Rationale
Credit institutions, insurance companies and financing companies (Credit Card, Auto Loan etc…) carry a range of liabilities on their balance sheet. In order to reduce the strain on their balance sheet and improve their Tier1 capital adequacy, these risk carriers have used securitisation as an instrument to "sell" their risk. By securitising the risk associated with their loan portfolio, these institutions transform a liability into a financial instrument. The buyer of the financial instrument buys the risk and obtains the rewards associated with the revenue streams attached to this risk.
Types of Liabilities
The most common liabilities are linked to real-estate loan portfolios. By securitising the loan portfolio, the financial institution effectively sells it to third-parties. As opposed to traditional financing mechanisms, such as traditional bond issuance or bank loans, securitisation removes the liability from the institution's balance sheet.
This method can be used for other types of debt, for instance trade finance is another good example. In trade finance the buyer of the goods usually pays upon receipt of the goods. The seller of the goods, however, often makes substantial investments to produce and ship the goods. Trade finance compensates the seller ahead of receiving the proceeds of the buyer. This creates a liability which a credit institution can carry or sell to potential investors. Auto loans, credit card debt, advance payment of sales agent commissions - in essence all future payment or cash flows which are financed - can be packaged into a securitisation vehicle.
Functioning
Liabilities are usually grouped by nature in order to re-package them into a securitisation vehicle. Once the portfolio has been defined, the offering memorandum is drafted to define the underlying assets, the risks associated with future payment of the income and the remuneration of the investors. The most common structure is the issuance of bonds by the securitisation vehicle, with a fixed or variable coupon.
As for a normal bond issue, the securitisation vehicle can be submitted to a rating agency to obtain a credit rating and therefore help clients evaluate the risks associated with their investment.
Unlike a bond which carries risks associated with the issuer's capacity to pay interest and principal, a securitisation vehicle carries two types of risk:
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Non-payment of income streams and principal by a range of often unknown debtors (for example home owners, credit card holders, car buyers).
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Fluctuating value of the principal, which typically serves as collateral to the bond holders (for example the value of the homes purchased with mortgage loans).
The range of applications is wide and the treatment of securitisation under Basel III will probably undergo changes in the future. However, securitisation remains a powerful, flexible and cost-effective alternative to traditional bond issuance and many other forms of financing.
The bonds issued by securitisation vehicles can be purchased by institutional and qualified investors and represent an attractive opportunity for higher yields in a low-interest environment.
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