Evolution of the Fixed Income Market
Finance 472: Trading & Markets
September 10, 2004
Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities in the United States.
Contents
Section
1
Unsecured Debt and Swap Market
2
Development of Mortgage and Asset Backed Securities
3
Issuer Case Study: Capital One
2
Unsecured Debt and Swap Market
Section 1
“Neither a borrower,
nor a lender be. . . ”
--Polonius, to his son Laertes, in Hamlet
4
What is Debt Capital Markets?
The bankers within
DCM focus principally
on the Liabilities
component of the
balance sheet. While
definitions can vary
by firm, at DB all of
the corporate-facing
debt originators and
risk marketers are
within DCM
n
Envision the corporate balance sheet. Specialist bankers are responsible for covering
each component of a corporate balance sheet. In addition to delivering their own
specialties, these bankers also work together to deliver multi-disciplinary solutions that
encompass more than one section of the balance sheet.
Assets
M&A and corporate
finance bankers
=
Liabilities + Shareholders’ Equity
Debt originators and
derivative marketers
Equity capital markets and corporate
finance bankers
n
The debt originators are responsible for underwriting transactions with their client base
in a broad range of currencies: USD, EUR, GBP, JPY and AUD, as well as smaller
ones.
n
The risk marketers -- all highly specialized -- focus separately on interest rate,
currency, commodity and credit risk
5
Key Players in the Origination, Sales and Trading
of Corporate Debt
The Capital Markets
process of matching
investors with issuers
requires intricate
coordination between
various parts of an
investment bank
Cash bond traders
Credit Trading
Credit
Research
Credit default swap traders
Debt originators
Issuers
DCM
Syndicate
Sales
Investors
Derivative marketers
Interest rate swap traders
Interest Rate Trading
Treasury traders
6
Treasury Yield Curve
Normal Curve
6%
5%
Flat Curve
4%
Yield
Yield Curve
Curve as
as of
of 9/7/04
9/7/04
33 month
month
66 month
month
11 year
year
22 year
year
33 year
year
55 year
year
10
10 year
year
30
year
30 year
3%
Inverted Curve
2%
1%
1.62%
1.62%
1.88%
1.88%
2.11%
2.11%
2.56%
2.56%
2.89%
2.89%
3.46%
3.46%
4.24%
4.24%
5.01%
5.01%
Steep Curve
0%
1yr
5yr
10yr
15yr
20yr
25yr
30yr
7
Treasury Yield Curve
Last 20 years
Interest rates have
fallen dramatically
over the last 20 years
The principal reason
for this secular
decline in rates has
been a precipitous
decline in inflation
In recent years a
decline to new low in
rates has been driven
by the 2001-2002
recession and
accommodating Fed
monetary policy
US Treasury Yield Curve
14%
Inverted yield curve
12%
Flat yield curve
10%
Steep yield curve
8%
6%
4%
2%
0%
1984
1986
1988
1990
1992
1994
1996
1998
2yr
2000
5yr
2002
10yr
2004
30yr
8
Credit Spreads Relative to Treasuries
High-quality
corporate bonds are
quoted as basis point
spreads to Treasuries.
The basis point
spreads equate to
incremental yield for
the greater credit risk
of a corporate bond
versus a Treasury
bond
10%
9%
8%
Capital One Fin.: Baa3/BB+ ( +130)
7%
6%
5%
Georgia Pacific:
Ba1/BB+ ( +158)
Ford: A3/BBB- ( +199)
Boeing: A3/A ( +65)
Capital One Fin.: Baa3/BB+ ( +85)
2%
Dow Chemical: A3/A- ( +126)
GlaxoSmithKline: Aa2/AA ( +69)
Comcast: Baa3/BBB ( +95)
3%
1%
GM: Baa1/BBB ( +229)
Xerox: Ba2/BB- ( +233)
4%
Corporate credit
spreads are
theoretically driven by
the probability of
default (failure by the
borrower to pay
principal or interest)
and the anticipated
recovery of principal
(as a % of par) if there
is a default
AT&T: Ba1/BB+ ( +281)
GECC: Aaa/AAA ( +52)
GECC: Aaa/AAA ( +34)
Disney: Baa1/BBB+ ( +45)
Comcast: Baa3/BBB ( +42)
0%
1yr
5yr
10yr
30yr
9
Corporate Credit Spreads
Closer Look
Corporate Yield = Treasury Yield + Corporate Spread (bps)
= Treasury Yield + (Amortization of implicit premium generated by
writing puts on the equity of the specific company)
n
Corporate bond investor accepts risks that equity cushion (SE = Assets minus
Liabilities) will decline or even become negative (leading to an event of default)
n
Equity volatility (both company-specific and in index form, as expressed by the VIX)
influences corporate spreads as well. Low volatility translates into low implicit option
premium and tight corporate spreads. Conversely, high volatility leads to high
premium and wide spreads.
n
Capital structure arbitrageurs look to profit from discrepancies in valuation of different
layers of a given company’s capital structure.
10
Historical Credit Spreads
Periods of low
volatility are typically
accompanied by small
spread increments for
differing levels of
credit risk
Stock market bubble bursts, economy
goes
recession,
frequency
Historical into
Credit
Spreadsdefault
Over 10yr
Treasuries
accelerates
2.5%
2.0%
Periods of high
volatility typically see
much greater spread
increments for the
same differences in
risk
1.5%
Spread Decompression
US economy
begins to
recover; assets
reflate
Russian debt
default/LTCM
Spread Compression
Asian crisis
1.0%
0.5%
0.0%
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
AA
2002
A
2003
2004
BBB
11
Historical Issuance Volume
Historical US Investment Grade and High Yield Issuance
Issuance volume has
multiplied as funding
cost became cheaper
800
14%
700
12%
600
10%
8%
400
6%
Inv. Grade (LHS)
300
High Yield (LHS)
200
4%
10y Treasury Note (RHS)
2004 YTD
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
0%
1987
-
1985
2%
1984
100
1986
$ Billions
500
Rates
Issuance Volume
12
Historical Default Rates
Global Corporate Bond Default Counts & Dollar Volumes, 1982-2003
$160
180
$140
Volume (US$ Billions)
After prolonged
periods of economic
growth, lax
underwriting
standards and/or
investor avarice can
exacerbate the
pressures of
economic weakness
200
$120
Volume (US$ Billions) (LHS)
Default Count (RHS)
Oops! Corporate
bonds actually do
carry principal risk!
160
140
120
$100
100
$80
80
$60
Default Counts
Recessions lead to
sharp increases in
default frequencies
$180
60
$40
40
$20
20
$0
0
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Source: Moody’s Investor Services
13
Historical Default Migration
Average One-Year Ratings Transition Matrix: 1920-2002
Default frequencies
for B and Caa-Ca
illustrate the term
“junk bond”
In bond market
parlance, an NCAA
champion is a bond
that defaults before
the first semi-annual
coupon is paid –
“no coupon at all”
Ratings From
Default migration
studies measure how
badly and how quickly
credit can deteriorate
Aaa
Aa
A
Baa
Ba
B
Caa-C
Aaa
88.37%
1.17%
0.07%
0.04%
0.01%
0.00%
0.00%
Aa
6.31%
86.99%
2.36%
0.25%
0.08%
0.04%
0.02%
A
0.96%
5.75%
86.09%
3.92%
0.42%
0.14%
0.03%
Ratings To:
Baa
Ba
0.20%
0.01%
0.63%
0.15%
4.78%
0.62%
82.66%
4.72%
4.76% 78.41%
0.56%
5.86%
0.32%
1.21%
B
0.00%
0.02%
0.10%
0.65%
5.38%
75.99%
4.59%
Caa-C
Default
0.00%
0.00%
0.00%
0.07%
0.02%
0.12%
0.09%
0.29%
0.50%
1.11%
3.22%
3.67%
71.72% 13.27%
WR
4.15%
5.21%
5.82%
7.38%
9.33%
10.52%
8.84%
Average Cumulative Credit Loss Rates from 1 – 5 years (1982 – 2003)
1yr
2yr
3yr
4yr
Aaa Aa 0.00%
0.03%
0.08%
A
0.01%
0.05%
0.14%
0.24%
Baa
0.15%
0.40%
0.69%
1.13%
Ba
0.88%
2.50%
4.49%
6.56%
B
4.19%
9.75% 15.12% 20.37%
Caa-Ca 17.14% 30.91% 44.84% 55.91%
5yr
0.03%
0.14%
0.34%
1.55%
8.59%
25.27%
66.80%
Source: Moody’s Investor Services
14
Corporate Debt Issuance—Sellers (“Issuers”)
Autos
1% TMT
5%
Other
2%
Consumer/Retail
3%
Examples
Energy/Power
13%
Healthcare
5%
Financial
63%
Industrial
8%
Financials
Domestic
Bank
25%
Foreign Bank
9%
Specialty
Finance
9%
Insurance
10%
Captive
Finance
12%
Broker/Dealer
22%
REIT
13%
Auto (Captive Finance)
Ford Motor Co.
General Motors
American Honda
Telecom/Media/Technology
AT&T
Motorola
IBM
Consumer/Retail
Anheuser-Busch
Wal-Mart
Procter & Gamble
Financials
Citigroup
Washington Mutual Bank
Allstate
Industrial
General Electric
Caterpillar
John Deere
Healthcare
GlaxoSmithKline
Pfizer
Energy/Power
Con Edison of New York
Pacific Gas and Electric
Other
FedEx
Berkshire Hathaway
Sovereign/Supranationals
Republic of Philippines
International Finance Corp.
15
Sample Buyers of Corporate Debt
n
Asset Managers:
Blackrock, PIMCO, WAMCO, etc.
n
Banks:
Bank of New York, Citibank, HSBC, etc.
n
Corporates:
Caterpillar Investment Management, Fannie Mae,
Microsoft, etc.
n
Hedge funds:
BlueBay, SAC Capital, Solent, etc.
n
Insurance Companies:
Aegon, AIG, Northwestern Mutual Life, etc.
n
Mutual Funds:
Dreyfus, Fidelity, Vanguard, etc.
n
Pension Funds:
General Electric Pension Fund, Teachers Insurance &
Annuity Assoc., etc.
n
Retail (“mom-and-pop”):
Muriel Finkelstein in Boca Raton, FL, plus hundreds of
thousands of others.
n
State Fund:
Alabama State Fund, California PERS, Maryland
State Retirement and Pension System, etc.
16
Evolution of the European Corporate Credit Market
Historical European Investment Grade and High Yield Issuance
Arrival of Monetary
Union created a
single-currency eurodenominated credit
market to rival the US
market
600
AAA/AA
500
400
A/BBB
High Yield
“Belgian dentist” buys
individual bonds from
highly-rated, highly
recognized companies like
Siemens, BT, GE, and Ford
300
200
100
2004 YTD
2003
2002
2001
2000
1999
1998
1997
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
-
1984
$ Billions
The
“institutionalization”
of European money
management has
turned credit into an
asset class
700
1996
Recent issuance
growth among
European A/BBB
rated entities have
outpaced AAA/AA
rated issuers
Year
17
Largest Debt Transactions in History
The largest capitalraising initiatives ever
have occurred in the
unsecured debt
market
Rank
1
2
3
4
5
6
7
8
9
10
Date
June 2003
March 2001
June 2000
May 2001
March 2002
November 2001
December 2000
October 2001
January 2001
July 1999
Issuer
General Motors/GMAC
France Telecom
Deutsche Telecom
WorldCom
General Electric Capital Corp. (GECC)
AT&T
British Telecom
Ford/Ford Motor Credit
Ford Motor Credit
Ford/Ford Motor Credit
Size
$17.5 Bn
$16.4 Bn
$14.6 Bn
$11.9 Bn
$11.0 Bn
$10.1 Bn
$10.0 Bn
$9.4 Bn
$9.3 Bn
$8.6 Bn
Currencies
US$, Euro, GBP
US$, Euro, GBP
US$, Euro, GBP, JPY
US$, Euro, GBP
US$
US$, Euro
US$
US$, Euro
US$, Euro
US$
Deals in bold indicate Deutsche Bank served as Bookrunner
18
Innovations in US Corporate Bond Market
n
Early ‘80s
Ø
Swaps to create funding efficiencies and foster cross-currency funding
opportunities
n
Early/mid ’80s
Ø
Deep and liquid high-yield market (“junk bonds”)
n
Late ’80s
Ø
Puttable bonds
n
1993
Ø
100-year bonds (“Century Bonds”)
n
1993
Ø
Tax-deductible preferred stock (equity credit at a debt cost)
n
Continuous
Ø
Issuance in new currencies (e.g., CZK, DKK, HUF, NOK, SGD, ZAR)
n
1995
Ø
Retail investor-targeted debt ($25 par baby bonds, MTNs)
n
1996-1997
Ø
Synthetic put bonds (derivatives market-enhanced optionality for issuers)
n
1997
Ø
Inflation-linked debt
n
1997
Ø
GIC-backed notes
n
Late ’90s
Ø
Evolution of European credit market
n
2000
Ø
Extendible notes (expand 2a7 money fund capacity at status quo backstop bank
facility capacity)
n
Early ’00s
Ø
Credit default swaps as a risk management tool
19
Interest Rate Swaps
n
An interest rate swap is an agreement between two counterparties to exchange a set of
cashflows over an agreed time period in the future.
5yr Interest Rate Swap Diagram
LIBOR, reset semiannually
Client
5yr Swap Rate = 3.92%
n
An interest rate swap is essentially a PV-weighted average of expected future LIBOR rates.
Intuition Behind Pricing
Illustrative Cashflow
LIBOR Forwards vs. Swap Rate
5.50%
Fixed Leg
5.00%
Beg of End of
period Period
9/9/04 3/9/05
3/9/05 9/9/05
9/9/05 3/9/06
3/9/06 9/11/06
9/11/06 3/9/07
3/9/07 9/10/07
9/10/07 3/10/08
3/10/08 9/9/08
9/9/08 3/9/09
3/9/09 9/9/09
4.50%
4.00%
3.50%
3.00%
5yr Swap Rate = 3.92%
2.50%
LIBOR Fwd Curve
2.00%
1.50%
1.00%
3/05
9/05
3/06
9/06
3/07
9/07
3/08
9/08
3/09
9/09
Discount
Factor Coupon
0.9896
3.92%
0.9761
3.92%
0.9605
3.92%
0.9429
3.92%
0.9246
3.92%
0.9047
3.92%
0.8845
3.92%
0.8637
3.92%
0.8428
3.92%
0.8214
3.92%
NPV
Floating Leg
PV Pmt
1.94
1.91
1.88
1.85
1.81
1.77
1.73
1.69
1.65
1.61
17.86
LIBOR
2.08%
2.72%
3.22%
3.63%
3.98%
4.28%
4.51%
4.74%
4.93%
5.11%
NPV
PV Pmt
1.04
1.36
1.56
1.77
1.83
1.99
2.02
2.08
2.09
2.14
17.86
20
Interest Rate Swaps: Who Uses and Why?
Pay Floating;
Receive Fixed
Banks
Agencies/
Mortgage
Hedge
funds
Corporates
Fund
managers
Receive Floating;
Pay Fixed
Match assets with liabilities;
Leverage balance sheet
Match assets with liabilities
Convexity hedging /
Manage prepayment risk
Convexity hedging / Manage
average life extension risk
Relative value / Yield
enhancement / Yield curve
riding / leverage asset base
Relative value /
Yield enhancement
Hedging interest
rate exposure (mostly
converting fixed debt
to floating)
Hedge anticipated
fixed-rate issuance or
swap floating-rate
bank debt to fixed
Relative value / Yield
enhancement
Relative value / Yield
enhancement
21
Floating Interest Rates – Forward Curve
In a steep yield curve
environment, such as
the current one,
forward rates suggest
a rapid near-term rise
in rates
Many market
participants will elect
to “bet” against this
by overweighting
fixed-rate assets or
floating-rate liabilities,
or both.
3m LIBOR Forwards
6.00%
5.00%
Current
Current 3mL
3mL (9/7/04)
(9/7/04)
4.00%
Current
Current Swap
Swap Rates
Rates (9/7/04)
(9/7/04)
3.00%
1-Year
1-Year
2-Year
2-Year
3-Year
3-Year
4-Year
4-Year
5-Year
5-Year
2.00%
1.00%
Sep '04
Mar '05
Sep '05
Mar '06
Sep '06
2.42%
2.42%
2.95%
2.95%
2.34%
2.34%
3.66%
3.66%
3.92%
3.92%
Mar '07
Sep '07
Forward
Forward LIBORs
LIBORs
Sept
’04
Sept ’04
Dec
Dec ’04
’04
Mar
Mar ’05
’05
Jun
’05
Jun ’05
Dec
Dec ’05
’05
Dec
’06
Dec ’06
Dec
Dec ’07
’07
Mar '08
Sep '08
Mar '09
1.86%
1.86%
1.86%
1.86% (+0bps)
(+0bps)
2.29%
2.29% (+43bps)
(+43bps)
2.59%
2.59% (+73bps)
(+73bps)
2.86%
(+100bps)
2.86% (+100bps)
3.27%
3.27% (+141bps)
(+141bps)
3.99%
(+213bps)
3.99% (+213bps)
4.51%
4.51% (+265bps)
(+265bps)
Sep '09
22
Overprediction of LIBOR Forward Curves
The “hair chart”
illustrates that
forward curves have
nearly systematically
overpredicted the
eventual path of
LIBOR
11.00%
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
Actual LIBOR
Historical LIBOR forward curves
2.00%
Current LIBOR forward curve
1.00%
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
23
Cross-Currency Swaps
Euro/USD Cross-Currency Swap
n
A cross-currency swap can be used to convert
interest and principal denominated in one currency
into another currency (e.g., from the foreign
currency into a company’s functional, or local,
currency)
Euro Fixed
Client
US$ Fixed
Components of a Euro/USD Cross Currency Swap
Euro Fixed
A cross-currency
swap, in essence is
an aggregate of
multiple swap
positions
n
Euro Fixed/Floating Swap: The Euro LIBOR leg
is eventually crossed out by the Euro LIBOR leg
from the Basis swap
Client
Euro LIBOR
Euro LIBOR
n
n
Basis swap: Adjusts floating-rates across different
currencies: in this example between US$ LIBOR
and Euro LIBOR
USD Fixed/Floating Swap: The US$ LIBOR leg
crosses out the US$ LIBOR leg from the Basis
swap
Client
US$ LIBOR + Spread
US$ LIBOR + Spread
Client
US$ Fixed
24
Cross-Currency Issuance Case Study:
SLM Corporation (A2/A) in Australian Dollars
Fixed-Rate Notes
Student lender SLM
Corp. used crosscurrency swaps to
capture a window in
the “kangaroo”
market to raise
A$600m swapped
back into US$
($438.3m) at a cost
savings versus US
issuance while
generating substantial
investor
diversification
Floating-Rate Notes
Announcement Date:
May 5, 2004
Announcement Date:
May 5, 2004
Maturity Date:
May 18, 2009
Maturity Date:
May 18, 2009
Size:
A$375mm
Size:
A$225mm
Launch Spread:
Mid Swaps + 40 bps
Launch Spread:
Bank Bills + 40 bps
Bookrunners:
Deutsche Bank, UBS
Bookrunners:
Deutsche Bank, UBS
Co-Managers:
CBA, Citigroup, NAB, RBC
Co-Managers:
CBA, Citigroup, NAB, RBC
Transaction Highlights and Motivation
n
This transaction represents SLM’s inaugural offering in the Australian market, and at a total size of A$600mm, this was the largest
single-A kangaroo bond ever issued in the Australian market
n
With total annual unsecured debt issuance needs of $10+ billion, SLM looks to maximize investor diversification by issuing in multiple
currencies and regions. Investor diversification leads to increased demand for SLM’s paper and ultimately more attractive debt
pricing
n
As such, Deutsche Bank recommended an Australian transaction, providing SLM with access to a completely new investor base.
Being a new issuer in the Australian market, SLM was able to achieve attractive pricing as investors looked to include a new US
credit in their portfolios
n
As the US Dollar is SLM’s functional currency, the entire deal was swapped to US$. The attractive basis swap between A$ and US$
allowed SLM to meet its funding targets
n
This transaction met SLM’s goals of investor diversification and issuance at levels slightly better than US$ levels (2 to 3 bps)
n
With such a successful transaction, SLM has positioned itself well to be a regular and well-received issuer in the domestic Aussie
market
Evolution of the Interest Rate and Currency Swap
Market
Historical Interest Rate and Currency Swap Notionals
160
140
120
100
$ Trillions
80
60
40
20
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
-
1987
The near exponential
growth of the swap
market has been
driven by a broader
awareness of and
comfort with this
technology’s ability to
mitigate risk,
transform cash flows
and generate returns
Year
Source: International Swap and Derivatives Association
26
Development of Mortgage and Asset Backed Securities
Section 2
Development of the Mortgage Backed Securities
Market
Size of the Mortgage Backed Securities (“MBS”) Market
§ Total Size of U.S. Mortgage Market: $7.5 Trillion
Non-Agency
CMO's
13%
§ Roughly $4.0 Trillion in MBS outstanding
§ $3.5 Trillion in Agency MBS outstanding
Agency MBS
62%
§ $2.5 Trillion in Agency MBS
$1.5 Trillion FNMA
§ $0.6 Trillion FHLMC
§ $0.4 Trillion GNMA
§ $1.0 Trillion in Agency CMOs
§ $0.5 Trillion FHLMC
§ $0.4 Trillion FNMA
§ $0.1 Trillion GNMA
§
Agency
CMO's
25%
§ Roughly $0.5 Trillion in Non-Agency CMOs
Source: Bond Market Association Statistics (March 31, 2004), Deutsche Bank Securities
28
Mortgage-Backed Securities
Securitization: Turning Loans into Securities
Birth of Mortgage-Backed Securities
8% 30 Year Mortgage Obligation,
with house pledged as collateral
BANK
Borrows Money
INDIVIDUAL HOMEOWNER
$100,000
29
Mortgage-Backed Securities (continued)
Mortgages Swapped to become Mortgage-Backed Securities
With possession of
FNMA instead of
Mortgages, Bank can:
1. Sell FNMA into liquid
__market
2. Borrow against it
__efficiently
3. Keep it on balance
__sheet with less
__capital
$1 million 7.5%
FNMA Certificate
backed by ‘Full
Faith and Credit’ of
U.S. Government
8% 30 Year Mortgage Obligation,
with house pledged as collateral
BANK
Borrows Money
INDIVIDUAL HOMEOWNER
$100,000
Bank swaps a pool of ten
$100,000 8% interest rate
mortgages
Pays insurance
premium 0.25%
Continues to receive
Servicing Fee 0.25%
FNMA
(“Federal National Mortgage
Association”)
30
Typical Bank Balance Sheet
Assets
Liabilities
Senior
More Liquid
FNMA
Certificates
Deposits
Single-Family
Mortgages
Term Notes
Student Loans
Less Liquid
Auto Loans
Credit Card Loans
Preferred Stock
Equity
Subordinated
31
Collateralized Mortgage Obligations
§ CMO’s allowed cash flows of 30 year mortgages to be cut up and tailored to suit investor
preferences.
Tranching of Cash Flows
FNMA 7.5% CASH FLOW (12 YEAR AVERAGE LIFE, 30 YEAR AMORTIZATION)
Investment Horizon:
Short Term
Intermediate Term
Intermediate/Long Term
Long Term
Average Life:
2 years
5 years
10 years
20 years
Amortization
Window:
4 years
4 years
8 years
14 years
Investor Type:
Banks
Banks/Insurance
Insurance
Insurance/Pension Funds
32
Impact of CMO’s on Mortgage Costs
30 Year Mortgage Benchmark vs. 30 Year Treasury Benchmark
20%
18%
Advent of Early CMO's
16%
14%
12%
10%
8%
6%
4%
2%
0%
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Spread to 30 Year Treasury Benchmark
Average Spread Before CMO's:
286 bps
30 Year Mortgage Benchmark
30 Year Treasury Benchmark
Average Spread After CMO's:
134 bps
Source: Freddie Mac & Bloomberg
33
ABS Market Overview
§ Wall Street starts to turn its attention to securitization of other asset categories:
–
1985: Auto Loans, 1987: Credit Cards, 1988: Home Equity Loans, 1993: Student
Loans
ABS Market Continues Growth Trajectory
billions
$763.8
$750
$700
$650
$600
$550
$500
$450
$400
$350
$300
$250
$200
$150
$1.2
$100
$50 $0.2
$1.0
$0
85
$161.6
$581.3
$128.5
$434.7
$313.9 $343.9
$91.9
$465.4
$271.2 $273.9
$167.0
$113.5
$10.0
$24.4 $43.4
$52.1 $55.9
$63.1 $81.8
$19.5
$9.1
$14.9
$3.2
$2.2
$11.0
$8.0
$5.2
$2.7
$22.6
$12.9
$2.8
$10.3
$21.9
$17.1
$6.7
$6.9
$17.4
$24.9
$8.3
$9.4
$19.6
$25.8
$19.5
$11.1
$32.1
$19.1
$16.1
$2.7
$6.4
$2.2
$6.9
$5.8
$0.2
$9.8
86
87
88
89
90
91
92
93
94
Automobile
Credit Card
$109.3
$100.7
$70.7
$188.9
$109.1
$103.0
$69.5
$42.5
$38.7
$310.2
$96.6
$219.0
$77.2
$87.5
$73.8
$57.6
$68.4
$70.2
$64.9
$54.4
$47.4
$49.4
$41.0
$42.8
$41.4
$49.6
$69.8
$77.7
$82.4
$37.8
$40.2
$83.6
$36.4
$75.9
$30.5
95
96
97
98
99
00
01
02
03
04*
Home Equity
Other
* Data annualized.
Source: Deutsche Bank, Thomson Financial Securities Data
34
ABS Market Overview (continued)
Estimated Outstandings of U.S. Fixed Income Securities – $22.8 Trillion
Asset Backed, $1.8
trillion, 7.8%
Mortgage Related,
$5.4 trillion, 23.5%
Municipal, $2.0
trillion, 8.6%
Money Market, $2.6
trillion, 11.6%
Corporate, $4.6
trillion, 20.0%
Fed Agencies, $2.8
trillion, 12.1%
As of Q2 2004
US Treasury, $3.8
trillion, 16.5%
Source: Bond Market Association
35
The Forces Driving Asset Securitization
Issuer Incentives
–
Capital efficiency
–
Funding diversification
–
Asset-liability management
–
Accounting gain on sale
–
Manage portfolio growth
Investor Incentives
–
Attractive nominal yield and
better credit relative to corporates for
similar ratings
–
Generally low payment variability
relative to MBS
–
Excellent liquidity in most sectors
36
Some Top Clients
37
League Tables: Total ABS Market
2003
2004 Year to Date (2)
(Excluding Self-Funded Issues & Shelf Issues)
(Excluding Self-Funded Issues & Shelf Issues)
Lead Manager
1
Citigroup
Principal (mm) (1)
Market Share (%)
$45,555.2
11.8
Lead Manager
1
Citigroup
Principal (mm) (1)
Market Share (%)
$32,328.0
12.5
2
Deutsche Bank Securities
40,502.0
10.5
2
Deutsche Bank Securities
25,211.0
9.7
3
JP Morgan
36,735.2
9.5
3
JPMorgan
23,385.7
9.0
4
Credit Suisse First Boston
34,849.9
9.1
4
Greenwich Capital
21,724.4
8.4
5
Banc of America Securities
30,473.5
7.9
5
Credit Suisse First Boston
21,191.1
8.2
6
Morgan Stanley
29,261.3
7.6
6
Merrill Lynch
21,109.3
8.2
7
Lehman Brothers
25,878.6
6.7
7
Banc of America Securities
17,967.2
6.9
8
Greenwich Capital
25,160.0
6.5
8
Lehman Brothers
16,750.9
6.5
9
Merrill Lynch
20,865.0
5.4
9
Morgan Stanley
15,575.9
6.0
5.0
10
10
Bear Stearns
19,314.2
UBS
14,746.7
5.7
Total of top 10 Managers
$308,594.9
80.2%
Total of top 10 Managers
$209,990.2
81.1%
Industry Total
$384,944.3
100.0%
Industry Total
$258,987.8
100.0%
Source: Thomson Financial Securities Data (SDC) and Deutsche Bank Securities
1) In U.S. dollar equivalents based on exchange rate as of pricing date.
2) As of July, 2004
38
Case Study: Capital One
§ As the ABS Market has grown to rival corporate market, an increasing number of major
corporations have used securitization as a principal means of financing their business:
Capital One: Alternative Funding
On-Balance Sheet Funding
Assets
Off-Balance Sheet Securitization Funding – Liability Structure
Credit Cards
Liabilities
Sub-Prime Autos
Prime Autos
Autos
81.25%
Credit
Cards
92.0%
Corporate
Debt
8.0%
Equity
97.55%
AAA
2.45%
A
87.0%
AAA
13.0%
O/C
(L+11)
BBB
(L+70)
10.0%
International
AAA
7.25%
1.5%
A
(L+36)
BBB
(L+83)
O/C
AAA-BBB avg = L+ 70 bps vs. AAA-BBB avg = L+ 19 bps
39
History of ABS – An Issuer’s Perspective
Steve Linehan, SVP & Treasurer, Capital One Financial Corporation
41
Capital One is:
A major
credit card player
A diversified
consumer financial
services company
34th largest
depository institution
in the U.S.
A significant capital
markets issuer
• 5th Largest Visa/Mastercard issuer
• $45.3 managed U.S. credit card assets
•
•
•
•
2003: $1.1B net income, ROA 1.52%, ROE 23.4%
$71.8 B in managed loans
37% of assets are outside of U.S. Card
18% of Q1 2004 profits are non U.S. Card
• $23.6B in deposits
• Direct Retail Deposits
• Brokered Deposits
• Over $20.2B of Capital Markets issuance in 2003
• ABS programs include U.S. credit card,
non-prime and prime auto, U.K. credit card
• Unsecured programs include senior and
subordinate debt
• Ratings: BB+/BBB- Baa3/Baa2
42
Capital One continues to deliver strong earnings
Earnings Per Share
$5.60 $5.90 1
$6.00
$4.85
$5.00
$3.93
$4.00
$2.91
$3.00
$2.24
$1.72
$2.00
$1.32
$1.00
$0.48
$0.64
$0.77
1994
1995
1996
$0.93
$0.00
Growth Rate
33%
21%
1997
21%
1998
42%
1999
30%
2000
30%
2001
30%
2002
35%
23%
2003
15-22%
One of three companies to earn > 20% EPS growth for 10 consecutive years
1) As of July 21, 2004.
43
2004E
Capital One’s Killer App: The Information Based Strategy- IBS
World Class
People &
Analytics
Massive
Innovation
Scientific
Laboratory
Microsegmentation/
Mass
Customization
One of the
Largest
Databases in the
World
Quantum
Advance in Risk
Management
44
We are using IBS to diversify our assets
Diversified Managed Outstandings
100%
13%
90%
Auto
($9.4B)
80%
25%
70%
GFS
($18.7B)
60%
50%
40%
62%
30%
20%
10%
0%
1997
1998
1999
2000
2001
45
2002
2003
Q204
Card
($45.2B)
Funding Mix – Securitization is important to Capital One
Total Managed Liabilities and Capital
100%
8%
5%
Capital
Other Liabilities*
27%
Deposits
9%
Senior Notes
Auto
Securitizations
80%
60%
8%
40%
43%
20%
0%
1998
1999
2000
2001
2002
2003
Q2 2004
* Includes repos, Fed Funds, trust preferred46securities, various payables and other liabilities
Off-Balance
Sheet
Securitizations
The Rationale for Securitization
•
Allows lower-rated companies to fund at
approximately AA levels
•
The higher ratings on issuer’s securitization “debt”
vs. its unsecured debt broadens its investor base
and enhances its liquidity
•
Transactions may represent risk transfer and qualify
as sales
Funding Cost
Funding,
Diversification,
& Liquidity
Accounting &
Regulatory Capital
Requirements
–
–
Asset
Liability
Management
•
Issuers don’t need to hold capital against securitized assets
for regulatory capital requirements
Issuers don’t need to reserve against loan losses on
securitized assets
Securitization transactions are an effective tool for
asset liability management, including maturity,
currency, and basis (fixed vs. floating) management
47
Securitization enables us to access deeper investor
bases at lower costs
HIGH
AVAILABILITY
COST
MOST
COMMERCIAL
BANKS
AND FINANCE
COMPANIES
COB COFC
LOW
AAA
AA
A
BBB
BB
B
C
D
Securitization benefit increases during times of market disruptions
48
Credit Card securitization involves the issuance of securities
secured by a designated pool of asset receivables “sold” to a
bankruptcy remote entity
Capital One Bank
(originator of assets)
Receivables on
Accounts
Capital One
Master Trust
Proceeds from ABS Issuance
49
Asset Backed
Securities
Investors
The financial engineering of cash flows creates
credit rating efficiency
To achieve investment-grade ratings, credit
enhancement is needed to protect investors from
changes in loss performance.
Capital One Subordination Structure
Senior
As unsecured revolving debt obligations, credit card
receivables offer limited recovery in the event of
cardholder default.
Class A
81.25%
(“AAA”)
Credit enhancement is provided through:
Subordination (Class B and C tranches)
–
Excess spread is the net income of a securitization trust
that flows back to the issuer.
Spread or reserve accounts
•
A mechanism to capture excess spread if performance begins to deteriorate.
Excess spread is function of:
Trust revenue
Gross portfolio yield
Trust expenses
Investor coupon
Servicing fee
Charge offs
Trust net income
Excess spread
Class B
10% (“A”)
Class C
7.25% (“BBB”)
Class D
1.50% (“BB”)
20.00%
Excess Spread
-5.00%
-2.00%
-6.00%
Spread Account
7.00%
50
Credit
Enhancement
–
Interest and principal payments are made to subordinate tranches only after all
senior payments have been made.
Subordination
•
Subordinate
–
Credit Card ABS have bullet maturities just like corporate unsecured
bonds making them attractive to a broad investor base
Investment: Credit card ABS, three-year bullet maturity
Bond cash flow
$10,000,000 investment
10,000,000
8,000,000
Interest paid to investor
6,000,000
Principal paid to investor
4,000,000
2,000,000
0
1
2
3
4
5 6
7
8
9 10 1 1 12 13 1 4 15 16 1 7 18 19 20 21 22 23 24 25 26 27 28 29 3 0 31 32 3 3 34 35 3 6
Accumulation period
Revolving period
Collateral balance ($)
Collateral: Credit card accounts, monthly principal and interest receipts
Excess seller interest
Required seller interest
Investor interest
6
12
18
Revolving period
24
30
36
Accumulation period
51
Funding costs are lower and less volatile than the
company’s corporate debt
Indicative 5 Year Fixed Rate Cost of Funds for Capital One
12.0%
11.0%
10.0%
High
6.13%
11.29%
5.95%
Deposits
Corporate Debt
Card ABS
9.0%
Low
Average
3.60%
4.72%
3.78%
6.66%
3.13%
4.37%
Std Dev
0.60%
1.92%
0.76%
8.0%
7.0%
6.0%
Corporate Debt
5.0%
Deposits
CARD ABS*
4.0%
3.0%
2.0%
1.0%
Jun-04
May-04
Apr-04
Mar-04
Feb-04
Jan-04
Dec-03
Nov-03
Oct-03
Sep-03
Aug-03
Jul-03
Jun-03
May-03
Apr-03
Mar-03
Feb-03
Jan-03
Dec-02
Nov-02
Oct-02
Sep-02
Aug-02
Jul-02
Jun-02
*ABS represents the weighted avg. cost of funds for 5 year COMET deal including A, B and C tranches
52
Securitization is an effective capital management tool
% of Capital
Required
12%
Illustrative Example
ROE
25%
10%
20%
8%
15%
6%
10%
4%
5%
2%
0%
0%
With Securitization
Without Securitization
53
Securitization markets provide flexibility to meet our
asset-liability management objectives
Deterministic Net Interest Income Sensitivity
Percent Change in 12-Month NII
6%
% Change in 12 Month NII
4%
2%
Limit
0%
7/31/04
NII rises
1.4% or
$78MM
Limit
-2%
-4%
-6%
Down 300
Rate Shock
Down 200
Down 100
Basecase
Up 100
Up 200
Programs
•
•
•
•
Fixed Rate 3, 5, 7 years
•
Floating Rate 3, 5, 7 ,10, 15 years
£ Denominated transactions using •
US Collateral
€ Denomintaed transactions using
US Collateral
£ denominated transactions
using £ collateral
€ denominated transactions
using £ collateral
$34B swap book also used to manage interest rate & currency risk
54
Up 300
Capital One continues to enjoy success in the
capital markets
U.S. Card Securitizations
Triple-A
Single-A
Triple-B
U.K. Card Securitizations (1)
Auto Loan Securitizations
Prime
Non-Prime
Senior Notes
Subordinated Notes
Total
2003
1H 2004
$5,100
$1,100
$1,375
$981
$3,100
$650
$668
$1,249
$2,000
$2,125
$2,000
$500
$20,271
$850
$1,000
$1,000
$10,279
1) In U.S. dollar equivalents based on exchange rate as of pricing date
55
Capital One expects to remain a lead issuer in the
securitization market
US Cards
US Autos
2003
Issuer
2004 YTD
Total $
(billions)
(%)
Issuer
2003
Total $
(billions)
(%)
Issuer
2004 YTD
Total $
(billions)
(%)
Issuer
Total $
(billions)
(%)
1
Citibank
14.1
21.7
1
Bank One
5.7
18.8
1
GMAC
10.4
13.4
1
GMAC
4.6
9.0
2
Bank One
10.4
16.1
2
MBNA
5.2
17.2
2
Honda
6.1
7.8
2
Ford
4.6
9.0
3
MBNA
9.1
14.0
3
Capital One
4.6
15.1
3
Nissan
5.9
7.6
3
WFS
4.1
8.0
4
Capital One
6.9
10.7
4
Citibank
4.4
14.4
4
WFS
4.8
6.2
4
Daimler Chrysler
4.1
8.0
5
Chase
6.5
10.0
5
Chase
3.4
11.1
5
Ford
4.7
6.0
5
Honda
3.5
7.0
6
Discover
3.6
5.5
6
American Express
3.4
11.0
6
Daimler Chrysler
4.3
5.5
6
USAA
3.0
6.0
7
American Express
3.1
4.8
7
Providian
1.5
4.8
7
Chase
3.6
4.6
7
Nissan
2.5
5.0
8
Gracechurch
3.0
4.6
8
GE
1.0
3.3
8
Capital One
3.5
4.5
8
Capital One
2.5
5.0
9
Household
2.3
3.5
9
Gracechurch
0.8
2.6
9
Americredit
3.3
4.3
9
AmeriCredit
2.0
4.0
Advanta
1.5
2.3
10
World Financial Network
0.5
1.7
10
Toyota
2.9
3.7
10
Chase
1.5
3.0
64.9
100.0
30.5
100.0
77.7
100.0
50.8
100.0
10
Industry Total
Industry Total
Industry Total
Source: Deutsche Bank Securitization Monthly
As of July 31, 2004
#3 ABS Issuer in 2003
#1 ABS issuer YTD 2004
56
Industry Total