Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A security is a financial instrument that can be traded on financial markets. Securitization allows the creator of assets to remove them from its balance sheet while simultaneously providing access to low-cost funding.
How Securitization Works
The securitization process involves several major parties:
The Originator
The originator is the entity that owns the assets to be securitized. The originator is usually a company like a bank, mortgage lender, or auto finance company that generates or originates assets like loans, leases, or receivables as part of its normal business activities.
When a sufficient volume of assets has accumulated on the balance sheet, the originator will sell the assets to a special purpose vehicle (SPV). This sale is typically achieved by over-collateralizing the asset pool. The SPV will pay the originator for the assets from the proceeds of the securities that the SPV sells to investors.
The Special Purpose Vehicle
The special purpose vehicle, or SPV, is an essential entity in the securitization process. It is created solely for a single securitization transaction or program. The SPV purchases the assets from the originator and becomes the legal owner of the underlying asset pool throughout the life of the securities. The SPV insulates investors from the risks associated with the originator. If the originator goes bankrupt, the underlying assets are beyond its reach and cannot be reclaimed.
The SPV issues securities which are sold to investors. The proceeds fund the SPV’s acquisition of assets. The SPV services as a vehicle to transfer assets liabilities away from the balance sheet of the originator. It is a “bankruptcy remote” entity whose only mission is to own and manage the asset pool ensuring that payments are directed to the security holders.
Underwriter
The underwriter plays an advisory role for the originator in structuring transactions. Underwriters guide originators regarding prevailing market conditions, asset pricing, credit risk assessment, and ratings. Underwriters use their expertise so securities can be optimally structured to meet investor demand.
Underwriters also play a key role in marketing securities to investors. Securities can be sold publicly or privately. For public offerings, the underwriter will distribute a prospectus and lead securities sales efforts. For private offerings, the underwriter identifies suitable private investors through their vast network of financial institution relationships.
Servicer
A servicer is an entity that manages the asset pool underlying the securities. The servicer is typically the originating financial institution because that entity has in-depth knowledge and experience managing the assets. A key servicer duty is to collect payments from individual borrowers and distribute them to security holders according to the terms of the securities.
Servicers provide regular standardized reports on pool asset performance to other parties. They also handle duties like customer service, escrow administration, and default management on behalf of Investors. The servicer levies a regular fee based on a percentage of the outstanding principal balance of the asset pool. This is called the “servicing fee.”
Credit Enhancer
Credit enhancers are intended to mitigate credit risks in securitization transactions so that securities can attain higher credit ratings. They improve the credit profile of bonds through a variety of mechanisms like overcollateralization, third party guarantees, bond insurance, and credit default swaps (CDS). Credit enhancers allow Ratings Agencies to assign higher ratings on securities.
Ratings Agencies
Ratings Agencies like Standard & Poor’s, Moody’s, and Fitch assign credit ratings to securities that indicate their creditworthiness. Credit ratings impact investor demand and security pricing. The highest rating that can be assigned by ratings agencies is AAA.
Obtaining good credit ratings from agencies is usually an important objective for originators. Ratings Agencies use financial models to evaluate underlying collateral. They also assess the capabilities of servicers and structural mechanisms intended to protect bondholders.
Securitization Process Flow
The key steps in a securitization process flow are:
- Origination – The financial institution originates a pool of assets like residential mortgages, credit card balances, auto loans, equipment leases over a period of time.
- Warehousing – The accumulated assets are warehoused waiting to be securitized. Pool balances must reach optimal levels to maximize offering proceeds.
- SPV Establishment – An SPV is established. It is capitalized by the originator.
- True Sale – Assets are sold by the originator to the SPV through a true sale, relinquishing ownership rights over the assets. Sale proceeds fund originator reimbursement.
- Servicing Agreement – The originator continues to provide servicing and administer the assets as per a Servicing Agreement with the SPV. The originator typically receives an ongoing Servicing Fee paid from the SPV over the life of the transaction.
- Credit Enhancements – Credit Enhancements may be added to the SPV to improve the credit rating of the securities. Examples include third-party guarantees, overcollateralization, bond insurance and derivatives like credit default swaps.
- SPV Issues Securities – The SPV issues securities “backed” by the underlying assets. Investors purchase securities and the SPV receives proceeds from the sale.
- SPV Acquires Assets – The SPV uses proceeds from securities to purchase assets from the originator. This reimburses the originator for assets transferred to the SPV.
- Ongoing Administration – The originator services the assets in the pool as per the Servicing Agreement with the SPV. The originator collects borrower payments and forwards them to the SPV.
- SPV Passes Payments to Investors – The SPV receives payments from the originator out of underlying asset pool collections. The SPV uses funds to make scheduled principal and interest payments to investors.
This process demonstrates how securitization enables originators to remove assets and associated funding liabilities off their balance sheets through assets sales to an SPV conduit funded by external investors.
Securitization Structures
There are two primary structures used to securitize assets:
Pass-Through Structures
In pass-through structures, investors purchase securities representing fractionalized interests in an underlying asset pool. Investors receive regular pro-rata principal and interest payments from the collateral cash flows “passed through” the SPV.
Mortgage-backed securities (MBS) are a common example. Homeowners make monthly mortgage payments that consist of both principal and interest components. These payments pass through the SPV to investors holding bonds backed by the mortgages.
Since all investors are exposed on a pari-passu basis to the risk of the collateral pool, securities issued under pass-through structures usually carry a single credit rating. If collateral performance deteriorates leading to payment delays or defaults, all bond classes uniformly absorb losses.
Pay-Through Structures
Pay-through structures issue multiple classes of bonds to appeal to investors with varying risk appetites. Junior bond classes are subordinate to more senior classes and act as credit protection. If some payments from underlying assets are delayed or missed, losses first impact junior bondholders while more senior classes continue to receive contractual payments.
In pay-through structures, originating institutions continue servicing assets. However, payment waterfalls to various security classes differ based on seniority priorities specified in intricate transaction legal documents.
Junior bond classes offer higher coupons relative to more senior classes to compensate for increased risks. Since securities of varying seniority have divergent exposures to potential losses, rating agencies assign different credit ratings to individual bond classes.
Securitization Costs
There are several costs associated with sponsoring securitization transactions:
Structuring Fees
Structuring fees compensate underwriters for providing advisory services around deal structure, collateral pool composition, credit enhancements required, etc. to align with investor preferences.
Legal Fees
Law firms draft contracts, conduct due diligence around asset transfers, and provide formal legal opinions on various matters. Counsel is required for both the originator and SPV.
Accounting Fees
Accounting firms ensure compliance with reporting standards and analyze collateral performance, cash waterfall computations and investor payments.
Trustee Fees
Trustees collect regular fees over transaction lifecycles to cover monitoring investor interests, managing accounts, and approving servicer actions on collateral.
Rating Agency Fees
Ratings agencies assess deals to assign credit ratings on issued securities. Higher ratings allow bonds to get sold more easily at better prices.
Miscellaneous Administration Expenses
Further costs stem from the administrator, custodian, auditor and other parties that facilitate smooth deal operation over long periods.
While securitization costs can seem excessive upfront, they usually represent a small percentage relative to overall funding raised through issuing securities. Costs are exceeded by the benefits of securitization such as balance sheet management, liquidity generation and risk transfer.
Securitization Process
Successfully executing securitizations requires coordinated efforts across multiple specialists. Key steps include:
Planning Stage
- Assess goals
- Estimate funding requirements
- Identify assets available for securitization
- Initiate underwriter discussions
Pre-Securitization Stage
- Accumulate target assets on balance sheet
- Assess asset eligibility and risk profile
- Develop servicing capabilities
- Plan SPV framework and structure
Structuring Stage
- Appoint key parties like underwriters, trustees and servicers
- Develop waterfall payment structure
- Model bond yields and returns for investors
- Design credit enhancements if required
Execution Stage
- Transfer assets to SPV
- Issue securities to generate funding
- Use proceeds to purchase assets
- Monitor early deal performance
Post-Securitization Stage
- Service assets to maximize collections
- Administer waterfall distribution of payments
- Manage deal accounts and reporting
- Govern collateral performance and cash flows
Successfully navigating these steps enables originators to cost-effectively fund themselves through capital markets while optimizing balance sheet usage.
Types of Securitizations
There are many assets that get securitized through financial engineering. Some major examples include:
- Mortgage-Backed Securities (MBS)
- Asset-Backed Securities (ABS)
- Collateralized Debt Obligations (CDO)
- Whole Business Securitizations (WBS)
- Intellectual Property (IP) Securitizations
- Agency Bonds
Conclusion
In conclusion, securitization is a powerful financial tool enabling companies to cost effectively fund assets, generate liquidity, transfer risks, and optimize balance sheet usage. The multi-step securitization process engages many parties who must work together cohesively. Despite complexities, securitization provides economic utility explaining its immense and still expanding popularity globally.