Unit 4 Portfolio Securitization.docx.pdf

PORTFOLIO SECURITISATION Securitization is the process of taking an illiquid asset or group of assets and, through financial engineering, transforming it (or them) into an investable security. A mortgage-backed security (MBS) is a classic example of securitization. Securitization is a crucial financ...

PORTFOLIO SECURITISATION Securitization is the process of taking an illiquid asset or group of assets and, through financial engineering, transforming it (or them) into an investable security. A mortgage-backed security (MBS) is a classic example of securitization. Securitization is a crucial financial process that has fundamentally transformed capital markets and enabled greater access to credit. By converting illiquid assets into tradable securities, securitization provides numerous benefits to both lenders and investors. Features of Securitization 1. Creation of Financial Instruments Additional financial instruments by way of new securities are created which are backed by collaterals. 2. Bundling and Unbundling When the mortgaged based assets are combined into a pool on the basis of same rate of interest and maturity period by the originator, it is bundling and when these are broken into instruments of fixed denomination by the SPV, it is unbundling. 3. 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 from the originator. 4. Structured Finance The process of securitization is a structured finance as the financial instruments are tailor made to meet the risk return trade profile of the investors. 5. Securities are divided into tranches Portfolio of different receivables or loans are divided into several parts based on risk and return which are called tranches. 6. Homogeneity Under each tranche, the securities issued are of homogenous or similar nature and even meant for small investors who can afford to invest in small amounts. Types of Securitizations 1. Collateralized debt obligation (CDO) Collateralized Debt Obligations (CDOs) bundle loans and other debt instruments together and issue securities backed by this diversified pool of credit assets. CDOs provide investors collateral protection since identified assets can be liquidated if borrowers default. 2. Pass-through securitization These involve an intermediary collecting payments on the underlying loans in a securitization pool, retaining a small fee, and passing the residual cash flows directly to investors. This allows investors to gain targeted exposure to the interest and principal repayments generated by the assets. 3. Pay-through debt instrument Under this, investors own securities backed by the asset pool but not the loans themselves. This provides more flexibility for the issuer to alter payment flows and terms based on the underlying credits rather than directly passing cash flows to security holders. The pool acts more as collateral than a defined source of cash flows. Types of Securitized assets Any type of asset with a stable money flow can be grouped, securitized, and sold to investors. There are certain types of assets that are more commonly turned into asset-backed securities (ABS). They include: 1. Mortgages: Bundling together groups of home loans and selling portions to investors originated with the creation of mortgage-backed securities in the 1970s. This remains one of the largest securitization markets globally. 2. Auto loans: Similar to mortgages, auto loan contracts are structured into securities with varying risk-return profiles and sold to investors seeking exposure to consumer credit. 3. Credit card receivables: Investors can purchase securities derived from pooled credit card balances. These tend to allow more flexibility as new debt and payments continuously modify the underlying pool. 4. Student loans: Loans issued to students by private lenders and government programs are securitized to meet investor demand. These provide exposure to the education financing sector. Process of Securitization 1. Asset origination: The process begins with a lender, such as an investment bank, issuing loans to borrowers. These loans can be in business lines of credit, mortgages, auto loans, credit card receivables, or other types of credit. 2. Create asset pools: The lender selects a pool of loans with similar characteristics, such as loan type, maturity, and credit quality. This pool of loans will serve as collateral for issuing securities. 3. Create the special purpose vehicle (SPV): The lender establishes a separate legal entity called an SPV) or a special purpose entity. The SPV is designed to be bankruptcy-remote, meaning that if the lender goes bankrupt, the assets held by the SPV won't be affected. 4. Transfer the assets: The lender sells the pool of loans to the SPV, effectively removing the assets from its balance sheet. In return, the SPV pays the lender for the assets, often using funds raised from issuing securities. 5. Trenching: The SPV divides the pool of loans into different risk classes, known as tranches. Each tranche has a different level of risk and return, catering to different investor risk appetites. The tranches are typically considered senior, mezzanine, and junior (or equity). 6. Credit enhancement: The SPV may use various credit enhancement techniques to make the securities more attractive to investors. These can include over-collateralization (i.e., putting more collateral in the pool than the value of the securities issued), reserve accounts, or third-party guarantees. 7. Rating: The SPV hires credit rating agencies to assess the creditworthiness of each tranche. The rating agencies assign ratings to the tranches based on their perceived risk, with the senior tranches receiving the highest ratings and the junior tranches receiving the lowest. 8. Marketing and sale: The securities, now backed by the pool of loans, are marketed and sold to investors through investment banks. Investors can invest in different tranches based on risk tolerance and investment objectives. 9. Distribute cash flows: As borrowers of underlying loans make payments, the cash flows are collected by a servicer and distributed to the investors according to the terms of the securities. The senior tranches get priority over junior tranches in receiving payments. 10. Monitoring and reporting: Throughout the life of the securities, the servicer monitors the performance of the underlying loans and provides regular reports to the investors. Benefits of Portfolio Securitization 1. Diversification These products cover various underlying assets such as mortgages, auto loans, and future cash flows from royalties or intellectual property, spreading risk across different asset classes and potentially boosting overall performance. 2. Risk management Securitized products offer diverse risk and return profiles, enabling investors to tailor their exposure based on risk tolerance and objectives. Some products offer higher yields with increased credit risk, while others provide stable cash flows with lower returns, allowing for effective risk management. 3. Enhanced yield potential Particularly those backed by mortgages or consumer loans, securitized products can yield higher returns compared to traditional fixed-income securities in low-interest-rate environments, appealing to investors seeking greater income generation. 4. Liquidity Many securitized products trades in liquid markets, facilitating easy buying and selling. This liquidity enhances portfolio flexibility, enabling investors to adjust asset allocations in response to market changes or new investment prospects. Problems in Securitization 1. Lack of standardization Every originator follows his own procedure for documentation and administration of the securitization process. So, having lack of standardization is another obstacle in the growth of securitization. 2. Inadequate Debt Market Lack of existence of a well-developed debt market in India is another obstacle that hinders the growth of secondary market of securitized or asset backed securities. 3. Ineffective Foreclosure laws Since Foreclosure laws are not supportive to lending institutions, this makes securitized instruments less attractive as lenders face difficulty in transfer of property if borrowers’ default. Participants in Portfolio Securitization A] Primary Participants Originator – It is basically the initiator of the securitization process. It sells the illiquid assets lying in its books to the special purpose vehicle. Special Purpose Vehicle (SPV) – After purchasing the illiquid assets from the originator, the SPV makes an upfront payment to it. Then, it converts those illiquid assets into marketable securities and issue it to the investors. The Investors - Investors are the buyers of securitized papers which may be an individual, an institutional investor such as mutual funds, provident funds, insurance companies, mutual funds, Financial Institutions etc. B] Secondary Participants Obligors - They are the parties who owe money to the originators. The amount due from the obligors is transferred to SPV which in turn passes it on to the investors of securitized instruments. Rating Agency - Since the securitization is based on the pools of assets rather than the originators, the assets have to be assessed in terms of its credit quality and credit support available. Credit Rating Agencies provide that. Receiving and Paying agent (RPA) - Also, called Servicer or Administrator, it collects the payment due from obligor(s) and passes it to SPV.  Agent or Trustee - Trustees are appointed to oversee that all parties to the deal perform in the true spirit of the terms of agreement. Normally, it takes care of interest of investors who acquires the securities. Credit Enhancer – It provides additional comfort to the investors to whom the securitized instruments are issued in the form of additional collateral or third-party guarantee such as letter of credit or surety bond. Structurer - It brings together the originator, investors, credit enhancers and other parties to the deal of securitization. Normally, these are investment bankers i.e. merchant bankers also called arranger of the deal. It ensures that the deal meets all legal, regulatory, accounting and tax laws requirements.