Sunday, September 28, 2008

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.

Saturday, September 27, 2008


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 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.

Tuesday, September 23, 2008

Quantitative analyst.

Saya pernah tahun 1996 ikut kursus Financial engineering di Bangkok. Yang mengadakan adalah world bank cabang Asia. Hanya saya saja yang tidak S1. Itu karena saya aktifis salah satu ormas sayab Golkar, sehingga bisa ikut. Memang waktu test di Menlu, saya lulus. Kursus dilakukan 3 bulan. Sejak awal kursus sampai sebulan, saya seperti katak dalam tempurung. Bengong engga jelas. Mengapa? Walau saya paham teori dasar ekonomi tapi saya engga paham ekonomi makro, ekonometri. Engga paham matematika lanjutan. Tetapi saya hanya menyinyak saja. Saya berniat ingin mengakhiri kursus. Pulang ke jakarta. Lagi ngapain buang waktu untuk sesuatu yang engga saya pahami. Apalagi sesuai kata pengantar dari pengajar, itu ilmu baru. Benar benar baru. Waktu itu namanya Quantitative analyst.

Tetapi entah mengapa saya perhatikan semua yang hadir dalam ruang kursus. Mereka semua manusia. Sama dengan saya. Yang saya pelajari bukan llmu ghaib. Tetapi ilmu nyata. Ah kenapa saya kalah sama orang lain. Saya harus bisa. Masuk bulan kedua, saya mulai serius belajar. Caranya?. Saya jejerkan di tempat tidur semua modul kursus. Dari modul A sampai Z. Modul A sampai L itu berkaitan dengan definisi beragam produk finance, philosofi, dan pemanfaatan ilmu statistik dan matematika untuk menghitung probability masa depan seperti teori portofolio dan analisis investasi, keuangan korporasi, market microstructure theory, financing & risk, valuasi aset & derivatif, manajemen aset, fixed income & term structure, algorithmic trading, structured & hybrid product, financial technology.

Kemudian saya pandang deretan modul itu dari jauh seraya duduk di korsi. Lama saya pandang modul itu sambil merokok. Akhirnya saya paham kerangka berpikir hewan bernama Financial engineering. Modul A sampai L itu dalam dua hari selama weekend tuntas saya baca dan saya paham. Selanjutnya saya pergi ke perpustakaan membaca buku matematika lanjutan dan ilmu statitik. Saya harus kuasai tekhnik dasar cara berhitung matematika lanjutan seperti algoritma, integral. Itu untuk memperkuat pemahaman saya tetang modul A-L.

Setelah itu saya mulai melakukan simulasi tentang definisi masing masing produk investasi secara matematika. Ah saya paham semua. Bulan kedua saya sudah lancar ikut kursus. Bulan ketiga, saya udah ogah ogahan kursus. Karena saya sudah kuasai semua materi. Saya justru lebih banyak di perpustakaan membaca berbagai studi kasus financial engineering berkaitan dengan investasi dan korporasi. Mengapa? bagi saya studi kasus itu lebih penting untuk hidup saya. Itu pengalaman nyata dan cara menyelesaikan masalah berdasarkan keilmuan.

Akhir kursus, diadakan ujian. Ujian berupa study kasus. Peserta diminta untuk menjawab secara bebas dengan dasar pengetahuan finacial engineering. Ujian diadakan dua sesi. Jam 9 sampai 12 dan dilanjutkan dari jam 1 sampai jam 5 sore. Besok kemudian di umumkan kelulusan. Tetapi malamnya selesai ujian saya  udah pulang ke jakarta. Ogah nunggu pengumuman lulus atau engga. Belakanga saya tahu.  Dari 48 perserta kursus. Yang lulus hanya 8 orang termasuk saya. Salah satu perserta kursus itu jadi sahabat saya sampai sekarang. Karena dia jadi Direksi BUMN China.

Hikmah cerita : tidak ada ilmu nyata yang sulit. Asalkan ada motivasi untuk belajar. Motivasi itu kekuatan kita untuk membangkitkan otak kita memahami ilmu itu dengan mudah. Jadi, motivasilah murid dengan benar agar mereka bisa sukses belajar. Ingat motivasi bukan karena gelar atau ijazah tetapi ilmu. Mencari ilmu adalah ibadah. Tuhan tidak suruh kita cari gelar. Tanpa ilmu tidak ada peradaban bisa dibangun. Paham kan sayang.

Monday, September 22, 2008

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.