What is securitization?

Securitization refers to the conversion of loans such as auto, house, credit cards etc. of banks and
lenders into debt instruments.

1. Many banks and lenders have receivables from auto, student, equipment and house loans, credit
cards, trade lease etc. Securitization converts these into debt instruments.

2. A Special Purpose Vehicle (SPV) is set up which pools these assets and issues debt instruments
which are called Pass Through Certificates (PTCs).

3. By making these debt instruments available in the markets, the organization manages to transform
illiquid assets to liquid assets which can be used to fund other business.

4. When the original lender recovers money from the original borrower, it is then passed on to the SPV,
which then disburses it to the investor in the form of a fixed income.

5. All the PTCs in the market are rated by agencies which tell the investor about the quality of the
underlying securities.

Securitization: the chicken and egg version

What is securitization?

Securitization is a way of transferring assets and risk to investors, and generating funding for more
assets. A bank might lend money to homebuyers. It can put these mortgages in a special vehicle (a shell
company), which then issues bonds. Investors buy the bonds, and the bank receives the cash, via the
vehicle. The investors receive income based on the mortgage payments. The bank has (mostly) moved
the mortgages off its balance sheet and can issue new mortgages with the new funding. I am still
unclear — can you provide me with a frivolous* analogy? Yes. Consider a chicken farmer. Imagine
you have 100 chickens and they each lay one egg per day. One day, you decide the egg business is not
necessarily the best way to make money — owning so many chickens is tiresome, and takes a long time
to become profitable. So you speak to a group of people from another village who need a long-term
supply of eggs. After much discussion, you agree to create an enormous special “coop” for the chickens
(a “shell” company), somewhere between your respective villages. The investors pay a lump sum up
front (for the value of 95 of the chickens — you retain five of them) and in return, they receive nearly
all of the eggs the chickens lay each day. You receive a few daily eggs for yourself, and a few eggs are
left to one side. So far, so good. You have saved these people the trouble of tracking down eggs from
different farms. Within such a large coop, the risk of the flow of eggs drying up is low, and if the
chickens stop laying eggs, the investors can legally sell them to a butcher to recoup some value. You do
not need to worry about looking after your chickens any more, and anyway, they are not really “yours”
— except for those five you retained. Some of the leftover eggs can be used to hire someone to look
after the coop, and paid into a store of “spare eggs” in case the chickens stop laying. You have also
brought in “funding” from the investors, which you can use to breed or buy new chickens in your
considerably more spacious village, and ultimately repeat the whole process, assuming enough people
are addicted to eggs. Hold on — isn’t that what caused the crisis? Avian flu? No — the financial crisis?
Hold on indeed. Securitisation is certainly associated with the crisis. To put it simply, there were lots of
coops and not enough people tending to them, some of the chickens laid poor quality eggs, and some of
them did not lay any eggs at all. Many of the farmers sold on their rights to their five eggs, weakening
that sacred bond between chicken farmer and chicken, and diminished their incentives to breed good
chickens. (Also, the chicken certification authorities did not anticipate the risks embedded in these huge
coops. Also, some of the chickens were “synthetic” . . .) Those especially useless chickens were US
subprime mortgage-backed securities. But it is important to point out that the European chicken
coops . . . The chicken analogy has run its course . . . Fine — plenty of European residential mortgage-
backed securities, auto-backed securities and other highly rated products performed well during the
crisis. Some asset-backed securities are viewed as extremely safe products and provide a very low
income indeed (these are, in effect, chickens that lay small, high-quality eggs — enough). So what is
the problem? Many people within the industry have complained that the asset class as a whole has been
unfairly tarnished (and stringently regulated) because of the harmful practices that became prevalent in
the US. Lots of politicians and central bankers in Europe — who want to boost economic growth —
seem to agree with them. But securitisation markets in Europe are still struggling to free themselves
from their post-crisis reputational trauma (the industry’s darkest night came when its annual party was
held in a hotel overlooking a motorway in London). Volumes remain extremely low and banks and
insurance companies who buy ABS need a lot of capital to do so. The European Commission is trying
to reduce capital charges on “simple, transparent and standardised” securitisations as a way of reviving
the market, but, unsurprisingly, simplicity is a fairly elusive concept when it comes to structured
finance. Why should I care about any of this? First, if you believe securitisation can help boost
Europe’s economy, you might have a stake in its revival. Second, and conversely, if you believe
securitisation still presents dangers, as per the crisis, you might have different views on the
commission’s plans. Third, much of the debt that features heavily in your day-to-day life — mortgages,
credit card debt, auto loans — is often, or at least could be, funded through securitisation. Fourth, if you
have a pension, or insurance, or investments, you might have an indirect stake in ABS, somewhere. If
we are continually consuming eggs, it might be worth knowing how they are hatched.
*DISCLAIMER: chickens do not quite “amortise” in the way many ABS financial assets, like
mortgages, do — at a stretch we could say older chickens lay fewer eggs. In reality the coop will be
divided into different “tranches” — with lower, riskier tranches of the coop taking losses first, and
paying out more eggs.

Finally, securitization can confer benefits on banks in terms of their balance sheet management and the
amount of capital they need against different kinds of assets.

Securitization of Loans - An Overview

Introduction

Securitization is the process of transformation of non-tradable assets into tradable securities. It is a

When a bank or financial institution is in need of additional capital to finance a new facility, to raise the
fund, instead of selling the assets, the financial institution decides to sell the portion of the loan to a
Trustee named as Special Purpose Vehicle (SPV) and collect the fund up front and remove the loan
asset from the balance sheet of the institution. SPV holds the asset as collateral in balance sheet and
issues bonds to the investors. It uses the proceeds from those bond sales to pay the originator for the
assets.

Securitization Process Flow

The detailed securitization process with typical components has explained with typical components in
the diagram below:

The roles and responsibilities of various components involved in the securitization structure are
explained below:

 Borrower – An Individual or organization which obtains loan from financial institution / bank
and pays the monthly payments.

 Mortgage Broker - Acts as a facilitator between a borrower and the lender. The mortgage broker
receives fee income upon the loan's closing.

 Issuer - A bankruptcy-remote Special Purpose Entity (SPE) formed to facilitate a securitization

 Lender - An entity that underwrites and funds loans that are eventually sold to the SPE for
inclusion in the securitization. Lenders are compensated by cash for the purchase of the loan
 and by fees. In some cases, the lender might contract with mortgage brokers. Lenders can be
banks or non-banks.

 Servicer - The entity responsible for collecting loan payments from borrowers and for remitting
these payments to the issuer for distribution to the investors. The servicer is typically
compensated with fees based on the volume of loans serviced. The servicer is generally
obligated to maximize the payments from the borrowers to the issuer, and is responsible for
handling delinquent loans and foreclosures

 Trustee - A third party appointed to represent the investors' interests in a securitization. The
trustee ensures that the securitization operates as set forth in the securitization documents,
which may include determinations about the servicer's compliance with established servicing
criteria.

 Securitization Documents - The documents create the securitization and specify how it operates.
One of the securitization documents is the Pooling and Servicing Agreement (PSA), which is a
contract that defines how loans are combined in a securitization, the administration and
servicing of the loans, representations and warranties, and permissible loss mitigation strategies
that the servicer can perform in event of loan default.

 Underwriter - Administers the issuance of the securities to investors.

 Credit Enhancement Provider - Securitization transactions may include credit enhancement

Note

Not all securitizations are identical. For example, the lender and the servicer are sometimes the same
entity, or in other arrangements brokers may not play a role.

Securitization takes the role of the lender and breaks it into separate components. Unlike the more
traditional relationship between a borrower and a lender, securitization involves the sale of the loan by
the lender to a new owner--the issuer--who then sells securities to investors. The investors are buying
‘bonds’ that entitle them to a share of the cash paid by the borrowers on their mortgages. Once the
lender has sold the mortgage to the issuer, the lender no longer has the power to restructure the loan or
make other accommodations for its borrower. That becomes the responsibility of a servicer, who
collects the mortgage payments, distributes them to the issuer for payment to investors, and if the
borrower cannot pay, action is taken to recover cash for the investors. The servicer can only do what
the securitization documents allow it to do. These contracts may constrain the servicer's flexibility to
restructure the loans
For example, suppose that a financial institution has processed 10 housing loans under the total worth
of 5,000,000 USD (each loan for 500,000USD). The Maximum Tenor for the loan is 20 Years and
aggregated Monthly Installment for the housing loan is 50,000USD.

In order to overcome the financial crisis, the financial institution decided to sell the loan assents and
raise capital. It sold the loan assets to an SPV for 7,000,000 USD and got the profit of 2,000,000 USD.

Once the contract has been signed after the legal verification, the financial institution becomes the
service provider for borrowers and SPV. It transfers the monthly payments / interest / charges / Fees /
Prepayment / penalty charges directly to SPV as per the agreement.