Securitization is the process of pooling multiple financial products of the same class and then marketing them and then sell them to another financial institution.
So, the securitization of assets follows the same logic.
A bunch of the same financial assets are pooled together and converted into one marketable security. Now, these can be mortgages, corporate bonds, or car loans.
Securitization has dual advantages for both the securitizer and the person or entity buying the securitize assets. Securitization provides liquidity to the entity that securitized the asset and it provides a great financial asset to the buyer.
The securitization of assets creates a complex class of financial products that have a non-static credit rating. It means that the credit rating of these financial products keeps on changing.
This is due to the fact that the underlying assets in a securitized financial product may be deteriorating. The quality of the underlying assets may also increase depending upon the performance of these assets. So, the credit rating is affected by these underlying loans.
Securities and securitization differ on one point. The securitization assets provide a fixed return such as government or corporate bonds, whereas the securities such as stocks may not do so.
Concept of securitization
The concept behind securitization is risk management. By pooling the same asset class securities under one marketable financial product, the yield of the securitized assets go up, but the risk still remains low.
As these securitized assets consist of hundreds of thousands of same asses class, so if a couple of assets deteriorate majority of the assets are still all right. This also helps in mitigating the credit risk that arises from a single asset.
The securitized assets consist of tranches (a layer of products). So, if the securitized assets are properly layered, they provide great risk management, which reduces risk but increases the yield of these financial products.
Special types of securitizations
There are four types of special securitizations each with its advantages and disadvantages. These four types of securitizations are depicted in figure one below:
Figure 1: Special types of securitizations
The four special types of securitizations depicted in figure 1 are Master trust, Issuance trust, Grantor trust, and Owner trust. All four special types of securitizations are explained in great detail below:
Master trust can be described as a securitization which is a special purpose vehicle or an SPV which has the ability to handle multiple types of securitization at one time.
Basically, how a master trust works is that a securitizer issues receivables on a particular debt, takes credit card receivables in this example, and then the Master Trust issues securitizations which are backed by the credit card receivables.
Sometimes, a Master Trust may issue multiple securities based on one receivable. In this scenario, the Master trust tranches the receivables into multiple layers.
One of the biggest disadvantages of these types of trust is that the owner has to wait to receive income until the earnings are amortized.
Issuance trust was introduced by Citibank in the early 2000s. One of the biggest advantages of the Issuance trust against the Master Trust is that the Issuance Trust does not have any limitations.
These do not have any subordinate or senior tranches as the Master trusts do. This leads to a more simplified tranche structurization.
The other advantage of the Issuance Trust is the flexibility that it provides. This allows them to issue multiple investment-grade securities backed by a single asset.
This means the capital of pool in these investments increases as the funds like pension funds are only allowed to invest in investment-grade securities.
The Grantor trust is used mainly for the mortgage and car loan securities. The method of issuance for securitized assets is the same as the Master Trust.
The originator gives the assets to the Grantor trust which uses these assets or credit loans to issue securities backed by these assets.
The earnings are given to asset owners after subtracting the costs associated with the issuance of these securities. These are based on pro-rata, meaning proportionally.
An owner trust is a highly flexible specialized purpose vehicle that allows for use of interest and securities to pay to senior securities by the sub-ordinating securities.
This flexibility allows the Owner trust to tailor the securities issued by it to the specifications requested by the investors.
How the earned income and interests are paid depends wholly on how the tranches are structured. Well-structured tranches of securities allow for better risk management and a higher yield on the assets backed by these securities.
Example of securitization of assets
A widely used example for securitization of assets is mortgage-backed securities or MBS. The MBS uses house mortgages, bundles them all into one marketable security, and then sells these securities.
MBS is one of the most widely used financial products. This is because the returns provided by them are stable and the cash flows are highly predictable.
Main advantages of the securitization of assets
The main advantages of securitizations of assets are as follows:
i) Better risk management of assets.
ii) A Higher yield on assets is achieved.
iii) We are able to predict the future cash flows with high accuracy.
iv) The securitization allows for easier trading of untradeable lower-quality assets.
Main disadvantages of the securitization of assets
The main disadvantages of the securitizations are as follows:
i)These are highly complex products.
ii) Their trenching and structure make it incredibly difficult to know what types of assets are in them.
iii) The deterioration of the underlying assets can quickly spiral out of control.
Securitization of assets allows for better risk management while also increasing the yield on the assets whose underlying yields would have been low if they were not all bundled together.
But, there are also some very clear risks associated with the securitized product that must be kept in mind when thinking of investing in them.