Securitization - Hero or Villain?
Securitization has played a fundamental role in Western capital markets since the 1970s and has played a pivotal role in ensuring credit creation and economic growth. In the last few years, however, the media have re-cast it from hero to zero, from magic bullet to credit crunch villain.
It is surely more appropriate to characterize the credit crunch as a housing bubble and crisis in lending standards that later infected the securitization markets. It is true that some of the more exotic structured financial fauna of the bubble era, such as "alphabet soup" derivative products, have been killed off for good. Few will miss them. But the importance of "bread and butter" securitization remains undiminished. It is no coincidence that recent tentative steps towards global economic recovery have gone hand in hand with a partial revival of the market for asset backed securities.
The near collapse of the Western financial system in October 2008, as credit markets dried up and Lehman Brothers collapsed, merely serves to show the critical role that structured finance plays in modern capitalism. The core benefits of securitization - legal isolation of assets, the ability to segment risk and deliver stable and cheap funding - remain as compelling as ever.
Securitization Basics
The description below is purely academic and theoretical and is not in any way offered as investment or professional advice. In a real transaction, a multitude of factors including structural complexity, asset type, legal jurisdiction and structure and other legal, fiscal and regulatory factors will determine how a deal is structured. There are very significant differences between European and North American ABS markets which are outside the scope of this hub.
The essence of securitization is sale and legal isolation of a pool of assets. Assets are sold to convert a future cash flow (from thousands of receivables over many years) into a single, up-front cash flow.
Basic concepts
1. Seller sells loans to an SPV. In a securitization, a pool of eligible receivables (e.g. mortgages, student loans or auto loans), is sold by the seller to a bankruptcy remote "special purpose vehicle",or SPV. This is company created purely for the transaction and is normally referred to as the "Issuer". Legal title,or retention of title, in the assets is typically transferred to this Issuer and a "true sale" takes place.
2. Seller continues to service the receivables. Typically the Seller, in its capacity as Servicer, will continue to "service" the transaction. This means that it collects payments ("collections"), chases up delinquent customers etc. In a revolving structure new loans will continue to be originated and sold into the structure on a regular basis, provided they meet certain quality requirements of "eligibility criteria". In an amortising structure the pool is cut only once and will simply amortize down over time, as borrowers repay their loans.
3. Notes are issued. The Issuer now holds the legal security interest in the collateral. It will then issue a series of asset-backed notes to investors, backed up by the pool. The notes will typically be sliced into tranches,or classes, according to their relative seniority in the structure. Interest and principal on senior notes gets paid first in the monthly allocation of cash known as the waterfall, so these notes may be given a AAA rating by the rating agencies. Clearly such a "gold star" rating would be dependent on an evaluation of the underlying assets, the credit collection and management policies of the Servicer and a legal and structural analysis of the deal.
Credit enhancement
The junior notes, if any, will typically be subordinated to the senior notes, meaning that any credit losses will be applied against them first. In other words, they take the hit if the pool performance deteriorates (too many loans go bad). The amount of subordination, including reserve accounts, that supports the senior notes is called credit enhancement. Unsurprisingly, junior notes are assigned a lower rating, if any, by the rating agencies so offer a higher coupon to investors as a reward for the extra risk. Some junior notes may be retained by the Seller,so they keep some "skin in the game".
Benefits of securitization
The senior and junior notes may be issued publicly or in a private trade. The Seller receives the cash proceeds. This is the essence of securitization - the conversion of myriad future cash flows from a pool of receivables into a single up-front cash flow. For issuers, securitization is a stable and long term source of funding. Because the credit rating of the notes depends on the asset quality and is independent of the credit rating of the Issuer, it is often a cheap source of funds compared to unsecured financing (bonds, medium term notes etc). Historically it has offered capital and off balance sheet financing benefits in certain jurisdictions. Even very highly rated issuers will include securitization in their treasury strategy because it diversified their funding sources. For a corporate investor, securitization theoretically allows targeted risk exposure (via tranches) and potential dispersal of risk through the large pool of underlying receivables which can be cut to avoid undesirable geographical or obligor concentrations.
So that's securitization in a nutshell. The market seized up from August 2007 as the sub-prime crisis worked its way through the system. An inability to access wholesale funding markets was a key factor in the collapse of several leading banks, proving again the vital importance of asset backed markets to the global economy. However supported by the TALF (Term Asset Backed Lending Facility) in the U.S., the securitization market has come slowly back to life in 2009.
(c) WestOcean 2009
