How does securitization work

Advantages of securitisation can be summarised as follows —. For seller or originator, securitisation mainly results in receivables being replaced by cash thereby improving the liquidity position. It removes the assets from the balance sheet of the originator, thus liberating capital for other uses, and enabling restructuring of the balance sheet by reducing large exposures or sectoral concentration.

It facilitates better asset liability management by reducing market risks resulting from interest rate mismatches. The process also enables the issuer to recycle assets more frequently and thereby improve earning. Finally, transparency may be improved since securitisation results in identifiable assets in the balance sheet.

Since securitised assets go off the balance sheet of originator, asset base is pruned down, thereby reducing the regulatory capital requirements to support the assets. Moreover, asset portfolio is liquidated releasing cash, which, in turn, reduces the need for demand and time liabilities that are subject to statutory reserves. In brief, original lender transforms his illiquid assets like mortgages, lease rentals etc.

The additional funds raised can be used to increase business. Cost of raising funds will be lower as there will be wider investment base and liquidity.

Further, credit risk will be diversified. For investor, securitisation essentially provides an avenue for relatively risk-free investment. The credit enhancement provides an opportunity to investors to acquire good quality assets and to diversify their portfolios. From the point of view of the financial system as a whole, securitisation increases the number of debt instruments in the market, and provides additional liquidity in the market. It also facilitates unbundling, better allocation and management of project risks.

It could widen the market by attracting new players on account of superior quality assets being available. The credit rating is of the transaction of the assets securitised and not of the originator or issuer. Thus, it is possible that credit rating of the securitised assets will be quite different from the credit rating of the originator. In extreme case, even if the originator company is liquidated, the asset securitised will still be good and the investor investing in the securitised asset will be protected.

Similarly, the Asset Reconstruction Company does not own the assets and hence even if it goes into liquidation, security of investor does not get affected.

Section 17A of Securities Contracts Regulation Act makes provision for public issue and listing of the securitised certificates or instruments.

Securitised certificate or instrument — Securitised certificate or instrument is any certificate or instrument by whatever name called , issued to an investor by any issuer being a special purpose distinct entity, which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be [section 2 h ie of SCRA].

Issuer of securitised certificate or instrument will make application for listing to one or more recognised stock exchanges, before issuing offer document to public [section 17A 2 of SCRA]. If permission for listing is refused by any stock exchange, the issuer shall repay all moneys to applicants with eight working days. All provisions relating to listing shall apply to listing of such securities [section 17A 4 of SCRA].

As per the Sarfaesi Act, the financial asset will be first acquired by Asset Reconstruction Company from bank or financial institution.

SO E dated The Asset Reconstruction Company will devise a separate scheme for each of the financial asset taken over. Words in italics inserted vide Amendment Act.

The Asset Reconstruction Company will realise the assets and redeem the investment and payment of returns to QB under each scheme.

Account of each scheme of every financial asset will be kept separately by Asset Reconstruction Company and funds realised from that asset will be utilised only for redemption of investments and payment of returns under that scheme.

The security receipt represents undivided interest in financial asset. It does not create, declare, assign, limit or extinguish any right, title or interest to or in immovable property except to the extent of undivided interest afforded by the security receipt. Often the reference portfolio—the new, securitized financial instrument—is divided into different sections, called tranches. The tranches consist of the individual assets grouped by various factors, such as the type of loans, their maturity date, their interest rates, and the amount of remaining principal.

As a result, each tranche carries different degrees of risk and offer different yields. Higher levels of risk correlate to higher interest rates the less-qualified borrowers of the underlying loans are charged, and the higher the risk, the higher the potential rate of return. Mortgage-backed security MBS is a perfect example of securitization. After combining mortgages into one large portfolio, the issuer can divide the pool into smaller pieces based on each mortgage's inherent risk of default.

These smaller portions then sell to investors, each packaged as a type of bond. By buying into the security, investors effectively take the position of the lender. Securitization allows the original lender or creditor to remove the associated assets from its balance sheets.

With less liability on their balance sheets, they can underwrite additional loans. Investors profit as they earn a rate of return based on the associated principal and interest payments being made on the underlying loans and obligations by the debtors or borrowers.

The process of securitization creates liquidity by letting retail investors purchase shares in instruments that would normally be unavailable to them. For example, with an MBS an investor can buy portions of mortgages and receive regular returns as interest and principal payments.

Without the securitization of mortgages, small investors may not be able to afford to buy into a large pool of mortgages. Unlike some other investment vehicles, many loan-based securities are backed by tangible goods.

Should a debtor cease the loan repayments on, say, his car or his house, it can be seized and liquidated to compensate those holding an interest in the debt. Also, as the originator moves debt into the securitized portfolio it reduces the amount of liability held on their balance sheet.

With reduced liability, they are then able to underwrite additional loans. Of course, even though the securities are back by tangible assets, there is no guarantee that the assets will maintain their value should a debtor cease payment. Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations.

But that doesn't help much if the loan holders' default and little can be realized through the sale of their assets. Different securities—and the tranches of these securities—can carry different levels of risk and offer the investor various yields. Investors must take care to understand the debt underlying the product they are buying. Even so, there can be a lack of transparency about the underlying assets. MBS played a toxic and precipitating role in the financial crisis of to Our overall message is optimistic,".

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Naturally, the interest received is used to pay the interest on the securities issued, while the capital received is used to repay the securities themselves. Due to the nature of the underlying assets, which will typically be repaid sooner or later through staggered payments one of the problems that the arranger must face is dealing with the early repayment of debt , the securities issued can be amortized, which means that the face value decreases over the life of the security.

Therefore, one characteristic of ABS is that, quite often, the effective date of repayment s is not specified at the time when the security is issued. 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. Excess spread : the interest rate offered on the securities issued is less than the average interest rate received on the underlying assets.

Overcollateralization : 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 risk is compensated by higher interest rates: the higher the risk of default, the higher the interest rate will be. Guarantee by a third party : monoline 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.

The diagram below visually represents how the techniques of subordination tranches , overcollateralization excess collateral , and interest rates excess spread work. The diagram below shows the different actors involved in a securitization transaction along with their respective roles.

This diagram has been reproduced with the kind permission of its author, Mr. Despite some of the risks associated with ABS such as prepayment or extension risk, the significant credit enhancement and structural support inherent in most transactions make ABS a quality fixed income investment choice for the institutional portfolio. In principle, securitization helps to spread out risk within the market, so that the risk is no longer concentrated solely in the hands of credit agencies.

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. What happened? It is not really within the scope of our work at fimarkets to delve into economic analyses; nevertheless, here are a few ideas that you can investigate further in the articles cited at the bottom of this page.

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. 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.