Legal Risks of Conventional- and Synthetic Securitisation

University essay from Lunds universitet/Juridiska institutionen

Author: Mikael Harstad; [2006]

Keywords: Bankrätt; Law and Political Science;

Abstract: Since the accomplishment of the first conventional securitisation transaction in the beginning of the 1980's, both conventional- and synthetic securitisation have played an important role in corporate finance and risk management. Banks and corporations have used these advanced financial instruments to, for example, obtain new funding for big investments, improve balance sheet characteristics and capital ratios and achieve a healthy risk management. But the mere complexity of the different arrangements and transactions involved in these financial structures, combined with the lack of established standards and usages, make both the conventional- and synthetic securitisation vulnerable to individual legal risks and uncertainties. Legal risks are dangerous to the development of a healthy securitisation market, as they may obstruct initiators and investors from participating in an otherwise profitable securitisation procedure. Legislators must therefore try to keep legal impediments to a minimum, so that the creative forces of the capital market are not held up by legal uncertainties. Although the conventional- and synthetic securitisation have similar structures, and are often deployed to achieve the same results, they do not share the same legal risks. When a bank arranges a securitisation, the primary goal is to get rid of the risk of borrowers defaulting of their loan payments to the bank. By removing this risk, the bank is able to free up more capital that can be used for new lending, as the risk of borrowers defaulting no longer affect the bank's risk calculations of future possible liabilities. Securitisation then works as a kind of insurance for the bank: if the borrower fails to perform on his payments to the bank, a third party will take the loss. Conventional securitisation is based on the idea of legally transferring a number of specific assets, and all risks associated with them, from the initiator and his balance sheet. Naturally, a majority of all the legal risks associated with this procedure will have its origin in the establishment of a legal separation and an actual true sale of the assets. Synthetic securitisation is not based on the actual transfer of the specific assets, but rather on contractual agreements between different parties that transfer some of the economic interests of the assets through so-called credit derivatives. The legal risks of synthetic securitisation will therefore not have their origin in the establishment of a legal separation of the assets, but are more dependent on the contractual drafting and the definitions of the credit derivatives. With the different legal risks of conventional- and synthetic securitisation in mind, it is possible to distinguish a connection between the haltering development of the continental European securitisation market and the legal foundation offered in civil law jurisdictions. Both the conventional- and synthetic securitisations are products of the American capital market. Consequently, these financial structures have been developed to fit the laws and practices offered in common law jurisdictions. When simply implementing the Anglo-American securitisation model into the civil law legal system, legal uncertainties are bound to arise. However, as the conventional securitisation, more then the synthetic structure, is dependent on common law concepts and legal instruments, unknown to several civil law jurisdictions, the more flexible characteristics of the synthetic structure work to its advantage. The universal principle of freedom of contracts liberates the parties of the synthetic securitisation from legal risks created by jurisdictional differences, whilst the parties of the conventional securitisation are more obstructed by statutory laws in their development. Although the synthetic securitisation is troubled by several legal risks and uncertainties, these are not connected with the civil law legal framework, and the civil law initiator of a synthetic structure can therefore compete on the same terms as the rest of the world.

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