Explain the process of asset securitization and carefully elaborate on the implication for the Treasury Manager when using this form of financing.
Asset securitization is way of financing for lenders to obtain funds in the capital markets for the origination of consumer and business loans. It is different from the traditional way of financing, where lenders finance loan originations with deposits. Started in 1970, the asset securitization market had a remarkable history of growth and development. By 2000, it became the largest sector of the U.S fixed income securities market. In matured capital market, asset securitization has proven to be an efficient way of financing in that it reduces the ultimate funding cost for the borrower, improves the financial operation for the lender and provides diversified investment products for the investor.
The process of asset securitization
In today’s world, asset securitization means a process by which one entity pools its interest in a series of identifiable future cash flows and then transfers the claims on those future cash flows to another entity which is established for the sole purpose of holding those claims. This other entity issues securities which are backed by the claims on the future cash flows. When realized, the cash flows are used to pay principal and interest to the investors over time. Credit support from source other than the cash flows may or may not be used to pay off investors. Therefore, a securitization transaction is used to provide financing (through the sale of assets). However, it is not financing in the common sense of the word, since the entity that securitizes its assets is not borrowing money, but instead is selling cash flows that would accrue to the entity even without the securitization transaction. The entities that securitize assets could be private corporations (financial or non-financial) or public enterprises.
The process of securitization begins with an individual or institution taking a loan or mortgage from a bank, some other financial institution or a company in any industry. This company has many customers (individual and institutional) to whom they give loans to and they expect to receive timely payments from them, in the form of principal and interest. In other words, they have receivables on their balance sheets. Because this company originated the loans, we will refer to it as the “originating company” or the “originator”. Originators can be banks, mortgage companies, finance companies, investment banks and other entities. The originator identifies a group or pool of receivables (loans) that meet some quality criteria and decides to securitize those receivables. This pool of receivables is then transferred to another entity called “special purpose entity” (SPE) or “special purpose vehicle” (SPV). In most cases, the pool of receivables or the asset pool is transferred at par value; that means it is transferred at the outstanding principal of the loans in the pool. The purpose of the SPE/V is to hold the asset pool and to pay to the originator for it by issuing securities. This means that the SPV will issue securities (in most cases bonds or commercial paper) to the general public and it will use the proceeds to pay the originator for the asset pool.
The securities issued by the SPV are evaluated separately by the credit rating agencies and obtain credit rating separately from the originator, based solely on the quality of the assets in the pool, not on the credit condition of the originating company. By issuing the securities, the SPV has a liability towards the investors of those securities. The SPV should repay the principal and should pay interest in the future. When the asset pool’s cash flows are realized at a later stage; that is, when the borrowers repay the loans in the pool, the SPV will use these cash flows to pay the investors of the securities issued by the SPV. Therefore, the previously issued securities are backed by the asset pool. Investors in the securities issued by the SPV are mostly institutional investors like pension funds, mutual funds, insurance companies and money managers. Usually, these securities are not marketed to retail investors. The cash flows from the asset pool will be used on a mutually exclusive basis.
This means two things; first, the originator does not have any claim on the receivables in the pool. Second, the investors in the securities issued by the SPV do not have any claim against the assets of the originator, except to the extent of the guarantee provided by the originator.
In general, the process of securitization involves the following parties:
Originators – the parties, such as mortgage lenders and banks that initially create the assets to be securitized.
Aggregator – purchases assets of a similar type from one or more Originators to form the pool of assets to be securitized.
Depositor – creates the SPV/SPE for the securitized transaction. The Depositor acquires the pooled assets from the Aggregator and in turn deposits them into the SPV/SPE.
Issuer – acquires the pooled assets and issues the certificates to eventually be sold to the investors. However, the Issuer does not directly offer the certificates for sale to the investors. Instead, the Issuer conveys the certificate to the Depositor in exchange for the pooled assets. In simplified forms of securitization, the Issuer is the SPV which finally holds the pooled assets and acts as a conduit for the cash flows of the pooled assets.
Underwriter – usually an investment bank, purchases all of the SPV’s certificates from the Depositor with the responsibility of offering to them for sale to the ultimate investors. The money paid by the Underwriter to the depositor is then transferred from the depositor to the Aggregator to the Originator as the purchase price for the pooled assets.
Investors – purchase the SPV’s issued certificates. Each Investor is entitled to receive monthly payments of principal and interest from the SPV. The order of priority of payment to each investor, the interest rate to be paid to each investor and other payment rights accorded to each investor, including the speed of principal repayment, depending on which class or tranche of certificates were purchased. The SPV makes distributions to the Investors from the cash flows of the pooled assets.
Trustee – the party appointed to oversee the issuing SPV and protect the Investors’ interests by calculating the cash flows from the pooled assets and by remitting the SPV’s net revenues to the Investors as returns.
Servicer – the party that collects the money due from the borrowers under each individual loan in the asset pool. The Servicer remits the collected funds to the Trustee for distribution to the Investors. Servicers are entitled to collect fees for servicing the pooled loans. Consequently, some Originators desire to retain the pool’s servicing rights to both realize the full payment on their securitized assets when sold and to have a residual income on those same loans through the entitlement to ongoing servicing fees. Some Originators will contract with other organizations to perform the servicing function, or sell the valuable servicing rights.
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Figure : Process of securitization
No one works at the SPV and it does not have physical location. Moreover, it cannot make business decisions. To achieve the two goals of transferring the assets and at the same time creating some financial instrument, an entity like the SPV is created. The SPV is a mean which provides assurance that the assets are isolated from the risk of default by the originator. This means that the SPV is “bankruptcy remote”. This legal entity is created for the sole purpose of holding the transferred assets and for the subsequent issuance of securities backed by those assets. Therefore, in effect, investors do not have to hold the originator’s assets directly. Instead, they do so indirectly through the SPV. Practically the SPV is a sort of intermediary between the originator and he investors.
The SPV is basically an entity with nominal equity capital and with no substance. This means that the SPV acquires the asset pool, but it does not have the necessary infrastructure to collect the receivables. Therefore it cannot perform the collecting and servicing function. The servicing function includes services to borrowers, collecting cash flows and redirecting those cash flows to the investors. Because the originating company has the necessary infrastructure and system in place to provide these services, in most cases, it retains the servicing function and it charges a servicing fee. That is why borrowers do not know that their loans have been securitized. However, the originating company does not have the ownership of the assets, like before the securitization transaction. The difference, with asset securitization, is that after collecting the loan repayments, the originator will redirect the cash flows to the SPV. The servicing function can, also, be assigned to a third party, if that party has comparative advantage in servicing.
Credit rating agencies must assign a credit rating to the ABSs in order for the issue to be regarded as marketable. They give their opinion on the quality of the asset pool and based on that, a credit rating is assigned. Usually the securitization transaction must have AAA credit rating to be seen positively by the investors.
Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.
In addition to subordination, credit may be enhanced through:
A reserve or spread account, in which funds remaining after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPE expenses are greater than its income.
Third-party insurance, or guarantees of principal and interest payments on the securities.
Over-collateralisation, usually by using finance income to pay off principal on some securities before principal on the corresponding share of collateral is collected.
Cash funding or a cash collateral account, generally consisting of short-term, highly rated investments purchased either from the seller’s own funds, or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows.
A third-party letter of credit or corporate guarantee.
A back-up servicer for the loans.
Discounted receivables for the pool
BENEFITS OF ASSET SECURITIZATION
The evolution of securitization is not surprising given the benefits that it offers to each of the major parties in the transaction.
Securitization improves returns on capital by converting an on-balance-sheet lending business into an off-balance-sheet fee income stream that is less capital intensive. Depending on the type of structure used, securitization may also lower borrowing costs, release additional capital for expansion or reinvestment purposes, and improves asset/liability and credit risk management.
Securitized assets offer a combination of attractive yields (compared with other instruments of similar quality), increasing secondary market liquidity, and generally more protection by way of collateral overages and/or guarantees by entities with high and stable credit ratings. They also offer a measure of flexibility because their payment streams can be structured to meet investors’ particular requirements. Most important, structural credit enhancements and diversified asset pools free investors of the need to obtain a detailed understanding of the underlying loans. This has been the single largest factor in the growth of the structured finance market.
Borrowers benefit from the increasing availability of credit on terms that lenders may not have provided had they kept the loans on their balance. For example, because a market exists for mortgage-backed securities, lenders can now extend fixed rate debt, which many consumers prefer over variable rate debt, without overexposing themselves to interest rate risk. Credit card lenders can originate very large loan pools for a diverse customer base at lower rates than if they had to fund the loans on their balance sheet. Nationwide competition among credit originators, coupled with strong investor appetite for the securities, has significantly expanded both the availability of credit and the pool of cardholders over the past decade.
Reasons why organizations go for securitization
Securitization is one way in which a company might go about financing its assets. There are generally seven reasons why companies consider securitization:
To improve their return on capital, since securitization normally requires less capital to support it than traditional on balance sheet funding.
To raise finance when other forms of finance are unavailable ( in a recession banks are often unwilling to lend and during a boom, banks often cannot keep up with the demand for funds).
To improve return on assets, securitization can be a cheap source of funds, but the attractiveness of securitization for this reason depends primarily on the costs associated with the alternative funding sources.
To diversify the sources of funding which can be accessed, so thst dependence upon banking or retail sources of funds is reduced.
To reduce credit exposure to particular assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitization can remove some of the assets from the balance sheet).
To match fund certain classes of asset – mortgages assets are technically 25 year asset, a proportion of which should be funded with long term finance, securitization normally offers the ability to raise finance with a longer maturity than is available in other funding markets.
To achieve a regulatory advantage, since securitization normally removes certain risks which can cause regulators some concern, there can be a beneficial result in the terms of the availability of certain forms of finance (for example , in the UK building societies consider securitization as a means of managing the restriction on their wholesale funding abilities).
Assets that can be securitized include the following:
trade/commercial accounts receivable;
credit card receivables;
factored trade receivables;
royalty payment streams; and
Generally speaking, any asset that generates cash flow has the potential to be securitized.
IMPLICATIONS OF ASSET SECURITISATION
Risks for banking organizations
The securitization process, if not carried out prudentially, can leave risks with the originating bank without allocating capital to back them. While all banking activity entails operational and legal risks, these may be greater the more complex the activity. But the main risk a bank may face in a securitization scheme arises if a true sale has not been achieved and the selling bank is forced to recognize some or all of the losses if the assets subsequently cease to perform. Funding risks and constraints on liquidity may also arise if assets designed to be securitized have been originated, but because of disturbances in the market the securities cannot be placed. There is also at least a potential conflict of interest if a bank originates, sells, services and underwrites the same issue of securities.
A bank that has originated and transferred assets effectively may nonetheless be exposed to moral pressure to repurchase the securities if the assets cease to perform. The complexity of securitization schemes could contribute to such pressure. After having completed the securitization transaction the seller does not in general disappear but exercises other functions in the process. These functions and the fact that the investors are well aware of the identity of the provider of the assets backing the securities may give rise to links between seller and investors that could, at least morally, cause the seller to be under pressure to protect its reputation and to support the securitization scheme.
The risks for banks acting as a servicer are principally operational and are comparable to those of an agent bank for a syndicated loan. However, the number of the loans in the portfolio and the different parties involved in a securitization scheme mean that there are higher risks of malfunction for which the servicer might also become liable. Thus, servicers need to engage sophisticated personnel, equipment and technology to process these transactions in order to minimize operational risk.
It is sometimes contended that banks in seeking a good market reception for their securitized assets may tend to sell their best quality assets and thereby increase the average risk in their remaining portfolio. Investor and rating agency demand for high quality assets could encourage the sale of an institution’s better quality assets. Moreover, an ongoing securitization programmer needs a growing loan portfolio and this could force a bank to lower its credit standards to generate the necessary volume of loans. In the end a capital requirement that assumes a well diversified loan portfolio of a given quality might prove to be too low if the average asset quality has deteriorated.
The securitization of revolving credits such as credit-card receivables is a particularly complicated example which involves the issue of securities of a fixed amount and term against assets of a fluctuating amount and indefinite maturity. A portfolio of credit-card receivables fluctuates daily as the individual accounts increase and decrease, and because of the different repayment patterns by credit-card users (e.g. by fast and slow payers). It is also likely that as a scheme matures the security-holders will be repaid out of a fixed share of gross flow on the accounts in the pool, so deriving repayment principally from fast payers who resolve their debts quickly. Such schemes need a structure adequate to ensure control of the amortisation process and to ensure appropriate risk-sharing during amortisation by the security-holders.
Implications for financial systems
The possible effects of securitization on financial systems may well differ between countries because of differences in the structure of financial systems or because of differences in the way in which monetary policy is executed. In addition, the effects will vary depending upon the stage of development of securitization in a particular country. The net effect may be potentially beneficial or harmful, but a number of concerns are highlighted below that may in certain circumstances more than offset the benefits. Several of these concerns are not principally supervisory in nature, but they are referred to here because they may influence monetary authorities’ policy on the development of securitization markets.
While asset transfers and securitization can improve the efficiency of the financial system and increase credit availability by offering borrowers direct access to end-investors, the process may on the other hand lead to some diminution in the importance of banks in the financial intermediation process. In the sense that securitization could reduce the proportion of financial assets and liabilities held by banks, this could render more difficult the execution of monetary policy in countries where central banks operate through variable minimum reserve requirements. A decline in the importance of banks could also weaken the relationship between lenders and borrowers, particularly in countries where banks are predominant in the economy.
One of the benefits of securitization, namely the transformation of illiquid loans into liquid securities, may lead to an increase in the volatility of asset values, although credit enhancements could lessen this effect. Moreover, the volatility could be enhanced by events extraneous to variations in the credit standing of the borrower. A preponderance of assets with readily ascertainable market values could even, in certain circumstances, promote liquidation as opposed to going-concern concept for valuing banks.
Moreover, the securitization process might lead to some pressure on the profitability of banks if non-bank financial institutions exempt from capital requirements were to gain a competitive advantage in investment in securitized assets.
Although securitization can have the advantage of enabling lending to take place beyond the constraints of the capital base of the banking system, the process could lead to a decline in the total capital employed in the banking system, thereby increasing the financial fragility of the financial system as a whole, both nationally and internationally. With a substantial capital base, credit losses can be absorbed by the banking system. But the smaller that capital base is, the more the losses must be shared by others. This concern applies, not necessarily in all countries, but especially in those countries where banks have traditionally been the dominant financial intermediaries.
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