Chapter 1
Introduction to Securitization and Asset-Backed Securities

Perhaps the best illustration of the flexibility, innovation, and user-friendliness of the debt capital markets is the rise in the use and importance of securitization. As defined in Sundaresan (1997, page 359), securitization is "a framework in which some illiquid assets of a corporation or a financial institution are transformed into a package of securities backed by these assets, through careful packaging, credit enhancements, liquidity enhancements, and structuring."

The flexibility of securitization is a key advantage for both issuers and investors. Financial engineering techniques employed by investment banks today enable bonds to be created from any type of cash flow. The most typical such flows are those generated by high-volume loans such as residential mortgages and car and credit card loans, which are recorded as assets on bank or financial house balance sheets. In a securitization, the loan assets are packaged together, and their interest payments are used to service the new bond issue.

In addition to the more traditional cash flows from mortgages and loan assets, investment banks underwrite bonds secured with flows received by leisure and recreational facilities, such as health clubs, and other entities, such as nursing homes. Bonds securitizing mortgages are usually treated as a separate class, termed mortgage-backed securities, or MBSs. Those with other underlying assets are known as asset-backed securities, or ABSs. The type of asset class backing a securitized bond issue determines the method used to analyze and value it.

The asset-backed market represents a large and diverse group of securities suited to a varied group of investors. Often these instruments are the only way for institutional investors to pick up yield while retaining assets with high credit ratings. They are considered by issuers because they represent a cost-effective means of removing assets from their balance sheets, thus freeing up lines of credit and enabling them to access lower-cost funding.

Instruments are available backed by a variety of assets covering the entire yield curve, with either fixed or floating coupons. In the United Kingdom, for example, it is common for mortgage-backed bonds to have floating coupons, mirroring the interest basis of the country's mortgages. To suit investor requirements, however, some of these structures have been modified, through swap arrangements, to pay fixed coupons.

The market in structured finance securities was hit hard in the wake of the 2007-2008 financial crisis. Investors shunned asset-backed securities in a mass flight to quality. As the global economy recovered from recession, interest in securitization resumed. We examine the fallout in the market later in this chapter. First we discuss the principal concepts that drive the desire to undertake securitization.

The Concept of Securitization

Securitization is a well-established practice in the global debt capital markets. It refers to the sale of assets, which generate cash flows, from the institution that owns them, to another company that has been specifically set up for the purpose, and the issuing of notes by this second company. These notes are backed by the cash flows from the original assets. The technique was introduced first as a means of funding for mortgage banks in the United States, with the first such transaction generally recognized as having been undertaken by Salomon Brothers in 1979. Subsequently, the technique was applied to other assets such as credit card payments and leasing receivables, and has been employed worldwide. It has also been employed as part of asset-liability management, as a means of managing balance sheet risk.

Reasons for Undertaking Securitization

The driving force behind securitization has been the need for banks to realize value from the assets on their balance sheet. Typically these assets are residential mortgages, corporate loans, and retail loans such as credit card debt. The following are factors that might lead a financial institution to securitize a part of its balance sheet:

1. If revenues received from assets remain roughly unchanged but the size of assets has decreased, this will lead to an increase in the return on equity ratio.
2. The level of capital required to support the balance sheet will be reduced, which again can lead to cost savings or allow the institution to allocate the capital to other, perhaps more profitable, business.
3. The financial institution can obtain cheaper funding: Frequently the interest payable on ABS securities is considerably below the level payable on the underlying loans. This creates a cash surplus for the originating entity.

In other words, a bank will securitize part of its balance sheet for one or all of the following reasons:

1. Funding the assets it owns
2. Balance sheet capital management
3. Risk management and credit risk transfer.

We consider each of these in turn.

Funding

Banks can use securitization to (1) support rapid asset growth, (2) diversify their funding mix and reduce cost of funding, and (3) reduce maturity mismatches. All banks will not wish to be reliant on only a single or a few sources of funding, as this can be risky in times of market liquidity difficulty. Banks aim to optimize their funding between a mix of retail, interbank, and wholesale sources. Securitization has a key role to play in this mix. It also enables a bank to reduce its funding costs. This is because the securitization process separates the credit rating of the originating institution from the credit rating of the issued notes. Typically most of the notes issued by special purpose vehicles (SPVs) will be more highly rated than the bonds issued directly by the originating bank itself. Although the liquidity of the secondary market in ABSs is frequently lower than that of the corporate bond market, and this adds to the yield payable by an ABS, it is frequently the case that the cost to the originating institution of issuing debt is still lower in the ABS market because of the latter's higher rating. Finally, there is the issue of maturity mismatches. The business of bank asset-liability management (ALM) is inherently one of maturity mismatch, because a bank often funds long-term assets, such as residential mortgages, with short-asset liabilities, such as bank account deposits or interbank funding. This funding "gap" can be mitigated via securitization, as the originating bank receives funding from the sale of the assets, and the economic maturity of the issued notes frequently matches that of the assets.

Balance Sheet Capital Management

Banks use securitization to improve balance sheet capital management. This provides (1) regulatory capital relief, in some cases (depending on the form of the transaction), (2) "economic" capital relief, and (3) diversified sources of funding. As stipulated in the Bank for International Settlements (BIS) capital rules,1 also known as the Basel rules, banks must maintain a minimum capital level for their assets, in relation to the risk of these assets. Under Basel I, for every $100 of risk-weighted assets a bank must hold at least $8 of capital; however, the designation of each asset's risk-weighting is restrictive. For example, with the exception of mortgages, customer loans are 100 percent risk weighted regardless of the underlying rating of the borrower or the quality of the security held. The anomalies that this raises, which need not concern us here, were partly addressed by the Basel II rules, which became effective from 2007. However, the Basel rules that have been in place since 1988 (and effective from 1992) were a key driver of securitization. Because an SPV is not a bank, it is not subject to Basel rules, and needs only such capital as is economically required by the nature of the assets it contains. This is not a set amount, but is significantly below the 8 percent level required by banks in all cases. Although an originating bank does not obtain 100 percent regulatory capital relief when it sells assets off its balance sheet to an SPV where it will have retained a first-loss piece out of the issued notes, its regulatory capital charge may be significantly reduced after the securitization.2

To the extent that securitization provides regulatory capital relief, it can be thought of as an alternative to capital raising, compared with the traditional sources of Tier 1 (equity), preferred shares, and perpetual loan notes with step-up coupon features. By reducing the amount of capital that has to be used to support the asset pool, a bank can also improve its return-on-equity (ROE) value. This will be received favorably by shareholders.

Risk Management

Once assets have been securitized, the credit risk exposure on these assets for the originating bank is reduced considerably and, if the bank does not retain a first-loss capital piece (the most junior of the issued notes), it is removed entirely. This is because assets have been sold to the SPV. Securitization can also be used to remove nonperforming assets from banks' balance sheets. This has the dual advantage of removing credit risk and removing a potentially negative sentiment from the balance sheet, as well as freeing up regulatory capital as before. Further, there is a potential upside from securitizing such assets: If any of them start performing again, or there is a recovery value obtained from defaulted assets, the originator will receive any surplus profit made by the...