What do you understand by the term “securitisation” of bank loans, and why might a bank choose to securitise some of its loans?
Table of contents
(i) Abstract
(ii) How securitisation works
(iii) Reasons for Securitisation – Why banks secure some of their assets
a) Management of risk and the balance sheet
b) Higher funding
c) Lower costs
(iv) Conclusion
(v) Bibliography
A) ABSTRACT
Securitisation is the structured process whereby interests in loans and other receivables are packaged, underwritten, and sold in the form of “asset-backed” securities. From the perspective of credit originators, this market enables them to transfer some of the risks of ownership to parties more willing or able to manage them (Comptroller’s Handbook, 1997).
The idea of securitisation started to develop in the 1970s in the United States, when home mortgages were pooled by government-related agencies. Over the course of time, other income-generating assets – such as commercial mortgages, car loans, student loans or credit card debt obligations – started to become securitised (Finance and Development September, 2008).
In the last decade, the subprime mortgage crisis that began in 2007 has given the concept of securitisation a bad reputation. For instance, there have been a number of lawsuits attributable to three leading rating agencies – Moody’s, Standard & Poor’s, and Pitch – for their misconduct in managing the securitisation food chain. Notwithstanding, the process still remains extremely popular within the international banking system since it is a financial instrument that can benefit banks considerably.
B) HOW SECURITISATION WORKS
· In this section, I will discuss how securitisation works using a diagram that I have drawn (presented below). This diagram focuses on the three players in the process: the asset seller or originator (which in this case is a bank); the issuer (SPV/SPI); and the Capital Market Investors. The diagram aims to outline how these three interact to fulfil themselves and create a securitised asset that the originator can sell to the general public.
In its most underlying form, the process involves three steps. Firstly, a company with loans or other income-producing assets – also known as the asset seller, or originator – chooses the assets it wants to take away from its balance sheet and pools them into what is called the reference portfolio or collateral. This reference portfolio can hold a vast number of assets – such as mortgage loans or car loans – which are diversified internally within the same asset class. An asset class comprises those assets that are homogenous; have similar terms (for example, fixed or floating interest rates); and have a similar statistical history of losses.
The originator then sells these reference portfolios to an issuer. There are two main types of issuers: (1) The SpeciaI Purpose Vehicle (SPV)—an entity set up, usually by a financial institution (or the originator), specificaIIy to purchase the assets and realise their off-balance-sheet treatment for IegaI and accounting purposes. (2) The Structure Investment Vehicle (SIV) is a Iimited-purpose operating company that undertakes arbitrage activities by purchasing portfolios of Ioans and assets, and funds itseIf through cheaper, short-term paper.
Once the portfolios are sold to an SPV/SIV, they automatically become “bankruptcy-immune” or “bankruptcy-remote”, which means that they cannot be economically affected by the originator that the SPV is working with. The portfolios’ originator does not retain any interest in these because the SPV is established in such ways to avoid being treated as a subsidiary or affiliate of the originator, and therefore it is not affected by its very insolvency. In other words, SPVs are independent vehicles that are set up to eliminate the risk of the final investor vis-à-vis the issuer of the assets. In most cases, an SPV does not need to have its balance sheet consoIidated with the originator's baIance sheet – aIthough this may depend on the accounting practices and various other ruIes in the reIevant jurisdictions of the originator and the SPV.
In the second stage, portfolios have to be researched about and catalogued into a group of assets for the sake of improving asymmetric information, which will clarify the main features of the portfolios that the SPV holds and that capital market investors want to invest in. These groups of assets are called tranches, and they are designated according to their seniority. (Andreas Jobst, 2008).
Tranches are structured in three risk-related tiers — senior, mezzanine, and junior. This structure concentrates expected portfolio Iosses in first Ioss position (the junior) , which is usuaIIy the smaIIest of the tranches but the one that bears most of the credit exposure and receives the highest return. On the other hand, the last tranche (the senior) is viewed as the one with least credit exposure, which will in turn receive the lowest return. In other words, the least risky tranche has first call on the income generated by the underIying assets, while the riskiest has last claim on that income. This stage is carried out by credit rating agencies (CRAs).
Alternatively, the SPV might consider to improve the quality of some of the portfolios that they have received from the originator, which would result in a higher credit rating. At this point, credit enhancers are used to achieve this desired rating for securities. In this “enhancement” stage, any risks identified by the rating agencies appointed to provide a rating for such securities are usually managed by structuring the securitisation in a manner which complies with the applicable rating criteria and methodology of each such rating agency (Thomson Reuters, 2017).
Once securities have been “polished” by credit enhancement agencies, the SPV would finance the acquisition of the pooled assets by issuing tradabIe, interest-bearing securities that are sold to capitaI market investors. In most cases, the investors will receive fixed or fIoating rate payments from an account managed by an individual who controls funds for the benefit of another party – a trustee account – funded by the cash fIows generated by the reference portfolio. Capital market investors will then choose which assets to acquire based on the ratings that the portfolios received by the rating agencies and their very own necessities.
The third stage is the simplest one as it is the one which comes about when the capital market investors pay back for the assets that they have acquired. The payment flows are directed towards the originators, and these will start giving out loans to potential clients, who would finance the whole securitisation process.
C) REASONS FOR SECURITISATION: WHY BANKS SECURE SOME OF THEIR ASSETS
In this section, some of the motives behind the securitisation of banking assets will be discussed. It is important to note that this a generic overview of how banks can benefit from securitisation, and that there many more motives than those outlined.
(i) Management of risk and the balance sheet
In theory, securitisation shifts the originator’s credit risk away, as assets are transformed into packages in the first phase of the securitisation process and sold to an SPV, which then sells the acquired assets to capital market investors. This is completely efficient if the SPV is bankruptcy-remote, otherwise risk will only be eliminated to a certain degree, and there will remain a contingent liability with the originator.
Securitisation protects the bank from the risk of the securitisable assets, while also protecting capital market investors in the securitised assets from the risks of the bank. These securitised assets do not depend on the performance of the bank, but rather on the performance of the portfolio of assets. Selling portfolios will allow banks to generate equity capital, which will be displayed on the balance sheet. This is mainly done to improve shareholders’ expectations and attract future external investment to the company. This will also reduce the originator’s gearing (debt-to-equity ratio), allowing the bank to “(1) borrow more, (2) obtain better returns on capital, and (3) comply more adequately with financial covenants in respect of its on-balance sheet borrowing”. (Slaughter & May, 2000)
Nonetheless, it is important to remember that schemes created specifically to decrease the capital cost of risky assets on banks’ balance sheets were widely blamed for fuelling the 2007-08 financial crisis, as these involved the securitisation of banks’ non-existing assets (Financial Times, 2009). Professionals now suggest that the tangibility of the assets is a pivotal point in evaluating the effectiveness of the benefits of a bank shifting away risk by securitising their assets.
Chiesa (2004)
(Duffie, 2007).
(ii) Higher Funding
An adequate management of risk will therefore make an impact on the second motivation for a bank to securitise its assets: the funding motive.
An investor would always favour investing in securities backed by a subset filled with banking assets rather than to invest in the bank itself, and for this very reason, securitisation comes in handy. The process of securitising assets allows banks to expand their sources of financing for bank loans, which will secure funding for new loans without the cost of increasing the interest on deposits which would involve the bank paying a higher interest rate on deposits the bank will . A banking entity would use an extensive portfolio of mortgage loans, which could be used as collateral to increase funding, which could, in turn be employed to again increase lending (Fabozzi, Davis, & Choudhry, 2006).
(iii) Lower Costs
This is an expansion of Section 3.1 and 3.2. A cost reduction is a direct consequence of both shifting the credit risk away and having higher funding. In principle, securitisation aims to break the originator’s portfolio into levels of risk, attempting to align them to diversified risk appetites. In practice, this works because the weighted overall cost of the originator would be lower than a company that depends on generic funding. The process reduces the total percentage of risk capital and/or equity required in the balance sheet for regulatory purposes. This is beneficial for the originator because lower borrowing costs go along with lower lending costs.