Securitisation is a financial term referring to the process of using financial engineering to take an asset or group of assets that are illiquid and turn them into securities.
Securitisation often turns debts into securities, although it can be used with a variety of financial assets including residential or commercial mortgages, credit card debt obligations, auto-loans, or forms of assets that are not debt-related but which generate receivables. An introduction to receivables can be found in the PDF attachment to this post.
In securitisation, these types of assets are pooled, and the related cash flows are then sold as securities to third party investors. The interest cash flows as well as the principal are used to repay investors, with the interest collected from the underlying debt or asset being redistributed through the new financing’s capital structure.
Domen Zavrl has extensive experience in international business and cites securitisations as one of his key areas of expertise. Securitisation gained a bad reputation in the wake of the 2007 global financial crisis caused by the securitisation of risky subprime mortgages. However, over the past decade, securitisation has evolved and become less risky.
Securitisation History
The modern version of securitisation dates back to around 1968, when mortgage-backed securities first began to be issued. An MBS is when a collection of mortgages is used to secure an asset-backed security.
Following the advent of mortgage-backed securities came new types of securitisation, such as the introduction of collateralised mortgage obligations in 1983. These types of financial packages gained in popularity throughout the 1990s and beyond.
However, the practice of securitisation can be dated back as far as the late 18th century and the modern practice has its roots in the Dutch Republic in the 17th century. A popular early example of securitisation would be farm railroad mortgage bonds issued in the United States in the middle of the 19th century.
Securitising Assets
Theoretically it is possible to securitise almost any financial asset, which means turning that asset into a fungible item which has monetary value and is therefore tradeable. A definition of fungible can be seen in the embedded short video.
However, securitisation is most often used with assets that generate receivables, which are usually forms of debt such as loans. Contractual debts like credit card debt or auto loan obligations are pooled to create assets.
The company that owns the assets, such as a bank, begins by gathering together all the data on each asset that it wishes to remove from its balance sheet, such as mortgages that it no longer wants to service. The group of assets that have been gathered are then referred to as a reference portfolio.
The bank can then sell the reference portfolio to a third party who creates tradeable securities from the assets. These can then be sold on again to investors who will generate profit from their investment at a specified rate of return.
Tranches
The third party or issuer who initially purchases the reference portfolio from the originator or bank may choose to divide the portfolio into different sections before approaching investors. Each section is called a tranche and each tranche has different characteristics. Assets are divided according to various factors including interest rates, types of loan, amount of principal remaining, and maturity date. Each tranche offers the possibility of different yields, with the potential for higher rewards growing in relation to the risk carried by each tranche.
The infographic attachment looks at some of the motives for securitisation.
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