SECURITISATION

The various definitions and explanation given to the concept of Securitisation is as follows: 

• The process of creating a financial instrument by combining other financial assets and then marketing them to investors (Investment Dictionary, 2000).
• The process of creating a security marketable in the capital markets and backed by a package of assets such as mortgage loans. Example of this is: Mortgage loans insured by the Federal Housing Administration are good assets for A lender can organise a pool of such loans and create a collateralised mortgage obligation for sale to investors (Real Estate Dictionary, 2004).

Conversion of bank loans and other assets into marketable securities for sale to investors. Securities offered for sale can be purchased by other depository institutions or nonbank investors. By securitising bank loans and credit receivables, U.S. Financial institutions are able to remove bank assets from the balance sheet if certain conditions are met; thus boosting its capital ratios, and make new loans from the proceeds of the securities sold to the investors. The process effectively merges the credit markets (for example, the mortgage market in which lenders make new mortgages) and the capital markets, because bank receivables are repackaged as bonds collateralised by pools of mortgages, auto loans, credit card receivables, leases, and other types of credit obligations. As banks look to investors as the ultimate holders of the obligations created by bank lending, banks as an industry are inclined to act more as sellers of assets, rather than portfolio lenders that keep all the loans they originate in their own portfolio. Securitisation also redefines the bank definition of Asset Quality, and loan underwriting standards, because lenders will be looking at loan quality more in terms of their marketability in the capital markets than probability of repayment by the borrowers.

For regulatory reporting purposes, a loan that is converted into a security and sold as an asset-backed security qualifies as a sale of assets. The seller retains no risk of loss from the assets transferred and has no obligation to the buyer for borrower defaults or changes in market value of securities sold. Asset transfers where the buyer has recourse against the selling institution are treated as financings or a borrowing secured by assets. Securitisation of bank assets is further complicated by Securities and Exchange Commission regulations, and accounting guidelines. Tax counsel is advised in structuring new issues for market (Banking Dictionary, 2006).

Securitisation, in its most basic form, is a method of selling assets. Rather than selling those assets “whole”, the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or “spinning off,” a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now. The term ‘Securitisation’ is derived from the fact that the form of financial instruments used to obtain funds from the investors is securities.   

 As a portfolio risk backed by amortising cash flows, and unlike general corporate debt, the credit quality of securitised debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss (Raynes & Rutledge, 2003). All assets can be securitized so long as they are associated with cash flow. Hence, the securities which are the outcome of Securitisation processes are termed asset-backed securities (ABS). From this perspective, Securitisation could also be defined as a financial process leading to an issue of an ABS.

Motives for securitisation

Advantages to issuer

• Reduces funding costs: Through securitisation, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points.
• Reduces asset-liability mismatch: “Depending on the structure chosen, securitisation can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis” (Lederman, 1990). Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitisation allows such banks and finance companies to create a self-funded asset book.
• Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitising some of their assets, which qualify as a sale for accounting purposes, these firms will be able to lessen the equity on their balance sheets while maintaining the “earning power” of the asset.
• Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
• Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitisation makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.
• Off balance sheet: Derivatives of many types have in the past been referred to as “off-balance-sheet.” This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognised in the income statement on a similar basis as the underlying assets and liabilities.
• Earnings: Securitisation makes it possible to record an earnings bounce without any real addition to the firm. When a Securitisation takes place, there often is a “true sale” that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the “true sale” to stick and thus this sale is reflected on the parent company’s balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.
• Admissibility: Future cash flows may not get full credit in a company’s accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a Securitisation effectively turns an admissible future surplus flow into an admissible immediate cash asset.
• Liquidity: Future cash flows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates. 

Disadvantages to issuer

• May reduce portfolio quality: If the AAA risks, for example, are being securitised out, this would leave a materially worse quality of residual risk.
• Costs: Securitisations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in Securitisation, especially if it is an atypical securitization.
• Size limitations: Securitisation often requires large scale structuring, and thus may not be cost-efficient for small and medium transactions.
• Risks: Since Securitisation is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.

Advantages to investors

• Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)
• Opportunity to invest in a specific pool of high quality credit-enhanced assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitisation, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.
• Portfolio diversification: Depending on the Securitisation, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitisations because they may be uncorrelated to their other bonds and securities.
• Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under Securitisation it may be possible for the Securitisation to receive a higher credit rating than the “parent,” because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable). 

Risks to investors

• Liquidity risk
• Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings (Dwight Asset Management Company, 2005). However, the credit crisis of 2007-2008 has exposed a potential flaw in the Securitisation process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and Securitisation, which doesn’t encourage improvement of underwriting standards.

The European Group of Valuers’ Association (TEGoVA, 2002) defines securitisation as the process whereby loans, receivables and other financial assets are pooled together, with their cash flows or economic values redirected to support payments on related securities. These so called “asset-backed securities” (ABS) are issued and sold to investors who use securitisation to finance their business activities. The financial assets that support payments on ABS include any asset that has a reasonably ascertainable value or that generates a reasonably predictable future stream of revenue. Those assets are residential and commercial mortgage loans (residential mortgage backed securities or RMBS and commercial backed securities or CMBS) as well as non-mortgage assets such as credit card balances, consumer loans, trade receivables, etc.

Mortgage securitisation is an unbundled process divided into origination, grouping and funding of loans followed by the structuring and the rating of the new mortgage assets. The credit institution first creates a legal entity known as a special purpose vehicle (SPV) and sells mortgage loans that it has originated (“receivables”) to this SPV. The SPV issues securities that are sold to investors such as credit institutions, insurance companies, pension funds and the like. The SPV is bankruptcy-remote, which means that the assets of the SPV are legally separated from the assets of the originator, thereby leaving the SPV out of the reach of any potential receiver for the originator.

Valuers dealing with property valuation for securitisation purposes need to focus on market and property-related risk criteria of the mortgage assets. The aim is to provide originators, rating agencies and MBS-investors with transparency regarding both market and sustainable net asset values for individual properties and/or portfolios and market and property risk details, thus facilitating the structuring of mortgage loan portfolios, portfolio ratings and investor decisions. It is therefore necessary to define a set of detailed criteria allowing the determination of the risk profile of the underlying property assets. The following 6 risk buckets are suitable to accurately reflect the long term quality grade of a property and to calculate its net asset value for securitisation purposes:

• market risks
• location risks
• property related risks
• partnership risks
• fiscal and legal risks
• financial risks.

Furthermore, it is necessary to distinguish between three types of mortgage loan portfolios:

• Residential mortgage backed securities (RMBS) based exclusively on retail mortgage loans (mortgage loans to private customers investing in not more than 3 residential properties)
• Residential mortgage backed securities conceived as a commercial business (loans to commercial investors holding 4 or more residential properties, condominiums)
• Commercial mortgage backed securities (CMBS) based on commercial properties

The process described below must always apply to valuation of properties and the identification of market and property related risks, including regular updates, if mortgage loans are suitable to be securitised. It is addressed towards professional property Valuers. The transparency of other risk aspects relating to the assets, such as debt service coverage and credit quality of the borrower, are not the subject of a Valuer’s work and are therefore not subject of the following description.

Valuation Process: In order to provide the necessary transparency, a two-step process divided into the traditional valuation of the property and an assessment of the specific property risk profile is being recommended to Valuers. According to the national practice, qualified Valuers using transparent valuation methods that are recognised by national Valuers’ associations have first to proceed to a traditional valuation, i.e. to determine market value and sustainable net asset value for each property in a portfolio to be securitised at the moment when the individual property is financed. If the assessment of the sustainable net asset value was not carried out at the time when the individual property was financed, this must be done at the moment when the mortgage loans are being sold to the special purpose vehicle. In addition to the property valuation, a structured risk assessment (market and property risks, see above) has then to be produced for each property of the commercial and investor related residential mortgage loan portfolios at the moment when the individual property is financed. Regarding the retail residential loan portfolio, a cluster analysis should be used to divide the entire portfolio into homogeneous clusters which should be valued by means of a simplified method taking into account value determining parameters. If this assessment was not carried out at the time when the individual property was financed, this must be done for each property at the moment when the mortgage loans are being sold to the special purpose vehicle.

Benefits of securitisation: There are many reasons for mortgage lenders to use securitisation techniques:

• it offers the perspective of providing a vehicle for transforming relatively illiquid, individual financial assets into liquid and tradable capital market instruments;
• securitisation enables the mortgage lender to transfer the credit risks associated with risk assets, thus enabling the bank to hold less regulatory capital;
• by leveraging the balance-sheet of the mortgage lender, the lender locks into the origination and servicing revenues associated with the relevant loans, whilst effectively minimising the credit costs – this enables returns on capital to be optimised to a greater extent as capital can potentially be employed to support the origination of assets at higher return;
• significant operational efficiency enhancements are a result of the discipline imposed on banks’ business by MBS servicing requirements;
• securitisation is a more flexible and adaptable nature of financing in relation to more traditional alternatives. The issuer can better manage the balance sheet and can achieve a more precise and efficient matching of the duration of its assets and liabilities by subdividing and redirecting cash flows from underlying financial assets.

References

European Group of Valuers’ Association (TEGoVA) & the Association of German Mortgage Banks (2002).

Wikipedia (2017).