Business, Legal & Accounting Glossary
The process of pooling assets and selling interests in the pool to investors.
In simple terms, securitization is a type of structured process pertaining to finance in which risks is distributed. The way this is handled is by aggregating debt within a pool. From there, new securities that are backed by the pool are issued. When looking at the term “securitization”, it is derived from the understanding that the type of financial instruments needed to obtain funds from investors is “securities”.
For instance, if a portfolio had risk backed by cash flows that had amortized then the quality of the securitized debt from a credit standpoint would be non-stationary because of volatile, time/structure-dependent changes. Keep in mind that this portfolio risk is not the same as what you would see with a standard kind of corporate debt. Now in this case, if the transaction is structured correctly, and if the pool is able to perform as needed, credit risk for all aspects of the structured debt would see improvement.
On the other hand, with securitization, if the transaction were not structured correctly, then all aspects of the structured debt would deteriorate from a credit standpoint significantly, as well as experience incredible loss. However, it is possible for all assets to be securitized but only if they are connected with cash flow. This means in summary, securitization results in securities. Sometimes, this process is also called “asset-backed securities” or “ABS”, which means the same thing – securitization is a process used within the financial world that ultimately leads to a situation of “asset-backed securities”.
Usually, when you hear of securitization, you would find that it often uses what is termed an SPV or “special purpose vehicle” or as some people call it, and SPE or “special purpose entity”, or SPC, “special purpose company”. In this case, the risk of bankruptcy is greatly reduced. In addition, securitization will lead to lower interest rates being secured from different and potential lenders. Sometimes, a credit derivative would be used to help alter the quality of the credit for the portfolio, making it more compelling and acceptable to investors.
Interestingly, securitization actually got started during the latter part of the 1970s. At that time, it was used primarily as a key funding source. In fact, securitization is said to have an outstanding balance within the United States of $10 trillion and in Europe, specific to 2007 and 2008 second quarter, $2.25 trillion. This means that asset-backed securities have reached more than $3.4 billion within the United States and $652 billion in Europe.
In its basic structure, securitization is a method used for financing assets. In other words, instead of selling assets as a “whole”, the assets are added into a pool, which is then split into shares. Next, investors would purchase the shares, which means they would take some responsibility for the risk, but also reward from the way in which the assets perform. The deals associated with securitization vary, which some being a third-party guarantor. In this case, this individual or corporation would guarantee in whole, or in part the assets for a fee, as well as the principal and any interest payments.
A securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a financing company that has issued a large number of auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing loans, but there isn’t a liquid secondary market for individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the pool to investors. For the financing company, this raises capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a diversified pool of auto loans, which may be an attractive alternative to a corporate bond or other fixed-income investment. The ultimate debtors—the car owners—need not be aware of the transaction. They continue making payments on their loans, but now those payments flow to the new investors as opposed to the financing company.
All sorts of assets are securitized:
Assets are often called collateral.
In a typical arrangement, the owner—or “originator”—of assets sells those assets to a special purpose vehicle (SPV). This may be a corporation, US-style trust, or some form of partnership. It is established specifically to facilitate the securitization. It may hold the assets—collateral—on its balance sheet or place them in a separate trust. In either case, it sells bonds to investors. It uses the proceeds from those bond sales to pay the originator for the assets.
Most collateral requires the performance of ongoing servicing activities. With credit card receivables, monthly bills must be sent out to credit card holders; payments must be deposited, and account balances must be updated. Similar servicing must be performed with auto loans, mortgages, accounts receivable, etc. Usually, the originator is already performing servicing at the time of a securitization, and it continues to do so after the assets have been securitized. It receives a small, ongoing servicing fee for doing so. Because of that fee income, servicing rights are valuable. The originator may sell servicing rights to a third party. Whoever actually performs servicing is called the servicing agent.
Cash flows from the assets—minus the servicing fees—flow through the SPV to bond holders. In some cases, there are different classes of bonds, which participate differently in the asset cash flows. In this case, the different bonds are called tranches. If the securitization is structured as a pass-through, there are not tranches, and all investors participate proportionately in the net cash flows from the assets.
When assets are transferred from the originator to the SPV, it is critical that this be done as a legal sale. If the originator retained some claim on those assets, there would be a risk that creditors of the originator might try to seize the assets in a bankruptcy proceeding. If a securitization is correctly implemented, investors face no credit risk from the originator. They also face no credit risk from the SPV, which serves merely as a conduit for cash flows. Whatever cash flows the SPV receives from the collateral are passed along to investors and whatever party is providing servicing.
Collateral will typically pose credit risk. For example, people may fail to make their credit card payments, so credit card receivables entail credit risk. This can be addressed with some sort of credit enhancement such as over-collateralization or a third party guarantee. Tranching is also widely used to allocate credit risk among investors.
Credit ratings are often obtained for securitizations that entail credit risk, and most ratings are investment grade. If a securitization has different tranches, each may receive a different credit rating.
With a securitization, the party underwriting credit risks is not the party taking that credit risk. This opens the door to various abuses. Such abuses, especially with regard to securitizations of subprime residential mortgages, were a primary cause of the 2008 financial crisis.
Standard categories of securitizations are
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This glossary post was last updated: 30th December, 2021 | 0 Views.