difference between
the original and the market value of the reference entity in
cash. A credit default swap is illustrated in figure 10.
8 The J. P. Morgan Guide to Credit Derivatives, September 1999, p. 14

Figure 10: Credit Default Swap
Protection
buyer
Source: J. P. Morgan
X bp pa
Contingent payment
There are various advantages of CDS.These are for the protection
buyer the ability of gaining credit line and capital relief and the
ease of execution.The protection seller achieves diversification and
yield enhancement.
Credit-Linked Notes (CLNs)
‘Credit-linked notes are funded balance sheet assets that offer synthetic
credit exposure to a reference entity in a structure designed
to resemble a synthetic corporate bond or loan’ 9 .
The originator pools together assets and creates a reference pool.
Then the originator issues notes, which are linked to the reference
pool. The investor purchases the notes and the originator
receives cash in exchange. During the life of the CLN the investor
receives interest.At maturity of the notes the investor receives the
principal amount minus allocated losses.
The most important advantage of CLNs compared to asset-backed
notes is that the credit risk of the reference portfolio is completely
shifted to the capital markets by avoiding the legal complexity
of a true sale transaction. The process is illustrated in figure 11.
9 The J. P. Morgan Guide to Credit Derivatives, September 1999, p. 23
Protection
seller
25

Figure 11: Credit-linked Note
Source: Deloitte & Touche
3. Synthetic CLO Structure
‘Synthetic securitisation combines the merits of credit derivatives
and conventional securitisation’ 10 . Synthetic securitisation overcomes
the disadvantages of conventional securitisation by combining
credit derivatives with securitisation structures. Meaning,
the originator maintains the securitised corporate loans on its balance
sheet and transfers the credit risk to investors, utilising the
structure of a conventional securitisation.
For banks, which mainly pursue regulatory capital arbitrage and
credit risk management but are not interested in true sale funding,
synthetic securitisation could be a better choice. There is no basic
synthetic model. Some synthetic structures use an SPV and
others do not.
Securitisation structures using an SPV
The structure involving an SPV will be presented briefly. The originator
(bank) engages in a credit default swap with an SPV re-
10 Hermann Watzinger, Cheap and easy, Credit Risk Special Report, Risk March 2000
26
Issue of CLNs
X bp pa
Originator Investor
Cash Proceeds
Repayment of the principal
amount minus allocated losses

ferring to a certain reference portfolio (corporate loans) in its asset
pool. It will receive a periodic fee, the protection payment, in
return for a contingent payment. Then the SPV issues CLNs with
the reference portfolio as the underlying asset to investors at par
value.Cash proceeds generated through the CLNs are usually used
to buy triple A rated assets which are used as collateral.
The investor holds both the risks for the collateral and the reference
portfolio. As compensation they receive LIBOR + x bp (interest)
and at maturity par value minus contingent payment. According
to J.P. Morgan the yield on the credit-linked note is
higher than that of the underlying collateral and the premium on
the credit swap individually. In the case of a credit event, e.g. part
of the reference portfolio defaults the swap counterparty, the originator
receives the contingent payment.The investor receives par
minus contingent payment.The structure is displayed in figure 12.
Figure 12: Synthetic CLO structure including an SPV
Originator
Bank
Protection payment
Contingent payment
Transfer of Risk
Credit Default Swap Credit-linked Notes
Special
purpose
vehicle
Purchase of
AAA securities
AAA
securities
Libor + bp
Par minus contingent payment
Source: Based on the J.P. Morgan Guide to Credit Derivatives
Par
Investor
27

Synthetic securitisation without an SPV
The most common structure and the one relevant for the following
case study will be explained in more detail.Most of the structures
use a combination of CLN and CDS but do not use an SPV.
The issuer (bank) and the originator (bank) are one entity. In other
words, the originator is the asset and the issuer is the liability
side of the balance sheet of the bank.The originator pools together
an asset pool, which is synthetically securitised by the issuer partly
by issuing CLNs. A credit link exists between the CLNs and the
reference portfolio. To transfer the remaining part of the reference
portfolio’s credit exposure the issuer engages in a CDS,which
is normally underwritten by an OECD bank for risk weighting reasons.
As a result the whole credit risk exposure is transferred to
the capital market by using CLNs and CDSs.Only the CLNs are funded.
CLNs are comparable to conventional ABS notes.They are issued
in different tranches with different risk characteristics. These are
rated by the rating agencies. The issuer normally enters into credit
enhancement structures to receive a higher rating for the
tranches. One of the most common credit enhancements is to use
part of the cash proceeds generated by the CLNs to buy triple A
rated assets and use them as collateral for the senior CLN
tranche.Most of the banks buy treasuries or Pfandbriefe 11 , as they
attract very low risk weightings. For instance, Pfandbriefe require
10% risk weighting. However, if they are issued by a bank’s
mortgage subsidiary it may be possible to accomplish full capital
relief on a consolidated basis.
Another credit enhancement is the subordination meaning that
the losses are allocated from the junior CLN tranche to the super
11 Zahn Dictionary 1996 (p. 341) defines Pfandbriefe as Mortgage bond (debenture). Pfandbriefe are
issued by private and public sector mortgage banks as well as ship mortgage institutions to fund
housing and shipbuilding loans. According to the German Mortgage Bank Act these fixed-rate instruments
must be fully collateralised by first mortgage loans.
28

senior credit default swap. Figure 13 illustrates a synthetic CLO
structure excluding an SPV.
Figure 13: Synthetic CLO structure excluding an SPV
Servicer
Originator
Bank
Source: Based on CAST 1999-1
The other participants, the trustee and the servicer, in this structure
have similar duties as in a conventional securitisation transaction.
4. Risks
Administration
Reference Pool
Credit Link
Monitoring
Asset Liability
Trustee
Issuer
Bank
Credit
Enhancer
Credit
Enhancement
Super Senior
Credit
Default Swap
Senior
CLN Class
Mezzanine
CLN Class
Junior
CLN Class
Rating
Agency
Swap
Partner
OECD
Bank
Investor
Fewer risks occur in a synthetic transaction in comparison to a conventional
transaction.Only credit and currency/exchange rate risks
apply in a synthetic transaction. Liquidity, prepayment and reinvestment
risks do not have to be taken into consideration as most
synthetic structures have replenishment and no SPV.
Loss Allocation
29

5. Advantages of Synthetic CLOs
Various advantages are attached from a bank point of view. The
advantages for conventional CLOs apply to a great extent for synthetic
CLOs, e.g. regulatory capital relief, which is illustrated below.
Figure 14: Example of Regulatory Capital Relief
Assumes (1) dollar-for-dollar capital charge on retained equity, (2) 20% risk
weight counterparty for super senior swap and (3) assets that collateralise the
notes pay LIBOR – 15 bps.
Source: Merrill Lynch
However, there are some advantages that only apply for synthetic
CLOs. The most essential ones are listed below:
30
Example of funding costs
Fully Funded (pa) assuming 5% LIBOR
Partially Funded
Senior Notes
(90)
L+25
Mezzanine Notes
(4) L+60
29 bps 18 bps
Senior Notes (90) L+27
Mezzanine Notes
(4) L+60
Junior Notes (3) L+150 Junior Notes (3) L+150
Retained Equity (3) Retained Equity (3)
Pre-Deal Regulatory Capital =
Post-Deal Regulatory Capital =
Regulatory Capital Relief =
Cost Per Unit of Capital Relief =
Fully Funded/Conventional
8.00%
3.00%
5.00%
0.17 bps
Super Senior Credit
Default Swap
(87)
10 bps
Partially Funded
= 8.00%
= 4.39%
= 6.61%
= 0.20 bps

Avoidance of true sale treatments
As the corporate loans stay on the balance sheet, synthetic securitisation
circumvents all likely problems arising through the
transfer of the assets (true sale). As a result there are fewer difficulties
in having a reference pool containing assets from various
jurisdictions. Therefore it is easier to set up and less costly.
Cheap transfer of credit risk exposure
Cheap transfer of credit risk exposure occurs especially for the underlying
portfolios, which are mostly securitised by a high portion
of super senior credit default swaps. To securitise these assets
without credit derivatives would require the issuance of notes.
In the best case scenario these notes would be triple A rated
and investors would only demand a small spread above the reference
rate. By engaging in a synthetic structure the credit default
swap counterpart will only demand a small fee as most of the risk
in this transaction is based in the junior CLNs.
Capital Market
By using synthetic securitisation to securitise corporate loans the
amount that can be issued exceeds conventional securitisation
as it is only partly funded. For instance, a bank might be able to
synthetically securitise €5bn corporate loans, where the funded
part is e.g. 10% (€20bn). But it would be very difficult for a bank
to conventionally securitise €5bn, as it is funded 100%. By using
a CDS the protection buyer can use the capital market and private
investors for the combined protection of an asset portfolio.
Securitisation of a ‘heterogeneous’ asset pool
In contrast to conventional securitisation it is feasible to securitise
assets from jurisdictions with transferability obstacles or unfunded
assets (e.g. guarantees). As a result various synthetic
transactions are linked to a portfolio of multi-jurisdictional loans.
31

Documentation
As the assets are not taken off the balance sheet the documentation
is easier as the regulatory, tax, legal and accounting purposes,
which need to be established for a true sale, can be neglected.
6. Disadvantages of Synthetic CLOs
There are some disadvantages which occur if corporate loans are
securitised synthetically:
In the most common synthetic structure the reference pool is only
partly funded, which is a disadvantage if the salient objective
is to generate a new funding source.
The interest that has to be paid on CLNs is higher than on comparable
asset-backed notes.The reason is that the market demands
a higher premium,as synthetic securitisation is a fairly new financial
innovation.
No impact on the size of the balance sheet.As some analysts concentrate
on the size of the balance sheet this could be a disadvantage.
‘The main disadvantage of synthetic securitisation is the need for
counterparty risk lines, required for the credit default swap on the
senior tranche with the OECD bank.The amount of lines depends
on the replacement value of the contract in the case of a counterparty
default, which is a function of the volatility of the underlying
risk and the correlation between the underlying risk and
the protection provider. When hedging the most senior tranche,
the line allocation is only a small fraction of the notional amount’ 12 .
12 Hermann Watzinger, Credit Risk Special Report, Risk March 2000, p. 13
32

CASE STUDY
Christian Solbach
1. Introduction
The following case studies will give a detailed overview of two
very significant securitisation structures in the German market.
Most of the information used is based on: CORE 1999-1 Offering
Circular, CAST 1999-1 Information Memorandum, conducted
survey and interviews with professionals within the securitisation
market, and articles from Euroweek and the International Securitisation
Report (ISR).
2. CORE 1999-1
CORE 1999-1 is a conventional securitisation transaction. The
name CORE originates from the COrporate and Real Estate division
of the Deutsche Bank (DB). The CORE 1999-1 is the successor
of CORE 1998-1, which was the first public CLO issued by a German
bank.
General structure of the CORE 1999-1 transaction
The originator pooled together a reference pool of 5,117 German
corporate loans with a value of €2.48bn (USD2.72bn). The borrowers
are German Mittelstand companies (smaller and medium
sized companies, “the heart of the German economy“). These
loans are sold to CORE 1999-1 Limited, an SPV with charitable status
registered in Jersey. To finance this true sale transaction the
SPV issues asset-backed notes consisting of three classes A, M and
B which are divided in 12 tranches. The characteristics of the asset-backed
notes: volume, tranche, floating or fix and currency de-
33

nominations are depicted in the following table.
Table 4: Asset-backed Notes
€ 365,800,000 Class A – 1a Floating Rate Notes of 1999/2000
USD 194,000,000 Class A – 1b Floating Rate Notes of 1999/2000
USD 274,400,000 Class A – 2 Floating Rate Notes of 1999/2009
€ 1,034,100,000 Class A – 3a Floating Rate Notes of 1999/2009
USD 250,000,000 Class A – 3b Floating Rate Notes of 1999/2009
€ 231,100,000 Class A – 4 Fixed Rate Notes of 1999/2009
€ 44,700,000 Class M Floating Rate Notes of 1999/2009
€ 49,600,000 Class B – 1 Floating Rate Notes of 1999/2009
€ 20,600,000 Class B – 2a Floating Rate Notes of 1999/2009
€ 29,000,000 Class B – 2b Fixed Rate Notes of 1999/2009
€ 7,900,000 Class B – 3a Floating Rate Notes of 1999/2009
€ 47,000,000 Class B – 3b Fixed Rate Notes of 1999/2009
Source: Offering Circular, CORE 1999-1 Limited
The tranches are rated by rating agencies and carry a spread
above the base rate (in this case LIBOR and EURIBOR) or a fixed
rate.Both kinds of interest rates carry a premium according to their
individual risk.The lowest tranche carries the highest risk and premium
as the risks are allocated from the bottom to the top class.
The originator continues to service the reference pool, which is
common for all securitisation transactions.The issuer enters in credit
enhancements and swaps.
The placement in the American market and Rule 144A 13 made it
necessary to have an American bank as trustee. As a result the
trustee is the Frankfurt branch of Chase Manhattan, acting on behalf
of the investors. Figure 15 depicts the CORE 1999-1 structure.
13 The SEC introduced Rule 144A, which allowed the sale and subsequent trading of Eurobond
among those investors who met the private-placement criteria.
34

Figure 15: CORE 1999-1
Servicer
Deutsche
Bank AG
Originator
Deutsche
Bank AG
Swap Partner
Deutsche
Bank AG
Administration
Reference Pool
True Sale
Reserve
Fund
Trustee
The Chase
Manhattan Bank
New York
Issuer
SPV
CORE 1999-1
Credit
Enhancement
Source: Based on the Offering Circular
Excess
Spread
Fund
Class A notes
Class M note
Class B notes
Investor
Rating Agencies
Swaps
In order to generate the required cash flows, the SPV enters into
three swap contracts with DB as the counterpart: Floating interest
rate swap with a constant margin over EURIBOR, fixed interest
rate swap and Euro-dollar currency swaps.
If the credit rating of DB falls below a certain threshold the swap
agreements will be supported externally or transferred to other
institutions, as this is the standard of the industry.
Credit enhancements
To avoid possible shortfalls in interest payments, realised losses
and to achieve a high credit rating of the issued notes, the CORE
structure uses various credit enhancements.
First, the excess spread that is generated by the difference between
the collective loan repayments and the obligations on the
notes is used as follows: cover any realised losses, to build up a
Loss Allocation
35

eserve fund up to €57.15m and finally to pay the servicer additional
performance related compensation.The excess spread is estimated
to be 180bp.
Second, a non-declining reserve fund will act as a kind of buffer.
The buffer will have an initial value of €32.30m(1.3%) and it will
increase to €57.15(2.3%) supplied by the excess spread. This represents
DB’s only capital commitment to the portfolio.
Third, the CORE 1999-1 structure itself acts as a credit enhancement.
According to Lindon Neil, associate director of structured
finance ratings at S&P, ‘you achieve a credit enhancement by the
structuring of the liabilities’. In this case most of the risk is allocated
to the B tranches, thus the losses are allocated from the bottom
to the top tranche as illustrated in the CORE 1999-1 structure.
As a result, even if there are possible shortfalls in interest payments,
e.g. caused by prepayments, repurchases, defaults or liquidations
they must at least exceed €32.30m (depending on the
supply of the excess spread may achieve up to €57.15m) before
there is any impact on the B-3 tranche, the most junior. In short,
any interest shortfall up to €57.15m may be insufficient to have
an impact.
Funding
The CORE 1999-1 deal is 100 % funded which is common for a conventional
securitisation transaction. In short, the value of the reference
pool of €2.48bn (USD2.72bn) and the value of the assetbacked
issued notes are equal.
Description of the reference pool
The compilation of the reference pool is very important for both
rating agencies and investors,particular concerns are:current principal
balances, remaining terms to maturity, loan ages, corporate
36

isk factors, industry sector distribution of loans and the geographic
distribution of the loan, which are presented to the investor
in the Information Memorandum. The following features illustrate
the compilation of CORE 1999-1 14 .
� As of the Cut-off date, the Pool included 5,117 Loan Claims to
3,743 obligors, with an aggregate principal balance of
€2,484,404,326.32. The maximum concentration to any single
obligor is no more than 1.5% of aggregate principal balance of
the Pool.
� The weighted average Remaining Term to maturity as of the Cutoff
Date was approximately 51.9 months.The longest Remaining
Term to Maturity of the Loan Claims as of the Cut-off Date was
99 months.
� The weighted average Loan Age as of the Cut-off Date was approximately
23.9 months.
� The weighted average Current Loan Rates as of the Cut-off Date
was approximately 5.703%.
The preceding features show that CORE 1999-1 has a very well diversified
portfolio.This is one of the main reasons for its great success
in the capital market.
Rating of the notes
The rating of asset-backed notes is very important for the originator
as it is the most important indicator on how high the spread
over the reference base rate (in this case LIBOR and EURIBOR)
has to be. The higher the rating, the lower the spread the originator
needs to offer. Not only is the compilation of the pool an
important factor for the rating but also the weighted average
life is salient as it is reasonable to assume that a loan is more
14 CORE 1999-1 Offering Circular, p. 30
37

likely to default in 10 years than in 1 years’time.The rating of Standard
& Poor’s and Moody’s, Percentage of Total, Note Subordination,
Interest Rate,Weighted Average Life (yrs) and Payment Window
are outlined in table 5.
Table 5: Rating of the notes
Expected Percen- Note Wtd
Rating tage Subordi- Avg. Payment
Class Moody/S&P of total nation Interest Rate Life (yrs) Window
A-1a P-1/A-1plus 21.8% 8.0% 3 Mo EURIBOR + 6 bps 0.536 6/99-12/99
A-1b P-1/A-1plus 3 Mo EURIBOR + 3.5 bps 0.536 6/99-12/99
A-2 Aaa/AAA 10.1% 8.0% 3 Mo LIBOR + 8 bps 1.063 12/99-6/00
A-3a Aaa/AAA 50.8% 8.0% 3 Mo EURIBOR + 21 bps 2.999 6/00-6/04
A-3b Aaa/AAA 3 Mo LIBOR + 19.5 bps 2.999 6/00-6/04
A-4 Aaa/AAA 9.3% 8.0% 3.9750% 6.087 6/04-12/05
M Aa2/AA 1.8% 6.2% 3 Mo EURIBOR + 30 bps 6.794 12/05-12/05
B-1 A2/A 2.0% 4.2% 3 Mo EURIBOR + 45 bps 6.794 12/05-12/05
B-2a Baa2/BBB 2.0% 2.2% 3 Mo EURIBOR + 100 bps 6.794 12/05-12/05
B-2b Baa2/BBB 4.8150% 6.794 12/05-12/05
B-3a Ba2/BB 2.2% 3 Mo EURIBOR + 300 bps 6.794 12/05-12/05
B-3b Ba2/BB 6.8150% 6.794 12/05-12/05
Source: Offering Circular, CORE 1999-1 Limited
As presented by the previous table 92% or the first 6 tranches of
the issuance receive the highest rating that Moody’s and Standard
& Poor assign. A further reason for this high rating is that none of
the loans have been in arrears or have required any bad-debt provisions.The
junior tranche (so called First-loss-piece) which is covered
by the reserve fund represents 2,2% of the reference portfolio.
38

Tranches and market information
According to Detlef Bindert, group treasurer at DB, CORE 1999-1
has been a great success. However, due to unfavourable market
conditions CORE was not launched as planned at the end of 1998
but was postponed until February 1999.As it turned out, the postponement
was a prudent decision.The two main factors leading
to favourable market conditions were the introduction of the
Euro and a rapid pick up in the fixed-income market. As a result
of the deferment, the issue was 1.8 times oversubscribed.
The first three tranches DB issued were short-term tranches.Tranches
A-1a, A-1b had a weighted average life of 0.536 years and
tranche A-2 had a weighted average life of 1.063 years.These three
tranches accounted for 31.9%. The objective of these issues was
to broaden the investor base.The investors in the short-term tranches
were mainly money market accounts in Germany,France,Belgium
and the US.
The CORE 1999-1 deal included three tranches denominated in
dollars, class A-1b, class A-2 and class A-3b, with a total volume of
USD718.4m. The other nine tranches were denominated in EUR.
This was mainly done to broaden the investor base.
The two A3 tranches, which represent over 50% of the total issue,
were denominated in dollars and Euros.According to Tamara Adler,
head of Deutsche Bank’s European securitisation group in London,
there were more than 50 investors (pension funds, insurance
companies,asset managers,corporates,banks and hedge funds).
German and UK investors mainly bought the EUR tranche whereas
the dollar tranche was mainly bought by US investors. The
dollar tranches sold in the US were in accordance with Rule 144A.
The A4 tranche was a fixed rated tranche and was mainly bought
by German and French insurance companies.
39

2. CAST 1999-1
CAST 1999-1 is a synthetic transaction issued by Deutsche Bank
(DB) and was regarded as a benchmark deal.It was DB’s fourth securitisation
transaction backed by German corporate loans.
General structure of the CAST 1999-1 transaction
The originator in this transaction pooled together a reference pool
of 4,389 German corporate loans. The reference pool has an original
value of €2.9bn and the borrowers are German Mittelstand
companies. This structure does not use an SPV.
The issuer and the originator belong to the same entity of DB. As
mentioned in chapter Synthetic Collateralised Loan Obligations,
it could be said that the originator represents the asset side and
the issuer the liability side of DB’s balance sheet concerning the
securitisation of the reference portfolio.
DB issued credit-linked notes with a total value of €391.5m.They
contained six subordinated classes (from A to F) which were subdivided
into 12 tranches. All of the tranches are issued in EUR.
The characteristics of the credit-linked notes: volume, tranche, floating
or fix and currency denominations are depicted in table 6.
40

Table 6: Credit-linked Notes
Class Class Principal Amount Interest Rate
Class A-1 € 84,500,000 EURIBOR + 0.35%
Class A-2 € 17,000,000 5.55%
Class B-1 € 45,000,000 EURIBOR + 0.47%
Class B-2 € 13,000,000 5.67%
Class C-1 € 18,000,000 EURIBOR + 0.72%
Class C-2a € 30,000,000 5.92%
Class C-2b € 10,000,000 5.92%
Class D-1 € 31,500,000 EURIBOR + 1.30%
Class D-2 € 26,500,000 6.51%
Class E-1a € 16,500,000 8.54%
Class E-1b € 12,500,000 8.54%
Class F € 87,000,000 EURIBOR + 0.50%
Source: CAST 1999-1 Information Memorandum
The CLNs are rated by rating agencies and carry a spread above
the base rate (in this case EURIBOR) or a fixed rate. Both kinds of
interest rates carry a premium according to their individual risk.
To achieve a high credit rating DB engages in various credit enhancements.However,
the CLNs only account for 13.5% of the reference
portfolio.The interest for the CLNs is paid directly by the
issuer.According to Tamara Adler there is a huge demand for credit
(default) linked notes.
The remaining 86.5% are issued through a credit default swap with
an OECD bank to accomplish regulatory capital relief.This is a typical
structure for a synthetic securitisation transaction having
CLNs for the junior tranches and enters in a credit default swap
for the more senior ones.
DB continues to service the reference pool, which is common for
every kind of synthetic securitisation transaction. Figure 16 describes
the CAST 1999-1 structure.
41

Figure 16: CAST 1999-1
Source: Based on the Information Memorandum
Swaps
Swap agreements are not explicitly mentioned in the CAST information
memorandum.However,the eventuality of the bank entering
into similar swap agreements, as in the CORE 1999-1 structure,
is highly likely. But, as the reference portfolio is not transferred
to a separate entity the swap agreements are part of the normal
risk management of the bank.
Credit enhancements
DB engages in five credit enhancements: Eurohypo Pfandbriefe,
Interest Subparticipation, Subordination,‘liquidity facility’(for the
interest payments) and replenishment.
Eurohypo Pfandbriefe: the classes A and B which have a value of
42
Servicer
DB AG
Originator
DB AG
Administration
Reference Pool
Credit Link
Asset Liability
Trustee
Deloitte &
Touche
GmbH
Issuer
DB AG
Eurohypo
Pfandbrief
Interest
Subparticipation
Credit Default Swap
Class A to B Notes
Class C to E Notes
Class F Notes
Loss Allocation
Rating
Agency
Swap
Partner
OECD
Bank
Investor

€101.5m and €58m will be collateralised by floating rate public
sector Pfandbriefe issued by Eurohypo, DB’s mortgage bank subsidiary.They
match the maturity and interest payments of the class
A and B notes.The Pfandbriefe will only be used as collateral if DB
defaults.In short, if the securitised assets default but DB ‘survives’
the Pfandbriefe (collateral) may not be realised by the investors.
The trustee, Deloitte & Touche, holds the Pfandbriefe.
Interest Subparticipation: a credit enhancement, which applies to
the tranche F and is activated when loans default. The interest,
which is generated through the reference portfolio, will first be
used to replace losses allocated to tranche F. This is best explained
using an example. If a loss of €50m occurs and the interest
generated by the reference pool is €10m,the €10m would be used
to reimburse the class F noteholders.Assuming the portfolio constantly
generates €10m it would take 5 years to reimburse the class
F noteholders. Although, the noteholder does not receive any interest
on the defaulted loans, he at least regains the invested principal
amount. As a result the spread received is just above class
B noteholders but below class C noteholders.
Subordination: allocating the losses from the bottom to the top
class is seen as credit enhancement.
Liquidity facility:the issuer independent of the performance of the
reference portfolio pays the interest.Therefore, if one of the loans
has not paid interest on the due date this does not affect investors
as the issuer pays the interest.However,if one of the loans defaults
the issuer stops paying interest to the investor for this loan.
The process is similar to cash collateral, but the difference is that
no separate account is created.The bank itself is the cash collateral.
Replenishment: normally, if prepayments occur the CLNs are paid
back from the senior class of notes to the junior. In the case of replenishment
the funds paid back through prepayments will be
43

used to replace the prepaid loans. As a result there is no prepayment
risk, as effectively the asset pool remains fixed. The replenishment
has to fulfil certain conditions that try to ensure that the
quality of the reference pool is maintained.
Funding
The CAST 1999-1 transaction is only 13.5% funded.The greater part
is unfunded, with the credit default swaps accounting for 86.5%.
As a result the bank “only” generated €391.5m in cash.
Description of the reference pool
The compilation of the reference pool is very important for both
rating agencies and investors,particular concerns are:current principal
balances, remaining terms to maturity, loan ages, corporate
risk factors, industry sector distribution of loans and the geographic
distribution of the loans which are presented to the investor
in the Information Memorandum. The following features illustrate
the compilation of CAST 1999-115 :
� As of the Cut-off Date, the Pool included 4,389 Reference Claims
to 3,012 obligors, with an aggregate principal balance of
€2,899,730,334.63.
� The weighted average Loan Age of the Reference Claims as of
the Cut-off Date was approximately 27 months.
� As of the Cut-off Date, the average Current Principal Balance of
the Reference Claims was €660,681.32, the minimum Current
Principal was €14,760.46 and the maximum Current Principal Balance
was €51,125,000.00.
� The weighted average Remaining Term to Maturity of the Reference
Claims as of the Cut-off Date was approximately 40
months.The longest Remaining Term to Maturity of the Reference
Claims as of the Cut-off Date was 85 months.
15 CAST 1999-1 Information Memorandum
44

The preceding features show that CAST 1999-1 is a very well diversified
portfolio.This is one of the main reasons for its great success
in the capital market.
Rating of the notes
The rating of the notes is very important for an issuer. Table 7 illustrates
the rating and the resulting interest for each tranche.This
table does not include the credit default swap, which accounts for
86.5% of the transaction.
Table 7: Rating of the notes
Class Scheduled
Rating Percentage Subord. Maturity
Class Moody/S&P of total Interest Rate Percent Date
Class A-1 Aaa/AAA 3.50% EURIBOR* +0.35% 10.00% Oct-06
Class A-2 Aaa/AAA 5.55% 10.00% Oct-06
Class B-1 Aaa/AA 2.00% EURIBOR* + 0.47% 8.00% Oct-06
Class B-2 Aaa/AA 5.67% 8.00% Oct-06
Class C-1 Aa3/A 2.00% EURIBOR* + 0.72% 6.00% Oct-06
Class C-2a Aa3/A 5.92% 6.00% Oct-06
Class C-2b Aa3/A 5.92% 6.00% Oct-06
Class D-1 Baa1/BBB 2.00% EURIBOR* + 1.30% 4.00% Oct-06
Class D-2 Baa1/BBB 6.51% 4.00% Oct-06
Class E-1a Ba3/BB 1.00% 8.54% 3.00% Oct-06
Class E-1b Ba3/BB 8.54% 3.00% Oct-06
Class F ** 3.00% EURIBOR* + 0.50% —— Oct-06
*As determined on each EURIBOR Determination Date
** The Class F Notes are expected to be privately rated by Fitch IBCA and
Moody’s
Source: CAST 1999-1 Information Memorandum
45

It can be seen from the above table that the first 9 tranches (nearly
90%) are all investment grade (above Baa/BBB) rated.The first
two classes A and B receive the highest rating Moody grants (S&P
differs from Moody in the B class, it rates the B class with AA).The
reason for this high rating can mainly be seen in the Pfandbriefe,
which are used as collateral. DB is rated AA therefore the only
classes that are rated below are the D and E class.
Though the F tranche is unrated it can be assumed that the rating
is investment grade and therefore exceeds the rating of the
two above tranches.This is unusual since the lowest tranche is expected
to hold the worst rating. Although losses first occur in the
tranche F the interest subparticipation enhances the credit rating.
As a result more than 90% (including tranche F) are investment
grade rated.This is important for some investors who are restricted
to investing mainly in investment grade rated assets.
The supersenior CDS, which is in terms of subordination the
highest tranche, has no official rating, but is called the AAAA-class
because it has less risk than the Class A-1 CLN.
Tranches and market information
The cash generated by the class A and B CLNs will be used to buy
Pfandbriefe issued by Eurohypo, DB’s mortgage bank subsidiary,
which are used as collateral for the A and B notes. Class A and B
notes must offer a higher spread than the Pfandbriefe, otherwise
there would be no incentive for the investor to buy CLNs, this
negative spread should be compensated by the reference portfolio.
For instance the reference portfolio generates 10% and the bank
issues CLNs that have to pay 8% interest.As a result the bank would
generate a 2% riskless profit. If it has to buy Pfandbriefe as collateral
as in CAST 1999-1,which produces a negative spread,the profit
may diminish to 1.5% but it is still a riskless profit.
46

Classes C, D and E are direct unsecured obligations of DB.The ‘D’
and ‘E’ notes are the only tranches that have a fixed rate. The
deal will reach legal maturity in 2008 and has an expected maturity
in 2006 and will revolve throughout its life.
Usually the issuer keeps the unrated tranche but in CAST 1999-1
DB sold it and gave investors credit enhancement via interest subparticipation.
This move could allow DB to risk weight the F
tranche at 100% instead of a one-for one-capital charge.
There were three major types of investors: funds (46%), insurance
companies (37%) and banks (17%). Over half of the investors
were from Germany (56%) followed by Holland (10%) and
France (9%).
3. Analysis
The following paragraphs will outline the differences between synthetic
and conventional CLOs. CAST 1999-1 will be used as a synonym
for a synthetic CLO and CORE 1999-1 as a synonym for a
conventional CLO.
Costs
By using the CAST 1999-1 structure the credit risk of the linked
loans was transferred through notes which DB issued directly.This
structure does not include an SPV in contrast to CORE 1999-1,
which does. Most of the synthetic CLO structures do not employ
an SPV.As a result several advantages occur:costs are saved as synthetic
structures are less work intensive and can be set up faster.
If the originator’s motives are to free up regulatory capital and
transfer the credit risk to the market, it is cheaper to engage in a
synthetic securitisation transaction consisting of CLNs and one or
more supersenior credit default swaps. The main reason for this
47

is that credit default swaps are unfunded.This applies particularly
to banks with low funding costs.
Premium/Spread
Credit-linked notes (synthetic securitisation) carry a slightly
higher spread than asset-backed notes (conventional securitisation).
According to an investor, the main reason for a higher spread is
that synthetic securitisation is a fairly new financial product and
the market requires a higher premium for new products.Another
possible explanation for the existing gap could be the lack of investor’s
experience related to synthetic structures.However, in the
future the spread gap between CLNs and asset-backed notes
should narrow.
The spread on CAST 1999-1 and CORE 1999-1 are not comparable,
as they were not issued at the same time.
Currencies
CAST 1999-1 is only issued in Euros compared to CORE 1999-1,
which is issued in USD and EUR. The main reason for issuing
CORE 1999-1 in EUR and USD was to broaden the investor base
and is unrelated to the structures.According to market participants
it is easier to include assets in multiple currencies by using synthetic
structures.
Reference pool
Investors look for well-diversified portfolios and the originator
wishes to achieve a high credit rating.As a result the reference pool
has to be well-diversified independent of the chosen structure.
CORE 1999-1 and CAST 1999-1, securitised extremely well diversified
reference pools.
There are still some comparable features between conventional
and synthetic securitisation concerning the reference pool.In both
48

cases the notes are separated into different tranches with different
risk characteristics and rating agencies assess these.
Transfer of ownership
CORE 1999-1 requires the transfer of ownership of all loan claims,
with the aim of achieving a true sale. The transfer of ownership
can be time consuming and therefore represents an additional cost
factor.
CAST 1999-1 does not need to transfer the ownership, as the
notes are credit-linked to the underlying reference pool.
The structures have different effects on the balance sheet.In a conventional
CLO transaction the corporate loans have to be taken
off the balance sheet whereas they remain on the balance sheet
in a synthetic CLO structure.
Floating and fixed tranches
CAST 1999-1 has more fixed tranches (7) than CORE 1999-1 (3) and
conversely CORE 1999-1 has more floating tranches (9) compared
to CAST 1999-1 (5).The difference between the fixed and floating
tranches is not dependent on the structure but rather on
the market requirements at the time. According to market participants
it is easier to structure fixed rate bonds by using a synthetic
process.
Flexibility
Synthetic CLO transactions normally consist of a smaller capital
market base as they are usually only partly funded.Therefore the
bank has more flexibility about when to issue the notes.
Synthetic structures that do not include an SPV are ‘flexible’ as to
where they obtain the money in order to pay the interest. This is
due to the fact, that the originator pays it independently of the
interest generated by the reference pool.
49

Transfer of the credit risk
Conventional and synthetic structures transfer the entire credit
risk to the capital markets. However, by using synthetic structures
it may be possible to create an additional link to another reference
portfolio, if Pfandbriefe are used as collateral for the senior
tranches.By using a fully funded and fully collateralised (Pfandbriefe)
synthetic structure it is possible to fund twice the initial
pool volume of the securitisation transactions (funding of the underlying
reference pool and the Pfandbrief-linked asset portfolio).
Funding
CORE 1999-1 is 100% funded which is common for a conventional
CLO transaction.CAST 1999-1 is partly funded like most synthetic
CLOs.These structures contain CLNs for the junior part (funded)
and CDS for the more senior part (unfunded). However, the
percentage of funding for synthetic structures can vary. The two
extreme cases are also feasible:fully funded,e.g.HypoVereinsbank’s
Geldilux and completely unfunded transactions.
Administration
Administration of a synthetic CLO structure is usually much simpler.
It is not necessary in a synthetic CLO transaction to enter into
various swap agreements to obtain the required interest rate
and currency underlying the asset-backed notes.The reason being
that the interest is paid by the bank and not by the interest generated
by the reference portfolio.
Credit enhancements/Insolvency
The different structures require different credit enhancements.In
a conventional CLO structure separate funds are needed, as the
SPV is a separate entity, e.g. a reserve fund as in CORE 1999-1. To
cover credit risk synthetic structures usually engage in interest subparticipation
as credit enhancement.Additionally synthetic structures
require credit enhancements in case the originator defaults,
50

e.g. Pfandbriefe in CAST. In short, for conventional structures
there is a need for protection concerning the possible insolvency
of the SPV, whilst for a synthetic structure, without an SPV, protection
is required for the highly unlikely insolvency of the originator.
Waterfall
Waterfall describes the sequence of payment for the interest generated
from the reference pool. In the case of CORE 1999-1 it is
called core priority of distribution. CAST 1999-1 does not need a
waterfall, as the interest payments are independent of the cash
flow of the underlying portfolio. The only time there is a similar
event in a synthetic structure is when the principal is repaid.
There is also a reverse waterfall in respect of allocated losses.
Maturity
In CORE 1999-1 there is no definite date (only estimated) of maturity,
in contrast to CAST 1999-1. This occurs because the prepayments
in CORE 1999-1 are allocated according to the waterfall.
In CAST 1999-1 there is replenishment. As a result prepayments
are reinvested and the initial amount on the notes is repaid
on maturity. In short, the reference pool for CORE 1999-1 diminishes
and is fixed for CAST 1999-1.
Interest payments
The originator retains CAST 1999-1’s interest payments. For economical
reasons most of the amount should however be used to
pay the interest on the notes. But there is no legal commitment
as to how the generated money should be allocated. In short, the
CLNs are unconditional obligations of the bank.
The interest payments of CORE 1999-1’s reference pool are retained
by the SPV to pay the participants according to the waterfall.
51

Motivations
The objectives of the originator determine the choice of structure.The
main motivations for conventional securitisation of the bank
are transfer of credit risk and assets, funding and regulatory arbitrage.
The motives behind synthetic securitisation are mainly the
transfer of credit risk and regulatory arbitrage. In short, if the sole
purpose of a bank is to free up regulatory capital and to transfer
credit risk exposure to the capital market synthetic securitisation
becomes more attractive. However, if funding is a relevant factor,
the bank should take into consideration a conventional CLO as the
required spread on asset-backed notes is less compared to CLNs.
Table 8 presents a brief summary of some of the differences between
synthetic and conventional securitisation.
Table 8: Differences between synthetic and conventional
securitisation
Conventional Synthetic
Securitisation Securitisation
Credit line management Yes Yes
Regulatory capital management Yes Yes
Reduction in balance sheet size Yes No
Credit risk protection cost* High Low
Low transaction cost* No Yes
Funding cost Low High
Transfer of ownership Necessary Not necessary
Ease of execution Medium High
Administrative ease Medium High
Flexibility
* Not included in the original table
Source: Hermann Watzinger
Medium High
52

GERMAN TAX TREATMENT OF SYNTHETIC
SECURITISATION
Dr. Martin Böhringer
1. Introduction
The tax treatment of synthetic securitisations is not clearly established.
Since the tax authorities have not published comprehensive
guidance as of the date of this writing, a number of
issues are still open.Because synthetic securitisations employ credit
derivatives, the following describes in general terms the possible
tax treatment of credit derivatives and their influence on the
underlying’s tax regime (i.e., the receivables), if any. It is assumed
that both parties to the transaction are accrual method taxpayers.
2. Direct Synthetic Securitisation (Not Using an SPV)
Two categories of assets should be analysed, i.e. the securitised
receivables and the credit derivative on the originator level,as well
as the credit derivative on the investor level.The exact treatment
depends upon the specific credit derivative entered into.
2.1 General Issues
As a general rule, tax follows book.Thus, the accounting treatment
is normally decisive, unless specific tax rules dictate otherwise.
Since very few specific tax rules exist in the field of (credit) derivatives,
the accounting treatment will in general control.
53

Integration or separation
First, income derived from the underlying loans or receivables (in
general, interest income) should be treated as such under general
rules of tax accounting.This reasoning should not be modified
by the fact of entering into a credit derivative. Second, an issue
arises as to whether the underlying assets (i.e. the loans or receivables)
and the hedge (i.e. the credit derivative) should be valued
separately or if such positions should be integrated („Bewertungseinheit“).
From an accounting perspective, it would appear
that the taxpayer, under certain circumstances, may be permitted
to elect integration treatment, but would not be obligated to do
so.Although not entirely clear,the tax treatment should follow such
accounting treatment. Accordingly, the taxpayer should be permitted
to effectively elect integration treatment for tax purposes.
When integration treatment applies, in case of a decline in value
of the underlying assets due to credit events, such loss should not
be taken into account, since the credit derivative’s value should
increase by a corresponding amount.
On the other hand, if the underlying asset and the hedge are not
integrated, each item should be treated separately. The derivative
should in general be taxed as an open transaction, with the
exception of CLN, which should be characterised as contingent
debt instruments. The underlying asset should be treated according
to its nature under general rules of tax accounting.
Indirect taxes
Value Added Tax (VAT) and Insurance Premium Taxes („Versicherungssteuer“/IPT)
are the main categories of indirect taxes that
parties to a synthetic securitisation must be aware of.It would appear
that neither of these two main categories of taxes should
apply to transactions involving credit derivatives. First, with respect
to VAT, the tax authorities have held in a published ruling that
54

cash-settled financial derivatives should not fall within the scope
of the VAT statute. In any case, derivative transactions falling
within the scope of the VAT statute should nevertheless be taxfree
under such a statute. Second, with respect to insurance premium
taxes, it would appear that derivative transactions should
in general not be characterised as insurance in this respect.
Loss limitations on certain derivative instruments
Under a newly enacted statutory provision, losses on certain derivative
instruments (e.g.,futures,options,swaps) suffered by a taxpayer
may not be offset against other items of income, but may
only be offset against income resulting from similar derivative
transactions. Losses are defined for purposes of this provision as
the excess of items of deduction and loss over items of income
and gain from the relevant derivative instrument. Within certain
limits, such losses may be carried back and/or forward. The loss
carry-forward would not be limited in time.
However, the above limitation is not applicable if the derivative
instrument is entered into either (i) in the ordinary course of the
trade or business of a taxpayer qualifying as a bank or financial
institution, or (ii) in order to hedge the taxpayer’s ordinary business
activities.In the case of synthetic securitisations, the taxpayer
should in general be able to claim hedge treatment.
Transfer of tax ownership of the underlying
The issue is different for different categories of credit derivatives.
From a financial perspective,for example,a total return swap could
be analysed as a sale of the underlying loan portfolio by the protection
buyer to the protection seller and a repurchase of such
loan portfolio at the swap’s maturity. More specifically, the originator
(i.e.protection buyer) would deposit the purchase price with
the investor (i.e. protection seller), and the investor would pay interest
at a rate equal to the rate on a reference security in ex-
55

change for such deposit.At the swap’s maturity,the investor would
return the deposit to the originator, who in turn would use the
funds to buy back the loans at their current fair market value.
However, it does not appear that tax law follows the approach developed
by financial analysis. Tax ownership of assets is transferred
according to general criteria developed by the Courts and
the Service.In general,if all burdens and benefits of ownership are
transferred to another party, transfer of tax ownership will occur.
The originator is not required to continue to own the loan portfolio
and maintains its right of disposition. All the investor has is
a secured (or unsecured, depending on the case) creditor’s claim
to receive payments from the originator based on the economic
performance of such loans.The originator is in general under no
obligation to hold all or any portion of the existing loan portfolio,
and the investor in general has no right to obtain any or all of
such loans from the originator.The latter remains free to alter the
portfolio’s composition by entering into new loans or by selling
loans contained in the underlying portfolio, and is not required
to hand over any of these proceeds to the investor. In addition,
specifically with respect to securities, recent cases have held that
possession of the asset is a required element of tax ownership.
Thus, in general, no transfer of tax ownership should occur.
2.2. Tax Treatment of Specific Credit Derivatives
2.2.1 Originator Level
Total Return Swaps
Total return swaps should be treated analogous to interest rate
swaps. As a consequence, swap payments (including apprecia-
56

tion and depreciation payments) should be included in income
or deducted, as the case may be.
Credit Default Swaps
Such derivative instruments could be analysed as either guarantees
or options. It is at present not entirely clear which approach
the tax authorities will follow. Banking and accounting regulations
appear to characterise default swaps as options,and it is thus
not unlikely that the tax treatment will follow suit.However,a short
description of both alternatives will be given hereinafter.
If the default swap is analysed as an option, the originator should
be viewed as acquiring an intangible asset. The basis of such an
asset should be equal to the option premium paid to the investor.
Thus, no current deduction for the option premium is available.
Payments received under the default swap should be included
in income. Further tax consequences only arise upon the
sale exercise or lapse of such option.
If the default swap is analysed as a guarantee, the tax treatment
is somewhat different. Guarantees are similar to contingent obligations,insofar
as an obligation arises once a specified contingency
occurs (i.e. a credit event).Premiums paid under the swap should
be deductible, in the same manner as guarantee fees or similar
items of expense.However, the originator may only reflect a claim
against the investor when the credit event occurs.
Credit-Linked Notes
Because repayment of the note’s principal is contingent upon the
occurrence of a specified credit event, the originator should treat
the note as a contingent debt instrument.The note should probably
not be segregated into a ‘straight’ debt instrument and an
option component. Interest paid on such note should be deductible
under the general rules.In particular, an option premium will
be factored in the interest rate applicable to such a note. How-
57

ever, since the note should not be bifurcated, interest payments
should not be recharacterised in part as an option premium and
should remain fully deductible. If the repayment is made at a
value less than the nominal amount of the credit-linked note, the
resulting gain would be included in income. In general such gain
would offset the loss realised on the underlying asset.
2.2.2 Investor Level
Tax consequences will depend upon the specific derivative, which
the investor has entered into, as well as on the investor’s tax status
as resident or non-resident.
Total Return Swaps
Swaps are generally treated as open transactions. However, swap
payments should be included in income or deducted, as the
case may be, under general rules of tax accounting.This holds true
for both current swap payments and depreciation or appreciation
payments.The character of such payments should be viewed
as genuine, and thus not as payments of interest.
If the investor’s position under the swap turns negative, accounting
rules provide for the setting up of a loss reserve. However, a
specific tax rule prohibits the setting up of such a loss reserve for
tax purposes.
In case of a non-resident investor, no withholding tax on payments
under the swap should be levied. Because genuine payments
should not fall within any withholding provisions of domestic
law, there should be no withholding tax charge, even absent
treaty protection. In addition, if a tax treaty based upon the
OECD model treaty with the investor’s country of residence exists,
treaty relief should be available under art. 21 of the OECD model
treaty (other income).
58

Credit Default Swaps
As stated above, the default swap may be analysed as either an
option or a guarantee.
First, in the case of option treatment, any option premium received
by the investor, at least under the tax authorities’ analysis,
should be immediately taxable.Payments made under the default
swap should constitute items of ordinary business expense. In
case of a non-resident investor,however,no withholding tax should
be levied on such option premium.
Second, in case of guarantee treatment, the main issue appears to
be at which point in time the investor may accrue a liability or set
up a loss reserve. Under general rules of accounting (and tax accounting),the
investor should accrue a liability when the credit event
occurs. However, a loss reserve should be set up if there is a reasonable
likelihood of such a credit event occurring.Although not entirely
clear, it would appear that such a loss reserve should be deductible
for tax purposes,since it reflects a future liability,as opposed
to an impending loss from an open transaction. In addition, payments
received under the default swap, that is, guarantee fees under
this analysis, should not be subject to withholding tax.
Credit-Linked Notes
As discussed above, under German GAAP, it appears that such
notes should be segregated into two components,i.e.‘straight’debt
and an optional element in the form of a default swap.It is at present
unclear whether the bifurcation approach is followed by tax
rules.In general, tax rules tend rather to employ an integration approach.This
latter approach has been codified in the field of cash
method taxpayers,and it would not appear that the analysis should
be different for accrual method taxpayers. However, this issue is
currently under discussion, and it does not appear that a definite
answer can be given.
59

As a result, it would appear that credit-linked notes should be characterised
as contingent debt instruments. Such instruments
should, as a general rule, be treated analogous to “straight” debt
instruments. A write-down of the asset (i.e. the note) is only permitted
to the extent that the depreciation is probably permanent.
An investor should be able to make an argument in favour of the
permanent character of the decline in value if the note may only
be sold or exchanged at a value less than its nominal amount
at the end of the taxable year.
Because payments on credit-linked notes should be characterised
as interest, such payments should be subject to withholding
tax under domestic law, if such interest is paid or accrued to resident
investors.
In the case of non-resident investors, interest payments by German
residents are generally not subject to withholding.However,
interest paid or accrued on certain complex debt instruments,such
as contingent notes, should also in general be subject to withholding
tax.Gains derived from the sale, exchange or redemption
of credit-linked notes should in general trigger withholding tax,
since such gains are recharacterised as interest for withholding
tax purposes.
However, under most German treaties, Germany is not permitted
to levy withholding tax on payments of interest or on capital gains.
3. Synthetic Securitisation Using an SPV
The use of an SPV generally occurs in the context of conventional
asset securitisations, where such an SPV acquires the receivables
and issues notes to investors. While its use is certainly
possible in synthetic securitisations, it is definitely less widespread
for a variety of reasons.
60

First, as regards traditional asset securitisations, - nonofficial - announcements
of the tax authorities to treat the SPV as having its
place of management and control in Germany and thus a resident
taxpayer have caused a great deal of uncertainty in the marketplace.
The tax authorities appear to reason that because the originator
continues to service the receivables and the SPV in general
has no staff to perform such duties, these activities should
somewhat be imputed to the SPV, which would as a result be managed
and controlled in Germany. It is at current unclear whether
this view will prevail within the tax authorities, and no official
pronouncement has been made to date.
While this should generally not cause concerns from a corporate
tax perspective, the trade tax implications are not to be underestimated.
In effect, from a corporate tax perspective, the SPV
should have little taxable income, if any, since interest expense on
the notes issued to investors should approximately match interest
income on the underlying receivables. However, for trade tax
purposes,only 50% of the interest expense on so-called long-term
debt (i.e., with a maturity in excess of one year) is deductible.
Second, in the case of synthetic securitisations, the existence of
an SPV as such has no influence on the tax treatment of credit derivatives.
As a general rule, in contrast to traditional securitisations,
the SPV does not purchase receivables from the originator,
but rather serves as the counterparty to the credit derivative. Additionally,
the SPV may hold collateral to secure its obligations under
the derivative, but in general no servicing of receivables occurs.
It appears thus less likely than in the case of traditional asset
securitisations that the SPV should be viewed as managed and
controlled in Germany.
However, certain additional tax issues may arise. Because the SPV
will most likely be established in a jurisdiction with a favourable
tax regime, issues such as German CFC legislation or foreign fund
61

legislation may have to be dealt with. Further, withholding tax
issues on payments from Germany to the SPV (in general, payments
under the derivative), as well as on payments from the SPV
to the investors need to be addressed. Finally, it is important to
ensure that no entity level tax on the SPV’s income arises. In that
respect, the SPV should in general either benefit from a favourable
tax regime or at least be able to deduct payments made to
its noteholders in determining taxable income.
62

REGULATORY ENVIRONMENT
Dr. Martin Böhringer, Ulrich Lotz, Christian Solbach
1. Basle I
The 1988 Basle Accord on capital adequacy, which became effective
in 1993, was one of the main reasons for the sharp rise in
securitisation. The motivation for this Accord was to strengthen
the international banking system and to create a level playing field
among international banks. In order to achieve this, the Accord
required a minimum 8% ratio of capital to risk weighted credit exposures,the
regulatory capital.Capital constitutes of Tier One 16 and
Tier Two 17 capital. However, the required capital had to consist of
at least 50% of Tier One capital.
By placing the assets in different categories according to their risk
the Bank of International Settlement (BIS) tried to derive a sound
capital adequacy framework. There are five categories, which
range from 0% to 100% (see Appendix B). For instance, residential
mortgages carry a 50% weight and claims on the private sector (excluding
banks) carry a 100% weight irrespective of their credit rating.
‘Basle’s crude measures of classifying risk meant that banks had
to put aside less capital against a loan made to the government
of a banana republic than to a blue-chip company like General
Electric. Equally, lending to a company with a just-less-than-topnotch
credit rating required no more capital to be set aside than
a loan to a near-junk-status firm’ 18 .
16 Tier One Capital consits of equity capital, disclosed reserves and non-cumulative
17 Tier Two Capital consits of undisclosed reserves, revaluation reserves, general provisions/general
loan loss reserves, hybrid dept capital instruments and subordinated term dept (the latter is limited
to 50% of Tier Two Capital)
18 th The Economist, Stronger foundations, January 18 , 2001
63

According to Thomas Fischer, group risk officer and treasurer at
Deutsche Bank, having a large balance sheet simply doesn’t pay,
because the cost of capital required to set aside against corporate
loans is too expensive.
By securitising corporate loans (100% risk weight) through a true
sale the bank receives cash (0% risk weight) and as a result reduces
the regulatory capital required. This process is sometimes called
regulatory arbitrage.
2. German Regulatory Treatment
In Germany, essential features of Basle I have been transformed
into domestic law.The German Banking Act („Kreditwesengesetz,
KWG“), as well as regulations issued under such a statute („Grundsatz
I“) contains detailed rules designed to provide guidelines for
capital adequacy for banks and financial institutions.The German
banking supervisory authority („Bundesaufsichtsamt für das Kreditwesen,
BAKred“) is authorised to provide further guidance by
means of rulings and is also prepared to deal with individual letter
ruling requests.
While no regulatory framework on point dealing with synthetic
securitisations has been developed to date, the BAKred has
issued two rulings of interest in this context. These rulings deal
with regulatory capital aspects of (i) conventional securitisation
transactions (issued in 1997), and (ii) credit derivatives (issued in
1999). Because synthetic securitisations may be viewed as combining
elements of both conventional securitisations and the use
of credit derivatives, both of these rulings should be combined
in order to depict the currently applicable regulatory treatment
to synthetic securitisations.
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2.1. Conventional Securitisation
In a ruling dated May 20, 1997 (Ruling 4/97), the BAKred has laid
down criteria applicable to conventional securitisation. The purpose
of the ruling is to provide banks and certain financial institutions
with reliable guidelines for the structuring of asset-bakked
securities (ABS) transactions. Prior to the publication of the
ruling, there was uncertainty as to whether and to what extent
the securitisation of bank assets provided a possibility to exclude
such securitised assets for purposes of determining regulatory
capital requirements under the capital adequacy rules.
In order to achieve off-balance-sheet financing, a sale of receivables
must qualify as a true sale. Only when the receivables are
effectively sold, this goal will be achieved. An effective sale is defined
in this context as the elimination of credit risk with respect
to the sold receivables.The ruling describes several conditions to
be complied with for true sale treatment.
First and foremost, there should be no recourse against the originator
other than recourse based upon liability for the legal existence
of such securitised receivables or violation of the selection
criteria.
In addition, a number of other requirements will have to be met.
For example, clean-up calls, which are often a matter of economic
necessity, are permissible within certain limits.More precisely, less
than 10% of the transferred receivables may be repurchased at
the term of the transaction, at the market value of such receivables.
With respect to credit enhancements and financing provided to
the SPV,the ruling requires originators to observe a number of restrictions,
such as limits to overcollaterialisation and similar
issues. However, provision of short-term liquidity facilities for the
SPV is permissible.
65

Two additional important conditions are worthwhile mentioning.
First, the originator should not engage in cherry-picking, i.e. the
selection process of loans to be securitised should be guided by
the principle of a minimum diversification, such as to avoid securitising
(almost) exclusively “good” or “bad” loans. Thus, the selection
of receivables must be made on a random basis. BAKred
retains the right to impose certain restrictions. Second, no moral
recourse obligations for the originator should arise. BAKred appears
to reason that, in this case, no complete transfer of economic
risk of the underlying receivables would be achieved, since
the originator, although not legally required to do so, but due to
market pressure, would almost certainly step in should a decrease
in value of the securitised receivables occur. BAKred is
likely to give more consideration to this issue in the future.
2.2 Credit Derivatives
Given the increasing use of credit derivatives in the international
financial markets, German market participants felt a need for published
guidance from the regulatory authorities. Although the
regulations under the banking supervisory law have not been modified,
BAKred’s ruling 10/99 (June 16, 1999) responds to that need
and describes in some detail the conditions under which regulatory
capital relief through the use of credit derivatives may be obtained,
as well as implications of the use of credit derivatives with
respect to certain reporting and other issues („Groß- und Millionenkreditvorschriften“).
The ruling deals only with the most
widespread credit derivatives in the German marketplace i.e. total
return swaps, credit default swaps and credit-linked notes.The
regulatory treatment of other credit derivatives,such as credit spread
products, will be handled by BAKred on a case-by-case
basis.
66

Regulatory capital treatment of credit derivatives depends upon
the specific portfolio the derivative is entered into. More specifically,
a distinction between a trading book and bank book is
made, and the impact of credit derivatives on protected underlying
asset in both books, as well as regulatory treatment of the
credit derivative itself, is considered.
As a general rule, regulatory capital relief for a given asset is granted
once a complete transfer of credit risk by means of a credit
derivative has been achieved. In other words, regulatory capital
relief is only granted for perfect micro hedges. Certain documentation
requirements will have to be observed, and no major
maturity mismatch between reference asset and derivative must
occur (with the exception of certain maturity mismatches of a maximum
of one year). An overview of international regulations for
credit derivatives is presented in Appendix A.
Overall, the regulatory treatment can be described as a substitution
of the specific risk weighting of a given debtor in exchange
for the specific risk weighting of the counterparty to the derivative.
If such counterparty is low-weighted (for example an OECD
bank) or has adequately collateralised its obligations under the
derivative, regulatory capital relief will be achieved. If no transfer
of risk is achieved, the protection buyer will have to provide regulatory
capital for both the underlying and the derivative, according
to the rules applying to each category of financial instruments.
For the protection seller, the transferred loans are subject to the
reporting obligations required by the KWG (“Groß- und Millionenkreditvorschriften”).
In the case of transferring the risk of a
loan portfolio, it may be difficult to meet such reporting obligations
due to two reasons: (a) the single loans within the portfolio
are usually not fully disclosed to the protection seller, and (b)
there may be a less-than-100%-protection.To evaluate the risk of
67

misreporting it should be considered whether the maximum loan
amount and/or the average loan amount within the portfolio
exceed the amount for reportable large exposures according to
sec. 13, 13a, 14 KWG. Currently, uncertainties have to be discussed
with BAKred on a case-by-case basis.BAKred indicated the intention
to issue a general ruling on this problem,which also should
comprise an actual statement according to new developments of
the securitisation market.
Currently, credit-linked notes appear to be the most favoured credit
derivative in the marketplace.The reason for this is that a risk
weighting of 0% generally applies, since the protection seller (i.e.
the holder of the note) has posted cash collateral to secure his obligations
under the derivative at the issuance of such note.
2.3 Impact on Synthetic Securitisation
As synthetic securitisations are generally done by employing a credit
derivative, it appears that the regulatory treatment of credit
derivatives, as laid down in the above ruling, should be given considerable
weight.However,this should be combined with the main
features of conventional asset securitisations, specifically when an
SPV is used.Thus, in general, capital requirements for the first loss
piece will be on a one-to-one basis. Further, no moral recourse
against the originating bank should be permitted.
3. Basle II Proposal
‘In view of the vast developments that have occurred in financial
markets since the introduction of the 1988 Basle Accord
(Basle I), the Committee recognises the importance in developing
a comprehensive capital framework for asset securitisation, in-
68

cluding traditional forms as well as synthetic forms of securitisation’
19 .‘New Proposal for regulating banks are both a step in the
right direction and evidence of how hard it is to monitor the riskiness
of the banking system’ 20 .
Until the final publication at the end of 2001 (planned) it is very
likely that further changes will be made. The New Proposal will
replace the Basle I risk weightings. These try to establish a more
accurate correlation between the real risk and the capital weighting
required as illustrated in the following table.
Table 9: Basle II – Draft 2 (16 January 01)
AAA to AA A+ to A- BBB+ to BBB- BB+ to BB- Below BB- Unrated
ABS Current 100% 100% 100% 100% deducted from Capital
Proposed 20% 50% 100% 150% deducted from Capital
AAA to AA A+ to A- BBB+ to BBB- BB+ to BB- Below BB- Unrated
Sovereigns (OECD) Current 0% 0% 0% 0% 0% 0%
Proposed 0% 20% 50% 100% 150% 100%
Banks (incorporated Current 20% 20% 20% 20% 20% 20%
in OECD countries) Proposed 20% 50% 100% 2 100% 150% 100% 2
50% 3 50% 3
Non-central gover- Current 20% 20% 20% 20% 20% 20%
ment public sector Proposed 20% 50% 100% 100% 150% 100%
entities (OECD) 1 50% 50%
Corporates Current 100% 100% 100% 100% 100% 100%
Proposed 20% 50% 100% 100% 150% 100%
(to BB-) (below BB-)
1 – Exceptions are Belgium, Denmark, Finland, Luxembourg, Netherlands, Austria, Sweden and Spain.
2 – Option 1 of new proposal: risk weighting is based sovereign in which bank is incorporated
3 – Option II of new proposal: risk weighting is based on the assessment of the individual bank.
Source: Basle, DKWR
19 Basle Committee on Banking Supervision, Consultative Document Asset Securitisation, January
2001, p. 1
20 th The Economist, Stronger foundations, January 18 , 2001
69

The salient element of the New Proposal is to develop a system
that is capable of measuring the actual level of risk of a bank. To
accomplish this the New Proposal is based on three pillars: minimum
capital requirement, supervisory review process and market
discipline.
The Proposal addresses three risks: credit, market and operational
risk. Therefore, the new formula for the capital adequacy
ratio (8%) is:
total capital/(market risk + credit risk + operational risk).
The methodology for measuring credit risk has changed.The New
Proposal emphasises internal (internal measurement approach,
based on internal ratings) over external (standardised approach,
based on external ratings) risk assessment approach.
There are two internal approaches: the foundation IRB approach
and the advanced IRB approach. Banks with more sophisticated
risk weighting systems will be allowed to use the advanced IRB
approach.The main difference between these two approaches is
the calculation of the loss probability in the event of default. Regulators
will provide the loss probability for banks using the
foundation IRB approach whereas the advanced IRB approach allows
banks to calculate the loss probability themselves.However,
in both approaches the banks use their own assessments to calculate
the probability of default.‘The aim will be for all banks to
work their way up the ladder to reach the advanced IRB approach’
21 .
Further the New Proposal distinguishes between the different
roles (investor, liquidity provider, originator, sponsor and credit enhancer)
a bank can play in a synthetic and a conventional securitisation
transaction.Although the New Proposal suggests various
21 ISR March 2001, Enter the regulator, p. 54
70

changes for all roles, this chapter will concentrate solely on the
changes from an originator’s perspective for both conventional
and synthetic transactions.
First conventional securitisation:The New Proposal introduces the
clean break approach. It is very similar to the requirements of a
true sale. ‘The clean break approach establishes regulatory requirements
regarding the transfer of assets from the originating
bank and limits the roles that originating banks are permitted to
perform in an attempt to separate the seller legally and economically
from the securitised assets’ 22 .If these requirements are not
fulfilled the assets remain on the balance sheet.
Second synthetic securitisation: The BIS acknowledges the risks
created by synthetic securitisation transactions and the need to
assess them correctly. However, the Proposal still needs to be finalised.‘The
Committee intends to finalise its work on the capital
requirements and the operational requirements related to synthetic
securitisations in the near term. The operational requirements
would be in addition to those for credit risk mitigation,
which, given the nature of synthetic securitisations, are applicable
to these instruments’ 23 .’The proposals with regard to synthetics
are extremely unclear and will require a lot of input from
the industry’ 24 .
The New Proposal recognises the possibility that the originator
may provide implicit support/recourse (beyond any contractual
obligations) in case of credit deterioration. Possible implicit recourse
actions are: Exchanging performing for non-performing assets,
selling assets to an SPV at a discount from book value and
deferral of fee income.
22 Basle Committee on Banking Supervision, Consultative Document Asset Securitisation, January
2001, p. 2
23 Basle Committee on Banking Supervision, Consultative Document Asset Securitisation, January
2001, p. 16
24 Alexander Batchvarov, Merrill Lynch, ISR March 2001, p. 56
71

In order to prevent originators undertaking such actions the New
Proposal suggests the following punitive measures in case of implicit
support:
� All assets of a securitisation transaction, which obtained implicit
support, will be treated on balance.
� Subsequent implicit recourse occasions will lead to on balance
sheet treatment for all securitised assets.
� Public disclosure of the bank’s actions and the consequences
The effect of the New Proposal will depend largely on how the
different regulators will implement them.The market predicts the
following impacts:
� ‘The bank balance sheet market will slow down, but there will
still be other drivers for securitisation such as liquidity and diversification
of your investor base’ 25 .
� ‘The new Basle proposals have increased the uncertainty with
respect to synthetic transactions.We expect to see transactions
emerging which are short issues, or that incorporate a break
clause or call option, because of a possible negative outcome
from Basle 26 ’.
� According to Merrill Lynch, the anticipated changes under the
new Basle accord are likely to temper the European bank CLO
landscape in terms of volumes, structures and underlying asset
types.
25 Iain Barbour, ISR March 2001, p. 55
26 Birgit Specht, ISR April 2001, p. 24
72

OUTLOOK AND CONCLUSION
Jochen Wentzler and Christian Solbach
What will happen to the securitisation market in the future?
There are several events that indicate a growth in the securitisation
market over the next few years.
The growing importance of the shareholder value concept is a central
factor for the further growth of both synthetic and conventional
securitisation as both are capable of increasing certain relevant
ratios.Jürgen Bilstein,a member of the CORE board of Deutsche
Bank, sees further securitisation as a key tool to improve
banks’ returns on their regulatory and economic capital.Deutsche
Bank has already begun homogenising their lending practices to
make securitisation easier and wants to create a capital market
for corporate debt in Europe, which remains dominated by bank
loans when compared with the US.
The Euro could be another factor that will help the European securitisation
market grow as it broadens the investor base eliminating
currency and interest rate risk within EU countries. According
to market participants as currency and interest rate plays vanish,investors
may turn to the ABS market as a safe source of yield.
As risk management plays an even more salient role, conventional
and synthetic CLOs could be used as an effective credit risk
management tool.Both structures are capable of transferring credit
risk to the capital markets. If a bank’s sole purpose is to transfer
credit risk exposure to the capital markets synthetic securitisation
could be a more attractive alternative.
For investors securitisation is also a very efficient instrument in
order to manage their asset portfolios.They can invest in reference
73

assets, to which they have no direct access, or they can manage
their credit risk and yield structure by buying very specific tranches
of asset-backed or credit-linked notes.
The New Proposal could have different impacts on the securitisation
market:
� First, most of the transaction have a termination clause to
avoid a negative impact under the new rules. If the originator
is able to set up an internal rating procedure under the New Proposal,
which generates a portfolio with a high credit rating, it is
very likely that the transaction will be terminated.
� Second, the new rules could constrain a bank to transfer credit
risk into the market to ensure its capability to generate new
business.
� Third, some investors have to invest in asset-backed or creditlinked
notes,since they have no other access to asset classes with
a comparable rating.
International market participants have the following expectation
of the securitisation market:
� ‘2001 should see more spread differentiation between asset
types and at the lower end of the credit spectrum, as asset quality,
in particular of European corporates, is threatening to deteriorate.
We believe that ABS will continue to be a safe haven
with selection being the key’ 27 .
� ‘For banks, however, whose primary goal is capital relief securitisation
may diminish in importance, and in particular for
those banks, which can apply sophisticated internal ratings approach
to size their capital needs.Conversely,banks without such
capabilities would continue to rely on securitisation techniques 28 ’.
27 Dresdner Bank, Securitisation market overview 200, p. 1
28 Merrill Lynch, The Basle Committee ’Strikes Back’, January 2001, p. 9
74

� ‘Synthetic structures should dominate the market going forward
and European bank CLO to slow moderately in 2001, continuing
a trend that began some three years ago. 29
The expectations for the German market are as follows.
� ‘Growth is expected to be strong in 2001, with new entrants to
the market, especially among the mortgage banks’ 30 .
� ‘We are expecting the securitisation market to show strong
growth this year, especially as banks are now focusing on return
on equity’ 31 .
� ‘The focus this year could be the securitisation of real estate portfolios,
especially as the banks are focusing on becoming more
capital efficient 32 ’.
� ‘The programme to securitise loans to German small mediumsized
enterprises launched by Kreditanstalt fuer Wiederaufbau
(KfW) will also push transaction volumes. 33 ’
� ‘The innovation in 2001 will be the evolution in synthetic structures,
and discovering the opportunities that synthetic structures
present. 34 ’
� ‘We will see more synthetic RMBS, CMBS, and CLO transactions.
We will also see more corporate transactions, possibly from midsize
corporates, though it is more than likely that they will go
through the conduit route. 35 ’
29 Merrill Lynch, Cash and Synthetic European Bank CLOs, November 2000, p. 33
30 Francesca Murra, ISR, Market promises, April 2001, p. 23
31 Dr. Robert Grassinger, ISR April 2001, p. 23
32 Jack Asher, ISR April 2001, p. 23
33 Stefan Bund, ISR April 2001, p. 23
34 Torsten Althaus, ISR April 2001, p. 24
35 Klaus Distler, ISR April 2001, p. 26
75

� ‘The complexity of the transactions will increase, especially with
deals in the telecom and utilities sector, which will be looking
at securitisation as a way to lower their overall cost of debt. 36 ’
Conventional securitisation of corporate loans has only emerged
as an important asset class over the past five years. Synthetic securitisation
of corporate loans has developed in even less time.
However, in spite of their short life span so far both structures
have seen rapid growth.
There is a growing need for banks to examine new financial tools
to generate a higher return on equity in order to satisfy
shareholders’objectives.Synthetic and conventional securitisation
are capable of achieving this and have additional benefits: freeing
up regulatory capital, transferring credit risk exposure, improvement
of the risk adjusted performance and credit limit management.
Both securitisation methods differ in various points, the principal
ones being asset transfer and funding.Conventional CLOs are fully
funded whereas the most common synthetic CLO structure is
only partly funded.Furthermore, conventional securitisation provides
cheaper funding because asset-backed notes carry a lower
spread than new products as structured credit derivatives.
The bank’s decision whether to engage in a synthetic or a conventional
structure to securitise corporate loans or assets depends
largely on the bank’s motivation. For instance, whether the interests
of the bank are centred primarily on funding or alternatively
freeing up regulatory capital.
There are various factors that could influence the further development
of the securitisation market. These include the shareholder
value concept, the Euro, risk management and the New BIS
36 Jack Asher, ISR April 2001, p. 26
76

Proposal. Although these factors could have either a negative or
a positive impact on the development of the securitisation market
it is more likely that they will have a beneficial effect.
To conclude, the securitisation market has seen rapid growth in
recent years with both synthetic and conventional structures currently
having a strong market presence. However, as the market
becomes more familiar with the newer synthetic structures the
spread gap may narrow. This in turn could lead to even more
issues carried out using synthetic structures. As a result, it is likely
that the ratio of conventional and synthetic structures will alter
in favour of synthetic structures.
77

APPENDIX A
Summary of International Bank Regulations for
Credit Derivatives
Banking Book Canada France Germany UK US
Capital Relief Yes, if similar to Yes, if similar to Yes, if similar to Yes, if similar to Yes, if similar to
OECD guarantee OECD guarantee OECD guarantee OECD guarantee OECD guarantee
Maturity mismatch No mismatch Mismatch gets Mismatch OK No mismatch Mismatch OK
allowed 70 % RW for total return
swap but not
default swap
allowed
Reference asset OK if same OK if same OK if same OK if same OK if same
mismatch obligor and obligor and obligor and obligor and obligor and
Trading Book
seniority seniority seniority seniority seniority
Eligibility Not addressed Security and Only security Security and Security and
loan reference reference assets loan reference loan reference
assets OK if OK if credit assets OK if assets OK if
credit derivative derivative credit derivative credit derivative
tradable tradable tradable tradable
Offsets Not addressed Perfect offsets Perfect offsets Perfect and Perfect and
only recognised only recognised partial offsets partial offsets
recognised recognised
Counterparty Risk Add-on Risk
Guarantor
Investment grade N/A Interest rate Equity Interest rate Equity
Noninvest. grade
Beneficiary
N/A Equity Equity Equity Commodity
Investment grade N/A Equity Equity Interest rate Interest rate
Noninvest.grade
Baskets
N/A Commodity Equity Equity Equity
Guarantor Direct credit Direct credit Not addressed Direct credit Direct credit
substitute; substitute substitute; substitute;
Notional = Notional unclear Notional = loss Notional =
loss exposure exposure for
investment grade
asset & sum of
assets for subinv.
grade assets
loss exposure
RW based on RW is weighted RW same as RW same as
highest RW asset average of assets highest RW highest RW
in basket asset asset
Beneficiary Smallest & N/A N/A Can choose Smallest &
lowest RW asset asset that lowest RW asset
N/A – Not Addressed
RW – Risk Weighting
receives relief receives relief receives relief
Source: Deutsche Bank Research
78

Appendix B
Risk weights by category of on-balance-sheet asset
0% (a) Cash 37
(b) Claims on central governments and central
banks denominated in national currency and
funded in that currency
(c) Other claims on OECD 38 central governments 39
and central banks
(d) Claims collateralised by cash of OECD central government
securities 39 or guaranteed by OECD
central governments 40
0,10,20 % or Claims on domestic public-sector entities, exclu-
50% (at natio- ding central government, and loans guarannal
discretion) teed 40 by such entities
20% (a) Claims on multilateral development banks (IBRD,
IADB, AsDB, AfDB, EIB) 41 and claims guaranteed
by, or collateralised by securities issued by such
banks 40
37 Includes (at national discretion) gold bullion held in own vaults or on allocated basis to the
extent backed by bullion liabilities.
38 For the purpose of this exercise, the OECD group comprises countries which are full members of
the OECD or which have concluded special lending arrangements with the IMF associated with
the Fund’s General Arrangements to Borrow.
39 Some member countries intend to apply weights to securities issued by OECD central
governments to take account of investment risk. These weights would, for example, be 10% for all
securities or 10% for those maturing in up to one year and 20% for those maturing in over one
year.
40 Commercial loans partially guaranteed by these bodies will attract equivalent low weights on
that part of the loan which is fully covered. Similarly, loans partially collateralised by cash or securities
issued by OECD central governments and multilateral development banks will attract low
weights on that part of the loan which is fully covered.
41 Claims on other multilateral development banks in which G-10 countries are shareholding members
may, at national discretion, also attract a 20% weight.
79

(b) Claims on banks incorporated in the OECD and
loans guaranteed 40 by OECD Incorporated banks
(c) Claims on banks incorporated in countries outside
the OECD with a residual maturity of up to
one year and loans with a residual maturity of up
to one year guaranteed by banks incorporated
in countries outside the OECD
(d) Claims on non-domestic OECD public sector entities,
excluding central government, and loans
guaranteed 40 by such entities
(e) Cash items in process of allocation
50% (a) Loans fully secured by mortgage on residential
property that is or will be occupied by the borrower
or that is rented
100% (a) Claims on the private sector
(b) Claims on banks incorporated outside the OECD
with a residual maturity of over one year
(c) Claims on central governments outside the
OECD (unless denominated in national currency
– and funded in that currency – see above)
(d) Claims on commercial companies owned by the
public sector
(e) Premises, plant and equipment and other fixed
assets
(f ) Real estate and other investments (including
non-consolidated investment participations in
other companies)
(g) Capital instruments issued by other banks (unless
deducted from capital)
(h) All other assets
80

LIST OF FIGURES
Figure 1: New European ABS Note issuance and total securitisation
Figure 2: New issuance in 2000 (by originator type)
Figure 3: Types of asset securitisation
Figure 4: Asset type distribution in 2000 (all currencies)
Figure 5: US vs. European ABS issuance
Figure 6: German term structured finance market since 1995
Figure 7: Conventional CLO structure
Figure 8: Management of the Capital Ratio
Figure 9: Outstanding volume of Credit Derivatives (in bn)
Figure 10: Credit Default Swap
Figure 11: Credit-Linked Note
Figure 12: Synthetic CLO structure including an SPV
Figure 13: Synthetic CLO structure excluding an SPV
Figure 14: Example of Regulatory Capital Relief
Figure 15: CORE 1999-1
Figure 16: CAST 1999-1
81

LIST OF TABLES
Table 1: Illustration of the Benefits of Issuing CLOs
Table 2: Example of CLOs in facilitating a higher RAROC on
investment-grade Assets
Table 3: Market share of credit derivatives
Table 4: CORE 1999-1, Asset-backed Notes
Table 5: CORE 1999-1, Rating of the Notes
Table 6: CAST 1999-1, Credit-Linked Notes
Table 7: CAST 1999-1, Rating of the Notes
Table 8: Differences between synthetic and conventional
securitisation
Table 9: Basle II – Draft 2 (16 January 01)
82

INDEX
Advanced IRB Approach 70
Advantages 30
– Conventional CLO 15
– Protection buyer/synthetic CLO 30
Asset-Backed Securitisation 3
– Documentation 21, 32
– History 3
– Types 7
Asset-Backed Commercial Paper Programs (ABCP) 8
BAKred 64, 65, 66
– Credit Derivatives 66
Balance Sheet Characteristics 20
Bank of International Settlement (BIS) 63, 71
Basle Accord 63
– Basle 1988 63
Capital Adequacy 63
Capital Ratio 16
Cash Collateral Account 43
CAST 1999-1 40
Clean break approach 71
Clean-up calls 65
Collateral 10, 27, 61, 68
– Pfandbriefe 28, 42, 46, 50
Collateral Bond Obligation (CBO) 6
Collateral Debt Obligation (CDO) 6
Collateral Loan Obligation (CLO) 2, 6, 7, 10, 11, 22, 33, 40
Conventional Securitisation 33, 52
CORE 1999-1 33
Costs 5, 17, 21, 23, 47, 52, 64
Credit Default Swap (CDS) 24, 57, 59
Credit Derivatives 22, 23, 53, 56, 66, 78
83

Credit Enhancements 13, 28, 35, 42, 50
– external 13
– internal 13
Credit Limit Management 20
Credit Linked Note (CLN) 25, 28, 32, 41, 46, 51, 54, 57, 59
Credit risks 1, 31, 76
Currency Exchange Agreement 14
Development of the ABS Market 3, 76
– in Europe 4
– in Germany 8
Direct Credit Substitution (DCS) 14
Disadvantages 32
– Conventional CLO 20
– Synthetic CLO 26, 32
Foundation IRB Approach
Funding Source 16, 36, 44
German Regulatory Issues 64
Guaranteed investment contracts (GIC) 13
Investor 12, 14, 25, 31, 34, 39, 58, 74
– Credit Risk 12
– Currency/Exchange Rate Risk 12
– Liquidity Risk 12
– Prepayment Risk 12
– Reinvestment Risk 12
Issuer 5, 28, 40, 43
– Junior Class 10
– Mezzanine Class 10
– Senior Class 10, 11
Letter of Credit 14
Moral Recourse 66, 68
Multiseller conduits 8
Overcollateralisation 13
Pass-through structures 14
84

Pay-through structures 14
Rating 16, 21, 28, 37, 45
Reference pool 11, 25, 32, 33, 36, 40, 44, 48
Regulatory Capital 1, 15, 26, 41, 47, 52, 63, 66, 76
Return on Equity (RoE) 17, 75
Risk Adjusted Performance 19, 76
Risk Management 20, 26, 42, 73, 76
Rule 144A 34, 39
Special Purpose Vehicle (SPV) 10, 50, 71
Standardised Approach 70
Synthetic Securitisation 60
Spread Account 13
Swap Arrangements 14, 35, 42
Tax Treatment 53
– Direct Synthetic Securitisation (not using an SPV) 47, 53
– Integration Treatment 54
– Synthetic Securitisation using an SPV 53
– Withholding Tax 58, 59, 60, 62
Tier One Capital 63
Tier Two Capital 63
Total Return Swaps 23, 55, 56, 58
Tranches 10, 13, 33, 38, 39, 46, 49, 74
True Sale 11, 31, 33, 44, 64, 71
Trustee 10, 29, 43
Yield Spread 13
85

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in the securitisation market, ISR, July 1999
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The securitization Conduit, Vol.1, No.2, 1998
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and its Proposal for Securitisations
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June 1999
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88

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CONTACTS
Deloitte & Touche
Securitisation Group
Bahnstraße 16
40212 Düsseldorf
Tel. +49 (0) 211-87 72-0
Fax +49 (0) 211-87 72-277
WP/StB Jochen Wentzler
Telephone: + 49 (0) 21 18 772-381
Email: jwentzler@deloitte.de
WP/StB/CPA Ulrich Lotz
Telephone: +49 (0) 21 18 772-375
Email: ulotz@deloitte.de
StB Dr. Martin Böhringer LL.M
Telephone: +49 (0) 21 18 772-532
Email: mboehringer@deloitte.de
MSc Christian Solbach
Telephone: +49 (0) 21 18 772-174
Email: csolbach@deloitte.de
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About Deloitte & Touche
We are one of the leading audit and consulting firms in Germany.
For more than 90 years, our clients have benefited from our
comprehensive and high-quality range of services. Our philosophy
that to deliver effective audit and consulting services requires
close cooperation with our clients is reflected by our 19 practice
offices. In line with our market position, we serve a representative
cross-section of German business covering every type
and size of enterprise and organisation in almost all industries.
Internationally, Deloitte Touche Tohmatsu employs around 92,000
people and operates in over 130 countries.
Deloitte & Touche Securitisation Group
Deloitte & Touche is one of the leading companies providing securitisation
services around the world. Deloitte practitioners
have worked on over 7.000 securitisation transactions.To meet all
the specific needs and expectations of our clients we have established
a global network of seasoned professionals in over 40
countries. In 1999 and 2000 Deloitte & Touche was awarded Best
Accounting Firm concerning securitisation for Europe and North
America by ISR (International Securitisation Report) and also best
accounting firm for Asia Pacific in 2000.
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The German securitisation group offers the following services to
manage strategic, tax, accounting and operational challenges of
asset securitisation:
� Due Diligence/Assurance
� Legal Services
� Tax Services
� IT-Systems/Cash Flow Modelling
� Structuring
� Trustee Services
� Tax Representative
We have been involved as advisor, auditor or trustee for banks, insurance
companies and corporates in numerous ABS-, CDO-, CP–
and synthetic transactions in the German market.
Using teams of chartered accountants (“Wirtschaftsprüfer”), tax
advisors, banking specialists, structured finance consultants, lawyers
as well as IT – specialists our German group provides the
full range of support of originators, arrangers and investors from
first planing and structuring until the final realisation of asset securitisations.
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