Securitization

Securitization is a structured finance process in which assets, receivables or financial instruments are

acquired, classified into pools, and offered as collateral for third-party investment.[1] It involves

the selling of financial instruments which are backed by the cash flow or value of the underlying

assets.[2]

Securitization typically applies to assets that are illiquid (i.e. cannot easily be sold). It is common

in the real estate industry, where it is applied to pools of leased property, and in the lending

industry, where it is applied to lenders' claims on mortgages, home equity loans, student loans and

other debts.

Any assets can be securitized so long as they are associated with a steady amount of cash flow.

Investors "buy" these assets by making loans which are secured against the underlying pool of assets and

its associated income stream. Securitization thus "converts illiquid assets into liquid assets"[3] by

pooling, underwriting and selling their ownership in the form of asset-backed securities (ABS).[4]

Securitization utilizes a special purpose vehicle (SPV) (alternatively known as a special purpose entity

[SPE] or special purpose company [SPC]) in order to reduce the risk of bankruptcy and thereby obtain

lower interest rates from potential lenders. A credit derivative is also generally used to change the

credit quality of the underlying portfolio so that it will be acceptable to the final investors.

Securitization has evolved from tentative beginnings in the late 1970s to a vital funding source with an

estimated total aggregate outstanding of $8.06 trillion (as of the end of 2005, by the Bond Market

Association) and new issuance of $3.07 trillion in 2005 in the U.S. markets alone.[citation needed]

Structure
The diagram describes a typical transaction with this separate company (usually referred to as a Special

Purpose Vehicle SPV or in the USA as a Special Purpose Entity SPE
The diagram describes a typical transaction with this separate company (usually referred to as a Special

Purpose Vehicle SPV or in the USA as a Special Purpose Entity SPE

Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company looking to

either raise capital, restructure debt or otherwise adjust its finances. Under traditional corporate

finance concepts, such a company would have three options to raise new capital: a loan, bond issuance,

or issuance of stock. However, stock offerings dilute the ownership and control of the company, while

loan or bond financing is often prohibitively expensive due to the credit rating of the company and the

associated rise in interest rates.

The consistently revenue-generating part of the company may have a much higher credit rating than the

company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and

it will receive a cash flow over the next five years from these. It cannot demand early repayment on the

leases and so cannot get its money back early if required. If it could sell the rights to the cash flows

from the leases to someone else, it could transform that income stream into a lump sum today (in effect,

receiving today the present value of a future cash flow). Where the originator is a bank or other

organization that must meet capital adequacy requirements, the structure is usually more complex because

a separate company is set up to buy the debts.

A suitably large portfolio of assets is "pooled" and sold to a special purpose vehicle (the issuer), a

tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are

transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy

remote," meaning that if the originator goes into bankruptcy, the assets of the issuer will not be

distributed to the creditors of the originator. In order to achieve this, the governing documents of the

issuer restrict its activities to only those necessary to complete the issuance of securities.

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale

and part-financing.[5] In a sale, the originator is allowed to remove the transferred assets from its

balance sheet: in a financing, the assets are considered to remain the property of the originator.[6]

Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer,

in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE".

Because of these structural issues, the originator typically needs the help of an investment bank (the

arranger) in setting up the structure of the transaction.