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Securitization | Definition, Types, Benefits, Instruments, Application & Mechanism of Debt Securitisation


What is Securitization ?

Securitization refers to the process of converting existing or future cash inflows into trad-able securities. Such securities may then be sold in the market. Cash inflows are generated from several financial assets such as automobile loans, mortgage loans, trade receivables and credit card receivables. These inflows may be used as collateral for securing loans. Such securitization helps in imparting liquidity to illiquid assets. This process is also known as Debt Securitisation or Asset Securitization.

Definition of Securitization

According to Oxford Dictionary :
"Securitization means to convert an asset (specially a loan) into marketable securities for the purpose of raising cash or funds".

Thus, the process of securitization deals with 'pooling of assets and selling these to investors through a specialized intermediary created for this purpose'.

Examples of Securitisation of Debt

  • City Bank transfers its home loan portfolio to State Bank.
  • The Housing and Urban Development Corporation Ltd. (HUDCO), which carries out infrastructure financing, securitizes its future cash inflow.

Parties Involved in Securitisation

Following are the main parties involved in the process of securitization :

1) Originator : 
The originator is also known as the seller to whom the portfolio belongs. This portfolio is used for creating Asset Backed Security.

2) Special Purpose Vehicle (SPV) : 
A Special Purpose Vehicle is also known as a Special Purpose Entity (SPE). These entities are created for carrying out any specific purpose related to the business. Such SPVs are generally employed in structured finance transactions such as joint ventures, asset securitisation etc. Such vehicles can be created by various entities such as firms, trusts and corporations. These entities are created for the purpose of arranging finance. Special Purpose Vehicles are the intermediaries and offer gap between the instrument and the originator.

3) Investors : 
Such investors may be individuals or corporate such as Foreign Institutional Investors or Mutual Funds. Such investors take a stake in the pool and receive interest and principal on agreed terms.

4) Other Parties :
Other parties are :

i) Obligor : 
The originator's debtor is the obligor. 

ii) Servicer : 
The servicer is responsible for heating all the administrative responsibilities related to the process of securitisation.

iii) Trustee : 
The trustee or the investor representative is required to act in a guardian manner to protect the interests of various investors. 

iv) Credit Rating Agency : 
The credit rating agency is entrusted with the task of providing an objective of evaluation of the credit risk involved in the transaction. This is done by assigning credit rating.

v) Regulators : 
The regulators offer caution over various issues such as liquidity, credit quality, capital adequacy and accounting treatment of the deal. 

vi) Service Providers : 
Credit enhancers and liquidity providers are included in the category of service providers.

vii) Specialist Functionaries : 
Specialist functionaries are the professionals such as accountants, tax counsels, legal specialists, etc. which provides special services.

Types of Securitized Instruments

Following are the main securitized debt instruments :
  1. Mortgage-Backed Securities (MBS) which are sponsored by mortgages.
  2. Asset Backed Securities (ABS) which are sponsored by consumer debt. 
  3. Collateralized Debt Obligations (CDO) which are sponsored by corporate debt including bonds.
These instruments or Types of securitized assets offer the opportunities and risks associated with their underlying assets.

Types of securitization

Mortgage Backed Securities (MBS)

Mortgage backed securities (MBS) are made from the pools of mortgages. These pools are divided into various tranches which are sold afterwards. The resulting security has the same rights and obligations with regard to amortization level, adjustable rate, payments, etc. They also have same maturity time and interest rate attached to them. The originator is entrusted with task of mortgage payment collection, which is then passed to the security holders. Various fees and guarantees are deducted from such payments.

The securitisation of assets was originally started with residential mortgages. Such mortgages still form the bulk of securitization market. Various characteristics of residential mortgages such as lesser chance of value erosion through depreciation, make them more suitable for such securitisation.

Mortgage Backed Securities (MBS)

Following are the main characteristics of residential mortgages: 
  1. These mortgages are medium to long-term in their duration and are more suitable for meeting the requirements of various investors.
  2. The receivables are homogeneous in nature which are underwritten by the help of standardization and thus are responsible to standardized procedures. 
  3. Such mortgages are guaranteed by the Government in the United States, which is the place of origination of these instruments. 
  4. These receivables are good for risk diversification since these are spread over vast geographical area.
In the Indian scenario, the housing sector is expected to boom. It is estimated that the current five year plan will entail Rs.1,50,000 crore for the sector. Formal sector is expected to contribute nearly Rs.52,000 crore. The remaining needs to be fulfilled through alternative sources. In such a case, securitization can come to the aid. It helps in lowering the cost of providing funds to the housing sector. It may also help in creating strong long term debt market. It is likely that secularization may create about Rs.2,500 crore during this five year plan. 

Asset-Backed Securities (ABS)

Asset Backed Securities (ABS) refers to bonds which are made out of different consumer debts such as car loan home equity or personal loan. Such loans are treated as assets by the financial institutions which extend such credit. These assets may then be sold to a corporation known as trust and these trusts only exist on paper. The sole purpose of such trusts is to issue bonds which use such loans as the backing securities. 
For example, an auto loan may be securitized whereby the loan repayments flow to the trust and then to the investors who purchased the securities backed by such loans.

Collateralized Debt Obligations (CDO) 

Collateralized Debt Obligations are the assets created mainly out of non-mortgage loans. These also include debt obligation. A Collateralized Debt Obligation may also be known as Collateralized Loan Obligation or Collateralized Bond Obligation. However, in such cases, the security consists of only loans or bonds respectively. The credit risk is borne by the investors. The instruments are released in several tranches by CDO. which help in offering different levels of credit risk and maturity terms.

The several categories of tranches are senior, mezzanine and subordinate or equity. Such categorization is made according to the level of credit risk. In case of default or under performance, the senior tranches are given priority for payments. Next priority level is mezzanine and so on. Senior and mezzanine generally have A to AAA ratings and B to BBB ratings respectively. The rating signifies the quality of the underlying asset. It also shows the level of protection provided to the tranche by other tranches lesser to it.

There is a sponsoring organization behind a Collateralised Debt Obligation. Such organization is a special purpose vehicle for holding collateral as well as issue securities. Various institutions such as banks or investment managers may act as sponsors. Expenses of such sponsors are deducted from the payments made to the investors. Such organizations also retain a major portion of subordinate equity tranches. 

Benefits/Advantages of Securitization 

Following are the main benefits of the process of debt securitisation :

1) Benefits to Issuers/Originator : 
Securitisation is helpful to the issuer as it provides a convenient and cost-effective source of funding. It helps in transforming capital intensive assets into capital lean assets. It also generates additional revenue through fees and charges.

i) Diversification and Reduction in Cost of Funding : 
Securitisation helps in diversifying the sources of revenue for the originators. It also helps in reducing cost of funding. For example, issuing corporate bonds entail higher expenses than generating funds through securitisation.

ii) Management of Regulatory Capital : 
Asset securitization may also be used for the purpose of managing risk-based capital requirements. Such concept is popular in developed markets in the United States and Europe. The increased deregulation is also expected to push the use of securitisation as a management tool further.

iii) Generation of Servicing Fee Income : 
Asset Securitisation lets the issuer make the best use of capital intensive assets. It helps in increasing various fees such as origination. fee and servicing fee without any corresponding change in its capital base. This is generally done by securitisation and i then selling the loan. However, the servicing part is retained by the firm itself. The servicing fee is used for providing general services. It is also used for paying the proceeds to the paying agent for the die securitized assets, who is generally also the servicer for the issue. In such cases, the financial institutions may take benefit of securitization as they already possess the required infrastructure.

iv) Management of Interest Rate Volatility : 
Securitisation helps the firms in managing volatility in the interest rates. Adverse change in interest rate may have deep impact on the finances of a financial institution. In such cases, the institutes may securitize the assets which are highly volatile, while the other assets may be retained by the firm for improving its assets and liability position. Thus, in such cases, the financial institutions act both as an issuer as well as an investor.

2) Benefits to Investors : 
Securitisation helps in turning fixed assets into liquid sources of funds. It helps in reducing credit risk as : 
  • These are backed by a vast collection of loans.
  • It leads to credit enhancement, which is a financial tool for reducing the credit risk. 
  • It helps the investors in diversifying their investment avenues. 
  • It also helps in reducing costs of inter-mediation and thus improves the returns.

3) Benefits to Borrowers : 
As a financial or non financial firm may securitize the loans originated by it, the issuer enjoys better liquidity by selling such securitized assets. This helps in meeting his capital requirements. It also helps in reducing the gap between interest. spread accruing from securities such as Treasuries and leading rates. This is prevalent in home mortgage market. Now, the trend is reaching automobile loan segment as well. With the improvement in market, more and more originator may resort to securitisation, leading to lower interest spreads in the market Such transactions have profitable effect and may spread to other markets as well.

Application of Debt Securitization

Following are the main applications of debt securitisation :

Application of Debt Securitisation

1) Creation of Marketable Securities : 
Securitisation technique is useful for creating marketable securities out of the instruments which are not freely trad-able. The main reason behind this transformation is to provide liquidity and transferability. This is especially important for the organizations which have substantial amounts of receivables on their asset side of balance sheet. The main characteristic for an instrument to be suitable for securitization is that it should be repayable over a defined period of time. Such payments should also be certain House mortgages and car leases fulfill these criterion's. In present day, utility companies, insurance companies, aviation sector, etc. is also moving towards securitisation.

2) Identification of Cash flows : 
Securitisation is a process which helps in transforming financial claims into marketable securities. The process entails converting the potential cash flows, present or future claims against third party into tradable securities. Such claims are identified, pooled and then converted into tranches which are sold to the investors.

3) Securitisation of Receivables : 
This is a prime example of the use of concept of securitization. Generally, it is the claim on the issuer which is securitized. For example, the issue of debenture brings about the claim on the issuing company. However, in the case of securitizing receivables, it is the claim on the third-party which is being securitized. Thus, the investor gets the recourse to the debtor of the originator.

4) Funding Alternatives : 
The process of securitisation also involves debtors. This fact adds unique dimension to the process:
  • There is an existence of legal possibility that the claim against a third-party may be transformed into a marketable instrument. The fact is that an entity may create a marketable instrument on a claim on itself. However, the scenario is different when the claims against other parties are converted into trad-able securities.
  • The process lets the issuers have a unique advantage of designing the product which. has the characteristics of its backing asset. The issuer's commitment is not relevant to the securities. Thus, the credit rating of the issuer is not of much importance for such securities.

5) Re-allocation of Risks : 
Securitisation helps in transferring the credit risk to the investors who buy such securities. It further aids the process of letting the originator undertake larger risk by bigger exposure. Securitization also helps in moving the market risk. Such risks are related to interest rate, liquidity or pre-payment. It also reduces the requirement for risk capital, which further helps in better pricing of the backing assets.

6) Balance Sheet Management : 
Securitisation helps in freeing-up the capital belonging to the originator. It also helps in reducing the leverage post-securitised sale as it adds new asset class to the balance sheet. The process of securitization may help in generating matching funds for the balance sheet assets. It further helps in disposing off non-core assets by appropriate structuring.

Mechanism of Debt Securitization/Process of Securitization

The main part of debt securitisation is the creation of a Special Purpose Vehicle (SPV) for inter-mediating between the primary market and the secondary market. The primary market is required for the underlying security while the secondary market is for the newly made asset backed security. Following steps are taken for the purpose of debt securitisation : 

Securitization process steps

1) The lending institution or the originator is required to identify the assets which may be securitized. It should be ensured that there is an optimum mix of securities with homogeneous characteristics such as maturity time.

2) Such pool of specific securities is "passed through" to other entities which are known as Special Purpose Vehicles. These are generally formed as trusts and are entrusted with the task of issuing the securities to the investors. Once such securities are issued, these are no longer kept in the portfolio of the originator.

3) The Special Purpose Vehicle splits such securities into various pools, which are then sold to the investors. Such securities are called pass through certificates or pay through certificates. Such securities do not provide recourse to the originator. Though, the investor may hold Special Purpose Vehicle liable for any default on the payment of principal or interest.

4) The SPV's may undertake additional steps by entering into an insurance policy for making the issue more attractive to the investors. It may also range for a third-party credit facility for covering the delayed payments. The Special Purpose Vehicle may also resort to credit rating to enhance the marketability of the instrument. It helps in imparting liquidity. The confidence of the investors is increased by owning the objectivity of the third party. The pass through certificates are trad-able on secondary markets for confirming the security. The investor may hold the security till its maturity or may trade it to someone else. The end investor holding the security at the time of maturity is entitled to receive redemption value. The above figure shows the clear representation of the process of securitization.

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