LO 35.1: Define securitization, describe the securitization process and explain the

LO 35.1: Define securitization, describe the securitization process and explain the role o f participants in the process.
Securitization is the process of transforming the illiquid assets of a financial institution or corporation into a package of asset-backed securities (ABSs) or mortgage-backed securities (MBSs). A third party uses careful packaging, credit enhancements, liquidity enhancements, and structuring to issue securities backed by the pooled cash flows (i.e., principal and interest) of the same underlying assets. Cash is transferred to the selling party, and the obligation is effectively removed from the sellers balance sheet if the sale is made without recourse. Hence, securitization represents an off-balance-sheet transaction.
A wide range of assets can be securitized (e.g., mortgages, credit card receivables, auto loans, etc.). The common feature of all ABS and MBS is that the underlying assets generate cash flows. It is important to note that the third party in the securitization process is not involved in the origination of the assets underlying the securitized product.
The two key participants in the securitization process are the originator and the issuer. The originator is the entity that seeks to convert its credit-sensitive assets into cash. The credit risk is then transferred away from the originator. The issuer is a third party who stands between the originator and the eventual investor that purchases the securities. The issuer buys the assets from the originator. The issuer must be a distinct legal entity from the originator in order for the sale of the assets to be considered a true sale. In a true sale, the assets are transferred off the originators balance sheet and there is no recourse. A special purpose vehicle (SPV) [also sometimes referred to as a special purpose entity (SPE)] is a separate legal trust or company that is set up specifically for the purpose of securitization.
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The SPV separates the underlying asset pool supporting the securitized issues from the other assets of the originator. This is an important step in the process because it ensures that the securitized assets are not affected if the originator becomes insolvent. This process of securitization provides credit enhancement to the newly issued securities as the third party SPV guarantees the credit quality of the issues. Thus, the investors purchasing the securitized issues are not concerned about the financial strength or creditworthiness of the originator. Investors are only concerned about the credit quality of the securitized issues and the SPV guaranteeing them. Thus, in the event that the originating financial institution becomes financially insolvent, it would not impact the SPV (except for any consideration on the first-loss piece which will be discussed later).
As stated previously, the SPV may be designated as a corporation or a trust. For tax purposes, SPVs are often incorporated in offshore locations such as the Cayman Islands, Dublin, or the Netherlands, which are regions that have SPV-friendly legislation. If the SPV is set up as a corporation, the originator sells the assets to the SPV in exchange for cash. The SPV, in turn, issues claims directly against the assets of the SPV. In European countries, accounting regulations allow SPVs to be structured as corporations. However, this method may not distance the originator from the assets enough for accounting purposes in the United States. Therefore, in the United States, the SPV trust is the most common structure.
The most common application for an SPV is to set up cash flow securitization where the originator sells the assets to the SPV who funds the purchase of the assets by issuing notes to investors. However, SPVs are also used to convert the currency of underlying assets through currency swaps, issue credit-linked notes (CLNs), and transfer illiquid assets into liquid assets (e.g., accounts receivables from equipment leases).
The structuring agent is the de facto advisor for the securitization issue. This agent is largely responsible for the security design (e.g., maturity, desired credit rating, credit enhancement, etc.) and forecasting the interest and principal cash flows. The structuring agent may also be the sponsor as the two roles have natural overlap.
In the event of a default, a trustee is charged with the fiduciary responsibility to safeguard the interests of the investors who purchase the securitized products. The trustee will monitor the assets based on pre-specified conditions of the asset pool such as minimum credit quality and delinquency ratios.
An insurance company referred to as the financial guarantor is sometimes used to wrap the deal by providing a guarantee of financial support in the event the SPV defaults. Financial guarantors are more common in a master trust arrangement, which we will cover later in this topic.
The custodian was initially responsible for safeguarding the physical securities. This role has evolved to also include the collection and distribution of the cash flows of assets like equities and bonds.
Credit rating agencies such as Moodys, Standard & Poors, or Fitch also play an important role in the securitization process. The rating agencies provide formal credit ratings for each securitization. The rating agencies quantify the corporate credit quality of the originator. In addition, they provide analysis on competitors, the industry, regulatory issues, the legal
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structure of the SPV, and cash flows. If the credit rating is too low, the securitization deal may be restructured by the structuring agent to offer additional credit enhancements.
Figure 1 illustrates how the SPV purchases assets from an originator. The purchase of these assets is funded by issuing notes and selling them to investors. The structure of the issues is often customized to meet the credit quality needs of the investors via tranches. As mentioned, the process of securitization allows the originator to remove credit risk and assets from their balance sheet.
Figure 1: Securitization Process
Credit T ranches Class A notes
Class B notes
Class C notes
Class D notes
C a s h W a t e r f a l l P r o c e s s