Securitization Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Securitization is the process of creating securities from other assets by pooling and repackaging them. Assets are combined into a pool that is split into shares, ideally structured in such a way as to reduce credit risk and improve profit, though securitized assets are indeed considerably more volatile than many other types because of the amortizing cash flows that back them and the possibility of debt-backed securities being at risk when that debt is defaulted upon.

Mortgage-based securities are a common securitized asset, their risks amply demonstrated by the subprime mortgage crisis. But the advantage is just as clear: the value of a mortgage is too large for a single investor to take on, just as a company is too large for a single investor. Pooling mortgages and dividing them into shares creates an investment opportunity as flexible as the stock market. Investment banks generally structure securitized assets, either of their own origination or more commonly on behalf of the originator.

Securitization is one of the main processes of structured finance, which has become an important part of the finance industry in the 21st century, using various financial and legal instruments to manage risk. Assets that are securitized are generally structured in other ways as well. After being pooled together, they are sold to a special trust called a special purpose vehicle (SPV), which exists for the purpose of funding and issuing the security. At that point they are generally tranched. Tranching is the diversion of cash flow from an underlying asset to the investors who own the structured notes backed by it. Tranching in turn is served through credit enhancement, in order to create a credit-rated security from unrated assets or a security with a higher rating than the average rating of the assets backing it.

Tranching is accomplished by dividing—tranche comes from the French for “slice”—the pool into related securities with different ratings, offered as part of the same transaction. Those with first lien on the underlying assets are the senior tranches, the least volatile and usually highest rated. Senior tranches often form part of the portfolio of pension funds and other risk-averse investment groups. Second-lien or no-lien tranches comprise the junior notes, much higher risk and appealing to high-risk/ high-return investors like hedge funds and structured finance specialists.

A special type of SPV is the master trust, which is formed for the purpose of pooling credit card balances for securitization. These must be structured and handled somewhat differently from other debt-backed securities because of timing concerns; while credit card–backed securities may not mature for years, the underlying receivables pay off faster than that. Credit card–backed securities are usually structured with a revolving period (when cardholders’ payments are used to purchase receivables), an accumulation period (when payments are diverted to a separate account), and the amortization period (when payments are passed on to the investors of the notes).

Securitization began with mortgage-based securities in the 1970s, and in the 1980s was first applied to car loans, with other debt-based securities following shortly after and growing in popularity through the 1990s to become a significant part of investor activity in the 21st century. Forms of structured assets include collateralized debt obligations backed by corporate bonds or leveraged bank loans; collateralized fund obligations backed by private equity and hedge funds assets; collateralized mortgage obligations; and credit derivatives.

Bibliography:

Satyajit Das, Credit Derivatives: CDOs and Structured Credit Products (Wiley, 2005);
Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, Securitization: Structuring and Investment Analysis (Wiley, 2003);
Frank J. Fabozzi, Handbook of Structured Financial Products (Wiley, 1998);
Frank J. Fabozzi and Vinod Kothari, Introduction to Securitization (Wiley, 2008);
Vinod Kothari, Securitization: The Financial Instrument of the Future (Wiley, 2006);
Arnaud de Servigny and Norbert Jobst, The Handbook of Structured Finance (McGrawHill, 2007);
Janet M. Tavakoli, Credit Derivatives and Synthetic Structures: A Guide to Instruments and Applications (Wiley, 2001).

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