In its simplest form securitisation is a process whereby individual financial assets such as mortgage debts, leases, loans, credit card balances, trades receivable, etc. are bundled together to be sold as fixed income securities to capital markets investors.
The basic process starts when a company (the originator) generates new assets (either through lending or acquisition), which are analysed either individually or as a portfolio, and then sold to a Special Purpose Entity.
Next the SPE issues tradable securities, which are purchased by investors. As cash flows from the assets are collected, they are used by the SPE to make principal and interest payments to the investors.
Securitised transactions date back to the early 1970s with the sales of pooled mortgage loans by the Government National Mortgage Association (Ginnie Mae).
These transactions were followed by the Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae) in the early 1980s.
These securities (also known as single-class mortgage pass throughs) carried an implied AAA credit rating. However, the capital markets were looking for more technological innovations to satisfy investors’ need.
They were looking for a diverse “maturity” mortgage product which gave rise to the concept of collateralised mortgage obligations (multi-class mortgage pay-throughs, CMOs) soon to be followed by asset-backed securities.
Some of these securities have managed to become among the most innovative securities in the global markets.
Securitisation is a powerful financial tool that helps institutions and investors worldwide allocate capital more efficiently, access diverse and cost effective funding sources, and better manage risk. Today it is an integral part of the global financial services scene-several trillion dollars are currently under securitisation.
Securitisation finances the homes we build, the automobiles we drive, the planes that fly over our heads and, the office buildings we work in. Beyond residential mortgage loans various other types of assets may be securitised:
• Commercial loans on properties such as offices, shopping centers, and so forth.
• Automobile loans and equipment loans on trains, boats, planes and industrial equipment.
• Business trade receivables and credit card loans.
• Corporate loans when companies borrow from banks.
• Student loans to finance education.
Why would investors and originators use securitisation?
Securitisation is as necessary to the economy as any organised markets are. The following can be seen as the economic merits in securitisation:
• It facilitates creation of markets in financial claims by creating tradable securities out of financial claims, which would, in its absence, have remained bilateral deals.
• Disperses holding of financial assets by spreading financial assets between an important numbers of investors.
• Reduces costs as securitisation tends to eliminate fund-based intermediaries and be more efficient.
• Diversifies risks between originators and investors. When assets are removed from the originator’s balance sheet, without recourse, all the risks associated with the cash-producing assets are eliminated at the originator level and is passed to the investors through a variety of financial instruments with different risk and reward structures.
Securitisation is no more than a tool, but what a wonderful tool it is.
It is ever changing, ever growing, ever striving to become even more efficient. Even if the securitisation concept dates from the early 1970s, it is still a new concept for most of us.
It is important to understand the basics as there is tremendous growth and opportunities for the forthcoming years as this concept matures and introduces new financial instruments.