SECURITIZATION

SECURITIZATION

(March 2019)

One method for addressing the management of complex risk is to gain greater, direct access to the international capital market. An increasingly popular way to do so is called securitization, which refers to the process of converting non-liquid assets into market-acceptable securities. The property that undergoes this financial transformation is called a securitized asset. Many types of property, both tangible and intangible, may be converted into securitized assets including:

Note: This asset’s use is likely to be substantially reduced and highly scrutinized due to its contribution to the global financial crises that involved the abusive practice of securitizing tranches of sub-prime home mortgages.

Securitization Benefits

The originator firm (see definition below) may benefit from asset securitization in several ways. The benefits associated for a firm’s decision to securitize a given asset depend upon the applicable contracts arranged in order to complete the process. Entities that use securitization usually experience a higher level of liquidity, a reduced risk of owner-related liability, improved cash flow and cost savings for capital funding. Investors are attracted to these securities because they represent a chance to diversify their investment dollars and the interest rate payments are usually high.

Related Article: Convergence Products

Note: See the portion of the article and diagram below concerning insurance-linked securities.

Securitization Process

Securitization begins by selecting the property intended to go through the process. While many types of assets may be used, they have the following characteristics in common:

 

Example: Skynd Animals, Inc. decides to look into securitization:

Scenario 1: Skynd decides to securitize its inventory of stored minks and other furs. They make other plans when their attorney reminds them that the furs belong to their various customers and they can’t securitize what they do not own.

Scenario 2: Skynd decides to securitize its book of storage rents due from their customers’ annual storage fee agreements. They proceed when their attorney advises that they own and control their rental fee receivables.

 

Example: Pies A-Burning Ltd. wants to securitize some assets. They are foiled in their attempt when it is known they want to, as a package, securitize their book of loans, their inventory of machinery and their rental properties.

Once a pool of eligible assets is created, their ownership must be transferred to an entity, called a special purpose vehicle (SPV) that is independent from the originator firm. Generally, a separate trust is created for this purpose. The originator firm sells the selected, pooled assets to the SPV and it becomes the legal owner of the property. Then, the SPV markets securities to outside investors. The securities sale is backed by the very assets entrusted to the SPV. It is when the assets are used as collateral that they officially are considered “securitized.” Prior to that point, they are merely segregated trust property.

 

 

Securitization Risks

A firm that goes through the process faces a set of associated exposures including:

In addition, firms that securitize assets must be sure that those assets are reported properly for accounting purposes. Often such assets may be treated as sales, but the details of a given agreement may create separate obligations and trigger less preferential tax treatment.

A major problem is that securitization can involve a substantial moral hazard due to various actors having roles that overlapped when they should have been separate. The overlap allowed a high degree of self-interest, especially with regard to the quality (creditworthiness) of the underlying assets.

Definitions

Various terms are associated with the above process, including the following:

Asset-backed Security – any asset that is used as collateral in support of securities sold to investors for that asset.

Conduit – a trust established for the single purpose of receiving a given firm’s assets and issuing various types of debt, backed by those assets.

Depositor – a limited purpose entity which initially accepts assets intended for securitization from an originator firm and then transfers the assets to an SPV (also known as Special Purpose Entity).

Marketable Security – an item that may be freely traded among interested parties (investors) according to an agreed, generally fluctuating price.

Multi-Seller Conduit – a trust that receives assets from more than one originating firm and issues various types of debt, backed by those assets. Each originating firm’s assets are kept in separate, securitized accounts.

Originator Firm – the entity that is the original owner of the securitized property. This firm makes the initial decision to go through the asset securitization process.

Securitized Asset – any property that, via a financial transaction, is transformed into a marketable security.

Securitization Vehicle – see special purpose vehicle.

Special Purpose Vehicle – also known as Special Purpose Entity, refers to the entity (typically an association, corporation partnership or a trust) that acquires the ownership rights to property that is undergoing securitization. It is the SPV that sells securities that are backed by the income flow generated by the securitized property.

Sponsor – another term for originator firm.

SPV – see special purpose vehicle