Securitization

Explained:

servicing agent

servicing fee

servicing rights

securitization

tranch


 
   

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:

auto loans

student loans

mortgages

credit card receivables

lease payments

accounts receivable

corporate or sovereign debt, etc.

 

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 is only one tranch, 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

mortgage-backed securities (MBS), which are backed by mortgages;

asset-backed securities (ABS), which are mostly backed by consumer debt;

collateralized debt obligations (CDO), which are mostly backed by corporate bonds or other corporate debt.

Related Books

       

Related Internal Links

asset-backed security A securitized interest in non-mortgage assets.

bond Securitized debt.

collateralized debt obligation A securitized interest in debt.

collateralized mortgage obligation A type of MBS with cash flows segregated into bonds offering different maturity and risk characteristics.

credit enhancement Any methodology that reduces the credit risk of a transaction with a counterparty.

credit risk Risk due to uncertainty in a counterparty's ability to meet its obligations.

hybrid instrument A financial instrument that blend characteristics of debt and equity markets.

medium-term note A debt security issued through shelf-registration under US law.

mortgage-backed security Securitized interest in a pool of mortgages. CMOs are a type of mortgage-backed security.

off-balance sheet financing Financing that doesn't appear on a firm's balance sheet.

option-adjusted spread Yield spread not attributable to embedded options.

prepayment The early retirement of debt. This article discusses metrics for MBS prepayment, including SMM, CPR and PSA.

security A financial instrument such as a stock or bond.

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copyright © Glyn A. Holton, 2004

Although the information in this website has been presented with care and obtained from sources the author believes to be reliable, there is no guarantee that it is accurate. Such information may be incomplete, condensed, outdated or presented with errors. The content of the website is for information purposes only. It is provided gratuitously, so the author shall not be liable under any theory for any damages suffered by any user. The author does not provide investment advice, and this website is not a vehicle for communicating investment advice.