CH8 - Securitisation

Question 1

What is securitisation?

Answer 1

Refers to the creation of securities that are used to fund asset purchases and borrowing, such as residential and commercial mortgages, auto loans, and student loans.

1. Investors buy ABSs
2. The proceeds of the sale of securities are used to lend money to a pool of borrowers of a specific asset
3. Borrowers make regular interest/principal payments
4. The interest payments go to the investors
5. The principal repayments either amortise the securities or fund new loans to borrowers

Question 2

What is the attraction of securitisation?

Answer 2

-It enables both the funding of loans and the transfer of the associated credit risk to capital market investors
-Initial attraction for banks was that they could originate and make profits on loans without actually holding these capital-intensive assets on their balance sheets
(able to maintain client-lending relationships without the drag of the capital cost

Question 3

What are the building blocks of securitisation?

Answer 3

1. Collateral: Assets are generated by banks, corps etc; they are sold to a SPV; the cost of funding the assets is cheaper than if they are funded by their own liabilities
2. Issuer: the SPV purchases the assets; funding comes from the issuance of securities in the capital markets
3. Securities: are sold to institutional investors; several tranches based on subordination and ratings; investors receive regular interest payments; principal is paid back as assets amortise

Question 4

Why is collateral important in structuring securitisation?

Answer 4

• Assets are normally of the same nature. A transaction to finance mortgages is built around, for instance, 1000 mortgages.
• Collateral refers to the pool of assets that are funded
• Two types of instruments: secured (e.g. auto, home loans) and unsecured (e.g. credit card) borrowing
• Before investing in a ABSs, one must be fully convinced that the collateral is strong enough to generate enough cash flow to service the interest and principal of securities

Question 5

How is securitisation used for risk transfer?

Answer 5

Apart from funding financial assets, securitisation is also used to transfer risk to the capital market. In these cases, the proceeds of the sale of securities are not used to fund assets.

• The transactions work like insurance policies
• Securities sold to investors, and proceeds kept in an escrow account.
• The protection buyer pays a premium, and this payment, together with the amount in the escrow account, is used to make coupon payments to investors.

Question 6

How is securitisation used for risk transfer? (2)

Answer 6

• If a loss event occurs, the funds in the escrow account are transferred to the protection buyer, and the investors forego some or all of their principal.
• Not all counterparty risk is eliminated from these transactions, because the SPV receives the proceeds and invests them, so technically it faces its own counterparty credit risk.
• Advantage of this method is that it allows protection buyers access to alternative markets populated by investors like hedge funds who are comfortable in taking unusual risks in exchange for high expected return