Financial products evolve, and their structure changes with the needs of investors and borrowers. Sometimes it can be altered because of the changing regulatory environment. Such is the case with securitization instruments.
The term securitization is used for transactions when a group of loans or receivables are collected in a NewCo, a special purpose vehicle, or SPV.
These repackaged assets are then resold to investors.
What is the primary reason for securitization?
In today’s complicated economic environment?
Financial authorities ask banks to maintain a capital adequacy ratio within specific parameters. This means that the equity to loans ratio on a bank’s balance sheet must cover a certain threshold. If it doesn’t, a bank is considered under-capitalized and problematic after the financial crisis of 2008.
Monetary authorities have been cautious with bank capitalization and perform audits and asset quality reviews to ascertain if banks have sufficient capital. But how does a bank ensure it has sufficient capital? Well, it needs to pay attention to the following equation. The capital adequacy ratio equals the bank’s tier-one capital, plus its tier-two capital divided by the risk-weighted assets. Calculating tier-one and tier-two capital and risk-weighted assets requires a lot of technical expertise. Still, there are two ways to improve a bank’s capital adequacy ratio raising capital or decreasing risk-weighted assets.
Raising capital is costly for existing shareholders and reduces the return on equity. Decreasing risk-weighted assets means giving fewer loans, which restricts business. That’s why financial engineers came up with securitization. The bank uses this mechanism to package some of its loans and sell them to investors. In theory, how investors are repaid should resemble how a bond functions. Each loan in the portfolio is entitled to a pre-determined schedule of payments.
Cash receivables investors will be paid the amounts contained in these receivables and earn interest on top of the capital they’ve provided. Think of a package of credit card loans. When consumers repay their loans, bondholders will receive cash flows. This means the bank can transfer the risk of these loans or receivables to investors and can therefore clean up its balance sheet and continue to lend money to new clients.
Why would a bank want to do that?
The bank acts as an originator. They earn good money from commissions and then make additional ROI from reselling. The loans have favorable conditions.
Why would investors be interested in these securities?
Securitization benefits investors by allowing them to access new asset classes and diversify their portfolios. A pension fund can’t lend money to consumers, but if the pension fund buys securitized consumer loans, it would gain access to an asset class that was previously unavailable, and This is how the market for securitized assets functions.
