Many classes of debt have been securitised over the years making, in the case of consumer debt such as credit card and car loans, securitisation a trillion-dollar market. There have even been some exotic products such as securitising the royalty streams from songs performed by famous artists such as David Bowie. So why not apply this technique to more conservative products which are more comprehensible to institutional investors, such as project finance loans?

In basic terms, securitisation represents an elegant way of recycling capital without having to wait for debts to be fully paid off by borrowers. The ability to recycle capital in a standardised and cost effective way also increases the amount of capital available for borrowers. In turn, this can help make loans more competitive. From a banking point of view it means risk can be passed on freeing extra capital which has to be set aside as a contingency against defaults under central bank regulations. Under BIS (Bank of International Settlements) regulations, banks have to set aside 8% of their capital against loans made. With securitisation, these loans are removed from the books thus, depending on the holding of the ?first loss? piece, the bank may release the 8% capital originally supporting the loan pool.

Securitisation is not cheap but it does give banks an attractive option in managing their capital base. During the last recession, this technique was a popular means for re-floating a struggling bank's capital base. It is also a useful tool for aggressively expanding banks to grow their capital base more quickly without borrowing or issuing extra shares. Essentially, securitisation is an arbitration between the price of the project, and that of packaging it and selling it off as an asset backed bond. The total interest paid out on the different tranches of the asset-backed bonds should come to less than that paid out by the sum total of the interest from the projects in the pool

However, all these benefits are probably still some way off for project finance loans where the technique has yet to establish itself. Credit Suisse First Boston (CSFB) is endeavouring to change all that and has been working on it for several years.

The first out of the CSFB stable was the groundbreaking $617 million Project Funding Corporation 1 which was well received by investors. ?Investors saw this as a new asset class, which carried a higher yield than other similarly rated securitised products,? explains Adebayo Ogunlesi, Managing Director and Head of CSFB Global Energy and Project Finance Group.

From the point of view of institutional investors higher yielding top investment-grade securitised debt is indeed attractive. It is also safer than buying bonds issued on the back of a single project as the securitised version derives its income from a pool of projects with little or no correlation. So if one defaults, the others remain unaffected, with those holding investment grade debt unlikely to suffer income losses. The first losses are absorbed by holders of equity, mezzanine or below investment-grade paper. Often those lower grades of paper such as the equity portion are held by the bank.

The latter tranche will usually not comprise more than 4% to 5% of the overall deal. The type of investors attracted to this new class of debt are pension funds, other institutional investors and the treasury departments of banks.

However, securitised project finance bonds have yet to properly take-off despite their potential attractions to investor and originator alike. According to both CSFB and rating agency Standard & Poor's, the concept has yet to establish itself with little in the way of a track record for investors to look at. Many wonder, for instance, if the success of the first CSFB issue wasn't just a fluke and rode on its rarity value.

A second CSFB deal is in the process of being issued. ?This CSFB deal is going to be watched carefully by investors and by other banks to see how it performs in the market,? says Guy Cirincione, Director of Project Finance at CSFB.

Scott Friedman, an analyst with Standard & Poor's, confirms that this is the case: ?I think a lot of banks have been doing some work on this area and are interested in seeing it becoming established.?

It is thought Goldman Sachs and Merrill Lynch may well be planning issues of their own if the second CSFB transaction makes strong headway. To many investors, however, securitised project finance loans are still somewhat mysterious and perhaps even exotic. They are impossible to compare with consumer packaged loans. ?A $1 billion securitised consumer issue can contain hundreds of thousands of standardised loans and a couple of defaults is not going to hurt the overall credit quality of the issue,? explains Friedman. ?While a couple of defaults in a similar sized project finance issue will have a disproportionate impact because there may be only 50 projects in the pool for example.?

Also, each project in the pool needs to be carefully assessed and evaluated for its risk potential. Various financial stress evaluations have to be made. For instance, how would a particular US power plant survive in a market of falling electricity prices as the US electricity market is deregulated? Consumer loans on the other hand are standardised.

All this comes under the banner of project risk and presents at least one explanation as to why project finance securitised loans will carry a higher coupon rate to other identically rated issues. In other words, consumer debt is more predictable. Many investors are also aware that there have been defaults in Asian countries, such as in Indonesia, following the Asian crisis, although not to the extent some commentators initially feared.

This means the projects in the pool have to be assessed case by case. How would rising natural gas prices affect a power plant in Canada? Would the Chilean government allow a large copper mine to close if the price of metal collapsed? And so on.

With emerging market countries there are other issues over political and economic risk. Although this can be mitigated to a certain extent by political risk insurance, and by paying all the income into a separate entity and first deducting the interest before remitting the balance to the project operator.

However, concern over emerging market risk partly led the CSFB team to reduce the number of emerging market projects packaged in the second issue to below 10%. Also, with higher US Treasury yields and general nervousness in the bond markets, the issue had to receive those changes to bring it into line with current investor sentiment. Nervous bond investors tend to look for safety and shun debt, which has lower credit ratings and/or is difficult to understand.

The second deal will be comprised of power deals (50%) and with the balance coming from sectors such as telecommunications, chemicals, metals, and oil and gas. The equity piece will make up 5% of the transaction with 72% of projects based in countries rated above investment grade.

Also, for the technique to become established, it has to be viable for the banks who own the project debt. One of the problems highlighted by Friedman is that consumer loans often carry rates of interest sometimes as high as 19%. The eventual coupon of the asset-backed instrument will just be a few basis points over Libor. For financing of a power plant the loan may have been made at a few points above Libor, which gives smaller margins and less room to manoeuvre when structuring the asset-backed transaction.

Too much padding out of the transaction to elevate its credit quality can mean that the technique is no longer that attractive for the issuing bank. They will still be left with too many liabilities on their books in the form of below investment-grade debt and equity.

Also, it is not as if any project finance loan can be packaged into an asset-backed transaction. For instance, there may be problems revolving around the legal structuring of the original loans. ?They may contain assignability problems or there may be issues over covenants and cash flows,? says Friedman. For instance, securitisations are often done through Cayman Islands-registered corporate vehicles and the covenants in the original loan may not allow for this kind of procedure.

Cirincione recognises that this could be an issue as far as certain deals are concerned. However, he foresees future loans for projects being legally and financially structured in such a way to make them securitisation friendly later on.

Also, a number of banks with projects on their books seem to be content to keep them and pick up an income stream from them every month, adds Cirincione. ?To make an asset-backed transaction viable, you need critical mass, it needs to be large enough to give it economies of scale? says Cirincione.

This poses challenges when marketing the asset-backed deal to investors, particularly if few are convinced about the concept. Hopefully CSFB's second asset-backed project finance deal will do much to alleviate investor uncertainty over this new class of instrument and help get it established.

But there are also a number of positives: project finance loans tend to be amortising, which builds up the proportion of equity in the project concerned. This makes the loan safer and enhances the credit quality of the overall loan. If the project performs as planned, the project's ability to service its debts is enhanced as cash flows strengthen and the proportion dedicated to interest rate payments diminishes. ?Towards the end of the loan's life the chance of default are greatly diminished,? explains Friedman.

The lack of correlation between projects distributed over sectors and geographical areas also decreases overall default risk. What may adversely affect a power plant in New York won't necessarily hit a power plant in California, and is highly unlikely to impact toll road projects in Western Europe. On the other hand, a downturn in the US economy would hit the quality of US originated consumer loans right across the board. ?A diverse pool of loans from different industries with no correlation is good,? said Friedman.

Although Ogunlesi believes there will be a developing market for this new class of securities, he doesn't think it will be huge. ?I reckon we could see 30 to 40 deals a year once it is established,? he said. If the technique can be properly established for project finance loans there is certainly years of deals that can be sold off. However, the early batches of asset-backed deals have to demonstrate their worth to investors. Initially, this means issues have to contain pools of high-quality projects. This may constitute projects with a track record and those largely located in G7 countries.

Once a liquid market is established for this segment it is more than likely that new investors will emerge who are willing to take on higher risk portfolios containing emerging market projects or projects at the construction stage. At the same time, the cost of structuring securitised products has to justify banks making the effort to do it. This also requires the originators and credit rating agencies to educate and provide investors with plenty of information on how these products are structured, how they behave and the risk factors involved.