A financial transaction known as securitization entails the release of securities backed by a collection of assets, typically debt. The phrase “securitization” refers to the process by which the underlying assets are “converted” into securities, and the term “ABS” refers to the income received by the security’s holder from the products of the underlying assets (Asset-Backed Securities).
Note: Although not as directly as in the case of securitization, all securities are, of course, in some way backed by an asset:
The most apparent connection may be seen in the case of fund units, such as UCITS. Each team in a mutual fund represents an investment in stocks or bonds made by the fund management, and the unit’s value is directly related to the market value of the underlying securities.
When it comes to stocks and bonds, the security itself is both an asset and a liability for the issuer, representing capital in the case of stocks and a long-term loan in the case of bonds. This liability aims to finance investments, though. The motivation to buy the security comes from the investor’s belief in the issuer’s capacity to raise the investment’s value (i.e., produce assets).
In contrast, the ability of the issuer to ultimately repay the security issued in the case of stocks and bonds is susceptible to various certainties that go beyond the issuer’s administrative and entrepreneurial abilities. The ability of the issuer to make the required payments depends only on the quality of the underlying debt in the event of a security formed through the securitization process because the security is backed by a pool of assets that already existed before the securitization took place. When referring to securitization, we use the phrase “refinancing” rather than merely “financing” because the asset has typically already been established. Some securities, however, may also be backed by future debt.
A securitization transaction has the benefit of making it possible for the owner of the underlying debt to refinance that loan. Smaller-scale debts, such as consumer debt, are also included in the securitization process. These debts generate relatively little income on their own (in compared the revenue typically generated by institutional investors), but. Still, they are bundled together to form a larger pool with more outstanding excellence.
A few instances of assets that can be securitized are as follows:
There is a vocabulary explicitly used in ABS. However, given the recent drop in securitization deals, it’s probable that some of these phrases are soon losing their meaning.
First off, the term ABS is a little confusing; for convenience’s sake, it is used to refer to any security formed by securitization since the name already implies that. The term ABS should actually be used to refer to any security that is not backed by mortgage loans because the moniker ABS is truly deceptive. With this definition of ABS, we are left with three categories for medium- and long-term securities, and two categories (the type of underlying assets is indicated in parenthesis) for short-term securities:
Mortgage-Backed Securities (MBS) are mortgage loans that have been bundled together and include:
Mortgages are often not included in collateralized debt obligations (CDOs), which are instead structured into “tranches” that correspond to different risk categories and consist of various assets. Short-term securities backed by commercial debt are known as ABCPs (asset-backed commercial paper).
Securitization is a process.
Securitization is a multi-step process with numerous actors. The basic PR strategy of transferring assets and generating securities is depicted in the diagram below, which was derived from the IMF website.
The process is started by the entity that first holds the assets (the originator) selling the assets to a legal entity called an SPV (Special Purpose Vehicle), which was specifically designed to reduce the risk of the ultimate investor compared to the asset issuer. Then, depending on the circumstance, the SPV either issues the securities directly or resells the asset pool to a “trust” that misgives the securities. An SPV is also known as a “conduit” (the trust is actually used for several securitization transactions and therefore oversees several SPVs).
An SPV functions more as a legal framework than as a participant in the transaction. The arranger, usually a bank, puts up the transaction and assesses the asset pool, how it will be fed, the features of the securities to be issued, and the potential structuring of the fund. This is their main responsibility.
The goal of structuring is to model the securities’ qualities to be compatible with the ultimate investor’s requirements. The amortization criteria for the security are established in advance rather than just paying the ultimate investor the revenue earned by the assets.
Some ABSs allow for the pool of assets to be replenished over the security’s lifecycle or “filled up.” This enables the refinancing of short-term obligations with long-term bonds, including credit card debt.
Finally, the distributor is crucial in getting the securities to the final investors (distribution). The securities are frequently supplied over the counter to a select group of investors rather than being issued on an exchange.
Securitization also allows banks to reduce their balance sheets, making it more straightforward for them to comply with regulatory requirements, as we’ve seen. They seized the chance with both hands. At the same time, they have diverged from their core purpose, the proper assessment of credit risk, which is their cornerstone. Credit agencies are less strict regarding the ultimate borrowers’ quality as credit is extended with increasing ease. The banks have moved away from their duty of financing the economy, preferring instead to adopt (albeit not entirely) a merely intermediate role in an economy that seems to have ultimately “marketized” today; the situation is reaching its limits and is known as a “moral hazard.”
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