LO 35.4: Explain the reasons for and the benefits o f undertaking securitization.

LO 35.4: Explain the reasons for and the benefits o f undertaking securitization.
Benefits to Financial Institutions
The three main reasons for a financial institution to use securitization are for funding assets, balance sheet management, and risk management. Typically a financial institution specializes in financing specific assets such as residential mortgages, automobile loans, commercial loans, or credit card debt. Securitization of these assets provides funding for the financial institution that helps support growth, diversifies the funding mix, and reduces maturity mismatches. The diversification of the funding mix reduces risk and the cost of funding. The originator separates the assets from its balance sheet by going through a third party (i.e., the SPV).
Asset-backed securities (ABS) issued by a SPV often have higher credit ratings than the original notes issued by the originator. If the SPV has a higher credit rating, then the originating institution benefits by lowering the cost of issuing debt when going through the SPV. ABS markets are not as liquid as bond markets, but the lower credit ratings of SPVs typically make them a more cost effective funding option. Thus, the cost savings from securitization creates a cash surplus for the originator. In addition, financial institutions often use short-term liabilities (such as savings and checking account balances) to fund long-term assets (such as residential mortgages). Securitization allows notes to be issued
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Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
by the SPV that match the time horizon of the underlying asset. At the same time, the originator is able to remove the risk of mismatched durations on the balance sheet.
Another reason financial institutions securitize assets is to manage the capital on their balance sheets. The Basel I Accord set capital requirements for banks based on the riskiness of the assets. Basel I capital requirements provided a big incentive for banks to securitize assets in order to gain regulatory capital relief. SPVs are not categorized as banks, so they are not subject to the same capital requirements as banks. For example, regulators may require banks to hold capital of 8% of the banks total asset value. An originating bank is able to reduce capital requirements by selling assets to an SPV. As mentioned earlier, originators often keep a portion of the capital exposure by retaining the first-loss piece. Therefore, the capital requirements from the securitization are significantly reduced, but not completely eliminated. By reducing capital requirements, securitization is a form of raising capital. Banks need to issue less preferred stock and other forms of equity when they securitize assets. The reduction of capital also increases the return on equity (ROE) which is a key ratio for investors.
In addition to providing regulatory relief, securitization provides additional risk management benefits in the form of removing non-performing assets from the balance sheet. Securitization removes the credit risk as well as the negative sentiment associated with non-performing assets. Furthermore, the originator may receive surplus profit from the SPV in the event these non-performing assets start returning cash flows in the future.
Benefits to Investors
Securitization also provides benefits for investors. As a result of securitizations, investors have access to new liquid assets that were previously not available to them. This allows investors to create different risk-reward profiles and diversify into new sectors. Securitized notes often provide higher risk-reward incentives than corporate bonds with the same credit rating. The improved performance results from the originator maintaining the equity tranche. In addition, holding a securitized asset diversifies the risk exposure because the securitized asset is purchased from an SPV with a pool of assets as opposed to a corporate bond from one entity. Securitization broadens the market for buyers and sellers through diversification and customization of new liquid products. The increased liquidity reduces transaction costs, which benefits both borrowers and investors.
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