What is Securitization?
The process of pooling cash flow generating assets and converting the asset pool in the form of marketable interest bearing securities via a special purpose entity or special purpose vehicle is known as Securitization.
Let's understand this in more detail.
The financial institutions especially banks are into lending
business and if we look at the balance sheet of banks, the asset side consists
of the loans sanctioned by the banks. These loans can be a mix of retail loans,
commercial loans, etc.
Now when a bank goes for fund raising in the capital market,
their business is assessed based on the quality of the assets on its balance
sheet, that is to say the loan portfolio of the bank – whether the loans are
performing with regular receipt of repayments, what is the percentage of NPA,
etc.
Now sometimes, due to a complex portfolio of loans, banks
face difficulty in raising funds because of various reasons. For example, if a
bank’s loan portfolio is heavily tilted towards commercial and corporate loans,
it exerts more risk as compared to retail loan portfolio and hence would
adversely impact the cost of raising the capital.
Thus in order to solve the above problem, Banks resort to
Securitization.
In order to simplify their asset side, they will want to
remove some part of the loan portfolio which may be performing but would not be
fitting into the core business area that it would be focusing on.
And here securitization will come to its rescue.
There will be a special purpose entity (SPE) set up by a
financial institution to buy the loan portfolio which the bank would like to
sell, and against this portfolio, the SPE will issue securities. These
securities will be backed by the cash flow generated from the loan portfolio in
form repayments including interest and principal. These repayments will then be
passed on to the investors who have bought the securities.
Finally...
Securitization
This process of pooling cash flow generating assets and
converting the asset pool in the form of marketable interest bearing securities
via a special purpose entity or special purpose vehicle is known as
Securitization.
Asset Backed Securities (ABS)
These securities issued by SPE with the backing of cash flow
generating assets are known as Asset Backed Securities (ABS).
Mortgaged Backed Securities (MBS)
When a bank sells a home loan portfolio with mortgages, the securities issued by the SPE by pooling the portfolio will be referred to as Mortgaged Backed Securities (MBS).
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