What is Securitization?
Securitization refers to the process of turning assets into securities – financial instruments that can be readily bought and sold in financial markets, the way stocks, bonds and futures contracts are traded.
When used in relation to real estate, securitization means taking mortgages issued by banks and other lenders and converting them into securities that can be sold to investors.
In other words, securitization deals with the conversion of assets which are not marketable into marketable ones. For the purpose of distinction, the conversion of existing assets into marketable securities is known as asset-backed securitization and the conversion of future cash flows into marketable securities is known as future-flows securitization.
Some of the assets that can be securitized are loans like car loans, housing loans, etc. and future cash flows like ticket sales, credit card payments, car rentals or any other form of future receivables.
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The process leads to the creation of financial instruments that represent an ownership interest in or are secured by a segregated income-producing asset or pool of assets. The pool of assets collateralizes securities.
These assets are generally secured by personal or real property (e.g. automobiles, real estate, or equipment loans), but in some cases are unsecured (e.g. credit card debt, consumer loans).
While securitization means different things to different people, it is worth considering the basic concept, at the same time realizing that structures can differ greatly in detail.
Two definitions, as good as any, are:
- Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors;
- Securitization is the unbundling of risk and the packaging of cash flows to fit investor’s preferences in respect of yield, maturity, liquidity and risk.
Investors buy the repackaged assets in the form of securities, which are collateralised (secured) by the underlying pool and its associated income stream.
Securitization generally involves the creation of a homogeneous pool of assets, which are often retail assets such as car loans, mortgage loans or trade receivables, but which can also be corporate loans or commercial real estate loans.
Need for Securitization
The motivating force behind securitisation has been the need for banks and others financial institutions to realise value from the assets on their balance sheet. Typically these assets are residential mortgages, corporate loans, and retail loans such as credit card debt.
There are many reasons why firms go for securitizations. These are as follows:
- Additional Funds Requirements: Banks and other financial institutions need additional funds for lending and investment purpose. Securitisation is another mode of financing. By securitizations of its debts, banks and financial institution is able to transform its assets (loans) into marketable securities like bonds and notes. Using securitization, bank is able to raise capital from the capital markets.
- To obtain cheaper funding: Frequently the interest payable on Assets Backed Securities (ABS) is considerably below the level payable on the underlying loans. This creates a cash surplus for the originating entity (Bank/FI).
- Capital adequacy requirement: The capital adequacy requirements for banks in the recent past have urged banks to securitise their assets. Through securitization, the level of capital required to support the balance sheet are reduced to a large extent, which again can lead to cost savings or allows the banks/ FIs to allocate the capital to other perhaps more profitable, business.
By taking off the assets side of the balance sheet through securitization, there is proportionate reduction in the capital required to be maintained on the liabilities side. This is also called ‘capital relief’.
- Enhanced Liquidity: The rationale of securitization also lies in the fact that the banks and financial institutions wants to leverage their strength of well- performing loan portfolio to raise additional resources.
Through securitization, otherwise illiquid, long- term assets (such as home loans, car loans) is converted into easily marketable securities in form of bonds, notes etc.
For example, home loans granted by a bank have long term maturity (20-30 years) and bank has to wait for long period to realise the principal amount and the interest. Securitization helps the bank to avoid such a long and provide immediate funds.
Advantages of Securitization
There are many advantages associated with securitization. Some of the advantages of securitization have been explained in the need for securitization section.
The various advantages of securitization as explained below:
Benefits for Originator
Securitization provides issuers or originators generally banks/FIs with an alternative to traditional on-balance sheet lending. It allows them to convert previously illiquid assets into liquid assets and to expand the volume of their business without a corresponding increase in their equity capital.
Additionally, securitization can offer the following benefits to issuers:
- Off Balance-sheet financing: Securitization can be a useful tool for balance sheet management. When a company’s liabilities have a different maturity than its assets, i.e. in case of “duration” mismatch, the company can greatly suffer from an interest rate change.
As a matter of fact, a rise in the cost of funds, not immediately compensated by an increasing return on assets causes the interest margin to come under pressure. By securitizing certain assets, the company can reduce this risk.
- Risk management: A securitization is also a useful tool for risk management, since (part of) the credit, liquidity, interest rate and maturity risk can be transferred to the investors through different structural mechanisms.
- Improved performance: Securitization can positively impact performance ratio’s, such as return-on-equity and return-on-assets. Indeed, securitization creates a leverage effect since the proceeds of the asset-backed issue can be used for new opportunities (e.g. to finance internal or external growth) without increasing the capital base. As a result, securitization is not a mere funding instrument, but can also enhance the company’s performance.
- Alternate funding: Securitization offers institutions a new way to attract alternative funding and diverse it’s financing schedules. Since the asset-backed securities are mostly placed with institutional investors and additionally attract new investors, the more conventional funding methods are safeguarded.
- Recycling of funds: The originator recycles the funds effectively through securitization. Through securitization, banks are enabled to extend large volume of loans. It helps the banks to increase their asset turnover.
- Reduced borrowing costs: Since the securitised securities are rated by rating agency, the originator is able to sell these securities at a reduced interest rate. This gives the benefit of borrowing at reduced rate.
Benefits for Investors
Investors can benefit from the securitization process in a number of ways:
- High return: Asset-backed securities (ABS) and mortgage-backed securities (MBS) typically offer a yield premium over comparably rated government, bank or corporate bonds. This yield premium is related to the more complex structure in general and some specific risk elements in particular.
- Wider Investment Avenues: Asset-backed and mortgage-backed securities offer a broad range of investment opportunities, as pools of assets are repackaged and divided into separate tranches or parts with specific maturity and risk (based on credit rating) profiles.
- The packaging of assets provides investors with the opportunity to participate in a particular market, while being protected against event risk and rating downgrade due to their multiple layers of credit enhancement.