DEBTS SECURITIZATION

Securitization is the process through which illiquid assets are pooled and packaged into batches
of marketable securities that are backed/securitized by the original debts and then sold to
investors
Securitization is a financial innovation that involves issuing securities that are backed by a
number of debts. The debts issued by a lender are assets of the lender. Securitization is the
process of transforming these assets into asset-backed bonds securities. In case the borrower
defaults on their debt, the assets that backed the debt is sold to recover the loaned funds. The
action of going after the assets when someone defaults on the loan is the reason why the
securities are called securitized.
Types of Securitized Assets
Debt Instruments forms the Securitized assets. Any assets backed up by a loan can also be
securitized.
The most common types of debt assets include credit card receivables, auto loans and leases
backed by a vehicle, mortgages, student loans, and equipment loans and leases.
Less uncommon types of assets include franchise loans, taxi medallion loans, state tobacco
settlement payments, stranded utility costs, and royalty payment streams.
i. Mortgage-backed Securities (MBS) are bonds that are secured by homes or real estate
loans. They are created when a large number of mortgages are pooled together and then the
pool is sold to a government agency like Ginnie Mae, Fannie Mae, or to a securities firm who
will use it as collateral for another mortgage-backed security.
There are two types of mortgage-backed securities:
a) Residential mortgage bonds are composed of various mortgages on real estate, land,
houses, jewelry, and other valuable items.
b) Commercial mortgage bonds are created when various commercial assets, such as office
buildings, industrial land, plants, factories e.t.c.
ii. Asset-backed Securities (ABS) are bonds that are created from consumer debt. When
consumers borrow money from the bank to fund a new car, student loan or credit cards, the
loans become assets in the books of the lender. The assets are then sold to a trust whose sole
purpose is to issue bonds that are backed by such securities. The payments made on the loan
flow through the trust to the investors who invest in these asset-backed securities.
1) Collateralized Debt Obligations (CDOs) are bonds created by re-bundling individual loans
to sell to potential investors on the secondary market.
2) Securitization Of Future Cash Flows A debt receivable in the future is used as collateral
for the issuance of these instruments by the corporation. Even if these liabilities are secured
against the company’s future receivables, the firm can satisfy the principal and interest
payments through its regular business activities.
Parties involved in the debt securitization process
i. The borrower who took out a loan and promised to repay it.
ii. The loan originator which is the entity that approved the loan such as mortgages, auto
loans, or receivables that it wishes to repackage and sell. Originators include commercial
banks, thrift institutions, computer companies, airlines, manufacturers, insurance companies,
and other finance companies. The loan originator has the initial claim to the borrower's
repayments. But the originator/bank might want to realize its profit from the loan much
faster than the 20-year or 30-year term of the loan permits. The bank can cash in

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 immediately by selling this loan and others in its possession for face value or close to face
value to a third party.
iii. The issuer. The issuer is a Special Purpose Vehicle (SPV) that has a separate legal identity
from the originator. The assets being securitized permanently shift from the originator’s
books of the SPV. The SPV repackages the loans into different structured tranches with
different payment priorities and features (such as interest rates and then sells them to
investors through private placement or publicly issue.
iv. Underwriter the underwriter aggregates the underlying loans and designs the securitization
structure, including things such as coupon rates, tranche sizes, and triggers. In some cases,
the underwriter may also be the originator as the two roles have a natural overlap.
The underwriter bears warehousing risk, the risk that the deal will not be completed and
consequently, the value of the accumulated collateral still on its balance sheet will fall.
v. Credit Rating Agencies responsible for evaluating the company’s creditworthiness and
whether the SPV can effectively pay interest and principal to investors. Help investors to
assess the riskiness of an investment by assigning credit ratings to various tranches
engineered. Attachment points and the subordination structure are key in the rating process.
vi. Servicer/custodian: collects principal and interest from the loans in the collateral pool and
disburses the same to the liability holders. In most cases the originator also acts as servicer.
Servicers actively monitors the collateral pool and may extending the term of the loan or
foreclose distressed debts.
vii. Arranger is a financial institution such as investment bank appointed by the originator to
design and create the securitization framework. An arranger determines the structure of the
risk profile of the receivables to create different tranches of security. An arranger may also
set up the SPV and design credit enhancement and liquidity support for the transaction. The
arranger runs the deal and brings all the different parties together.
viii. Credit Enhancement provide reassurance to investors that the SPV will honor the payment
obligations when they fall due. can be internal and external. Internal credit enhancement is
provided by the firm and the most common types include subordination, over-
collateralization, and excess spread. External credit enhancement, on the other hand, is
provided by third parties and includes guarantees and first loss investments.
ix. Investor comprise financial institutions, insurance companies, pension funds, hedge funds,
companies, and high net worth individuals. They buy the SPV's securities based on their
risk/return preferences. Tranching allows investors to diversify their portfolios by purchasing
securities with varying seniorities and yields.
The Process of Securitization
1. The originator sells the assets to a special purpose vehicle (SPV).
2. The SPV issues the assets directly or pays the originator the balance on the debt that is sold,
which increases the liquidity of the assets.
3. The debt is then divided into securities, which are sold on the open market. In the case of a
mortgage-backed security, if the owner defaults, the house would be foreclosed and result in
some recovery of the loaned funds. The action of going after the assets when someone
defaults on the loan is the reason why the securities are called securitized.
Examples
A company has 100 home loans, each with a balance of sh1,000,000, hence a total of
sh100,000,000 in outstanding debt. They converted the loans into two separate securities:
Security A with sh90 million and Security B of sh10 million. The collateral is the home loans,

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 will be analyzed by rating agencies, and a transaction model is constructed. This helps the
agencies determine the levels at which they will assign an A rating to the securities. The
investment banks, will promote and sell these ABS bonds to investors in public and private
markets with comprehensive transparency regarding collateral and home loans. If this is the case,
then it is likely that investors such as pension schemes can purchase shares in them.

advantages of securitized debt instruments

i. They allow banks to offer bonds at different levels of risk. The bonds can be divided into risk
tranches where one class of the bonds receives less money but will not suffer any
consequences should the homeowner default on the loan payments. A second bond class will
receive a higher payment but will face a loss in the case of foreclosure of the home. The
different bond class offerings allow investors to choose the level of risk they want to invest
in.
ii. Management of risk is better. For example, the financial institution lending cash can
securitize its receivables to shift the risk of bad debts.
iii. an investor can get a highly diversified portfolio by integrating securitized bonds.
iv. Securitization frees up the blocked capital to retain liquidity. Thus, the originator is relieved
of the obligation to seek financial leverage in the event of sudden requirements.
v. Securitization helps institutional investors to access assets that would otherwise not be open
to them, e.g., credit card receivables.

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vi. Securitization offers investors unique investment opportunities and attractive risk-return
profiles compared to other asset classes such as government and corporate bonds.
vii. Securitization creates competition among banks in offering loans to borrowers thus more
competitive rates, favorable collateral terms, and quicker processing times.

Disadvantages
i. Transparency is absent. Investors may not be provided with all the information on the assets
included in a securitized bond.
ii. Handling it can be difficult as the entire securitization process involves several parties. Also,
the assets must be blended intelligently.
iii. Floating a securitized bond is often expensive. This cost includes underwriting, legal,
administrative, and rating expenses.
iv. The investor bears the risk. If the obligations owed by the borrower are not repaid, the
investors will suffer a loss.
v. They create a complex financial system. When a securitized debt is pooled and sold, it
becomes difficult to identify who owes money and to whom they owe it to. It results
in economic problems that can affect the entire financial system.