Asset securitization can be defined as the partial or complete segregation of a specific set of cash flows from a corporation’s other assets and the issuance of securities based on these cash flows, i.e exchanging one asset for another. The types of financial assets involved in asset securitization transactions are often receivables. The practice of securitization originated with the sale of securities backed by residential mortgages, but the framework of asset securitization has rapidly expanded from its initial root of mortgages and receivables to other more variable cash flows in home equity loan markets, commercial loan markets, credit card receivables, auto loans, small-business loans, corporate loans, state lottery winnings, and litigation settlement payments and other types of loans.
Asset securitization is the transformation of a mix of illiquid individual loans that are combined into relatively similar pools and transformed into highly liquid bonds traded in securities markets and usually, when securities are backed by non-mortgage loans, they are referred to as asset-backed securities (ABS). Securities issued exclusively against credit and loans with mortgage guarantees are referred to as mortgage-backed securities (MBS). Assets like ABS, MBS and it likes are now widely spread in fixed income portfolios at both the institutional and individual investor level. Although the largest and most well known example of asset securitization is the residential mortgage market. The dealings of asset securitization transactions vary, the typical transaction involves the sale by a bank or financial institution (who are called originator) of certain assets on its balance sheet to a trust, corporation or a separate entity, called special purpose vehicle (SPV). Thus, through the asset securitization process, SPV is funded by issuing securities whose payments are backed by the performance of the bought assets. Usually, the securities issued by the SPV to enhance the marketability are usually evaluated by bond-ratings agency, such as Moody’s, Fitch and Standard and Poor’s. The least risky tranches receive the highest credit rating and the most risky tranche receives no rating at all also, like in the event of a private placement, ratings are not always necessary since investors with technical know-how themselves can evaluate the securities. The credit rating received depends on the risk of the pool of assets as collateral.
Risks for Banking Organizations
The securitization process, if not carried out prudentially, can leave risks with the originating bank without allocating capital to back them. While all banking activity entails operational and legal risks, these may be greater the more complex the activity. But the main risk a bank may face in a securitization scheme arises if a true sale has not been achieved and the selling bank is forced to recognize some or all of the losses if the assets subsequently cease to perform. Funding risks and constraints on liquidity may also arise if assets designed to be securitized have been originated, but because of disturbances in the market the securities cannot be placed. There is also at least a potential conflict of interest if a bank originates, sells, services and underwrites the same issue of securities.
A bank that has originated and transferred assets effectively may nonetheless be exposed to moral pressure to repurchase the securities if the assets cease to perform. The complexity of securitization schemes could contribute to such pressure. After having completed the securitization transaction the seller does not in general disappear but exercises other functions in the process. These functions and the fact that the investors are well aware of the identity of the provider of the assets backing the securities may give rise to links between seller and investors that could, at least morally, cause the seller to be under pressure to protect its reputation and to support the securitization scheme.
The risks for banks acting as a servicer are principally operational and are comparable to those of an agent bank for a syndicated loan. However, the number of the loans in the portfolio and the different parties involved in a securitization scheme mean that there are higher risks of malfunction for which the servicer might also become liable. Thus, servicers need to engage sophisticated personnel, equipment and technology to process these transactions in order to minimize operational risk.
It is sometimes contended that banks in seeking a good market reception for their securitized assets may tend to sell their best quality assets and thereby increase the average risk in their remaining portfolio. Investor and rating agency demand for high quality assets could encourage the sale of an institution’s better quality assets. Moreover, an ongoing securitization programmer needs a growing loan portfolio and this could force a bank to lower its credit standards to generate the necessary volume of loans. In the end a capital requirement that assumes a well diversified loan portfolio of a given quality might prove to be too low if the average asset quality has deteriorated.
The securitization of revolving credits such as credit-card receivables is a particularly complicated example which involves the issue of securities of a fixed amount and term against assets of a fluctuating amount and indefinite maturity. A portfolio of credit-card receivables fluctuates daily as the individual accounts increase and decrease, and because of the different repayment patterns by credit-card users (e.g. by fast and slow payers). It is also likely that as a scheme matures the security-holders will be repaid out of a fixed share of gross flow on the accounts in the pool, so deriving repayment principally from fast payers who resolve their debts quickly. Such schemes need a structure adequate to ensure control of the amortization process and to ensure appropriate risk-sharing during amortization by the security-holders.
Implications for Financial Systems
The possible effects of securitization on financial systems may well differ between countries because of differences in the structure of financial systems or because of differences in the way in which monetary policy is executed. In addition, the effects will vary depending upon the stage of development of securitization in a particular country. The net effect may be potentially beneficial or harmful, but a number of concerns are highlighted below that may in certain circumstances more than offset the benefits. Several of these concerns are not principally supervisory in nature, but they are referred to here because they may influence monetary authorities’ policy on the development of securitization markets.
While asset transfers and securitization can improve the efficiency of the financial system and increase credit availability by offering borrowers direct access to end-investors, the process may on the other hand lead to some diminution in the importance of banks in the financial intermediation process. In the sense that securitization could reduce the proportion of financial assets and liabilities held by banks, this could render more difficult the execution of monetary policy in countries where central banks operate through variable minimum reserve requirements. A decline in the importance of banks could also weaken the relationship between lenders and borrowers, particularly in countries where banks are predominant in the economy.
One of the benefits of securitization, namely the transformation of illiquid loans into liquid securities, may lead to an increase in the volatility of asset values, although credit enhancements could lessen this effect. Moreover, the volatility could be enhanced by events extraneous to variations in the credit standing of the borrower. A preponderance of assets with readily ascertainable market values could even, in certain circumstances, promote liquidation as opposed to going-concern concept for valuing banks.
Moreover, the securitization process might lead to some pressure on the profitability of banks if non-bank financial institutions exempt from capital requirements were to gain a competitive advantage in investment in securitized assets.
Although securitization can have the advantage of enabling lending to take place beyond the constraints of the capital base of the banking system, the process could lead to a decline in the total capital employed in the banking system, thereby increasing the financial fragility of the financial system as a whole, both nationally and internationally. With a substantial capital base, credit losses can be absorbed by the banking system. But the smaller that capital base is, the more the losses must be shared by others. This concern applies, not necessarily in all countries, but especially in those countries where banks have traditionally been the dominant financial intermediaries.