Securitization
In the last decade, securitization has been one of the most significant innovations made by the financial markets. In the United Kingdom, the development of securitization has occurred since the mid 1980s. As far as secondary securitizations in the modern form are concerned, the United States of America has led all the way; its market is the most matured. Although the United Kingdom has been the most developed of the European markets, secondary securitization in Europe is still very much in its infancy. However, in the United Kingdom, the sale of receivables has existed in some form for a very long time indeed (Oditah 1996). What securitization has done is to reinvent the wheel by wrapping the sale of financial and trade receivables around marketable securities. Assignment, which provided the basic framework within which sale of receivables was consummated from the17th century onward, still provides the basic structure for vesting the securitized assets in the special or multi purpose vehicle which modern secondary securitizations utilize. Securitization is a buzz word lacking any technical meaning. It is a market usage which can mean different things to different people (Oditah 1996).
Three usages may be distinguished: first, securitization is used to describe the transmutation of illiquid assets such as mortgages, into tradable securities. This involves the pooling, unbundling, repackaging and refinancing of existing income producing financial assets into securities that can be sold to investors in the capital markets. Mortgage securitization is the best example of this. Secondly, securitization is often used to describe any sale of financial assets, whether or not involving the creation of securities (Ben-Ami 2001). Even where existing participations are notated by the filling and filing of the prescribed forms with the agent bank, the prescribed form itself is not a security, although often referred to as a transferable loan certificate. Thirdly, securitization is sometimes used to describe the process of issuing tradable debts, whether or not the traded securities are backed by some underlying receivables. Securitization in all three senses raises a variety of issues. Some relate to the marketing of the securities and depend upon the type, place and manner of issue and marketing of the securities; some relate to the assign ability of the underlying receivables and the requirements of different national laws as to the creation and perfection of the sale of receivables and the security interest, if any, which secures the marketable securities; some relate to credit, liquidity, reinvestment and insolvency risks; some concern the accounting treatment which the vendor or originator of the pool of receivables requires; tax considerations play a dominant role as do capital adequacy and other regulatory constraints (Ben-Ami 2001).
Securitization has threatened the role of depository institutions in their traditional financial intermediation. If large corporations continue to by-pass depository institutions in favor of capital market intermediated credit, securitization, which enables this to happen by channeling debt finance directly between borrowers and lenders, would reduce the role of traditional intermediation in corporate finance and enable large corporations who have access to the capital markets to avoid the costs associated with traditional intermediation. At the same time, it has led merchant and investment banks into another form of financial intermediation, namely capital market-based intermediation. Instead of earning a margin or spread through traditional lending and intermediation, the emphasis has shifted to non-interest income from services associated with arranging, placing of debt securities with investors, underwriting the issues and trading in the securities (Osano & Tachibanaki 2001). Underwriting, broking and placing are all forms of market-based intermediation which are income producing for the depository institutions. As with traditional intermediation, lenders and borrowers are brought together through placing and underwriting. Underwriting provides liquidity in the capital markets because the underwriter, for a fee or spread dependent upon uncertain market conditions, absorbs the uncertainty about the market demand for the borrower's debt securities. These off-balance sheet activities are now significant sources of funds for banks without tying up bank capital. Securitization, by dis intermediating depository institutions from their traditional role of providers of intermediated credit, has, in relation to large corporations partially crowded them out of the corporate financing sphere (Osano & Tachibanaki 2001). Securitization makes use of special purpose entities to reduce any risk of bankruptcy for a firm and make sure that lenders would offer lower interest rates. Securitization helps in minimizing the mismatch between an asset and liability and it helps to decrease capital requirements. On the other hand securitization can create additional costs. It also has limitations that depend on the size of the business.
Asset backed securities
The return on an asset-backed security obviously depends on its price and its coupon, both of which are related to the risk of the underlying assets. In situations where a security's yield is greater than that of the underlying loan, securitization offers no benefits. Several options are available to change risk/return relationship associated with securitized assets. In the case of loan-backed bonds, for example, over collateralization will reduce risk as well as return (Smith & Walter 1997). There is also the possibility of insuring the securities themselves, in which case it is the insurer who bears the default risk: the insurer will have to evaluate the portfolio, and will charge a premium commensurate with that evaluation. This indicates the importance of the ability to evaluate the pool of loans that underlies asset-backed securities. The securitization process is clearly dependent on rating agencies' and investors' abilities to understand the loans. Highly complex loan portfolios or loans that have complex credit characteristics are unlikely to be well suited to securitization. The success of securitization will also depend on the payment patterns and maturities (Smith & Walter 1997).
Loans with poorly defined payment patterns and with maturities of less than two years are less attractive candidates for securitization, because the costs of securitization are more difficult to recoup over a short period and investors are not as attracted by short maturities, although credit card-backed securities are a notable exception. The costs of securitization consist of administrative costs primarily investment banking fees and the costs associated with providing information to investors and rating agencies. The benefits from securitization include protection from interest-rate risk, increased liquidity for original lenders and for investors, a more efficient transfer of resources from surplus to deficit financial sectors, and new and less expensive sources of capital for the original lenders (Liaw 1999). Securitization also serves to liquefy a bank's balance sheet and to provide additional funding sources. Securitization is particularly common in the case of smaller loans, which would be difficult to sell individually. Investors can achieve higher levels of diversification because, with the same nominal exposure, a bank in fact takes the credit. All asset-backed securities share most of the following characteristics: they are off balance sheet for the asset provider, the assets physically are deposited into a trust supervised by an independent trustee, the pool of assets is somewhat greater than the ace value of the security or a condition called over collateralization, and the value of the assets in the pool is marked to market periodically. If the value of the assets in the pool falls below a minimum, the provider must contribute additional assets to meet the required standard (Liaw 1999).
Many asset-backed securities have credit enhancement features, such as a guarantee of a bank or an insurance policy with one mortgage insurance groups. As a result of all of these features, the security is usually able to receive AAA or AA bond ratings. The securities are sold in the market, however, at a premium over the corresponding rate for comparably rated finance company securities. The securities are relatively safe, but they are also complex and subject to thin secondary market trading. The simplest forms of investment companies are asset-backed securities, which are claims on a share of a group of assets passively held by a closed-end pool. The assets in the pool are initially chosen from a group of fairly homogenous assets, and the asset holdings are fixed over the life of the pool (Murphy 2000). All interest and principal payments from the assets in the pool are passed through to the investment company shareholders as they are made and the pool's life terminates with the final principal payment on the pool's assets. Asset-backed securities are often therefore called pass-through securities. Asset-backed securities usually have some form of credit guarantee from the issuer or seller of the pool. These credit enhancements frequently take the form of a blanket guarantee of full payment of principal on any asset in the pool that defaults on a payment. However, some credit enhancements only guarantee up to a certain amount of the pool's assets in which case losses from defaults over that amount would have to be borne by the pool's shareholders. In all cases, the value of such guarantees is only as good as the credit quality of the guarantor (Murphy 2000). Asset Backed security is a type of security which has value and income payments. Such payments are usually derived from and collateralized by pool of assets. Asset Backed security ensures that assets deemed as not tradable can be combined and changed into instruments that may be sold in the capital markets. By selling such instruments a company will be able to facilitate the marketing of its bonds to investors who usually has changing investing time horizons and risk appetites.
The recent issue of CDO and MBS bonds
Mortgage-backed securities (MBS) or mortgage pass-through securities have developed into a tremendous market in the 1980s. Investors in mortgage pass-through include institutional investors such as commercial banks, insurance companies, mutual funds, and pension funds as well as individuals. The investor in a pass-through security receives a portion of the interest and principal payments of the mortgagors. The originator or a servicing institution collects the payments from the mortgagors and passes them through to the security holders. The guarantee covers the investor for the risk of default by mortgagors in the pool. The agencies involved in mortgage backed securities do not guarantee the return on investment and do not guarantee the maturity date of the security (Nowak 1993). As with any fixed income security, when market interest rates raise, the value of a mortgage pass-through security falls, and as market rates fall, the value of a mortgage pass-through rises. Mortgage-backed securities, collateralized mortgage obligations, and other derivative securities are loans arranged by bankers that are sold and repackaged as securities. These securities, which are available to both institutional buyers and to the public, are also sensitive to changes in interest rates (Nowak 1993).
Pass-through are created when holders of mortgages form a pool and sell shares of participation certificates in the pool. The cash flows earned by investors in pass-through securities are based on principal and interest payments on the underlying mortgages. MBSs also can be transformed into new assets through additional securitizations or the use of mortgage derivatives. Collateralized debt obligations are termed secured debt. If the collateral is real estate, the claim is called a mortgage (Squires 2004). A claim on other collateral is typically referred to as a lien. More than one collateral claim may exist on the same asset, but typically the claims are rank ordered, with the first claim having a prior claim over a second collateral claim, which in turn represents a prior claim on the asset over all other claims. For instance, a holder of a first mortgage on real estate collateral has a prior claim on the real estate over that of a second mortgage, while the holder of the second mortgage has a prior claim on the asset over all other claims. Some debt is collateralized by assets that are legally owned by a special third-party trustee. This ownership structure provides the creditors with better control of the assets if their claim is not paid off (Squires 2004). The issues of CDOs and mortgage-backed securities contributed and affected subprime mortgage bonds which are one of the reasons for the international crisis. As the mortgages in CDO's decline in value, company's holding CDOs face a problem in assigning a certain price to their holdings. Many companies just try to sell their CDO assets at par to avoid the onset of other problems. The issues of CDO and MBS bond require company to carefully plan their purchase or sale of assets. Through specialized project finance added with proper use of asset backed securities a company would survive the bond issues and the international financial crisis. The specialized project finance would help in adjusting to the changes brought by the bond issues. The asset backed securities would help in formulating appropriate techniques to counter the issues.
References
Ben-Ami, D 2001, Cowardly capitalism: The myth of the
global financial casino, John Wiley & Sons, New York.
Liaw, TK 1999, The business of investment banking, Wiley &
Sons, New York.
Murphy, A 2000, Scientific investment analysis, Quorum
Books, Westport, CT.
Nowak, LS 1993, Monetary policy and investment
opportunities, Quorum Books, Westport, CT.
Oditah, F (eds.) 1996, The future for the global securities
market: Legal and regulatory aspects, Clarendon Press,
Oxford.
Osano, H & Tachibanaki, T (eds.) 2001, Banking, capital
markets and corporate governance, Palgrave, New York.
Smith, RC & Walter, I 1997, Global banking, Oxford
University Press, New York.
Squires, GD (ed.) 2004, Why the poor pay more: How to stop
predatory lending, Praeger, Westport, CT.
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