The Concept of Securitization

Securitization is a process by which identified pools of receivables, which are usually illiquid on their own, are transformed into marketable securities through suitable repackaging of cashflows that they generate.

The Broader Meaning of Securitization

  • Securitization is the process of commoditization. The basic idea is to take the outcome of this process into the market, the capital market. Thus, the result of every securitization process, whatever might be the area to which it is applied, is to create certain instruments, which can be placed in the market.
  • Securitization is the process of integration and differentiation: The entity that securitizes its assets first pools them together into a common hotchpot (assuming it is not one asset but several assets, as is normally the case). This process of integration. Then, the pool itself is broken into instruments of fixed denomination. This is the process of differentiation.
  • Securitization is the process of de-construction of an entity. If we think of an entity’s assets as being composed of claims to various cash flows, the process of securitization would split apart these cash flows into different units. We classify these units, and sell these classified units to different investors as per their needs. Therefore, securitization breaks the entity into various sub-sets. We will discuss further the present-day meaning of securitization after some more understanding of generic meaning of the term. The process of converting an asset or a relationship into a security or a commodity.

Meaning of Security

The meaning of security in the context of securitization is not static but dynamic. With respect to securitization, the word “security” does not mean what it traditionally might have meant under corporate laws or commerce: a secured instrument. The word “security” here means a financial claim that is generally manifested in form of a document, its essential feature being “marketability”. To ensure marketability, the instrument must have general acceptability as a “store of value. Therefore, it is generally rated by credit rating agencies, or it is secured by charge over assets. In addition, to ensure liquidity, the instrument is generally made in homogenous lots.

Securitization Process

The successful execution of a securitization depends on the investor’s uncontested right to securitized cash flows. Hence, securitized loan need to be separated from the originator of the loan. In order to achieve this separation, a securitization is structured as a three-step frame work:

  1. A pool of loan is sold to an intermediary by the originator of the loans. This intermediary (called a special purpose vehicle or SPV) is usually incorporated as trust. The SPV is an entity formed for the specific purpose of transferring the securitized loans out of the originator’s balance sheet, and does not carry out any other business.
  2. The SPV issues securities, backed by the loan, and by the payment streams associated with these loans. These securities are purchase by investors. The proceeds from the sale of the securitized are paid to the originator as a purchase consideration for the loan receivables.
  3.  The cash flows generated by the loans over a period of time are used to repay investors. There could also be some credit support built into the transaction to protest investors against possible losses in the pool. However, the investors will typically have no recourse to the originator.

Securitization Process

Need for Securitization

The generic need for securitization is similar to that of organized financial markets. From the distinction between a financial relation and a financial transaction earlier, we understand that a relation invariably needs the coming together and remaining together of two entities. Not that the two entities would necessarily come together of their own, or directly. They might involve a number of financial intermediaries in the process, but a relation involves fixity over a certain time. Financial relations are created to back another financial relation, such as a loan being taken to acquire an asset, and in that case, the needed fixed period of the relation hinges on the other that it seeks to back-up.

Financial markets developed in response to the need to involve a large number of investors. As the number of investor’s keeps on increasing, the average size per investors keeps on coming down, because growing number means involvement of a wider base of investors.

The small investor is not a professional investor. He needs an instrument, which is easier to understand, and provides liquidity and legal sanction. These needs set the stage for evolution of financial instruments which would convert financial claims into liquid, easy to understand and homogenous products. They would be available in small denominations to suit even a small investor. Therefore, securitization in a generic sense is basic to the world of finance, and it is right for us to say that securitization envelopes the entire range of financial instruments, and the range of financial markets.

Reasons for Growth of Securitization

  1. Financial claims often involve large sums of money, which is outside the reach of the small investor who lacks expertise. In order to cater to this need development of financial intermediation. In a simple case an intermediary such as a bank obtains resources of the small investors and uses the same for the larger investment need of the user.
  2. Small investors are typically not in the business of investments, and hence, liquidity of investments is most critical for them. Underlying financial transactions need fixity of investments over a fixed time, ranging from a few months to may be a number of years. This problem could not even be sorted out by financial intermediation, since, the intermediary provided a fixed investment option to the seeker, and itself requires funds with an option for liquidity. Or else, it would be into serious problems of a mismatch. Hence, the answer is a marketable instrument.
  3. Generally, instruments are easier understood than financial transactions. An instrument is homogeneous, usually made in a standard form, and generally containing standard issuer obligations. Hence, it can be understood generically. Besides, an important part of investor information is the quality and price of the instrument, and both are difficult to be ascertained.

The need for securitization was almost inescapable, and present day’s financial markets would not have been what they are, unless some standard thing that market players could buy and sell, that is, financial securities, were available. Therefore, there is large scope for development in this area. Capital markets are today a place where we can trade, claims over entities, claims over assets, risks, and rewards.

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