Securitization

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security

Asset Backed security-  A bond offering that has no such certainty. Government or private company does not back the security in most cases but rather a creditor most often a lender issues securities supported by stream of income. There is no guarantee that the income will be received as anticipated, sometimes the asset will be liquidated then expected which results in less interest income then the bondholders assumed they would receive. Hence the future cash flow can only be guessed.  Accepting this uncertainty, investors are able to achieve higher returns then on a regular government or corporate bond.

Asset backed securities are sold either fixed rates of interest or floating rates.

Divided into two categories.

Mortgage backed securities- supported by first mortgages on residential properties.

Non-Mortgage securities- These can be backed by assets of any other sort, including house related loans other then first mortgages.

   

The entity that originally holds the assets (the originator) initiates the process by selling the assets to a legal entity, an SPV (Special Purpose Vehicle), specially created to limit the risk of the final investor the issuer of the assets. An SPV is also referred to as a “conduit.”  Depending on the situation, the SPV either issues the securities directly or resells the pool of assets to a “trust” that, in turn, issues the securities (the trust is actually used for several securitization transactions and therefore oversees several SPVs).

An SPV is more of a legal framework than an element that plays an active part in the transaction. The most important role is played by the arranger, typically a bank, who sets up the transaction and evaluates the pool of assets, the way in which it will be fed, the characteristics of the securities to be issued, and the potential structuring of the fund.

The object of the structuring is to model the characteristics of the securities such that they correspond to the needs of the final investor. Instead of simply paying the final investor the revenue generated by the assets, the amortization rules for the security are defined in advance.

Some ABSs can be “topped up,” meaning that the pool of assets can be referred during the life of the security. This allows it to refinance short-term debts with long-term bonds.

Finally, the arranger plays an important role in distributing the securities to the final investors (distribution). Quite often, the securities are not issued on an exchange, but are distributed over-the-counter to a small number of investors.

The trio of actors comprising the “originator, SPV, and arranger” constitutes the “Originate-to-Distribute” model, which has thrived over the course of the past few years.

An important distinction must be made between “traditional” securitization, where the assets are actually sold to the SPV (“true sale”), and what is known as “synthetic” securitization, where the originator retains ownership of the assets and transfers only the risk to the SPV, via a credit derivative. This transaction brings no liquidity to the assignor, but enables to externalize the risk associated with holding the securitized assets.

Advantages of Securitization

The Seller    Main reason for securitizing is to reduce the amount of assigned debt from his balance sheet, which on the one hand leads to a corresponding reduction in his regulatory capital requirements under Basel II, and on the other hand enables him to bring in additional liquidity (which can be used to make new loans).

The investor    ABS presents an opportunity to invest in asset classes that are not accessible in the markets and that offer a risk/return profile that is, in principle, attractive. “ABS are a means of diversifying a portfolio into low-risk products that, by virtue of their structure, offer exposure to a diversified portfolio.”

“Since the underlying assets are diversified, clearly identified, and pledged to the holder, the credit rating agencies claim that in the event of default (theoretically speaking), the recovery rate for the holder is very high.”

The Market   Securitization helps to spread out risk within the market, so that the risk is no longer concentrated solely in the hands of credit agencies.

Drawbacks of securitization

Information Asymmetry   Issuer of the securities knows much more about what he is really selling than the buyer (investor) does. Akerlof first described this mechanism in terms of the used-car market (“The market for Lemons”).

People become suspicious of any product falling within that category – since you really need to be an expert to be able to evaluate a securitization program –and suddenly nobody wants to buy them anymore.  

Moral hazard   The banks have moved away from their role of financing the economy, seeking instead to assume (fortunately, not completely) a purely intermediary role in an economy that seems to have become completely “marketized.” Today, the situation is reaching its limits.