The Pros and Cons of Securitization

Securitization forces banks to compete with institutional investors and other financial institutions for the business of prime borrowers. In response, banks are beginning to provide borrowers with a range of fee-earning services that facilitate the sale of debt instruments to investors. For example, banks offer borrowers note-issuing or underwriting facilities instead of loans and agree to help borrowers sell their debt instruments to investors as and when needed. Banks may also agree to purchase only the unsold portion of the debt issue. Thus, securitization is moving banks away from performing traditional banking functions, such as extending credit in exchange for periodic interest payments. In addition, securitization provides the creditor with two significant benefits. Because the lender can choose whether to trade the notes or to hold them to maturity, the lender can better manage its credit limits and asset portfolio. The bank also earns a major part of its income on the underwriting facility from fees paid for its services, rather than from periodic interest payments.

Securitization is attractive to borrowers because it gives them increased financing flexibility. Borrowers can time the issuance of their securities to coincide with their financing needs . In addition, because more investors are willing to purchase debt securities than participate in syndicated or term loans, borrowers have more financing options available. This lowers the overall cost of financing, provided that the issuer can sell the securities at an acceptable price.

But securitization also raises legal issues for borrowers. As debt is now issued in the form of tradable securities, debt issues are affected by applicable securities regulations as well as banking regulations. Debtors must contend with complicated and expensive registration procedures in some countries, such as the United States. Failing to satisfy these regulatory requirements results in restrictions on security sales, which can in turn affect the price of the security.

Securitization creates tangible economic benefits. The most important benefits of securitization are:

  1. Market Efficiency: Through securitization process the companies holding financial assets like loans have ready access to low cost sources of fund and can reduce their dependence on financial intermediaries for their capital requirement. This translates into lower interest cost the benefits of which are also passed to the end consumers.
  2. Specialization: The classic bank/financial institution model of Origination-Funding-Credit administration of loans has led to an unbundling of roles and greater specialization as various player can now concentrate on their core function, be it origination, funding or credit administration.
  3. Streamlined system and process: Securitization demand high levels of data transparency and requires robust system. This enhances the overall monitoring and control of asset portfolios.

Benefits of Securitization from Originator’s Perspective

  • Efficient Financing: In securitization it is possible to achieve much higher target rating for instrument than the originator’s credit raring by providing credit rating enhancements for the transaction. Thus the borrower can obtain fund at lower interest rates applicable to highly rated instrument and gain a pricing advantage.
  • Off balance sheet funding: For accounting purposes securitization is treated as a sale of assets and not as financing. Therefore the originator does not record the transaction as a liability on its balance sheet. Such off balance sheet raise funds without increasing the originator’s or debt equity ratio.
  • Lower capital requirement: Securitization enables banks and financial institutions to meet regulatory capital adequacy norms by transferring assets and their associated risks off the balance sheet. The capital support the assets is released and the proceeds from securitization can be used for further growth and investment.
  • Liquidity management: Tenor mismatch due to long term assets funded by short term liabilities can be rectified by securitization as long term assets are converted into cash. Thus securitization is a tool of asset liability management.
  • Improvement in financial ratios: Since securitization help in undertaking larger transaction volumes with the same capital profitability and return on investment ratios increase post securitization.
  • Profit on sale: Securitization helps in up-fronting profits. This would otherwise accrue over the tenor of the loans. Profits arise from the spread is booked as profit leading to increased earnings in the year of securitization.

Benefits of Securitization from Investor’s Perspective

Securitized instruments offer investors an attractive investment proposition since they combine above average yields with a strong credit performance. Potential investors in securitized instruments should consider the following factors:

  • Safety Features: Securitization offers investors a diversification of risks, since the exposure is to a pool of assets. Most issuances are highly rated by independent credit rating agency and have credit support built into the transactions. Investors get the benefit of the payment structure closely monitored by an independent trustee which may not always be in the case of traditional debt instruments.
  • Performance track record: Securitization instruments have demonstrated consistently good performance with no downgrades or defaults on any instrument in India.
  • Yields: Yields of ABS/MBS/CDO are higher than those of other debt instrument with comparable rating. Spreads of securitized instrument are typically in the range of 50-100 basis points over comparable AAA corporate bonds.
  • Flexibility: An important advantage of securitization is the flexibility to tailor the instrument to meet the investor’s risk and tenor appetite.
    • Duration’s can range from few months to many years.
    • Repayment are usually made on monthly basis but can be structured on a quarterly or semi annually basis.
    • Interest rate can be fixed or floating depending upon investor preferences.

Benefits of Securitization to Borrowers/Consumers

  • Access to competitive rates and terms
  • Access to cheaper financing
  • Availability of array of financing alternatives
  • Funding availability for all types of borrowers
  • Reduced processing time

Benefits of Securitization to Arranger/Investment Bankers

  • Increased product lines and fees
  • Increased opportunities to expand operation nationally and globally
  • Increased trading volume and profit
  • Improved efficiency and specialization