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Securitization: A transaction with endless possibilities

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Securitization: A transaction with endless possibilities

The underlying principles

Who can opt for securitization?

What does a bank which has a fine portfolio of assets with assured cash flows do to expedite them to the present day and improve its liquidity? What does a lending institution with a slightly lower credit rating do to borrow at a better rate which is usually reserved for an institution with a higher rating? What does an insurance company which wants to correct the asset-liability mismatch in its books usually look to do? And finally what does a government which is debt-ridden do to improve its economy? If there has to be one common answer to this, it will be in the form of a financial instrument – Securitization.

Since the 1970s, when the first form of securitization appeared in the US home mortgage

The basic principle of a securitization transaction is pooling together a large amount of similar risk rated or similar obligations such as loans or mortgages that are backed by a collateral, financial papers or instruments and any form of receivables, to create a new security which is

Banks irrespective of size and nature, specialized lending agencies including government agencies, corporates, and micro-lenders are the main players in the securitization business. The securitized products often referred to as bonds are traded in the marketplace and bought by various investors in including banks, financial institutions, mutual funds, institutional investors and corporates. There is another entity in this cycle – often referred to as the Special Purpose Vehicle (SPV) or Special Purpose Company. The

markets, it has evolved, taken various shapes and forms, appeared in many different avatars and is still growing world-wide. Along the way securitization was part of many a scandal in different economies at different points of time which could have slowed down its spread, but did not. The financial significance and implications of securitization are so integral and essential to the world of finance that it continues to thrive as time goes by. There is an estimated outstanding amount of 2.1 trillion Euros in the European securitization market as of 2011 end. And in the US market this amount is estimated at 10.04 billion.

then sold to investors. The payments on the securitized collateral are then received by these investors. In short, securitization is selling of future cash flows which otherwise would have accrued over a long period of time.

role of a SPV, called the issuer, is often varied. It ranges from being the executor of the transaction to being just an intermediary. They would sometimes be involved in reinvesting or re-adjusting the cash flows and related activities depending on the end objectives of the securitization transaction. The issuers often issue the securitized products in tranches in order to improve its marketability. This is done on the basis of yield, cash flows, the underlying asset quality or safety.

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The benefits

How securitization benefits the economy?

As a financial instrument the benefits that securitization transaction provides to the various participants is enormous and varied. It is therefore not at all surprising that the instrument has grown in leaps and bounds over a period of time.

• Improves liquidity: The factor that fuels every market, liquidity! This is the constant benefit afforded by securitization, as it provides a conduit to banks to convert their locked assets to liquid ones.

• Diversified Risk: Very few instruments give investors such as wide choice of diversifying 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.

Apart from benefiting every participant in the securitization transaction, it also has deeper, greater implications on the financial system. Most importantly securitization provides additional links in the financial transaction chain. An obvious proof of this is the mortgage-backed securitization market in the United States which propelled the growth of the housing sector and enabled housing for a large section of the population.

• Reduces cost of capital: As liquidity improves with lower risks, so does the cost associated with it. Securitization enables justified costs as it manages to lower illiquidity and also offers a wide range of yields to the investors associated with it.

• Ensures safety: Many securitized products are fully backed with assets and often earn a high investment grade when traded in the markets. The products are sometimes built with internal standards. Apart from this, issuers also fortify the products with external aspects such as a built-in insurance features or corporate guarantees.

Traditionally, the lending market is imperfectly competitive which results in limited options for financing. This imperfection is corrected by securitization where creativity abounds when it comes to product configuration. Issuers thrive in creating a wide ranged menu when it comes to securitized products and this improves the spread of products on offer. The result – a move towards an efficient, sophisticated and perfect market.

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Regulation in the securitization framework

How technology can enable securitization?

As in all other products and sub-products, the securitization world also needs an efficient set of regulatory conduct to enable and normalize the participants. Most of these regulations focus on the need to strengthen the nature of involvement of market participants in order to deepen their relationships in transactions. The issues for instance are guided with regulations revolving around increased disclosures with respect to the level of retention

It is impossible to ignore the role that technology has played in the securitization transaction. It has provided limitless capabilities to the many processes that abound the securitization lifecycle transaction. This ranges from pool selection and designing, pricing, rating, loan and trust accounting, monitoring, reconciliation, bond administration and analytics. The entire industry has seen a turnaround when it comes to easing the administration of such large volumes

in the transaction. This is about 5% in many countries. They also provide investors with access to all relevant underlying data including exposures, collateral and cash flows and in some countries, even loan-level data. Further, issuers will have to carry out rigorous due diligence, stress tests and ongoing monitoring on their securitized holdings with failure to comply attracting severe penalties.

possible only due to the ease of transaction supported by technology. Technology has also contributed to increased complexity, diversity, proliferation and most importantly creativity in this industry. So as we see the instrument of the future – securitization evolve in its various avatars we may not know whom to thank for it, but surely do know what to thank for its growth!

Anuradha MallyaPrincipal Consultant, Product Strategy, Infosys

Further, being an instrument that provides sufficient amount of information up-front in terms of the risk, collateral and cash-flows, securitization fuels efficiencies in the process of capital formation. This increases standardized practices in the lifecycle and encourages best practices in the areas of legal, contracting and the like. All the above benefits have culminated into growth of capital markets in securitization-friendly countries of the world.

However, there is also a downside. But a quick check on real-world failures associated with

the transaction shows that the issues were with the system and not with the instrument. Wrong market practices such as toxicity of the underlying instruments, over-rated credit rating to instruments and a high default rate of underlying securities have crept into the system. But that has not slowed down market growth. On the positive side these crisis events have increased demand for market transparency, improved regulatory balance and brought the market under the focus of policy makers.

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