How Asset Securitization Works? ( Example and Explanation)

Assets securitization

Assets securitization is the process of converting illiquid non-tradeable assets into liquid tradeable securities that can be issued to the investors. The different financial assets like loans and other receivables are underwritten and sold in the form of asset-backed securities.

Different financial assets are combined to produce consolidated financial instruments and issued to the investors. This helps the financing company to manage the risk of ownership.

The financing company/bank gets access to the funds and investors to earn quality interest as a return on their investment.

Asset securitization greatly helps the financing company to get the cash as they might have depleted their treasury by disbursing the loan to a large number of borrowers.

In this case, asset securitization can be an excellent approach to add dollars to the financing company and enhance the liquidity of the company’s operations as they can disburse new loans to the customers.

On the other hand, the investors get the diversification of their investment portfolio and earn returns on their investment.

Hence, the arrangement of the asset securitization is beneficial for both investors and the company actually carrying out the process of securitization.

How asset securitization works?

The financing company/bank records the financial asset in their balance sheet after disbursement of the funds as a loan to the borrower. The party that disburses the fund originally is said to be the originator of the securitization process.

The originator gathers all the financial assets at one place that need to be scrutinized, the portfolio created is known as reference portfolio.

The referenced portfolio is actually sold to the issuer who creates tradeable securities and sells to the investors at some specified rate of interest.

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The reference portfolio is often divided into different sections called trenches. The trenches are classified based on the characteristics of the financial instrument.

For instance, the trenches are classified on the basis of loan maturity, rate of interest, type of loan, the balance remaining as principal. Hence, the risk attached to each trench is different. So, the yield on the trench is different as well.

Example of securitization

The mortgage-backed security is an example of the securitization process. The large portfolios of the mortgage-backed securities are referenced and the issuer can reference the pool of assets to be divided into smaller portions based on their characteristics and associated risk.

Risk of the securitization process

The process of securitization is not free from strategic and operational risk. The strategic risks include increasing competition due to securitization, credit quality & origination, and the internal capability of the originator.

The operational risk arises in areas of liquidity, credit management, and the risk of compliance.

To ensure appropriate risk management of the securitization the originator needs to assess if the strategic goals and the financial expectation of the securitization process are in line.

Further, a detailed assessment needs to be made if there is the requirement for some system upgrades to support the process as the process is complex and requires appropriate monitoring to be profitable in a long term.

In addition to this, the resource requirements need to be assessed at the start of the project to ensure an efficient flow of operational and strategic activities.

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Advantages of securitization

Following are some of the advantages associated with the process of securitization.

1) For originator

The prime advantage of the securitization process is the conversion of the on-balance sheet lending into off-balance sheet items. This helps to improve the return on capital employed for the originator.

Further, the process of securitization provides additional capital to the originator for further expansion or management of the operations. Hence, it’s an excellent tool to improve the mechanism of credit risk management for the financing company.

2) For investors

The investors/leaders of the asset-backed security are at advantage in several ways that include attractive yields on their investments, collateral coverage, and guarantees by stable entities with excellent credit ratings, flexibility in the measurement of interest payments, and diversification of the backed investment pool that makes it an attractive investment opportunity for the lenders.

The collateral coverage and diversification of the backed asset pool has been the main reason for the attraction of the securitization financing.

It gives an investor peace of mind regarding the security of their investments and frees them from obtaining understanding about the underlying asset.

3) For borrowers

The borrowers get the availability of the financing on soft terms. The reason for soft term is that the originator does not have these loans on their balance sheet and disbursing loans on the lower rate of interest does not dilute theirs on balance rate of returns. Hence, it puts them in a position to grant a loan at a concessional price. 

For instance, many borrowers prefer to obtain a loan at a fixed rate of interest rather variable rate as it does not expose them to the risk of fluctuation in the interest rate. The lenders with securitization can offer this facility as the market exists for mortgage-backed assets.

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Disadvantages of securitization

Given are some of the disadvantages of the securitization process.

1) For the originator

For the originators, it can really be a complicated process to monitors initiate, and monitor the entire process of securitization.

In addition to this, if the originator decides to take back the assets processed in the securitization it can be an expensive decision indeed. Further, the originator does not have direct control over the assets.

2) For investors

Investors may find it difficult to assess the innate risk of the securities as they usually rely on financial institutions. The biggest risk for the investor is that if the borrower fails to pay the ultimate loss has to bear by investors.

Further, there might be a lack of transparency as investors may not have sound knowledge of the mortgage portfolio and fail to predict appropriate risk. The financial crisis of 2007 is a prime example of the risk in mortgage-backed securities.

Further, if the borrower makes the prepayments for the loan the investor/lender has to compromise on their gains.

Overall, the disadvantages of securitization lie in the area of complex handling, difficulty in assessment of the risk, lack of transparency, prepayments by the borrower, and higher cost and monitoring is associated with the process of securitization.