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Home > Financing Best Practice > Using Securitization as a Corporate Funding Tool

Financing Best Practice

Using Securitization as a Corporate Funding Tool

by Frank J. Fabozzi

Executive Summary

  • Securitization involves the creation of one or more securities backed by a pool of loans or receivables.

  • Securitization is an important vehicle for raising funds that are used by nonfinancial and financial firms.

  • The motivation for the use of securitization rather than the issuance of a secured corporate bond is the potential to reduce funding costs, particularly for firms that have a low credit rating.

  • Another reason for the use of securitization is to manage corporate risk.

  • The securitization process involves the creation of a special-purpose vehicle and the transference of assets to that entity.

  • All securitization transactions require one or more forms of credit enhancement to obtain a credit rating.

Introduction

Securitization is the process of creating securities backed by a pool of loans or receivables. For a corporation, securitization is an alternative fund-raising process to the issuance of secured corporate bonds. The securities issued via the securitization process differ from traditional secured corporate bonds, where it is necessary for the corporate issuer to generate sufficient earnings to repay the bondholders. So, for example, if an equipment manufacturer issues a bond in which the bondholders have a first mortgage lien on one of its plants, the ability of the manufacturer to generate cash flow from all of its operations is required to pay off the bondholders. In contrast, in a securitization transaction, the burden of the source of repayment to those holding the created securities shifts from the cash flow of the corporate issuer to the cash flow of a pool of loans or receivables, and/or to a third party that guarantees the payments if the asset pool does not generate sufficient cash flow.

Although securitization was first used in the late 1960s by US government entities to create mortgage-backed securities, it was not used by nonfinancial corporations (i.e., corporations whose principal activity is the production of goods and nonfinancial services) to raise funds in the public market until March 1985 when Sperry Lease Finance Corporation (now Unisys) issued securities backed by a pool of lease receivables. Despite a major setback in the securitization market due to problems with one asset class—residential mortgage-backed securities backed by subprime borrowers—securitization continues to be an important funding alternative for nonfinancial corporations.

Types of Assets Securitized

The types of assets that have been securitized can be divided into four general categories: Mortgage loans, retail loans, wholesale loans, and operating revenue.

The securities created by securitization of a pool of mortgage loans are referred to as mortgage-backed securities (MBS). Those backed by a pool of high-quality residential mortgage loans are called residential mortgage-backed securities, and those backed by a pool of commercial loans (i.e., mortgage loans for income-producing properties such as apartment buildings, office buildings, and shopping centers) are called commercial mortgage-backed securities. These securitized products are typically used as funding vehicles for financial entities such as depository institutions (banks and savings and loan associations) and finance companies. For nonfinancial entities the bulk of securitizations use account receivables.

When securities are backed by a pool of retail loans, they are referred to as asset-backed securities (ABS). The major types of retail loans securitized include credit card receivables, home equity loans, automobile loans, and student loans. In fact, the largest sector of the asset-backed securities market is the mortgage-related asset-backed securities market, the sector that saw a major meltdown starting in the summer of 2007. The wholesale market includes commercial loans and bonds. The security created from the securitization of these types of debt instruments is called a collateralized debt obligation. Finally, a special area which has been used primarily in Europe is the securitization of operating revenue.

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Further reading

Books:

  • Davidson, Andrew, Anthony Sanders, Lan-Ling Wolff, and Anne Ching. Securitization: Structuring and Investment Analysis. Hoboken, NJ: Wiley, 2003.
  • Fabozzi, Frank J. (ed). Issuer Perspectives on Securitization. Hoboken, NJ: Wiley, 1999.
  • Fabozzi, Frank J. (ed). Accessing Capital Markets through Securitization. Hoboken, NJ: Wiley, 2001.
  • Fabozzi, Frank J., and Vinod Kothari. Introduction to Securitization. Hoboken, NJ: Wiley, 2008.
  • Kothari, Vinod. Securitization: The Financial Instrument of the Future. 3rd ed. Hoboken, NJ: Wiley, 2006.
  • Peaslee, James E., and David Z. Nirenberg. Federal Income Taxation of Securitization Transactions. 3rd ed. New Hope, PA: Frank J. Fabozzi Associates, 2001.

Articles:

  • Fabozzi, Frank J., and Vinod Kothari. “Securitization: The tool of financial transformation.” Journal of Financial Transformation 20 (2007): 33–45. Online at: tinyurl.com/3ahfwdv [PDF].
  • Roever, W. Alexander, and Frank J. Fabozzi. “A primer on securitization.” Journal of Structured Finance 9:2 (Summer 2003): 5–19. Online at: dx.doi.org/10.3905/jsf.2003.320307

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