Financial institutions that originate loans (originators) - including banks, credit card providers, auto finance companies and consumer finance companies - turn their loans into marketable securities through a process known as securitisation .  The loan issuers are often known as the issuers of asset backed securities, but in fact they are sponsors, not the direct issuers of these securities.

The conceptual development of the ABS market dates back to the early 1970s when the United States Government National Mortgage Association ("Ginnie Mae") issued Ginnie Mae Pool No.1, which were securities backed by residential mortgages. In 1981 the Chrysler Financial Corporation faced with a deep recession in the domestic economy and unable to fund via the commercial paper market, issued its receivables in the form of securities. Since then the global public ABS market has risen to an estimated $584 billion in outstanding balances. This growth has been encouraged by the benefits that securitisation of financial assets brings to both issuers and investors. For issuers it offers cheaper and more efficient funding for operations combined with greater balance sheet flexibility. For investors, securitisation provides a broad selection of fixed income investment alternatives, most with higher credit ratings, less downgrade risk than corporate bonds and, more stable cash flows than other fixed income securities.

The United States is the largest ABS market in the world and generally leads the way in both transaction volume and technology. The market saw tremendous growth between 1986 and 1998 with a total value of some $1.2 trillion of paper issued in total.

Securitisation in Canada continues to experience significant growth. According to some sources outstanding asset-backed commercial paper grew from Can$41 billion at the end of 1998 to Can$53 billion at the end of 1999 - and represented almost half of all non-government Canadian short-term debt.  Outstanding term asset-backed securities (ABS) grew from C$8 billion to CS 13 billion, a record-breaking increase. All in all, Canadian ABS has increased at an annual rate of 56% since October 1997. As to mortgage-backed securities (MBS), 1999 saw an all time record of C$13 billion in new issuance, up 42% over the previous year. Outstanding MBS volume at year-end totalled C$28 billion, up from C$20 billion at the end of1998. The main players in Canadian securitisation markets are banks and trust companies.

ABS provide several benefits to Canadian users including access to relatively low cost funds, off-balance sheet treatment which improves accounting presentation and reduces capital tax, and access to more funding due to higher loan to value ratios than traditional finance. These benefits can also assist users who are in regulated industries in maintaining their regulatory capital without need for additional equity offerings. For  some markets, such as mortgage backed securities (‘MBS’), securitisation plays an important role in ensuring  liquidity for new mortgages. Banks and other financial institutions, which are the traditional sources of new  residential mortgages, achieve the ability to finance larger mortgage pools without having to increase their own portfolios. 

Before the assets, such as loan receivables, can be converted to securities it is necessary for the originator to get the asset “off balance sheet” by selling the receivables to a third party who will then repackage the asset as asset backed securities for sale on the capital markets.  The third party will usually be a company known as a special purpose vehicle (SPV) created specifically for the transaction.  In order to effect a valid sale and to avoid consolidation it is necessary that the originator does not own the SPV.  In order to secure tax and other advantages the SPV is often created offshore.  In the Cayman Islands SPV’s are normally owned by charitable trusts or purpose trusts specifically created in accordance with STAR trust legislation unique to the Cayman Islands.  Mind and management must also be separate from the originator and over the years a number of management companies in the Cayman Islands have developed special expertise in supplying management facilities to SPV’s including an autonomous board of directors if required.  In recent years the Cayman Islands have become the jurisdiction of choice for special purpose vehicles (‘SPVs’) established to facilitate asset backed securitisations. 

An important advantage to the investor is that since the underlying assets producing the income stream have been removed from the balance sheet of the originator the credit rating of the securities is no longer influenced by the credit rating of the originator, which may not have been at an investor acceptable level.  The security rating is based solely on the structure of the securitisation itself.  Apart from the rating of the underlying assets a key consideration is the jurisdiction in which the SPV is established.

Credit worthiness is rated by credit-rating agencies, dominated by two giants, Moody’s and Standard & Poor’s.  In effect, these companies rank others based on their chances of defaulting.  The highest quality rating is AAA, followed by AA, and so on. Rating below BBB is referred to as non-investment quality or junk bonds,  where non-investment means that certain institutional investors are not allowed by law to invest in these bonds. 

The SPV should be located in a jurisdiction which will not introduce any additional or excess tax cost to the transaction but there are a number of other significant considerations to be taken into account. The SPV will most probably be the issuer of the securities and therefore a key structural component.  It will therefore come under the scrutiny of the rating agencies, and its jurisdiction will provide a key consideration. 

The Cayman Islands are a dependency of the British Crown and its economy and government are stable.   There are no income taxes of any sort and there is an abundance of banking, legal, accounting and management expertise.  These attributes have contributed to many securities issued by Cayman SPVs receiving AAA ratings from Standard and Poors Rating Services Inc.
The structuring of a securitisation should not be either driven or hampered by local jurisdictional requirements. Relevant Cayman Islands law is permissive and supportive rather than dictatorial, and whilst the finance industry is closely regulated, the regulatory framework and policy recognise the need to accommodate the demands of the structure.

The Cayman Islands are the fifth largest banking centre in the world in terms of banking deposits and the fourth in relation to numbers of international banks registered there.  There are therefore a large number of banks, custodians and administrators well established in structured finance and the administration of SPVs. In many cases it is essential that the SPV can be demonstrated to stand alone and outside the control of the originator of securitised assets and that it operates and is centrally managed and controlled in the Cayman Islands. This would not be possible without an infrastructure of experienced company management firms who are able to supply the necessary experienced and qualified board of directors.
A special purpose vehicle can be established in the Cayman Islands as an ‘exempt’ company which will pay no income tax, corporate taxes, transfer, gains, value added or other taxes. The Cayman Islands tax regime is unique in that there never have been any taxes and therefore it is not necessary to isolate or ring-fence foreign investment from local enterprise.
There are no securities issuance or transfer taxes and duty on authorised share capital is minimal as are filing,  regulatory, registration fees and other statutory costs.

Theoretically, any asset that has a revenue stream can be transformed into a marketable debt security. In practical terms, however, the vast majority of ABS are collateralised by loans and other financial assets.

Home-Equity Loans now constitute the largest sector of the ABS market. Forty-two percent of the ABS issued in the first half of 1998 were backed by closed-end home-equity loans and open-end loans. Both types of loans enable homeowners to borrow against the non-mortgaged value of their homes, and often use these loans to consolidate all their debt into one monthly payment. 

Securities collateralised by credit card receivables are one of the oldest segments of the ABS market, representing 18.8% of ABS issuance in the first half of 1998. Until the last few years credit cards were the predominant sector of the ABS market. Holders of credit cards may borrow funds, generally on an unsecured basis up to an assigned limit, and pay the principal and interest as they wish, as long as they make a small required minimum payment on a regular basis -- generally once a month. Consumers may also borrow more money while paying off the old debt, if they do not exceed the credit limit. Because cardholders do not have to pay off the principal on a schedule, credit card debt has no actual maturity and is therefore a classic example of a non-amortising loan.

The third largest, and the oldest, asset class in the ABS market is auto loans.  Most auto ABS are supported by prime loans -- those made to borrowers with very strong credit histories. But some auto ABS are collateralised by loans to sub-prime (also called B, C and D) borrowers. 

Although a relatively small part of the ABS market , securities backed by loans for manufactured housing, or mobile homes, have been issued for over a  decade. 

Another comparatively small portion of the ABS market  is represented by securitisations of equipment leases for computers, telephone systems and other kinds of business equipment.  Equipment lessees are usually corporations, rather than individuals, and have good credit profiles.

Although boat and RV loans are different types of collateral, they nevertheless have certain common characteristics. Both are amortising loans for leisure items usually purchased by relatively affluent people with comparatively strong credit histories. The securities they collateralise currently represent only a very small part of the ABS market. 

There are several other emerging asset classes, including auto leases, small-business loans, short-term auto dealer inventory loans and trade receivables (particularly hospital receivables). 

A recent innovation is the securitisation of insurance risk.  Securitisation of insurance risks is essentially a re-packaging of insurance risks into capital  market transactions. As with all securitisations if assets can generate an income stream over a period of time, then they are capable of being securitised and sold to an investor in return for immediate payment of a capital sum. With securitisation,  risks are removed from the balance sheet. 

Nearly all insurance risk securitisation transactions have been carried out offshore11 in jurisdictions such as the Cayman Islands and are structured through SPVs.  In this case the SPV is specifically developed to isolate insurance risks and enable investors to buy this kind of risk isolated from all the other factors that can affect the profitability of an insurance portfolio. 

One new class that has made news recently is royalties payable to rock stars from a specified pool of their works. The first privately issued ABS of this kind  was a $55 million issue of bonds collateralised by royalties from a number  of albums by singer David Bowie.

Issuers and investment banks will  continue to search for -- and find -- new types of assets to securitise to meet the growing investor demand for ABS.  Similarly more and more of these securitisations will gravitate offshore11 to jurisdictions such as the Cayman Islands which have the necessary professional and financial infrastructure to service the desires of the industry for tax neutrality and an hospitable regulatory climate.

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International Management Services Ltd
P.O. Box 61, 
Harbour Centre
George Town, 
Grand Cayman, 
Cayman Islands 

Phone:  345 949 4244 
Fax:  345 949 8635 
Email: ims@candw.ky

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