MTN Program

What are “medium-term note programs”?
Medium-term note (“MTN”) programs enable companies to offer debt securities on a regular and/or continuous basis.

Traditionally, the securities issued under these programs have filled the financing gap between short-term commercial paper, which has a maturity of nine months or less, and long-term debt, which has maturities of 30 years or more. As compared to other forms of debt securities, MTNs tend to have their own type of settlement procedures and marketing methods, which are similar in some respects to those of commercial paper.

Although medium-term notes typically have maturities of between two to five years, they are not required to have medium terms. In fact, it is common for companies to issue both short-term and long-term securities under an MTN program.

Why would a company have a medium-term note program?

Like a shelf registration statement, an MTN program enables a company to sell a wide range of debt securities without having to complete the SEC’s registration or review process for each issuance. See “How are MTN programs registered?” In addition, an MTN program uses a master set of disclosure documents, agreements with selling agents or dealers, and issuing and paying agency agreements to help minimize the new documentation that is needed for each offering.

Who develops MTN programs?

Historically, many MTN programs were developed by the commercial paper departments of investment banks. Securities from these programs were offered and sold on a principal or agency basis from a broker-dealer’s trading desk. The programs often were administered by a bank’s specialty group rather than through the typical relationship bankers.

What types of issuers establish MTN programs?

MTN programs typically are used by large companies that have an ongoing need for capital and that are eligible to file shelf registration statements for delayed and continuous offerings. Most large financial institutions, and many “industrial companies,” have an MTN program. A number of government-sponsored entities, such as Fannie Mae and Freddie Mac, also have MTN programs.

Are the debt securities in an MTN program ever guaranteed by an entity other than the issuer?

Yes. Particularly among financial institution issuers, it is common for an operating subsidiary (such as a bank subsidiary of a bank holding company) to have a higher credit rating on its indebtedness than the parent corporation (such as a bank holding company). Accordingly, many MTN programs are structured so that: the operating subsidiary is the actual issuer of the securities, and the parent holding company is the guarantor; or
the parent holding company is the issuer of the securities, and one or more operating subsidiaries are guarantors.

What types of offerings are completed using MTN programs?

In light of the convenience offered by shelf registration and MTN programs, issuers use MTN programs: to effect small and medium-sized offerings of debt securities to investors that seek specific terms (known as “reverse inquiry” trades) (see “What are “reverse inquiry” transactions, and how do they impact the MTN market?”); to effect large syndicated offerings of debt securities that might, in the absence of an MTN program, be offered through a shelf-takedown; to offer structured notes, such as equity-linked, currency-linked, and commodity-linked securities; and to operate a “retail note program,” in which an issuer offers debt securities with small minimum denominations to “retail” investors.

What types of securities normally are sold through medium-term note programs?

Historically, the most common type of security issued under an MTN program is a fixed-rate, non-redeemable senior debt security. However, MTN programs typically include other types of debt securities, including floating rate, zero coupon, non-U.S. denominated, amortizing, multi-currency, subordinated, or indexed securities. Common reference rates for floating rate securities issued under MTN programs include LIBOR, EURIBOR, the prime rate, the Treasury rate, the federal funds rate, and the CMS rate. Most MTN programs are rated “investment-grade” by one or more nationally recognized rating agencies.

Who sets the terms of medium-term notes?

Similar to the commercial paper market, the traditional market for MTNs is investor-driven. Dealers continuously offer MTNs within a specific maturity range, and an investor can negotiate to have the dealer meet its particular investment needs at a specific maturity level. See “What types of offerings are completed using MTN programs?”

Investors in MTN securities make their investment decisions based upon credit ratings, an evaluation of the issuer and its business, the maturity of the notes, and the yield on the notes.

MTN buyers include the institutional buyers of underwritten corporate debt securities. In the case of structured products and retail notes sold from an MTN program, individual investors also may be purchasers.

Are medium-term notes sold on a firm commitment basis or a best efforts basis?

It varies. The dealer’s traditional obligation is to sell the MTN securities on a “best efforts” basis. However, on occasion, competitive pressures result in a dealer purchasing MTN securities as principal. In addition, large syndicated MTN offerings often are effected on a firm commitment basis. In both cases, the MTN dealer is usually regarded as an “underwriter” for Section 11 purposes.

How are MTNs “posted” and sold?

Through its selling agents, an issuer of MTNs “posts” offering rates over a range of possible maturities: for example, nine months to one year, one year to eighteen months, eighteen months to two years, and annually thereafter. An issuer may post rates as a yield spread over Treasury securities having the same maturity. The selling agents provide this rate information to their investor clients and to regional dealers.

Issuers are likely to lower their posted rates once they raise the desired amount of funds at a given maturity. In addition, issuers will change their offered rates as market conditions and prevailing interest rates change. Issuers may effectively withdraw from the market by suspending sales or, alternatively, by posting narrow offering spreads over the comparable Treasury yields at all of the posted maturity ranges.

When an investor expresses interest in an MTN offering, the selling agent contacts the issuer to obtain a confirmation of the terms of the transaction. Within a range, the investor may have the option of selecting the actual maturity of the notes, subject to final agreement by the issuer.

What are “reverse inquiry” transactions, and how do they impact the MTN market?

Investors often play an active role in the MTN market through the “reverse inquiry” process. An investor may seek an investment in a specified principal amount, with a specified credit rating, and a specified maturity. If a security with the desired terms is not available in the corporate bond market, the investor may be able to obtain it in the MTN market through reverse inquiry. In this case, the investor will communicate the terms of the investment it is seeking to an issuer of MTNs through the issuer’s selling agent. If the issuer finds the terms of the reverse inquiry acceptable, it may agree to the transaction even if it was not posting rates at the desired maturity.

Reverse inquiry transactions play an important role in both “plain vanilla” debt issued in MTN programs and more exotic structured securities.

What is a “retail MTN” program?

Historically, some issuers would not issue MTNs except in fairly significant principal amounts, as bookkeeping and administrative costs can become disproportionately burdensome with smaller offerings. However, book-entry clearing through DTC and advances in computer bookkeeping decreased the cost of issuing debt securities in small denominations. As a result, a variety of issuers have registered MTN programs with minimum denominations of $1,000, or even less. Although most MTNs are still sold to institutional investors, reducing the minimum denominations has enabled issuers to reach smaller investors.

A “retail MTN program” is specifically designed to offer debt securities to the retail market, while maintaining administrative costs to issuers at acceptable levels. In order to achieve those objectives, the process of issuing retail MTNs may differ slightly from the process of selling MTNs to institutions.

In one type of retail MTN program, an issuer will post rates weekly with retail and/or regional brokers. During the week that these rates are posted, the brokerage firms market the securities to retail investors, who place orders in the applicable minimum denominations. At the end of the week, the retail and regional brokerage firms will contact the corporate issuer and indicate the aggregate amount of orders for notes at each maturity, and the corporation will issue one series of notes at each maturity. For example, several hundred retail investors could place orders for MTNs with maturities of two and five years, but the administrative costs for the corporate issuer would reflect only two issuances from the shelf registration.

Significant U.S. arrangers for retail MTNs include Incapital (and its InterNotes program) and Merrill Lynch.

The Working Group in an MTN Program

What is the role of the arranger of an MTN program?

The arranger of an MTN program serves a variety of roles, including:
-serving as principal selling agent for the MTN securities;
-advising the issuer as to potential financing opportunities in the MTN market;
-communicating to the issuer any offers from potential investors to buy MTNs;
-advising the issuer as to the form and content of the offering documents, including the types of securities to be included;
-helping the issuer draft the offering documents and related program agreements;
-negotiating the terms of the agreements on behalf of itself and the other selling agents;
-coordinating settlement of the MTN securities with the issuer, the trustee, and the paying agent; and
-making a market in the issued and outstanding securities issued under the program.

What is the role of the other selling agents in an MTN program?

The MTN program may have selling agents other than the arranger who offer the issuer’s securities. Having multiple selling agents encourages competition among the selling agents to market the issuer’s securities, and may lower the issuer’s financing costs for securities issued under the program. In addition, having more selling agents quote prices for the MTN securities may lead to more “reverse inquiry” transactions. See “What are “reverse inquiry” transactions, and how do they impact the MTN market?”

How do the selling agents conduct due diligence with respect to an MTN program?

Whether the selling agents are acting on a “best efforts” or “firm commitment basis” in connection with a takedown, they are subject to liability as “underwriters” under Section 11 of the Securities Act. See Are medium-term notes sold on a firm commitment basis or a best efforts basis? However, because takedowns from a program may be frequent, and often occur on short notice, the selling agents are not likely to be able to initiate and complete a full due diligence process at the time of each offering. Accordingly, it is fairly common for the selling agents on an active MTN program to conduct “ongoing due diligence” with respect to the issuer, so that their investigation is complete and up-to-date at the time of each takedown.

With respect to so-called “legal due diligence,” the issuer under an MTN program will often designate a law firm, known as “designated underwriters’ counsel,” to conduct ongoing legal due diligence, and to share its material findings with the relevant selling agents on a particular takedown.

What is the role of regional dealers in the MTN market?

At one time, the major New York-based investment banks distributed nearly all MTN securities to investors. As the market matured, regional dealers began to play a larger role in selling MTNs. Regional dealers receive information about MTN issuers’ offering rates from MTN selling agents. In turn, the regional dealers communicate this information to their investor clients.

When an investor buys an MTN through a regional dealer, the dealer typically receives a selling concession from the MTN selling agent. These placements through regional dealers improve efficiency in the market by broadening the potential investor base for MTNs.

What is the role of the trustee or paying agent in an MTN program?

The trustee or paying agent in an MTN program serves a variety of roles, including:
-processing payments of interest, principal, and other amounts on the securities from the issuer to the investors;
-communicating notices from the issuer to the investors;
-coordinating settlement of the MTN securities with the issuer and the selling agent;
-assigning security identification codes to the MTN securities (in the case of U.S. programs, the trustee typically obtains a block of CUSIP numbers for the relevant issuer’s program and assigns them on an issue-by-issue basis);
-processing certain tax forms that may be required under the program; and
-in the case of a trustee of a series of U.S.-registered notes, acting as representative of the investors in the event of any claim for payment if a default occurs.

Registration of Medium-Term Note Programs –Offering Documents

How are MTN programs registered?

MTN programs typically are registered on a shelf registration statement under Rule 415.
Issuers that are “primarily eligible” to use Form S-3 or Form F-3 may file a shelf registration statement under clause (x) of Rule 415(a)(1), permitting continuous or delayed offerings. MTN issuers not eligible to use Form S-3 or Form F-3 are limited to continuous offerings under clause (ix), may not wait to commence offers once the registration statement has been declared effective, and must be offering the securities on a continuous basis. Accordingly, MTN programs generally are limited to larger public companies, with at least a $75 million public equity float.

Companies can register MTN programs on Form S-1 or Form F-1. However, this is rarely done due to the potential need to update the MTN registration statement to reflect developments in the issuer’s business and finances.

Are MTN programs always registered with the SEC?

No. Some MTNs are offered in bank note programs exempt from registration under Section 3(a)(2) of the Securities Act of 1933, or in Rule 144A programs in which the securities are offered exclusively to qualified institutional buyers. In the past, some issuers operated programs that were conducted as private placements in continuous Section 4(2) programs. In addition, issuers may establish Regulation S programs in which the securities are offered outside the United States, such as in the case of European Medium-Term Note Programs (“EMTNs”), Global Medium-Term Note Programs (“GMTNs”), or Australian Medium-Term Note Programs (“AMTNs”). Two or more of these types of programs may be combined, such as an EMTN program that also provides for the issuance of securities to qualified institutional buyers in the United States under Rule 144A.

Non-U.S. issuers that wish to access the debt markets in the United States without registering under the Securities Act often establish a Rule 144A program and/or a Section 3(a)(2) program (if they are banks).

Typically, the offering circular and settlement process for non-registered MTN programs are somewhat similar to registered MTNs. The primary difference is the nature of the offerees.

What offering documents are used in an MTN program?

The issuer’s registration statement for an MTN program typically consists of:
-a “universal” shelf registration statement for debt and other securities; or
-a shelf registration statement providing only for debt securities; or
-a prospectus pertaining to the MTN program itself.

In the first two cases, after its registration statement becomes effective (or upon filing, in the case of a well-known seasoned issuer, or “WKSI,” filing an automatically-effective shelf registration statement), the issuer will prepare and file an “MTN prospectus supplement” under Rule 424(b) that describes the securities to be issued under the MTN program and provides the names of the selling agents. See “What is a prospectus supplement?” in these FAQs. Traditionally, the prospectus supplement sets forth the aggregate U.S. dollar amount of the securities that may be offered under the program. Many WKSIs no longer provide that amount, because a WKSI shelf-registration statement is not required to specify the aggregate amount of securities that will be issued.

The terms of a takedown from an MTN program are set forth in a “pricing supplement” that is filed with the SEC under Rule 424(b). The pricing supplement may be very short, especially in the case of “plain vanilla” securities. Alternatively, it may be very long, in the case of complex structured securities offered from an MTN program.

Since the SEC adopted Rule 159 in December 2005, many issuers have attempted to describe as many of the potential terms of the securities as possible in the base prospectus or the MTN prospectus supplement rather than in the pricing supplement. This disclosure strategy enables issuers to limit the information that needs to be provided to an investor at the time of pricing or in the pricing supplement. Such issuers are attempting to reduce the likelihood that an investor can claim that the information it received prior to its agreement to purchase the securities was inadequate without the information in the pricing supplement.

Under SEC Rule 424(c), the base prospectus and the MTN prospectus supplement need not be re-filed with the SEC via EDGAR at the time of a pricing with the applicable pricing supplement if those two documents have not changed since their previous filing. However, some issuers choose to re-file those documents together with the pricing supplement in order to provide investors more convenient access to all of the relevant disclosure.

What other offering documents may be used in an MTN offering?

In addition to the base prospectus, MTN prospectus supplement, and pricing supplement, an issuer and the selling agent may use several other disclosure documents in the offering process:

-Preliminary and Final Term Sheets: subject to the filing requirements of Rule 433 and other SEC rules relating to “free writing prospectuses,” an issuer or a selling agent may use preliminary and final term sheets to negotiate the terms of an offering with potential investors, to broadly market an offering, or to set forth the agreed-upon final terms of an offering. As per the discussion of Rule 159 above, providing a final term sheet at the time of pricing also may help bolster the position that the investor received all of the relevant required information at the time it entered into its agreement to purchase the securities.

-Free Writing Prospectuses: issuers and selling agents may use brochures, pamphlets, websites, and other types of documents to market potential offerings from an MTN program.

-Product Supplements: issuers of structured products from MTN programs often use a “product supplement” to describe the detailed terms, risk factors, and tax consequences of a particular type of product to potential investors.

-Underlying Supplements: some issuers of structured products from MTN programs use an “underlying supplement” to describe one or more equity or commodity indices that will be linked to the relevant security.

-Press Releases: particularly in the case of a large syndicated offering, the issuer may issue a press release after pricing to describe the transaction. For a registered offering, the content of such a press release is limited by Rule 134.

How do the offering documents differ for a non-registered MTN program offered in the United States?

Because Rule 144A and Section 3(a)(2) programs are not subject to the SEC’s registration requirements, these programs do not involve the filing of a registration statement. Instead, the principal document used to describe the securities and the issuer is an “offering memorandum,” which may be called an “offering circular.” In addition to a detailed “description of the securities” section, an offering memorandum will either include a description of the issuer’s business and financial statements, or incorporate them by reference from the issuer’s publicly-available documents in the United States or its home jurisdiction.

In addition, the issuer and the selling agents for these offerings may use a variety of term sheets to offer these securities, which are not subject to the filing requirements of Rule 433.

What additional exhibits are required in the registration statement for an MTN program?

If not otherwise filed with the registration statement, the issuer under an MTN program must also file:
-the distribution agreement with the selling agents;
-the indenture (or indentures) with the indenture trustee;
-an Exhibit 5.1 opinion as to the legality of the notes to be issued under the program;
-in the case of complex securities, an Exhibit 8.1 opinion as to the disclosure of the U.S. federal income taxes; and
-the form of the note or certificate representing the medium-term notes.

Issuers often file these documents as to the program as a whole at the time the MTN prospectus supplement is filed. However, depending upon the circumstances and the terms of the relevant offering, these documents may be filed at the time of a specific take-down.

Establishing a Medium-Term Note Program

What documents are used to establish an MTN program?

In addition to the disclosure documents (see “Registration of Medium-Term Note Programs – Offering Documents”), the following documents are typically used to establish an MTN program:
-one or more indentures with the indenture trustee (in the case of an SEC-registered program), or paying agency agreements with the paying agent (in the case of an unregistered program);
-a distribution agreement (or “program agreement”) between the issuer and the selling agents or dealers; and
-an “administrative procedures memorandum,” which describes the exchange of information, settlement procedures, and responsibility for preparing documents among the issuer, the selling agents, the trustee or paying agent, and the applicable clearing system in order to offer, issue, and close each series of securities under the MTN program.

Additional agreements for an MTN program may include:
-A calculation agency agreement: under this agreement, the calculation agent, which often is the trustee or the paying agent, agrees to calculate the rate of interest due on floating rate notes. This type of agreement also may be used in connection with structured notes to calculate the returns payable on the note. In the case of structured notes, a broker-dealer (usually, the arranger or one of its affiliates) is more likely to serve as calculation agent.

-A currency exchange rate agency agreement: under this agreement, an exchange rate agent (again, often the trustee or the paying agent) converts the payments made by the issuer on foreign currency-denominated MTN notes into U.S. dollars for the benefit of U.S. investors.
In addition, at the time an MTN program is established, the issuer generally is required to furnish a variety of documents to the selling agents, as would be the case in a typical underwritten offering:
-officer certificates as to the accuracy of the disclosure documents;
-legal opinions as to the authorization of the program, the absence of misstatements in the offering documents, and similar matters; and
-a comfort letter from the issuer’s independent auditors.

Depending upon the arrangements between the issuer and the selling agents, some or all of these documents will be required to be delivered to the selling agents on a quarterly basis as part of the selling agents’ ongoing due diligence process. See “How do the selling agents conduct due diligence with respect to an MTN program?” Some or all of these documents also may be required in connection with certain takedowns, such as large syndicated offerings.

What types of provisions are in the distribution agreement for an MTN program?

A distribution agreement (which may be called a “program agreement” or a “sales agency agreement”) is similar to an underwriting agreement in many ways, but is designed to provide for multiple offerings during the life of the program. Typical contents include:

-representations and warranties of the issuer as to the accuracy of the offering documents, the authorization of the program, and other matters;
-the steps to be followed if the MTN prospectus supplement is amended or the size of the program is increased;
-the steps to be followed, and the approvals required, if any free writing prospectuses are to be used;
-requirements as to the conditions precedent, documents, and deliverables for establishing the program and/or conducting takedowns;
-requirements as to any subsequent deliverables from the issuer to the selling agents, such as periodic comfort opinions, legal opinions, and officer certificates;
-provisions allocating program expenses among the issuer and the selling agents;
-indemnification of the selling agents for liabilities under the securities laws;
-provisions relating to the determination of the selling agents’ compensation, or a schedule of commissions; and
-provisions for adding additional selling agents, whether for the duration of the program or for a specific offering.

The representations and warranties under the distribution agreement typically are deemed to be made both at the time of the signing of the agreement and at the time of each takedown.

What kind of bond indenture is used for an MTN program?

In the case of a registered program, the indenture or indentures for an MTN program must be qualified under the Trust Indenture Act of 1939. The indenture may or may not be designed for specific use with an MTN program. The indenture is usually open-ended, and does not limit the amount of debt securities that can be issued. The indenture may have restrictive covenants, affirmative covenants, and events of default that vary depending upon the nature of the issuer.

What forms of notes are used for an offering under an MTN program?

The notes issued under an MTN program typically are in global form, with a single master certificate representing each series. In U.S. programs, an investor’s interest in the global note is held through a direct or indirect participant in the DTC system.
In a typical U.S. offering of debt securities that does not involve an MTN program, the form of note used to represent the securities is customized specifically for that offering. However, in the case of an MTN offering, it may be an unnecessary cost to create a customized form of note for each offering. Accordingly, an MTN program often will involve one or more forms of notes that consist of two key parts:

-detailed provisions that could apply to many different types of notes (fixed and floating; the calculation of different types of base rates); and
-a short leading page or cover page for the note that indicates (through “check boxes” and blank lines) which of those detailed terms are applicable to the specific issuance.
Although notes of this kind may be rather lengthy, this formulation enables the issuer and/or the trustee to create the forms of notes for actual take-downs more efficiently. Of course, in the case of more complex securities, such as structured notes, more customized forms of global notes often must be created.

Are MTN programs rated by rating agencies?

The issuer’s credit rating plays an important part of an investor’s decision to purchase MTNs. Accordingly, an issuer of MTNs usually will have either credit ratings for its indebtedness generally, or credit ratings that are specific to the MTN program. Most MTN programs carry an investment grade rating. The issuer will deliver copies of the applicable ratings letters to the arranger, and generally is required to inform the selling agents of any changes in its ratings.

Effecting an MTN Offering

How complicated is a takedown for a MTN program?
A takedown from an MTN program can be very simple. Each takedown only requires a few matters to be addressed, including:
-agreeing upon the terms of the takedown (frequently done orally, with written confirmation);
-in certain cases, such as a large syndicated takedown from an MTN program, delivering an updated comfort letter, legal opinions, and officers’ certificate to the selling agents;
-delivering the base prospectus, MTN prospectus supplement, and pricing supplement to investors (which may occur via “access equals delivery” under SEC Rule 172);
-completing a note, either in global or certificated form, which is done by the trustee or issuing and paying agent upon the issuer’s instructions (see “What forms of notes are used for an offering under an MTN program?”; and
-filing a pricing supplement under Rule 424 with the SEC.

What is disclosed in a “pricing supplement” for a MTN offering?
For a simple debt security, very little information is required in the pricing supplement. The pricing supplement will include the final terms of the offering, such as:
-the title of the securities;
-the issue date;
-the maturity date;
-the interest rate;
-the redemption dates, if any;
-the underwriter or selling agent; and
-the selling agents’ compensation for the offering.

How do MTN securities settle and clear?

MTN offerings settle and clear in the United States through the issuance of securities in global form. Beneficial interests in these global notes are held by direct and indirect participants of The Depository Trust Company (“DTC”). When an MTN is issued under the book-entry system, an agent bank for the issuer uses a computer link with DTC to enter the descriptive information and settlement details of the offering. The selling agent receives a copy of the computer record from DTC, and the investor receives a trade confirmation from the selling agent and periodic ownership statements.

Secondary market trades also are recorded with computer entries. Under the book-entry system, an issuer of MTNs, through the trustee or paying agent, makes a single wire transfer to DTC that covers all interest payments on each interest payment date, and only one transfer of funds on the maturity date to DTC.

This system differs from a “paper certificate” system, in which the issuer must make separate payments to each security holder. In addition to reducing the cost of securities issuances, the book-entry system reduces the likelihood of delayed delivery because of logistical problems, and reduces the chances of failed trades arising from paperwork errors.

CHINA and US

Between 1978 and 2007, China's GDP grew at an average annual rate of 9.75 percent and reached 24.6619 trillion yuan ($3.43 trillion) in 2007. With a total annual trade volume of over $ 2 trillion, China's foreign exchange reserves have reached $1.68 trillion as of March 2008 and continues to grow rapidly.

While pursuing sound economic development, China is opening up its economy and actively seeking to expand its economic and trade ties with the developed world, including the US. At present, China and the US have become economically interdependent and their interests intertwined.

The US has made significant gains from its economic and trade relations with China.

First, low-priced and good-quality goods and services imported from China have raised the consumer surplus and eased the inflation pressure in the US. According to a Morgan Stanley report, trade with China in 2004 alone saved American consumers $100 billion and created 4 million new jobs.

Second, China's imports from the US have added new momentum to the US economy. For five consecutive years, China has been the fastest growing market of American exports. And over the past decade, US exports to China increased more than 350 percent, which is about six times the growth of US exports to other regions. Whereas China was the 13th largest export market for US products in 1995, it is now the US' fourth largest market.

Third, US investments in China have yielded high returns. As of November 2007, US investors had poured in a total of $56 billion into 51,555 enterprises in China. These investments have obtained high returns and shared China's economic success. A study by the US-China Chamber of Commerce showed that 70 percent of American companies operating in China profited from their local businesses, and 42 percent of them reported profit margins in China higher than their global average. According to the US Bureau of Economic Analysis, since 1990 the remittance of investment proceeds generated in China by US companies, not including retained earnings and reinvestments, has totaled $ 20.8 billion, which is about 8 percent of their global total ($270 billion) over the same period.

Fourth, China's large-scale purchase of US dollar-denominated assets has helped lower US long-term interest rates, thereby providing cheaper capital for supporting US economic growth. Though enjoying a rapid and sustained growth, the economic and trade relations between the two countries are not free of problems or frictions, among which the most notable are the trade imbalance, the RMB exchange rate, and the protection of intellectual property rights. Views on these issues vary. I will comment on each of them in turn.

There are three factors contributing to the China-US trade imbalance.

The first factor is the declining savings rate in the US in recent years. Because private savings, especially the individual savings, continue to slump, coupled with the change from fiscal surplus to deficit, the US economy has become dependent on foreign capital to fill its investment gap, which could give rise to a trade deficit.

The second factor is the US export control policy. Despite the enormous demand for new and high-tech products from China, many US goods and products do not have access to the Chinese market because of the longstanding control imposed by the US government over high-tech exports to China. This has hampered growth of US exports to China. Although the US is the world's largest country in terms of number of technology innovations, it ranks only third in China's technology imports. In my view, advancement in technology is achieved mainly through applications. An export control policy hinders this advancement. For one, export controls prevent the US from gaining the potential profits from selling high-tech products and equipment to China.

The third factor is the acceleration of economic globalization. Globalization has sped up the flow of production factors and the transfer of industries. Labor and other advantages have made China a favorite destination of such transfers and, as a result, the "world's factory". Processing for direct and re-export trade of these foreign-invested enterprises is the major source of China's trade surplus with the US. In essence, this China-US trade surplus is largely a shift of the same "surplus" of Southeast Asian countries in their trading relations with the US.

To support this, we notice the fact that despite the rise of US trade deficit with China in recent years, American trade deficit with East and Southeast Asian countries has not seen a significant increase, which is a natural outcome of this trade surplus transfer. As to the RMB exchange rate, many in the US blame the RMB exchange rate as the culprit behind the China-US trade imbalance and call for an immediate, hefty appreciation of the RMB. I do not think this will effectively solve the trade deficit issue. In fact, most US economists and government officials are aware that the RMB exchange rate has little to do with the size of the US trade deficit, and that an appreciation of the RMB cannot solve the problem of the US trade imbalance.

Then, why is there still so much clamor on RMB exchange rate? Two underlying reasons come to mind.

First, it is the unique American election culture. Politicians like to point to a scapegoat for domestic problems. It is easier to find a foreign one, for otherwise they will be challenged by the American people for their policy failures. This behavior is best depicted by an old Chinese saying, "Blame others to avoid being blamed".

Second, which needs no elaboration, there are a few people in the US who are interested in slowing down China's development by this or other means. As to the Intellectual Property Rights (IPR), the Chinese government is committed and has been working vigorously to improve and enforce the relevant laws and regulations to protect IPR. Our American colleagues are well aware of this. What I want to emphasize is that protection of IPR is absolutely necessary, but should also be appropriate. Otherwise, not only will it be difficult to enforce such protection, but such measures would also be detrimental to human development.

Take, for instance, the patent rights for AIDS medication. If the royalties run too high, AIDS patients in developing countries will not be able to afford these medicines. As such, control over AIDS and similar epidemics will be compromised and holders of the patent will not benefit as much as they could from much broader applications. Royalties have the same effect on intellectual piracy as tariffs have on commodity smuggling. High tariffs charged for the purpose of protecting domestic "infant" industries also make smuggling a profitable business. In the same way that reducing tariffs is the best means to crack down on smuggling, lowering royalties and shortening IPR protection periods to appropriate levels are the best methods to end piracy. Economic globalization is an irreversible trend; both the US and China benefit from it. Unfortunately but understandably, opposing voices and forces against economic globalization exist in both countries and in other parts of the world.

If the US and China cannot cooperate with each other and spread the benefits of globalization to most countries and peoples in the world, globalization is likely to be obstructed. If this happens, the loss will be borne not only by China and the US, but by the whole of mankind as well. Being both stakeholders in supporting economic globalization, the two countries should work together for a solution to their trade problems on the basis of mutual benefit and through consultations on equal footing. As Thomas J. Christensen, Deputy US Assistant Secretary of State for East Asian and Pacific Affairs, recently put it, "the United States and China must further expand and deepen cooperation and have frank and candid consultation on the differences between the two sides".

We are pleased to see that the two countries have established a Strategic Economic Dialogue mechanism and other consultation channels. China, for its part, has taken a series of measures, including reforming its exchange rate regime, lowering export tax rebates, and encouraging imports.

The Mid-Term Loan Agreement of Sovereign-Based Financing Cooperation between China and the US, as signed and executed by the Exim banks of both sides, is one of these measures. All these are designed to create more favorable conditions for US exports to China. We hope that the US will change its trade philosophy and adopt constructive measures toward resolving the bilateral trade issues. Special attention should be paid to avoiding the rise of trade protectionism because it undermines the trade and interests of both countries.

A research by Morgan Stanley shows that a 27.5 percent tariff, if imposed on Chinese exports to the US, would have made American companies pay an extra $69 billion in 2005, or 10 percent of the total profits of companies on Standard & Poor's 500 Index. In short, I am confident that, as long as the two countries take serious and concerted efforts, the bilateral trade and economic problems can be solved smoothly.

Credit enhancement

Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization.There are two primary types of Credit Enhancement: Internal and External.

Internal Credit Enhancement

Excess spread
The excess spread is the difference between the interest rate received on the underlying collateral and the coupon on the issued security. It is typically one of the first defenses against loss. Even if some of the underlying loan payments are late or default, the coupon payment can still be made. In the process of "turboing", excess spread is applied to outstanding classes as principal.

Overcollateralization
Overcollateralization is a commonly used form of credit enhancement. With this support structure, the face value of the underlying loan portfolio is larger than the security it backs, thus the issued security is overcollateralized. In this manner, even if some of the payments from the underlying loans are late or default, principal and interest payments on the ABS can still be made.

Reserve account
A reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the reserve. To increase credit support, the reserve account will often be non-declining throughout the life of the security, meaning that the account will increase proportionally up to some specified level as the outstanding debt is paid off.

External Credit Enhancement

Surety bonds
Surety bonds are insurance policies that reimburse the ABS for any losses. They are external forms of credit enhancement. ABS paired with surety bonds have ratings that are the same as that of the surety bond’s issuer. By law, surety companies cannot provide a bond as a form of a credit enhancement guarantee.

Wrapped Securities
A wrapped security is insured or guaranteed by a third party. A third party or, in some cases, the parent company of the ABS issuer may provide a promise to reimburse the trust for losses up to a specified amount. Deals can also include agreements to advance principal and interest or to buy back any defaulted loans. The third-party guarantees are typically provided by AAA-rated financial guarantors or monoline insurance companies.

Letter of credit
With a letter of credit (LOC), a financial institution — usually a bank — is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount. Letters of credit are becoming less common forms of credit enhancement, as much of their appeal was lost when the rating agencies downgraded the long-term debt of several LOC-provider banks in the Fixed Income Sectors: Asset-Backed Securities—6 early 1990s. Because securities enhanced with LOCs from these lenders faced possible downgrades as well, issuers began to utilize cash collateral accounts instead of LOCs in cases where external credit support was needed.

Cash collateral account
With a cash collateral account (CCA), credit enhancement is achieved when the issuer borrows the required credit support amount from a commercial bank and then deposits this cash in short-term commercial paper that has the highest available credit quality. Because a CCA is an actual deposit of cash, a downgrade of the CCA provider would not result in a similar downgrade of the security.

Henry Paulson Will Morph Toxic Banks into Toxic Dollars - This Doesn't Have to Happen

On Thursday right before CNBC reported on rumors of the bank bailout plan, Ben Bernanke was meeting with lawmakers and selling the plan to them. Inside a conference room that is part of Speaker of the House Nancy Pelosi's office he was meeting with the Congressional leadership. According to the Washington Post he told them that if they don't pass the plan "it will be nothing short of disaster for our markets." He claimed that stock market would crash and money market funds would get wiped out.

In a conference call with Republicans on Friday Bernanke said, "many of your constituents hold money in money markets — those funds are losing money" and now the "critical issue is what do we do about these bad assets clogging up our credit system.”

And the Congressional leadership caved in. Bernanke who once spoke about helicopter money drops to pump the economy is now using B-52 carpet bombing. The banks will be saved, but in the end the US economy may be destroyed. This weekend the Treasury Secretary submitted a $700 billion dollar bailout plan for the banks. The bill will authorize the Treasury Department to simply print Treasury bonds to pay for it. The effect of this will be to end the insolvency crisis for banks and turn that crisis into an eventual dollar crisis.

Over the next two years you can expect to see the value of the dollar drop, bonds drop, and gold skyrocket. The question we need to ask ourselves now is how bad will the inflation get? Will it turn into a hyperinflationary explosion that will totally destroy the value of the dollar and wipe out the savings of millions of Americans? Will the Fed one day say we must fight inflation by raising interest rates to 20% or beyond like the Fed did in 1980 or will the Fed let the value of the dollar literally go to zero. These are the end game scenarios we are now headed to. I don't know what will happen in the end, but am going to be prepare myself for either possibility.

Now Bernanke and Paulson said that if there were plan was not enacted the economy would collapse. On Saturday I watched FOX News do a morning special on the crisis hosted by Neil Cavuto. Bush gave a radio address in support of the plan and Cavuto's attitude seemed to be "Bush is a great leader. If we don't do this plan there will a Great Depression. We must support Bush so trust him and obey." Hank Paulson appeared on Sunday's Meet the Press and in response to serious questions about the plan basically said this is a crisis and this is the only choice we have. The talking points seem to be we must accept this plan or we will have a depression.

Well none of this is true. There are alternatives to simply buying all of the bad debt off the balance sheets of all of these banks. Not every bank in the country is bankrupt, but the problem is that so many of the largest banks are saddled with bad debts - and losses that are hidden due to accounting tricks - that banks have ceased to lend to one another. That is the essence of a credit crisis. There is a problem of confidence, but this is not the only way to solve it.

A banking crisis happened in the beginning of the Great Depression, but Franklin Roosevelt and the government did nothing like what is being proposed today. They did not bail out the banks. What Roosevelt did was declare a banking holiday. He shut the banks down. for about a week Then he had officials go into all of the banks and look at their financials to determine which banks were truly bankrupt, which were fine, and which could be saved with a little bit of money. When the bank holiday ended the banks that were bankrupt did not open back up and the ones that were fine did.

Confidence was restored, because depositors now knew if their bank was fine or not - and it didn't require putting the financial future of the entire country at risk to do this. It cost hardly a dime. Yes some people lost money. A lot of banks went under, but the dollar didn't go to zero and future generations weren't saddled with debts. The credit freeze ended in a week.

The same thing could be done now as an alternative. But this is not a plan that Goldman Sachs or Morgan Stanley would like. And the bankers own Bernanke, Paulson, and the Congressional leadership . They are the top contributors to both John McCain and Barak Obama. In a time in which there are alternatives to what is being done none are being presented to the American people. It is a lie to say the only choice we have is to do what Paulson and Bernanke propose or we will have a Great Depression.

What is being planned does not have to happen. And we can solve this crisis without bailing out all of the banks and putting the solvency of the entire country at risk. We need real leaders and not pretend leaders. We need people to speak out. We need you to pick up the phone and call your Congressmen. You need to right a letter to your local newspaper. You need to act right now.

Saturday the Treasury Secretary presented his plan to Congress and put a "fact sheet" up on his website. I haven't heard anyone comment on this, but inside of the plan is a request for total immunity from lawsuits. The plan states, "Decisions by the secretary pursuant to the authority are non-reviewable … and may not be reviewed by any court of law or any administrative agency."

This is absolutely outrageous, as it puts the Treasury Secretary above the law. Even the President can be taken before a court - remember Bill Clinton. Nixon had to be pardoned so he wouldn't have to go to court. Our whole system of government is based on checks and balances, but this bill takes all of that away when it comes to the Treasury Secretary. It is a mad power grab. Who knows what measures he may propose or carry out in the future with these new powers? This is the dangerous road that the government has now put us on. The politicians and Federal Reserve are willing to put the savings of every American at risk to protect the banks.

According to the Wall Street Journal, "the central bank is taking on a potentially big risk: If these assets fall in value or default, it may be on the hook, because the Fed cannot claim anything other than collateral as repayment. Officials say the assets are safe and the move is a temporary measure to provide liquidity to the market."

In other words the Fed could totally destroy its balance sheet and bankrupt the country - the Fed could risk putting the US dollar into a hyperinflationary death spiral. We need to think ahead to this possibility and that is something that I am going to spend time thinking about this week. In short though you want to protect yourself by being out of US dollars and in other assets that will appreciate in value if the dollar declines - of course that means gold, and physical gold if it is possible. It also means stocks, foreign currencies, and even real estate - although I wouldn't be a buyer of real estate until real estate bottoms, perhaps next year. And as for stocks in a hyperinflationary environment investing in foreign stocks would be better than investing in US stocks. What you don't want is cash in savings accounts and money market accounts. That type of money should be in physical metals. Even if the worst case scenario doesn't happen you can surely bet there will be a continued decline in the dollar, rise in inflation, and increase in gold prices over the next two years. Position yourself for that and you will benefit no matter what happens.

I have had a very uneasy feeling about the financial markets the past few days. One I've never had before. The feeling isn't a fear of it dropping, but that somehow a lot of integrity has been taken out of the markets.

It is almost like you can't trust the markets now, because of what the government has done and how it has acted in the past week. I almost no longer feel comfortable investing in the United States. By setting up this bailout plan and suddenly banning short selling in bank stocks the government has shown to me that it can and will do anything for the banks, will change the rules of investing with no notice, and is incompetent. This is very disturbing.

Let's just take the short selling restrictions on bank stocks for instance the SEC announced last week. It seems like short selling is being used as a convenient scapegoat to distract people from the real cause of the banking crisis - incompetent management at the banks that made stupid investment decisions, a government that encouraged their reckless behavior, and a SEC that allowed them to play games with their balance sheets for years. People warned that Fannie and Freddie were doing accounting games for years and the regulators sat there and did nothing.

The truth is short sellers play a positive role in the market, by providing liquidity. Short selling is used by options traders, market makers, and long/short funds to hedge positions. For instance a lot of times when you buy an option a floor trader or market maker will have a short position on the other side to cover the option they created and sold for you. By banning short selling the SEC blew a lot of these guys up and for some reason I doubt they'll get a bailout. But not only that they will take a lot of liquidity away from the bank stocks by banning short sales.

If bank stocks end up dropping again after this rally there will be no shorts to buy to close their positions on the way down. Another drop in bank stocks would end up being faster and much sharper than the one we have just seen. By banning short selling the SEC has made the financial markets even more dangerous and has proven itself to be totally incompetent. It doesn't appear to understand markets and doesn't know what it is doing. After making its short selling announcement the regulators then announced that it was going to almost double the margin requirements for gold futures contracts. In an instant they changed the rules in the gold game.

It makes me feel very uncomfortable about investing and trading in the US markets when the SEC does something like this. Who knows what rule changes could happen down the road. It is almost as if they are taking the integrity away from the stock market. I'm short US bonds right now, having entered the position right on the gap up of last week, but if bonds go into a death spiral who is to say that the SEC won't ban short selling of bonds?It is very difficult to make investment or trading decisions in this type of environment. It's like trying to go to bat with a blind umpire.

In the future I plan on buying more stocks outside of the United States. Many of the stocks I buy are mining stocks that also trade in Canada. In the future when I buy them I am simply going to buy them directly off of the Canadian exchanges instead of on one the US exchanges - mainly because of the potential danger of a falling dollar. There are also ETF's on exchanges outside of the US that track the S&P 500 and individual stock sectors. If you live outside of the US you would be better off buying them in the future than buying US ETF's.

By owning foreign stocks if the dollar declines in value against the currency of that country then I will benefit from a decline in the dollar. If I were to simply keep buying everything in the US and then one day in the future the dollar went into a hyperinflationary spiral I would be screwed. It is important to begin to diversify out of US dollars and securities.

Now there are many brokers in the US that allow Americans to buy stocks directory from foreign exchanges. Etrade now has this capability. Penntrade and Mytrack allow their customers to buy from the Canadian exchanges, while Interactive Brokers gives access to virtually every single major world market. If your broker doesn't allow you to do this then you may want to consider moving to one of these brokers. As for foreign money markets and CD's you may want to check out Everbank.com. It may even be worth considering opening up a foreign brokerage account to protect yourself from the risk of one day having to face capital controls.

It is time to think about diversifying yourself out of the US dollar.
@Mike Swanson (09/22/08)

short selling

In finance, short selling or "shorting" is the practice of selling a financial instrument the seller does not own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond, in contrast to the ordinary investment practice, where an investor "goes long," purchasing a security in the hope the price will rise. Often the seller will "borrow" or "rent" the items to be sold, and later repurchase identical items for return to the lender. However, the practice is risky in that prices may rise indefinitely, even beyond the net worth of the short seller.

The act of repurchasing is known as "covering" a position. The term "short selling" or "being short" is often also used as a blanket term for strategies that allow an investor to gain from the decline in price of a security. Those strategies include buying options known as puts. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Similarly, a short position in a futures contract, or to be short on a futures contract, means the holder of the position has an obligation to sell the underlying asset at a later date, to close out the position.

To profit from a stock price going down, short sellers can borrow a security and sell it, expecting that it will be cheaper to repurchase in the future. When the seller decides that the time is right (or when the lender recalls the shares), the seller buys back the shares in order to return them to the lender. The process generally relies on the fact that securities are fungible, so that the shares returned do not need to be the same shares as were originally borrowed.

The short seller borrows from their broker, who usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to lend to the short seller.[1] The lender of the shares does not lose the right to sell the shares. Short selling is the opposite of "going long." The short seller takes a fundamentally negative, or "bearish" stance, intending to "sell high and buy low," to reverse the conventional adage. The act of buying back the shares which were sold short is called 'covering the short'. Day traders and hedge funds often use short selling to allow them to profit on trading in stocks which they believe are overvalued, just as traditional long investors attempt to profit on stocks which are undervalued by buying those stocks.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate." Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security. The vast majority of stock borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below).

Sometimes brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker cannot borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale.

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements

For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner (paying a fee for having borrowed the shares) and make a $200 profit (minus the fee for having borrowed the shares).

This practice has the potential for losses as well. For example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500. Because a short is the opposite of a long (normal) transaction, everything is the mirror opposite compared to the typical trade: the profit is limited but the loss is unlimited. Since the stock cannot be repurchased at a price lower than zero, the maximum gain is the difference between the current stock price and zero. However, because there is no ceiling on how much the stock price can go up (thereby costing short transactions money in order to buy the stocks back), an investor can theoretically lose an arbitrarily large amount of money if a stock continues to rise. Also, in actual practice, as the price of XYZ Company began to rise, the short seller would eventually receive a margin call from the brokerage, demanding that the short seller either cover his short position or provide additional cash in order to meet the margin requirement for XYZ Company stock.

The Lehman Lesson

The sad fate of Lehman Brothers is a cautionary tale of what's gone wrong with Wall Street. Lehman ended up on the financial scrapheap because it played - and ultimately lost - a dangerous game involving high-stakes bets and huge borrowings. The firm's reported profits grew nicely through last year. But to keep its profits growing, Lehman was taking on more and more risk.

Lehman (LEH, Fortune 500) borrowed too much money, put too much of it into deals of dubious quality, and then insisted for months that all was well when it was apparent that all wasn't well. Monday's bankruptcy filing is a sad end for a firm once regarded as prudent and well managed.

The saddest thing of all is that decades ago Dick Fuld, now Lehman's CEO, bitterly opposed having the firm do big, aggressive deals with its own capital. But as we said in July, during one of Lehman's recurring crises, Fuld's decision to do the risky things that he opposed in the 1980s hurt Lehman badly.

Back then, Fuld's trading faction from the old Lehman Brothers was struggling against the firm's banker faction, led by Steve Schwarzman and Pete Peterson. The bankers wanted the firm to use its own capital to do deals. The traders opposed it. The trader-banker war so weakened Lehman that it sold out to American Express (AXP, Fortune 500) in 1984. Fuld, a Lehman lifer, stayed on, while Schwarzman and Peterson went off to found the Blackstone Group (BX) and become billionaires.

In 1994, AmEx, giving up its "financial supermarket" strategy, spun off a small, undercapitalized firm called Lehman Brothers, with Fuld as CEO. (That's why, despite what you read, Lehman wasn't a 158-year-old firm; it was a 14-year-old firm with a 158-year-old name.) Lehman's leverage - borrowings relative to capital - grew and grew, even as other firms were cutting back as the credit crunch worsened.

For example, last October, with the real estate collapse well underway, Lehman (in partnership with the Tishman Speyer real estate firm) paid a whopping $22.2 billion to do a leveraged buyout of a big apartment developer, Archstone. Losses on the deal began to surface almost immediately. Alas, we can't give you Fuld's take on all this; he's declined to talk with us for months. Lehman looked as if it would be able to survive more or less intact after the Federal Reserve Board announced in March that it would make huge loans available to eligible investment banks. This came shortly after the Fed and the Treasury forced a fire sale of Bear Stearns, and let it be known that the timing was no coincidence.
But Lehman never fully regained the market's confidence, Fed and Treasury support notwithstanding.

That leads us to a second Wall Street lesson from Lehman: that the Fed and Treasury can no longer control events as they once could.
By Allan Sloan and Roddy Boyd

Infrastructure funds

Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure where project debt and equity are used to finance the project. Usually, a project financing scheme involves a number of equity investors, known as sponsors, as well as a syndicate of banks which provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project itself and paid entirely from its cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the mining, transportation, telecommunication and public utility industries. More recently, particularly in the world , project financing principles have been applied to quasi-privatizations of publicly-held infrastructure (e.g., hospitals, light rail, , Harbor , Water Supply , Power Pkant, etc.) under so-called public-private partnerships (PPP).

Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, particularly in developing countries and emerging markets. Financial institutions and project sponsors may conclude that the risks inherent in project development and operation are unacceptable (unfinanceable). To cope with these risks, project sponsors in these industries (such as power plants or railway lines) are generally completed by a number of specialist companies operating in a contractual network with each other that allocates risk in a way that allows financing to take place.

The various patterns of implementation are sometimes referred to as "project delivery methods." The financing of these projects must also be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved.

A riskier or more expensive project may require limited recourse financing secured by a surety from sponsors. A complex project finance scheme may incorporate corporate finance, securitization, options, insurance provisions or other further measures to mitigate risk.

Project finance shares many characteristics with maritime finance and aircraft finance; however, the latter two are more specialized fields.The main challenges of financing large-scale projects.Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging.

First, they require large indivisible investments in a single-purpose asset. In most industrial sectors where project finance is used, such as oil and gas and petrochemicals, over 50% of the total value of projects consists of investments exceeding $1 billion.

Second, projects usually undergo two main phases (construction and operation) characterised by quite different risks and cash flow patterns. Construction primarily involves technological and environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of inputs or outputs) and political risk, among other factors. Most of the capital expenditures are concentrated in the initial construction phase, with revenues instead starting to accrue only after the project has begun operation.

Third, the success of large projects depends on the joint effort of several related parties (from the construction company to the input supplier, from the host government to the off-taker)so that coordination failures, conflicts of interest and free-riding of any project participant can have significant costs. Moreover, managers have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behaviour and inefficient investments.

The key characteristics of project financing structures

A number of typical characteristics of project financing structures are designed to handle the risks illustrated above. In project finance, several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behaviour by any party involved in the project. The project company operates at the centre of an extensive network of contractual relationships, which attempt to allocate a variety of project risks to those parties best suited to appraise and control them:

for example, construction risk is borne by the contractor and the risk of insufficient demand for the project output by the off-taker (Graph 3). Project finance aims to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and, at the same time, the importance of effectively monitoring managerial actions and ensuring a coordinated effort by all project-related parties.

Large-scale projects might be too big for any single company to finance on its own. On the other hand, widely fragmented equity or debt financing in the capital markets would help to diversify risks among a larger investors’ base, but might make it difficult to control managerial discretion in the allocation of free cash flows, avoiding wasteful expenditures. In project finance, instead, equity is held by a small number of “sponsors” and debt is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce projectspecific governance rules for the purpose of avoiding conflicts of interest or suboptimal investments.

The use of non-recourse debt in project finance further contributes to limiting managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flows. Moreover, non-recourse debt and separate incorporation of the project company make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets. In fact, despite some variability across sectors, the mean and median debt-to-total capitalization ratios.

for all project-financed investments in currently were around 70%. Nonrecourse debt can generally be deconsolidated, and therefore does not increase the sponsors’ on-balance sheet leverage or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination. In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors’ core businesses. One drawback of non-recourse debt, however, is that it exposes lenders to project-specific risks that are difficult to diversify. In order to cope with the asset specificity of credit risk in project finance, lenders are making increasing use of innovative risk-sharing structures, alternative sources of credit protection and new capital market instruments to broaden the investors’ base.

Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the idiosyncratic risks specific to individual projects are diversified away by financing a portfolio of assets as opposed to single ventures. Public-private partnerships are becoming more and more common as hybrid structures, with private financiers taking on construction and operating risks while host governments cover market risks.

There is also increasing interest in various forms of credit protection. These include explicit or implicit political risk guarantees,6 credit derivatives and new insurance products against macroeconomic risks such as currency devaluations. Likewise, the use of real options in project finance has been growing across various industries.7 Examples include: refineries changing the mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices; real estate developers focusing on multipurpose buildings that can be easily reconfigured to benefit from changes in real estate prices.

Finally, in order to share the risk of project financing among a larger pool of participants, banks have recently started to securitise project loans, thereby creating a new asset class for institutional investors. Collateralised debt obligations as well as open-ended funds have been launched to attract higher liquidity to project finance.

The term structure of credit spreads in project finance

The specific risks involved in funding large-scale projects and the key characteristics of project financing structures illustrated in the previous sections (in particular high leverage and non-recourse debt) have important implications for the term structure of credit spreads for this asset class.

First, based on the widely used framework for pricing risky debt originally proposed by Merton (1974), we should expect to observe a hump-shaped term structure of credit spreads for highly leveraged obligors. In this approach, the default risk underlying credit spreads is primarily driven by two components:
(1) the degree of firm indebtedness or leverage and
(2) the uncertainty about the value of the firm’s assets at maturity.

Given Merton’ s assumption of decreasing leverage ratios over time, postponing the maturity date reduces the probability that the value of the assets will be below the default boundary when repayment is due. On the other hand, a longer maturity also increases the uncertainty about the future value of the firm’s assets. For obligors that already start with low leverage levels, this second component dominates, so that the observed term structure is monotonically upward-sloping.

For highly leveraged obligors, instead, the increase in default risk due to higher asset volatility will be strongly felt by debt holders at short maturities, but as maturity further increases, the first component will rapidly take over, thanks to the greater margin for risk reduction due to declining leverage. This leads to a hump-shaped term structure of credit spreads for highly leveraged obligors.

Second, despite the extensive network of security arrangements, the credit risk of non-recourse debt remains ultimately tied to the timing of project cash flows. In fact, projects which are financially viable in the long run might face cash shortages in the short term. Ceteris paribus, obtaining credit at longer maturities implies smaller amortising debt repayments due in the early stages of the project. This would help to relax the project company’s liquidity constraints, thus reducing the risk of default. As a consequence, longterm project finance loans should be perceived as being less risky than shorterterm credits.

Third, the credit risk of non-recourse debt might be affected not only by the timing but also by the uncertainty of project cash flows and how the latter evolves over the project’s advancement stages. In fact, successful completion of the construction and setup phases can significantly reduce residual sources of uncertainty for a project’s financial viability. Arguably, extending loan maturities for any additional year after the scheduled time for the project to be completely operational might drive up ex ante risk premia but only at a decreasing rate.

Finally, the term structure of credit spreads observed in project finance is likely to be affected by the higher exposure of large infrastructure projects to political risk and by the availability of political risk insurance for long-term project finance loans. While long maturities and political risk represent in principle separate sources of uncertainty, commercial lenders are often willing to commit for longer maturities in emerging economies only if they obtain explicit or implicit guarantees from multilateral development banks or export credit agencies. As political risk guarantees are most often associated with longer maturities, lenders should not necessarily perceive political-risk-insured long-term loans as being riskier than uninsured short-term loans, ceteris paribus

After bailout...

As we all know, Fannie Mae and Freddie Mac were being nationalised a couple of days ago. The US government has put in $US1 billion of new capital (in the form of preferred shares) and says it might put in up to $US200 billion more. At the same time, it will take over the management of these two companies. Consequently, the stock market all over the world cheered this news in exuberance.

This is a farce.

There is a cost to this nationalization, which as we said two months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?,

“The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.”

Now consider the situation of the US government budget as reported in ‘Frannie’ bailout heavy with irony:

“ According to the US Government’s Accountability Office the national debt stood at $US4.4 trillion early this year. Unless the habit of deficit spending is arrested quickly this figure will double in the next ten years. Meanwhile, the social security system faces an unfunded liability estimated by the Government Accountability Office at $US6.7 trillion and the unfunded liability of Medicare is $US34 trillion.”

If the US government has to bail out more and more blow-ups in the financial system, there is only one way the level of national debt can go: up and up to the sky. It has come to a stage that the word “billion” is not enough to describe the magnitude of the debt- “trillion” has used instead. That level of debt is approximately $150,000 for every man, woman and children in the United States.

Is the US government going to pay all these debt by raising taxes? With rising unemployment, record levels of private debt and wobbly economy, do you think this idea can ever be entertained? If it is politically impossible to raise taxes, what else can be done? Default or print money?

Strangely, the market reacted to this news by bidding up the US dollar

CDOs

Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided by the ratings firms that assess their value into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs serve as an important funding vehicle for fixed-income assets.

Some news and media commentary blame the financial woes of the 2007 credit crunch on the complexity of CDO products, and the failure of risk and recovery models used by credit rating agencies to value these products. Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows. On the other hand, some academics maintain that because the products are not priced by an open market, the risk associated with the securities is not priced into its cost and is not indicative of the extent of the risk to potential purchasers.As many CDO products are held on a mark to market basis, the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs in 2007. Major loss of confidence occurred in the validity of process used by ratings agencies to assign credit ratings to CDO tranches and persists into 2008.

Market history and growth
The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation on June 22, 1990. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles. It may also reflect the greater profit margins that CDOs provide to their manufacturers.

A major factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs. According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007. Research firm Celent estimates the size of the CDO global market to close to $2 trillion by the end of 2006.

Concept
CDOs vary in structure and underlying assets, but the basic principle is the same. Essentially a CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:
A special purpose entity (SPV) acquires a portfolio of credit (finance). Common assets held include mortgage-backed securities, Commercial Real Estate (CRE) debt, and high-yield corporate loans.
The SPV issues different classes of bonds and equity and the proceeds are used to purchase the portfolio of credits. The bonds and equity are entitled to the cash flows from the portfolio of credits, in accordance with the Priority of Payments set forth in the transaction documents. The senior notes are paid from the cash flows before the junior notes and equity notes. In this way, losses are first borne by the equity notes, next by the junior notes, and finally by the senior notes. In this way, the senior notes, junior notes, and equity notes offer distinctly different combinations of risk and return, while each reference the same portfolio of debt securities.

A CDO investor takes a position in an entity that has defined risk and reward, not directly in the underlying assets. Therefore, the investment is dependent on the quality of the metrics and assumptions used for defining the risk and reward of the tranches. The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. An investment in a CDO is therefore an investment in the cash flows of the assets, and the promises and mathematical models of this intermediary, rather than a direct investment in the underlying collateral. This differentiates a CDO from a mortgage or a mortgage-backed security (MBS).

The loss of an investor's principal is applied in reverse order of seniority (i.e., highest credit risk tranches to lowest). The senior tranche is protected by the subordinated security structure; thus, it is the most highly rated tranche. The equity tranche (also known as the first-loss tranche or "toxic waste") is most vulnerable, and has to offer higher coupons to compensate for the higher risk.

Structures
CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follows:
Source of funds -- cash flow vs. market value
Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.
Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDO's portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs are longer-established, but less common than cash flow CDOs.
Motivation -- arbitrage vs. balance sheet
Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated.
Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk.

Funding -- cash vs. synthetic
Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.

Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche receives a periodic payment (the swap premium), with the junior tranches offering higher premiums.

A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the CDO could have to pay up to a certain amount of money in the event of a credit event on the reference obligations in the CDO's reference portfolio. Some of this credit exposure is funded at the time of investment by the investors in funded tranches. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis points below LIBOR. The return from these investments plus the premium from the swap counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs and a payout to the swap counterparty is required, the required payment is made from the GIC or reserve account that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike a cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and may have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDO's tranches can be precisely structured.

Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets. A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that may be required under the credit default swaps. The CDO receives payments from three sources: the return from the cash assets, the GIC or reserve account investments, and the CDS premiums.

Single-tranche CDOs
The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.

Variants
Unlike CDOs, which are terminating structures that typically wind-down or refinance at the end of their financing term, Structured Operating Companies are permanently capitalized variants of CDOs, with an active management team and infrastructure. They often issue term notes, commercial paper, and/or auction rate securities, depending upon the structural and portfolio characteristics of the company. Credit Derivative Products Companies (CDPC) and Structured Investment Vehicles (SIV) are examples, with CDPC taking risk synthetically and SIV with predominantly 'cash' exposure.

Taxation of CDOs
CDOs are bonds issued by special purpose vehicles that are backed by pools of bonds, loans or other debt instruments. CDOs are typically issued in classes or “tranches” with some being senior to others in the event of a shortfall in the cash available to make payments on the bonds. The issuer of a CDO typically is a corporation established outside the United States to avoid being subject to U.S. federal income taxation on its global income. These corporations must restrict their activities to avoid U.S. tax; corporations that are deemed to engage in trade or business in the U.S. will be subject to federal taxation. However, the U.S. government will not tax foreign corporations that only invest in and hold portfolios of U.S. stock and debt securities because investing, unlike trading or dealing, is not considered to be a trade or business, regardless of its volume or frequency.

In addition, a safe harbor protects CDO issuers that do actively trade in securities, even though trading in securities technically is a business, provided the issuer’s activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar business.

CDOs are generally taxable as debt instruments except for the most junior class of CDOs which are treated as equity and are subject to special rules.

Types of CDOs
A) Based on the underlying asset:
Collateralized loan obligations (CLOs) -- CDOs backed primarily by leveraged bank loans.
Collateralized bond obligations (CBOs) -- CDOs backed primarily by leveraged fixed income securities.
Collateralized synthetic obligations (CSOs) -- CDOs backed primarily by credit derivatives.
Structured finance CDOs (SFCDOs) -- CDOs backed primarily by structured products (such as asset-backed securities and mortgage-backed securities).
Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities.
B) Other types of CDOs include:
Commercial Real Estate CDOs (CRE CDOs) -- backed primarily by commercial real estate assets
Collateralized bond obligations (CBOs) -- CDOs backed primarily by corporate bonds
Collateralized Insurance Obligations (CIOs) -- backed by insurance or, more usually, reinsurance contracts
CDO-Squared -- CDOs backed primarily by the tranches issued by other CDOs.
CDO^n -- Generic term for CDO^3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO^2/CDO^3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying CDO.

Types of Collateral
The collateral for cash CDOs include:
Structured finance securities (mortgage-backed securities, home equity asset-backed securities, commercial mortgage-backed securities)
Leveraged loans
Corporate bonds
Real estate investment trust (REIT) debt
Commercial real estate mortgage debt (including whole loans, B notes, and Mezzanine debt)
Emerging-market sovereign debt
Project finance debt
Trust Preferred securities

Transaction Participants
Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys.

Investors
Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating. In some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior tranche and their cost of borrowing. This is because senior tranches pay a spread above LIBOR despite their AAA-ratings. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset manager, and the credit support built into the transaction. Investors include banks and insurance companies as well as investment funds.

Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals.

Underwriter
The underwriter, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDO's portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.

The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDO's rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.

Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands) that will purchase the assets and issue the CDO's tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDO's transaction documents and other files.

The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.

According to Thomson Financial, the top underwriters are Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued.

The Asset Manager
The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDO's portfolio. The manager can maintain the credit quality of a CDO's portfolio through trades as well as maximize recovery rates when defaults on CDO assets occur.
The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.

Even by the issuance date, the asset manager often will not have completed the construction of the CDO's portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.

However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDO's "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities. Within the confines of the trading restrictions specified in the CDO's transaction documents, the asset manager can also make trades to maintain the credit quality of the CDO's portfolio. The manager also has a role in the redemption of a CDO's notes by auction call.

The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff. There are approximately 300 asset managers in the marketplace. Some collateral managers are active whilst some are nothing more than placebos where the investor will be at risk to the underlying portfolio. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
See also: List of CDO Managers

The Trustee and Collateral Administrator
The trustee holds title to the assets of the CDO for the benefit of the noteholders (i.e. the Investor). In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington Trust, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:

Bank of New York Mellon (note: the Bank of New York Mellon recently also acquired the corporate trust unit of JP Morgan which is the market share leader)
HSBC
LaSalle Bank (Recently acquired by Bank of America)
Wells Fargo
Deutsche Bank
US Bank (note: US Bank recently also acquired the corporate trust unit of Wachovia)
Fortis Intertrust (note: was formerly known as MeesPierson Intertrust)
BNP Paribas Securities Services (note: currently serves the European market only)
Wilmington Trust Company
Sanne Trust
State Street Corporation

Accountants
The underwriter typically will hire an accounting firm to perform due diligence on the CDO's portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral security. Source documents or public sources will typically be used to tie-out the collateral pool information. In addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in compliance with such tests.

The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be made to the noteholders.

Attorneys
Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be circulated to investors. It is common for multiple counsels to be involved in a single deal due to the number of parties to a single CDO from asset management firms to underwriters.

IMF and World bank ?

The World Bank and International Monetary Fund (IMF) have wielded great power over developing countries for the past three decades. Yet it is now widely acknowledged that the neoliberal policies forced on the global South by these two institutions were responsible for increasing poverty and causing economic stagnation across the developing world during the 1980s and 1990s - the two 'lost decades' of development. The Bank and Fund have tried a public relations makeover, rebranding themselves as fellow combatants in the 21st century fight against global poverty. Yet mired in scandal and with their policies largely unchanged, the two institutions now face a crisis of legitimacy.

The World Bank and IMF have attracted intense criticism for the damage caused by their policy prescriptions to developing countries. The World Bank's own internal evaluations have acknowledged the failures of these policies over the 1980s and 1990s. In country after country, the privatization and trade liberalization programmes of the Bank and Fund led to structural dislocation and economic stagnation, with dramatic increases in poverty as a result.

Yet even today the Bank and Fund continue to force these same failed policies on developing countries as a condition of receiving their loans or debt relief. Despite suggesting that they have changed their approach to allow for greater participation by civil society groups in the South, both institutions continue to impose damaging economic conditions on developing countries, including the privatisation of public services. The World Bank's private sector arm, the International Finance Corporation, also continues to promote an unreconstructed privatization programmed, despite all the evidence against it.

The World Bank and IMF also face a crisis of legitimacy in respect of their own anti-democratic governance procedures. Set up at the Bretton Woods conference in 1944, both institutions provide rich countries with in-built control over their programmes. As a result of their 'one dollar, one vote' system, the US, Japan and EU dictate the terms of development to developing countries which rely on finance from the Bank and Fund. Similarly, a long-standing pact allows the US to choose each new head of the World Bank and the EU to appoint each head of the IMF, without any reference to the wishes of the broader membership. Following the scandal surrounding the appointment and subsequent resignation of Paul Wolfowitz as president of the Bank, an international outcry demanded fairer procedures for future appointments. Yet the EU and US refuse to countenance any democratic reforms which might see a challenge to their power.

In frustration at this continuing travesty, developing countries are now trying to break free from the Bank and Fund so as to be able to determine for themselves the development policies best suited to their own needs. Several Latin American states have chosen to sever links with the IMF and World Bank, and some have announced the creation of a rival development bank - the Bank of the South - which would be run on democratic principles. Even developed countries have begun to voice their discontent with the Bank and Fund's approach to development, with the UK government withholding funds in protest and others withdrawing their support from key World Bank projects. In the face of such unprecedented challenge, the World Bank and IMF have a genuine crisis on their hands.

OTC

Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

OTC-traded stocks
In the U.S., over-the-counter trading in stocks is carried out by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC stocks are not listed or traded on any stock exchange. Although stocks quoted on the OTCBB must comply with SEC reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through Pink OTC Markets.

The OTC market presents investment opportunities for informed investors, but also has a high degree of risk. Many OTC issuers are small companies with limited operating histories or are economically distressed. Investments in legitimate OTC companies can often lead to the complete loss of the investment. Investors should avoid the OTC market unless they can afford a complete loss of their investment. Investors should never purchase any security without first evaluating the fundamentals of the company and carefully reviewing the financial statements, management background and other data. Investors who purchase securities based on a "hot tip" or the advice of chat room touts may often be disappointed.

OTC market statistics
Data provided by Pink Sheets:
Securities quoted exclusively on Pink Sheets - 5,019
Securities dually quoted on Pink Sheets and OTCBB - 3,445
Securities quoted exclusively on OTCBB - 130
Total OTC securities - 5,149

OTC contracts
An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement.

This segment of the OTC market is occasionally referred to as the "Fourth Market."
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.