Securitized Debt – Facts to Know
Securitized debt is a form of structured finance. A portfolio of debt which is packaged together and then sold off in tranches.
The highest ranking tranche (the one that gets repaid first) may be rated as AAA or equivalent; that is to say, in the opinion of a rating agency, the chances of losing money on the AAA portion are the same as the chances of losing money lent to any other AAA rated borrower, like a well-financed government.
Below the AAA tranche, which is usually by far the largest, are a series of lower ranking tranches and the lowest is often called the equity tranche because it is as risky as holding highly geared equity.
The interest rate paid on the AAA tranche should be consistent with the interest rate paid on any other AAA rated security and this and the interest payable on other higher ranking tranches should be well below the interest being paid by the borrowers. This means the interest rates on the lower rated tranches can be a lot higher (but, to large extent, this just compensates them for the extra risk involved in holding the lower rated tranches since they bear the first losses in the portfolio if a borrower or borrowers cannot repay their loans.
Securitization is a process by which financial intermediaries, such as investment banks, create securitized bonds. Such bonds can offer various advantages over more conventional investing instruments and can form a valuable addition to your portfolio. Securitized instruments, however, have unique characteristics that you must understand before investing your hard-earned cash in them.
Securitization involves pooling a large number of loans and passing the resulting payments to bondholders. A bank, Since the mortgage proceeds are pooled and then divided by 1,000 before being paid out, the default of any one homeowner would have a small impact on the average bond. And even in case of default, the house would be foreclosed upon and result in some recovery of loaned funds. This recourse to go after assets of borrowers in case of default is the reason such securities are referred to as securitized.
Common Securitized Bonds
Bonds that are backed by mortgage payments are the most popular type of securitized debt instruments. However, any type of loan can be securitized. Auto loans, backed by the vehicles themselves, are also commonly pooled to create securitized debt instruments.
Although credit card debt and student loans are usually not backed up by a specific collateral, the lender can go after the borrower’s assets. Bonds backed by these kinds of personal loans are also popular investment vehicles. To distinguish these bonds from mortgage-backed securities, they are often referred to as asset-backed securities. Keep in mind that any receivable is, technically, an asset.
An advantage of pooling receivables is the ability to offer debt instruments with varying degrees of risk and return. Instead of passing the average monthly payment of 100 homeowners to 100 bondholders, the bonds can be divided up into risk tranches. One class of bonds can receive less money but would not shoulder any of the losses resulting from homeowner defaults up to a certain limit. A second set of bonds would receive more money every month as long as there are no or few defaults, but all of the loss from defaults and resulting foreclosures would hit those bondholders first. Such structuring allows you, the investor, to select the kind of risk level and potential return with which you are comfortable.
No Intermediary Risk
Another advantage of securitized bonds is that they carry no intermediary risk. In simpler terms, you won’t suffer a loss if the bank that has sold you the bonds backed by mortgage or car loan payments goes bankrupt. After all, the monthly payments you are receiving come from the homeowner or other individuals who have borrowed money. This does not mean that securitized bonds are always safe, of course. Should mass defaults occur and seized assets fall far short of the money owed by borrowers, holders of securitized bonds can lose large sums of money, as in the housing crisis of 2007.
Debt Securitization Process:
The steps involved in Securitization process are the following:
- A company that wants to mobilize finance through securitization begins by identifying assets that can be used to raise funds.
- These assets typically represent rights to payment at future dates and are usually referred to as ‘receivables’.
- The company that owns the receivables is usually called the ‘originator’.
- The originator identifies the assets out of its portfolio for Securitization.
- The identification of assets will have to be done in a manner so that an optimum mix of homogeneous assets having almost same maturity forms the portfolio.
- Assets originated through trade receivables, lease rentals, housing loans, automobile loans, etc. according to their maturity pattern and interest rate risk are formed into a pool.
- The aforementioned identified and pooled assets are then transferred to a newly formed another institution called a ‘special purpose vehicle’ usually by way of a trust.
- Such trust usually, an investment banker, issues the securities to an investor.
- Once the assets are transferred, they are no longer held in the originator’s portfolio.
- After acquisition of the assets from originator, the SPV splits the pool into individual shares or securities and reimburse itself by selling these to investors.
- The securities, so issued, are known as ‘pay or pass through certificates’.
- The securities are normally without recourse to the originator, thus investor can hold only SPV for the principal repayment and interest recovery.
- In order to make the issue attractive, the SPV enters into credit enhancement procedures either by obtaining an insurance policy to cover the credit losses or by arranging a credit facility from a third party lender to cover the delayed payments.
- To increase marketability of the securitized assets in the form of securities, these may be rated by some reputed credit rating agencies.
- Credit rating increases the trading potentials of the certificate, thus its liquidity is enhanced.
- A merchant banker or syndicate of merchant bankers will be appointed for underwriting the whole issue.
- The securities have to be sold to the investors either by a public issue or by private placement.
- The passes through certificates before maturity are tradable in a secondary market to ensure liquidity for the investors.
- Once the end investor gets hold of these instruments created out of Securitization, he is to hold it for a specific maturity period which is well defined with all other related terms and conditions.
- On maturity, at the end, investors get redemption amount from the issuer along with interest due on the amount.
Features of Securitization: The securitization has the following features:
(i)Creation of Financial Instruments – The process of securities can be viewed as process of creation of additional financial product of securities in market backed by collaterals.
(ii)Bundling and Unbundling – When all the assets are combined in one pool it is bundling and when these are broken into instruments of fixed denomination it is unbundling.
(iii)Tool of Risk Management – In case of assets are securitized on non-recourse basis, then securitization process acts as risk management as the risk of default is shifted.
(iv)Structured Finance – In the process of securitization, financial instruments are tailor structured to meet the risk return trade of profile of investor, and hence, these securitized instruments are considered as best examples of structured finance.
(v)Trenching – Portfolio of different receivable or loan or asset are split into several parts based on risk and return they carry called ‘Trenche’. Each Trench carries a different level of risk and return.
(vi)Homogeneity – Under each trenche the securities are issued of homogenous nature and even meant for small investors who can afford to invest in small amounts.
Benefits of Securitization
The benefits of securitization can be viewed from the angle of various parties involved as follows:
From the angle of originator
Originator (entity which sells assets collectively to Special Purpose Vehicle) achieves the following benefits from securitization.
(i)Off – Balance Sheet Financing: When loan/receivables are securitized it release a portion of capital tied up in these assets resulting in off Balance Sheet financing leading to improved liquidity position which helps expanding the business of the company.
(ii)More specialization in main business: By transferring the assets the entity could concentrate more on core business as servicing of loan is transferred to SPV. Further, in case of non recourse arrangement even the burden of default is shifted.
(iii)Helps to improve financial ratios: Especially in case of Financial Institutions and Banks, it helps to manage Capital -To-Weighted Asset Ratio effectively.
(iv)Reduced borrowing Cost: Since securitized papers are rated due to credit enhancement even they can also be issued at reduced rate of debts and hence the originator earns a spread, resulting in reduced cost of borrowings.
From the angle of investor
Following benefits accrues to the investors of securitized securities.
- Diversification of Risk:Purchase of securities backed by different types of assets provides the diversification of portfolio resulting in reduction of risk.
- Regulatory requirement: Acquisition of asset backed belonging to a particular industry say micro industry helps banks (which can also act as an Investor) to meet regulatory requirement of investment of fund in industry specific.
- Protection against default: In case of recourse arrangement if there is any default by any third party then originator shall make good the least amount. Moreover, there can be insurance arrangement for compensation for any such default.
Techniques of credit enhancement
Until recently, ABS had a good reputation in the markets, as they were thought to have a risk profile identical to that of a bond while at the same time being more lucrative. Nonetheless, there is still a risk of default on the pool of underlying assets. Therefore, there are several techniques, known as “credit enhancement,” that can be used to reduce the risk of default.
Excess spread: the interest rate offered on the securities issued is less than the average interest rate received on the underlying assets.
Over Collateralization: the overall value of the underlying assets is higher than the total nominal value of the securities issued.
Subordination: the securities issued are not all identical, but are divided into a series of tranches. The repayment of each tranche is subordinates to (contingent upon) the repayment of the tranche that is immediately above it. The higher tranche is said to be more “senior,” therefore has priority over the intermediate “mezzanine” tranche, etc. The risk is compensated by higher interest rates: the higher the risk of default, the higher the interest rate will be. The lowest tranche, called “equity,” is typically not issued to investors, but is held by the originator.
Margin deposit: the assignor makes a margin deposit with the SPV.
Guarantee by a third party: Insurance companies specialize in providing guarantees for securitization structures.
Derivatives (credit derivatives): the use of derivatives, particularly credit derivatives, also makes it possible to hedge against the risk associated with the pool of collateral.
Drawbacks of Securitization
With the subprime mortgage crisis and the ensuing crisis of confidence, the securitization market is losing steam, and certain segments, particularly those concerning the most complex products, have come to a complete standstill.
In reality, the complexity of the different types of securities is a disadvantage because it leads to what is known as information asymmetry. In other words, the issuer of the securities knows much more about what he is really selling than the buyer does. As long as the securities issued behave as indicated in the brochure, all is well and nobody asks any questions. But as soon as problems begin to arise for certain types of securities, people become suspicious of any product falling within that category since you really need to be an expert to be able to evaluate a securitization program and suddenly nobody wants to buy them anymore. In this regard, the credit rating agencies have received a great deal of blame for having been too generous in awarding “AAA” ratings, but the real problem is the loss of confidence that spreads throughout an entire asset class to a completely irrational degree.
Moreover, securitization, as we have seen, offers banks an opportunity to trim their balance sheets, which makes it easier for them to fulfill their regulatory obligations. They have jumped at the opportunity. At the same time, they have veered away from their basic function, the cornerstone of which is to accurately assess credit risk. With the extension of credit becoming increasingly easy, credit agencies have become less stringent with regard to the quality of the final borrowers. This is referred to as “moral hazard.” The banks have moved away from their role of financing the economy, seeking instead to assume (fortunately, not completely) a purely intermediary role in an economy that seems to have become completely “marketized.” Today, the situation is reaching its limits.