The Mechanics of Securitization,
The Mechanics of Securitization,
Introduction to Securitization and Asset-Backed Securities
Perhaps the best illustration of the flexibility, innovation, and user-friendliness of the debt capital markets is the rise in the use and importance of securitization. As defined in Sundaresan (1997, page 359), securitization is "a framework in which some illiquid assets of a corporation or a financial institution are transformed into a package of securities backed by these assets, through careful packaging, credit enhancements, liquidity enhancements, and structuring."
The flexibility of securitization is a key advantage for both issuers and investors. Financial engineering techniques employed by investment banks today enable bonds to be created from any type of cash flow. The most typical such flows are those generated by high-volume loans such as residential mortgages and car and credit card loans, which are recorded as assets on bank or financial house balance sheets. In a securitization, the loan assets are packaged together, and their interest payments are used to service the new bond issue.
In addition to the more traditional cash flows from mortgages and loan assets, investment banks underwrite bonds secured with flows received by leisure and recreational facilities, such as health clubs, and other entities, such as nursing homes. Bonds securitizing mortgages are usually treated as a separate class, termed mortgage-backed securities, or MBSs. Those with other underlying assets are known as asset-backed securities, or ABSs. The type of asset class backing a securitized bond issue determines the method used to analyze and value it.
The asset-backed market represents a large and diverse group of securities suited to a varied group of investors. Often these instruments are the only way for institutional investors to pick up yield while retaining assets with high credit ratings. They are considered by issuers because they represent a cost-effective means of removing assets from their balance sheets, thus freeing up lines of credit and enabling them to access lower-cost funding.
Instruments are available backed by a variety of assets covering the entire yield curve, with either fixed or floating coupons. In the United Kingdom, for example, it is common for mortgage-backed bonds to have floating coupons, mirroring the interest basis of the country's mortgages. To suit investor requirements, however, some of these structures have been modified, through swap arrangements, to pay fixed coupons.
The market in structured finance securities was hit hard in the wake of the 2007-2008 financial crisis. Investors shunned asset-backed securities in a mass flight to quality. As the global economy recovered from recession, interest in securitization resumed. We examine the fallout in the market later in this chapter. First we discuss the principal concepts that drive the desire to undertake securitization.
The Concept of Securitization
Securitization is a well-established practice in the global debt capital markets. It refers to the sale of assets, which generate cash flows, from the institution that owns them, to another company that has been specifically set up for the purpose, and the issuing of notes by this second company. These notes are backed by the cash flows from the original assets. The technique was introduced first as a means of funding for mortgage banks in the United States, with the first such transaction generally recognized as having been undertaken by Salomon Brothers in 1979. Subsequently, the technique was applied to other assets such as credit card payments and leasing receivables, and has been employed worldwide. It has also been employed as part of asset-liability management, as a means of managing balance sheet risk.
Reasons for Undertaking Securitization
The driving force behind securitization has been the