Academic journal article Duke Journal of Comparative & International Law

Synthetic Securitization: Use of Derivative Technology for Credit Transfer

Academic journal article Duke Journal of Comparative & International Law

Synthetic Securitization: Use of Derivative Technology for Credit Transfer

Article excerpt

I. INTRODUCTION

Magazines are fond of lists, and none more so than specialist magazines. A particular favorite of specialist magazines is the listing of their core subject matter in a "hit-parade" of success. Legal magazines love to publish yearly lists of the top 100 most profitable firms and, no doubt (although the authors freely admit the subject lies some way beyond their ken) lists of the 500 largest shippers of bulk fertilizer grace the pages of specialist chemical publications. Magazines dealing with the banking industry are no different and regular competitive lists are hardy perennials. However, those who have been reading magazines aimed at the banking community over a number of decades will have noticed a near universal shift in the manner in which these lists of the current "best banks" have been set out.

Twenty or so years ago, although these listings contained much information about the financial institutions that were lucky enough to make it into their pantheon, the fundamental organizing principle was "asset base." In other words, the "greatest banks in the world" were ranked by reference to how much money they had lent. This reflected the view of most banking executives, including the CEOs of most banks, that a bank's success was measured by size.

A quick glance at today's magazines is likely to reveal a dramatic change. The same publications that ranked financial institutions by their sheer bulk now compile the same lists on very different bases. The chief organizing principle of the annual compilations will almost always turn on some form of profit measure: it might be a straight-forward measure such as an absolute dollar amount or a more subtle measure such as return on capital or profit margins. Balance sheet obesity is no longer "in." Behind this editorial shift lies a fascinating story of transformation in the banking industry over the last two decades which in many ways culminates in the more than $1.5 trillion synthetic securitization market in the United States alone.

This article will briefly deal with the history that led to the merging of securitization technology with derivative technology to create the risk transfer machine that is the synthetic securitization market and the business drivers behind it. It will then seek to describe the most common forms of credit derivatives. The article will then set out the various forms of synthetic securitizations and their advantages and drawbacks, before concluding with a description of a classic synthetic securitization transaction. In an article of this length, one can do little more than flag the major landmarks leaving more detailed analysis for a different forum.

II. THE DEVELOPMENT OF THE SYNTHETIC SECURITIZATION MARKET

A. Banks

To understand the development in banking of the last twenty or so years it is important to keep in mind the simple picture of what is, or as we shall see, increasingly was, a "bank." The term "bank" is used here to refer to a deposit-taking and lending institution, therefore encompassing institutions that may have different legal forms such as savings and loans institutions, mutual savings banks, and building societies, but excluding classical "investment banks." A bank is an entity that is good at locating people and companies that have money they do not presently need, on the one hand and, on the other hand, people and companies that have a need for money they do not presently have. The bank borrows the money from the former (its depositors, lenders, and shareholders) and lends the same money to the latter (its borrowers). It pays the former for the use of their cash and collects money from the latter for the use of the money it has borrowed from the former. The difference between what it is required to pay to the former and that received from the latter, post expenses, represents the bank's profits. This is the classic paradigm of banking where the bank intermediates the capital markets. …

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