Securitization, also known as asset-backed securitization or structured financing, has been defined as a financing instrument whereby a company transfers rights in current or future receivables or other financial assets to an entity that serves as a “special purpose vehicle” (SPV), which in turn issues securities to capital market investors and uses the proceeds from the issue to pay for the financial assets. The source of the receivables could be any right of payment or asset that generates an income with a stable cash flow. The existing or future receivables could be the income generated, among others things by residential or commercial loans, credit card receivables, automobile loans, student loans, royalties on intellectual property, tax receivables or any other income source that is regular and predictable.
Read More: The Concept of Securitization
Securitization can also be considered a form of arbitrage between a less-efficient traditional debt market and a more-efficient capital market where old securities are dressed up as new asset-backed securities by financial firms for profit. Therefore, the slicing and dicing of cash flows and credit risks of the underlying pools of assets into securitized products with varying risk/return profiles and maturity spectra, and the spreading of risk among wider classes, serves the interest of consumers, borrowers, and the nation at large.
Read More: Process of Securitization
Major benefits of securitization as follows:
1. Cheaper Financing
By using securitization techniques to separate a pool of underlying receivables, the originator may be able to generate a lower cost of financing than it can through various forms of borrowing. This is because receivables are often a better credit quality than the originator itself. Without securitization, the originator would finance itself through borrowing based on its own creditworthiness, therefore incurring additional debt. This “swapping” of one credit for another is known as credit arbitrage, and may arise because, either:
- The debtors under the receivables contracts are a better credit risk than the originator. For example, if the originator is A-rated and sells and delivers goods to AA-rated trade buyers (the debtors) on one-month credit terms and the originator’s rights under the credit agreements represent the receivables, the short-term debt obligations of the AA- rated trade buyers, when isolated from the other rights and obligations of the originator, provide a better credit risk than the obligations of the A-rated originator to which the debt is owed; or
- A pool of receivables, when isolated from the general credit risk of the originator and broken down into its component parts (i.e. tranching), may, with the benefit of credit enhancement and liquidity support provide a statistically more reliable credit risk than the credit of the originator (and a better credit risk than any single debtor under a receivables contract). That is, the probability that a specified percentage of all debtors in the pool will default is more certain, and therefore could be more efficiently priced, than the probability that any one debtor in the pool will default or the probability that the originator will default. In addition, because it is possible to isolate different risks associated with different pools of receivables, they can be parceled off to parties who are best able to manage and price them, so increasing the investor base to which the securities can be sold (i.e. tranching).
2. Balance Sheet Benefits
Securitization accelerates cash receipts from the receivables while removing the accounts receivables from the originator’s balance sheet. This reduces the originator’s debt/equity ratio so that it is better able to: (i) comply with financial covenants in respect of its on-balance sheet borrowing; (ii) borrow more; and (iii) improve the return on capital.
The International Financial Reporting Standards (IFRS) (which replaced the International Accounting Standards (IAS)) have made securitization structures that allow an originator to remove receivables from its balance sheet harder to achieve. Whether or not these are applied, and the effect of other accountancy practices affecting off-balance sheet treatment, depends on the jurisdiction. However, balance sheet considerations continue to be an element of financial structuring.
To achieve off-balance sheet treatment, the originator may need to show: (i) that it does not effectively control the SPV, as to ensure that the SPV’s accounts do not need to be consolidated with its accounts; and (ii) that it does not have a significant interest in the risks and rewards associated with the receivables.
Assets off-balance sheet are worth more than on it. The volume of securitized instruments implicitly confirms the value added through securitization. This value added is filtered down to various players in a securitization process that makes every player better off without making some one worse off, thereby increasing overall economic welfare for the global economies. Following table illustrates the value added and increased transparency through securitization by comparing assets (loans) on balance sheet and the asset backed securities ABS created off-balance sheet using the pool of loans as collateral.
Loans on Balance Sheet
|Asset Backed Securities (ABS) Off-Balance Sheet
|Illiquid and non-tradable
|Highly liquid and tradable
|Valued by originator
|Value is determined in the market daily
|Risk assessed by originator
|Risk assessed by rating agencies
|Originator has high cost of funding
|Originator has low cost of funding
|Have lower ratings
|Credit enhanced with higher ratings
|Concentration risk is high
|Market is local
|Market is national and global
|Limited in terms, rates, duration, convexity, etc.
Offers investors/borrowers variety of options
3. Capital Adequacy
In most jurisdictions, financial institutions must hold a minimum capital requirement (essentially equity, reserves and various forms of subordinated debt) against “risk-weighted” assets (that is, the value of assets taking into account a risk weighting which is based on the likelihood of the asset value being realized). The requirement is expressed as a ratio that is set by the relevant regulatory authority in a specific jurisdiction. The sale of receivables for cash effectively removes risk weighted assets from the regulated institution’s balance sheet and reports additional cash instead. This balance sheet “exchange” of receivables for cash improves regulated institution’s capital structure and reduces regulatory cost.
4. Alternative Source of Funding
Asset securitization provides the originator with additional source of funding or liquidity because this financing technique basically converts an illiquid asset (e.g. receivable deriving from a consumer loan which itself cannot be sold) into (i) cash for the originator and (ii) a security with greater marketability for investors. Further, the ability to sell these securities worldwide diversifies the institution’s funding base, which reduces the institution’s dependence on local economies.