by Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).
The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.
The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances (but also includes businesses established specifically to generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates.
Purpose of Securitisation
Normally, a lender (financier) finances loans to borrowers and gets repayment with interest over a period. The lender would collect the periodic instalments and use them to finance new loans. This limits his capacity to give fresh loans, as he has to wait till, he recovers the instalments along with interest. Instead of waiting for a long time, he can pool the loans together and sell his right to receive future payments from the borrowers of these loans.
This is termed as securitisation of loans. The original lender will receive consideration for the same upfront, i.e. immediately, by securitising his loan portfolio. Of course, he will get the amount at a discounted value. He can then use the proceeds to further develop his business, which is of giving loans.
Securitisation is a form of financing involving pooling of financial assets and the issuance of securities that are repaid from the cash flows generated by the assets. This is generally accomplished by actual sale of the assets to a bankruptcy remove vehicle, i.e. a special purpose vehicle (like Asset Reconstruction Company), which finances the purchase through issue of bonds.
These bonds are backed by future cash flow of the asset pool. The most common assets for securitisation are mortgages, credit cards, auto and consumer loans, student loans, corporate debt, export receivables, off shore remittances etc.
These ‘Securitised loans’ will be purchased by mutual funds, provident funds and insurance companies, which have funds but do not have mechanism to assess, grant and recover loans. Thus, corporate bodies like finance companies having expertise in assessing, granting and recovering loans get the funds from corporate bodies like mutual funds, provident funds, insurance companies etc. which have funds but do not have expertise in loan assessment and disbursal, through process of securitisation. Thus, securitisation helps both.
Securitisation is done through Special Purpose Vehicles (SPVs). These are termed as Asset Reconstruction Companies in the present SARFAESI Act.
Thus, securitisation is a process through which illiquid assets are transferred into a more liquid form of assets and distributed to a broad range of investors through capital markets. The lending institution’s assets are removed from its balance sheet and are instead funded by investors through a negotiable financial instrument. The security is backed by the expected cash flows from the assets.
Securitisation is a process under which a pool of individual homogeneous loans is packaged and distributed to various investors having liquid funds in the form of coupons/pass through or pay through certificates; through SPVs (Special Purpose Vehicles), with the provision that the inflow of cash in the shape of recoveries will be distributed pro-rata to coupon holders.
In securitisation, the lending institution’s assets are removed from balance sheet of that lending institution and are instead, funded by investors. These investors purchase a negotiable financial instrument evidencing this indebtedness.
Basically, all assets which generate cash flow can be securitised e.g. mortgage loans, housing loans, automobile loans, credit card receivables, trade receivables, consumer loans, lease finance etc. A perfectly healthy and normal financial asset is normally securitised. It is not necessary that it should be non-performing asset.
Securitisation and factoring – distinction– Difference between factoring and securitisation is that in case of factoring, the assets are debts which have crystallized but are not due.
Securitization v/s Factoring
- Under factoring there are two parties that is the bank and the company while under securitization there are many investors involved who invest in the securitized asset.
- While factoring is arrangement between the banks and a company in which financial institution purchases the book debts of a company and pays the money to the company against receivables whereas Securitization is the process of converting illiquid assets into liquid assets by converting longer duration cash flows into shorter duration cash flows.
- While factoring is done for short term account receivables ranging from 1 month to 6 months whereas securitization is done for long term receivables of the company.
- Since factoring involves only bank and the company there is no need for any credit rating while securitization involves many investors and therefore it is necessary to take credit rating before going for securitization of receivables.
- While factoring is of many types and can be with or without recourse while securitization is done without recourse.
Securitization
- It is something with loans.
- It is related with loans.
- Medium or long term.
- Agencies will look after collections.
- Originator will take portion of credit risk.
Factoring
- It is something with bills receivables.
- Short term.
- It is related with book debts.
- Factor will look after collections.
- Factor will take 100% credit risk.
Features of Securitization
Commoditization:
Securitization is the process of commoditization, where the basic idea is to take the outcome of this process into the capital market. Thus, the result of every securitization process, whatever might be the area to which it is applied, is to create certain instruments which can be placed in the market.
Merchantable Quality:
To be market acceptable a securitized product should be of saleable quality. This concept, in case of physical goods, is something which is acceptable to merchants in normal trade. When applied to financial products, it would mean that the financial commitments embodied in the instruments are secured to the investors’ satisfaction. To the investors satisfaction is a relative term and therefore, the originator of the securitized instrument secures the instrument based on the needs of the investors.
For widely distributed securitized instruments, evaluation of the quality, and its certification by an independent expert, viz., rating is common. The rating is for the benefit of the lay investor, who otherwise not expected to be in a position to appraise the degree of risk involved.
In case of securitization of receivables, the concept of quality undergoes a drastic change, making rating a universal requirement for securitization. As already discussed, securitization is a case where a claim on the debtors of the originator is being bought by the investors. Hence, the quality of the debtors’ claim assumes significance, which at times enables investors to reply purely on the credit rating of debtors (or a portfolio of debtors) and so, make the instrument totally independent of the originators’ own rating.
Marketability:
The very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument is structured in such a way as to be marketable. This is one of the most important features of a securitized instrument, and the others that follow are mostly imported only to ensure this feature. Marketability involves two concepts:
(1) The legal and systematic possibility of marketing the instrument.
(2) The existence of a market for the instrument.
As far as the legal possibility of marketing the instrument is concerned, traditional mercantile law took a contemporaneous view of marketable documents. In most jurisdictions in the world, laws dealing with marketable instruments (also referred to as negotiable instruments) were mostly limited in relation to what was then in circulation.
The very purpose of securitization will be defeated if the instrument is loaded on to a few professional investors without any possibility of having a liquid market. Liquidity is afforded to a securitized instruments either by introducing it in to an organized market (such as securities exchanges) or by one or more agencies acting as, market makers i.e. agreeing to buy and sell the instrument at either pre-determined or market-determined prices.
Wide Distribution:
The basic purpose of securitization is to distribute the product. The extent of distribution which the originator would like to achieve is based on a comparative analysis of the costs and the benefits that can be achieved Wider distribution leads to a cost benefit, in that the issuer is able to market the product with lower return, and hence, lower financial cost to him. But a wide investor base involves the high cost of distribution and servicing.
Pass Through Certificates
A pass-through certificates is an instrument that evidences the ownership of two or more equipment trust certificates. In other words, equipment trust certificates may be bundled into a pass-through structure as a means of diversifying the asset pool and/or increasing the size of the offering. The principal and interest payments on the equipment trust certificates are “passed through” to certificate holders. A pass-through certificate is an instrument which signifies transfer of interest in receivables in favour of the holder of the Pass-Through Certificate. The investor in a pass-through transaction acquire the receivables subject to all their fluctuation, prepayments etc. the material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayment etc., transferred to the investor.
Investors who purchase a pass-through certificate may think that this investment is more secure or less risky than others. The problem is that mortgages in the securitized instrument may not actually be entirely risk free, however. For example, when a mortgage goes into default, the holder of the securitized instrument loses money. This can result in the holder such as a major government-sponsored entity not being able to cover its payments or costs associated with business. This creates a downward cycle of money in the process of buying and selling a pass-through certificate.
