Learn more about Securitisation

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.