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Home > Financing Best Practice > Securitization: Understanding the Risks and Rewards

Financing Best Practice

Securitization: Understanding the Risks and Rewards

by Tarun Sabarwal

Executive Summary

Securitization creates value for organizations, investors, and consumers:

  • It separates the funding of receivables from their origination and servicing, and allows origination and servicing revenues to grow without additional balance sheet financing.

  • It provides cash flow and balance sheet management benefits.

  • It allows for targeted asset liquidation, improvements in asset liquidity, and access to capital markets at rates different from enterprise credit ratings.

  • The flexibility in transforming risks permits mutually beneficial matches in targeted market opportunities, both for organizations and investors.

  • Deeper capital markets allow for price discovery of illiquid assets, greater access to funds for new firms and consumers, and greater financial innovation.

Securitization creates risks of moral hazard and lack of transparency:

  • Separation of funding from origination can create moral hazard, generating higher-than-expected risks and leading to conflicts between investors, firm shareholders, and firm creditors.

  • Complexity of structural transformations creates lack of transparency, which, in turn, can lead to greater illiquidity and possible market failure. These effects are worse in globally inter-connected markets.

Introduction

In broad terms, securitization can be viewed as pooling receivables and selling claims to these receivables in capital markets. For example, a mortgage lender may pool together thousands of mortgages and sell claims on mortgage receivables to investors. Historically, the first securitizations in the 1970s in the United States were those of pools of mortgages. With the success of mortgage-backed securities, other groups of receivables were securitized as well, including auto loan receivables, credit card receivables, and home equity receivables.

Although a majority of securitizations are of receivables on consumer debt1 (whether mortgage or nonmortgage), in principle, any cash flow receivable can potentially be securitized. There are several so-called “exotic” securitizations—for example, securitization of mutual fund fees, movie revenues, tobacco settlement fees, and even music royalties. Moreover, student loans, manufactured housing loans, equipment leases, and commercial mortgages are also securitized.

Securitization Basics

Securitized products have some common characteristics.2 They typically involve an originator of receivables who forms a pool of receivables that is then sold to a special-purpose entity. This entity in turn issues securities backed by a beneficial interest in the receivables. For a successful securitization, it is important to understand this process in detail.

The originator of receivables identifies a pool of receivables to be securitized. For example, a mortgage lender identifies which loans will form a particular pool for a securitization. As borrower and loan characteristics affect receivables and losses on a loan, the credit quality of the receivable pool is affected by its loan quality.

The originator transfers the receivable pool to a special-purpose entity (SPE), typically a type of trust. Accounting rules govern the balance sheet treatment of such a transfer. For example, if this transfer is classified as a sale, an originator can remove these receivables from its balance sheet, but in the case of a financing, it cannot do so. Moreover, for a transfer of receivables to be a true sale, the ownership of these assets should be separated from the transferor to the extent that in the case of the transferor’s bankruptcy, the transferor’s creditors should not be able to access these receivables and jeopardize the beneficial interest of the investors in the securities.3

The SPE issues securities backed by the collateral of receivables in the pool. Different securities (or tranches) issued on the same collateral pool may have very different risk characteristics, depending on how pool receivables are allocated to securities and depending on credit enhancements. For example, a senior tranche may have first access to pool receivables as compared to a junior or subordinate tranche, and therefore, the senior tranche would have a relatively lower risk. Similarly, a credit enhancement, such as third-party insurance of promised cash flows, lowers the credit risk of the security. Therefore, depending on the structure of the transaction, securities issued on the same collateral pool may carry different credit ratings. Over time, securitization structures have evolved in complex ways to take advantage of diverse demands by investors.4

The differential risks of these securities may change over the life of the securities. For example, credit risk for issued securities depends on the performance of the underlying collateral pool and on credit enhancements, both of which may vary over time. Important factors affecting pool performance include a lender’s underwriting criteria (such as credit score of the borrower, credit history, down payment, loan-to-value ratio, and debt service coverage ratio), economic variables (such as unemployment, economic slowdown, and bankruptcies), and loan seasoning (payment patterns over the age of loans). Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security to achieve a higher credit rating, lower protection can help to create new securities with differently desired risks, and these differential protections can help to place a security on more attractive terms. Violation of credit enhancements can trigger an “early amortization” event, which starts prepayments on securities using available SPE resources.

Therefore, pool performance evaluation, security cash flow allocation, and servicing of receivables continue on an ongoing basis. In particular, bond rating agencies assign a credit rating to each security issued by the SPE, and they evaluate this rating periodically. Moreover, for publicly issued securities, periodic financial reports are filed with regulatory agencies. The originator of receivables typically continues to service the receivables (i.e., collect payments on the receivables, manage delinquent accounts, and so on) for a fee.

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Further reading

Book:

  • Fabozzi, Frank (ed). The Handbook of Fixed Income Securities. 7th ed. New York: McGraw Hill, 2006.

Reports:

  • The Bond Market Association and the American Securitization Forum. “An analysis and description of pricing and information sources in the securitized and structured finance markets.” October 2006. Online at: tinyurl.com/38s5g6n [PDF].
  • European Securitisation Forum. “ESF securitisation data report.” Online at www.europeansecuritisation.com/dynamic.aspx?id=194

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