Covered Debt Instruments

Abstract

“Modern capital markets financing is increasingly an act of faith. We rely on ratings, on the words of economists and pundits who quite often live in worlds completely disconnected with reality”. I believed I had cause for a rant… I had an argument with my bank’s portfolio manager. How much return was acceptable for a cash-backed loan that my client wanted? He expounded the LAW to me: Return requirements depend on ratings. [fair enough]. Ratings depend on the probability of default. [with you so far] and The Probability of default has nothing to do with the cash collateral. [huh!]. “It is 101 of banking – what’s your first way out? Cash flows? This is a weak company. So, there is a good chance they will default.” [True enough. But what about the cash?]. “We will give it credit under FSV – Forced Sale Value of collateral @ 95%…” and that was my own little Siddhartha moment… not the moment of startling clarity under the Bodhi tree… rather the moment when he walked out of the house in search of an answer to old age death and disease Banking lives in a complex world of formulae. Capital adequacy. Risk weight and Forced Sales Value for different types of collateral. It is gotten to the point where if your rating is below a certain investment grade, it does not matter what the causes are or what case you build. Financing costs will tend to be unviable. A cash-backed bond will not be AAA. True, these situations are rare. But a bond backed by AAA-rated collaterals? What about a bond backed by a pool of Commercial vehicle loans which if they had been securitized would have been AAA? What about loans backed by receivables of AAA-rated companies? What about a 2x cover on receivables of AA-rated companies?