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Securitization: A transaction with endless possibilities

Date post: 13-Nov-2014
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www.infosys.com/finacle Universal Banking Solution | Systems Integration | Consulting | Business Process Outsourcing Securitization: A transaction with endless possibilities Thought Paper
  • 1. Securitization: A transaction withendless possibilitiesThought Paperwww.infosys.com/finacleUniversal Banking Solution | Systems Integration | Consulting | Business Process Outsourcing

2. Securitization: A transaction with endless possibilities What does a bank which has a fine portfolio ofmarkets, it has evolved, taken various shapes assets with assured cash flows do to expedite and forms, appeared in many different avatars them to the present day and improve its and is still growing world-wide. Along the way liquidity? What does a lending institution with securitization was part of many a scandal in a slightly lower credit rating do to borrow at adifferent economies at different points of time better rate which is usually reserved for anwhich could have slowed down its spread, institution with a higher rating? What does anbut did not. The financial significance and insurance company which wants to correctimplications of securitization are so integral the asset-liability mismatch in its books usually and essential to the world of finance that it look to do? And finally what does a governmentcontinues to thrive as time goes by. There is an which is debt-ridden do to improve its economy? estimated outstanding amount of 2.1 trillion If there has to be one common answer to Euros in the European securitization market as this, it will be in the form of a financial of 2011 end. And in the US market this amount instrument Securitization.is estimated at 10.04 billion. Since the 1970s, when the first form of securitization appeared in the US home mortgage The underlying principles The basic principle of a securitization transaction then sold to investors. The payments on the is pooling together a large amount of similar securitized collateral are then received by these risk rated or similar obligations such as loans investors. In short, securitization is selling of or mortgages that are backed by a collateral, future cash flows which otherwise would have financial papers or instruments and any formaccrued over a long period of time. of receivables, to create a new security which is Who can opt for securitization? Banks irrespective of size and nature, specializedrole of a SPV, called the issuer, is often varied. lending agencies including government agencies, It ranges from being the executor of the corporates, and micro-lenders are the maintransaction to being just an intermediary. They players in the securitization business. The would sometimes be involved in reinvesting securitized products often referred to as bonds or re-adjusting the cash flows and related are traded in the marketplace and bought by activities depending on the end objectives of various investors in including banks, financial the securitization transaction. The issuers often institutions, mutual funds, institutional investors issue the securitized products in tranches in and corporates. There is another entity in this order to improve its marketability. This is done cycle often referred to as the Special Purposeon the basis of yield, cash flows, the underlying Vehicle (SPV) or Special Purpose Company. The asset quality or safety.02 Thought Paper 3. The benefitsAs a financial instrument the benefits that Reduces cost of capital: As liquidity improvessecuritization transaction provides to thewith lower risks, so does the cost associatedvarious participants is enormous and varied. It with it. Securitization enables justified costsis therefore not at all surprising that the as it manages to lower illiquidity and alsoinstrument has grown in leaps and bounds over a offers a wide range of yields to the investorsperiod of time. associated with it. Improves liquidity: The factor that fuels Ensures safety: Many securitized products every market, liquidity! This is the constantare fully backed with assets and often earn benefit afforded by securitization, as ita high investment grade when traded in the provides a conduit to banks to convert their markets. The products are sometimes built locked assets to liquid ones.with internal standards. Apart from this,issuers also fortify the products with external Diversified Risk: Very few instruments giveaspects such as a built-in insurance features investors such as wide choice of diversifyingor corporate guarantees. their risk portfolio as securitization. As assets are pooled and then distributed it gives investors the choice of diversifying their risk across a wide range of portfolio of their choice.How securitization benefits the economy?Apart from benefiting every participant in the Traditionally, the lending market is imperfectlysecuritization transaction, it also has deeper,competitive which results in limited optionsgreater implications on the financial system. Most for financing. This imperfection is corrected byimportantly securitization provides additional securitization where creativity abounds whenlinks in the financial transaction chain. An it comes to product configuration. Issuersobvious proof of this is the mortgage-backed thrive in creating a wide ranged menu whensecuritization market in the United States which it comes to securitized products and thispropelled the growth of the housing sector improves the spread of products on offer. Theand enabled housing for a large section of result a move towards an efficient, sophisticatedthe population.and perfect market.Thought Paper 03 4. Further, being an instrument that providesthe transaction shows that the issues were sufficient amount of information up-front inwith the system and not with the instrument. terms of the risk, collateral and cash-flows, Wrong market practices such as toxicity of the securitization fuels efficiencies in the process of underlying instruments, over-rated credit rating capital formation. This increases standardizedto instruments and a high default rate of practices in the lifecycle and encourages bestunderlying securities have crept into the system. practices in the areas of legal, contracting andBut that has not slowed down market growth. the like. All the above benefits have culminatedOn the positive side these crisis events have into growth of capital markets in securitization- increased demand for market transparency, friendly countries of the world.improved regulatory balance and brought the market under the focus of policy makers. However, there is also a downside. But a quick check on real-world failures associated with Regulation in the securitization framework As in all other products and sub-products, thein the transaction. This is about 5% in many securitization world also needs an efficient setcountries. They also provide investors with of regulatory conduct to enable and normalize access to all relevant underlying data including the participants. Most of these regulations focus exposures, collateral and cash flows and in some on the need to strengthen the nature of countries, even loan-level data. Further, issuers involvement of market participants in order will have to carry out rigorous due diligence, to deepen their relationships in transactions.stress tests and ongoing monitoring on their The issues for instance are guided with securitized holdings with failure to comply regulations revolvingaroundincreasedattracting severe penalties. disclosures with respect to the level of retention How technology can enable securitization? It is impossible to ignore the role that technology possible only due to the ease of transaction has played in the securitization transaction. Itsupported by technology. Technology has also has provided limitless capabilities to the many contributed to increased complexity, diversity, processes that abound the securitization lifecycleproliferation and most importantly creativity in transaction. This ranges from pool selectionthis industry. So as we see the instrument of and designing, pricing, rating, loan and trustthe future securitization evolve in its various accounting, monitoring, reconciliation, bondavatars we may not know whom to thank for administration and analytics. The entire industry it, but surely do know what to thank for has seen a turnaround when it comes to easing its growth! the administration of such large volumesAnuradha Mallya Principal Consultant, Product Strategy, Infosys04 Thought Paper 5. About FinacleFinacle from Infosys partners with banks to transform process, productand customer experience, arming them with accelerated innovationthat is key to building tomorrows bank.For more information, contact [email protected]/finacle 2012 Infosys Limited, Bangalore, India, Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosysacknowledges the proprietary rights of the trademarks and product names of other companies mentioned in this document.