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
of auto loans, which may be an attractive alternative to a
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
All sorts of assets are securitized:
sovereign debt, etc.
Assets are often called
In a typical arrangement, the owner—or "originator"—of assets sells those
assets to a special
purpose vehicle (SPV). This may be a
trust, or some form of partnership. It is established
specifically to facilitate the securitization. It may hold the
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
bonds are often called tranches. If the
securitization is structured as a
pass-through, there is only one class of bonds, and all investors participate proportionately in the
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
Depending on the nature of the collateral, it may or may not
pose credit risk. For example, people may fail to make their credit card
payments, so credit card receivables entail credit risk. On the other hand, many
mortgage-backed securities in the
United states have little or no credit risk.
Ginnie Mae guarantees timely payment of
interest on its mortgage pass-throughs.
Ginnie Mae is backed by the full faith and credit of the US government, so the
pass-throughs are free of credit risk.
If collateral entails credit risk, a securitization will often be structured
with some sort of credit enhancement.
This may include over-collateralization, a third party guarantee,
or other enhancements. Also, by their nature, securitizations diversify the
default risk of the underlying assets.
Credit ratings are
often obtained for those securitizations that entail credit risk, and most
investment grade. If a securitization has different classes of bonds, each
may receive a different credit rating. Credit ratings can be misleading for
novices. The fact that a securitization has a AAA rating doesn't mean it is risk
free. It only means that the chance of a bond holder incurring a loss
attributable to default on the underlying assets is remote. Other risks, which
can affect the timing of payments, may be considerable. Also, because valuing
the underlying assets is often difficult, there is a risk that an investor will
overpay for a securitization the investor is ill-equipped to value on its own.
Standard categories of securitizations are
securities (MBS), which are backed by mortgages;
securities (ABS), which are mostly backed by consumer debt;
debt obligations (CDO), which are mostly backed by corporate bonds or other
Each segment of the market offers unique opportunities and
risks, reflecting the nature of the underlying assets and market conventions
that have evolved over time.