Securitization

1.- Brief introduction.

2.- What is securitization?

• What is securitization’s usefulness?
• Types of securitizable assets.
• Agents involved in securitization.

3.- Cash flow, synthetic and market value securitization.

4.- Securitization example.

5.- Credit enhancement mechanisms.

•  Internal
•  External

6.- Effects of EU Regulation 2017/2402.

7.- Advantages and disadvantages of securitization.

8.- Conclusion.

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1. Brief Introduction.

Currently a booming financial technique, securitization saw its peak shortly before the 2008 Financial Crisis. After the Financial Crisis, it was clear that if used correctly, securitization would prove invaluable both for financial institutions, investors and the market itself.

Securitization contributes to the smooth functioning of financial markets. It also allows risk diversification and a more coherent distribution of financing sources within the EU financial system.

Securitization makes it possible to lighten the balance sheets of the originator entities, thus enabling them to lend more to the economy by improving the efficiency of the financial system by providing new investment opportunities.

Securitization is “another” link between the banking and capital markets, which can maje financing and lending to businesses, as well as credit cards and mortgages, cheaper.

However, excessive leverage is also a risk in itself and therefore any activity that contributes to indebtedness needs to be closely monitored by the European Systemic Risk Board (ESRB) and national competent authorities.

In this article, we will explain what is the mentioned securitization, and the reasons behind its constant use nowadays.

2. What is Securitization?

As we mentioned before, it is a financial technique. Its mechanism lies in transforming a set of credit rights into financial securities that can be traded. This set of credit rights must be homogeneous. Let’s define this term in a more specific way.

Definition.

• The most accurate definition of securitization, in addition to the one provided by the doctrine, is give in Regulation EU 2017/2402. The most relevant aspects to be taken into account are the following:
• Securitization allows the refinancing of a set of credits. The EU Regulation sets various examples such as loans or credits. We, as far as this article is concerned, will use mortgage credits as the main example.
• This credit rights set is transformed into marketable securities. Thus, they will be classified in different risk categories which we will explain later.
• They allow investors to invest in credits and loans which they would otherwise not have direct access.
• They also allow financing and provide liquidity to financial institutions.

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Credit Assignment and Assignment of Litigious Credit in Spain

Credit Assignment in Spain comprises that of all ancillary right thereof, such as any sort of collateral, guaranty, mortgage, pledge or privilege.

Analyzing this concept, it is logical to have some doubts about it. The main one will be :

What is securitization’s usefulness?

We will subsequently break down its benefits and detriments. However, we have to keep in mind some relevant information.

• It provides liquidity to financial institutions. For example when the bank is a mortgage creditor. This kind of credit involves low liquidity. Thus, when securitization appears, the bank will receive an amount of money for the mortgage credits, providing it with the required liquidity.
• It lowers the risks. Risks that are inherent in terms of obtaining liquidity. Thus, they will be able to grant new loans which will make them grow and expand their bussiness. These new loans can be reused in securitization.
• For investors, the profitability of securitization is an incentive to consider. This will enable them to diversify their investments, obtaining greater results.

Types of securitizable assets.

We are going to make the distinctions in a logical order. It is worth highlighting the compatibility of one with the other, as we shall see:

First of all, there is a distinction between short and long- term securitizations. In fact, long-term securitizations, such as mortgages ones, are the most successful securitizations. In long- term securitizations we find another división, this time between asset-backed securities (ABS) and those backed by corporate debt (CDO).

Asset-backed securitizations are undoubtedly the most frequent ones. The main división of ABS is usually made by distinguishing securitizable on balance assets from securitizable not on balance assets.

• Securitizable on balance assets: They include a large variety of examples. The most frequent ones are the security rights such as mortgage loans (Mortgage backed securities, MBS). We can also mention both personal loans and collection rights, financial leasing contracts, etc.
• Securitizable not included on balance assets : Some of the most common ones are the ones that come from property rentals, in addition to the ones coming from service contracts and exploitation rights.
• It is also common to find an even more generalized division, this time between the previously mentioned mortgage backed securitization and non-mortgage backed securitization.

Agents involved in securitization.

We have mentioned some of them before, but it is now time to analyze them in greater detail.

1. Issuer or transmitter. Generally, financial entities, and even more so in the area of mortgages. This implies that it is not always a financial entity that issues securitized assets. Rather, both stock and limited companies (the latter recently permitted) can also be issuers. Logically, the transmitter is the holder of the credit rights. With the credit rights’ disposal, i twill obtain the liquidity and security it seeks by getting rid of the inherent risks of such credits.
2. Investment funds. We will mention them briefly. These are Collective Investment Institutions that act as funds without legal personality. They are also a necessary agent in securitization, as they group the various credits and act as intermediary with the investors.
3. Their investments provide outstanding returns in securitization. This securitization also allows them to diversify their investments. Another incentive fort hem ist he different degree of risk within the securitization itself, which we will later explain.
4. Rating agencies. They certify the quality of the bonds issued. Thus, they have the last word in terms of what rating each tranche of these bonds should have. Once qualified, the manager of the Investment Fund may or may not agree with the qualification. If he considers it incorrect, he can vary the size of the trenches or make credit improvements. The main rating agencies are: Standard and Poor’s, Moody’s, Fitch and DBRS.

3. Cash flow, synthetic and market value securitizations.

We have mentioned the tranches within the bonds and the possibility of modifying them, as well as stablishing credit improvements. In this section and in the following one, we will talk about both issues.

We previosly mentioned the types of securitizable assets. Now, we will discuss the types of asset securitizations that exist.

1. Cash flow securitization.

The most common one, and on which we have based our explanation. It is based on the issue of different debt tranches by the Investement Funds. Thus, they use the money collected for the purchase of the components of their assets, which are always with credit risk.

Cash flows generated by the assets are redirected to play the investors. These payments will be made according to the rank of the assets, which corresponds to the tranche in which they have invested.

• AAA: The most secure tranche. The investors here are the first ones that get paid, but obtain less profitability in return.
• BBB: Medium term. More profitability than the AAA tranche, but also more risk. They get paid before the equity tranche.
• Equity: Those with higher profitabilty and greater risk. They are the last to be paid.

And how is the principal of the bonds amortized? There are two methods: pass through and defalut.

• Pass Through: Usually used in mortgage backed securitizations, and therefore is the most used method. It is periodic, which means the bonds are amortized as the securitized mortgages do. Although in the example in section 4 below we shall determine how it Works, a brief description should be made. This method causes the principal to be amortised sequentially. That is, they pass on to the investors the monthly payment of principal and interests derived from the mortgage loan that supports it. Thus payment is then distributed among the investors according to the tranche in which they have invested. Again, we will develop this concepts in section 4.
• Default method: It stablishes an schedule that is independent of the payments that occur on the fund’s own assets. That is, a date (or dates) is set on which the bonds are settled. It is independent of the fact that the principal and interest of the collateral are being paid month by month.

2. Synthetic securitizations.

The asset in this case is created through credit derivatives. Sometimes they can be complemented with other securities. Here it is the investors who effectively assume the losses and risks when the assets are being unfulfilled.

This kind of securitization occurs when financial entities don’t need liquidity. However, they do want to protect themselves against the risks. Thus, investors commit tho being liable for the posible unfulfillment of the loans the financial entity gave. It is in this case when the investor will have to give money to the financial institution. Therefore, it works as a kind of non-compliance insurance for the financial institution. Again, in this case we will see the tranches division explained above.

3. Market value securitization.

Being the least frequent, they are the most effective ones when it comes to securitization of umpredictable cash flow assets. In this case there is usually no classification into tranches, since the bonds are sold in private placements and the investors usually are institutional.

4. Securitization example.

For this example, we will use the securitizations we have been explaining so far: mortgage assets.

In this case, we have a financial entity, the bank. It will provide a certain amount of money to its client through a mortgage. In this way, the bank will obtain a constante income month after month, but of a small size.

However, this situation does not provide the bank with the liquidity it needs. So it decides to sell a set (bundle) of these mortgage loans to a third party. In this case, this third party will be the Investment Fund. Thus, the financial entity will obtain the desired liquidity, and will lose the risk that these assets entail. And with what money do the Investment Funds buy these bundles? With the money of the investors who, worth the redundancy, invest in it.

This Investment Fund acquires these mortgage loans, and groups them into different categories. Categories that, as we have seen before, will be divided into three: AAA (more security, less benefit to investors), BBB (medium term between security and benefit) and Equity (more risk, more benefit). After grouping them, and with the previous step of the rating through the rating agency, the Investment Fund will issue these bonds. With the logical objective that the investors decide to invest, it is worth the redundancy, in the same ones.

After this, the rating agency comes into play. The agency will decide whether this tranche rating is correct, or whether the credits should be reorganised. If it is not correct, the Fund manager may resort to credit enhancement mechanisms. These mechanisms are explained below. But who hires these rating agencies? The answer is the issuer of these bonds. Therefore, the Investment Fund, which is the agent that will remain in direct contact with the aforementioned rating agency. This contract with the rating agency will last a maximum of four years.

Once this is done, investors come into play. Depending on the type of investors they are, they will decide to invest in one category or another. How do these investors receive the money? Through the Investment Fund. That is, the bank continues to maintain contact with the client and receive their payments. Once received, the bank transfers the money to the Investment Fund, since these credits no longer belong to it. And finally, it is the Investment Fund that distributes this amount among the investors.

And how are these profits distributed to the investors? We will explain it in a simplified way, taking into account the differentiation between tranches. It should also be mentioned that the example given refers to cash flow securitizations using the “pass through” method explained above. We will also do so under the consideration that the securitised loans have been satisfactorily paid in that month.

Firstly, it is important to bear in mind that the method and amounts of payment are particular. In other words, the way in which each Fund distributes the profits obtained from the securitized loans will be set out in the bases of each Fund. The example given below is therefore merely indicative. The bases will establish the percentages to be returned in terms of interest and the nominal value of the bonds.

The tranches have an inherent interest rate that is different according to the risk they carry. Thus, the AAA tranche will have the lowest interest and therefore will entail less earnings. In return, they have greater security and get paid earlier. With the money provided (principal plus interest) monthly by the mortgage debtors, investors in the AAA tranche start collecting. They will do so by collecting the corresponding interest.

Then, as the loans have been duly paid, it is the turn of the BBB tranche, which will also charge interest. This interest will be higher than the interest on the AAA tranche, as is to be expected.

Now, before the interest on the equity tranche is paid, part of the principal of the AAA debt is repaid. Of the remaining money, depending on the amount, most will normally be stored as insurance. That is, in order to be able to continue making payments in the following months. And the remaining, final amount will be used to pay the interest on the equity tranche. As we can see, they are the last ones to be paid, which has certain consequences that we will explain below.

The example given above denotes a clear dependence on the number of securitised loans that have been satisfactorily paid. In other words, if the mortgagors meet their obligations, the payments to the tranches can be made accordingly. However, as the mortgagors begin to default, the amount to be distributed will obviously be lower. And so, it will start by cutting back on the Equity tranche payment. This demonstrates the risk inherent in such a tranche, as well as the benefit they can obtain.

Therefore, we see the dependence of benefits on the fulfillment of their obligations by the mortgage holders. As well as the security that can have one stretch or another, which will make them able to continue collecting constantly. Or on the contrary, that they stop collecting the first ones, in exchange for greater benefits when they can collect.

5. Credit enhancement mechanisms.

As we have seen, the manager may disagree with the tranches rating. Thus, one of the methods to try and change the rating is stablishing this credit enhancements mechanisms. We will briefly mention them, dividing this methods between internal and external.

•  External

We are talking, for example, about insurance contracts. They cover the maintenance of the assets value, or the possible losses due to the debtors’ non-payments. We also find subordinated credits or loans, which will cover eventual liquidity needs and necessary expenses, among others.

•  Internal

As we have mentioned, we can change the previous tranches structure. But we can also set up reserve funds to support possible losses. We can even under-issue assets, which means reducing the bonds issuing to a quantity below the volume of securitized assets.

6. EU Regulation 2017/2402 effects.

The recent EU Regulation has had a number of clear effects on securitization. The main intention of this regulation is to stablish a common framework for securitization, which main characteristic would be : « simple, transparent and standardised ».

• True acquisition by the SSPE (vehicle specialized in securitization). The titularity transfer will not be subject to strict rescission clauses if the seller becomes insolvent.
• Before prices are set, certain information must be made available to the investors, such as information about the historic and current behaviour of non-payments and losses of the securitizised credits.
• Compliance with the risk retention requirement stablished in article 6 of the Regulation. Non-conclusion of derivative contracts by the SSPE. Apropiate moderation of interest and exchange rate risks, among other measures.

    7. Advantages and disadvantages of securitization.

 Advantages

• It allows the development and improvement of the finantial system, by bringing a new product to the market, reducing financing costs, etc.
• The financial Institution will have several benefits, such as obtaining liquidity and reducing risks. With this liquidity, it will be able to grant new loans that will also re-enter securitizations.
• Clients and debtors will still have the same relationship as before, which means the debtors will still pay the loans tho the Institution.
• Possibility of balance sheet clean-up by the Financial Institutions.
• As for the investors, we have mentioned some benefits before. The profitability and possibility of expanding their investments are key, as well as the wide range of securitizations and its risk/return ratios.

Disadvantages.

•  As we have seen, there are certain benefits that may be detrimental to others, such as the risk, which in this case will be assumed by the investors even if the Financial Instituion benefits from it.
• The mentioned risk is also reflected in the early amortization, being the investors the ones who will asume the risks again.
• Possible malfunction at the time of collecting the payments and defenselessness in that situations. Again, it usually affects the investors.

8. Conclusion

Securitization is an effective and useful investment mechanism. Its correct and proper use provides benefits not only to Financial Institutions but also to investors. Thus, these Financial Institutions will see its liquidity rise while their risks reduce. When it comes to the investors, whey will be able to diversify their investments, deciding the profitability they will have based on the tranche of assets they want to invest in. Therefore, this instrument allows the entry of different types of investors that can seek for either more security or more profitability. Therefore, there is no doubt about the effectiveness of this investment tool.