Securitizations

Securitization is a financial-product-creation-process that results in a cycling of cash through the banking system.[1] It involves aggregating various types of contractual debt obligations, such as mortgages, auto loans, credit card debt, or corporate debt, and converting them into securities that can be sold to investors in the capital markets. The original purpose of the securitized product was to transform illiquid assets into more easily tradable securities, thereby providing liquidity to the originators of the assets and enabling them to recycle capital for further lending. For example, originally illiquid mortgages held by banks in various regions of the country could be sold and pooled together to create an asset backed security that is liquid.[2]

Here's a thorough explanation of the securitization process:

§  Asset Selection: The process starts with the selection of a pool of assets that will serve as collateral for the securities to be created. These assets typically have a stream of future cash flows, such as loan payments or interest payments.

§  Formation of Special Purpose Vehicle (SPV): A Special Purpose Vehicle, is created to hold the pool of assets separate from the originator's balance sheet. This entity is usually a bankruptcy-remote legal structure, meaning that if the originator faces financial distress, the assets in the SPV are protected from creditors of the originator.

§  Transfer of Assets to SPV: The selected assets are transferred to the SPV, which then issues securities backed by those assets. This transfer is usually achieved through a sale or a true sale, where the assets are sold to the SPV without recourse to the originator.

§  Tranching: The securities issued by the SPV are often divided into different tranches, each with different risk and return profiles. The most common tranches include senior, mezzanine, and junior (or equity) tranches. Senior tranches are the first to receive payments from the underlying assets and are therefore the least risky but offer lower returns. Mezzanine tranches are subordinate to senior tranches but offer higher returns. Junior tranches are the riskiest but offer the highest potential returns.

§  Credit Enhancement: To enhance the credit quality of the securities, various techniques can be employed, such as overcollateralization, where the value of the collateral exceeds the value of the securities issued, and credit enhancements like insurance policies or letters of credit.

§  Issuance of Securities: The securities are then sold to investors in the capital markets. Investors are attracted to securitized products because they offer diversification, potentially higher yields, and exposure to different types of underlying assets.

§  Cash Flow Distribution: As the underlying assets generate cash flows (e.g., loan payments), these cash flows are collected by the SPV and distributed to the holders of the securities according to the terms outlined in the offering documents. Typically, senior tranches receive payments before mezzanine tranches, and mezzanine tranches receive payments before junior tranches.

§  Servicing of Assets: The SPV or a third-party servicer is responsible for collecting payments from the underlying assets, managing delinquencies, and administering any necessary foreclosure or repossession proceedings.

§  Rating Agencies Evaluation: Rating agencies assess the credit quality of the securities issued by the SPV and assign credit ratings based on factors such as the creditworthiness of the underlying assets, the structure of the transaction, and the credit enhancements in place.

§  Market Liquidity: Once issued, the securities can be traded in the secondary market, providing liquidity to investors who wish to buy or sell them before maturity.

Overall, securitization allows financial institutions to mitigate risk, manage capital more efficiently, and provide investors with access to a wide range of investment opportunities. However, it's essential to note that securitization played a significant role in the 2008 financial crisis when subprime mortgage-backed securities suffered massive losses, leading to a global financial meltdown. Hence, proper risk assessment, transparency, and regulatory oversight are crucial in ensuring the stability and integrity of securitization markets.

[1] Please contact us if you have an economic study on the effects on the velocity of money in the U.S. or other financial systems resulting from the securitization of bank loans.

[2] ASSET-BACKED SECURITY.—The term ‘‘asset-backed security’’— (A) means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including— (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the Commission, by rule, determines to be an asset-backed security for purposes of this section; and (B) does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company. 15 U.S.C. 78c(a)(79).

See also The Monoline Insurers, Other Insurance Products, The Securities Act of 1933, and Regs. S-K and S-X.