Securitisation

Suppose bank A has lent money to Mr.X and kept his house as guarantee. Now the real estate market crashes.  In this case the bank would be in possession of a non-performing asset and would hence suffer a loss. In came securitization. Securitization evolved in the 1970s as a risk reduction tool.

In securitization receivables are sold to a SPV. Receivables could mean any kind of asset like house mortgages, consumer loans. Some assets are better suited for securitization. For example, a house mortgage loan will have a longer life and is hence better than say a credit card receivable. An asset with a short life will need constant “topping up” and may hence not be profitable in the long run.

The purpose behind selling it to a SPV is to get it off balance sheet. Once the asset has been sold to the SPV, bankruptcy of the Originator won’t affect the assets. The basic theory behind securitization is that of repackaging bad assets with attractive gift-wrapping and converting them into profitable ones.

The SPV has to be a created as a separate legal entity and is generally set up in a tax free jurisdiction like Cayman Islands, Jersey, Bermuda, British Virgin Islands, Guernsey or Luxembourg to maximize profits.   

The sale must be true and complete or the transaction will be considered a sham and may even suffer the risk of recharacterisation as a security interest.

Creating the SPV independently also ensures that the credit rating assigned to the receivables will be separate from that assigned to the Originator.

The receivables are made profitable through the process of credit enhancement. Credit enhancement implies various means which are employed to improve the tradability of the assets. For example, third party guarantee. The two most common methods of credit enhancement are over-collateralization and subordination. Over collateralisation means selling more receivables than are needed to cover the underlying portfolio. Therefore, even if there is default in some of the cases, the portfolio amount is still secure and covered. Subordination or tranching of receivables is when risk is distributed in an uneven manner depending on the tier in which the investor happens to fall. The junior notes will be the first to be hit. They receive repayment only when the senior tranches have been repaid. A waterfall clause is provided that contains this classification.