Example of Securitization
Securitization is a process of pooling together multiple liquid assets and turning them into securities. These securities are then sold out in the secondary marketplaces where investors can invest in them. Sounds confusing? Here is an example to help you better understand how securitization works:
A bank named New Bank is going for securitization. New Bank has lent 100 mortgage home loans to 100 different individuals, each amounting to ₹10 lakhs. Since it is a mortgage home loan, the borrowers have also mortgaged properties equal to ₹10 lakhs so the bank can claim the property in case the home loan becomes NPA.
The total loan lent by the bank amounts to
₹10 lakhs x 100= ₹100 millions
New Bank will turn these ₹100 million into securities (which may be split as per different risk levels) and take it off their balance sheet. It is done so by transferring the security to a Special Purpose Vehicle (SPV), a separate entity with a portfolio manager. The securities are then sold to investors by SPV. Upon purchasing these securities, investors will become shareholders.
Now, upon receiving the interest on these mortgage home loans from the borrowers, SPV will share the interests with the investors. This way, banks can split the risk of loans with investors and get more cash from the investors that can be utilised to lend more loans.
Key Takeaways
- Securitization is the processes of pooling together different loans and credits to turn them into investable securities
- Securitization helps bank clear their balance sheet to create funds for lending more loans
- Tranches in securitization are created based on different risk level of each tranche
- Investors benefit from the interest and principal share of the loan collected by the servicer
- Securitization are often created by pooling asset-backed mortgage-backed loans like student, home, or auto loans
Tranches
When a bank turns liquid funds into securities, it may divide these securities into different parts. These parts are usually divided on the basis of the risks involved with each part.
For instance, New Bank created a security pool of 100 different mortgage home loans. These securities can be divided into 10 parts where 1st part will be a low-risk security while the 10th part will be a high-risk security. These parts are termed tranches in securitization. Now, based on the risk appetite of investors, the securities may be sold.
Here is the division of tranches:
- Senior Tranche
The senior tranche has the lowest risk and highest chances of receiving payments. It also has the highest claim on the backed assets. However, these have lower yields which is why they are also low on risk.
- Mezzanine Tranche
Mezzanine tranches are similar to senior tranches. However, the risk involved is higher than the senior tranches but less than junior tranches. The yield is also intermediate.
- Junior Tranche
Junior tranches are also termed equity tranches. These have the highest risks involved. The chances of receiving the payment are also low. However, it offers a high yield which eventually compensates for the high-risk exposure of the investor.
Steps In Securitization
Securitization is a time-consuming and complex task. The process involves various steps that lead to successful securitization and selling of securities. Here is how it is done:
- Originating assets
Securitization is prepared when a bank has lent several loans or credit. So, the first step of securitization is creating assets. Assets are created when banks lend loans in the form of credit, auto loans, home loans, mortgage-backed loans, etc. to the borrowers
- Pooling of assets
The second step is creating a pool of assets. The chosen assets for securitization must be related to each other in some way. For instance, assets with the same maturity time or the same types of loans or credits are usually pooled together for securitization.
- Special Purpose Vehicle (SPV) creation
For securitization, the bank creates a Special Purpose Vehicle (SPV). It is a separate and independent entity with a portfolio manager and other members. SPVs are bankruptcy-remote meaning, even if the bank goes bankrupt, the securities with SPV will remain unaffected
- Selling of pool to SPV
Once the SPV is created, the bank will transfer and sell the securities to the SPV. Once sold, the loans will be taken off the balance sheet of the bank. SPV pays the bank for the securities. It is usually done using the funds that SPV receives by selling securities to investors.
- Creating tranches
SPV creates tranches in the securitization to divide the pool into different risk categories. Tranches in securitization help split the risks of different loans. It also ensures different investors can invest as per their specific risk appetite!
- Credit enhancement and rating
SPVs use various financial techniques to boost the attractiveness of the tranches and securities. It may use third-party guarantees, over-collateralisation, and more. It is done to attract more investors.
Also, with the help of third-party agencies, SPVs assign creditworthiness for each tranche based on their potential risks. Accordingly, the investors can invest in their preferred tranches and securities.
- Selling of tranches
Once the tranches are finalised with assigned credit ratings, it is marketed and sold to eligible investors. Different investors can choose securities from different tranches as per their preferences.
- Cash flows
In the process, you may remember that the initial loan is borrowed by the borrowers who may be individuals or firms. They pay their regular instalments servicer. The services/SPV will then keep the fees and distribute the remaining amount to the investors.
As discussed above, the tranche with the lowest risk (senior tranche) will receive the payment first followed by the mezzanine, and then the junior tranche at last.
- Monitoring of securities
SPVs continuously keep a tab on the performance of the securities. From time to time, they provide investors with the reports.
Types of Securitization
Now that you are aware of the process of securitization, let’s understand the various options that you have under securitization. There are different types of securitization based on the type of security they are backed by and the way they function. Read on for more details.
Types of securitization divided based on their function include three types. These are:
- Pass-Through Securitization
Pass-through securitization is a pool of fixed-income securities that are also backed by assets is known as pass-through securitization. In this type of securitization, the intermediary (which is mostly the SPV) collects the monthly instalments from the loan borrowers. Upon collecting the amount, the SPV/intermediary transfers the amount to the investors as per their investment. SPV issues certificates to the investors upon purchasing securities.
Since the process involves collecting installments and passing the remaining it to the investors, it is termed pass-through securitization. There are no tranches involved in this. One such example is Fannie Mae.
- Pay-Through Debt Instruments
Pay-through debt instruments are also known as CMOs (Collateralised Mortgage Obligations). CMOs are more complex compared to other types of securitization. Under pay-through debt instrument securitization, the installments collected from the loan borrowers are used to pay the interest to the SPV for the securities. Once the fee is deducted, the remaining amount is transferred to the investors.
Let’s understand this with the example of the New Bank given above. When the SPV sells security to the investors, it also issues pay-through debt instruments in the form of certificates to the investors. In case tranches of an investor turn to NPA, using this pay-through debt instrument, the investor can claim rights over the backed asset.
- Collateralised Debt Obligations (CDOs)
CDO or Collateralised Debt Obligations is a securitization of debt Obligations. It involves assets like loans, corporate bonds, mortgage-backed or asset-backed securities, etc. These are further divided into tranches like that in CMOs with each tranche having its own risk profile. The tranches are then sold to the investors.
Securitization is also divided on the basis of security they are backed by, that is, asset or mortgage. These are:
- Asset-Backed Securities (ABS)
ABS or Asset-Backed Securities are the assets that are backed by non-mortgage assets. Non-mortgage assets are pooled together to create securitization which is then sold to the investors. One such example is student loans.
- Mortgage-backed securities (MBS)
MBS or Mortgage-Backed Securities are the pooling of assets that are backed by mortgages. Investors receive certificates upon investing in Mortgage-Backed Securities so they can claim rights over the mortgaged asset in case the loan turns into an NPA. One such example can be a mortgage home loan.
Advantages and Disadvantages of Securitization
There are various advantages and drawbacks of securitization for the bank and especially for the investors. Read on to learn more.
- Advantages of Securitization
Here are some of the striking advantages of securitization:
- Helps banks turn loans into securities
- Banks can clear their balance sheet with space for more loans
- Banks receive capital to lend more loans
- Investors can receive regular income
- A good option to diversify a portfolio, especially for small investors.
- Disadvantages of securitization
Some of the drawbacks of securitization include:
- Investors take up the role of a creditor, more like a bank
- There is always a risk of default on the loan which may turn into an NPA
- Transparency regarding assets may be compromised
- If the borrower makes early repayment, it may affect the investor’s potential returns on the securities.
The Bottom Line
Securitization lets banks pool together debts and turn them into investable assets. Investors can take it as an opportunity to diversify their portfolio and become a shareholder. Classic examples of securitization include home loans, student loans, and auto loans. Turning these liquid assets into marketable instruments can bring benefits to both the bank and the investors. However, the process has to be carefully done or it may remind people of the 2007-08 financial crisis, the conditions of the banks, and the Wall Street.
FAQS
- What is Meant by Securitization of Loans?
When different loans are pooled together to turn them into securities, it is known as securitization. After turning them into securities, the assets are then sold out into the secondary marketplaces. Here, investors can invest in their preferred asset.
- The Purpose of Securitization of Loans
When a bank is planning to create space for lending more loans, it has to shake off the existing loan from its balance sheet. To do so, the bank turns loans and credits into securities and transfers this to the SPV who further sells the securities to the investors. Once the bank sells securities to the SPV, it is taken off the balance sheet of the bank. Thus, the bank now has space to lend more loans.
- What Do Investors in Securities Issued Against Loans Get?
Under securitization, investors receive their share of returns on loans paid by the borrowers. The amount is collected by the servicer (SPV) who passes the amount to investors based on their tranche and maturity period. The low-risk tranche (Senior tranche) receives the payment first. Investors become the shareholder in the security by purchasing it.
- How the Securitisation of Any Type of Loan Can Be Done
A bank can perform securitization by pooling different loans (which must be similar on some ground, for instance, similar maturity date or type of loan). The pool of assets is then sold to a third-party SPV who finally sells the securities to investors.
Once a bank sells securities to the SPV, it is taken off the balance sheet of the bank. Further monitoring and management of securities are done by the SPV.
- What are the Types of Securitised Instruments?
There are broadly three types of securitised Instruments based on their functions. These are:
- CMO (Collateralised Mortgage Obligations)
- CDO (Collateralised Debt Obligations)
- Pass-Through Securitization
Based on the type of asset backed by the securities, it may be divided into two types:
- Asset-Backed Securities (ABS)
- Mortgage-backed securities (MBS)
- Which Agencies Regulate Securitization?
In India, all the securitization processes are regulated by the Reserve Bank of India.
