Securitisation Meaning, Nature, Mechanism, Benefits, Issues

Table of Contents:-

  • What is Securitisation?
  • Meaning of Securitisation
  • Nature of Securitisation
  • Parties Involved in Securitisation
  • Mechanism of Securitisation
  • Benefits of Securitisation
  • Issues in Securitisation

What is Securitisation?

Securitisation is a well-established practice in the global debt capital market, involving the sale of income-generating assets from the owning institution to a specifically established company. This secondary entity issues notes, with their value secured by the cash flows generated from the original assets. Introduced initially as a funding method for mortgage banks in the United States, the inaugural transaction is widely acknowledged to have been initiated by Salomon Brothers in 1979. Over time, this technique expanded beyond mortgage assets and found application in diverse sectors, including credit card payments and leasing receivables, gaining widespread adoption on a global scale. Furthermore, securitisation has been employed as an integral component of asset-liability management to mitigate balance sheet risks effectively.

Meaning of Securitisation

Securitisation involves converting individuals’ existing or future cash inflows into tradable securities, which can then be sold in the market. The cash inflow from financial assets such as mortgage loans, automobile loans, trade receivables, credit card receivables, and fare collections becomes the security against which borrowings are raised. Even individuals can use securitisation instruments for better economic efficiency. Since the illiquid financial assets or debtors are converted into securities through securitization, it can also be called ‘Debt or Asset Securitisation.’

According to Oxford Dictionary, “Securitisation means to convert an asset (specially a loan) into marketable securities for the purpose of raising cash or funds”.

Thus, the process of Securitisation involves ‘pooling of assets and selling these to investors through a specialized intermediary created for this purpose”.

Examples of Securitisation of Debt

1) City Bank carved out car loan portfolios to ICICI Bank.

2) The Housing and Urban Dev Corporation Ltd., (HUDCO) which finances infrastructure finance, wanted to securitize its future receivables.

Nature of Securitisation

The following are the nature of securitisation:

1) Merchantable Quality

To be market-acceptable, a securitized product should be of saleable quality. In the case of physical goods, this concept is acceptable to merchants in regular trade. When applied to financial products, it would mean that the financial commitments embodied in the instruments are secured to the satisfaction of the investors.

2) Homogeneity

To serve as a marketable instrument, the instrument should be packaged into homogenous lots. Most securitized instruments are broken into affordable lots to the marginal investor; hence, the minimum denomination becomes relative to the needs of the minor investor.

3) Marketability

The very objective of securitisation is to provide marketability to financial shares. Hence, the instrument is structured to be marketable. This is one of the most important features of a securitized instrument and the others that follow are mostly imported only to ensure this feature.

4) Integration and Differentiation

Securitisation is the process of integration and differentiation where the entity that securitizes its assets first pools them together into a common hotchpot (assuming it is not one asset but several assets, as is usually the case). This is the process of integration. Then, the pool itself is broken into instruments of fixed denomination. This is the process of differentiation.

5) Wide Distribution

The primary objective of securitisation is to distribute the product. The scope of distribution that the originator would like to achieve is based on a comparative analysis of the costs and the benefits that can be achieved.

6) De-construction

Securitisation is the process of de-construction of an entity wherein, if one envisages an entity’s assets as being composed of claims to various cash flows, the process of securitisation would split apart these cash flows into different buckets, classify them and sell these classified parts to different investors according to their needs. Thus, securitisation breaks the entity into various subsets.

7) Commoditization

Securitisation is the process of commoditization, where the fundamental idea is to take the result of this process into the capital market. Thus, the development of every securitisation process, whatever the area to which it is applied, is to create specific instruments that can be placed in the market.

Parties Involved in Securitisation

The parties involved in the securitisation include the following:

1) Originator

The Originator – also interchangeably referred to as the Seller is the entity whose receivable portfolio forms the basis for Asset-Backed Security (ABS) issuance.

2) Special Purpose Vehicle (SPV)

A special purpose entity (SPE), more often called a special purpose vehicle (SPV), is created to carry out a specific business purpose or activity. SPVs are frequently used in structured finance transactions, such as asset joint venture and securitizations, or to isolate certain company assets or operations. SPVs can be created through a variety of entities, such as trusts, corporations, limited partnerships, and limited liability corporations. SPVs are used by many companies for an array of financing purposes. The Special Purpose Vehicle (SPV), the issuer of the ABS, ensures sufficient separation of the instrument from the originator. The entity that intermediates between the originator of the receivables and the end-investors is known as a ‘Special Purpose Vehicle’.

3) Investors

The investors may be Individuals or institutional investors like FLS, mutual funds, etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per the agreed pattern.

4) Other Parties

Other parties include:

i) Obligor: The obligor is the debtor of the originator, referring to the borrower of the original loan.

ii) Servicer: The servicer, who bears all administrative responsibilities relating to the securitisation transaction.

iii) Trustee: The Trustee or the Investor Representative, who acts in a fiduciary capacity safeguarding the interests of investors in the ABS.

iv) Credit Rating Agency: The Credit Rating Agency, which provides an objective estimate of the credit risk in the securitisation transaction by assigning a well-defined credit rating.

v) Regulators: The Regulators, those principal concerns relate to capital adequacy, liquidity, and credit quality of the ABS, and balance sheet treatment of the transaction.

vi) Service Providers: Service providers such as Credit Enhancers and Liquidity Providers, and,

vii) Specialist Functionaries: Specialist functionaries such as legal and tax counsels, accounting firms, pool auditors, etc.

Mechanism of Securitisation

The crucial link in the securitisation chain is the creation of a special purpose vehicle (SPV), which intermediates between the primary market for the underlying asset and the secondary market for the asset-backed security. The steps involved in the securitisation process are the following:

1) The originator or lending institution identifies the assets out of its portfolio for securitization. The identification of the assets has to be done in a manner so that an optimum mix of homogeneous assets having almost the same maturity forms the portfolio.

2) The a fore mentioned pool of identified assets is then “passed through” to another institution, called a special purpose vehicle (SPV) usually by way of a trust. Such a trust, which is usually an investment banker, issues the securities to investors. So once the assets are transferred, they are no longer held in the originator’s portfolio,

3) After the acquisition of the assets, the SPV splits the pool into individual shares or securities and reimburses itself by selling these to investors. These securities are known as pay or pass-through certificates. These securities are normally without recourse to the originator. Thus, investors can hold only “SPV liable for principal repayment and interest recovery.

4) To make the issue attractive, the SPV enters into credit enhancement procedures either by obtaining an insurance policy to cover the credit losses or by arranging a credit facility from a third-party lender to cover the delayed payments. To increase the marketability of the securitized assets in the form of securities, these may be rated by some reputed credit rating agencies.

Credit rating increases the trading potential of the certificate; thus, its liquidity is enhanced. The investor’s confidence is heightened owing to the third-party objectivity of the rating agencies. The pass-through certificates before maturity are tradeable in a secondary market to ensure liquidity for the investors.

Once the end investor gets hold of these instruments created out of securitization, he will hold them for a specific maturity period, well-defined with all other related terms and conditions. On maturity, the end investors get a redemption amount from the issuer along with interest due on the amount. The image given below gives the diagrammatic representation of the process of securitization.

Benefits of Securitisation

The following are the benefits of securitisation:

1) Benefits to Issuers/Originators

Given the current and potential growth of securitisation globally, it is important to understand the reasons for the proliferation of this innovative technology. From the issuer’s perspective, securitisation offers several advantages, such as the creation of alternative and often cheaper funding sources, conversion of capital-intensive assets to capital-economizing assets, generation of servicing fee income, and, in certain instances, reduced exposure to interest rate volatility.

i) Diversification and Reduced Cost of Funding

The securitisation of assets enables originators of assets to broaden finding sources and often reduce funding costs. Corporate issuers may find it more cost-effective to raise funds via asset securitisation rather than offering a typical corporate bond.

ii) Management of Regulatory Capital

Asset securitisation can be used as a tool to manage risk-based capital requirements, this is an issue that directly affects the US, financial institutions such as thrifts,  banks, and insurance companies. However, the concept of using asset securitisation as a means of attaining optimal capital adequacy standards is aho of direct relevance to European financial institutions, for which increased competition due to deregulation and changing regulatory and environmental trends indicates an increased interest in asset securitisation in the context of asset/liability  management.

iii) Generation of Servicing Fee Income

Asset securitisation allows the issuer to convert capital-intensive assets to a less-capital-intensive source of servicing fee income, thereby increasing its servicing and origination fees without increasing its capital base.

This is done by securitizing and selling the loans while retaining the servicing. The servicing fee that is retained compensates the servicer for providing the normal clerical, computational, and collection functions involved in receiving payments from borrowers and remitting the proceeds to the paying agent for die securitized assets. The issuer of the die asset-backed structure is usually also the servicer for the issue. In this respect, financial institutions such as banks, thrifts, and finance companies that are also originators of assets are uniquely positioned to take advantage of the growth of securitisation since the infrastructure of these institutions includes the human and technical resources required to service assets.

iv) Management of Interest Rate Volatility

Financial institutions are exposed to interest rate risk – the risk that a change in interest rates will hurt the financial institution. Concerning the management of interest rate volatility, the securitisation of assets fulfils a dual role. The dual role stems from the fact that the institution can securitize assets that expose the institution to higher interest rate risk and retain certain customized parts of the asset securitisation transaction to attain an improved asset/liability position. In this respect, the financial institution serves the dual role of investor and issuer.

2) Benefits to Investors

Securitisation converts illiquid loans into securities with greater liquidity and reduced credit risk. Credit risk is reduced because:

i) It is backed by a diversified pool of loans, and

ii) There is credit enhancement.

Credit enhancement is a financial device to reduce the credit risk associated with loans. This allows investors to expand their universe of investment opportunities. It also tends to improve returns through the reduction of the cost of intermediation.

3) Benefits to Borrowers

Because a financial or non-financial entity can securitize a loan it originates, or sell it to some entity that will securitize it, the lender now has a more liquid asset that it can sell if capital is needed. This should lower the spread between safe assets and lending rates such as treasury securities. We have observed this phenomenon in the mortgage market and, to some extent, in the automobile loan market. As the market matures, competition among originators should produce lower lending rate spreads in other loan markets.

Issues in Securitisation

The use of securitisation as a viable financial services has the following issues:

1) Debility (Incapability) to Central Bank

The securitisation process may lead to a diminishing of the importance of banks in the financial intermediation process, by causing a reduction in the proportion of financial assets and liabilities held by banks. This would in turn render more difficult, the execution of the 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.

2) Heightened Volatility

The transformation of non-liquid loans into liquid securities, facilitated by the process of securitization, 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 predominance of assets, with readily ascertainable market values, could, even in certain circumstances, promote liquidation, as opposed to the going-concern concept for valuing banks.

3) Pressure on Profitability

The securitisation process might lead to some pressure on the profitability of banks if non-banking financial institutions, exempt from capital requirements, were to gain a competitive advantage in investment in securitized assets.

4) Eroding Capital Base

Securitisation 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. However, a smaller capital base will entail larger losses to be shared by fewer.

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