John is a young and dynamic financial Analyst. He is working with one of largest Fund Services Company since two years in New York City. He always dreamt about his own big home in New York City. This year he has decided to buy home in any situation, but the problem is how?He doesn’t have enough savings to buy home in single down payment. He is thinking about various options. Finally he found the solution; one of hisclose friend suggested him to approach JKM Bank which is well known for his best services in home loan in New York. So he headed towards the JKM bank. As soon as he reached at the loan counter in the bank. He has warmly -welcomed by a beautiful lady Christina with smiley face sitting to his opposite side. He told his requirement of $100000 and purpose of loan to Christina. Meanwhile Christina analyzed documents carefully including his job history, salary. After analyzing all documents; JKM bank sanctioned him a loan of $80000 and in return JKM bank received rights of mortgage. It means JKM bank will receive principle with interest amount over fixed period of time. Finally John is very happy because he has successfully perused his dream of home in New York City. This is how john benefited but do you know how the bank would? Let’s understand the other side of the story.
Generally banks sell these mortgages to investors more than they issues loan. Bank will sell these mortgages to investor and make immediate profit. This is the one of the way that banks make money for themselves. JKM Bank issues thousands of loans in New York City and they get right of mortgages over the loan. JKM bank creates a pool of this all mortgage loan into the market securities. We can say that tradable market security this process of converting pool of mortgages loans into the market security called securitization. This is just general idea. Let’s get the gist of securitization.
What is Securitization?
Securitization is the process conversion of receivables and cash flow generated from a collection or pool of financial assets like mortgage loans, auto loans, credit card receivables etc into the marketable securities. These securities are backed by respective assets.
Various Financial institutions that originate loans including banks, credit card providers, auto finance companies and consumer finance companies, turn their loans into marketable securities with the help of SPV (special purpose vehicle)
Asset securitization is the process whereby interests in loans and receivables are packaged and sold in the form of ABS asset backed securities.
Parties involved in securitization
The originator is the original lender and the seller of the receivables.
- Mortgage financiers
- Finance companies
- Credit card companies
- Public utilities
- Intellectual property holders
- Insurance companies
- Aviation companies
The borrower is the counter party to whom the originator makes the loan.
Typically SPV is setup by trust The trust issues securities with the help of SPV and then investors subscribe these securities.
Investors are the persons who subscribe the securities. Banks, Financial Institution, NBFC and Mutual Fund are the main investors in securitized paper.
Trustees are normally reputed Banks, Financial Institutions or independent trust companies set up for the purpose of settling trusts. Trustees oversee the performance of the transaction till maturity and are vested with necessary powers to protest investor’s interests.
Credit Rating agencies
Independent rating agencies analyze the risks associated with a securitization transaction and assign a credit rating to the instrument issued. These rating agencies perform vital role in structured Finance. They are evaluating the credit quality of the transactions. They are expertise in evaluating various underlying asset type. Ratings are important because investors generally accept ratings by the major public rating agencies like Moody, standard and poor.
Special Purpose vehicle
SPVs are companies or trusts formed for the specific purpose of issuing securities in securitization transactions whose ownership and management are independent of the Originator .SPV is mainly formed to raise funds by collateralizing future receivables.
Typical securitization structure
Analyze Bellow picture to get the general idea of securitization structure.
- As you know John wants to buy house and he approached to the Loan originator i.e. JKM Bank.
- There are thousands of Johns who are getting loan from bank by keeping different type of mortgages.
- Bank issues loan to them and create a pool of mortgages.
- Bank then sale these pool of mortgage to the SPV (Special Purpose Vehicle) with the intention to convert these pool of mortgages into marketable securities.
- Then credit rating agencies and investment banks (Ancillary service providers) come into the picture. Credit rating agencies give rating to the securities and investment bank provide liquidity support to the security.
- When such structured securities are issued in the market, many Investors subscribe to them.
Must Know Concepts in securitization of Assets
Asset back securities (ABS)
Asset-backed securities are the bonds or notes backed by some financial assets. These assets consist of receivables such as mortgage loans, credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.
Collateralized debt obligation
It is an investment grade security backed by a pool of various other securities..
Mortgage-backed securities (MBS)
Mortgage-backed securities are bonds that are backed by pools of mortgage loans. Examples Mortgage papers, house papers, land and Property papers.
Collateralized Mortgage Obligations (CMOs)
The CMO is a multiclass bond backed by a pool of mortgage pass-through or mortgage loans. CMOs may be collateralized by both mortgage pass-through securities or mortgage loans, or some combination
Difference between MBS and ABS
|1||The Duration for trading is more than 15 years.||The Duration for trading is up to 5 years.|
|2||Securities: Mortgage papers, house papers, land and Property papers.||Securities: Credit card papers, Share certificates, Auto or vehicle papers.|
Benefits of Asset Securitization
Securitization improves ROC (returns on capital). Securitization may also lower borrowing costs, release additional capital for expansion, improve asset/liability and credit risk management.
Securitized assets offer a combination of attractive yields, greater liquidity of security in market and protection by way of collateral.
Borrowers benefit from the increasing availability of credit on terms that lenders may not have provided had they kept the loans on their balance sheets.