What is Securitization?”
The term securitization refers to a process whereby illiquid assets/claims/debt such as car loans, bank loans, student loans, mortgages, and credit cards are pooled or transformed into tradeable securities (which are asset-backed securities (ABS)) and financial instruments that are interest-bearing.
Securitization is both a credit risk transfer tool and a means to raise money on the capital markets. From the perspective of capital markets, the advantage of securitization is that it can provide additional and diversified investment opportunities to institutional investors that have different asset diversification, and risk and return profiles.
Key Learning Points
- The common types of securitized debt instruments are mortgage-based securities, collateralized debt obligations (CDO’s), credit card receivables, and auto loans ABS;
- There are several advantages and disadvantages of securitization;
- There are measures to analyze the performance of securitized debt instruments, for example, the delinquency ratio and the default ratio.
Types of Securitization
The common types of securitized debt instruments are:
Mortgage-based securities (MBS): the residential mortgage-backed securities are secured against residential real estate, while commercial-backed securities are secured against commercial real estate.
Collateralized Debt Obligations (CDO): is an example of a complex structured finance product, which are bundles of loans or packages – auto loans, credit card receivables, corporate loans, or mortgages (i.e. a product) – that are sold by banks to institutional investors in the secondary markets.
Credit card receivables ABS: are fixed-income bonds, which are based on the stream of cash flows from pooled credit card accounts.
Auto loans ABS: these are based on the cash flow of customer payments from a specific pool of auto loans.
Advantages and Disadvantages of Securitization
There are several advantages of securitization for original lenders or originators – such as liquidity creation, lowering of funding costs, diversification of funding sources, transfer of risk and risk reduction (for example, a lender who issues asset-backed securities can benefit through the removal of potentially risky loans from their balance sheet).
For investors, securitization helps in the diversification of portfolios for investors looking to invest in other markets, sharing of risks, and provides an alternative investment vehicle (i.e. asset-backed securities) that gives higher yields than government bonds.
Securitization has some disadvantages too – such as lack of due diligence when evaluating the credit risk of the underlying assets in the pool, the potential of widespread defaults, and creation of a complex financial system among others.
Securitized Debt Instruments and Performance Measures
There are measures to evaluate the performance of securitized debt instruments. Given below are examples of ratios that can be used when analyzing credit card ABS, and MBS.
There are three ratios that are used to analyze the performance of credit card asset-based securities (ABS):
Delinquency Ratio = Credit card receivables over 90 days past due/total pool of credit card receivables
Default Ratio = Amount of credit card receivables that are written off/total pool of credit card receivables.
Monthly Payment Ratio: Monthly interest and principal payments/ total pool of credit card receivables
With the MBS securitization market, there is a wide range of mortgage pools that are offered to investors. One of the key measures to evaluate the performance of an MBS (associated with commercial mortgages) is the Debt Service Coverage Ratio (DSCR):
DSCR = Net operating income/total debt service
Net operating income = remaining income, revenue, or cash flows after deducting all operating expenses
Total debt service = scheduled interest payments + principal payment and other obligations.
Performance Measures – Example
Given below are two examples. The first example relates to three performance measures used to analyze the performance of credit card asset-based securities (ABS). The second example relates to one of the performance measures used to analyze mortgage-backed securities (MBS).
In the first example, the delinquency ratio, default ratio, and the monthly payment rate have been calculated from the information given below. In this example, we assume that an ABS originated by a bank that is a credit card issuer has the following data:
Next, in this example, the debt service coverage ratio (DSCR) has been calculated for an MBS issued by a US-based bank. Since the ratio is above 1, it implies that sufficient cash flows are generated by the underlying asset pool of commercial mortgages.