Securitization: An Overview
Securitization is a powerful financial tool that renders possible the profitability of illiquid assets. We all agree that securitization contributed to the 2008 Financial Crisis, demonstrating how this powerful business instrument is a double-edged sword: it is capable of both boosting and devastating an economy. The United States also commonly known as an unchallenged leader in securitization markets. However, much of the current activity is happening in the Middle East, including the United Arab Emirates, where the new wave of securitization markets is emerging.
Through this financial process, several illiquid assets are packaged into pools and transformed into securities. The third-party investors in a secondary market then purchase these securities or their related cash flows. In other words, the security interests in the pool are sold to investors. The process enables the conversion of an asset or a group of assets into marketable security. In this article, I aim to offer a comprehensive explanation of the nature of the underlying holdings of securitization, the function of Special Purpose Vehicles, regulatory responses to securitization after the financial crisis, and the impact the economic process has had on different markets.
An example of an illiquid asset is a debt instrument, which the originator (such as a bank) executes with numerous obligors (such as individuals who have a mortgage with the bank). These assets, which are into pools, can be various types of contractual debt (generally home equity mortgages) such as residential mortgages, commercial mortgages, auto loans, credit card debt obligations (or other non-debt assets which generate receivables). We combine these assets with other homogeneous assets, such as other mortgages issued on significantly similar terms, to form a pool. Then, they transfer it to trust or the Special purpose vehicle (SPV) which is the securitization vehicle. The company will sell the security interests to investors. They give the funds so raised to the Intermediary or Originator in consideration for the transfer of the assets.
It is important to note that the vast array of asset varieties and the creation of liquidity for an illiquid asset makes securitization a powerful and practical financial tool. Furthermore, a pool of securities can be divided and sold to different investors based on the risk level these investors wish to adopt. If they are willing to take on the risk of mortgages that may or may not be paid off, then they will purchase the higher risk part of the pool. If they are not willing to take on such risk, they will buy the lower risk part of the lake. Regarding value, mortgage-backed securities (MBS) dominate the global market, while asset-backed securities (ABS) feature steady growth rates.
Benefits of Securitization
The securitization process offers many essential benefits to participants. In this vein, it allows the originator to do the following things:
- It will enable the transformation of an illiquid asset into a liquid financial instrument, thus setting up future revenue.
- It enables borrowing at a better rate given that the risk premium demanded by the investor is proportionate with the underlying pool of assets.
- It improves balance sheet management with reduced leverage and gearing ratios by removing risky assets from its balance. It permits the use of capital to support loan writing and investment.
- The prepayment risk of the underlying assets is after that on the investor.
- It eliminates exposure to credit risk or the administration of the asset.
- The originator gains access to a broader banking/investor base in the financial markets.
Securitization will benefit the investor in the following ways:
- It enables the securities to obtain excellent credit ratings given that deals can entail credit enhancements.
- The yields offered by securities exceed those on comparable corporate bonds.
- The securities are liquid.
- It is an investment in a diversified pool. Investors will prefer to hold a portion of a pool of risky assets than a single risky asset.
I. Mortgage and Asset-Backed Securities (MBS)
Categorically, the division of assets is in two categories being mortgage-backed securities and asset-backed securities. The form of a securitization backed by mortgages is called mortgage-backed securities. It comprises three central types:
- mortgage pass-through securities
- stripped MBS
- collateralized mortgage obligations (CMO)
The fixes or floating rate mortgages sponsor these securities. An investor will purchase shares in a pool of mortgages, and receive a cash flow which basis on the features of the underlying mortgages such as principal amount, interest and payments made before the lease.
Moreover, a stripped MBS is derivative mortgage security. The division of principal amount and interest is so segregated in such a way that the price of each investor is different from the other. There is a possibility of a stripped MBS which the companies structure in a way that there is an interest-only investor class and a principal-only investor class.
Lastly, in a CMO, whole mortgages funded by debt issued in different tranches are purchased by the securitization vehicle. After that, there is a redistribution of Cash flows from the assets to different tranches. The principal and interest received by the securitization vehicle are used to pay attention to each branch. It creates different risk/yield relationships between investor classes by taking the mortgage (a single class instrument) and creating multi-class instruments. This type of mortgage-backed securities has developed immensely and has been the subject of considerable levels of financial re-engineering.
II. Asset-backed Securitizations (ABS)
Asset-backed securities are securitizations backed by non-mortgage assets. These include (but are not limited to) the following:
- automobile loans and leases
- credit and department store charge card
- computer and other equipment leases
- accounts receivables
- legal settlements
- small business loans
- student loans
- home equity loans and lines of credit
- boat loans
- franchise loans
- timeshare property loans
- real estate rentals
- whole business securitizations
Another vital perspective to consider to understand the securitization structure is the idea of credit enhancement. It is the way or strategy to enhance the procedure for assessment of a securitization exchange, as recommended by a credit rating agency keeping in mind the end goal to draw in financial investors for investing in these assets.
Special Purpose Vehicles (SPV)
SPV are subsidiary companies of a parent company, who provide an alternative mode of financing transactions. Given that there is the complete protection of assets from the actions of their parent company, they curb the financial risk to the property of the SPC. These vehicles play an indispensable role in the operation of global financial markets. The allow investors and businesses to raise capital, securitize assets, share risk, reduce tax and carry out activities without any chance (or at least not as significant a threat as would usually be the case). SPCs provide limited liability for shareholders, they can choose to operate on separate balance sheets than their companies (“off-balance sheets”), and they serve on these free balance sheets instead of recording transactions in the name of their parent companies. Following are the commonly used SPVs for the operations:
- Securing projects from financial, commercial or operational failures
- Securitizing Loans and Receivables. For instance, governments set up SPVs to fund their projects and the SPC entity enables the channeling of funds for projects in different areas.
- Transfer of Assets: upon the transfer of assets to SPC, they become unidentifiable. As a result, it protects the firms in the event of bankruptcy or liquidation. This invulnerability has led courts to rule that there is a link between SPC assets and funds with the originating company.
- Regulatory and Compliance: SPVs avoid regulation and compliance protocols since they can be set-up within orphan-like structures.
- Financing and Raising Capital: They can be used to finance new projects without increasing costs or altering the shareholding structure. It makes them particularly useful for financing aircraft, power and infrastructure projects.
Global Aspect of Securitization
Securitization also allows a company to deconstruct itself by separating highly liquid assets from the risks in association with the transaction. These assets are then used to raise funds in the capital markets at a lower cost, and a lower risk than if the company had grown funds directly (by issuing more debt or equity). The company will then retain the savings generated by these lower costs.
In the United Arab Emirates, the company establishes a system of Islamic Securitization. It is a legal structure which replicates the economic purpose of a traditional asset-backed securitization structure and satisfies the requirements of Islamic Finance. The terms Al-Task and Tawriq are the terms used for securitization under Islamic Law. Given that most Islamic financial principles basis its concept of asset-backing, securitization fits particularly well with Islamic Finance.
Conventional securitization, which originated in non-Islamic economies, involves interest-bearing debt. BY holding contingent claims on the performance of securitized assets, investors get entitled to pre-determines interest as well as the principal amount initially paid. However, Islamic finance principles prohibit profit from debt and speculation. Thus, the issuance of interest-bearing debt securities with a secured redemption conflict with Islamic financing principles. Despite the fact that securitization under Islamic Law bars interest income, the company structure it in such a process that it rewards investors for their direct exposure to business risk. Underlying securitization assets which do not comply with Sharia Law principles cannot securitize in the market.
In the United Kingdom
The UK is Europe’s Largest Securitization Market, with issues worth approximately US Dollars 26 billion in 1999. The first asset class securitized in the UK are private mortgage loans. Subsequently, the market has expanded significantly to include credit card receivables, other consumer loans, lease receivables and whole business securitizations whereby the securitizations is on the entire future receivables of a company. In the UK, there is a continuous introduction of new asset types and structures.
Germany market is not significant as the US. However, the ABS market in Germany has grown steadily since 1995. Housing loans, credit card receivables, and consumer loans are commonly the subjects of securitization processes in Germany. In mid of 1997, the German Bank Regulatory Office published a guideline allowing relief from capital adequacy requirements for banks if they meet the specific criteria. Since then, not only corporations but also banks have securitized many assets. In the past, traditional ABS transactions were based mainly on mortgage loans (residential and commercial), trade receivables, lease receivables and customer loans. Today, all kinds of assets can be securitized provided they are separable, transferable, pledgeable and free of objections.
In Asian Region
The Asian crisis has caused the securitization market in Asia to slow down. From properties to salaries, the market was continuously searching for new assets to securitize. The market was booming, as it was continually looking for innovative ways to overcome its legal, tax and accounting issues. But the market’s collapse in 1997 drastically slowed down securitization’s development process in the region. The market started to recover in 1998, and in total, four big deals were completed: in Hong Kong, Taiwan, Korea and an Asian Basket Deal (a CBO). 1999 saw a significant increase in activity focused on North Asia. Given that the central issue in the Asian market remained that of attracting investors, the focus in that region has been on credit enhancements and risk repackaging.
On the whole, securitization is a powerful financial tool that constitutes a significant part of today’s global generation of profit. Given that securitization’s abuses contributed to the global financial crisis, its regulation is critically important. US and European post-crisis regulation responses are insufficient. For achieving a more systematic regulatory framework, existing law will have to supplement.