Securitization
Meaning of Securitization
Securitization is a process where various financial assets/debts of the firm
are clubbed together into a consolidated financial instrument for trading in
the financial market. It converts the assets into tradeable securities that
carry interest which are sold to investors such as bonds and stocks. In
simple terms, it is a method which free up the blocked capital of firm by
transforming the illiquid assets into liquid assets. Securitization is an
efficient tool which enhances the overall liquidity in market by acting as a
source of funds especially for financial companies. In addition to this, it
offers better investment opportunities to investors with diversified portfolio
offering quality returns. Securitization generally takes place with loans and
assets that generates receivables like commercial or consumer debt.
Process of Securitization
Process of securitization is a very complex and lengthy process that
comprises of various stages and involving different parties.
These steps are discussed in detail as given below: –
1. Identification Process: First stage in the process of
securitization is termed as identification process. Financial
institution which chooses to go for securitization of its assets
is called originator. In this stage, originator selects a pool of
assets of homogenous nature in terms of rate of interest,
maturity period etc.
2. Transfer Process: This is the second stage of securitization
where transformation process of converting the selected pool
of assets into securities takes place. Once the pool of assets
to be securitized is identified by originator, then it is passed on
to another institution known as Special purpose vehicle (SPV)
or trust. Outright sales basis is the manner in which pass
through transaction takes place in between the originator and
SPV. The selected assets are removed from the balance
sheet of originator as soon this transfer process takes place.
3. Issue Process: In this process, SPV does the task of
converting the pooled assets into tradeable securities for
issuing them to investors. The package of assets is split into
individual securities of smaller denominations by SPV for
selling them to public. SPV gets its fees for carrying out these
functions out of the sale process of these securities. The
securities are issued in various forms such as “Pay through
certificates”, “Interest only certificates”, “Principal only
certificate” and “Pass through certificates”. Structure of these
securities is created in such a way that maturity of these
securities and maturity of securitized receivables synchronies
with one another.
4. Redemption Process: Redemption process is concerned
with interest payments and redemption of issued securities by
SPV via collections from securitized assets. Collection of dues
related to securitized assets is either done by originator
himself or a special service agent is appointed who charges
commission for this work. SPV plays a major role in
processing all payments related to interest and principal to the
investors. A pass through certificate is issued either with
recourse and without recourse certificate. If securities are
issued with recourse, in that case SPV will held the originator
liable in case of any default payments.
5. Credit Rating Process: It is the process in which passed
through certificates is granted a credit rating by rating
agencies to make it more attractive. It is the last stage in
securitization process which improve the credit worthiness of
certificates to increase their acceptability to investors. This
credit rating agency gives guarantee to investors for timely
payment of interest and principal by SPV.
Types of Securitization
There are distinct types of securitization which is determined in
accordance with type of receivables. Common types of securitization are
explained below: –
Types of Securitization
1. Asset-Backed Securities (ABS): Asset-Backed securities
are the bonds backed by underlying financial assets. Credit
card debts, auto loans, home-equity loans and student loans
are various types of receivables that are converted into ABS.
2. Commercial Mortgage-Backed Securities (CMBS): These
are bonds that are backed by pool of commercial assets
mortgage like industrial land, factory, plant, office building etc.
3. Residential Mortgage-Backed Securities
(MBS): Residential Mortgage-Backed Securities are those
bond which are secured by mortgage of house, jewellery,
land, property and various other valuable belongings.
4. Collateralized Debt Obligations (CDO): These are bonds
which are designed out of re-pooling the personal debts for
marketing in secondary market for investors.
5. Future Flow Securitization: These are the securities issued
against the future debt receivables. All principal and interests
are met by company out of its routine business activities.
Advantages of Securitization Process
There are several parties involved in process of securitization which gets
benefited through this process. Originator and investor are two major
parties who have major advantages which are discussed below: –
To Originator
1. Unblocks Capital: Major advantage of securitization to
originator is that free its locked capital by liquidating its assets.
The originator is able to get its lent funds much before the
maturity.
2. Grants Liquidity: It provides liquidity by converting the
illiquid assets into liquid ones which assists in acquiring
requiring funds timely.
3. Risk Management: Financial companies can easily lower
the risk by securitizing the amount lend by them which
reduces the chances of bad debts.
4. Overcomes Uncertainty of Profit: This process enables in
overcoming profit uncertainty by securitizing doubtful
obligation which reduces the chances of losses.
5. Lower needs for Financial Leverage: This process by
unblocking the capital helps in regulating liquidity of company
due to which originator does not need to go for financial
leverage for meeting its needs.
To Investor
1. Quality Investment: Securitization offers wise investment
options which grants reliability to investors by providing
Mortgaged and Asset backed securities.
2. Better Returns: Investors get access to superior returns
through the process of securitization. It offers securities of
companies enjoying better market position.
3. Diversified portfolio: Securitized bonds provide investors a
well-diversified portfolio that is created via pooling of
company’s assets. These instruments are distinct from other
classes of investment.
4. Less Credit Risk: The assets which are offered through the
process of securitization carries a less degree of credit risk as
they are rated by good credit rating agencies. Such assets
have higher creditworthiness in market.
and Disadvantages of Securitization Process
Disadvantages of Securitization Process
There are various drawbacks of this process which are explained below:
–
1. Lack of Transparency: Securitized bonds lacks
transparency as it does not reveal the details of assets
included in these bonds. SPV does not disclose such details
to investors.
2. Expensive: Expenses associated with securitized bonds is
higher as compared to share floatation. Various cost
comprises of legal, underwriting, administration and rating
charges.
3. Complex to Handle: Process of securitization is much
complicated to handle as it involves multiple parties. A pool of
assets needs due attention for creating a well-diversified
portfolio.
4. Investor bear Risk: Investor may end up in high amount of
losses in case the borrower fails to repay its debts. In such a
case, investor will be sole risk-bearer.
5. Loss in case of Prepayment: Investor may suffer losses
and not able to generate superior gains in case of prepayment
of debts by borrower.
Conclusion
Investors do not find the process of securitization as an excellent
opportunity of investment as it involves a high degree of risk even after
being secured by collateral security.
However, an investor may generate higher amount of returns if
creditworthiness of borrower is properly evaluated and proper analysis of
available investment opportunity is made.