Investment Banking and Operations Management Report

Asset Securitization

The size of investment assets began to overtake deposits in the United States of America in the 1970’s.This phenomenon eventually caused the need to enhance utilization of available and future assets. In a steady market, the bank uses the information conveyed in prices of assets to significantly allocate capital resource to the most profitable and ultimate use. The bank would consider selling securitize assets or syndicate assets, or borrow funds from another bank in order to meet the growing demand of loans. Most institutions have found asset securitization to be more desirable in building their capital structure. However, there are many ways in which organizations in the financial markets are able to raise funds. Each of the method has its own limitations and advantages. Some of the advantages are raising quick capital and receiving cash flows almost immediately. The limitations associated with borrowing are the risk inherent to the investor and the seller. Due to this disadvantage, most retail banks prefer the use of asset securitization. This is because of its ability to maximize capital and minimize risk through diversification.

Asset securitization over other methods of raising capital

Asset securitization refers to a modern way of bank financing where the investor aims at profiting from cash flows that are generated from assets being financed rather than the operating cash flows of the bank. Securitization involves grouping assets in single or different pools. The single pool is then sold to willing investors who end up receiving monthly payments in form of principle and interest from the purchased pool. The end result is the investor receiving a highly liquid investment that can offer them yield more than most corporate bonds. The investment also allows the investor to maintain high credit rating. The investor receives immediate capital rather than waiting for maturity of the assets sold. Moreover, asset securitization is deemed to be the best option for retail banking as compared to other funding alternatives suggested above.

Asset Pools, quality, and diversification

Sirbu & Tyaga (1995, p.54) noted that both performing and non-performing assets that represent future claims can be securitized in a principal market. Examples of asset securitized tools are mortgage –backed securities that contain assets of residential mortgages. The second type is the combined Asset Backed Securities. These types of securities contain assets such as credit card receivables as read from Stone et al. (2003, p.241).

Benefits of Asset securitization to the seller

The retailing bank benefits from the process by having its assets liquidated while at the same time continuing to focus on core competencies instead of trying to create competition in areas they have massive weaknesses.

Roth & Univer (2005, p.64) notes asset securitazation reduces the banks’ capital and liquidity requirements as the assets are moved off balance sheets. Asset securitization offers access to a larger base of capital from the institutional investors. It gives the bank an opportunity to maintain its customer relations services, hence possibility of a repeat transaction. Resnick & Zechauser (2002, p.656) states that the aim of this service is to maintain the customer within the continuous business line by offering guidance when required. Other benefits that arise from asset securitization are the conversion of solid assets into cash within a short period of time. This enable the bank to achieve low cost funds compared to traditional sources, variations arising from the various yield curves, as stated by Riedl & Konstan (2002, p.652). Furthermore, the seller receives more benefits when considering undertaking asset securitization.

Benefits of asset securitization to the investor

In this context, I assume the retail bank is the investor in asset securitization. The retail bank will achieve the benefit of access to a secure and most respected or senior rated investment. Sherstov & Stone (2004, p.188) observe that an investor will also have the chance to retain a liquid investment that would be marketed with ease if needed again. Asset securitization benefits both parties as it allows the adequate diversification of the risk inherent. Certain risks are passed over to the investors who are more willing and interested in holding them than the originators of the instruments. The retail bank would have access to secure and highly rated investment that earn attractive profits in the market whilst retaining a liquid investment that can be marketed easily if need arises. Tambe (1997, p.557) remarks that the process of asset securitization also benefits the investors by enhancing performance against targets, more so the banks return on assets and equity. This is achieved through a combination of lowered capital requirements and a fixed income stream that recognizes monthly income other than outright sale of assets that might require almost immediate recognition of income. Asset securitization has a positive effect on the corporate image of the retailing bank as noted by Tesauro &Das (2001, p.666).

Summary

Asset securitization is one of the greatest financial innovations that allow the financial institutions to package their cash flows and risks and sell them to investors who are willing to hold them, than have the bank to keep them on the balance sheets. It relieves the bank of the duty to manage asset-liability, hence giving it time to specialize in deal creation. Retail banks have higher interest in financing good assets as they are sure of positive returns in the long run. Vetsikas & Selman (2003, p. 480) add that asset securitization allows retail banks to specialize in certain fields with little or no worry of accumulating too much of the inherent risk. Although the process of securitizing an asset is costly, most retail banks are employing this strategy in their business today.

Asset securitizing allows the banks to specialize in particular areas, giving them a chance to gain much information and efficiency in assembling asset packages in those areas of specialization. It also allows the banks to put more focus on being middlemen rather than risk takers. They end up being financial intermediaries in their respective fields, with the ability to guide and influence the market operations as observed by Resnick et al. (2002, p.184).

The Trading and Dealing Mechanisms of Principal Markets

Principal markets in this paper refer to capital markets and money markets. Capital markets entail the trade of securities with an aim of raising funds for capital intensive projects like infrastructure. Money markets are meant to raise funds for the daily operation of the business. The amount raised is thus not as much as in the capital markets (Schafer 2001, p.54)

Dealers

These are businesses that act as intermediaries between the buyer and the seller of a financial instrument. They post continuous offers and bids on behalf of their principals. They are compensated implicitly through trading profits arising from a complicated structure of obligations and privileges. However, their powers and competitive positions are being weakened by technology. Customers in the principal market can easily use electronic order management system to revise and update their order limits efficient in response to market conditions (Shenker, 1994, p.24). They can supply liquidity at an opportune profitable moment and consequently withdraw their bids when the market turns volatile.

The United States over the-counter stock market, NASDAQ, have for a long period been known as a dealer market. The trading has over the recent past shifted to limit order markets, hence diminishing the dealer’s presence.

Dealers in the market have been known to facilitate large trade activities, otherwise known as block trade. This trade occurs in upstairs market and it is mainly institutional. The dealer acts like a principle when contacted to fill a large order by an institution. The dealer takes the other side of the order by committing capital, locates a counter party for the amount in full, or works on order over time as noted by Taylor et al (1978, p.81). The dealer is privileged at this point because of access to capital, potential counterparties, knowledge, and expertise. They have more advantage to the fact that they execute large orders over time hence the understanding of the essential algorithmic systems as observed by Smith (1962, p.65).

Bargaining

Tesfatsion, (2003, p.41) notes that some interaction at the security trading platform has a close resemblance to the normal vendor/customer relationship in goods market. The shopkeeper fixes a price and the customer can purchase or let the deal go. The interaction is in most cases take a microscopic view and is certain to be constrained by forces of competition (presence of substitute or alternative goods). In securities trading at NASDAQ, the dealer and the retail customer may be in the same situation.

A retail customer or retail bank in the United States contacts the broker to solicit prices at which the broker acting in capacity as the main dealer would sell or buy. The prices are stated by the broker and the client can accept to trade or not. The banks might search the prices of other dealers if faced with unfavourable terms and conditions. They mostly opt for the dealers they have had prior trading relationships with, but have individual accounts with various brokers. Thomas et al (2002, p.87) observe that recently, work on the municipal and local securities markets have highlighted the role of bargaining power in the dealer market as explained by Univer (2001, p.45).

Components of Discount & Interest Rates

Discounts and interest rates are the most crucial aspects of trading in principal markets. Waidspurger et al (1992, p.67) demonstrate that to determine the future value of an interest rate, an individual would have to measure an amount value, which will grow at an interest rate given over a period. For example, if an investor wanted to know how much $2,000 would be worth after a period of 4 years at a growth rate of 10% each year; the investor would have $2,000 x 1.10 or $2,200 the first year. Two years later, this would have grown into $2,420, which is the same as $2,200 x 1.10. The third year will be $2,420 x 1.10 = $2,662, and the fourth year will be $2,662 x 1.10 = $2,928.20 as in Regev (1998, p.90)

The various kinds of interest rates used consist of the most common one, the prime rate, which are non-fluctuating rates and mostly used by banks when making short-term loans to corporations. The prime rate also acts as the base for bank loans, and also the base rates that premiums get added to projected increases for customers, but normally, a bank will set the prime rates on the market bearings as read from Rosechein (1994, p.56). Other interest rates that are just as pertinent in capital investment decisions consist of: discount rates, commercial paper rate, Treasury bill rate, and Treasury bond rate. Discount rates are what the Federal Reserve places on loans that have been made to commercial banking institutions. Commercial paper rates are bonds that mature within six months and are short-term discount bonds that have been issued out by well-known corporate borrowers. Treasury bill rate are bills are normally short-termed within one year or even less and are safely issued by the United States government. These bills are readily available at a lesser redemption value when it matures. Treasury bond rate are not like the treasury bills because they will not mature until after one year. The bonds can last from 10 to 30 years and the interest rate will be different due to the maturity. Understandably the interest rates are compounded. A small business owner, along with other borrowers has the unpaid interest that is due from the principal, which is added towards the base figure to decide the interest for future payments. Businesses can get loans fixed where the interest is compounded annually (Block Hirt, 2005)

Present Value-Single Amount is precisely the opposite of future value. Another example could be used with the example above that shows a future value of $2,000 at 10% equals out to $2,928.20. If that were reversed, then the $2,000 future rate of $2,928.20 would presently be valued at $2,000. This indicates that the 10% interest or the discount rate is valued at the $2,000 at present as in Rusell &Norvig (2003, p.67).

Conclusion

Understanding the flow of funds is necessary to investors, financial institutions, and government agencies. The key to financial management involves the analysis of plentiful variables and terms involved in all equations of the flow of funds across industries and disciplines. The idea of the time value of money is that a dollar today is worth more than a dollar tomorrow. Risk is involved as the future is always unpredictable. Interest rates are applied primarily to compensate for these unavoidable risks when they are encountered.

List of References

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Vetsikas, IA & Selman, B 2003, ‘A principled study of the design tradeoffs for autonomous trading agents’, in second international joint conference on autonomous agents and multiagent systems, pages Melbourne, Australia, pp. 473–480.