Asset securitization works through a Special Purpose Vehicle (SPV). The SPV acts as a crucial link in the securitization chain, intermediating between the primary market for the underlying asset and the secondary market for the asset backed security. Following are the steps involved in the securitization process:
Assets are originated by a company, and funded on that company’s balance sheet. This company is normally referred to as the “Originator”.
Asset Identification and Pooling:
The asset to be securitized by the institution is identified, which comprises of the loans advanced by the institution. The identification of the assets is done in such a manner as to ensure an optimum mix of homogeneous assets having the same maturity.
Securities of uniform maturity are created out of the assets that are identified. These are then passed on to another institution called “Special Purposes Vehicle” (SPV). The SPV is a trust. Which like an investment banker, manages the issue of securities to investors. These securities are known as pay or pass through certificates. The SPV becomes liable to the investor for principal repayment and interest recovery.
The SPV engages itself in the task of enhancing its credibility in order to make the issue attractive. For this purpose, the SPV obtains an insurance policy to cover the credit losses, or arranges a credit facility from a third party lender to cover delayed payments.
The SPV issues trade able “securities” to find the purchase of assets. The performance of these securities is directly linked to the performance of the assets, and there is no recourse (other than in there event of breach of contract) back to the originator.
Investors purchase the securities, because they are satisfied (normally by relying upon a rating) that the securities will be paid in full and on time from the cash flows available in the asset pool. A considerable amount of time is spent considering the different likely performances of the asset pool, and the implications of default by borrowers. The proceeds from the sale of the securities are used to pay the originator.
Receipt of Benefits:
The SPV agrees to pay any surplus which arises during its funding of the assets back to the originator. This means that the originator, for all practical purposes, retains its existing relationship with the borrowers and all the economies of funding the assets [i.e. the originator continues to administer the portfolio, and continues to receive the economic benefits (profits) of owning the assets].
Rating and trading:
The SPV gets the securities rated by some reputed credit rating agencies so as to enhance the marketability of the securitized assets. In addition, credit rating increases the trading potential of the certificate in a secondary market, thus augmenting its liquidity potential.
On maturity of the security, the investors get a redemption amount from the issuer along with interest due to the amount.
Following are the purposes served by the securitization process:
1. To improve the return on capital, since securitization normally requires les capital to support than traditional on balance sheet funding
2. To raise finance when other forms of finance are unavailable (in a recession banks are often unwilling to lend, and during a boom, banks often cannot keep with the demand for funds).
3. To improve return on assets, since securitization can be a cheap source of funds. The attractiveness of securitization, for this reason, is dependent primarily on the costs associated with alternative funding sources.
4. To diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced
5. To reduce credit exposure to specific assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole then securitization can remove some of the assets from the balance sheet).
6. To match fund certain classes of asset mortgage assets are technically 25 year assets, a proportional of which should be funded with long term finance; securitization normally offers the ability to raise finance with a longer maturity than is available in other funding markets.
7. To achieve a regulatory advantage, since securitization normally removes certain risks which can cause regulators some concern. There can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitization as a means of managing the restriction on their wholesale funding abilities).