Securitisation has been a key factor in the rise of financial services businesses and it poorly managed sub-prime loans distributed across the world through securitisation led to the subprime crisis in 2008. In this article, lets look at the details of securitisation. Securitisation is the process of creating financial securities, that can be traded by the investors. Investment banks are sometimes referred to as Securities houses, as they are responsible for creating and trading of these financial securities by bringing and buyers and sellers together.
Imagine that an Investment Bank could originate 3 loans for example as shown below, $100,000 each, and then issue 2 bonds worth $150,000 each. The monthly interest paid by A, B and C could be distributed to D and E. A, B and C would pay the interest on the mortgage that would be passed on to the D and E as the coupon payment on the bonds purchased by them.
The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply to be to “split it”. For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00% for example (with the remaining .50% going to the servicing company to send out the monthly bills and perform servicing work).
This example depicted above is a simpler example explaining the securitisation process. In reality, this gets divided into several layers. Consider an example in which there are several banks or mortgage houses giving out loans and mortgages, they can pass on all these positions to an Investment Bank who will help securitize these loans by underwriting bonds and selling them to the investors as shown below.
Loans in reality are cash-flow products in which the loan interest acts as a cash flow to the bondholder. Securitization could be applied to individual loans, mortgages, credit card balances, etc. Due to this spreading out mechanism of financing liabilities, it also spread out the risk within the financial and economic system. In fact, it’s because of Securitization that in 2008, it became hard to find out who is going to lose out and by how much during the global credit crisis.
Securitization in Detail
Securitization is defined as a process, which involves pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors. All assets can be securitized as long as they are associated with cash flow. Securitization has evolved since 1980s to become a vital funding source for most parts of the economy.
Investors purchase the securities (bonds as in example above) the performance of the securities is then directly linked to the performance of the assets.
Credit rating agencies rate the securities which are issued in order to provide an external perspective on the liabilities being created and help the investor make a more informed decision.
Servicing: A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid.
Advantages to Issuer
It helps reduce funding costs: This is the key reason to securitize a cash flow and can have tremendous impacts on borrowing costs. Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualify as a sale for accounting purposes, these firms will be able to lessen the equity on their balance sheets while maintaining the “earning power” of the asset. Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does.
Disadvantages to issuer
Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.
Advantages to Investors
Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis) Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be uncorrelated to their other bonds and securities.
Risks to investors
Liquidity risk: Such assets may not be able to be bought and sold in the market at any time.
Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time.
Prepayment/reinvestment/early amortization: The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers.
“Asset securitization began with the structured financing of mortgages in late 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank. After the Second World War, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second in volume only to mortgages, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence. As the result of the credit crunch (defined as sudden freeze in lending provisions by banks) precipitated by the subprime mortgage crisis the market for bonds backed by securitized loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. Thus interest rates are rising for loans that were previously securitized such as home mortgages, student loans, auto loans and commercial mortgages
Market size and liquidity
The total market value of all outstanding U.S. Mortgage Backed Securities at the end of the first quarter of 2006 was approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger than the market value of outstanding asset-backed securities. Securitization has been expanded to cover student loans, credit card receivables etc. This makes the cost of financing cheaper (for students who need loans, credit card holders etc.) and spreads the risk of financing around, as shown in the diagram below.