It is a process in which entity securitizing its assets is not borrowing but selling a stream of cash flows that was otherwise to accrue to it. It is a process through which an issuer creates a financial product by combining other financial assets and then marketing different tiers of the repackaged instruments to investors for issuer’s funding. The repayment of securities is exclusively dependent on the performance of the assets.
Features of Securitization-
- The investor’s looks at the cash flows of the entity and not the entity itself hence it’s also called as assets backed financing.
- It is also called structured funding because risk is structured in accordance with investor’s needs.
- Originator’s liability is in the form of credit enhancement.
Difference between Securitization and Corporate Finance-
|Nature||General claim against the assets of an entity||Claim against specific assets of an entity, on mutually exclusive basis|
|Objective||To harness the strengths of the corporate’s balance sheet to raise funding||To strip the excess spread inherent in assets and service them on off-balance sheet basis|
|Investor risks||Subject to entity-wide risks||Isolated from entity risks|
|Structured funding||Less amenable to structured funding||More amenable to structured funding, since assets are hived off into a separate entity|
|Leverage||Leverage limited to entity wideprudential/regulatorylimits||Leverage based on portfolio risks – usuallyquite high|
Basic Model of Securitization-
- The originator either has or creates the underlying assets, i.e transaction receivables to be securitized.
- Selection of receivables to be assigned
- Formation of Special purpose vehicle (SPV)
- Special purpose vehicle (SPV) acquires the receivables under a discounted value
- The servicer for the transaction is appointed (normally originator)
- Servicer collects the receivables (usually escrow mechanism) and pays off the collection to Special purpose vehicle (SPV)
- The Special purpose vehicles (SPV) either pass the collection to the investor (or reinvest the same to pay off)
- In case of default the servicer takes action against debtors as Special purpose vehicle (SPV)s agent
- When only small amount of o/s receivables are left to be collected, the originator usually cleans up the transaction by buying back the o/s receivables
- At the end of the transaction, the originator profit, if retained and subject to any losses to the extent agreed by the originator in the transaction is paid off.
Requirement of Securitization-
- Legal environment
- Accounting environment
- Regulatory environment
- Tax environment
- Back office systems/Information
- Strong investor demand
Typical Originators of Securitization-
- Mortgage financiers
- Finance companies
- Credit card companies
- Public utilities
- Intellectual property holders
- Insurance companies
- Aviation companies
Risks in Securitization-
Following are the parties’ involved in Securitization-
- An Investors
- Swap Counterparties
- Liquidity provider
- Credit enhancement provider
- Lower cost – inherent cost and weighted average cost– The best example of economics of securitization is an arbitrage CDO
- Alternative investor base -institutional and retail
- Matching of assets and liabilities
- Issuer rating irrelevant
- Multiplies asset creation ability
- Non-conventional source; may allow higher funding-
- Off-balance sheet financing – removal of accounts
- Frees up regulatory capital
- Improves capital structure
- Higher trading on equity with no increased risk
Key Benefits of Securitization
- Typically cheaper financing than traditional funding
- Diversification of funding
- Non-recourse to the originator/seller of the receivables
- Early monetization of assets
- Control of obligor exposure
Terms Used in Securitization-
Bond- A debt financial investment in which an investor lends money to an entity such as corporate ,companies, government that borrows the funds for a specified period at a specified interest rate.
Investment Bank (IB)- An Investment bank is a financial intermediary which helps companies, agencies and government for raising money by issuing and selling securities in the primary market.
Mortgage Backed Security (MBS)- It is a type of asset-backed security that is secured by a pool of mortgage. These securities are grouped in one of the top two ratings as determined by credit rating agencies, like S & P, and usually pay periodic payments that are similar to interest payments.
Collateralized Debt Obligation (CDO)- Collateralized Debt Obligation involves the pooling of debt to hedge risk and raise returns. When a lot of debt for example home mortgages is pooled together and split into different tranches or slices, and also each slice is assigned a different payment priority and interest rate as per their grading by credit rating agencies. This overall process is known as securitization.
Yield- It is the income or return on an investment.