Advanc i ng t he

Sec ur i t i sat i on of
Aust r al i an
Agr i c ul t ur e: Hybr i d
Equi t y




A report for the Rural Industries Research
and Development Corporation


by Dr T M Dwyer
R K H Lim
Thomas Murphy



April 2004


RIRDC Publication No 04/055
RIRDC Project No BLC-4A


ii
2004 Rural Industries Research and Development Corporation.
All rights reserved.

ISBN 0 642 58765 5
ISSN 1440-6845

Advancing the Securitisation of Australian Agriculture

Publication No. 04/055
Project No. BLC-4A

The views expressed and the conclusions reached in this publication are those of the authors and not
necessarily those of persons consulted. RIRDC shall not be responsible in any way whatsoever to any person
who relies in whole or in part on the contents of this report.

This publication is copyright. However, RIRDC encourages wide dissemination of its research, providing the
Corporation is clearly acknowledged. For any other enquiries concerning reproduction, contact the
Publications Manager on phone 02 6272 3186.

Researcher Contact Details
Dr T M Dwyer
Visiting Fellow
Asia Pacific School of Economics & Government
Australian National Unisversity
CANBERRA ACT 2601
Phone: 02 6286 5900
Fax: 02 6286 4981
E-mail: terry.dwyer.phd@post.harvard.edu

R K H Lim
Level 9
275 George Street
SYDNEY NSW 2000
Phone: 02 9262 5399
Fax 02 9299 7020
E-mail: boblim@optusnet.com.au

T Murphy
Western Research Institute
C/- Charles Sturt University
BATHURST NSW 2795
Phone: 02 6338 4435
Fax: 02 6338 4699
E-mail: tmurphy@csu.edu.au


In submitting this report, the researcher has agreed to RIRDC publishing this material in its edited form.


RIRDC Contact Details
Rural Industries Research and Development Corporation
Level 1, AMA House
42 Macquarie Street
BARTON ACT 2600
PO Box 4776
KINGSTON ACT 2604

Phone: 02 6272 4819
Fax: 02 6272 5877
Email: rirdc@rirdc.gov.au
Website: http://www.rirdc.gov.au



Published in April 2004
Printed on environmentally friendly paper by Canprint


iii
Foreword

This project takes forward earlier research on securitisation in the Report Efficient Equity and Credit
Financing for the Rural Sector: New directions in rural and agribusiness finance (RIRDC
Publication 01/117) by analysing in more depth and by developing a practical model for
securitisation.

The earlier research Report concluded that Australian agriculture has been left behind in the financial
revolution of the 1980s and 1990s. Unlike other faster growing sectors of the Australian economy
agriculture has not enjoyed the benefits of sophisticated financial techniques, most particularly
securitisation, and related state-of-the-art techniques which now characterise the financial sector in
Australia and developed capital markets abroad. The Report argued that there is a need for the
agricultural sector to catch up with other sectors of the Australian economy and to become more
fully integrated with the now highly sophisticated Australian and overseas financial sectors.

This research project aims to provide a reference document and a platform for the progressive take-
up and commercialisation of securitisation techniques in Australian agriculture.

This project was funded from RIRDC Core Funds which are provided by the Federal Government.

This report is an addition to RIRDCs diverse range of over 1000 research publications, forms part of
our Global Competitiveness R&D program, which aims to identify important impedimnents to the
development of a globally competitive Australian agricultural sector and support research that will
lead to options and strategies that will remove these impediments.

Most of our publications are available for viewing, downloading or purchasing online through our
website:

downloads at www.rirdc.gov.au/fullreports/index.htm
purchases at www.rirdc.gov.au/eshop



Simon Hearn
Managing Director
Rural Industries Research and Development Corporation


iv
Acknowledgments

The researchers wish to thank the many individuals and organisations who have made their time and
technical expertise available in progressing this research task. Special thanks are due to the New
South Wales Farmers Association.

The encouragement of RIRDC and Dr J eff Davis, Program Manager, in supporting this project is also
gratefully acknowledged.

About the Researchers

Dr Terence M Dwyer
Is an economic consultant and Visiting Fellow at the Asia Pacific School of Economics and
Management at the Australian National University. Prior to establishing his firm, Dwyer Partners, in
1989 Dr Dwyer was a senior government official where he spent many years in taxation and
economic policy research and advising.

Dr Dwyer holds the degrees of Bachelor of Arts (Honours) and Bachelor of Economics (Honours)
from the University of Sydney and Master of Arts and Doctor of Philsophy in Economics from
Harvard University, as well as a Diploma of Law. He has been awarded numerous prizes and
scholarships in the course of his distinguished academic career, including the award of a Harkness
Fellowship in 1976 and the J oseph A Schumpeter Fellowship in 1979 for study at Harvard
University. He is a member of the Economic Society of Australia, the Australian Tax Research
Foundation, the Harvard Club of Australia and a life member of the American Economic
Association.

Robert K H Lim
Is an economic and public policy consultant and Executive Director of the Committee for Economic
Development of Australia (CEDA) in Sydney. He is a former Director of Policy Analysis and
Research at the Business Council of Australia (1992-1996) and has previously served in numerous
economic positions in the Department of Foreign Affairs and Trade, Treasury and Reserve Bank of
Australia.

Mr Lim holds the degree of Bachelor of Economics from Monash University and is a graduate of the
Advanced Management Program at The European Institute of Business Administration (INSEAD),
Fountainbleau.

Thomas Murphy
Is Director and Chief Executive, Western Research Institute, a non-profit economic, business and
social research organisation located on the Bathurst campus of Charles Sturt University. Mr Murphy
has held academic positions and researched and consulted widely in rural and regional economics
and industry development. He has served as an economic analyst in the Office of National
Assessments and was a Senior Consultant with KPMG Management Consultants.

Mr Murphy holds degrees of Bachelor of Economics (Honours) from the University of New England
and Master of Science (Economics) from Lancaster University, UK.


v
Contents

Foreword iii
Acknowledgments iv
About the Researchers iv
Executive Summary viii

1. INTRODUCTION 1
1.1 Background 1
1.2 Objectives of the Research 1
1.3 Methodology 1
1.4 Structure of this Report 1

2. THEORETICAL ISSUES 2
2.1 Securitisation 2
2.1.1 The investors 5
2.1.2 The end users of the funds 7
2.1.3 The originators 7
2.2 Application to rural industries 8
2.3 Key findings of the RIRDC/CEDA Conference 10

3. DEVELOPMENT OF A MODEL 15
3.1 General 15
3.1.1 Prerequisites for successful securitisation 15
3.1.2 Capital users 15
3.1.3 Capital suppliers 16
3.1.4 Securitisation originators: Capital adequacy requirements 17
3.1.5 Taxation issues 17
3.1.6 Insolvency quarantining 17
3.1.7 Accounting non-consolidation 18
3.2 A Securisation Model 20
3.2.1 The securitised assets 20
3.2.2 The pooling of the assets to be securitised 22
3.2.3 The investors 23
3.2.4 A diagram of the model 24
3.3 Institutional Issues 26
3.4 Regulatory Issues 29
3.5 Legal Issues 30
3.6 Farm Level Issues 31
3.7 Design Features of a Hybrid Equity Contract (HEC) 32
3.7.1 Basic form of the HEC 32
3.7.2 Allocation and assumption of risks in the HEC 33
3.7.3 Unacceptable and manageable risks for investors in HECs 35
3.7.4 Death, divorce or disability of the farm operator (personality risks) 36
3.7.5 Intergenerational transfer or sale of the farm 36
3.7.6 Crop shifting by farmers 37


vi
3.7.7 Under-investing or inappropriate investing by farmers 38
3.7.8 Theft or fraud 38
3.7.9 Over-borrowing 39
3.7.10 Insolvency of the farm operator 39
3.7.11 Legal design issues for a HEC 40
Non-voidability 40
No vicarious liability for actions of operator 40
A standardised HEC 41
Underlying legal relationship 41
3.7.12 Taxation treatment of HEC payments 43
3.7.13 Possible covenants and obligations for the HEC 44
Personal covenants by all parties 44
Land and other mortgage security 45
Bank guarantee or loan insurance 45
Rollover or redemption at maturity? 46
SPV rights and obligations under the HEC 46
Primary producer rights and obligations under the HEC 48
Obligations of the primary producer under a HEC 49
Farming obligations 49
Financial, administrative and insurance obligations 51
Termination of a HEC and dispute resolution 52
3.8 Issue, pricing and subsequent valuation of HEC 54
3.8.1 Due diligence preliminaries before issue 54
3.8.2 The pricing of a HEC at time of issue 54
3.8.3 Valuation of a HEC portfolio after issue 58
3.8.4 Securitisation vehicle (SPV) issues 59
Investor taxation 59
Stamp duties 60
Managing the SPVs assets 60
Registrar of HECs mortgages etc and crop payments 61
Tranching the SPVs securities 61

4. PROGRESSING SECURITISATION 63
4.1 Taking the Model Forward 63
4.2 Commercialisation Challenges 64

5. CONCLUSION 67

Boxes
Box 1: CBA considers $1bn securitisation 4
Box 2: Evolution of Securitisation 5
Box 3 Cutting the Cost of Borrowing 7
Box 4 Investors and Lenders Back a Capital Idea 8
Box 5 Farm Expansion Slowed by Lack of Equity 9
Box 6 The Debt/Equity Dilemma in Farm Finance 13
Box 7 Why has Agriculture Missed Out on Equity? 16
Box 8 The Changing Role of Banks 26
Box 9 Commercial Interest in New Securitisation Products 27
Box 10 NSW Farmers Association Input 32
Box 11 Debt versus Equity for Financing Agriculture 33
Box 12 Information Reporting the Key for Access to Capital 35


vii
Box 13: Intergenerational Change and Challenges 37
Box 14 Securitising small loans tipped as the next big thing 65

Appendices
1. Glossary of Terms 69
2. APRA: Extract from Prudential Standard APS 120 70
3. Relevant Legislation 73
4. Rural and Regional Survey Report Western Research Institute 86


References 92



viii
Executive Summary


Overview


Australian agriculture has been left behind in the financial revolution of the 1980s and 1990s.

Unlike other faster growing sectors of the Australian economy agriculture has not enjoyed the
benefits of sophisticated financial techniques, most particularly securitisation, which now
characterise the financial sector in Australia and developed capital markets abroad.

Agriculture needs to catch up with other sectors of the Australian economy and become more
fully integrated with Australias sophisticated financial sector and world capital markets.

Securitisation is the key to lifting Australian agricultures profile in the financial sector.
Securitisation could reduce the cost of finance, increase farmers wealth, facilitate
intergenerational transfers, and raise international competitiveness.

Agriculture, and agribusiness value chains more broadly, would with securitisation assume the
status of an identifiable new investment class for fund managers and institutional investors
comparable with other major asset classes presently being traded in financial markets.

Securitisation of agriculture would open up a new domestic investment channel for the
expanding superannuation and managed funds sector.


Securitisation


Securitisation is a rapidly expanding state-of-the-art financing technique in Australia and in
world capital markets. It has, for example, revolutionised housing finance in Australia leading to
lower interest rates and significant wealth creation for investors in Australias housing and
property sector.

Securitisation is a financing technique where individual streams of cash flow are bundled and on-
sold in capital markets to investors chiefly superannuation and managed funds, financial
intermediaries and the public.

The benefit to major institutional investors, like superannuation funds, is that higher returns can
be achieved by access to a new class of public securities in agriculture, which presently is an
unlisted and diffused asset class. The benefit to borrowers like farmers is increased
availability of capital, greater professional investor interest in agriculture, diversity of choice in
financial instruments and lower borrowing costs.

Solving the farmer equity gap which limits the ability of farms to expand and overcoming
the intergeneration family farm transfer problem are some of the additional benefits which
securitisation can bring to Australian agriculture.






ix

Financial Engineering Challenges


Securitisation typically requires considerable developmental effort by financial institutions.
Financial, legal, accounting, regulatory and other design issues need to be considered and
resolved before going to market. The financial sector also needs better information and
confidence about the farm sector to progress securitisation in agriculture.

These issues were first explored in an earlier RIRDC Research Report Efficient Equity and
Credit Financing for the Rural Sector: New directions in rural and agribusiness finance and
discussed at a CEDA sponsored Conference in Sydney in J une 2001.

This research Report takes forward that earlier RIRDC research on securitisation of Australian
agriculture with more in-depth analysis of technical issues, discussions and testing. The Report
refines and details a securitisation model for commercialisation.

The Hybrid Equity Contract model detailed in this Report is tailored to the special needs and
characteristics of the farm sector while balancing the needs and prudential requirements of the
financial sector.


Next Steps


This Report concludes the ground-breaking stage. The next step to making securitisation a
reality for Australian agriculture is to take it to market. That, of course, is a task for interested
financial institutions to consider and to take the lead in collaboration with farm organisations and
farmers.

Given the positive benefits for economic efficiency, wealth creation and international
competitiveness of Australias rural sector, governments both Commonwealth and State might be
expected to play a supportive role in the commercialisation phase.

Wider dissemination of the benefits of securitisation to the farm sector and facilitation of
effective discussion and technical problem solving are areas where additional funding, through
RIRDC, or other rural programs, could assist in successful up-take.





1
1.Introduction


1.1 Background

This research project builds on the earlier RIRDC Research Report
Efficient Equity and Credit Financing for the Rural Sector: New directions
in rural and agribusiness finance (RIRDC Publication No 01/117). That
research took a fresh look at the subject of rural financing in Australia
taking a tops down approach to the issue by considering from a financial
sector viewpoint how, and in what ways, rural and agribusiness financing
differs from mainstream contemporary practice in the financial sector,
including, in areas such as securitisation and mezzanine financing. An
integral element of the earlier project was the organisation of a Conference,
involving financing specialists and other interested groups, in Sydney in
J une 2001 sponsored by the Committee for Economic Development of
Australia (CEDA) which discussed and explored the issue of securitisation
of Australian agriculture.


1.2 Objectives of the Research

This project is designed to research securitisation for the rural sector
further. The objectives are to delineate the theoretical and technical
problems institutional, financial, legal and farm level including findings
drawn from discussions with relevant market players such as merchant
banks, trust funds, rating agencies, banks and finance houses, legal and
accounting specialists and regulatory agencies and to develop a model, or
template, for take-up of securitisation across a range of Australian rural
industries.


1.3 Methodology

Building on the insights gained in the earlier RIRDC project recent
developments in securitisation were researched in depth and a draft model
was prepared for discussion with a Reference Committee. The draft model
was then tested in further extensive discussions across a range of experts in
the financial sector, regulatory agencies and at the farm level. The model
was then refined and key issues relevant to commercialisation were
identified.


1.4 Structure of this Report

Chapter 2 discusses theoretical issues relevant to securitisation and its
application to the rural sector. Chapter 3 presents the model and discusses
the key themes arising from testing the concept from an institutional,
financial, legal and farm level perspective. Chapter 4 discusses how
securitisation may be taken forward and the commercialisation challenges.
Conclusions are summarised in Chapter 5.


2
2.Theoretical Issues

2.1 Securitisation

Securitisation is a term that describes a process. Although it has been an
outstanding feature of the evolution and sophistication of international and
Australian financial markets over the last 15 years securitisation does not
lend itself easily to precise definition (RBA 2003). As one text puts it
Securitisation is the issue of securities by a bankruptcy-remote special
purpose vehicle the proceeds of which are used to acquire, or lend against
the security of, a discrete pool of assets. Any type of asset which has a
stable or predictable cash flow (such as loans, securities, receivables or
leases) or has a value with a cash flow (such as commercial real estate or a
whole business) can be securitised.

(Mallesons 2003, p176)


Basically, securitisation is the process of taking one to one bilateral
contracts or rights bundling them together and selling rights in that bundle
of claims to investors in public securities markets. Securitisation of
housing loans by banks is the most obvious example (RBA 2003). Banks
make housing loans on a one to one basis, then may assign those loans to a
unit trust, say, and debt securities of that trust are then sold to
superannuation funds. The loans may continue to be administered by the
bank as agent of the unit trust but the beneficial and economic ownership
has shifted to outside investors and the loans are no longer on the banks
balance sheet.


Securitisation is generally viewed in terms of selling loan portfolios. Thus
Deloittes reports The Australian securitisation market continues to grow
with aggregate securities outstanding at 30 J une 2002 reaching $125.5
billion, up from $86.9 billion at 30 J une 2001. The RMBS (residential
mortgage backed securities) market continues its dominance of issuance
volumes in the Australian/New Zealand market accounting for 88.5% of
issuance in the six months to J une 2002, down slightly from the six months
to J une 2001 (89.4%). (Deloittes 2003, p1)


But securitisation is not confined to the bundling up of any standard type of
loan assets. There is however increasing investor willingness to accept
different asset classes and deal structures. This includes high LVR (loan
value ratio) and subprime mortgages within the RMBS asset class which
increased by $834 million from 1.9% of RMBS to 2.4%. (Deloittes 2003,
p2)


Commercial mortgage backed securities (CMBS) are also issued often on
behalf of large investors such as property trusts. Small and medium sized
business (SME) loans can also be securitised. SME loans have a
different dynamic to larger ticket property loans and have, historically, not

A Glossary of Terms is provided at Appendix 1

The concept
Rapid growth
of
securitisation
New areas of
financial
engineering


3
been securitised, due to a perceived higher risk profile. However, this
perceived higher risk is not necessarily a given in SME loan pools and the
US experience has shown that with diligent loan underwriting and servicing
policies, an SME loan pool can perform as well as, or better than, a larger
ticket CMBS loan pool. .... Traditionally SME loans have been the
domain of the trading banks and credit unions, who have been successful in
tapping into localised markets and developing relationships, and who have
typically funded the loans on balance sheet. However, in recent times the
spectrum of lenders to this market, predominantly in the US, has broadened
to include investment banks funding SME loans through securitisation
conduits. In the Australian market, a typical loan size would be in the order
of $500,000-$1.0 million. As such, the SME loan market is focussed on
the suburban/neighbourhood market including assets such as individual
retail shops, restaurants and cafes as well as small ticket manufacturing
facilities and offices. (Deloittes 2003, p8) The extension of securitisation
to small and medium enterprise loans is naturally an encouraging sign for
the prospects of farm loan securitisation.


But securitisation, in a broader sense, is not a technique which must be
confined to loan assets. Securitisation techniques can be applied to any
identifiable stream of cash flows which can be detached from their original
owner (AFR 2003; Securitisation Special Report, 24 April). For example,
retail or office properties may be sold by a life insurance company into a
unit trust and then units in the trust are sold to public investors. The net
rents, freeholds and leaseholds are bundled up and offloaded to the public.
This enables the life insurer to liquefy its mature assets and seek new real
estate development projects which it is better able to supervise than outside
public investors. Although not commonly described as securitisation, one
might even describe the process of floating a private company on the stock
exchange as a process of securitising business cash flows. An interesting
example of the securitisation of a contractual right with a variable cash
flow is the way in which the Weeks petroleum override royalty on Bass
Strait oil production was placed in the Bass Strait Oil Trust and floated on
the stock exchange. Units in the trust carry a variable return while being
redeemable for par at the end of their term.


These examples illustrate a feature of securitisation. It often occurs where
asset holders such as banks or life offices wish to free up their balance
sheets by offloading mature developed assets while investors are happy to
buy into mature assets with a record of cash flows. The advantage of
having a mature pool of assets to securitise is that the originator, on one
side, can get the best price while the investors on the other side get the
comfort of buying a pool of assets with a proven track record of cash flows
which can often be assessed, in the case of debt securities, by rating
agencies for their investment grade (Box 1).



Freeing up
balance sheets
Securitisation
expanding


4


BOX 1
CBA considers $1bn securitisation

Commonwealth Bank of Australia could free up to $1 billion in funding for
acquisitions or a buy-back through the securitisation of part of its
commercial property loan book. The move is understood to be under
consideration to be enacted before the end of the year. CBA could sell
the securitised commercial property portfolio to US investors, who have a
track record in such products, or test the market locally, analysts said.
The securitisation of part of CBAs commercial property portfolio would
be a first for the Australian majors, which have focused on the syndication
of their less-risky mortgage loan portfolios. Securitisation can involve the
packaging of a wide range of receivables to be bought by fixed-income
investors, typically priced at a premium to the benchmark bank bill swap
rate.

Source: AFR 18 J uly 2003, p71.


Although securitisation was developed as a means of shifting mortgage
loans off the balance sheets of financial institutions and reflects the interest
of such institutions in converting non marketable assets into saleable
securities, it should be noted that any cash flow or any asset can be
securitised. Securitisation developed as a means of bundling up and selling
interests in pools of mortgage loans but it is not confined to dealing with
pools of debt securities. For example, the commercialisation of shopping
centres can be regarded Westfield being an example as the
securitisation of the cash register rolls (as rent) of thousands of largely
small and diverse small businesses. Franchises could be similarly regarded
an example of securitisation. Whole business securitisations have
developed over the last few years, particularly in the UK. As the name
suggests, they allow the securitisation of the whole of the cash flows of an
operating business rather than relying on isolating particular assets.
(Mallesons 2003, p196)

Yet it is not always the case that securitisation must involve mature assets
or underlying loan assets graded by ratings agencies. Venture capital
funds, or hedge funds, can be offered to the public, with or without capital
guarantees. There is no reason in principle why a hybrid security with a
guaranteed capital return but a variable income return might be offered to
investors on the basis that its capital guarantee is assessed and graded by
ratings agencies but its income return is not graded because it depends on
the underlying vagaries of a business or asset class, as in a whole business
securitisation or the securitisation of royalty.

Securitisation is therefore a technique which can be applied to making
marketable cash flows of an equity or hybrid debt-equity nature as well as
fixed contractual payments of loan interest and principal.

The term securitisation looks at the process from the originators point of
view and reflects the historical origin of securitisation as a means for
Examples in
shopping
centres and
franchises
Securitisation
techniques
widely applied


5
financial institutions, as the first users of securitisation, to turn illiquid,
non-marketable loan assets into saleable securities to investors. But
securitisation involves other parties, notably the investors to buy the
securities and the end users of the funds. Securitisation cannot work if
these parties have no use for it.

The evolution of securitisation into even more sophisticated forms was
recently described by the Reserve Bank (Box 2):



BOX 2
Evolution of Securitisation

The packaging and sale of loan portfolios was piloted in the United
States over the same period [1970s/1980s] beginning with residential
mortgages. In a process known as securitisation, mortgages are sold by
the originating financial institution to a specially created company or trust
usually referred to as a special-purpose vehicle (SPV) which finances
the purchase by issuing securities to investors, using the home loans as
collateral.

Source: RBA 2003


The Reserve Bank goes on to observe Subsequently, securitisation has
been used in the United States and elsewhere to create a wide range of
asset-backed securities including for commercial property, trade and credit
card receivables, and car loans. Collateralised debt obligations (CDOs) are
similar to asset-backed securities, but with the securitisation techniques
applied to larger, less homogenous assets, typically corporate bonds or
loans. The end result is the same: credit risk is removed from the
originating institutions and dispersed via the capital markets in the form of
risk-bearing securities. These securities are usually issued in several
different tranches to provide investors with a selection of risk/return
options a process that requires a credit rating agency to provide an
external assessment of the quality of the underlying asset pool. In the
late 1990s, the trading of credit risk underwent a step change with the
emergence of credit derivatives. One of the characteristics of credit
derivatives is that they transfer credit risk without the sale or transfer of any
underlying assets. When this characteristic is combined with securitisation
techniques, credit derivatives facilitate a process known as synthetic
securitisation in which the credit risk associated with a pool of assets
rather than the assets themselves is assembled in an SPV. This avoids the
costs and complexities of transferring assets. (RBA 2003, pp55, 56)


2.1.1 The investors

Passive outside investors in a business are not business managers. They are
not there to run a business or monitor it from day to day. They want a
Synthetic
securitisation


6
return on their capital and do not wish to lose it in the process of seeking
that return.

Fundamentally, from their point of view, all investment is about cashflow
and yield, be it current yield, future yield or expected yield. In turn, yield
is about expected cash flows in relation to outlay. Investors, whether in
debt or equity or hybrid securities, want to know what are the likely cash
flows in return for their outlay, when they can be expected and what are the
risks. They want to know if the investment is income-secure or capital-
secure or both. They recognise the trade-off between risk and return and
know that a AAA-rated capital and income-secure security will have a
lower yield than ordinary equity which offers neither security of capital nor
income.

Investors know there is a spectrum of risks. They are willing to finance a
business knowing that equity returns may be affected by weather, interest
rate cycles, changes in fashions etc. External risks can usually be allowed
for in risk premiums on bond interest or equity pricing. But outside
investors are not willing to accept some risks, for example, fraud or moral
hazard by the managers or owners of a business. Fraud exists and will
always exist but investors cannot tolerate it. Passive outside investors will
not knowingly invest, whether by way of debt or equity, where there is a
risk that fraud is not controlled. Quite simply, one does not do business
with anyone whom one suspects may be dishonest nor does one invest
where such a question arises. All business is built on good faith and trust.

Outside investors, unlike insiders, have no way of checking on or
preventing internal risks such as fraud so they will only invest if they are
reasonably sure those risks are controlled. It is so basic as to be almost
taken for granted that a business will have proper accounting controls over
the handling of cash or negotiable instruments, that its assets will be legally
secure and that its books will be audited. Equity investors and bondholders
expect to be able to rely on objective information such as audited accounts
or professional valuations. That is why false accounting, as alleged in the
Enron, WorldCom or HIH cases, is so dangerous for marketing securities to
public investors such as retail investors or superannuation funds. Without
trust, securities markets evaporate.

To a large extent, the process of securitising assets involves creating trust-
building mechanisms to replace the obligations of the originator. Where
assets are held on the balance sheet of a financial institution or company,
their supervision is the responsibility of that institution and investors look
to the general position of that institution or company. When assets are
securitised, investors must look to a special purpose vehicle (SPV) to hold
and manage the assets. So trust-building mechanisms are needed by
investors to replace reliance on the originating institution. Outside
investors must insist that systems are in place for banking and controlling
moneys, that mortgages are registered or secure, that assets are supervised,
that accounts are billed and checked, distributions paid and that there is no
threat to their ultimate recourse to the securitised assets held for them.



Investment
reality
Risk and trust
issues


7

2.1.2 The end users of the funds

The end user of the funds may be the originator, as in a whole business
securitisation. More often, however, the assets being securitised are a
stream of cashflows representing funds advanced to borrowers or other end
users, as in securitisation of pools of housing mortgages or credit card
receivables.

Curiously, the end users of the funds may be totally unaware that
securitisation has occurred or is in any way relevant to them. All that they
may see is that banks or other mortgage originators are competing to offer
cheaper housing loans. That this competition is only made possible
because these loans can in turn be pooled, securitised and on-sold to
wholesale investors may be completely opaque to the end user. From an
economic point of view, however, the end users are central to securitisation
whether they know it or not because securitisation is simply a
disintermediated method of bringing borrowers/users and
lenders/investors together. It parallels the economic function of banks
and other financial institutions in mobilising capital for investment (Box 3).
Without end users willing to contract away part of their cashflows, there
would be nothing to securitise.


BOX 3
Cutting the Cost of Borrowing

The last few years have seen the distinction between the major bank and
the mortgage managers blurred. Initially, the mortgage managers were
able to gain market share by undercutting the traditional banking sector.
When Aussie Home Loans started business in 1992 they were able to
undercut the banks by over 4 percentage points. The banks responded by
offering their own no-frills loans and by tightening their lending margins
generally. Now that the banks have lifted their game, the difference
between the rates charged on the major banks standard variable loans and
the Aussie basic home loan interest rate has been reduced to just over half
a percentage point.

Source: Waxman and Davitt, 2002, p407.


2.1.3 The originators

Securitisation is not costless. It costs money to set up a special purpose
vehicle to hold securitised assets, to have the ratings agencies examine the
portfolio and to pay for ancillary management. Why would the holders of
assets wish to incur the real costs of shifting such assets off-balance sheet?
If you have good quality assets, why would you wish to sell them?

The desire of originators to securitise assets usually reflects the fact that the
originator has capital constraints or the assets no longer match its risk
profile.

End users
important
Originators
the key


8
For example, banks may not wish to tie up shareholders capital as a
mandated regulatory reserve against loan defaults. Merchant banks may
even see their business as not holding assets but earning fees from
arranging financing transactions on a fee income basis rather than earning a
traditional interest margin. J ust as banks have sold branch buildings and
leased premises to release capital so they may apply the same logic to other
assets. Is it necessary to own an asset in order to use it or get some benefit
from it? Banks may earn income just as well or better from creating and
selling financial assets as from holding them. So long as the originator can
keep the customer relationship, does it matter whether the funds going to
the customer are from the originators own balance sheet resources or not?

Further, banks and other financial institutions need to closely monitor
credit and interest rate risks on their portfolios. To finance long-term fixed
rate mortgages from a pool of at call deposits with floating rates can be a
recipe for financial disaster as American thrift institutions discovered.
J apanese banks have discovered that lending too much to, or holding equity
or quasi-equity in, industrial concerns can be also perilous.

Seen from this point of view, securitisation is not another management fad
but a sensible and useful tool for more closely matching risks and time
horizons within the economy (Box 4). Long-term users of funds are better
matched with long-term suppliers (RBA 2003).


BOX 4
Investors and Lenders Back a Capital Idea

The ballooning growth of the securitisation industry has cut interest rates
and offered investors more choice. Securitisation brings efficiencies by
not only managing the funding process more efficiently, but by delivering a
cheaper cost of funds that flow through to the end borrower.

Source: AFR, Securitisation: Special Report; 24 April 2003, p20.


2.2 Application to rural industries

As the National Farmers Federation has observed In 2000, farmers had
borrowings from banks and other financial institutions totalling $18.4bn (or
$177,700 per farm) and paid $1.9 bn in interest ($18,000 per farm).
Banking services are naturally vital inputs into farm production.
Agriculture differs from other industries in a number of ways (other than
those noted in section 3 above):


It is mostly made up of a large number of relatively small businesses.

The debt to asset ratio of 19.3% is greatly below the average of 70%.

Land is the key input to production, and makes up a bit under 70% of
total farm assets.

Special
features of
rural business



9
The last two facts mean that lending to agriculture is mainly low risk, as the
probability of losing principal is low. (NFF 2002, p6).

Nevertheless, as ABARE observes because ownership of Australian farms
is overwhelmingly dominated by small family businesses particular
difficulties arise in dealing with business development in the rural sector
(Box 5).



BOX 5
Farm Expansion Slowed by Lack of Equity Funding

Not having access to equity funding, the capacity of family farms to
expand is limited by the profits they can generate and the funds they can
borrow. Expansion for small and even medium sized family farms is often
slow and, in many cases, impractical. Over recent decades, many
operators of smaller commercial farms have sought more intensive land
management pursuits or have turned to off-farm income as an alternative
to farm expansion.

Source: ABARE 2002.



Most securitisations have involved bundling up of loan assets such as pools
of housing mortgages and credit card receivables. There is no reason in
principle why the same technique could not be applied to bundles of rural
loans. However, successful securitisation of debt instruments usually
requires a ratings agency assessment of both principal and interest cash
flows. This in turn requires a large volume of statistical data upon which
ratings agencies may assess default patterns and stress test the debt
portfolio. In the case of long-term rural loans, as opposed to housing loans,
the data may not be so readily available. This of course does not stop, and
has not stopped, trade sales between financial institutions of books of
rural loans. But the market for such trade sales is narrower than the
potential market of public or sophisticated private investors which
securitisation techniques seek to tap.

Where the rural debt is short-term, for example, loan advances secured
against the seasons crop delivery, securitisation of rural debt has
occasionally been practised through private offerings to investors since the
credit risk on such secured short-term advances is naturally lower.
Securitisation of long-term rural debt remains more problematic.

Further, if as the NFF notes, debt is only used for some 20% of farm
financing, it is appropriate to ask if the 70% land component of farm assets
could be used to raise finance by way of some form of equity participation
by passive investors. Hence, it seems natural to ask whether one could
securitise a share of farm output rather than ordinary mortgage debt.

There is no apparent in principle difficulty to securitising rural output as
a means of obtaining finance. This was confirmed earlier in the
RIRDC/CEDA Conference (section 2.3 below) and in the empirical work
The equity
problem
Farming can
be securitised


10
undertaken in this project (section 1.3 above). But the problem is to design
any such product to maximise its market and, most importantly, to allow it
to be offered within a price range acceptable to both investors and funds
users. When it comes to securitising debt, unless rating agencies have a
track record on which to grade an investment security, investors cannot
price it fairly. If they cannot price it, the risk premium they will add to
their implicit rate of return may make the debt securitisation too costly for a
primary producer compared to conventional bank debt financing.

But there is a more important issue in applying securitisation to primary
production. Most primary producers or farmers experience considerable
year-on-year fluctuation in cash flows depending on factors such as
weather and commodity prices. The fixed commitment represented by an
interest servicing charge may be an unwise obligation to undertake. If
primary producers have borrowed as far as they prudently wish to or as far
as the banking system will prudently allow, securitisation of long-term
rural debt may have advantages to borrowers and lenders in terms of
narrowing interest rate margins or improving balance sheet flexibility but
may not meet the underlying capital needs of primary producers. At the
end of the day, it is not sensible or desirable to finance a capital intensive
business with widely variable cash flows through excessive reliance on
debt. Equity or some form of hybrid equity will be required.

In principle, not only debt but equity and hybrid debt-equity assets can be
securitised. The greatest potential contribution of securitisation as a
financing technique for agriculture may eventually lie not in improving
access to debt finance but in creating new means to exchange future
variable cash flows for capital contributions to the business.

This paper will develop the theme that, instead of a whole business
cashflow securitisation, the securitisation model likely to be of most use to
primary producers (and of most interest to investors) is a part business
cashflow securitisation which allows passive quasi-equity investment in
unincorporated enterprises.

This will involve the development of a new asset class of standardised
generic crop/livestock claims which can be traded, registered, quarantined
from operator insolvency and tracked for financial performance. Contract
default risk could be checked by ratings agencies. Once such crop sharing
claims exist, they could be aggregated into diversified crop pools available
for private or public or institutional equity investment. Eventually, once
crop pools established an investment track record, one could foresee the
floating of such pools on the stock exchange and their routine inclusion in
fund managers asset classes.


2.3 Key findings of the RIRDC/CEDA
Conference

Before proceeding to develop such a model of rural securitisation, it is
worth revisiting some of the themes and conclusions which emerged from
the RIRDC/CEDA sponsored Conference of J une 2001 on Efficient Equity
and
Cash flow
problem in
farming
A new asset
class?


11
Credit Financing for the Rural Sector, (Dwyer and Lim, 2001). These are
set out below.

It was clear from the Conference that there were serious obstacles to rural
financing created by the ownership structure of most primary producers.
Because most primary producers are organised as private companies,
partnerships or trusts, they do not have access to outside equity finance
from the public or from institutional investors such as mutual funds or
superannuation funds. This was an obvious gap in sources of equity
financing and most primary producers, except for some corporate
operations, had no access to either public equity markets or to private
placements with institutions.

Nor was it easy to redress this problem by re-organising agriculture in the
corporate form. There are tax detriments to doing so. Like venture capital
and new technology start-ups, primary industries experience great
variations in returns often over long cycles. Unless losses and depreciation
allowances flow through, as they are incurred, to ultimate investors, the net
rate of return to investors in primary production is depressed relative to
other activities such as real estate where returns tend to be more stable. In
extreme cases, the inability of a primary producer to set off losses against
off-farm income could lead to insolvency. This was a problem for
companies and trusts and explained why primary producers tended to use
partnerships for their operating structures rather than the private company
used in other small to medium sized businesses.

There are also superannuation prudential restrictions which have had the
effect of diverting funds away from rural investments. Because of
(understandable) prohibitions against in house assets and the prudent
man rule for trustees, superannuation savings were not available as either
debt or equity to the great bulk of unlisted, non-corporate, primary
producers. Even the superannuation savings of rural Australia were often
not re-invested back in rural industries in the areas from which they came.
This might not matter if other funds were forthcoming, but given the
obstacles to equity investing in primary producers for institutions, this was
not the case.

Yet, paradoxically, the RIRDC/CEDA Conference showed there was
investor interest in agriculture. The tax driven schemes showed as much.
But, as always, it is a question of risk and rate of return. Investors who
lack hands on control often lose money in agricultural investment.
Equity investors could well be interested in tradeable, liquid securities of
primary producing businesses but these are not generally available.

That there was scope for equity finance to replace debt finance in primary
producing enterprises was illustrated by the observations that margins on
banks loans to agriculture were among their more attractive. For banks
and pastoral finance houses which had been able to take the long view,
rural finance had been generally profitable. A stronger equity base would
allow primary producers to offer higher-quality debt to lenders and reduce
their borrowing costs.

The importance of securing the broadest possible base for funding
investment in Australian agriculture is brought home by the potential
Ownership
structure of
farm business
Super Funds
rules
problems
Investor
interest


12
impact of globalisation. National banking systems are becoming less
important as agents of domestic economic investment and development
while global equity markets are becoming more important. J apanese banks,
for example, could not lend through the negativity of the J apanese and
world stock markets towards J apanese industry. Banks are increasingly
required by international regulators to take more and more stringent steps
to avoid equity risks and monitor credit risks. They must ensure their asset
growth is matched by injections of shareholder capital. They cannot afford
to carry their non-performing loans to industry as they may have done in
the past.

Nor is Australian agriculture any longer the beneficiary of a directed pool
of development funds. Institutions such as AIDC, the Rural Credits
Department of the Reserve Bank, the Primary Industry Bank have ceased to
exist or been absorbed into other, non-subsidised, financial concerns. At
the same time as directed loan credits have gradually faded into history,
banking and capital markets been opening across the world. This is not to
say that any industry should be sheltered from competition or enjoy a
subsidised life but to recognise that, in the final analysis, Australian
primary producers must now compete for funds with other enterprises
seeking funds across the globe. If Australian agriculture is off the map
for Australian fund managers, this would be more so for overseas fund
managers. The challenge is to ensure that debt and equity investment in
Australian primary production is on the menu for suppliers of capital
whether in Australia or overseas.

Part of the United States success in the world economy has rested on its
ability to improve and perfect its capital markets which had led to an inflow
of global funds to US markets, simply because they were there.
Countries and sectors without capital markets do not get capital; and
countries and sectors with less developed capital markets, get less capital
for their development. The Enron and HIH debacles in the United States
and Australia have also underscored the importance of data and accounting
integrity for functioning capital markets. The lesson for Australian primary
producers seeking to attract capital is that any form of securitisation,
whether of debt, equity or hybrid, must tackle the thorny problems of moral
hazard and building in proper governance, audit and fraud prevention
mechanisms.

The RIRDC/CEDA Conference demonstrated an acknowledged gap in
sources of funding for Australian agriculture. It has been left behind in the
financial revolution of the 1980s and 1990s in sophisticated areas like
securitisation. On the one hand there was no obvious route for public
equity investment in Australian agriculture, while, on the other, Australian
agriculture faced equity limits on the amount of bank debt it could
shoulder. Fortunately, Australian agriculture does not face a funding crisis
and, while there have been complaints of banks gradually withdrawing loan
support from marginal farmers, banks continue to lend to profitable and
solvent producers. However, the ability of banks to lend as generously or
for as long as they once might have has been affected by financial
deregulation, capital adequacy requirements and the rise of competing
repositories of funds.

The pay-offs
of efficient
capital
markets
Australian
agriculture
has been left
behind
Broadening
the base of
rural
funding


13
Reliance on debt funding would not matter if primary producers always had
sufficient equity to capitalise their businesses and support debt. But this is
not always the case. Especially for young farmers, farmers trying to
expand their holdings and farmers where succession planning will require
recapitalisation of a farm to buy out siblings a lack of equity may present
real problems, not to mention the obvious case where a run of bad seasons
has eroded both farm equity and off-farm investment reserves (Troeth
2003). It remains true that, as the NFF notes Growth of an efficient
business requires the use of external funds (debt or equity). The banking
system is the major source of debt finance for business in Australia. In
2000, financial institutions provided 70% of total debt to the rural sector
(total debt includes trade debt, leases and hire purchases). The average
farm debt to financial institutions was $177,700. However, farms have an
average debt ratio (20%) much lower than the business average (70%), so
they are generally lower risk. (NFF 2002, p5)

The RIRDC/CEDA Conference noted the lack of equity finance is
increasingly being recognised as a problem for primary producers. The
NFF has summarised the problem in the following way (Box 6):



BOX 6
The Debt/Equity Dilemma in Farm Finance

Most businesses need outside debt or equity financing in order to grow.
Very few are able to grow solely through retained profits. The majority of
the concerns expressed about farm finance relate to debt financing.
However, the NFF wishes to highlight concerns that exist over the ability of
farms and regional communities to access equity financing. To some
extent, the lack of adequate equity financing means that regional
businesses need to rely instead on debt financing, restricting their growth
and increasing reliance on banking services that are being withdrawn.
Therefore policies to encourage equity financing of farms and the regions
may address some of the problems caused by reductions in regional
banking services.

Source: NFF 2002, Ch.7


Among suggested causes of lack of equity investor interest are a lack of
mutual understanding between project proponents and potential investors;
fund managers not having the local connections or the appropriate
investment structures, to invest regionally; and, a mismatch between
superannuation funds, which invest equity in bulk, and smaller
disaggregated investment opportunities.

Australian primary producers have to look at diversifying their funding
bases with new and innovative financing techniques and instruments
tailored to contemporary best practice in Australian and global financial
markets. Securitisation of both debt and business cashflows is now a
major financing technique and it is in solving the problem of the equity
gap for primary producers that securitisation may prove most useful for
But fund
managers
lack local
knowledge
Reliance on
debt finance
by rural
business



14
farmers - by bridging the gap between small and medium enterprises and
wholesale equity investors.


15
3. Development of a Model

3.1 General

Before specifying a securitisation model relevant to the rural sector some
general issues are discussed in the following sections.


3.1.1 Prerequisites for successful securitisation

For securitisation to be successful it has to meet both the needs and demands of
capital users, of investors as capital suppliers and of originators, whether what
is being securitised is debt, equity or a hybrid of both and it must serve a
purpose for the originator (eg an insurance company or bank selling a portfolio
of property or loans into a securitisation vehicle).

The first issue is thus: what to securitise? What is the asset class which will
make up the securitised pool? What can a primary producer offer to an
investor in return for a cash injection into his business? Is it the land which is
being farmed? Is it the plant and equipment? Is it a loan made to the farmer?
Is it a share of the crop or livestock proceeds? If so, is it a share of the gross or
of the net profit?


3.1.2 Capital users

Capital users will want a competitive cost of capital compared to direct
borrowing and will want to retain normal management control of their
businesses.

We therefore assume - reinforced in our discussions and surveys

- that most
primary producers will not wish to securitise their land, that they will wish to
retain ownership of the farm, that they will not wish to become tenant farmers.
Similarly, we assume they are able to finance plant and equipment well enough
through leasing or hire purchase and any securitisation of lease or hire-
purchase receivables can already be done by finance companies or equipment
lessors. Similarly, we assume that banks could securitise their farm loan
portfolios if they wished. However, what has been identified as a need is
passive equity or quasi-equity capital. That means outside investors must be
given a stake in either the net profits of the business, as with a share in a
company, or a claim over the gross cashflows from the business. Given the
difficulty of establishing net profit without full rights of co-ownership in a
business through a partnership or company, the idea of securitising a pool of

The interviews, discussions and surveys for this project were undertaken on the basis
of non-attribution and respect for commercial confidentiality. Some findings reported
in the following pages have therefore been edited and given a generic source
description to ensure confidentiality.
Key questions
Identifying
farmers
needs


16
net profits seems unattractive. To offer a share of net profits would mean
primary producers would commercially have to allow passive equity investors
a say in deciding what was a legitimate deduction to arrive at the net profit.
This would conflict with the assumed desire of the farmer to retain normal
management control. By contrast, there is ample legal and practical precedent
for the use of sharefarming agreements based on a share of gross crop or
livestock proceeds. Farmers understand such agreements and they do not
require intrusive interference with farm management.


3.1.3 Capital suppliers

Capital suppliers will want competitive returns and protection against moral
hazard, fraud, adverse selection and like problems. They will want to be able
to understand the asset class being securitised. They will want to be sure that
the originator is dealing with the securitisation vehicle at arms length and that
they are not being sold poor assets without their knowledge. They will want to
be able to price the ultimate investment and to do so they will want reasonably
robust auditing and forecasting procedures for measuring cashflows (Box 7).



BOX 7
Why has Agriculture Missed Out on Equity?

The advantage of debt, and I think why there has never been much equity
funding in agriculture, is that debt is simple, and its low cost to manage.
Once you get into equity or hybrid equity funding instruments the cost of
management is much higher. If youve got a large portfolio of small exposures
and if youve got a high cost of management on each of those things, the cost of
management can eat up any return. A further issue is that returns at the
smaller end may be problematical where lifestyle issues may affect whether
farms are run as businesses. The upper end of agriculture has no problem
getting debt capital within prudent limits because farmers there are seen as
businesses and lending to them is just as safe and profitable as lending
anywhere else. But, as for equity, very few farmers would want investors to
become partners or co-owners, while investors are not comfortable with that
idea either. Investors are also basically troubled by the volatility of
agriculture with big swings in profits and liquidity for any given farm business.
So you have to find a way to solve the management problem and average out
volatility if you want to get equity or hybrid equity investment into
agriculture.

Source: A rural lender


Even if rural land were available to be securitised as an asset class, one doubts
that many investors would be keen to take on an asset which is worthless
without a class of willing and capable tenant farmers. Owning rural land
Lenders needs
Super Funds
requirements


17
involves assuming risks of ownership and management very different from
urban real estate such as office blocks, shopping centres or industrial parks.
Equally, passive equity investors like superannuation trustees equally do not
wish to accept the business risks of co-partners by sharing net profits. The
Partnership Acts and case law make it very likely that any attempt to share net
profits in a business renders the investor liable as a partner for all debts and
liabilities of the business. Sharing a part of the gross proceeds of a business
does not create these potential liability problems.


3.1.4 Securitisation originators: Capital adequacy
requirements

Banks and insurance companies are subject to capital adequacy or solvency
requirements. A motive for securitisation on their part is to release capital from
being held against securitised assets being sold off. A bank or insurance
company seeking to move assets off balance sheet into a securitisation vehicle
will therefore want to be sure that it has, in fact, done so and there is no further
requirement to hold capital against these assets or, if so, that need is addressed.

In the case of equity or quasi-equity hybrids, a bank may not wish to take such
assets on its balance sheet in the first place because they are not normal
banking loan assets. A banking group may choose instead merely to have a
member of its corporate group act as the arranger and manager for investors
from the original creation of the securitised assets.


3.1.5 Taxation issues

Because investors necessarily invest on the basis of after-tax returns and
liquidity, they will examine carefully whether double taxation of income
returns or withholding taxes are involved. They will be looking for flow
through or pay through income tax treatment which leaves taxation only on
the ultimate investor. They will also want to be sure there are no stamp duty or
other impediments to free transferability of investment interests in the special
purpose vehicle which holds the securitised assets on their behalf.


3.1.6 Insolvency quarantining

The securitisation vehicle and its assets need to be quarantined against
bankruptcy or liquidation of parties. It is necessary that the assets of the
securitisation vehicle are protected against both the bankruptcy of those
businesses against whom it holds claims and against the insolvency of an
originator or manager of the vehicle.

Taking the case of bankruptcy of a farmer, the ultimate investors do not want to
see their cashflows cut off by unsecured creditors of farmers. They want to be
sure that if they have advanced money in return for a percentage of crop or
Regulatory
issues
Tax traps?
Bankruptcy
protection


18
livestock proceeds for a certain period that they have some security over the
land, the crop and/or the livestock. This is a natural quid pro quo for adopting
the role of a passive equity investor: if you relinquish the right to active
management of the business, you expect to be compensated by a greater
measure of comfort that the cashflows you bought cannot be easily lost to, or
misappropriated by, others. Wherever there is passive equity investment, one
expects to find agents or representatives such as trustees or auditors who can
verify that inside management is not abusing its position to the detriment of
outside investors.

Equally, investors do not want to see the whole securitisation transaction
dragged down by insolvency of a manager or originator. If the originator is a
bank or insurance company, the latter event may be unlikely but investors
would still want to be sure that a liquidator could not set aside a sale and claw
back assets sold into their special purpose vehicle so that they ranked as
unsecured creditors. Investors who bought assets from an HIH Insurance, for
example, would be very concerned if such transactions could be undone by a
liquidator.


3.1.7 Accounting non-consolidation

In addition to legal quarantining, it will be necessary for the securitisation
vehicle to be a stand-alone accounting entity for reporting purposes even if
managed by an originator as its assets will not be available to any but its own
investors. Following the Enron debacle in the United States, accounting
standards for securitisations are undergoing revision to prevent abuse of off-
balance sheet vehicles but it would seem to defeat the purpose of securitisation
if an originator who had legally disposed of assets and no longer had any right
to or responsibility for them were to be required to show such assets on its
balance sheet or provide capital against them.

A particular difficulty may arise where the sale of the assets is carried out
through an equitable assignment which transfers the beneficial interest in the
securitised assets to a special purpose vehicle which is managed by the
originator or one of its subsidiaries. Given the continuing role of the originator
in servicing the securitised assets (often desirable to preserve customer
relationships and keep servicing costs down), one can see that an accounting
standard which requires consolidation of controlled entities (even if they are
not owned) could negate one of the objectives of securitisation. While one can
understand the adverse reaction to non-consolidation of off balance sheet
entities where there was ultimate recourse back to the parent (as in an Enron
situation), it would appear rather inappropriate to require consolidation of
securitised assets to which the originator had no legal rights and for which it
had no liability or carefully limited liability.

At the time of writing the issue is complicated in Australia by the move to
international accounting standards. The background is well explained by
Deloittes On 3 J uly 2002, the Financial Reporting Council (FRC)
Accounting
standards
issues


19
released a bulletin formalising support for the adoption by Australia of
International Accounting Standards (IAS) by 1 J anuary 2005. Subsequently,
the Federal Governments CLERP 9 proposals have endorsed the FRC's
comments.

The CLERP 9 proposals include a requirement that the body of IASB standards
would be adopted in Australian reporting periods beginning on or after 1
J anuary 2005. However, as a result of the need to present one year of
comparatives, the transition will commence for reporting periods beginning on
or after 1 J anuary 2004.

The actual process by which IAS are to be adopted in Australia is still unclear.
However, with regard to securitisation, we know that there will be
derecognition criteria, contained within IAS 39 Financial Instruments:
Recognition and Measurement, that will need to be complied with from 1
J anuary 2004. However, to complicate matters, in J une 2002, the International
Accounting Standards Board (IASB) issued an exposure draft with proposed
changes to IAS 39. The proposed changes included a major change to the
derecognition provisions.

The current IAS 39 is founded primarily on a control model (model used in US
FASB 140). However, it also uses risks and rewards (approach of UK FRS
5) as a basis for derecognition. The use of both models makes the application
confusing. Both the risks and rewards model and the control model have a
number of complexities and limitations, and there is extensive debate about
which should prevail.

The exposure draft with proposed changes to IAS 39 suggests an alternate
approach, using as the guiding principle a continuing involvement approach
that disallows taking a transferred financial asset off-balance-sheet to the extent
the transferor has any continuing involvement in the asset or a portion of the
asset it has transferred.

A transferor is regarded as having continuing involvement when:

(a) it could elect to or be required to reacquire control of the transferred
asset (for example, if the financial asset can be called back by or put to
the transferor, the transfer does not qualify for derecognition to the
extent of the asset that is subject to the call or put option); or

(b) it has a right or obligation to receive or pay subsequent changes in the
value of the transferred asset (for example, if the transferor provides a
credit guarantee either directly or through a subordinated interest or a
total return swap, derecognition is precluded up to the amount that may
be paid out under the arrangement).

The exposure draft neatly dismisses the need to develop separate consolidation
rules for many securitisation special purpose entities (SPEs). It introduces the
concept of a pass-through arrangement, that would theoretically allow the
SPE to derecognise transferred assets, or a portion of the transferred assets.
Accounting
technical
issues to be
cleared up
More on
accounting
standards


20
Therefore those derecognised assets or portions thereof would not be brought
back on the balance sheet in the transferors consolidated financial statements if
required to consolidate the SPE. However there is very little guidance on the
application of the pass-through arrangements, and the conditions to qualify
appear to ignore standard features of a securitisation arrangement, and it is
therefore questionable if it will be able to be applied in practice. (Deloittes
2003, pp4-5)

Whatever may be the outcome of these re-formulations of accounting
standards, one may hope that fully securitised assets will continue to be de-
consolidated. No accounting standard should presumably require the inclusion
in an originators accounts of assets to which it did not have any beneficial
title. What may be more problematic is the situation where an originator might
wish to improve marketability of the securitisation offering by giving a
guarantee of repayment of principal in, say, 10 or 15 years time. A lot would
then depend on how that guarantee was to be funded and whether it was with or
without full recourse to the originators general assets or to those of a
subsidiary or stand-alone special purpose vehicle.


3.2 A securitisation model

To show how securitisation might work to raise funds for primary production,
an illustrative outline of a securitisation model is set out below. A diagram is
provided at 3.2.4.

3.2.1 The securitised assets

The assets being securitised are a bundle of sharefarming agreements. These
are the primary non-marketable securities which are to be rendered liquid and
marketable through securitisation. The features of these individual agreements
could be as follows. There is in each case, a second mortgage repayable, say,
in 5, 10, 15 or 20 years. The second mortgage carries no fixed interest charge.
In lieu of normal interest, the primary producer contracts with the funds
provider to enter a sharefarming agreement to hand over, say, 10, 20, 25 per
cent of the gross crop or livestock proceeds and to execute annual crop liens or
stock mortgages as may be required. Obviously, the greater the funds
advanced, the greater will be the share of the crop proceeds required in return.
There is a natural limit to how great a share of the crop or livestock output can
be committed in this way. Farmers will not want to commit so much of the
gross proceeds as to deny the business the circulating capital and revenue it
needs to pay its bills and provide a living. The funds provider does not want to
imperil its investment by offering to take more of the output than the business
can safely finance, nor would it wish to run the risk that the farm business will
become run down or semi-abandoned. It is in its interest to ensure the primary
producer is left with sufficient profit incentive to manage the farm prudently.
That is why sharefarming agreements rarely exceed something like a third of
the crop.

Asset
specification


21
Having settled on the greatest amount of the gross farm proceeds that can be
safely committed to an outside funds provider, the basic point of negotiation
between the primary producer and the funds provider will be how much the
funds provider is willing to advance in return for a tranche of the crop
proceeds. The farmer will naturally want to commit as little as possible of his
crop for as large a lump sum advance as he can while the funds provider will
have the opposite motive in order to maximise the expected rate of return on its
funds.

To illustrate how this bargaining might work at an individual level, suppose,
for example, that a farms gross output has averaged $1 million per annum,
over the last 10 years, with variations from $200,000 to $2.4 million while
operating expenses before interest have varied from $200,000 to $400,000 so
that net profits have varied from zero to $2 million. Suppose the standard first
mortgage rural lending rate is 9.5%, the farm is worth $5 million and is already
mortgaged to the extent of $400,000 so that annual interest commitments are
$38,000 per annum leaving a loss after interest in the worst year. Suppose the
farmer wishes to expand and acquire another farm worth $2.3 million. If he
borrows (and can borrow) the whole amount his annual interest bill will jump
by $218,500 and, if borrowed on overdraft will be subject to the risk that rates
may rise and blow the interest expense out further. Neither he nor his bank
may be willing to run that risk, as his loan value ratio would blow out from
0.4/5 or 8% to 2.7/7.3 or 37%. This would be a large commitment for a
business which has once shown no net profit before interest.

If the bank declines to advance funds past a loan value ratio of 20%, the farmer
would only be able to borrow another $1.06 million and would need to raise
another $1.24 million to pay for the expansion.

This is where passive hybrid equity in the form of a sharefarming second
mortgage could bridge the equity gap. The funds provider might advance the
$1.24 million needed in return for a share of 20% of the gross output of the
first farm. Over, say, 10 years with the farms track record the average
expected return on the contract to the investors would be $200,000 per annum
with repayment or refinancing at the end of the term. This would represent an
expected average return to the investors of 0.2/1.24 or 16.13% but the annual
cash return could vary between $40,000 and $480,000, that is, between 3.23%
and 38.71%.

This simplified hypothetical example illustrates several points.

First, debt is cheaper than equity if you can get it. This is natural because
the lender takes little or no risk and, to the extent it does, will reflect that
in its interest charges. In the above example, a farmer raises the extra
$1.24 million from more expensive debt sources, such as a finance
company, on a fixed interest second mortgage at 12.5%.

Second, the more variable the cashflows from a business, the lower the
loan to valuation ratio a prudent financial institution will apply. That is
why banks lend up to 90% or beyond on residential rental real estate or
Bridging the
equity gap
An example
An example


22
why utility companies can borrow heavily for capital works. It is why
both banks and farmers are more cautious in how far they wish to lend or
borrow on rural properties.

Third, the more debt you need the less you may want it. The down side
risks of fixed high, second mortgage interest charges may be very great
for a variable cashflow business.

Fourth, the returns on equity or hybrid equity are variable. This shares the
risk between the owner-manager and the passive equity provider and is
the justification for the equity provider bargaining for an expected return
of 16.13% instead of 9.5% variable on first mortgage or 12.5% fixed on
second mortgage. The extra expected average cost of equity or hybrid
finance is the price of not losing sleep over defaulting on contractual
interest commitments.

Fifth, rural properties are lumpy investments. A well-established,
financially strong, property can be stretched when refinancing is required
for expansion. Even if expansion is initially financed by bridging debt, a
primary producer may well wish to reduce his exposure to fixed or
variable interest rate by substituting hybrid or passive equity for at least
some of the debt. Similar problems arise when a farm has to be
refinanced to accommodate inter-generational transmission with
provisions to be made for non-farming co-inheritors of a deceased
farmers estate.

Sixth, debt and equity are not alternatives. There is no right or wrong
about one or the other. It is all a question of balance - of balancing the
risk profile of the enterprises liabilities with its cashflows. But just as it
is dangerous to borrow long and lend short so it is dangerous to gear
high on uncertain cashflows, a lesson entrepreneurs such as Alan Bond
and J ohn Spalvins re-learnt in the 1980s. Primary producers have long
known this lesson, which is why they have used schemes such as income
equalisation deposits. Their problem is the lack of equity or hybrid equity
alternatives to borrowing when enterprise cashflow or outside savings
cannot supply enough internal owners equity to support borrowing
safely. This is the problem of the equity gap in rural finance.


3.2.2 The pooling of the assets to be securitised

A basic principle of insurance and risk management is that a bundle of assets,
even at the same kind, exhibits greater financial strength than any single one of
them - just as in the old story of the man who could not break a bundle of twigs
bound together (in years gone by the logo of MLC). The Economist in a recent
article on risk management notes The most basic principle of finance and
insurance is that spreading risks over large numbers of people can reduce their
impact. (The Economist, Risk Management for the Masses, 22 March 2003)



23
A portfolio of a 1000 hybrid equity securities of the type described held over
properties in different geographic regions would be very unlikely to exhibit
annual variations in returns between 3 and 387%. The variation on a portfolio
might be more between 10% and 20%. This diversification to reduce
variability of returns is part of the magic of securitisation. Individual investors
or fund managers who would think long and hard before purchasing a primary
security with widely variable returns will much more happily purchase a
secondary security representing a share in a pool of such securitised assets with
much lower variability and credit risk.

The special purpose securitisation vehicle sits between the ultimate
downstream investors and the user of the funds, much as a bank sits between
depositor and borrower. But whereas a bank is directly liable as a debtor to its
depositors, a securitisation vehicle such as a unit trust acts for investors as
owners, not creditors. If its assets are impaired, the loss falls on investors in
contrast to banks where bank shareholders rather than depositors bear the
burden of impaired bank assets (except in the case of bank failure).

This highlights the point that securitisation originated as a risk-shifting,
disintermediation, form of financing in situations where financial institutions
could no longer carry the risk of holding impaired assets.

It also explains why ultimate investors must demand much more information as
beneficial owners on the underlying assets. Instead of relying on the credit of a
bank, they must ensure procedures are in place to check the credit quality or
likely performance of their assets. Statistics, third party verification, credit
rating, auditors, trustees and custodians therefore play an important part in
giving investors confidence that their assets are there and their investment
decision needs only be based on expected or contractual cashflows.


3.2.3 The investors

Whereas previously a Superannuation or Managed Fund may have demanded
an expected threshold rate of return of, say, 15% before it was willing to
advance hybrid equity to a given primary producer, such investors would
demand a lower rate of return, say, 11% which would reflect both the risk
reduction achieved by portfolio pooling and the rate of return on other equity
investments. If stock markets are rising and yields are falling, then investors
may seek a lower rate of return and this in turn would eventually be reflected in
lower threshold rates of return sought by the Fund Managers on new equity
take-ups by primary producers.

From the investors point of view, investing in a special purpose securitisation
vehicle such as unit trust holding a portfolio of sharefarming second mortgages
would be much like buying a unit in the Bass Strait Oil Trust. Units in that
trust are redeemable by amortised payments over their life while profit
distributions depend on a share of the gross value of Bass Strait oil production.
In both cases, passive equity investors are accepting output and price risk in
exchange for a higher rate of return than that available on
Bundling of
assets
Information
for investor
confidence
Benefits for
the investors
SPV


24
securitised housing loans where both principal and interest payments are
entirely fixed. The advantage to an investor in a rural securitisation vehicle is
that he would not be limited to a share of output from one mature oilfield - a
rural hybrid equity fund could not only diversify across regions and operators
but across various kinds of crops or livestock.


3.2.4 A Diagram of the Model


A diagram of the model is provided below:







25





External Investors
Superannuation Funds, Managed Funds
Public
Overseas Investors
Distributions to investors (may
be both capital and annual
returns)
Purchase units
Secondary Securities, eg units in an ASX
Listed Unit Trust (eg a Farm Fund)
Computation of net returns on
portfolio
Capital of Fund
Special Purpose Securitisation Vehicle
(eg a unit trust)
Pooled annual proceeds
(diversifying operator, climate
and geographic risk)
Advances moneys
Primary Securities (the securitised assets)
(eg Gross proceeds farm sharing
mortgages)
Annual share of farm proceeds Farmers give
mortgage/liens for
moneys advanced
Farmers (offering, say 30, 20, 10 per cent
of gross farm proceeds as return on farm
sharing mortgage)


26
3.3 Institutional Issues

While the general idea of securitising a portfolio of hybrid equity claims is
simple enough, there are a range of institutional, regulatory, legal and
practical management issues which need to be dealt before one could have
a workable securitisation.

The institutional issues arise because it is necessary to identify the parties
who may be parties to securitisation and what roles they might play.

These potentially include trading banks, merchant banks, mortgage
originators, pastoral finance houses, trustee companies/custodians,
marketing boards, stock and station agents, farmers associations,
ratings agencies, fund managers, accountants and auditors.

As existing lenders to the rural sector, trading banks might have an
interest in rural securitisation for several reasons. First, by improving the
equity backing of rural borrowers, securitisation could be used to improve
the quality of existing loan portfolios, release capital and support new
lending opportunities. Second, as first mortgage holders, the consent and
cooperation of banks would be necessary in practical terms to the creation
of subordinated second mortgage securities. Third, trading banks could
maintain and strengthen their existing relations with their rural customers
by acting as administrative managers of the securitised assets. If a bank
holds the first mortgage in its own right there is no reason why it could not
hold the second mortgage on behalf of the special purpose securitisation
vehicle given that covenants required for first and second mortgages are
generally likely to be similar. J ust as banks have retained customer
relationships with housing borrowers even though the relevant loans have
been securitised and sold on to outside investors, it would often make sense
for a customers bank to handle the relationship (Box 8).



BOX 8
The Changing Role of Banks

This wider participation in the asset-backed securities market means
that banks now account for less than one-third of the underlying
origination. Nevertheless, they still play a pivotal role in the asset-backed
securities market through the provision of services such as liquidity
support, swap arrangements and administrative services to SPVs holding
non-bank-originated assets.

Source: RBA 2003, p59.

It is also possible that mortgage originators may wish in time to expand
their businesses from securitisation of pure housing loans to hybrid equity
based on second mortgages. It is also possible that merchant banks might
Role of
banks


27
be interested in playing the role in the structuring and wholesaling of
hybrid equity rural securitisations. Several interviewees noted that hybrid
equity generated by rural securitisation could be a useful new asset class
for venture capital firms to market to institutional investors such as
superannuation funds (Box 9).



BOX 9
Commercial Interest in New Securitisation Products

I am sure there are investors out there who would be interested in this
sort of hybrid equity. You just have to find those investors. The idea of
combining sharefarming and mortgages to create some kind of hybrid
equity for investors is a really nice concept. Its the sort of thing we would
be interested in continuing to explore. There is no reason why it shouldnt
be attractive to banks or other financial institutions. The real trick will be
to cover the initial development costs and streamline documentation and
administration. We are always looking for something to take to
superannuation funds and other institutional or offshore investors. They
are always looking for new investment outlets. The great thing about
securitising hybrid equity is that many investors are focussed on the
liquidity which securitisation can facilitate and they see liquidity of an
asset as even more important than a guarantee of capital repayment at the
end of 15 years because they dont plan to hold that long, though capital
guarantees naturally affect liquidity through re-sale prices.

Source: A venture capitalist


We really have to look at this wave of superannuation money coming
down the track. Its looking for a home. One of the issues we have to look
at is the extent to which these funds have to go out of the country for
investment because there arent enough assets to invest in here.

Source: A stockmarket analyst


Pastoral finance houses have a long history of lending on the security of
crops and stock. The securitisation model being explored here would
constitute an alternative or complement to such forms of debt financing.
Where a lender such as a bank or pastoral finance house has already taken
security over crops or livestock, it would be difficult or impractical to
create a saleable securitised asset involving such crops or livestock without
the co-operation of such a lender. By the same token, pastoral finance
houses may find it useful to be able to offer finance to their customers in
due course by way of hybrid equity financing where the securitised assets
do not have to be carried on their balance sheets.

Hybrid
equity
attractions


28
Trustee companies or custodians would need to play a role in protecting
the special purpose securitisation vehicle. Not only would it be necessary
for legal title to the securitised assets to be checked on behalf of investors
but where the legal title remained with the securitisation originator as in the
case of a bank making an equitable assignment of second mortgage share
farming loans, a trustee or custodian would be necessary to protect
investors property and keep assets segregated for the special purpose
vehicle in the unlikely event of bank insolvency. A trustee or custodian
would also be needed to check and monitor crop liens and stock mortgages
on an ongoing basis throughout the term of a share farming second
mortgage.

Because the income return from the hybrid equity asset is in the form of a
share of crop or stock proceeds, investors will want to be assured that
satisfactory contractual arrangements are included in the hybrid equity
documentation for collecting their share of sale proceeds at the point of
sale. Investors would be reassured by a marketing board (if any), other
marketing channel, stock and station agent, etc being designated as an
authorised withholding agent on behalf of the special purpose vehicle
holding the hybrid equity. At the same time as the marketing board or
stock and station agent was accounting to the primary producer for the bulk
of the proceeds of sale it would also collect and remit the share belonging
to the securitisation vehicle to its bank account. Investors would not wish
to lose the benefit of their crop lien or stock mortgage by allowing their
part of the proceeds of sale to pass into the hands of the mortgagor so that
they became unsecured creditors. J ust as solicitors do not release property
title deeds except on receipt of a bank cheque or electronic transfer, so the
manager of the special purpose vehicle would naturally require there be no
disposal of crops or stock without provision for simultaneous division of
the proceeds between the farmer and the securitisation vehicle acting for
the passive equity investors.

Farmers associations would most likely play a key role in forwarding
rural securitisation for at least two reasons. First, many people, and not
just farmers, are often cautious about accepting the products of financial
innovation at a retail level. For example, people remember the difficulties
created for some of the borrowers who took up the then new foreign
currency loans in the early 1980s and suffered from adverse exchange rate
movements. One reason that housing loan securitisation has been so
successful is that it is often entirely out of the sight of the borrower who
sees himself as simply taking a normal mortgage loan. A hybrid equity
share farming second mortgage would be an obviously different instrument
which would need to be explained to the customer. While share farming
agreements are well established, their remodelling as a financial instrument
would obviously benefit from close customer involvement. This is
especially true as sharefarming agreements naturally involve detailed
covenants. The reasonableness of such covenants must pass the scrutiny of
farmers and their representative associations if securitisation of hybrid
equity incorporating such covenants is to gain customer acceptance.
Second, some covenants may need referral to a third party or arbitrator to
Trustee
Companies
role
Agents role
Farmers
Associations
role


29
be commercially flexible and workable. In any business joint venture or
arrangement there will always be scope for disagreement often caused by
changing circumstances. It is usually better to have commercial
disagreements between partners in a business settled by an agreed
arbitration or third party consent procedure than to have the matter dealt
with by the Courts. J ust as real estate leasing contracts often contain
provisions for referral of rent renewal valuations or disputes to arbitrators
appointed by the Presidents of the Law Society or Real Estate Institute, so
sharefarming agreements could contain provisions for referral of disputes
or discretionary covenant waiver provisions to experts designated by a
farmers association, inter alia. For example, it may normally be a breach
of a mortgage condition not to repair fences but it may be reasonable to
waive such an obligation on a de-stocked farm in a drought and, if there
were disagreement on such a waiver, it could be settled by referral to
experts.

Ratings agencies have as their main historic focus assessing credit risk in
relation to repayment of interest and principal by corporate and
government bond issuers. This has been particularly important for US
investors buying foreign bonds. It is therefore natural that rating agencies
have been widely used to assess underlying credit risk where a pool of debt
or mortgage loans has been securitised. In many cases, institutional
investors such as insurance companies or superannuation funds cannot
invest in any debt security which does not carry a satisfactory rating from
unaccredited ratings agency such as Moodys or Standard and Poors. By
contrast, equity securities cannot be rated. There is no contractually fixed
dividend or terms of repayment for an investment in and ordinary share in
a company. But with a hybrid security such as a redeemable preference
share there is a role for ratings agencies because there is a contractual
commitment to repayment of the sum of money which involves assessing
the credit risk of the issuer. Accordingly, it can be expected that investors
in a securitisation of a pool of hybrid equity second rural mortgages would
want external certification and grading of credit risk as to principal, while
recognising that share farming returns cannot be guaranteed.

Accountants, auditors and security registrars would be required to keep
and check the books and accounting records and investor entitlement
details for the special purpose vehicle used to securitise hybrid equity.

3.4 Regulatory Issues

There are several regulatory issues which would affect any rural
securitisation. The Australian Prudential Regulation Authority (APRA)
has issued a standard APS 120 (Appendix 2) which sets out the
prerequisites for a securitisation to be recognised as successfully removing
assets from the balance sheet of a regulated financial institution. Unless a
securitisation can satisfy these requirements (which basically amount to a
clean sale), a financial institution cannot release shareholders capital by
carrying out a securitisation. The requirement for a clean sale does not,
Ratings
agencies
Accountants
role


30
however, prevent a financial institution which originates a securitisation
from using equitable assignments and holding the legal title to the assets on
behalf of the special purpose vehicle buying them for the investors.

Accounting standards are also relevant to securitisation. Unless there is a
careful separation of control and ownership securitised assets held in the
special purpose vehicle might still be treated as belonging to the
securitising entity under accounting consolidation principles.

A hybrid security based on second mortgage lending with supplemental
crop liens or livestock mortgages would also need to conform to the
requirements of the Credit Acts and in New South Wales would also be
subject to the Contracts Review Act. The Federal Trade Practices Act and
the State Fair Trading Acts would also apply. The general effect of these
acts is to prevent misleading and deceptive conduct or unconscionable
dealing and provide credit users with full details of their charges. They do
not appear to be an obstacle to creating a hybrid equity second mortgages.

The offering of interest to investors in the special purpose vehicle used for
a rural securitisation would of course need to conform to the managed
investments provisions of the Corporations Law relating to scheme
custodians, product disclosure requirements and compliance committees as
for any other unit trust or managed fund. Again, there is nothing in the
nature of hybrid rural equity which would appear to make it inherently
unsuitable for public offering under the managed investments regime.

3.5 Legal Issues

There are a range of legal issues which need to be considered from the
point of view of investors, the special purpose vehicle (SPV), the originator
and the primary producer. These are explored in more detail but they
essentially revolve around ensuring that rights of investors to the
securitised cashflows are protected, that trust is reinforced between the
parties and the primary producer is not subjected to unreasonable covenant
obligations.

An extremely important legal issue in a securitisation is ensuring that the
special purpose vehicle used for the securitisation is suitably quarantined
from any insolvency of the originator. The Bankruptcy Act and recovery
provisions in the Corporations Law allow wide scope for liquidators of an
insolvent company to claw back assets disposed of to other parties for
inadequate consideration or in anticipation of insolvency.

Because property held in trust for others is not regarded as an asset of an
insolvent person or company, a disposal of securitised assets to a unit trust
as a special purpose vehicle should not cause problems where the
securitisation originator is solvent at the time and the transaction is a clean
sale at a fair value.

Other
compliance
issues
Insolvency
issue
APRA


31
It is equally important that the hybrid equity rights held by the SPV are
protected against any insolvency of the primary producer. Where the form
of the hybrid equity is that of a second mortgage with an obligation to
grant further annual crop or stock mortgages, the practical issue will be
whether any such additional securities can be set aside by a trustee in
bankruptcy and whether there is adequate compensation to the SPV for the
premature termination of its sharefarming returns due to the demise of the
primary producers business. In this regard, legal doctrines which prevent
enforcement of penalties in equity and which void contractual dispositions
triggered upon bankruptcy are relevant.

3.6 Farm Level Issues

From the point of view of both farmer and SPV there are a number of
practical and commercial issues which will need to be examined. The most
important is how much of the output will be sold, for how long, and in
return for how much capital advanced. Unless the parties can agree on a
mutually satisfactory figure, securitisation will not proceed. Unless the
SPV is able to deliver investors an expected return above their hurdle rate
and unless farmers can be offered hybrid equity at a rate competitive with
risky debt, there will be no commercial agreement.

The design of a hybrid equity sharefarming contract must therefore aim to
reduce all sources of uncertainty as far as possible to enable parties to
bargain as efficiently as possible over the key questions of capital
advanced to the farmer versus the share of farm output committed to
investors in return.

The hybrid equity contract must deal with issues such as farming covenants
normal in any sharefarming agreement (and which may vary from crop to
crop) and with protecting cashflows from unauthorised dealings. It must
also ensure that reporting and verification arrangements are put in place.

With these objectives in mind we turn to the more detailed specification of
a potential form of hybrid equity contract.
As already noted in designing the securitisation model in this Report we
have built on the earlier RIRDC Report Efficient Equity and Credit
Finance for the Rural Sector: New directions in rural and agribusiness
finance (Dwyer and Lim 2001) and undertaken a range of discussions and
interviews with financial and regulatory experts, farmers and farm
organisations (Box 10). The Western Research Institute, Charles Sturt
University, Bathurst also surveyed a sample of farmers and financial
service providers in the Central West of New South Wales as an input for
this project. A summary report of that survey work is attached at Appendix
4. It should be cautioned that the funding available to this research project
limited the extent of survey work at the farm and regional level.
Accordingly, as discussed further in Chapter 4, it is noted that more
Specification
parameters


32
farm and regional level input, and dissemination of the securitisation
concept, would doubtless be required at any commercialisation phase.


BOX 10
NSW Farmers Association Input

The NSW Farmers Association assisted with input from farmers. While
recognising the in principle advantages of securitisation of Australian
agriculture some key issues identified were covenants; restrictions on
farmer management flexibility; lenders perception of higher levels of risk
in agriculture; taxation; intergenerational transfer; lack of understanding
of farm business by institutional investors; and, the need for plain
English dissemination of securitisation to farmers at the comercialisation
phase.

3.7 Design Features of a Hybrid Equity Contract

Because we have been discussing a financial product which does not yet
exist in any settled form, our language to this point has been necessarily
imprecise. We have spoken of cropsharing second mortgages, mezzanine
finance, hybrid equity, the securitised asset or the primary security. All
these terms are expressions of what we are seeking to achieve, a form of
passive quasi-equity investment in primary production which supplies
capital in return for a share of output but which leaves managerial control
in the hands of the primary producer. This form of quasi-equity we shall
call a hybrid equity contract (HEC).

3.7.1 Basic form of the HEC

A HEC would be a contract between the securitisation originator and the
primary producer. It would usually be held by the originator for the SPV.
The basic form of the HEC would be a second mortgage on the land used
for primary production together with a sharefarming agreement to provide
rights to a share of farm output in lieu of interest on the loan. The
sharefarming agreement would require collateral crop liens and stock
mortgages to be executed to protect the legal rights of the HEC holder (the
SPV) to its share of the crop proceeds as soon as they are derived.

The longer the term of the HEC, the lower the discounted value of the loan
repayment and the more the present value of the HEC depends on the
expected value of future crop returns.

Unlike current proposals which have been advanced for cutting
homebuyers interest costs by sharing capital gains on resale of a home in
return for lower interest charges, the HEC does not give the HEC holder
any right to capital growth in farm land value. It is a commercial contract
Hybrid
Equity
Contract
HEC design
features


33
aimed at financing rural business, not passive real estate holding or
consumer financing.

3.7.2 Allocation and assumption of risks in the HEC

Given that primary producers have variable cash flows and profitability, a
fixed interest contract seems to add no great benefit over ordinary bank
borrowing for farmers nor does it offer institutional investors such as
superannuation funds an exposure to upside swings in primary production
industries.

What farmers need is more equity investment rather than risking the
dangers of over-gearing with debt against fluctuating incomes (NFF;
ABARE op cit). Yet equity cannot be offered directly by the vast
majority of farmers to securities markets. If farmers wish to raise equity
funds, a way has to be found to create an enforceable and secured claim for
investors to a slice of farm cash flows which is still compatible with the
normal legal form of farm enterprises (unincorporated partnerships, trusts
or family companies).

Some form of profit or revenue-sharing contract is required to parallel the
usual case where equity investors in ordinary shares can lay claim to
dividends out of profits of a company (Box 11).


BOX 11
Debt versus Equity for Financing Agriculture

Farmers probably dont get enough funds flowing to their sector but the
question is why they dont raise more debt, rather than raising equity.
Theres an argument that farmers will gear higher as they become more
like corporates because debt at 6% or 7% today is a lot cheaper than the
cost of equity at 12% or 15%. But equity is usually more expensive since it
takes the risk which lenders wont take. And I suppose that is the problem.
Banks cant take equity risks and you cant expect to use debt as a
substitute for equity. By all means use debt as far as you sensibly can,
because it will carry a cheaper price tag, but its dangerous to use debt
when you cant carry the risk. The Commonwealth Government solved
much of the risk problem years ago with home mortgage insurance through
the Housing Loans Insurance Corporation. This allowed households to
borrow more, since they were now insured for some major risks. Its not in
the farmers interests to have more debt without equity to back it and act as
a form of risk insurance. But if you can insure risks or use equity to
absorb them, then it becomes easier to obtain debt financing too.

Source: A financial sector executive


Raising
equity
funds


34


Because farmers may want to raise more equity-type finance while
investors are unlikely to want exposure to normal equity in unincorporated
or unlisted enterprises, it is suggested that a HEC with some capital
guarantee and an equity-type sharing in profits or value of output will be
more attractive to both farmers and downstream investors. The basic form
of the HEC offers this capital guarantee to investors by backing the
obligation to repay at maturity with a second mortgage.


The HEC has to be designed to minimise unwanted (and unpriced) risks to
the investors cash flow from the security. The HEC has to allow
downstream equity investors in secondary markets to price risks which
may affect their returns. Identification and allocation of risks drives the
design of the HEC.


The major problem in securitising agriculture is designing a model for the
HEC which is to be securitised and how it deals with economic and other
risks. J ust as bank depositors do not know or care much about who a bank
lends to, so equity investors in the securitisation SPV do not want to
have to care about certain risks at the level of the HEC. They want to
know that they are buying a share of expected agricultural output and may
be presumed willing to share the usual equity-type risks provided they can
price their capital at an expected risk-adjusted rate of return (Box 12).
Equity-type risks which would flow through to investors in a pool of HECs
would include


output variability risk beyond control of the farmer (eg climate);

normal management risk (that is, risk of bona fide business
judgments turning out poorly);

price risk beyond the control of the farmer;

technology changes;

changes to international trade policies and patterns.








Risk
reduction


35


BOX 12
Information Reporting the Key for Access to Capital

When the whole issue of access to capital was raised and farmers groups
said there was market failure and a false perception of risk, what came out
was how central information was. If youve got good reporting, if you can
tell lenders or investors how its going, then they can get more
comfortable. They can benchmark your performance, they can get some
idea about risks of output fluctuations or default. If they can see that you
know what you are doing, and you and your neighbours can see how each
is doing, then lenders and investors can get a realistic idea of how much to
lend or invest and how to price their capital. The point is if you cant price
for risk you cant supply capital. It is those businesses which cant supply
information which have the most problems with access to capital and are
restricted to first mortgage loans within tight loan to valuation limits,
because thats a relatively easy information issue. Small business lending
is drying up where there is no transparency and no data. All deposit-
taking institutions have to worry about making sure they meet APRAs
capital and risk management rules they need to know what risks they run
as lenders, so cashflow lending is difficult for them.

Source: A rural lender


Note that futures markets allow farmers to hedge against price risk for a
limited period forward but not output risk. Crop insurance may limit some
output risk. HECs would allow primary producers longer-term protection
against both output and price risk in the sense that the capital advanced on
a HEC would have reduced the burden of financing charges on their gross
receipts.

More generally, the question of risk in agriculture and its assessment from
the viewpoint of borrowers and lenders depends in part on how those
perceived risks are covered off or ameliorated in one way or another.
Government programs, for example, drought relief and interest equalisation
deposits would be matters to be taken into account in this context (Truss
2003).


3.7.3 Unacceptable and manageable risks for investors in
HECs

External equity investors, however, are not likely to want to bear risks
which they have no means of controlling or managing. Investors will want
safeguards put in place in the design of a HEC to eliminate or minimise
exposure to unpriced risks.

Government
support
relevant to
risk


36
Thus downstream equity investors in a SPV holding a portfolio of HECs
will be concerned that the unit trust or investment fund (or other
securitisation vehicle) has taken steps to see that the bundle of HECs which
it holds for its investors are as insulated as possible against risks such as
those discussed in the following paragraphs. Some of these risks are
totally unacceptable (eg theft or fraud), others fall within a range of normal
commercial risk which must be more or less expected and managed as best
as possible by appropriate provisions in the HEC.


3.7.4 Death, divorce or disability of the farm operator
(personality risks)

These risks are peculiar to small business where there is no ongoing
corporate structure and where assets are often held through partnerships,
trusts or family companies with restrictive articles of association. Similar
risks arise in relation to housing loans (and in another form, when a well-
regarded CEO leaves a company). That is why some form of second
mortgage security is virtually essential in designing a HEC for passive
equity investment in an unincorporated enterprise. A mortgagee comes
ahead of any family law claim. Further by casting the HEC in the legal
form of a mortgage, mandatory covenants requiring life and disability
insurance may be included, just as homebuyers are required to take out
home loan insurance by lenders. The costs of such mandated insurance
could be automatically charged against the crop proceeds as part of the
administration of the HEC and investors would want a lien on any
insurance payouts to cover their loss of expected returns in the event of
premature termination of the HEC due to occurrence of an insured event.
Investors may also want the option to continue the security if an approved
manager is put in to manage the farm, eg in case of disability. Forcing a
foreclosure may be in no ones interests.


3.7.5 Intergenerational transfer or sale of the farm

Farms may be inherited or sold (Box 13). Investors may want the option to
either close out the HEC or to insist it be accepted by the transferee of a
farm. As in J apan where multi-generational mortgages have been used,
investors may not want their HEC investment easily able to be defeated
and paid out on a mere transfer of farm ownership. Some form of penalty
for loss of expected returns may be required to compensate the SPV
investors for premature termination of a primary security. It is noted that
any commercial penalty for HEC termination may have to be drafted
legally as a withdrawn concession to the borrower given that equitable
legal principles have special doctrines relating to penalty interest.

Another reason for sale of a farm and premature termination of a HEC may
be rezoning for a change of land use (eg dairy land to coastal/residential).
If this occurs and a farmer wishes to break his HEC, there may need to be
Typical
small
business
risks
Closing out
the HEC


37
either some sharing of the rezoning gain or compensation to the HEC
holder for loss of expected future crop shares for the remaining term. As
farmers may be expected not to want to surrender equity in the land value
which they may wish to re-invest in another farm, the latter seems the
natural choice.



BOX 13

Intergenerational Change and Challenges

In many ways the rural sector can be its own worst enemy. If farmers
cant adapt, they will be taken over by corporatised agriculture. There is a
generational shift occurring. Many farmers are hitting their seventies and
will be retiring in the next 10 years. If there arent methods to help adult
children take over the farm without being overburdened by debt to pay out
other family members, the farms will have to be sold to corporates. Stamp
duty and capital gains tax dont help either when it comes to re-arranging
farm ownership as so many farms are in trust and these get hit whenever
you have to do some succession planning.

Source: A farmer


3.7.6 Crop shifting by farmers

If one has advanced money to a farmer for a 50% share of his wheat crop
for 10 years, one would be vexed were he to shift to producing sheep
without any obligation to give notice, secure consent or share the proceeds
of his wool and lamb sales. Yet mixed farming is often economically
sound farm management indeed, it is a positive feature of the resilience
of the Australian rural sector overall. Given that mixed cropping or
switching to livestock may be rational, the HEC has to include options to
cover the possibility of crop or stock changes. These could be either
options on both sides to terminate the HEC but with break costs to be
paid to the HEC holder. Alternatively, the HEC might be drafted as a
share of whole crop/output claim, with a scheduled list of eligible crops
or stock, allowing the farmer the ability to manage his farm flexibly. The
holder of the HEC would thus rely on the farmer larger co-interest and
expertise in maximising farm production proceeds to lead to optimal crop
planting or livestock raising decisions. This option would be analogous to
shareholders trusting the management of a retail business to change from
selling more shoes and fewer shirts without shareholder approval, the
shareholders being content to know that they get the profits from the
business.


Mixed
farming
issues


38

3.7.7 Under-investing or inappropriate investing by
farmers

If a farmer receives a large lump sum upfront as the capital advanced under
the HEC, he may be inclined to under-invest in necessary operational
expenditure (such as fertilizer) to maximise crop output of which he will
receive a smaller fraction as proceeds. Alternatively, he may use the
proceeds to over-invest in unduly expensive or unnecessary plant and
equipment. One advantage of the form of HEC proposed is that the risk of
this kind of under-performance incentive is less than where an investor
shares in net profits and a farmer has less incentive for cost control.
Nonetheless it may be noted that, as a HEC nears the end of its term, there
could be incentives for a farmer to defer maintenance expenditure (eg
fertilizing fields) to a later period when 100% of the benefit of the
expenditure will accrue to him rather than having to share the value of
enhanced crop output with others.

But this risk should not be overstated and seems a tolerable commercial
risk. Farmers may often want to rollover a HEC (in which case the
incentive does not exist) and may have self-imposed operational
restrictions which limit the scope for such conduct. One must also keep a
sense of perspective. Equity investors in some of Australias major
publicly listed companies have in the past seen the destruction of billions
of dollars worth of shareholder value chaired by the (so it was then
thought) doyens of Australian business. By comparison, the performance
of the rural sector through severe droughts, floods, fires and commodity
price fluctuations seems to reflect quite prudent management. One
suspects some scarred institutional equity investors would welcome the
chance to invest through securitised HECs in smaller and medium
enterprises where there was strong and jealous proprietorial oversight of
the business such as typifies Australian agriculture.


3.7.8 Theft or fraud

Theft and fraud are, of course, totally unacceptable risks. No one deals
with a person whom he or she suspects may be fraudulent but it is also
necessary to minimise temptation. Investors in securitised HECs will be
concerned that there are accurate records kept of crop deliveries and sales
and that a reliable third party certifies the sales and handles the crop and
livestock sales cheques so that the investors share is not borrowed, for
example, by a farmer for use as temporary working capital. Information
reporting (including physical verification) by a trusted third party such as
the Wheat Board or other marketing agent or financial institution may be
required. These entities could perform a function much like company
registrars and stockbrokers with stock exchange transactions in vouching
for transactions and handling proceeds. From a practical point of view, the
design of a HEC has to incorporate procedures for handling sales cheques
Checks and
balances
Internal
controls
Farmers have
a good
management
record


39
and verifying proceeds. Such concerns do not matter so much for pure
debt instruments where the obligation to pay is known in advance and
secured, but they matter greatly in designing a quasi-equity HEC
instrument where the amount to be paid over depends on facts to be
ascertained and withholding of the HEC holders share has to be arranged.


3.7.9 Over-borrowing

When mortgages were securitised in California, a phenomenon occurred of
homeowners handing in the keys at the settlement. Borrowers had over-
borrowed on inflated valuations and were then happy to walk away with
the lenders cheque leaving him with a house worth less than the loan.
Securitisation vehicles holding primary securities will not want to advance
funds against so high a proportion of future crop receipts that the producer
loses incentive or is starved of cashflow needed for the next crop cycle.
Loan to value ratios (LVRs) or interest cover or ratios of recurrent income
to recurrent expenses, are just as important to investors in a securitisation
vehicle and its managers as are the same things to the credit department of
a bank. A first or second mortgage security on land or a crop lien or
livestock mortgage does not absolve the funds provider from the need to
ensure his client is not over-committed, as enforcement of legal security is
always a matter of a resort, usually involving loss to the funds provider as
well as the improvident user of funds. Securitisation should not be an
easy credit line for unbusiness-like farmers.

The best check on over-borrowing tendencies is for the SPV or originator
to insist that its HEC second mortgage not allow the farmer to exceed
acceptable LVR ratios. As the average rural sector debt is around 20% of
assets, there would seem to be scope to invest in primary producers whose
resulting LVR ratios after entering into a HEC would be well below the
trustee lending ratio of 60%. In any case, as a practical matter of fact,
over-borrowing does not seem to be a vice of farmers relative to the
corporate sector (ABARE 2003; NFF 2002).


3.7.10 Insolvency of the farm operator

Investors in securitised HECs want to ensure that their investment does not
disappear should the farm operator become insolvent. Insolvency is not
unknown in small business. Whereas investors in public company shares
are willing to take the risk of insolvency because they have an input into
management and accounting reporting to shareholders at regular intervals
this does not happen with primary securities such as home loans. Once
credit has been given or a HEC investment made lenders or investors have
little control over how a homebuyer or farmer manages his finances.
Hence, it is necessary that the HEC be quarantined from any insolvency
risk of the debtor. The HEC second mortgage may assure some security
for the outstanding principal but the crop/farm proceeds also need to have
LVR limits
Ring fencing
the risks


40
a prior claim registered over them so that they do not fall into the farmers
estate administered by a bankruptcy trustee or company liquidator. The
HEC would require supplementary stock or crop mortgages to be executed
by the farmer as required and some form of equitable assignment of crop
proceeds and custodianship of the crop cheque each year may be necessary
to insulate the investors return from a farmers creditors in bankruptcy. It
may be possible to appoint the SPV as his irrevocable attorney for the
purposes of executing and registering such securities annually or as needed
and a failure by the farmer to assist in executing such documents would be
an event of default. If this is possible, then as in the case of a bank with a
bankrupt mortgagor, the SPV holding the HEC can expect to be able to
realise the second mortgage security on the land and stock mortgages and
crop liens in the event of the primary producing entitys insolvency. The
SPV would thus effectively terminate the HEC with capital and accrued
earnings largely intact in order to cover break costs. As a secured
creditor, the SPV would stay outside the bankruptcy or insolvency.

On a technical level, the HEC will need to be drafted to cover the
possibility that a farm enterprise may be carried on by more than one legal
entity and that an act of bankruptcy by any one of those entities should be
enough to allow the SPV to terminate the HEC. For example, if the land is
held by a family trust but the business is a grazing partnership in which one
of the partners has become personally insolvent, the SPV should be able to
terminate the HEC and claim as second mortgagee of the land even if the
family trust is solvent as such. Of course, in such circumstances, the SPV
would still naturally come behind the first mortgagee and the exercise of its
rights would be tempered by the wishes of the first mortgagee.


3.7.11 Legal design issues for a HEC

Several legal design issues for a HEC are discussed below.

Non-voidability

Investors would want to be sure that their commercial investments in
securitised HECs could not be upset by appeals to the New South Wales
Contracts Review Act or to State or Federal Trade Practices Act or to
moneylenders legislation or State Credit Acts. The HEC should be an
arms length commercial transaction, not a voidable consumer transaction.

No vicarious liability for actions of operator

Clearly a passive equity investor in a business does not want to be liable
for the actions of the owner which he does not directly control. Yet
wherever one person has advanced money to another for a share of the
profits there has been a tendency for the Courts to find a partnership
relationship and hold the funding party liable as a partner for any
misconduct of the owner of the business (Higgins and Fletcher 2001, pp37-
57). It is thus particularly important the securitisation SPV is not
Farmers
must run
their own
businesses


41
deemed to be a legal partner of the farmer. Partners are jointly and
severally liable for all their business debts or defaults and even for
criminal breaches of legislative requirements affecting a business. The
securitisation SPV must not be able to be deemed a partner of the farmer
and therefore liable for any defaults under, for example, workers
compensation legislation or environmental legislation or for tortious
liability for failure to control genetically modified seed pollution or weeds
etc. Investors in the SPV holding the pool of HEC assets are not, and do
not want to be, partners, managers or controllers of the farmers business.
Nor will farmers want them to be. Fortunately the Partnership Acts
exclude from the prime facie presumption of partnership a contract for a
sharing of gross returns of a business and a loans at a rate of interest
varying with the profits of a business. However, the HEC has to be drawn
carefully so that the formal legal relationship does not go beyond debtor
and creditor. The price of immunity from vicarious liability for the SPV is
that holding a HEC claim does not allow it to tell the farmer how to run his
business (as opposed to setting some broad limits). Fortunately, this is
what we would imagine both parties would want as a commercial outcome
from a HEC in any case.

A standardised HEC

There are an infinite variety of potential quasi-equity securities which
could be invented to facilitate investment into unincorporated agriculture.
That is part of the problem. Securitisation requires homogenisation and
standardisation of legal instruments so that investors know what they are
buying. Ratings agencies and equity analysts need standardised HECs in a
portfolio to pass a judgment on the securities issued by the SPV which
holds the HECs. If you cannot be sure you understand the nature of the
underlying securitised assets, you cannot judge the worth of the SPVs
securities. Investors want a standardised underlying legal and financial
structure for the HECs so that they and market analysts can make
reasonable estimates as to expected yield on the portfolio of standardised
HECs offered to the public through, say, a unit trust SPV.

Underlying legal relationship

Although we have spoken of hybrid equity the law does not allow a
simple choice of categories such debt, equity or hybrid. Normal
farm mortgages could be securitised like housing loans (and perhaps that
may be another product for a securitisation SPV to offer). However, this
paper is concerned about creating some form of profit-sharing participation
for equity investors such as superannuation funds looking for counter-
cyclical exposure to agriculture. But in addition to the commercial
problems, there are legal problems to designing an equity rural
investment. The law knows no such thing as equity in a business. You
may become a co-partner in a business, or a shareholder in a company or
beneficiary of a trust that runs the business but you cannot simply buy
passive equity. That is why the underlying legal relationship must be
cast in the form of debt secured by a second mortgage.
Standardised
documentation
needed


42

This legal imperative to define the precise relationship between the
investing SPV and farmer as debtor and creditor is not, however, a
problem. The commercial risks inherent for an investing SPV buying
simple equity in a smaller or medium size business where there is no
room to control and no ASX listing to allow exit suggest a sharefarming
mortgage is likely to be the most useful approach to constructing a form of
passive investment participation. In any case, pure equity in a family
partnership or trust or family company would not be likely to be acceptable
either to farmers or investors in a securitisation SPV. Hence the legal
form of the primary security is likely to be debt with a rate of interest
varying with the farmers business revenues. Any other form of
investment would be likely to involve the securitisation SPV being deemed
to be a partner of a farmer or would require it becoming a shareholder in
unlisted private family companies, neither of which would be likely to be
acceptable to the parties. The HEC must therefore be cast in the legal form
of a second mortgage with a rate of interest set according to a sharefarming
agreement. The rights of the investing SPV are contractual and, beyond
contractual constraints, the investing SPV will have no right to tell a farmer
how to run his business. The basic idea is that investing SPV says to the
farmer in effect here is the money, pay us back in so many years and
meanwhile share part of the gross returns each year with us. We will not
tell you how to run your business and we trust you to be sensible but if you
do something which is in breach of a mutually agreed covenant and
constitutes an event of default, we will be able to take action to enforce
your contractual obligations. Obviously the design of a HEC on these
lines has to involve covenants which are mutually acceptable to both
farmers and investors in an SPV. Possible covenants are discussed below.

In terms of potential market acceptability of such a HEC to investors, we
note that a hybrid approach has been used very successfully by OM (in
connection with Ord Minnet) to introduce Australian investors to overseas
hedge funds. Investors subscribed capital willingly to a commodities
trading fund where there was a promise of repayment of capital at the end
of so many years but the returns during the term would depend on trading
profits generated by the manager of the fund. The repayment at the end of
the period was secured by Westpac bank guarantee. In the case of the HEC
proposed here, the legal form of debt would be used instead of an
(unavailable) alternative such as a redeemable share to form the basis of
the capital return and the second mortgage would take the place of a bank
guarantee.

There are many variations possible on the basic HEC design proposed here.
It would , for example, be possible to enhance the HEC (and reduce
farmers cost of capital) with some form of capital guarantee by an export
finance corporation, an insurer, or an originator such as a bank which held
the first mortgage over a property. Such a guarantee could be on a sliding
scale, say, 50-100% of capital returned after 10 or 15 years. But such
guarantees may not be necessary.
Equity
definition
elusive
More on
HEC design


43

The question of loan guarantees may also raise issues of capital adequacy
requirements for a sponsoring financial institution. It is therefore not
pursued further here, but we do note it could point to a useful role for
government in developing rural securitisation. The Australian housing
mortgage market was fostered by mortgage insurance underwritten by the
government sponsored Housing Loans Insurance Corporation, and
Australian exports are fostered by the Export Finance Insurance
Corporation, another government corporation. The Hon. J oe Hockey,
MHR, as Minister for Financial Regulation, did note that in markets such
as insurance when there is a market gap, as has happened with insurance,
there is a potential role for government in developing the market. We note
that rural securitisation may afford another opportunity for constructive
public-private partnership along these lines.

There are also other possible HEC variations such as a nil capital-return
HEC with a longer term. Where capital was not returnable by the farmer,
the HEC would be like the purchase of a crop annuity with no residual
capital value. A partial precedent for such a security may be seen in the
redeemable units issued by the Bass Strait Oil Trust where the capital value
of the units is amortised over their term while they share in the Weeks
override royalty on hydrocarbons produced annually.


3.7.12 Taxation treatment of HEC payments

For the farmer, a key issue is the tax treatment of the share of crop or profit
paid to the securitisation SPV. Either flow through or pay through
treatment is acceptable - the share of receipts paid to investors through the
securitisation vehicle is either treated as never the farmers income or
deducted from it. Equally, an issue for investors in the SPV securities
would be their tax treatment, which is discussed later.

If the HEC primary security is a proceeds sharing debt as proposed, the
apparent tax treatment is that the whole of the gross proceeds would be
counted as income by the farmer to be offset by an interest deduction for
the share of gross proceeds payable as a return on the primary security
(interest being defined in law as the cost of borrowing money and the
farmer treated as having constructive receipt of the whole crop proceeds).
An alternative possible tax scenario (which may depend on the precise
legal drafting) is that the farmer is only assessable on his net share rather
than gross crop proceeds with the securitisation vehicle assessable on its
share. The net income tax effect would be the same.

Borrowings and debt repayments would be treated as normal capital
receipts and payments and, as with normal borrowings and debt
repayments, there should be no capital gains tax consequences for either
the farmer or the SPV.

Effective tax
design
should be
possible


44
As for GST in the first case, there would be no difference as the supply for
GST purposes would be by the farmer as it was before, in the second case
the supply would possibly be by the SPV if it were construed to be
carrying on an enterprise. The drafting of the HEC should cover
assignment of GST obligations to confirm the position.

All income tax deductions relating to the crop or livestock planting or
tending would remain with the farmer who conducts the business, as it
would be if he simply obtained finance by a normal second mortgage
instead of a HEC and paid normal interest instead of a share of crop
proceeds.

There thus appear to be no inherent tax obstacles to using a HEC as a
financing instrument for farmers.


3.7.13 Possible Covenants and Obligations for the HEC

To conform to the design constraints, a HEC agreement could include the
following features and covenants. Many variations are possible.

Personal covenants by all parties

The legal form of the debt would include personal covenants to pay and
meet the other obligations of the HEC by all participants in the rural
enterprise. Personal covenants to pay are normal in Australian mortgages
and avoid the problem experienced in California where home buyers
sometimes handed back an over-mortgaged property in full satisfaction of
the debt and walked away with the loan proceeds. Having all parties in the
business join in signing the HEC would also be necessary to cover the
problems which would otherwise possibly arise in cases where the primary
production activity was conducted by one family entity while the land was
held by another. Unless all participants in the rural enterprise are parties to
the HEC, there would be a danger that the legitimate expectations of a
passive investor could be defeated by a dispute inter partes, eg a divorce,
maintenance agreement or a partnership dissolution between brothers or
parents and children. A key objective of a HEC is to create a form of
robust hybrid equity which is unaffected by any legal fragility of the
business structure. The holder of the HEC contract does not get the rights
of a shareholder or partner in the business and accepts a passive role. It is
therefore reasonable that in return for this passive role the holder be
entitled to rely on the direct commitment of all parties involved in the
business to meeting its obligations to share the crop proceeds and repay the
principal at the end of the term. It is also beneficial from the point of view
of ensuring good faith and avoiding moral hazard problems if all parties
involved with the rural enterprise are personally liable on the cropsharing
and other covenants embodied in a HEC. A person tempted to defraud a
financial institution of its entitlements under a HEC would be less likely to
do so if the result were merely to transfer burdens to other family members.
It should not be thought, however, that moral hazard problems
Covenants


45
are perceived to be a serious problem in rural finance or that farmers are
bad risks on this score this was confirmed in farm level research
undertaken in this Study. The real point is that collective responsibility for
a HEC acts as a form of trust building and creates a climate where
investors will be comfortable with HEC passive equity based on
contractual rights rather than direct shareholding or partnership in a
business.

Land and other mortgage security

The HEC debt and covenants would be backed by a second (possibly a
first) mortgage on the farm property and homestead, together with stock
mortgages and crop liens to be renewed as required. The term of a HEC
could be, say, 5, 10, 15, 20 years. It could be originated by a bank or
pastoral finance house which could remain the lenders administering agent
after the loan has been moved off balance sheet the beneficial interest in
the HEC has been sold into an SPV.

It would be unlikely that a HEC would be backed by a first mortgage as
plain vanilla debt within normal first mortgage limits would almost
invariably be cheaper for a farmer than hybrid equity. The ancillary liens
and mortgages over crops and stock would be necessary to come ahead of
unsecured creditors of the farm business in the event of insolvency. Thus a
HEC could be an alternative to annual pastoral lending on crops or stock:
the enterprise would get a larger amount upfront in return for a share of the
crop over several years with repayment deferred past the annual cycle.

Bank guarantee or loan insurance

To enhance credit rating of the portfolio of HECs in relation to principal
repayments, it may be possible for a HEC second mortgages to be be bank-
guaranteed or insured for default as to principal. Banks, being among the
likely securitisers and co-agents for the trustee of an SPV might be well-
placed to give such guarantees to facilitate the movement of their loans off-
balance sheet to a securitisation vehicle.

However, the giving of a bank guarantee would have implications for
capital adequacy which would need to be addressed. A guarantee could be
limited to recourse against a specified bank deposit withheld from the
funds advanced. (This involves a trade-off as the effective cost is increased
but may be worthwhile where institutional funds managers would
otherwise not invest.) Alternatively, a bank may sometimes feel that
securitisation brings its own rewards and capital adequacy requirements
can remain the same because asset quality is improved. By securitising
part of their rural loans and selling them as hybrid securities to investors,
banks would improve the credit quality of the remaining first mortgage
debt held by them. This may in some cases be sufficient inducement to
provide a guarantee as their exposure to loss of interest on the securitised
second mortgage would be removed, even though a guarantee remained as
to repayment of principal in several years time.
Security
backing
Guarantee
issues


46

Rollover or redemption at maturity?

It would perhaps be possible to include an option on the part of the primary
producer to renew or rollover the HEC for a further term at maturity on the
SPVs usual terms and conditions applying at the time of renewal.
Whether this would be commercially necessary or attractive is a matter for
the market as one would expect that many farmers would make plans to
renew, reduce, extend or payout the HEC at the end of its term and an SPV
may not wish to give an option which would be more an expression of
good intentions. In practice, one might expect rollovers to be planned as
the term of the HEC neared expiry.

SPV rights and obligations under the HEC

The SPV holding the HEC contract would expect to have the normal rights
of a lender and the holder of a sharefarming contract. Such rights would
include the right:


To a share of gross proceeds. The definition of gross proceeds
would need to be set out in a schedule to the HEC identifying
permissible land uses for crops and livestock and acreage over which
the HEC ran. Proceeds of one property may be covered by a HEC
but not of another farm owned by the same primary producers.

To handling of crop proceeds by a designated agent (eg
bank/marketing board/stock & station agent). The right to a share of
gross proceeds would be backed by the ancillary crop liens and stock
mortgages which would only be released when the crop or stock is
sold via a designated stock and station agent or rural marketing
board which would be on notice of the HEC interest. The agent
would hand over the SPVs share of the proceeds of sale in return for
discharge of the ancillary lien or mortgage by the SPVs lawyers.

To inspect the property whether in person or by designated agents.
While the SPV holding the HEC has no right to manage the
business, all lenders expext to be able to inspect, upon reasonable
terms, the subject of their security. In the case of an SPV holding a
HEC and located far from the property, such inspections would have
to be carried out by a designated and mutually acceptable trusted
third party such as a stock and station agent (who may also be the
party handing sale of crops or livestock).

To repayment of the amount advanced at the end of contract period

To call in the amount advanced and claim for break costs for
breach of a covenant. The SPV holding the HEC has no right to
interfere in day to day management: it cannot exercise a
Checklist of
rights &
obligations
Rollover
option?


47
shareholders or partners rights. Accordingly, it must be able under
the HEC to protect investors legitimate interests in not losing
expected shares of proceeds through mismanagement. Breach of
covenants is usually taken as an indicator of unacceptable
management and the holder of a HEC may wish to terminate the
contract. One of the difficulties in precise design of a HEC is to
ensure that covenants are not unreasonable or excessively onerous.
For example, this right may be tempered in relation to some
covenants by procedures such as antecedent permission or
arbitration which may excuse or waive non-performance of certain
less essential requirements. On the other hand, some breaches such
as committing fraud or an offence of dishonesty or an act of
bankruptcy would be reason to terminate any commercial
relationship as quickly as possible.

To copies of accounts, BAS reports & FOI authority to obtain ATO
BAS copies. Accountability is a key to building mutual trust. While
it is natural for someone to dislike another person looking over the
shoulder, one has to accept it if one is to use another persons
money. It is normal for lenders and equity providers to ask for
copies of accounts, whether audited or unaudited or produced solely
for management. A HEC could incorporate an obligation to furnish
copies of quarterly Business Activity Statements (BAS) sent to the
ATO and authorise release to the SPV by the ATO under the
Freedom of Information (FOI) Act of the ATOs copy of the BAS.
The benefit of this mechanism for building trust follows from the
inbuilt check it provides. A discrepancy between the BAS copy
furnished to the SPV and the copy provided to the ATO could
indicate fraud. If both copies were identical, any fraud would have
to involve a fraud on the Tax Office as well as the SPV. That would
be a very uncommon thing. It would, for example, be a very foolish
person who claimed deductions for a crop which was then handed
over covertly to a friend for sale outside BAS reporting of proceeds
to the ATO and outside accounting under the HEC. As a sign of
good faith, acceptance of accountability is most important to
suppliers of capital.

To exercise relevant liens upon default. For example, in an extreme
case, it may become necessary to harvest and sell crop if the farmer
abandons the farm: if the farmer abandons the crop or livestock
which are subject to the agreement, the SPV or its agent will be
entitled to enter the property, harvest the crop and sell the produce or
sell the livestock and retain its share of the proceeds. Also, the
farmer may be deemed to have abandoned the crop, for example, if
the SPV is advised accordingly or if the farmer, after seven days
from receiving service of a notice requiring the farmer to elect
whether or not the crop is to be abandoned, fails to notify the
mortgagee in writing that they do not intend to abandon the crop. A
possibly more likely case would be where a farmer becomes ill or


48
injured, advises the SPV and is happy to have the SPV organise the
harvesting through the local sales agent.

The SPV has obligations under the HEC. Its main obligation is to advance
the funds. Its second obligation is to authorise release to the farmer of his
share of the crop proceeds and release of liens or stock mortgages after
satisfying its share of the proceeds. These should be largely administrative
tasks.

A more important obligation of the SPV is to act in good faith. The rights
an SPV would expect to have are serious. A HEC should be a contract
uberrimae fidei, of the utmost good faith, with fiduciary obligations, like a
partnership or insurance contract. Its business efficacy will depend on
parties knowing that each is bound to abstain from sharp practice or abuse
of rights and that each has to be faithful and just in their dealings with each
other. Thus a farmer would be entitled to expect that the SPV holding a
HEC will allow the farmer to perform all acts necessary to the due, proper
and punctual performance of the farmers obligations under the agreement.

Primary producer rights and obligations under the HEC

The rights and obligations of the primary producer under a HEC contract
would largely be correlative with the rights and obligations of the SPV
holding the HEC.

The right to have the funds advanced. The first right the primary
producer has is the right to have the funds advanced. However,
because the HEC is designed to finance production rather than
consumption, this may be qualified by an obligation to apply the
funds to a range of permitted uses, such as acquisition of property,
plant and equipment, debt reduction or working capital. On the
other hand, such a requirement may be excessively paternalistic,
however, as a producer raising passive equity under a HEC would be
unlikely to want to apply the funds to consumption since he would
be the largest loser if productivity on his farm suffered for want of
crop planting, fertilizer etc. Further, there is little a supplier of funds
to a small business can do in any case to control the flow of funds as
money is fungible. In practice, what most suppliers of funds do is
make the application for the funds explain the purpose for which the
money is sought and incorporate such statements as part of the basis
of the contract. The funds supplier can thus keep in reserve the
option of calling up the funds if it becomes abundantly clear that the
borrower has set out to mislead the supplier as to the purpose of the
fundraising. Given the obligation on both sides to act in good faith,
however, it would be a rare occasion when an SPV would be likely
to feel either compelled or warranted in taking such action to
terminate a HEC. As a practical matter, if the HEC were being
administered by an originator such as a bank, on behalf of the SPV,
such action would only be likely where the originating bank
SPV role &
rights
Checklist
continued


49
felt there was serious deception, since the bank would be effectively
terminating the whole customer relationship.

The right to early repayment. Farmers may want the option of early
repayment, especially for a HEC with a longer term. There are
various reasons why this might be desirable. A farmer could come
into an inheritance or have a maturing superannuation benefit, or
have a relative now willing to come into the business as a full and
active equity partner. Hence, farmers may wish to buy out or
redeem the passive equity represented by the HEC. On the other
hand, the SPV holding a HEC for investors would not wish to be
bought out at par and forgo several years of potential equity level
returns. If a right to early repayment were incorporated in the HEC,
there would need to be a provision for calculating break costs to
compensate for the loss of the equity premium return over the
remaining period of the HEC. Otherwise, investors would be
supplying a free one-way bet to the farmer on a HEC by losing a
chance of the upside on the remaining term.. The same formula
could be used for other circumstances of termination, such as death
or disability or event of default. One approach would be to take the
assumed average value of the HEC cropshare used in writing the
contract and discount that remaining revenue stream by a market
interest rate to get its present value at the break date. This would
then be added to the present value of the principal.

Obligations of the primary producer under a HEC

Because a HEC will be a contract uberrimae fidei ( of the utmost good
faith), one of the first obligations of a farmer will be to disclose all relevant
information which may affect the crop or livestock. Thus, for example, all
the parties involved in a rural enterprise would have the obligation to
advise the SPV (or its administering agent) of material changes in
circumstances, such as the death or disability of a working business
proprietor or a natural catastrophe such as a flood or bushfire. In practice,
many of these covenants would be much the same as those incorporated in
a first mortgage and both might therefore be simply administered on behalf
of an SPV by a lending institution such as a bank which held the first
mortgage and which held the HEC on trust for the SPV.

Farming obligations

A HEC would incorporate, more or less, the usual type of covenants
associated with share farming agreements, such as

To farm, specifying the area of land to be cultivated and the crop or
crops to be sewn as well as appropriate use and application of
fertilizer and pesticides; in the case of dairy farming, for example, to
keep and milk the required number of cows.
Disclosure
duties


50

To farm and work the land in a proper and husbandlike manner
according to the best, most approved farming methods in the
particular district.

To comply with relevant legislation regarding prevention of bush
fires, noxious weeds, pests, plant and animal diseases.

To keep livestock and progeny in good health, providing appropriate
veterinary care and medication to maintain health, prevent and cure
illness.

To replace dead livestock with animals of the same or nearly as
possible similar kind, age, productivity and value to the deceased
animals and give notice to the mortgagor that this has been done.

To make a thorough search for any escaped livestock and make
every endeavour to recover missing livestock and to inform the
mortgagor.

To cultivate a proportion of the land for livestock feed to maintain
livestock.

To maintain sufficient water supply, eg dams, to water livestock.

To provide water and fodder for livestock from appropriate alternate
sources during drought.

To keep the land and crops in good condition and free from disease,
noxious weeds, and vermin or to keep livestock healthy and free of
parasites, predators, and disease.

To harvest the crop with reasonable sped and to deliver the crop at a
place specified after appropriate tallying and inspection.

To allow inspection of farm, crop and livestock.

Not to remove harvested crop or livestock until it has been inspected
and the whole of the produce or livestock is inspected and tallied.

To maintain all plant, farm machinery and tools and keep them in
good working order.

To maintain farm buildings, fences and gates in good repair and to
an appropriate standard and not to remove these or alter
improvements and farm layout without having informed or obtained
permission, as the case may be, from the SPV.

Not to permit or cause any waste or spoil of any part of the land.

To engage and maintain supply of reasonable labour at a reasonable
Further
checklists


51
cost to carry out the obligations of farming under the agreement.

Not to engage in any other business or farming activity to the
detriment of the performance of the covenants in the agreement.

To notify SPV or its agent if seeking governmental farming
assistance, bounties or grants.

Financial, administrative and insurance obligations-

To apply HEC proceeds for authorised purposes (seed, fertilizer,
machinery, land acquisition etc)

To grant crop liens and livestock mortgages to the SPV or its
administering agent.

To supply copies of accounts and BASs quarterly to the SPV or its
agent and to authorise FOI verification from the ATO.

To arrange for and supply copies of warrants and evidence of crop or
livestock herd tallies and evidence of delivery of harvest or livestock
to the appropriate co-op, facility, stock and station agent or
marketing board or other place as agreed.

To authorise the stock and station agent or marketing board or other
party charged with disposing of the crops or livestock to deduct and
remit the HEC share and any applicable reimbursable charges (eg for
agreed insurance) direct to the SPV or its administering agent against
release of crop lien or stock mortgages.

To pay bills and stay solvent.

To insure against death or disability and to assign such policies as
security to the SPV or its administering agent with authority to pay
the premiums necessary to keep the policies in force.

To take out mortgage insurance on grant of the HEC (so the SPV
holding the HEC is protected against loss of principal, though this
may be waived if, for example, there is a bank guarantee or a low
loan to valuation ratio for the HEC).

To insure and maintain insurance for workmens compensation,
buildings, machinery, livestock and crops with an appropriate or
approved insurer or insurers, such insurance to cover the crop
(standing or harvested) or livestock not yet delivered against loss -
for example, crop loss due to fire, storm, or hail. Further, to give
copies of such current polices to the SPV or its agent and/or to
authorise payment of premiums on such polices by the SPV or its
agent.


52

Not to, until harvesting of the crop (or annual arms length sale of
livestock such as beef cattle) sell, transfer, assign mortgage, charge
or encumber that share/interest in the crop or part thereof or in
livestock which is the subject of the agreement without the consent
in writing of the SPV or its agent.

Not to, during the continuance of the HEC agreement, sell, transfer,
assign, sublet or part with possession of the land without prior
consent in writing.

To notify of potential termination conditions, including intention to
abandon.

Termination of a HEC and dispute resolution

Obviously, a list of mortgage-style covenants such as the above, is, like
marriage, not lightly entered into by any responsible adult. For practical
purposes, the farmer entering a HEC agreement is almost taking on a silent
partner and each must have full trust in the other. That requires some
clarity in defining what are events of default under a HEC and what the
consequences of such a default are. This is where some finesse will be
required in drafting HEC agreements. Some forms of default are so
heinous that a HEC holder ought to be able to terminate the HEC without
further notice, eg conviction of an offence of dishonesty such as cattle
rustling. But other forms of default are either not really defaults at all or
are justifiable or merely technical. For example, the obligations to farm
or maintain water supplies may become meaningless in a drought. In
practice, a Court would give such clauses a liberal and sensible
interpretation to preserve the business efficacy of the agreement, but it
would also be sensible for the parties to classify the covenants into groups,
such as primary, secondary or tertiary (to use a non-legal terminology).

A primary covenant would designated as one the breach of which entitled
the HEC holder to terminate the HEC unilaterally or waive the breach. For
example, take conviction of an offence of dishonesty. Such a breach
should not entail automatic termination of the HEC. The HEC holder
should have the unfettered option to terminate the HEC (and trigger break
costs as compensation) or to affirm the contract and continue. A HEC
holder (or its administering agent) may well wish to terminate forthwith for
an offence of dishonesty involving common law theft, such as so cattle
rustling. But conviction for a statutory offence such as lodging a false tax
return because logbooks or receipts were not properly kept may not,
depending on the circumstances, be seen as reflecting a serious degree of
untrustworthiness. It might reflect the not uncommon situation where a
business person has postponed administrative tasks to carrying on the
business and a HEC holder may take a forgiving attitude to such a default.
For the protection of the farmer, a HEC holder should be required to elect
for termination or waiver reasonably promptly. The contract might
therefore provide that, if within 30 or 60 days after notification of default
Dispute
resolution
issues


53
in respect of a primary covenant, the HEC holder has not notified an
election to terminate, it will be taken to have waived its right to do so in
respect of that breach.

A secondary covenant might be one where the default did not give rise to
an unfettered option to terminate but the HEC holder had the right to
request rectification within a reasonable period after which the HEC holder
might elect to terminate. For example, a failure to maintain fencing may be
a remediable breach. Further, the farmer might wish to seek suspension or
waiver of the covenant altogether for a period. He may wish to argue that
the failure to maintain fences was due to force majeure, such as a flood, or
pointless because the property was destocked during a drought. Hence
failure to comply with a notice of breach might not still give the HEC
holder a unilateral right to terminate if the farmer invoked an appropriate
arbitration clause in the contract.

A tertiary covenant might be designated as one the breach of which does
not entitle the HEC holder to terminate if the farmers breach is excused by
an independent designated third party acting as referee. The referee might
be a local stock or station agent or a local graziers committee or President
of the Pastures Protection Board or some other person trusted by all parties.

The point of dealing carefully with the potential consequences of breaches
of covenants is that a HEC should not be an easily destroyed contract and
that its provisions should be designed to make the cropsharing parties work
together in good faith rather than allow either to pull the rug from under
the other. If there is anything which hard working commercial people hate
more than any other thing it is the thought of a long-term contract being
terminated abruptly in circumstances where they may be plunged into
insolvency. The holder of a HEC is intended to be a patient passive equity
investor, not an anxious at call creditor and should not be allowed to
withdraw his capital prematurely from the farm enterprise without good
cause.

The HEC should also incorporate a formal arbitration procedure so that if a
dispute cannot be mutually resolved or either party is unhappy with a local
referees decision there is formal arbitration under the agreement subject to
the Commercial Arbitration Act 1984, or any statutory modification or re-
enactment.

Some potential events of termination, may not mean an end to the farm
enterprise so much as a reconstitution, as when a partner leaves or enters a
trading partnership. Events such as death, disability, a claim under Family
Law Act (Commonwealth) or De Facto Relationships Act (NSW) or the
Family Provision Act, cessation of a business activity, winding up of
primary production trust or company or dissolution of partnership entity
may not require termination of a HEC. The parties mainly concerned may
wish to continue with the HEC notwithstanding a change in the legal
structure of the farm ownership or participating family members. A HEC
Novation
allowed


54
contract might therefore contain provisions allowing for novation of the
HEC obligations to a successor entity or entities carrying on the farm
business. For example, an adult son may take over on the death or
retirement of a father and that may be acceptable to all concerned.


3.8 Issue, pricing and subsequent valuation of
HEC


3.8.1 Due diligence preliminaries before issue

Before an SPV or a farmer entered into a HEC, the SPV would need to
have certain information in order to price the HEC. If an asset cannot be
priced, it cannot be securitised.

First, the SPV would need to have history of the volume and value of
crops/livestock produced on the relevant property over a period of years.
This information is needed, just like the dividend history of a company or
the rental history of a property trust, in order to project forward the likely
income return to the SPV. Depending on the data, various levels of
sophistication could be applied to making such projections. One could
make simple projections using the mean or median. Alternatively, one
might create a more sophisticated probability model which incorporated a
likely time pattern of returns as expected to be affected by weather cycles
and other variables. The difference between these 2 methods is similar to
the difference between computing the return on a life insurance contract by
assuming a certain death at the expected age of 72 as opposed to the more
precise weighting of possible payouts by the distribution of probabilities of
death over the whole future. Fortunately, we do not need to go into such
computations here and the level of sophistication used in pricing HECs
would probably increase with a growth in use and the building up of a data
bank.

Second, an SPV would need to be able to judge the risk on return of
principal on the second mortgage. This is where loan to valuation ratios
and any bank or mortgage insurance guarantees would be relevant. If an
originator wished the SPVs securities bought by institutional investors
such as pension funds a rating of the capital return part of the portfolio of
HECs might be required. Rating agencies regularly grade securitised
portfolios of housing mortgage loans, both as to principal and interest, to
assure investors of the quality of their interests in a SPV. Getting a grading
by a ratings agency of the capital return element of a HEC portfolio could
be particularly useful if the SPV were to trance its own securities so as to
allocate the risk of defaults between various investors.


3.8.2 The pricing of a HEC at time of issue

Before seeing how one might price a HEC at time of issue, consider the
pricing of a loan on its issue.
Data for
pricing
Funds
rating
needs


55

Suppose the loan rate of interest is 8% and the loan is for 10 years.

The present value of the loan at the time of issue is made up of the present
value of contractual interest payments plus the present value of the return
of principal at the end of 10 years. Taking a loan for $1,000,000 and
discounting at 8%, the present value of $80,000 per annum in interest
payments is $536,807. The present value of the return of principal at the
end of 10 years is $463,193. The present value is the sum of these 2 parts
and adds up to $1,000,000. If the discount rate is the same as the interest
rate at which the loan contract is written, this will naturally be the case. If
the loan is traded after interest and discount rates have risen the sum of the
2 parts will be below par and vice versa if interest and discount rates fall.

To price a HEC on its issue is a little more complicated. There is the
equity part, the right to a cropshare, which must be valued using the
equity discount rate at the time of issue (say, 15%) and the capital
repayment part which must be valued by discounting with a mortgage
interest rate (say, 8%).

The simplest method of valuing the equity part of a HEC for pricing
purposes would be to make a naive projection. One would take the mean
or median output of various crops over a past period, project that output
forward over the period of the HEC, apply forecasted crop/livestock prices
to the projected quantities and derive a forecasted gross annualised value of
output. The proportion of this flowing to the HEC holder is the equivalent
of the rents flowing to a property trust which generate the distributions to
investors. The SPV would apply its hurdle rate of return, say, 15% to that
projected income stream and offer a lump sum equivalent depending on the
proportion of output contacted under the HEC. For example, if the
projected annualised value of gross output were $2,000,000 per annum, a
12% HEC would pay the SPV an expected $240,000 per annum. At a
15% discount rate that stream of payments over 10 years would be worth
about $1,200,000.

But a HEC is a hybrid security. In addition to the stream of annuity
payments there is a lump sum repayment of the sum initially advanced at
the end of 10 years. The discount rate applied to this part of the HEC
would be closer to bond rate and much lower than the equity discount rate
applied to the share of crop returns, since it is secured by a second
mortgage and may even have a credit agency rating or a bank guarantee.
For example, $1,000,000 repayable at the end of 10 years discounted at 8%
has a present value of about $463,000.

The value of HEC either on issue or on market as rates of return varied
would depend on both the principal and annuity cashflows.

To see how a HEC could be valued,

let PV(A) =the present value of the crop annuity, in this case, $1,000,000
Pricing of
the HEC
A worked
Example


56

let PV(P) =the present value of the principal advanced, discounted in this
case at 8%.

Then P =PV(A) +PV(P)

The present value of $1 payable at the end of 10 years at 8% is 46 cents.

Hence, in this example, the equation becomes

P =PV(A) +.46*P

giving .54*P =PV(A)

This accords with the common sense that if you are giving up P dollars for
so many years that its present value is cut by 46%, you want to be given
something worth 54% of P dollars as a quid pro quo. This is the
equitypart of the HEC, the right to a share of crop proceeds for those 10
years. Note that the longer the period of the HEC, the lower the proportion
of its total value represented by the principal repayment and the higher the
proportion of value represented by the equity component and vice versa.

Given that PV(A) for a 12% HEC is estimated at $1,200,000, the total
value on issue of a 12% HEC would be given by -


P =PV(A)
.54

In this case, P =1,200,000 =$2.2 million.
.54

What a HEC is really doing is marrying second mortgages of land, plus
stock mortgages and crop liens to create a detachable cashflow which can
be valued like an expected stream of rent or royalty payments with a
cashback at the end of the period. The shorter the term of the HEC, the
more it resembles debt, the longer the term the more it resembles equity.

It might be asked why would a farmer pay 15% for capital when he can
borrow at 8%. The answer is he wont, but there may be no real choice.
Lenders may not be willing to lend at 8% once gearing ratios are exceeded.
Lenders may be asking for 10% or 12%. Over-borrowing is dangerous and
the farmer may realise he has to raise outside equity. To pay an expected
15% varying with the farm output (but no fixed liability) may be a lot safer
than committing to pay 12% on a normal second mortgage. Further, by
injecting some hybrid equity through a HEC, a farmer may be able to
improve his credit rating for existing debt and lower his interest rate on
existing debt.

Farmers
borrowing
problems


57
A farmers real choices may be between not being able to farm at all, not
expanding or having to take in a full equity partner. A full equity partner
would expect more both by way of return and control. A full equity
partner might even get to share in the appreciation of the land value of the
property. This does not occur with a HEC. The farmers core assets, his
land and plant remain his, and he is free to run his business largely as he
thinks proper. He is also free to buy out the HEC at the end of its term. If
his land valuation has risen and the farm has prospered, he may be able to
replace a HEC partly through his own savings and partly through cheaper,
but fixed interest, first mortgage debt. The point of a HEC is to provide
external quasi-equity over the business life cycle when the farm business
cannot safely rely on more debt. Debt, equity and hybrid equity are not
mutually exclusive. There is time and place for each in financing a
business.

Another question which farmers may ask is why should equity cost,
say,15% when yields on industrial shares are around 3-6%, and property
trusts yield from 6.5-9.5%. However, the running dividend yield is only
part of the true cost of equity. Investors in industrial shares expect to get
some accruing retained profits to drive future dividend growth and to
participate in all capital gains made by the business on its assets: that is
why they accept a low 3-6%. Investors in property trusts demand a higher
yield because there are no retained profits but they also expect to share in
capital gains and rental growth in perpetuity. A better indicator would be
to look at the yield to investors in the Bass Strait Oil Trust. The yield to
investors is roughly 12-13% but this reflects the facts that oil field
production is static or declining, that there is a fixed redemption of the
listed units by instalments up to termination in 2007 and that investors get
to share in income only not in any change in the value of the underlying
natural resource. This is much more like a HEC, which one would expect
to have a high headline yield to compensate for non-participation in growth
of rural land values and the terminable nature of the contract.

It is also obvious that if investors are expecting 12-13% on hybrid equity in
the form of a lien on enterprise output, the hurdle rate of return for an SPV
writing HEC agreements must be higher, say, 15%. A margin is needed to
cover the inevitable administrative costs of securitisation. This is not to
say that securitisation is a costly middlemans method of charging more for
finance. The costs of securitisation are well worth incurring if the end
result is a lower cost of finance overall for the rural sector because risks
can be diversified and there is an alternative to direct outside equity when
loan funds are simply not available or only at high rates and high risk. The
economic benefit of securitisation comes about because of risk
diversification. An investor who would either never invest directly in a
farm enterprise or who would demand 20-30% for the risk of taking up an
illiquid investment in one farm in one locality may be quite willing to buy
a unit in an SPV with a portfolio of HECs written at 15%, yielding 13% on
average to investors.


Yield
comparisons
Lower
capital
costs


58
3.8.3 Valuation of a HEC portfolio after issue

Once a HEC has been written, its valuation would change depending on
changes in expectations for future crop output and prices, together with
changes in the general level of interest rates and equity discount rates.
These need not move together. For example, investors in units of the Bass
Strait Oil Trust have had to balance expectations of declining output (a
negative) against rising oil prices and lower interest rates (both positive).

To see how such factors may affect a HEC take the previous example and
assume that after a years more data and after one years cropshare, crop
output and prices have improved so that expected annualised value of farm
output is $2,300,000. But interest rates have dropped so that loan rates are
now 7% and equity discount rates are 13.5%.

The 12% HEC now carries an expected income stream of $276,000 per
annum.

Hence PV(A) =$1.390 million, on discounting this annuity stream at
13.5% over the remaining 9 years of the HEC.

The present value of $1, discounted over 9 years at 7% is 54 cents. The
HEC was issued for $2.2 million a year ago and that $2.2 million will be
repayable in 9 years.

Hence PV(P) =.54*2.2 =$1.19 million.

The new present value of the HEC is thus given by -

PV(A) +PV(P) =1.390 +1.19 =$2.58 million.

Thus the HEC originally issued for $2.2 million is now worth $2.58
million and has increased in value even after paying out the first years
cropshare to the SPV and its investors.

This example shows how the value of a portfolio of HECs might rise, even
though they are terminable assets. This is much like valuing a leasehold
where the expected growth of rents and lower interest rates may increase
its market value even though each year brings the leasehold closer to
expiry.

Once one looks at a portfolio of HECs where each contract is being
replaced as it matures by a new contract, one can see that an investor is an
SPVs securitised portfolio of HECs is really buying a permanent stake in a
share of rural output. If the portfolio is lengthened, eg by writing more 20
year HECs to replace 5 year HECs the portfolio behaves more like equity.
An equity analyst would therefore value a unit in an SPV unit trust much
as he would look at a property trust and examine its lease expiry profile. In
each case the objective is to predict future earnings and discount them to
cash in todays terms.
Secondary
market issues
Comparison
with property
trusts


59


3.8.4 Securitisation vehicle (SPV) issues

The form of the securitisation vehicle (SPV) in the Australian context
would most likely be a unit trust or a limited partnership (if flow through
tax treatment becomes available).

Investor taxation

The benefits of securitisation can be destroyed by non-neutral taxation.
Unit trusts are well known to investors. The tax treatment of investors in a
unit trust would be based on the orthodox flow through treatment. The
only major problem with unit trust is that if there were a loss in the SPV
(not perhaps likely with a portfolio of hybrid equity assets). In such a case,
the investors would be denied the right to claim their share of those losses.
This is one reason why securitisations through unit trusts are generally of
assets where such an issue is unlikely to arise and the same consideration
applies to property trusts.

It is possible that in the course of time different SPVs could sell HEC
portfolios between themselves or to other investors rather than always
holding HECs to maturity. In that case, as noted above capital gains or
losses could arise on HECs. As with property trusts making gains on real
estate, such gains would be distributed to investors who would be able to
claim the 50% capital gains discount. Unfortunately, capital losses would,
like income losses, not be distributable to investors (in marked and
unfavourable contrast to the US treatment of investors in limited
partnerships). If an SPV unit trust started to wind down its HECs portfolio
and started returning capital to investors this would be naturally tax-free
but such a return of capital would be treated as a tax-deferred reduction in
the investors cost base of units in the unit trust and might therefore be
taxed indirectly.

Superannuation funds would be taxable on their income returns at 15%.
Non-resident investors would be liable to 10% interest withholding tax on
income returns unless specifically exempt. 10% interest withholding tax is,
however, better for a foreign investor than 15% or 30% dividend
withholding tax on an unfranked dividend. From the point of view of
attracting foreign investment into the rural sector, an SPV unit trust
offering foreign investors indirect investment in HECs could be quite
attractive compared to investment in an Australian corporate agricultural
venture.

As for investors buying and selling units in an SPV unit trust, the tax
treatment would be the same as for investors in property trusts. The market
value of the units in a listed unit trust securitisation vehicle could fluctuate
with agricultural or pastoral incomes. Hence there could be capital gains or
losses on units representing indirect claims to the returns
Tax
assumptions
Super Funds
& foreign
investors


60
from a portfolio of HECs. Capital gains tax would not be applicable to
overseas portfolio investors holding less than 10% in a unit trust listed on
the Australian Stock Exchange. For domestic investors, the tax treatment
would similar to rents, interest or capital returns distributed through a
property trust.

Stamp duties

Stamp duty is no longer payable on trading of listed securities and the
transfer of mortgage backed securities has ben exempted in New South
Wales. Without such an exemption securitisation of mortgages would be
completely prohibitive. However, mortgage duty is still levied on the
original mortgage contract. This represents a deterrent to shorter-term
HECs and may create problems where a HEC agreement allows for further
advances. At a rate of $4 for every $1,000 secured, or 0.4%, mortgage
duty represents a significant cost where an SPV has to operate on narrow
margins. Given that the farmer would have to execute supplementary crop
liens and stock mortgages, there also remains the possibility of double duty
as these additional securities appear to be defined as mortgages and could
therefore dutiable (Bevan 2002, Vol 17.30, p222). However, it appears
more likely they would be treated as collateral securities and liable only to
nominal duty at $10.

Managing the SPVs assets

Securitisation can only work if the price is right, that is to say, the cost is
worth it. It follows that a securitisation SPV must be designed to be as
economical as possible. Margins have to be kept low enough so that HECs
can be offered to farmers at an attractive rate relative to other sources of
equity or debt finance while investors have to see a net return from their
investment in the SPVs HECs portfolio which matches returns available
on other hybrid equity instruments.

Given the history of securitisation, it would not be surprising to see rural
securitisation originate from banks seeking to trim their risk levels and free
up capital. Since farmers will always have some debt and banks will
always want to hold first class first mortgages on well-run businesses in
any industry, banks are likely to remain first mortgagees on many (or most)
rural properties. It would make sense therefore for a securitisation SPV
(whether sponsored by the bank holding the first mortgage or not) to
employ the bank holding the first mortgage as its administrative agent in
monitoring second mortgage covenant breaches. The covenants are likely
to be similar in both first and second mortgages and it would save expense
for both mortgagees to share information.

There is one obvious problem: that a first mortgagee with its higher
security may be more relaxed about breaches than a second mortgagee
more likely to bear the loss. On the other hand, any administration contract
between an SPV and a bank (whether originator or not) could specify that
the SPVs auditors or custodian trustees could have access to
Duties
status
The price
must be
right
Banks key
originators?


61
the banks loan performance files as a quid pro quo for the banks being
paid administration fees. The trustees of any SPV unit trust would owe
fiduciary duties (and be personally liable) to the investors and could hardly
continue in office if they felt that a bank originator of the securitisation was
not being diligent in carrying out its duties as the agent or nominee of the
SPV unit trust. There is therefore a trade-off. Administrative efficiency
may dictate that the first mortgage bank handle the HEC as agent of the
SPV and even hold legal title to the second mortgage on trust for the SPV.
The bank may even initiate the HEC to ensure a prudent recapitalisation of
a rural enterprise. But if the bank wants the benefit of administration fees
from outside investors and the ability to liquefy its loan portfolio through
HEC securitisation to SPV investors its must accept that the SPV will need
independent trustees and it must deal with the SPV at arms length.

Registrar of HECs mortgages etc and crop payments

The SPV will need a custodian trustee to check registration of its
mortgages and handle and respond to HEC covenant notices from its
farmer clients (even if forwarded via the originating bank which may wish
to maintain the customer relationship). The SPV may have to make
decisions from time to time on whether to terminate a HEC for breach.

Further, the SPV will need to ensure that its custodian trustee is taking and
registering crop liens and stock mortgages and only releasing them against
cheques with certified sale proceeds from designated sales agents such as
stock and station agents or marketing boards.

The operation of an SPV is thus likely to involve an independent board of
SPV trustees, a general administrative agent over the HECs such as the
originating bank, a custodian trustee to police cash collections and
mortgage securities and an on the ground sales monitoring agent
reporting to the custodian trustee. All these costs must be met by the
margin between investors returns and SPV income.

Tranching the SPVs securities

So far we have assumed that the SPV securities offered to investors would
be homogeneous. But one of the benefits of securitisation is to allow
investors to choose their risk profiles, thereby lowering the cost of capital
to end users of funds such as farmers. An SPV need not raise all its capital
through one class of equity units. An SPV could even borrow.

For example, an SPV holding a portfolio of $500 million in HECs might be
able to borrow wholesale at a lower rate of interest than any individual
farmer. Where no one farmer would dare to borrow individually against
his uncertain crop returns an SPV holding a varied portfolio of HECs from
these same farmers may feel comfortable with some borrowing to fund
investment in HECs. Suppose the SPV could borrow at 6.75% instead of
the 8% available to farmers and raised an amount equal to 20% of the
Trustee
role
Investor
choice &
competition


62
value of its HECs portfolio to acquire more HECs. The interest cover
might well be ample enough. The gap between the borrowing rate of 6.5%
and the expected return of 15% might boost returns to equity unit holders
in the SPV, say, from 13% to 14.6%. Investors would then pour more
money into rural securitisation SPVs. Competition between SPVs looking
to write HECs might in turn eventually reduce the required return from
writing new HECs accordingly, much as competition between banks and
mortgage originators has driven down the spread on housing mortgage
loans.




63
4. Progressing Securitisation


4.1 Taking the Model Forward

Securitisation is not a perpetual motion machine. It is not costless. But
that does not mean that the proverbial cynical economist who says there is
no such thing as a free lunch is always correct. There are free lunches in
economics: they are called the gains from trade. Fundamentally,
securitisation is about cutting the overall cost of capital to end users and
augmenting its supply by spreading risk, whether from banks unable to
fund riskier loans on balance sheet, whether by replacing debt with equity
or quasi-equity or by inventing new asset classes for hungry fund managers
wanting to diversify.


The model set out above is capable of many variations. There could be
mortgage insurance guarantees, e.g., from a government farm loan insurer -
an Australian version of a Freddie Mac to help credit rating of the
principal repayment and make HECs more acceptable indirect investments
for superannuation funds. Many in the rural sector might argue that since
Federal superannuation legislation (introduced for its own persuasive
reasons) has had the unfortunate side effect of drawing funds out of rural
small and medium enterprise into large, urban-focussed, superannuation
funds, that bias should be corrected by facilitating reinvestment back into
rural enterprise.


Again, one could imagine terminable HEC agreements with no repayment
at the end in return for a higher crop share over the term of the HEC. This
might be suitable for income focussed pension funds in the rundown phase
with a shrinking pool of members (such as the Commonwealth
Superannuation Scheme) wishing to avoid a tontine windfall to the last
pensioners in the pool.


One might also imagine securitisation SPVs with sub-trusts based on
particular crops or output. A fund of funds SPV might allow investors to
hold wheat units, sugar units, wool units etc so that farmers and others
could deliberately expose themselves to offsetting risks. For example, a
bread producer might well like to acquire an indirect stake in the Australian
wheat crop to offset any adverse impact from higher wheat prices. A
confectionary manufacturer might similarly be happy to offset risk on
sugar costs by holding units in an SPV which held HECs written with
sugar farmers. Farmers themselves may wish to invest in SPVs to diversify
away from their own properties - they might sell part of their own crop
forward but buy interests in an SPV holding HECs in the same crop to lay
off location climate risk.
Cutting the
cost of
capital to
farmers
Super Funds
attractions
Wide variety
of
possibilities


64


4.2 Commercialisation Challenges

To set out a model for securitising agriculture does not mean it will be
taken up commercially. While a capital-guaranteed hybrid equity
agricultural listed security could be attractive to superannuation fund
trustees and other investors, someone has to invest the time and money to
create a securitisation SPV and bring it to market. It might be noted the
first securitisation in the USA was a commercial failure and it took time for
the idea to take off.


There is a parallel here with the emergence of limited partnerships for
venture capital. In October 1991, one of the authors of the present study
helped draft the Review of ACT Partnership Law which recommended
introduction of both limited and fully limited partnerships in the ACT to
help establish Australia as an international finance centre and remove
problems for small business. That report was not acted upon in Australia.
On the contrary, the taxation system was altered to discourage such
innovation by taxing limited partnerships as companies. But at about the
same time Texas was becoming the first US State to introduce the same
idea in the form of limited liability partnerships (LLPs). LLPs are now
widely used throughout the US by professional and other firms and have
now been introduced into the UK. Australia has still not done so, and
LLPs here would be taxed as companies. Meanwhile, the Federal
Government has had to create special tax treatment for certain venture
capital partnerships to undo the tax disincentives which blocked use of
limited partnerships and LLPs for investors in Australian R & D.


The moral of the story is that if an idea in finance is a good idea it will be
taken up and, if it is not taken up in Australia, it will be taken up overseas
and used by foreign investors to acquire equity in Australian industry.
There is a first mover advantage in using financial technology as much as
any other technology. Securitisation of agriculture should come at some
stage. The question is whether it will start in Australia and be used as a
financing technique to help small and medium enterprise or whether it will
be used to lower the cost of capital for corporatised agriculture (Box 14).






Good
financial
innovation
does take
off


65


BOX 14
Securitising small loans tipped as the next big thing

Patrick Eng, the former head of structured finance in Australia and New
Zealand for credit ratings analyst Moodys Investors Service, has seen the
future and it includes, among other things, the securitisation of small
commercial loans.

Mr Eng, who joined Credit Suisse First Boston last month as head of
structured finance in Australia, said the move would follow the classic
lines taken by the revolution in home-loan financing, which was triggered
in the mid-1990s in this country by securitisation.

Mr Eng said he believed small commercial loans would emerge in the
next year or two as an alternative asset class for investors who were
hungry for diversification and yield. The supply of securities backed by
commercial mortgages themselves a diversification from their residential
mortgage equivalents appeared to have peaked at least for now.

As Mr Eng said, investors wanted local market suppliers to provide them
with an alternative asset class. The demand exists. Investors need only
become accustomed to investing in small-business loans.

As with the home loan markets revolution of the mid-1990s led by non-
bank financiers the catalyst might be non-bank asset originators. You
need to have the intermediation broken up on the origination side, Mr Eng
said. Once that particular sector is opened up, you will have more
players.

Source: Australian Financial Review, 4 August. p23


If securitisation is to be advanced commercially in Australia, co-operation
between farmers organisations and financial institutions will be required.
No financial institution would risk incurring the costs of developing HEC
agreements and marketing them if farmers were unreceptive. In that sense,
securitisation of home loans was much easier. It could be completely
opaque to the borrower, whose only interest was in a lower mortgage rate.
Hybrid equity will require the borrower to be conscious of new and
different obligations - and advantages - of a new financing instrument,
even if it is offered and administered largely through the bank already
holding the first mortgage over the farm property.

The commercialisation phase would, therefore, probably need to be
accompanied, inter alia, by a program of dissemination of the benefits of
securitisation to the farm sector, more in depth data collection and
Disseminat-
ion &
discussions
at the
commercial
phase


66
effective discussion and technical problem solving of particular issues.
Data such as the class of farm (full time business; sub-economic; lifestyle
farmer; etc,), commodities produced, asset profile and land capital
component would be matters which could be expected to be factored into
any commercialisation exercise.

There might also be a potential role for the public sector. The US
securitisation market was made possible by mortgage insurance
underwritten by Federal agencies such as Fannie Mae and Freddy Mac.
Given that the relative flow of funds away from the rural sector has been
accelerated in part by changes such as compulsory superannuation, and
new bank capital adequacy rules, it might be argued that there is a
legitimate role for government in supporting a new rural mortgage
insurance institution to compensate for the adverse results of these
regulatory changes. There is precedent for government overcoming market
gaps by helping to create insurance markets. State Governments created
SGIOs to help underwrite workmens compensation insurance. The
Federal Government funded the Housing Loans Insurance Corporation and
has just set up the Australian Reinsurance Pool Corporation (ARPC) to
meet the lack of terrorism insurance. Insurance of capital returns on hybrid
equity could be a key feature in winning market acceptance by investors.
Hybrid equity such as a HEC with a guaranteed capital return would put
agriculture back on the map as a potential area for investment of
institutional funds, since protection of capital is the first duty of a trustee
investor.
Governments
may have a
facilitating
role to play


67
5. Conclusion


The most remarkable thing about the possible securitisation model for
primary producers outlined in this Report is that of the wide range of
experts interviewed no one thought it a futile exercise. This was in itself
surprising. Each group of persons interviewed could see advantages, from
increasing the pool of available asset classes for investors, for improving
the balance sheet resilience of the rural sector, to facilitating
intergenerational transfer of farming properties. The reaction was more
that securitisation would be a natural line of development for rural finance
to take. The problem which several interviewees pointed out was
essentially one of the costs of change as opposed to the need. The idea
may be logical and should be feasible but is there enough of a perceived
need to justify the trouble and commercial costs of developing a new
financing technique? If the consumer has been apparently happy enough
with the vanilla of first mortgage loan finance with some chocolate by way
of livestock or crop liens, how do we know he will buy choc mint?


It is not possible to answer that very practical commercial question. What
we can say is that participants interviewed in the rural and finance sectors
were aware of how changed circumstances have altered the flow of funds,
of how agriculture no longer gets preferential loan treatment and how
funds are directed by institutional investors away from rural enterprise for
want of acceptable investment opportunities. Farmers themselves are very
aware of the need to be conservative in relying on debt to finance their
capital intensive, but cyclical, businesses.


We can also say that we have not been able to think of any other feasible
way to inject passive equity capital into primary production without it
becoming an activity conducted by managers and paid employees of
corporations rather than by owner-occupiers of farms. We suspect that
would not be an optimal outcome, as primary production requires an
intimate knowledge of the local environment, often passed on from
generation to generation. While it is true that some primary producers are
not so much in business as pursuing a lifestyle, that is not true of most
farmers who run their farms as businesses, use futures contracts, research
via the internet and do as much as any other modern business to ensure
they turn a profit.


It is that majority of farmers who we believe may well embrace hybrid
equity contracts financed by securitisation if they are offered. They are
conscious of the need to escape the capital constraints on gearing when
they wish to expand or improve their properties. They are aware of their
overall cost of capital. They are aware of the problems of financing
Interviews &
discussions
encouraging
Commercial-
isation the
next stage


68
intergenerational transmission of a farm as a working property where there
is more than one child. J ust as agriculture has taken up computers and
other tools of modern management, if agriculture is to progress and
prosper, it needs access to capital and it needs access to the best modern
financial technology. Securitisation is a key element of the new global
financial system and Australian agriculture will benefit from learning to
turn it to advantage.






69
APPENDIX 1


Glossary of Terms


APRA Australian Prudential Regulation Authority

ARPC Australian Reinsurance Pool Corporation

ASIC Australian Securities and Investment Commission

ASX Australian Stock Exchange

BAS Business Activity Statement

CDO Collateratised debt obligations

CMBS Commercial mortgage backed securities

discount rate The interest rate applied by an investor to work out the present value of an
amount of money receivable in the future. For example, if the interest rate is 10%,
$220 in a years time is discounted as being worth only $200 today.

Fannie Mae Federal National Mortgage Association (USA)

Freddie Mac Federal Home Loan Mortgage Corporation (USA)

HEC Hybrid equity contract. As proposed in this study, the contract would provide for
return of capital at the end of its term but in lieu of normal interest payments the
financier would receive a share of gross farm output.

LLP Limited liability partnerships

LVR Loan to valuation ratio

RMBS Residential mortgage backed securities

SME Small and medium sized businesses

SPV Special purpose vehicle. This refers to a unit trust or company established as the
entity to hold a portfolio of assets such as a collection of HEC contracts transferred
into it by the securitisation originator. Outside investors may then acquire indirect
ownership of the securitised assets by buying units in the trust or shares in the SPV
company as the case may be.





70

APPENDIX 2

(Extract from Prudential Standard APS 120)


Sept 2000
APS 120 1
Prudential Standard
APS 120 - Funds Management &
Securitisation
Objective
This standard aims to ensure that ADIs adopt prudent practices to manage the
risks arising out of their involvement in funds management and securitisation
activities, and to ensure that appropriate capital is held against the risks
involved.
Index

Principles
Overview
1. Funds management encompasses the provision of investment and related services for the management
of investors funds. Securitisation involves the pooling of assets (or interests in assets) in a special purpose
vehicle (SPV), which is funded by the issue of securities.

2. ADIs 1 can incur financial, credit, operational and legal risks arising from the obligations associated
with their funds management and securitisation activities. Involvement in these activities can also yield
moral risk the possibility that an ADI will feel a moral obligation or a commercial need to support a
funds management or securitisation scheme, or the investors involved in such schemes, beyond any
explicit legal obligation to do so.

3. It is the responsibility of the Board and management of an ADI to put in place clear strategies and
policies to govern an ADIs involvement in funds management and securitisation activities. These should
incorporate appropriate management systems to identify, measure and control risks, including liquidity
risks and potential conflicts of interest, arising from the ADIs involvement in these activities.
Index ADIs Involvement in Funds Management & Securitisation Activities



1 For the purpose of this standard and the associated guidance notes, reference to ADI or ADIs includes an ADI
and its subsidiaries (as defined in Australian Accounting Standards) unless otherwise stated.



71
Sept 2000
APS 120 2

4. An ADIs role in a funds management or securitisation scheme can range from the establishment and
sponsorship of the whole scheme to the provision of a single facility or service to a scheme sponsored by
independent parties. Regulatory treatment, including for capital and disclosure, will vary depending on
the risks that the ADI has to bear.
5. Where the provision of facilities or services meet disclosure, separation and arms length criteria as
listed in the Guidance Notes, they will be subject to capital requirements in accordance with APS 112
Capital Adequacy: Credit Risk. Otherwise, an ADI may be required to hold capital (on a solo and
consolidated group basis) against the full value of securities 2 issued by the SPV 3 with which it is
involved.

6. Where the totality of an ADIs involvement in funds management and securitsation suggests that the
overall level and/or concentration of risks has become excessive relative to its capital, APRA may
require the ADI to maintain a buffer above the minimum capital ratio. In extreme circumstances, where
there is evidence of misleading investors or incorrect perception of ADI support, such that the additional
risks would not be adequately addressed by holding additional capital, an ADI may be precluded from
continuing to undertake funds management and securitisation activities.

7. This standard and its associated guidance notes apply to all forms of funds management and
securitisation activities undertaken by ADIs in both the retail and wholesale markets. It also covers
securitisation arrangements where the exposures do not cross an ADIs balance sheet. The provisions
should also be considered in any asset sales undertaken by an ADI where the ADI provides support
services or other facilities to the buyer.



2 Securities, in relation to funds management or securitisation schemes, include debt instruments, shares,
investment units, partnership interests, investment type products, and any other form of beneficial interest.
3 A SPV is an entity which holds assets and issues securities to (or receives funds from) investors inorder to
facilitate the management of investors funds and/or the securitisation of assets.





72
Sept 2000
APS 120 3

8. An ADI should consult APRA in advance of undertaking any new funds management or securitisation
schemes, except where the structure involved has been previously provided to APRA by the ADI.
Index
Disclosure

9. A key feature of funds management and securitisation schemes is that the payment of earnings and the
return of capital to investors hinge on the cash flows from the underlying assets in which their funds are
invested. Investors are exposed to investment risk, which may not be clear when investors are dealing
with an ADI. To eliminate confusion, an ADIs involvement in such schemes should be accompanied by
clear disclosure that the investment in the schemes does not represent deposit or other liabilities of the
ADI involved. Any recourse to the ADI for repayment of principal and/or interest will require
appropriate capital support.
Index
Separation

10. To achieve separation, an ADI must deal with a SPV and/or its investors at arms length and on
market terms and conditions. An ADIs undertaking in any funds management or securitisation scheme
should be stand-alone, with the extent of the ADIs obligations set out in legal documentation. Where
this does not occur, the ADI will need to hold capital against the full value of securities on issue.
Index
Clean Sale

11. An ADI will be relieved of the need to hold capital in support of assets sold to SPVs only where the
sale of the assets is clean and final (refer AGN 120.3). An ADI may incur risks or returns in respect of
the assets sold as a result of the ADI providing facilities covered by this Standard or the associated
guidance notes. Should the ADI retain any obligation, risk or interest relating to the assets sold other than
arising from such facilities, the assets must be treated as if they were still on the ADIs balance sheet. In
supplying assets to SPVs, ADIs should ensure that it would not lead to a deterioration in the average
quality of assets remaining on its balance sheet.
Index


APS 120 4
Application to Foreign ADIs

12. This Standard does not apply to foreign ADIs 4 , except for the provisions relating to disclosure and
separation. In their conduct of funds management or securitisation activities in Australia, foreign ADIs
should have regard to all the disclosure and separation requirements.
Index





4 For the purpose of this standard, foreign ADI has the same interpretation as in Division 1B of the Banking Act
1959.


73

APPENDIX 3

Relevant Legislation


This Appendix gives a brief prcis of what appear to be the most relevant pieces of legislation and offers
brief comments on how such legislation may affect commercial development of HEC agreements but
does not pretend to be comprehensive. All legislation is that of New South Wales, except as otherwise
indicated. The managed investments scheme provision of the Federalised Corporations Act would, of
course, apply to any public offer to subscribe for units in an SPV which held a portfolio of HECs, but as
that area is well understood, no further reference is made to that aspect in this Appendix.


Contracts Review Act 1980 No 16

Extracts

Part 2 Relief in respect of unjust contracts
7 Principal relief
(1) Where the Court finds a contract or a provision of a contract to have been unjust in the
circumstances relating to the contract at the time it was made, the Court may, if it considers it
just to do so, and for the purpose of avoiding as far as practicable an unjust consequence or
result, do any one or more of the following:
(a) it may decide to refuse to enforce any or all of the provisions of the contract,
(b) it may make an order declaring the contract void, in whole or in part,
(c) it may make an order varying, in whole or in part, any provision of the contract,
(d) it may, in relation to a land instrument, make an order for or with respect to requiring
the execution of an instrument that:
(i) varies, or has the effect of varying, the provisions of the land instrument, or
(ii) terminates or otherwise affects, or has the effect of terminating or otherwise
affecting, the operation or effect of the land instrument.
..


74

9 Matters to be considered by Court
(1) In determining whether a contract or a provision of a contract is unjust in the
circumstances relating to the contract at the time it was made, the Court shall have
regard to the public interest and to all the circumstances of the case, including
such consequences or results as those arising in the event of:
(a) compliance with any or all of the provisions of the contract, or
(b) non-compliance with, or contravention of, any or all of the provisions of the
contract.
(2) Without in any way affecting the generality of subsection (1), the matters to
which the Court shall have regard shall, to the extent that they are relevant to the
circumstances, include the following:
(a) whether or not there was any material inequality in bargaining power between
the parties to the contract,
(b) whether or not prior to or at the time the contract was made its provisions
were the subject of negotiation,
(c) whether or not it was reasonably practicable for the party seeking relief under
this Act to negotiate for the alteration of or to reject any of the provisions of
the contract,
(d) whether or not any provisions of the contract impose conditions which are
unreasonably difficult to comply with or not reasonably necessary for the
protection of the legitimate interests of any party to the contract,
(e) whether or not:
(i) any party to the contract (other than a corporation) was not reasonably able
to protect his or her interests, or
(ii) any person who represented any of the parties to the contract was not
reasonably able to protect the interests of any party whom he or she
represented,
because of his or her age or the state of his or her physical or mental
capacity,
(f) the relative economic circumstances, educational background and literacy of:


75
(i) the parties to the contract (other than a corporation), and
(ii) any person who represented any of the parties to the contract,
(g) where the contract is wholly or partly in writing, the physical form of the
contract, and the intelligibility of the language in which it is expressed,
(h) whether or not and when independent legal or other expert advice was
obtained by the party seeking relief under this Act,
(i) the extent (if any) to which the provisions of the contract and their legal and
practical effect were accurately explained by any person to the party seeking
relief under this Act, and whether or not that party understood the provisions
and their effect,
(j) whether any undue influence, unfair pressure or unfair tactics were exerted on
or used against the party seeking relief under this Act:
(i) by any other party to the contract,
(ii) by any person acting or appearing or purporting to act for or on behalf of
any other party to the contract, or
(iii) by any person to the knowledge (at the time the contract was made) of
any other party to the contract or of any person acting or appearing or
purporting to act for or on behalf of any other party to the contract,
(k) the conduct of the parties to the proceedings in relation to similar contracts or
courses of dealing to which any of them has been a party, and
(l) the commercial or other setting, purpose and effect of the contract.
(3) For the purposes of subsection (2), a person shall be deemed to have represented a
party to a contract if the person represented the party, or assisted the party to a
significant degree, in negotiations prior to or at the time the contract was made.
(4) In determining whether a contract or a provision of a contract is unjust, the Court
shall not have regard to any injustice arising from circumstances that were not
reasonably foreseeable at the time the contract was made.
(5) In determining whether it is just to grant relief in respect of a contract or a
provision of a contract that is found to be unjust, the Court may have regard to the
conduct of the parties to the proceedings in relation to the performance of the
contract since it was made.


76
Comment
The powers given to the Court are remarkably wide but the Courts have been conscious of the
need to respect commercial bargains. The Act does mean that any securitisation originator must
act with commercial probity and reinforces the Federal Trade Practices Act and the State Fair
Trading Act which proscribe misleading or deceptive or unconscionable conduct in trade or
commerce. As there is nothing in a HEC on the lines proposed which is inherently unfair or
unreasonable it is not anticipated there would be any problems posed for HEC contracts beyond
any other commercial contract.

Consumer Credit (New South Wales) Act 1995 No 7


Extract

6 Provision of credit to which this Code applies

(1) This Code applies to the provision of credit (and to the credit contract and related matters) if
when the credit contract is entered into or (in the case of pre-contractual obligations) is proposed
to be entered into-----

(a) the debtor is a natural person ordinarily resident in this jurisdiction or a strata
corporation formed in this jurisdiction; and
(b) the credit is provided or intended to be provided wholly or predominantly for personal,
domestic or household purposes; and
(c) a charge is or may be made for providing the credit; and
(d) the credit provider provides the credit in the course of a business of providing credit or
as part of or incidentally to any other business of the credit provider.



(4) For the purposes of this section, investment by the debtor is not a personal, domestic or household
purpose.

(5) For the purposes of this section, the predominant purpose for which credit is provided is-----

(a) the purpose for which more than half of the credit is intended to be used; or
(b) if the credit is intended to be used to obtain goods or services for use for different purposes, the
purpose for which the goods or services are intended to be most used.




77
Comment

This Act replaces for the most part the Credit Act 1984 (NSW) and applies the Queensland
Consumer Credit Code as part of a uniform consumer credit law. Given that a HEC would be a
business contract, a HEC should normally be outside the definition of consumer credit. However,
given that farms often contain family residences as well as productive land and HECs may be
sought to purchase both farm and residence, confirmation of exclusion may be sought as part of
the process of commercial development of rural securitisation. It might therefore be desirable to
seek regulatory change to prescribe HEC contracts as outside the definition of credit, as they are
more of a quasi-equity alternative to conventional credit. Confirmation of exclusion may be
particularly important as credit code restrictions on compulsory related insurance arrangements
may create administrative difficulties for SPVs and farmers wishing to ensure the proceeds of the
HEC contract is protected by specified crop insurance etc. These and related issues would need to
be considered in commercial adoption of securitisation. One would expect that any regulation to
confirm exclusion of a HEC from the Act would require the input of both financial institutions
and the relevant State farmers representative body


Farm Debt Mediation Act 1994 No 91

Extracts

farm mortgage includes any interest in, or power over, any farm property securing
obligations of the farmer whether as a debtor or guarantor, including any interest in, or
power arising from, a hire purchase agreement relating to farm machinery, but does not
include:
(a) any stock mortgage or any crop or wool lien, or
(b) the interest of the lessor of any farm machinery that is leased.

11 Certificate that Act does not apply to farm mortgage
(1) The Authority must, on the application of a creditor under a farm mortgage, issue a
certificate that this Act does not apply to the farm mortgage if:
(a) the farmer is in default under the farm mortgage, and
(b) no exemption certificate is in force in relation to the farm mortgage, and
(c) the Authority is satisfied that:


78

(i) satisfactory mediation has taken place in respect of the farm debt involved, or
(ii) the farmer has declined to mediate, or
(iii) 3 months have elapsed after a notice was given by the creditor under section 8 and the
creditor has throughout that period attempted to mediate in good faith (whether or not a
mediation session or satisfactory mediation took place during that period).
(1A) If the creditor has (in whatever terms employed) agreed in writing to extend the
period that will be available to the farmer for the conclusion of mediation between the parties
to beyond 3 months, the reference in subsection (1) (c) (iii) to a period of 3 months is taken to
be a reference to the extended period.
(1B) A failure by a creditor to agree to reduce or forgive any debt does not, of itself,
demonstrate a lack of good faith on the part of a creditor in attempting to mediate.
Note. Satisfactory mediation may nevertheless have taken place between the farmer and the
creditor despite such failure to agree (see section 4 (1A)).
(2) A farmer is presumed to have declined to mediate if any of the following circumstances is
established:
(a) the farmer has failed to take part in mediation in good faith or has unreasonably delayed
entering into or proceeding with mediation,
(b) the farmer has indicated in writing to the Authority or to the creditor that the farmer does not
wish to enter into or proceed with mediation in respect of the debt concerned,
(c) the farmer has failed to respond in writing, within 28 days, to an invitation that:
(i) is made in writing by the creditor and is identified as an invitation under this paragraph, and
(ii) invites the farmer to attend a mediation session, and
(iii) indicates that a failure of the farmer to respond in writing to the invitation might be taken to
be an indication that the farmer declines to mediate in respect of the farm debt.
(3) If the Authority does not issue a certificate because the Authority is not satisfied that the
creditor had attempted to mediate in good faith throughout the 3 months referred to in
subsection (1) (c) (iii), the creditor must not:


79
(a) give notice to the farmer under section 8, or
(b) make an invitation referred to in section 11 (2) (c),
in respect of the farm debt involved for a period of 12 months from the date on which the
creditor receives notice of the Authoritys decision to refuse to issue the certificate, unless the
farmer agrees to a shorter period.
Note. Under subsection (1) (c) (iii), attempting to mediate on the part of the creditor includes
making preparations for mediation even if no mediation session ever took place.
(4) A certificate may be given under this section (except where subsection (1) (c) (iii) applies)
whether or not any notice has been given under section 8.
(5) A certificate under this section remains in force until the date specified by the Authority
in the certificate. The date specified is to be calculated on the basis that the period for which
the certificate is to be in force is:
(a) if satisfactory mediation in respect of the farm debt concerned has taken place, the period
commencing on the date of its issue and ending on the third anniversary of the last date of the
mediation, or
(b) if the farmer has failed to take part in mediation in good faith, the period commencing on the
date of its issue and ending on the third anniversary of the last date of the mediation, or
(c) if the farmer has indicated in writing that the farmer does not wish to enter into or proceed
with mediation, the period commencing on the date of its issue and ending on the third
anniversary of the date the indication was given to the Authority or creditor, or
(d) if the farmer has failed to respond in writing, within 28 days, to an invitation referred to in
subsection (2) (c), the period commencing on the date of its issue and ending on the third
anniversary of the date that is 28 days after the invitation was given to the farmer, or
(e) if a notice was given by the creditor under section 8, the period commencing on the date of its
issue and ending on the date that is 3 years and 3 months after the date the notice was given,
or
(f) in any other case in which a certificate is issued, the period of 3 years commencing on the date
the certificate was issued.
(5A) A certificate may not be issued after the date on which any such certificate would,
if issued, expire under subsection (5).
(6) The expiry of a certificate under this section does not affect any proceedings for recovery
of a farm debt, or for the exercise or enforcement of any right of the creditor, already taken or


80
commenced by a creditor while the certificate was in force, and any such proceedings may be
continued and concluded as if the certificate were still in force.
(7) The reference in subsection (6) to the commencement of proceedings does not include a
reference to the giving of any statutory enforcement notice or other action taken in order to
fulfil a condition precedent to the enforcement of a right otherwise than through proceedings
in a court or tribunal.

Comment

A HEC, being a second mortgage over the farm property, would appear to fall within the semi-
mandatory mediation requirements of the Act. This seems not unreasonable and may even facilitate
drafting and acceptance of HEC agreements since it may not be necessary to provide for areas already
covered by mediation as provided for under the Act.


Liens on Crops and Wool and Stock Mortgages Act 1898 No 7

Extracts

4 Lien on yearly crops
In all cases where any person makes any bona fide advance of money or goods to any holder
of land on condition of receiving as security for the same the growing of crop or crops of
agricultural or horticultural produce on any such land, and where the agreement relating to
such security is made in the form or to the effect of the Second Schedule hereto, and purports
on the face of it to have been made as security for such advance, and is duly registered within
thirty days after its date in the General Register of Deeds, the person making such advance,
whether before, at, or after the date of such agreement, shall have a preferable lien upon, and
be entitled to the whole of such crop and the whole produce thereof, and possession thereof by
the lienor shall be to all intents and purposes in the law the possession of the lienee, and when
such advance is repaid with interest specified in such agreement the possession and property
of such crop shall revert to and vest in the lienor.
5 Lien not affected by sale etc of land
No such lien duly made and registered shall be extinguished or otherwise prejudicially
affected by the death or bankruptcy of the lienor, nor by any sale or mortgage of, or other
incumbrance upon the land on which any such crop is growing. And if such lienor, the
lienors executors, administrators, or assigns, neglects or refuses either to pay off the whole of
such advance with interest as agreed upon, or to give up such crop to the lienee thereof in
pursuance of the agreement, such lienee, the lienees executors, administrators, or assigns,
may enter into possession of such crop, and may gather, and carry away and sell the same,


81
and may apply the proceeds in paying himself or herself such advance, with interest as
aforesaid, and all expenses of gathering, carrying away, making marketable, and selling any
such crop, and shall pay the balance to the lienor, the lienors executors, administrators, or
assigns.
6 Lienee to pay rent of leased land before selling crop
If the lienor be a leaseholder then the lienee shall, before selling any such crop, pay to the
landlord of the land whereon such crop is growing such sum of money not exceeding one
years rent as may be due to the landlord for rent at the time of carrying away such crop, and
the lienee may repay himself or herself the sum so paid out of the proceeds of the sale of such
crop before paying over the balance to the lienor.
7 Lienee to pay interest to mortgagee of land before selling crop
If at the time of making any such lien there is in force a mortgage of the land whereon the
crop subject to the lien is growing, and the land is at the time of harvesting such crop in the
occupation of the mortgagee, the lienee shall, before selling any such crop, pay to the
mortgagee the amount of interest (not, however, exceeding twelve months interest) due upon
such mortgage at the time of carrying away or selling such crop; and the lienee may repay
himself or herself the sum so paid for interest out of the proceeds of the sale of such crop
before paying over the balance to the lienor.
8 (Repealed)
9 Duration of lien
No lien under this Part of this Act shall continue in force for more than one year from the date
thereof and the Registrar-General may, on the expiration of that period or at the request of
both parties, register satisfaction of the lien in the General Register of Deeds and destroy the
lien.
10 Penalties for frauds on lienee
Any lienor, whether principal or agent, who, by sale or delivery of any crop affected by such
lien, or of any part thereof, without the written consent of the lienee, or by any other means
defrauds such lienee of such crop or the value thereof, or any part thereof, and thus or by any
means directly or indirectly defeats, invalidates, or impairs the lienees right of property in the
same, shall be deemed guilty of an indictable offence, and shall be liable on conviction to a
fine not exceeding three times the amount of the loss thereby sustained, or to imprisonment
for any period not exceeding three years.
Part 3 Liens on wool and stock mortgages


82
11 Right of lienee to wool as security or in payment
In all cases where any person makes any bona fide advance of money or goods, or gives any
valid promissory note or bill to any proprietor of sheep on condition of receiving in payment
or as security only for such money, goods, promissory note, or bill, as the case may be, the
wool of the then next ensuing clip of such proprietor, and where the agreement relating to
such purchase or security is made in the form or to the effect in the Third Schedule appended
to this Act, and purports on the face of it to have been made in payment or as security for such
advance, and is duly registered within thirty days after the date of such agreement in the
General Register of Deeds, the person making such purchase or advance shall be entitled to
the whole of the wool mentioned in such agreement, whether such advance of money or
goods, or of such note or bill is made before, at, or after the granting of any such preferable
lien; and the possession of the wool by such proprietor shall be, to all intents and purposes in
the law, the possession of the person making such purchase or advance; and when such
advance is repaid, with such interest and commission as may be specified in any such
agreement, the possession and property of the said wool shall revest in such proprietor.
12 Right of lienee to ensuing clip of wool
(1) Where any person makes any bona fide purchase or advance, as in the last preceding
section mentioned, the preferable lien of the lienee making the same on the wool of the next
ensuing clip of such proprietor shall not be in anywise extinguished, suspended, impaired, or
otherwise prejudicially affected by any subsequent sale, mortgage, or other incumbrance
whatsoever of the sheep mentioned and described in the registered agreement relating to any
such preferable lien, nor by the subsequent bankruptcy of the lienor, but shall be as valid and
effectual to all intents and purposes whatsoever against any such subsequent purchaser,
mortgagee, incumbrancer, or other claimant or possessor of the said sheep, or against the
trustees or assignees of such bankrupt lienor as against the original proprietor thereof who
granted such preferable lien.
(2) If any such lienor, subsequent mortgagee, or incumbrancer, trustee, or other claimant or
possessor of such sheep neglects or refuses to shear and deliver the wool of any sheep for
which any such preferable lien shall have been granted as aforesaid in pursuance of the
provisions in that behalf contained in such registered agreement, it shall be lawful for the
lienee, the lienees executors, administrators, or assigns to take possession of the sheep
bearing such wool, for the purpose of washing and shearing the same; and all expenses
attending such washing and shearing and conveyance of the wool to the place of abode of
such lienee shall be incorporated with and be deemed in law part of the amount secured by
such lien.
13 Right of mortgagee although mortgagor in possession
All mortgages of sheep, cattle, and horses, which include the prescribed particulars, are made
bona fide and for valuable consideration, and are registered in the General Register of Deeds
within 30 days after the date of the agreement, are valid in the law to all intents and purposes
whether the money secured by the said mortgage is payable presently or not, and


83
notwithstanding that the said mortgaged live-stock are not delivered over to the mortgagee but
remain and continue in every respect, as theretofore, in the possession, order and disposition
of the said mortgagor, and though the said mortgagor afterwards takes the benefit of any law
now or hereafter to be in force in New South Wales for the relief of bankrupt debtors:
Provided that no mortgage shall protect the same from the operation of any such law unless
such mortgage shall have been executed at least sixty days before the date of the order for
sequestration, or unless the consideration thereof shall be an advance or loan made at the time
of the execution of such mortgage.
14 Mortgagor of sheep may with consent of mortgagee give lien
It shall be lawful for any mortgagor of sheep with the consent in writing of the mortgagee
thereof, but not without such consent, to make and give a valid lien on the next ensuing clip of
the wool of such sheep.
15 Liens and mortgages transferable by indorsement
All liens on wool, and all mortgages of sheep, cattle, or horses shall be transferable by
indorsement, and every indorsee thereof shall have the same right, title, and interest therein
respectively as the original lienee or mortgagee.
16 (Repealed)
17 Cancellation of lien on wool
At the end of twelve months next after the expiration of the year for which any preferable lien
on wool has been given as aforesaid, the Registrar-General may remove from the General
Register of Deeds such preferable lien, and may destroy or cancel the same, or at any time at
the request of both parties to any such preferable lien may register satisfaction of the lien in
the General Register of Deeds.
18 Registration of satisfaction of mortgage
In every case where the amount of principal and interest, or of the balance of principal and
interest due upon any mortgage of sheep, cattle, or horses is paid to the person entitled to
receive the same, or the persons agent in that behalf, and a receipt in writing for the amount
so paid is given, signed by the person so entitled, or by the persons agent acknowledging
such payment to be in satisfaction of the mortgage, the mortgagor, the mortgagors executors,
administrators, or assigns may cause the receipt to be registered in the General Register of
Deeds; and from and after the time of the registration of the receipt such payment shall
operate as an extinction of the mortgage, and of the right and interest thereby created, to all
intents and purposes whatsoever, but without prejudice to any previous sale, or any


84
conveyance in pursuance thereof, under such mortgage deed, and without prejudice to any
second or subsequent mortgage affecting the same stock or any part thereof then duly
registered, unless every party to the deed has, in writing at the foot of the receipt, signified the
partys assent to the registration of such receipt.
19 Saving of rights and prerogatives of the Crown
Nothing in this Part contained shall be construed to affect in any way the rights or prerogative
of the Crown as to any of the waste lands described in any such liens or mortgages as the
lands or stations where any such sheep, horses, or cattle may be depasturing.
20 Frauds by lienor, mortgagor or other person
And whereas it is expedient, with a view to increase the public confidence in the validity of
preferable liens on wool and mortgages of live-stock, to surround them with the penal
provisions necessary for the punishment of frauds: Be it enacted that:
(1) Any grantor of any preferable lien on wool under this Part, whether such grantor is principal
or agent, who afterwards sells or delivers to any purchaser, pawnee, or other person, the wool
under any such lien without the written consent of the lienee, or sells, steams, or boils down,
or causes to be sold, steamed, or boiled down, without such written consent as aforesaid, the
sheep whereon such wool is growing, with a view to defraud such lienee of such wool or the
value thereof, or,
(2) Any mortgagor of sheep, cattle, or horses, and their increase and progeny under this Part,
whether such mortgagor is principal or agent, who, after the due execution and registry of any
such mortgage, without the written consent of the mortgagee, sells and disposes of, or steams
or boils down, or causes to be sold and disposed of or to be steamed, or boiled down, any
sheep, cattle, or horses, or their increase or progeny, mentioned or described in any such
mortgage, or,
(3) Any such grantor or mortgagor, whether principal or agent, who in any way, or by any means
whatever or howsoever, directly or indirectly, destroys, defeats, invalidates, or impairs, or any
other person who wilfully and knowingly incites, aids, or abets any such grantor or
mortgagor, directly or indirectly, to defeat, destroy, invalidate, or impair the right of property
of any lienee in the wool of any sheep mentioned and described in any such registered
agreement as aforesaid, or the right of property of any such mortgagee as aforesaid in any
sheep, cattle, or horses, or their increase and progeny, mentioned in any mortgage duly
executed and registered as aforesaid under the provisions of this Part shall be severally held
and deemed guilty of an indictable offence and being thereof duly convicted shall be severally
liable in the discretion of the J udge or Court before whom any such offender shall be so
convicted to fine or imprisonment, or to both fine and imprisonment, for any period not
exceeding three years at the discretion of such Court or J udge.



85
Comment

This Act is central to protecting the SPV holding the HEC in its rights to a share of the farm output ahead
of unsecured creditors of the farmer. It should be noted that crop liens need annual renewal as an
administrative practice. The provision for criminal punishment for fraud is long established and well
understood and should give confidence to investors in an SPV holding a portfolio of HECs that their
interests are securely protected by law.


Partnership Act 1892 No 12

Extracts

2 (2) The sharing of gross returns does not of itself create a partnership, whether the persons sharing
such returns have or have not a joint or common right or interest in any property from which or from the
use of which the returns are derived.

2 (3) The receipt by a person of a share of the profits of a business is prima facie evidence that the
person is a partner in the business, but the receipt of such a share, or of a payment contingent on, or
varying with the profits of a business does not of itself make the person a partner in the business; and in
particular: .
(d) The advance of money by way of loan to a person engaged or about to engage in any
business on a contract with that person, that the lender shall receive a rate of interest
varying with the profits, or shall receive a share of the profits arising from carrying on
the business, does not of itself make the lender a partner with the person or persons
carrying on the business or liable as such: Provided that the contract is in writing and
signed by or on behalf of all the parties thereto:
3 Postponement of rights of persons lending or selling in consideration of
share of profits in case of insolvency
In the event of any person to whom money has been advanced by way of loan upon such a contract as is
mentioned in the last foregoing section, or of any buyer of a goodwill in consideration of a share of the
profits of the business being adjudged a bankrupt, entering into an arrangement to pay the persons
creditors less than one hundred cents in the dollar, or dying in insolvent circumstances, the lender of the
loan shall not be entitled to recover anything in respect of the loan, and the seller of the goodwill shall
not be entitled to recover anything in respect of the share of profits contracted for, until the claims of the
other creditors of the borrower or buyer for valuable consideration in money or moneys worth have
been satisfied.

Comment

A HEC which takes part of the gross crop for an SPV as interest would not therefore involve the SPV in
vicarious liability as a partner of the farmer. Nor would even a loan with interest varying with profits but
that would involve the potential disadvantage to an SPV of subordination to other creditors. (However,
the Commonwealth Bankruptcy Act and, in particular, its recognition of secured creditors rights would
appear to limit the actual scope of section 3).


86


APPENDIX 4

Summary of Interview Results by the Western Research Institute

This appendix summarises the results of structured interviews conducted by the Western Research
Institute (WRI) with a sample of farmers and financial services providers to the rural sector in the Central
West region of New South Wales. The purpose of these interviews was to explore existing financial
arrangements and tease out issues to be addressed in the design of a securitisation model.

The discussion of the interview results is organised into the following sections:

A description of the interview methodology and the sample characteristics;

An outline of the main quantitative responses;

A number of sections that discuss key securitisation issues; and

A summary of the main findings of the interviews.

Methodology

The interviews conducted by the WRI were structured, with a list of set questions to prompt discussion
plus a range of follow-up questions designed to elicit more information on key issues. The interviews
included questions with fixed responses (e.g. yes/no and Likert scales) plus open-ended questions. Most
interviews were conducted face-to-face with two members of the WRI research team present. However, a
small proportion of interviews were conducted via telephone.

The majority of the interview participants were selected randomly from the telephone directory.
However, key players of the Central West agriculture industry were also selected for interview on the
basis of the advice of the Rural Lands Protection Board in Bathurst and referrals by members of the rural
finance industry.

A total of 30 interviews were conducted, which included 13 farmers and 17 members of the rural finance
industry. The interviews with members of the rural finance industry included bankers, rural finance
companies, accountants, financial planners and solicitors.

Given the small size of the sample, and the fact that some participants were not selected randomly, the
interview results should be interpreted with caution. While it is not possible to reach statistically
significant findings the interview results provide insights into the attitudes of farmers and rural finance
service providers to the concept of securitising agriculture.

Quantitative Responses

This section outlines the main quantitative responses from the interviews with farmers and members of
the rural finance industry in the Central West. The figures in brackets show the number of interview


87
participants who agreed with a given response out of the total useable responses for that question. The
number of useable responses varies from question to question, as some interview participants did not
answer all questions.

The main quantitative results from the interviews with farmers were:

Banks are the main source of funding for farmers (7 out of 9);

Farmers are comfortable with banks being their main source of finance (7 out of 7);

Farmers believe the level of difficulty obtaining funding from banks is acceptable or not difficult (9
out of 9);

Farmers are interested in reducing the debt level on their farm (8 out of 9);

Farmers do obtain secondary finance from non-bank sources, including equipment leasing or hire
purchase (6 out of 13), credit cards (4 out of 13), crop or livestock mortgages (2 out of 13), private
finance (2 out of 13) and contract growing (2 out of 13);

The interest costs associated with secondary sources of finance was either comparable to banks (3
out of 8) or higher than that provided by banks (5 out of 8);

About half of the farmers interviewed were interested in having equity partners in their farm (5 out
of 11), while the other half were not interested (6 out of 11);

Less than half of the farmers interviewed were willing to share a proportion of their crop and/or
livestock receipts in return for paying no interest on part of their debt (4 out of 10), while more than
half were not interested (6 out of 10);

The maximum percentages of crop and/or livestock receipts a farmer was willing to share were: 0 to
10% (5 out of 10), 11 to 20% (1 out of 10) and 21 to 30% (3 out of 10);

One-third of farmers were willing to allow a third party (e.g. stock and station agent or bank) to
administer the splitting of receipts between the farmer and other equity investors (3 out of 9), while
two-thirds were not willing (6 out of 9); and

Half of the farmers interviewed were willing to accept restrictions on their ability to expand or create
other debts if they received hybrid equity (5 out of 10), while the other half were not willing to
accept these restrictions (5 out of 10).

The main quantitative results from the interviews with members of the rural finance industry are
discussed below. It should be noted that the following results are the expert opinions of members of the
rural finance industry in relation to their clients.

Farmers show widely varying cash flow patterns when they repay loans (8 out of 11);

Some farmers have planned programs for reducing or eliminating debt on their farms to withstand
financial shocks (4 out of 7), while others do not (3 out of 7);



88
The level of sophistication of the financial arrangements of farmers was considered moderate or high
(6 out of 8);

Most rural financiers had not experienced problems with farm loans being extended past prudent
loan to valuation ratios (5 out of 6) and none had experienced a loan default on a farm loan;

One quarter of the rural financiers believed that too many primary producers were undercapitalised
(2 out of 8), while three-quarters believed the level of capitalisation was acceptable (6 out of 8);

Rural financiers argued that it was moderately important to very important for farmers to have more
equity in their farm when they were seeking additional debt finance (5 out of 5);

More than half of the rural financiers interviewed did not think it would be advantageous if farmers
had longer term share farming agreements that resulted in elimination of some debt at the end of the
term (4 out of 6), although the remainder thought it would be advantageous (2 out of 6); and

Securitisation was considered to be a viable idea by rural financiers (8 out of 9).

The Role of Banks as the Primary Lender

Farmers tend to rely on the mainstream banking system for the bulk of their financing, which is
primarily debt secured by a mortgage over land as the principle asset. Farmers also indicated that
they would continue to rely upon banks for their main financing.

Some interview participants commented that the bank-farmer relationship had deteriorated in recent
years as it is more impersonal and people the farmer does not know are increasingly making the
decisions regarding their loan.

Rural financiers still have an interest in lending to farmers as it tends to be profitable and has a low
risk due to the high asset backing for farm loans. Indeed, levels of capitalisation, borrowing levels or
repayments were generally not seen as problems when seeking finance.

Most non-bank rural financiers were sympathetic to the idea of exploring methods of providing
farmers with low cost investment finance.

Most interview participants realised that while farms tend to have high asset backing farm income
levels are relatively low (i.e. the farm sector is asset rich but cash poor).

Banks tend to be cautious lenders with significant obligations imposed on rural borrowers with
security of principle and ability to make interest payments out of cash flow being the main criteria.

Banks appear to have improved their ability to manage farm loans by rescheduling debt repayments,
which are often allowed to vary with seasonal conditions. The use of ratings agencies to assess the
quality of farm loans is another strategy that banks use to manage risk in their loan portfolio. It was
recognised by some rural financiers that hybrid equity could assist banks to attract quality customers
and improve the credit rating of their loans.

The improved management of farm debt by banks has reduced many of the problems associated with
debt finance, especially the risk of foreclosure. It should be noted that under the hybrid equity
scheme payments automatically vary according to the level of production.


89

The Diversity of Farms

Rural financiers believed that securitisation might be better suited to larger farms, which tend to be
better managed. However, this is not always the case. There are a number of small but innovative
farms that have flexible management systems and could implement the necessary monitoring
systems. These firms may also benefit from securitisation.

The ability to manage a farm varied from person to person and was thought to include both technical
farming skills and business management skills.

Several interview participants believed it was important to view farming as a business rather than a
lifestyle. Some farmers also have an emotional attachment to the land, particularly if the farm had
been in the family for several generations.

A few respondents indicated that the rural sector was so diverse that securitisation may need to be
targeted at specific segments of the industry. For example, the financial product may be tailored for
medium to large-scale farms or farms that produce commodities for niche markets.

Although the management ability of farmers was considered to be variable, the risk of theft or fraud
on the part of the farmer was considered negligible. Indeed, farmers morals were considered to be
very high and thus problems of moral hazard were not seen as a problem for securitisation.

In many cases farms can only survive with the support of off-farm income from part-time jobs, social
security payments and investment income.

Farm Control and Monitoring

The interviews also show that many farmers manage their farm on the basis of tried and tested
experience. Farmers tend to be very reluctant to permit encroachment by outside institutions into the
management of their farms as they value their independence. For example, most farmers do not like
the idea of third parties being involved in managing farm receipts or sharing receipts with investors.

Some rural financiers held the view that farmers were in the best position to understand their
business and therefore the level of external control over farm decisions should be minimised.

The resistance of farmers to external controls over their management may create problems, as some
degree of external control is likely to be necessary to protect the interests of hybrid equity investors.

Another problem interview participants highlighted was the potentially high cost of monitoring. It
was suggested that the cost of monitoring is likely to be high for a finance organisation with little
experience in rural finance, especially if the average farm size is small, as this would increase
transaction costs. However, the cost of monitoring would be less for firms with experience in the
rural finance industry that are likely to be performing some monitoring functions already (e.g. sales
of chemicals and equipment). Thus, monitoring costs do not necessarily make securitisation
prohibitive.






90

Attitude to the idea of Securitisation Farmer Perspective

Rural financiers were primarily concerned with the consequences of securitisation for farmers, as
there was a general sympathy for their role in the economy. Thus, participants were prepared to
explore the idea of securitisation as the availability of hybrid equity might benefit farmers. The main
benefit that was highlighted was the opportunity to attract investment from sources other than the
mainstream banking system.

In general, interview participants believed that the idea of securitisation was feasible in principle.
However, more detailed information would be required before a final judgement regarding the idea
could be made.

Some rural financiers believed that wider access to investment finance would be an advantage for
farmers, in cases where mainstream sources of finance were overly cautious in their lending policies
and/or charged rates of interest that were seen as excessive.

Farmers tended to reserve judgement regarding the idea of securitisation, mainly because they
required more detailed information. In addition, some farmers who do not have much experience
with sophisticated forms of finance may not have fully understood the implications of securitisation
for their farm.

On the specific question of intergenerational transfer one farmer who took in a silent partner thought
that securitisation might have helped to solve his problems in these circumstances. Indeed, younger
farmers view securitisation as a vehicle for intergenerational transfer.

The better-informed farmers tended to be younger and involved in agribusiness, although their
annual turnover ranged from small to large. Of the four better-informed farmers, three where in
favour of securitisation and felt that it would enable farm expansion and increase peace of mind. The
remaining farmer felt that there were sufficient financing options available and that the time and
money spent on securitisation would not warrant the return.

Attitude to the idea of Securitisation Investor Perspective

Some rural financiers also raised questions regarding the protection of investor funds and the returns
that could be generated. For example, some interview participants expressed caution regarding the
lack of asset backing for agriculture securities. However, as discussed earlier, farms tend to have low
debt to equity ratios and high asset backing.

Concerns were expressed regarding the idea of sharing crop and/or livestock receipts, as investors
may not receive a return in some years due to the variability of farm incomes and the fact that many
farms appear to be unprofitable. However, these problems could be addressed by providing hybrid
equity to profitable farms from a diverse range of agriculture sectors across Australia. This industry
and geographic diversity should help to offset the impact of natural and market shocks on a pool of
agriculture securities and make them more attractive to long term investors.

Some rural financiers thought that investors might be reluctant to invest in agriculture securities if
higher returns can be achieved in other industries. Again this suggests that securitisation might be
more relevant to specific types of farms (e.g. medium to large scale, profitable, demonstrated
management ability, innovative, flexible, etc).


91
Main Findings

The mainstream banking industry is the primary source of funding for farmers, with secondary
sources of finance being hire purchase agreements and credit cards. Farmers are comfortable with
banks being their main source of finance and this suggests the banking sector would play an
important intermediation role in the securitisation of agriculture.

The mainstream banking industry continues to have an interest in lending to farmers, as it tends to be
profitable and has a low risk due to the high asset backing for farm loans. Banks have also improved
their ability to manage farm loans by rescheduling debt repayments and using ratings agencies to
assess the quality of farm loans. To some extent the way banks manage farm debt already provides
farmers with some of the benefits that securitisation would provide in terms of flexibility (i.e. to
some extent banks are quasi-equity partners).

Farmers tended to reserve judgement regarding the idea of securitisation, mainly because they
required more detailed information. However, of the better-informed farmers that were interviewed
the majority where in favour of securitisation, as it would enable farm expansion. In addition,
younger farmers view securitisation as a vehicle for intergenerational transfer.

Rural financiers are generally interested in the idea of securitisation as it creates opportunities for
increased investment in the agriculture industry. This is especially true in cases where mainstream
sources of finance were overly cautious in their lending policies and/or charged rates of interest that
were seen as excessive.

Some rural financiers believed that investors might be reluctant to invest in agriculture securities if
higher returns could be achieved in other industries. This suggests securitisation may need to be
targeted at specific segments of the industry, such as medium to large-scale farms, farms with above
average profitability and farmers with demonstrated management ability. Thus, securitisation may
not be appropriate for all segments of the Australian agriculture industry.

Members of the rural finance industry raised a number of issues such as: the variability of agriculture
incomes, the low profitability of many farms, the management ability of farmers, the resistance of
farmers to external control and monitoring, the protection of investor capital, and, the relevance of
trustee legislation.


92
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