The key stages undertaken when creating the asset-backed-securities
Basically, the structured process through which interest in receivables and loans are underwritten, packaged, and equally sold in form of the asset-backed-securities is what is dubbed as asset securitization. However, the security structure is usually stated by the type of collateral that supports it. The only main difference that exists between pools of securitized credit and participations or complete loan sales is what constitutes the transaction structuring process. Before the conversion of most loan pools into backed securities, there is often the need to structure them amicably to revise the returns and risks nature to the ultimate investors (Levin and Davidson, 2008, pp. 41-55). Thus, there are four notable main stages in the process of creating the asset-backed securities and these include:
- Segregation of assets from originator or seller
- Creation of a specialized functional vehicle to seize the asset to protect the interest of various parties
- Addition of credit enhancements to improve the salability
- Issuance of interest in asset pools
Assets Segregation
Securitization ideally allows the investors to assess the asset security quality individually except for the credit worthiness of the seller or originator. To realize this, the originator is deemed to convey the receivables to an existing trust for the advantage of the certificate holders. In cases appertaining to revolving type asset, the conveyance would cover the amounts of the receivables in certain consigned accounts on specific cut-off dates in addition to the trust’s option to purchase some new receivables which arise out of the designated accounts after the cut-off date. Actually, the receivables and accounts are exposed to specific representations, warranties, and eligibility criteria of the originator or seller.
Choosing the accounts: Initial pool selections, accounts removals, and additions
In step one, the accounts receivables to be vented to the trusts are designated by the seller. For instance, the past owing receivables might be left in eligible pools while accounts that have had write-offs or defaults might be excluded. Other choosing criteria may include the data element like maturity date, the account age relationship, the credit line size, or geographic location. Step two entails selecting the assets either inclusively to sell all the qualifying receivables, or randomly to create selections that represent the entire portfolio (Fabozzi, 2000, pp. 170). Additional accounts may also be designated for trusts that have revolving features for assimilation purposes while in some cases the sellers reserve the capacities to withdraw various accounts earlier allocated for the trusts.
Creation of the securitization vehicles
According to Levin and Davidson (2008, pp. 41-5), the banks often structure the asset-backed securities via owner trusts, revolving assets trusts, or grantor trusts, each one customarily issuing different kinds of securities. While selecting the structure of a trust, banks aim at ensuring that the transactions adequately protect the asset from the issuer creditor’s reach and that the securitization vehicle of the issuer and that of the investor receives a constructive tax treatment. For example, in grantor trusts, the investor or certificate holder is treated like the valuable holder of the sold assets. Conversely, in owner trusts, the asset in question is generally subjected to the lien of bonds through which issuing of notes takes place.
The provision of additional credit enhancement
The securitization process normally splits credit risks into various tranches by placing them with the parties who are deemed best able and willing to absorb them. The initial loss tranche becomes capped at a level near the normal or expected rate of the portfolio-asset credit loss. In essence, all the credit losses adding up to this end become successfully engrossed by the originator of the credit, since it classically receives the cash-flows portfolios after the expenses that include the expected losses excess spread forms. The subsequent tranche in asset securitization covers losses that surpass the originator’s caps. Apart from the paid coupon rate to savvy investors, there are large expenses incurred in the structuring of asset-backed securities, and this is called the credit enhancement cost.
Issuance of interest in asset pools
In the closing transaction date, the receivables become transferred indirectly or directly from the originator to the endowed trust-the exceptional purposed vehicle. Thereafter, the trust is deemed to issue a certificate that represents the interest of the benefits in that respective trust, certificates for the investors, as well as a transferor certificate when the revolving assets structures are embraced.
The assorted methods utilized in enhancing the asset-backed-securities credit rating
Credit enhancements are generally classified into two main domains namely the self (internal) enhancements and a third party or external enhancements. Currently¸ the credits enhancements methods widely embraced include the following:
Third-party or external parties credit enhancement
- Third-parties credit letters: For the issuers bearing credit ratings significantly less than the levels required for the issued security, the external parties might opt to offer credit letters to cover certain amounts of losses or percentage loss. The illustrations on the credit protection letters are habitually repaid from the surplus cash flows emanating from the portfolios securitized.
- Recourse to the sellers: primarily utilized by the non-banks issuers. The method ideally uses sellers’ limited collateral which covers a specific maximum quantity of pools losses.
- Collateral bonds: normally encompass warranty issued by the external parties like the rated mono-line insurance corporations. In essence, the surety bonds sources normally wrap or guarantee one hundred percent interests payments plus the principal.
Therefore, even though the ranking of the external parties’ credit-enhancer is seldom lowered, such events might lower the security’s ratings. Thus, the issuers tend to rely minimally on the external parties enhancements (Strassburger, 2008, pp. 9)
The provisional internal structure credit enhancement
The structural features may be created in order to raise the assets backed securities credit quality. However, a classic security structure might contain any of the subsequent internal enhancements:
Excess spread: In some given months, the yields on the portfolios receivables that supports asset backed securities seem to be generally greater when compared to expected losses, coupon, and servicing costs for the securities issued. Any finance charges that remains after servicing costs, losses, and funding is what is called the excess spread.
Spread accounts: The monthly backings charged from a pool of underlying receivables are offered to cover the unpredicted losses in any month. The excess spread normally relapses back to the sellers if it is not needed.
Cash collateral accounts: they are normally financed by issuers. However, the external parties reimbursable bank credits are in most cases used to finance its.
Invested collateral amounts: just like the cash collaterals, these asset pool besides attract losses, hence refundable via the excess potential threads.
Securitization and the financial meltdown
The latest turbulences in the capital markets more so in the financial sector underscore the magnitude with which asset securitization should be understood. Asset securitization as a practice that enables financial institutions to support their credit expansion by discarding credit risks and increase their investment needs is very important during this economic down-turn. In addition, the latest financial downturn has clearly indicated that financial institutions need instruments that can easily cushion them against bad loans (Martín-Oliver & Saurina, 2011, pp. 2). The only ways through which banks can be cushioned is by packaging the bad loans in their balance sheet and pass that credit to the third party. This can only be achieved through asset securitization. Therefore asset securitization process forms an essential part of the financial institution liquidity requirement and their investment arrangements (Martín-Oliver & Saurina, 201, pp. 2).
Properly operating stock markets offer information on stock prices which financial institutions use to distribute their resources cost-effectively. When money that is lent out in form of loans surpasses money deposited, the banks and other financial institutions are forced to look into other options that will finance the difference between the loans and the deposits. Options that are always available to banks include increasing deposits, get a loan from other financial institutions such as the central bank, sell its stocks in the exchange markets, or securitize its portfolios especially with larger credit value (Essay coursework, 2011 n.p). The best alternative that is majorly and always used to build the capital structure by many financial institutions is asset securitization. Many financial organizations prefer to securitize their assets since it allows optimal investment gains while at the same time spread risks to other investors.
Benefits of asset securitization
Asset securitization enables the investor access a secure and highly rated assets with better market rates and at the same time very liquid thus can be sold if need be. Besides it benefits both the investor and the issuer since it spread out the risks by transferring some of the risks to the investor who normally holds them relative to the institutions that produced the instrument. Furthermore, it will enhance the return on assets and equity resulting from condensed capital requisite as well as through fixed profit flow (Abrahams and Zhang, 2009, pp. 216). The asset securitization appreciates monthly income flows and can easily be distinguished from an entirety vending of assets that entail an instant acknowledgment of earnings. Additionally, asset securitization will improve the image of the firm in the stock market.
In asset securitization, investors depend on the created cash flows from that particular asset being funded instead of the institutions working cash flow (Essay coursework, 2011, n.p). In an economy that is experiencing recession as a result of the financial crunch asset securitization can easily help organizations to pull out of the downturn. This is because financial institutions gain from interests and principal which is paid on a monthly basis on the sale of the collective assets units. The assets in the pool are highly rated and more liquid thus offering greater yields than most of the corporate bonds (Senanayake, 2010, pp.35). The institutions that sell their pooled assets can easily get capital that can immediately be used to finance their loans instead of waiting for the maturity of the individual assets.
Assets that are credited in the cash flows such as the non-performing loans are securitized. Many financial institutions normally securitize mortgage loans as well as those that are asset based. Furthermore, pools with large number of securities determine the stability of the principal repayment rate. Asset backed securities do not easily change with the changes of the rate of interest (Essay coursework, 2011 n.p). In contrast, mortgage-backed securities that in most cases require huge capital investments are very susceptible to the interest rate changes. What determines the amount of credit expansion is the quality of the assets that is used to assemble the pool.
Asset securitization decreases the institutional resources and liquidity needs as is depicted in their balance sheet. In addition, it presents many opportunities to financial institutions in the capital market. Furthermore it offers a chance for the banks to uphold their customer relations. Other benefits are turning non liquid assets into liquid assets at a very cheaper cost compared with the traditional sources. Finally in asset securitization the seller benefits as much as the investor (Abrahams & Zhang, 2009, pp. 216).
The greater development that has been brought about by Asset securitization especially in the management of assets is that it gives the financial firms an opportunity to pool their credits and risks in their cash flows which are then bought by the investors who will keep them in their portfolios instead of financial institutions holding them in their balance sheet. Firms are very much interested in financing good assets since such assets fetch good prices. Furthermore, firms will focus on other financial transactions without fearing losses resulting from the risks that could have accumulated. Even though securitization of assets might seem to be expensive, many financial investment institutions are using this strategy to avert risks (Essay coursework, 2011 n.p).
Firms that are involved in asset securitization are able to specialize in specific areas and build enough experience in pooling those asset packages in those particular areas. This so because these firms pass risky assets to other firms who are much interested in diversifying their portfolios. In essence financial institutions become focal point in the capital markets rather than being risk takers. Diversification of asset securitization make the financial instruments be distributed to other sections of society that otherwise could have no opportunity to access these financial instruments (Kolb, 2010, pp.294). as stated borrowers of risky assets can easily access credit cards as many financial institutions that concentrates in the securitization of assets can spread their risks. The risks are wide spread to many investors or players in the financial market. Thus risky financial deals can be done making firms have an opportunity to look into the origination of the transaction rather than paying much attention to the risk.
Securitization and growth
But asset securitization need a well developed financial market. In other words there is need for large pool of investors who would be involved in buying some assets into their portfolios. The fact is that when the financial risks increases financial institutions center much of their attention on the risk management and diversification of ones asset is part of this management. With the anticipated increase in the financial risks and due to its importance in diversifying these risks, asset securitization will be practiced more in relation to the development of the capital markets (Essay coursework, 2011, n.p). Moreover, technological development in communication has caused greater global movement of capital posing greater risks to the investors.
Securitization and risk management
With the increase in the financial risks institutions that trade in the assets should center much of their efforts in the management of risks. In other words, well established practices in the management of risks should be in place especially in those institutions that are engaged in the securitization of assets. Therefore, financial institutions will be forced to set up an autonomous appraisal unit to supervise the securitization process. With the enormous risks existing in the securitization process it is necessary to institute a binding regulatory limit that would reduce the quantity of definite preserved interests used in shaping the capability of the regulatory resources (Kolb, 2010, pp.294). The accounting for the retained interest values are supposed to be rational, conventional, and enjoy the support of documents that can be approved. To ensure that risks related to securitization are sustained, financial institutions must ensure that they have enough capital.
Failures of asset securitization
The failures of asset securitization are stemmed from the pooling of assets, management of risks and change of company strategies. In fact dealings in the securitization process are difficult requiring a rethink in the financing of the off-balance sheet as well as on-balance sheet needs. With a lot of weight put behind the rewards founded on the balance sheet dimension there is eminent disagreement between the parties. It is also uneconomical to those who sell lesser volume in terms of original cost and duration. Vital requirements such as guaranteeing high quality credit, evaluation and reporting need huge capital to finance. The maintenance of the already securitized assets is necessary since any evasion from the collection will damage the reputation of the seller of the asset (Essay coursework, 2011, n.p). Furthermore, deals that were not properly managed can end up wasting money in form of requirements as well as the organization representation.
Conclusion
Asset securitization is a greater innovation in the current financial market since it enables the financial institutions to pool together their different assets and sell them to the investors thereby diversifying risks. Asset securitization has become the easiest way through which financial institutions fund their credits in the balance sheet. Today it has become the integral part of many organizations. The level in which the institutions use of asset securitization directly relates to the development of the capital markets.
References
Abrahams, C., R., and Zhang, M., 2009. Credit Risk Assessment: The New Lending System for Borrowers, Lenders, and Investors. San Francisco, USA: John Wiley and Sons.
Essay coursework, 2011. Asset Securitization. Web.
Fabozzi, F., J., 2000. Investing in asset-backed securities. Hoboken, New Jersey: John Wiley and Sons.
Kolb, R., W., 2010. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. San Francisco, USA: John Wiley and Sons.
Levin, A., and Davidson, A., 2008. The concept of credit OAS in valuation of MBS. Journal of Portfolio Management, 34(3), pp.41-55.
Martín-Oliver, A., and Saurina, J., 2007. Why do banks securitize assets? Web.
Senanayake, N., 2010. Asset-backed Securitization and the Financial Crisis: The Product and Market Functions of Asset-backed Securitization: Retrospect and Prospect. Hamburg, Germany: Diplomica Verlag.
Strassburger, C., 2008. Asset Backed Securities and Structured Finance. Munich: GRIN Verlag.