Why securitize? Benefits for issuers, investors and markets

What does securitization do?

Securitization pools cash-generating assets such as loans or receivables, transfers them to a separate legal entity, and has that entity issue securities that are paid from the pool’s interest and principal. The pool is called the securitized assets , and is also known as the collateral or the reference portfolio. Investors end up with a direct link to the borrowers.

The securities usually come in classes. Each tranche is a bond class with its own claim on the pool’s cash. In a senior/subordinated structure , the senior classes are paid first and the subordinated (junior) classes absorb losses first. All investors are paid from the same pool, so the tranching sets both the order of payments and the order of losses.

Who benefits, and how?

Securitization benefitsloans become tradable securities

• Issuers Memorize banks, finance companies, manufacturers
  • Capital relief Memorize assets and lending risk leave the balance sheet
  • Fee income Use it origination and servicing fees
  • More lending Memorize originate beyond the balance sheet
  • Cheaper funding Memorize investors price the loans, not the lender
• Investors Memorize pension funds, insurers, asset managers
  • Tailored exposure Memorize choose risk, return and maturity
  • Access Use it loan exposure without banking skills
  • Diversification Use it assets that do not move in step with the rest of the portfolio
  • Liquidity Use it trade and adjust holdings quickly
• Economies and financial markets Memorize the whole system
  • Liquidity Memorize tradable securities in place of illiquid loans
  • Price discovery Memorize secondary market sets prices for credit risk
  • Alternative funding Use it beyond bonds, preferred and common equity

Issuers. Banks traditionally keep loans on the balance sheet until they are repaid, which makes them illiquid. If a bank separates making a loan from funding it, it earns origination and servicing fees, and the sold loans no longer tie up capital. Selling illiquid assets also lets it lend beyond its balance sheet. A manufacturer’s finance arm gains too: keeping its customer loans would mean issuing more debt, which raises leverage and lowers credit quality, while selling them taps the market for cheaper funding without that cost.

Investors. Few investors can originate, monitor and collect loans, but many can buy a security backed by them. They choose a tranche that fits their risk, return and maturity needs. A pension fund with long-dated payments can buy a senior tranche with a matching average life and a higher yield than government bonds, add diversification and still sell quickly.

Economies and financial markets. The securities are more liquid than the loans, and trading them sets prices for credit risk. Securitization also adds a funding channel beyond bonds, preferred equity and common equity.

Why can funding be cheaper?

Investors in the notes are buying the loans, not the lender. A weak company can therefore raise money more cheaply through its loans than through its own bonds. The funding cost is the weighted average of the tranche spreads.

$$\text{Blend} = \sum_i w_i \, s_i$$

$$\text{Saving} = c - \text{Blend}$$

Exam tip Weight each spread by its share of the pool. A simple average of the spreads is always a trap option.

How complex can securitized products get?

Complexity ladderhow far the assets leave the originator

• 1. Covered bonds Memorize assets stay on the bank balance sheet, segregated; bank pays investors; not a full securitization
• 2. Pass-through securities Memorize true sale to a separate entity; payments passed through proportionally
• 3. Bonds with structural enhancements Memorize cash redistributed across tranches by a preset schedule or by seniority
  • Collateralized mortgage obligations (CMOs) Know the idea mortgage cash re-sliced into tranches by a preset schedule
  • Collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) Know the idea pools of loans or bonds, tranched by seniority

Covered bonds are the simplest structure. A bank, mostly in Europe, segregates a pool of mortgage loans on its balance sheet and uses it as collateral (“cover”) for bonds it issues. If the bank defaults, investors can claim the pool. The assets are not transferred to a separate entity, and investors are paid by the bank, not from the pool’s cash flows, so covered bonds are not a full securitization.

Pass-through securities are true securitizations. The pool is moved off the balance sheet into a separate legal entity, which issues securities backed by it. Principal and interest are passed through to investors in proportion, so their payments depend directly on the pool’s credit risk and payment pattern.

Bonds with structural enhancements go further. They redistribute the pool’s cash across tranches by a preset schedule or by seniority, which dampens unexpected defaults, prepayments and late payments, and credit enhancements can reduce risk further. By collateral, mortgage-backed securities are backed by a pool of mortgages. The distinction between mortgage-backed and other asset-backed securities is common in the United States.

What risks come with it?

Securitization is not free of risk. There are two kinds.

• Timing risk. Borrowers may repay early, a contraction risk that often follows falling rates. They may also repay late, an extension risk that often follows rising rates.
• Credit risk. The borrowers in the pool may default. Credit enhancement is the main tool against this.

Poor underwriting hidden in complex structures contributed to the turmoil of 2007 to 2009, so structure and disclosure matter.

Go deeper Whole-business securitization

Some pools are not loans at all. A whole-business securitization is backed by the future cash flows of an operating business, such as franchise fees or licensing royalties. A restaurant group, for example, can sell the right to its franchise fees to an SPE and fund itself from the notes. Investors usually ask for a higher yield on these notes than on consumer-loan ABS, because the cash flows are less standard and harder to model.

Go deeper Why finance arms securitize

A manufacturer that extends credit to customers through a finance subsidiary has to fund those loans. If it keeps them, it issues more debt, which raises leverage and funding costs and weakens its credit quality. Selling the loans to an SPE gets cash to finance new customers and sell more product, without that extra leverage.

Go deeper Is a mortgage-backed security an ABS?

Often the label asset-backed security (ABS) is used for products backed by non-mortgage assets, and mortgage-backed security (MBS) for those backed by mortgages. The distinction is common in the United States. In the curriculum’s wider sense, any security repaid from a pool of loans or receivables is an ABS.