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Securitisations

"Highly engineered financials; one useful tool."

  • Using Debt Instruments to Raise Money
  • Using Future Income Streams as Loan Security
  • Cashing-In on Cash Flow

Securitisation is the creation of asset backed securities. These are debt securities that are backed by a stream of cash flow. Typical debt securities may include;

  • Residential & Commercial Mortgages and Real Estate Leases
  • Consumer Assets such as Personal Loans, Vehicle Hire Purchase and Credit Card Receivables
  • Commercial Loans
  • Trade Receivables

The act of ‘securitisation’ is the taking of the cash-flow or income streams over the period of the obligation and rolling it into a current lump-sum value. It is effectively bringing future income into today’s value for today’s use.

Due to this act of ‘relying’ on future income, most securitisations are underwritten or insured.

Assets to be securitised are first sold (or transferred) to a special purpose vehicle company (SPV) in order to isolate them from any claim or repayment obligation of the end borrower. The SPV will then issue Bonds or other debt instruments or obligations. The SPV then uses the funds raised by issuing the debt securities to pay to the ultimate borrower for the assets.

The borrower has raised money without risking assets other than those held by the SPV and it has got a lump sum in return. It has lost some assets or cash flows in return for cash. The debt is also kept off-balance sheet. This is quite reasonable given the limited recourse. Securitisation can therefore be seen as a way of selling off a stream of cash flows.

Securitisation also has benefits for investors. It widens their choice of available investments. The asset backed securities created by securitisation may also be easier to analyse as investors need only evaluate the cash flows from a small pool of assets, instead of a whole complex business. The assets most often securitised are loans of one kind or another which are usually (when pooled, not individually) a low risk investment.

The last of these usually also means that, for the issuer, it is often a cheap way of borrowing.

Advantages to issuer

  • Reduces funding costs: Through securitisation, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitise a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody’s downgraded Ford Motor Credit’s rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.
  • Reduces asset-liability mismatch: “Depending on the structure chosen, securitisation can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis.” Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitisation allows such banks and finance companies to create a self-funded asset book.
  • Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitising some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to lower the equity on their balance sheets while maintaining the “earning power” of the asset.
  • Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitised, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
  • Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitisation makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bonds and Entertainment Securitisations. Similarly, by securitising a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.
  • Off balance sheet: Derivatives of many types have in the past been referred to as “off-balance-sheet.” This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.
  • Earnings: Securitisation makes it possible to record an earnings bounce without any real addition to the firm. When a securitisation takes place, there often is a “true sale” that takes place between the Originator (the parent company) and the qualifying Special Purpose Entity (SPE). This sale has to be for the market value of the underlying assets for the “true sale” to stick and thus this sale is reflected on the parent company’s balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.
  • Admissibility: Future cash flows may not get full credit in a company’s accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitisation effectively turns an admissible future surplus flow into an admissible immediate cash asset.
  • Liquidity: Future cash flows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitised, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.

Disadvantages to issuer

  • May reduce portfolio quality: If the AAA risks, for example, are being securitised out, this would leave a materially worse quality of residual risk.
  • Costs: Securitisations can be expensive if management and system costs, legal fees, underwriting fees, rating fees and ongoing administration are not properly managed. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitisation.
  • Size limitations: Securitisations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.
  • Risks: Since securitisation is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.

Advantages to investors

  • Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)
  • Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitisations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.
  • Portfolio diversification: Depending on the securitisation, hedge funds as well as other institutional investors tend to like investing in bonds created through securitisations because they may be uncorrelated to their other bonds and securities.
  • Isolation of credit risk from the parent entity: Since the assets that are securitised are isolated (at least in theory) from the assets of the originating entity, under securitisation it may be possible for the securitisation to receive a higher credit rating than the “parent,” because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

Risks to investors

  • Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For Asset Backed Securities (ABS), default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.
  • Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
  • Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Mortgages tend to be the most sensitive to changes in interest rates, while vehicle loans, student loans, and credit cards are generally less sensitive to interest rates.

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