Actuaries in Investment Banks UNSW Presentation 3 May 2004 Students have this idea they want to work in Corporates or Consulting Life v GI or Investment Banking But do you know what is Investment Banking

Agenda Investment Banks – History & Structure Actuaries Agenda Investment Banks – History & Structure Project & Structured Finance Mortgage Backed Securities Actuaries Role Questions Objectives: To give an idea of how Investment Banks are structured Where an actuary can work within them The nature of the work.

Investment Banks History & Structure Actuaries Investment Banks History & Structure Why are they called Investment Banks? Q. Who are the Players? Q. How are they Structured?

Investment Banks History & Structure Actuaries Investment Banks History & Structure Why are they called Investment Banks? Q to the floor – impressed if know the answer

Investment Banks History & Structure Actuaries Investment Banks History & Structure Q. Why are they called Investment Banks? Glass-Steagall Bank Act 1933 (USA) Separation of investment banking from commercial banking The origins lie in the great depression in 1933 in the US. A quarter of the formerly working population was unemployed & the nation's banking system was accordingly chaotic. Over 11,000 banks had failed or had to merge, reducing the number by 40 per cent, from 25,000 to 14,000. The governors of several states had closed their states' banks, President Roosevelt later closed all the banks in the country. Congressional hearings into the failures at the time showed the bankers and brokers were guilty of disreputable and seemingly dishonest dealings and gross misuses of the public's trust. The result was The (Glass-Steagall) Banking Act of 1933 The Act essentially erected a wall between commercial banking and investment banking, to counter the Banks perceived risky activities of securities trading.

Investment Banks History & Structure Actuaries Investment Banks History & Structure Investment Banking is the issuing, underwriting, selling, or distributing, stock, bonds, debentures, notes or other securities. Commercial Banking is basically deposit taking and lending. Commercial Banking = Savings & Loans Explain Underwriting (market making) ASIDE: Only Japan also has the separation (as after WWII they were forced to adopt the US banking statutes) In hindsight, it was seen as an overreaction (even Mr Glass one of the original proponents tried to have the Act repealed). One of the major reasons seen as a cause of collapse is the State based nature of the Banking system, which resulted in 90% of Banks having < $2m in assets. In the same period there were no failures at all in Canada which allowed Banks to operate Nationally. ASIDE: US lawmakers later enacted the Bank Holding Company Act to create a barrier between banking and insurance, to prevent banks making losses from underwriting insurances The Glass Steagall Act has actually been relaxed now

Investment Banks History & Structure Who are the players? Actuaries Q to the floor

Investment Banks History & Structure Who are the players? Actuaries Goldman Sachs Merrill Lynch Salomon Smith Barney / Citigroup Morgan Stanley / Dean Witter Lehman Brothers CS First Boston Deutsche Bank JP Morgan / Chase Manhattan ABN Amro Macquarie Bank UBS Global v Aus

Investment Banks History & Structure How are they structured? Actuaries Investment Banks History & Structure How are they structured? Q to the floor on divisions (since must be a few people who think they want to work in Inv B’g)

Investment Banks History & Structure How are they structured? Actuaries Investment Banks History & Structure How are they structured? Trading/Investing Underwriting Financial Advisory Broking Funds Management Equity Debt Hybrids M&A, Restructuring, Divestiture / Spin-Offs Treasury Commodities Capital Management Project & Structured Finance Underwriting is the traditional “Investment Banking” Trading / Investing is an add-on (not Investment Banking perse) – Stock brokers & Life Companies & Fund Managers Financial Advisory also can be performed by others NAB, Westpac all have investment or Institutional Banking Divisions Accounting Firms (PWC, E&Y, KPMG) are also active (Corporate Finance Advisory or Taxation) ASIDE Lately has caused all the issues of the original Glass Steagall Act about independence because of buy reccos in stocks the UW area was doing IPOs for. Other Add-ons Custodian Financial Planning Financial Advisory roles Funds Mgt (eg Aus Share Fund, fund manager: stock selection / sector selection / market timing or research analyst: individual stocks or economic variables) Lower pay Quant funds Broking (eg commissions) Prostitutes of the Investment industry (> 50% have buy recco’s) slimy salesman Rely on research analysts recos & experience of market vibe for directions Easier hours & lower pay Underwriting & Financial Advisory (Corporate Finance / Project & Structured Finance) One area puts deals together, other arranges finances (sometimes Funds Management area will run a fun that provides the funds) Financial Advisory areas: M&A Predominantly the area of accountants/economists No reason why actuaries cant work there, but no real skill set advantage, just intelligence M&A (buying/selling companies) sounds exciting, but a lot of accounting, simple analysis (P/E) and also legal in due diligence /warranties&indemnities Treasury – advice on the management of risks arising from interest rate, foreign exchange and investment markets. Commodities - advice on risk management in areas of energy markets, the agricultural sector and resources (eg hedging) Capital Management – optimisation of balance sheet debt/equity levels (eg share buybacks, private/public placements / IPO’s, rights offers) Importantly, flash back to the players - different banks may be specialists in different areas

Investment Banks History & Structure How are they structured? Actuaries Investment Banks History & Structure How are they structured? Further specialisation within Market Sectors. Resources Telco’s, Media, Entertainment & Technology Financial Institutions Industrials Property Understand Industries – special requirements Carve up clients

Project & Structured Finance Actuaries Project & Structured Finance Project Finance Involves non-recourse financing of the development and construction of a particular project in which the lender looks principally to the revenues expected to be generated by the project for the repayment of its loan and to the assets of the project as collateral for its loan rather than to the general credit of the project sponsor. Why Different to Bank lending? Scale (is common in capital intensive industries) Recourse / Guarantees Multiple Investors/lenders (although top 4 banks do share risks on large commercial loans)

Project & Structured Finance Actuaries Project & Structured Finance Project Finance Q. Typical Projects? Q to the floor

Project & Structured Finance Actuaries Project & Structured Finance Project Finance Q. Typical Projects? Power Plants / Pipelines Mining Facilities / Industrial Plants Transportation Systems (eg toll roads, rail, airports) Other Infrastructure (eg hospitals, prisons) New concept? Social Projects – Infrastructure: Government shifted funding to the private sector

Project & Structured Finance Actuaries Project & Structured Finance Project Finance Q. So what do Actuaries do?

Project & Structured Finance Actuaries Project & Structured Finance Project Finance Q. So what do Actuaries do? Model the future project cashflows Model the future debt obligation cashflows Identify & Analyse the risks Determine & communicate the key assumptions Set modelling assumptions Past experience Collateral data - Credibility issues Overseas experience Sensitivity Testing Can do anything, from originate deals (where the big salaries & bonuses are) but the traditional actuarial skillset is in modelling (extends naturally to deal design) Either build or review for the lead manager for an investor / fund manager for the ratings agency for the trustee Now PF is really a subset of SF so will discuss most of these later, but my project was building the M2 motorway, what would be my project cash flows

Project & Structured Finance Actuaries Project & Structured Finance Structured Finance Put simply, it is finance that has been structured in some way that sets it aside from traditional lending Encompasses: Project Finance, as well as Structured corporate finance (hybrid debt/equity) Cross-border leveraged leasing Subordinated Debt Securitisations Now I’ll focus on one aspect of structure finance - securitisations for the rest of this talk.

Project & Structured Finance Actuaries Project & Structured Finance Structured Finance Securitisation Q. What is it? Debt securities raised against a specific set of assets or cash flows. Q. Why do it? Cost of Funding Access to Funding Q. What is normally securitised? Q’s to the floor

Project & Structured Finance Actuaries Project & Structured Finance Structured Finance Securitisation Q. What is it? Issuing securities against a specific pool of assets or cash flows (normally illiquid). Q. Why do it? Cost of Funding Access to Funding Q. What is normally securitised? Pools of residential or commercial mortgages, car loans, credit card receivables. Why? Access to Funding (diversified sectors, demand deposits v wholesale market) Also by putting assets off balance sheet can reduce capital requirements, and change ratings Accounting Why mortgages. Familiarisation with the asset class The earliest securitised transactions date back to the early 1970s in the US and were the sales of pooled mortgage loans by the Government National Mortgage Association (Ginnie Mae). These transactions were followed by the Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae) in the early 1980’s. What else can be? Virtually anything. Other examples (insurance premiums, film receivables, lottery winnings, music royalties) Now lets focus on the most common form of securitisation, a mortgage backed security

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Model the future project cashflows Model the future debt obligation cashflows Identify & Analyse the risks Determine & communicate the key assumptions Set modelling assumptions Past experience Collateral data - Credibility issues Overseas experience Sensitivity Testing Q to the floor. What is the Asset/Cash Flow item. Why is it being securitised (eg Aussie Home Loans - access to funds) Important to know the above is an Iterative Process

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Model the future project cash-flows for a Residential Mortgage Backed Security (RMBS) Determine the types of mortgages in the pool Variable v Fixed rate Principal & Interest / Interest Only Obtain relevant data (commencement dates, loan terms, loan amounts, loan type, fixed rate periods, interest only periods, interest rates) Determine modelling methodology Weighted pool v Individual loan projections Timing and frequency of repayments etc Understand & communicate important modelling assumptions What is your model? Principal repayments, interest repayments and balance outstanding at the end of every month until the end of all future loan terms. Review Loan contract terms to understand products modelling

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Model the future debt obligations Tranches of Securities / Subordination Pass through / Redraw / Re-investment Sequential Pay / Planned Amortisation Coupon Periods & Rates Call Dates & Triggers & Step-up margins Initial Loss Reserves, Excess Spread Reserve Trust Expenses Liquidity facility Cash-flow waterfall Obtain draft debt obligation documents (informaiton memorandums) Call Dates (soft call 10%, hard call 5 years). Why have a hard call? What is subordinatation and why do it?

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Identify & Analyse the risks Response Credit Enhancement Techniques UCCC certification Mortgage Insurance Subordination – Tranches Excess Spread & Threshold rates Contractual Conditions & Default Fees Interest Rate & Basis Swaps Disclosure

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Determine & communicate the key assumptions & key attributes of the Data & their interaction. Assumptions Prepayment Rates Delinquency Rates & Periods Default rates Mortgage Data WARIO, WAS, WAM, WAF, WAMOT

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Set modelling assumptions Past experience Collateral data - Credibility issues Overseas experience Ratings Agency – Stress Testing Established Market, but always slight changes (eg non-conforming loans) – high credit risk

Mortgage Backed Securities Actuaries Mortgage Backed Securities

Mortgage Backed Securities Actuaries Mortgage Backed Securities

Mortgage Backed Securities Actuaries Mortgage Backed Securities So what do Actuaries do? Sensitivity Testing - Why? Investors - Repayment of Investment Rating Agencies Setting Terms of Offer What sensitivities are looked at? Interest rates (effect on capital outstanding) Margins Default Rates of underlying mortgages Levels of Loss Reserve, Coupon Rates, … Rating Agency Importance because effects cost of capital depending on rating Hence credit enhancement

Review Investment Banks Financial Advisory Actuaries Review Investment Banks Financial Advisory Project & Structured Finance Securitisation RMBS Drill Down

Actuaries Questions

Actuaries in Investment Banks UNSW Presentation 3 May 2004