OnSecuritisation

Securitisation is a major frontier of global FinancialCapital. Firms and other market entities are constantly looking for more and more ways to raise finance. Investors are looking for more and more investment opportunities. In short, there is an unceasing drive to open up new FinancialMarkets. This means - making more things tradeable, or able to be represented by 'securities'. Securitisation is just that - turning formerly untradeable assets, flows, promises, into securities.

In general the new securities are called 'AssetBackedSecurities'. Conventional bonds are IOU's issued by states, corporates, banks. When investors buy such bonds they are making an assessment of the issuer's ability to repay. They will need to consider the issuer's likely future business prospects, commitments, cashflows, etc., or less tangible properties such as the investor's good name and reputation. Behind these the issuer may have some assets or collateral that ultimately secures the bonds - in the last resort, is the issuer goes bust and defaults, bond holders may have first call on carving up its property and assets.

Asset backed securities are also bonds, but (the general idea is that) they are backed not by the issuer as a whole, but by particular assets. For example, a corporate may have some strong and some weak business lines. As a whole, the corporate has a low credit rating based on an assessment of all its business lines and assets. But it may have one strong business line or set of assets. If you can issue a bond that is backed just by these high-grade assets, then it will have a higher credit rating than the business as a whole.

There is an increasingly vast array of securitisation models and techniques. Basic to all of them is the creation of a new kind of financial entity - usually called a 'special purpose vehicle' (SPV). In general, the idea is that lenders don't want to expose themselves to all of the borrower's activities - they want to pick and choose. The SPV plays the key role of separating off the assets that are to be securitised from the other activities.

The most basic way to do this is though what is called a 'true sale' securitisation. The borrower transfers ('sells') the assets to be securitised to the SPV. (Note though that the SPV is just a paper entity, probably registered in Jersey or the Cayman Islands. It doesn't actually do anything with these assets - the borrower carries on its business as before, 'using' the assets as normal.) The role of the SPV is then purely to act as a bond issuer: it issues bonds, which are ultimately backed by the assets that have been transferred to it. The SPV passes the money it gets from selling the bonds back to the borrower.

This model then basically introduces a new kind of intermediary agent into the market. This can make terminology more confusing, but essentially you could think of:

Borrower = eg. corporate, state, bank etc.

Issuer = SPV

Lender = bond buyer

What do we mean here when we talk about an 'asset'? An asset is just anything (the borrower owns) that has value - that can be converted to money, or used to bring in money. It may be something tangible - like property or machinery. But more often we are talking about promises or obligations again. In fact, most commonly, the assets are loans.

For example: in securitisation, one major 'asset class' is the mortgage. This is so big, particularly in the US, that 'MortgageBackedSecurities' (MBS) are often considered as wholely separate to asset backed securities (ABS). In MBS, the assets transferred to the SPV are not physical properties, but the debts (mortgages) of property-owners held by banks. In the US (I think), in fact most residential mortages are securitised - sold on to SPVs - in this way. CMBS (commercial MBS) is less widespread and more complicated, but also big. In MBS:

Borrower = bank or mortgage-lender, transfers mortgages to SPV.

SPV = owns transferred mortgages. Sells MBS bonds. Passes money raised back to borrower.

Lender = buys MBS bonds.

Some important securitisation asset types are:

MortgageBackedSecurities - both residential (RMBS) and commercial (CMBS). CMBS is becoming big in the public sector eg. social housing, government property portfolios such as hospitals, prisons, military bases outsourced on a 'SaleAndLeaseback' basis.

CollateralisedLoanObligations (CLOs) - non-mortgage loans made by banks, usually to corporates.

Swathes of consumer bank loans: credit card repayments, car loans

ProjectFinance - securitisation increasingly used by states or corporates to fund big projects, eg. infrastructure schemes.

ExoticSecuritisations - eg. IntellectualProperty deals - DavidBowie securitised rights to some of his album sales.

FutureFlows - these are securitisations not of 'existing assets' (such as outstanding mortgages or other loans) but of anticipated future income. This is particuarly big in 'DevelopingCountries' where local banks securitise TradeReceivables and HardCurrency income flows.

WholeBusinessSecuritisations - an interesting hybrid between securitisation and more standard corporate bonds.

Synthetic Securitisations

As opposed to 'pure sale' securitisations.

Here the SPV does not actually own the assets. It acts as an intermediary in a derivatives contract (see DerivativesMarkets).

Synthetic securitisations are becoming increasingly common - partly because banks have less need to transfer assets under the new BaselTwo banking regime. (See history below). In a synthetic CLO, for example:

'Protection buyer' = bank. Bank wants to transfer away risk on some of its loans. To do this it makes a CreditDerivative contract called a Credit Default Swap (CDS) with the SPV. It agrees to make fixed payments to the SPV in return for a promise: if a specified 'credit event' occurs (eg. a proportion of loans in a given pool of loans default), the SPV will make it a large given payment to bail it out.

Issuer = SPV. The SPV issues a type of bond called a 'credit linked note' (CLN). Like any other note, investors pay the par value and receive coupons and eventual repayment of the par value. The SPV holds onto the initial proceeds of the bond sale and the regular payments in from the bank. It pays out the coupons. Eg - suppose the regular payments in from the bank cover the coupons out. Then there is a reserve held in the SPV from the initial sale of the bonds. If the credit event doesn't happen, eventually the investors get this back on maturity. But if the credit event does occur, the SPV uses this sum to pay the bank.

'Protection seller' = investors. They take the coupon payments (and principal repayments). In return, they take on the risk: if the credit event occurs, they will lose their principal. This risk is priced into the coupon payments.

The bank does not (in general) sell all the risk on a pool of loans. What usually happens is it retains the 'first loss risk' - it will take the losses from the first however many millions of dollars of defaults. It then securitises tranches of risk:

eg.

defaults totalling $0 to $20 million - bank retains (first loss risk)

$20 to $40 million - B rated bond holders (tranche c) - coupon: euribor + 300 bps

$40 to $60 million - BBB rated bond holders (tranche b)- coupon: euribor + 160 bps

$60 to $80 million - AAA rated bond holders (tranche a) - coupon: euribor + 40 bps

As in a more standard bond, the lower tranches are 'subordinated' to senior tranches. It may be that senior tranches are repaid but junior ones are not.

History of securitisation

Securitisation, with MBS leading the way, was pioneered by (US) banks in the 1980's. The reason is this: fundamentally banks' assets just are all the loans they make (to corporates, individuals, governments, homeowners etc.) To make money they want to lend as much as possible. But they have limits. They act as intermediaries, borrowing money which they then lend on. But they need to hold a certain amount in reserve against all their lending (this is their capital) in case borrowers default and they don't have enough coming back to repay their creditors.

To ensure the banking system doesn't collapse, governments (or government appointed regulators) tell banks how much capital they have to hold against their assets. This is called 'regulatory capital'. But banks think they know better - in general banks always believe they need to hold less capital than the regulator tells them. Securitisation was originally motivated to a large extent by banks trying to get around regulatory capital constraints ('regulatroy capital arbitrage'). When they transferred their assets to SPVs, these assets were 'taken off balance sheet' - and they no longer had to hold regulatory capital against them. (This has got a lot more complex recently with a new international banking regulation system called BaselTwo coming in - I will come to that later.)

Securitisation thus allowed banks to lend out lots more money than before. Basically, they lend out lots through mortgages, then borrow it back through securitisation. Each time getting their cut off the mortgage-borrowers, but effectively passing the risk on to the ABS/MBS bond holders. If the mortgages default, it is the income going in to the SPV that suffers, and thus the payments (coupons and principal repayments) to the MBS holders.

With BaselTwo regulatory capital arbitrage is becoming less important. However, the techniques that have been developed are found to be useful in new ranges of situations. Because they don't sell assets into the SPV, SyntheticSecuritisations generally involve less legal and administrative costs, and so with regulatory capital concerns disappearing synthetics become more prevalent. The two main motivations for securitisation are then: funding, i.e., using securitisation to create new and cheaper ways to borrow; risk transfer, banks in particular can use synthetic deals to get rid of the risk on their loans. Though they may no longer have to manage 'regulatory capital' so closely, the focus shifts to 'economic capital' - what their own risk models tell them they need to hod against assets. Securitisation is thus an important part of the dynamics and counter-dyanamics of 'DisIntermedition' in the financial markets and the changing role of banks.