Now that we are familiar with securitization, it would be nice to provide a real-life example of how it functions as a financial operation. Imagine you are the CEO of a bank in Europe operating mainly in Germany, Italy, and some of the Eastern Europe countries.
In the last few years, the European Central Bank has paid you several visits and they reiterated the same message over and over again. Your capital to risk-weighted assets ratio is too low and needs to be strengthened and this needs to happen fast. They require you to fix the issue within the next few months. There are two quick ways to improve the capital-to-risk-weighted assets ratio. The first one is to raise capital and increase the numerator.
However, you know that now is not the best time to do that. Several reputed newspapers and websites have recently reported that your bank isn’t in an ideal position in terms of capital sufficiency. In addition, last year’s financials were a bit contaminated. Given that your bank took a one-off write-off charge to Pad L due to some bad debts accumulated in previous years. So going to financial markets and raising equity during a moment of weakness isn’t the best idea because it will penalize current shareholders and we’ll sell the company’s shares at a price that is significantly lower than what you believe is a fair value.
The alternative is to decrease risk-weighted assets.
How can you do that?
Selling assets one by one under pressure isn’t an option. Sure, the bank owns non-operating assets, but if you rush their sale you will get 60 to 70% of their fair value. So you know that the most elegant way to decrease risk-weighted assets is securitization. Your bank has lent €400 million to credit card owners.
A total of 35,687 borrowers have used credit card services.
This is a portfolio of receivables that is very suitable for securitization for several reasons. The high number of borrowers allows for precision when performing statistical analysis. It is more or less clear what is the percentage of bad debt expected in this portfolio.
In addition, credit card debt repayments represent a stable cash flow that occurs every month. So all of these loans can be packaged together and sold to investors as a security. We use the term asset-backed securities ABS because this is an ownership claim. Investors buying the securities have a claim for asset receivables from credit card loans.
However, investors are interested in purchasing a security that is expected to pay a given amount of money. They don’t want to run a credit card receivables business to ensure everything will run smoothly in terms of administration and collection of these loans. A preliminary contract with a specialized firm needs to be signed. That way, when investors buy the asset-backed securities, they won’t have to go through the trouble of administering the loan portfolio.
Of course, the loan administration and collection firm would charge a commission for such services. Another important step before offering asset-backed securities to investors is to contact a credit rating agency. They need to examine the portfolio and assign a credit rating. As with most debt issuances, once the securities have been sold to investors, you receive cash and replace an asset that had a problematic risk weighting. This will help your bank increase its capital-to-risk-weighted assets ratio. Many banks prefer to engage in this type of business continuously and not only when they need to strengthen their risk-weighted capital ratio, providing a given type of loan. Packaging this loan into securities, Selling the securities to investors, and freeing up capital for new loans.
Such deals reduce a bank’s exposure in time, generate origination commissions, and ease the bank’s capital adequacy ratio.
