Securitisation of Bank Loans and Reasons Why Banks Securitise Some of its Loans - Essay Example

?SECURITISATION OF BANK LOANS AND REASONS WHY BANKS SECURITISE SOME OF ITS LOANS s Introduction According to Uzun and Webb (2007, p. 11), ssecuritisation involves the transformation of illiquid assets into liquid assets and the practices has been applied in USA ever since 1980s but started being used in the European Union at the beginning of 1990s. The practice has risen tremendously as noted by the great amounts of securitisation issuance. From 2000 to 2006, European securitisation increased to EUR 458.9 billion from EUR 78. 2 billion (Altunbas, Gambacorta and Marques, 2007, p. 3). Uzun and Webb (2007, p. 11) further describe securitisation as a financial practice which involves pooling together the various types of contractual debts for instance commercial and residential mortgages, automobile loans or credit card liability obligations and marketing the combined debt as bonds, securities or collateralized mortgage obligation to various investors. The principal and interests accruing from the debt and the underlying security is paid to the investors on regular basis. Securitisation has also been defined by (Samantha, 2005, p. 1) as the process of converting the existing assets or future cash flows into marketable securities. Converting existing assets to marketable securities is known as asset-backed securitisation while securities supported by the mortgage receivable are known as mortgage-backed securities (MBI) (Samantha, 2005, p. 1). Securitisation can help improve the liquidity, reduce risks associated with credit and interest rates; supplement fee income and boost the leverage ratios. Despite these gains, some financial institutions are reluctant to securitize their loans given the disadvantages of this practice. This paper will first assess the process of securitisation and then make a study into the reasons why banks securitize their loans (Altunbas, Gambacorta and Marques, 2007, p. 12). How securitisation works In the traditional financial practices; the bank would make a loan and maintain it as an asset on the balance sheet where it collects the principal and interest and monitor the credit worthiness of the borrower. Consequently, banks had to hold the loan given as an asset till maturity thereby blocking the funds of the bank in the loans. This reduced the available funds thereby limiting the ability of banks to meet the growing demand for loans and could only raise the additional funds from the market. However, securitisation provides a way for unblocking those funds and freeing them to be loaned to customers. The process of securitisation starts with the bank putting together a collection of loans it plans to issue to investors as collateralize notes (Simonson, 1995, p. 77). He asserts that the loans must be homogenous as regards to the underwriting standards of the issuing bank and should have a fixed maturity and in the case of credit card; a fixed revolving balance. Moreover, the pooled loans should have the same risk profile. After the loans have been bundled, the issuing bank comes up with a special purpose trust which acquires the bundled loans. Generally, the trust procures credit enhancement from a third party in the form of assurance in the portion the possible losses. Thereafter, the trust gets into a contact with an underwriter who issues the notes; usually at a high rate against the loans (Simonson, 1995, p. 77). Institutional investors are the ones who usually buy the notes as the bank continues the servicing the loans. To understand securitisation, (Simonson, 1995, p. 77) gives an example of a bank, ABC that gives out loans and these are maintained on the balance sheet as its assets. The bank therefore has a pool of funds that are locked up as loans. The customer who has been loaned by the bank is known as obligors. To unblock those funds, the assets have to be reverted back to the originator (ABC bank holding the assets) to a special purpose vehicle (SPV). SPV is also known as the issuer and is usually companies or trusts exempted from tax and are formed particularly to fund assets. SPV acts as an intermediary transforming the assets of the originator into marketable securities. According to (Simonson, 1995, p. 77), the issuer is usually bankruptcy remote which implies that in case the originator (bank) becomes bankrupt, the assets of the issuer are not used to pay the creditors of the originator. This is enforced by use of documents that restrict the issuer’s activities only to facilitating the issuance of securities. Securities issued to the investors by the special purpose vehicle are known as pass-through-certificates. The second stage in the process of securitisation is known as tranching (Adidam, 2008, p. 15). This stage entails designating the different groups of claimants on the cash flows collected by the trust. (Adidam, 2008, p. 17) explains that some claimants are given higher priority than others. (Altunbas, Gambacorta and Marques, 2007, p. 12) concur and assert that the cash flows generated from the loans including principal repayments, interest earned and any prepayments received from the obligors are paid to investors on a pro rata basis with the bank only deducting the service fees (Adidam, 2008, p. 16). He describes that tranching is a recipe which spells out which claimant loses their investment and under what conditions in case some pooled loans go bad. The tranches in the higher rank of securitisation have lower risks of losing of their investment in case the obligor defaults in paying their loans. However, junior tranches, that is, those who invested lower amounts stand a higher risk in case the obligator defaults to pay. Special purpose vehicle gets servicing fee from the difference between the interest rate accruing from the obligor and the rate of return paid up to the investors. Securitisation offers various advantages to the investors, issuer and the bank. However, securitisation has some risks that should be assessed before the bank makes a decision to securitize its loans and before investors buys the securities. Reasons why banks securitize their loans The first reason for securitisation of loans is to increase its liquidity and meet the funding needs. Banks offer obligors loans and this is a key source of revenues for the bank in terms of interests. The main source of the funds loaned out the customers come from depositors (Uzun and Webb, 2007, p. 17). However, the bank may loan out most of its reserves therefore remaining with low assets to loan out to more customers as the loans as blocked as assets on the balance. In addition, at those times, the cost of retail deposits may be high or low given the prevailing economic conditions. Consequently, banks results to selling out their loans to finance their assets without necessarily having to attract higher retail deposits (Altunbas, Gambacorta and Marques, 2007, p. 12). By securitisation their loans, the banks will be able to continue offering loans without having to raise the interest rates on deposits so as to attract more deposits. This therefore makes the banks loans remain fairly unaffected by forces in the market. Uzun and Webb (2007, p. 19) explains that banks securitize loans rather than raising the deposits given that they compete on financial statements on whether they are preferred choices for investors and to attract long-term funds. It is worth noting that through securitisation, banks are able to get funding without having to be subjected to the deposit insurance and reserve requirements. Therefore, the bank can offer loans over and above what it has held up in reserve. In traditional banking practices, in case most of the bank’s funds are blocked as assets on the balance sheet, it can only access more funds to loan out customers from the market and this would attract a certain percent of interest. However, by securitisation banks are able to give out more loans that do not attract interests on their side thereby increasing its profitability. The other reason that drive banks to securitize their loans are to reduce its exposure to risks in case the customers default in paying those loans. According to (Affinito and Tagliaferri, 2008, p. 3), the level of risk exposure determinant of the loans is a determinant of banks decisions to securitize its loans. They note that securitization is a major tool used in transferring credit risks with other investor. Banks with higher amounts of risky loans could turn to securitisation to reduce the burden on the balance4 sheet and to reduce the expected losses. Nevertheless (Affinito and Tagliaferri, 2008, p. 4) point that some authors feel that some banks could securitize high-quality loans and keep the low profile loans which happens when the economic capital associated with the market discipline is greater than the regulated capital. Consequently, securitisation would result in the more risk-weighted assets appearing to be highly attractive given the additional balance between the return and protection offered. Banks may result to securitisation loans as they seek to release capital since the cost of equity is usually taken to much greater than the cost of debt. Banks would seek capital relief either as they seek to comply with the capital adequacy ratios or as they seek to seek part of the blocked capital to expand their asset base (Affinito and Tagliaferri, 2008, p. 4). They explain that there are instances when regulatory authorities make changes to the capital ratios required for banks. In such circumstances, bank decides to securitize the available loans as rising it through other means may be unfeasible. Moreover, banks could securitize the loans to display a higher capital cushion when this is required by the capital markets and it results in being rated highly by rating authorities. Affinito and Tagliaferri (2008, p. 4) explain that loan securitisations practices are adopted by banks as they seek to avoid the disadvantages of associated with warehousing loans in addition to mitigating the risks of increased regulatory and capital markets requirements. These behaviours are known as regulation capital arbitrage and cheery picking (Affinito and Tagliaferri, 2008, p. 4). In regulation capital arbitrage; banks transfer the most risky loans and those having higher regulatory weighting after it exceeds the risk-asset ratio and substitute them with the loans having lower risks. In cherry picking; banks replace their present loans in the same risk-weight group with ones having similar regulatory weighting characteristics but having varying intrinsic quality and expected rates of returns. Banks also resort to securitisation of their loans to reap from opportunities in the market that can increase their profitability. Securitisation affords banks to profit when they realize that they identify that the value of loans in the market are higher than those of their book values. In addition, banks can sell of their loans as they seek to redeploy their funds in doing more profitable business investments (Altunbas, Gambacorta and Marques, 2007, p. 12). Despite the advantages of loan securitisation by banks, the practice has the disadvantage resulting in a reduction in tax benefits to the bank on the items on the balance sheet including debt. Moreover, the bank incurs high fixed costs in setting the program. Additionally, regulatory capital arbitrage is blamed as the key driver of transferring credit risks to investors. Conclusion Loan securitisation is a process of pooling together bundles of similar loans and transforming them into marketable securities. The process helps banks to unblock the funds that have been loaned out but are maintained as assets on the balance sheet. For the loans to be securitized, they must have the same repayment period, level of risks and have a fixed interest rate. The process begins with the bank pooling together all those loans that meet the above conditions and then a insurer, also known as a special purpose vehicle is selected to convert the asset into marketable securities. The insurer is usually a company or a trust exempted from tax. Following the conversion, tranching is done where the investors who buy the securities are categorized according to the risks that they can incur in case the creditors default in repaying the loan. The interest, principal repayments and prepayments made by the creditor are passed to the investors although this is usually done on pro rata basis; the investors who bought more securities are given priority to those who bought lesser securities. The prime motivation for banks resorting to securitisation is to ensure regulatory capital relief by removing low-risk assets from the balance sheets and maintain the high-risk assets. By securitisation, banks are able to improve their capital adequacy ratios in an attempt to comply with the regulations. Securitisation is also seen by banks as a strategy for reducing dealing with credit risks associated with loans and interests rates. Securitisation is also adopted as a process that will help increase the liquidity of the bank and enhance its ability to give credit to clients. Bibliography ADIDAM, P.T., 2008. Banking Industry in Spain: Trends in Securitization of Loan Portfolios. Journal of American Academy of Business, Cambridge, 12(2), pp. 15-21. AFFINITO, M., and TAGLIAFERRI, E., 2008. Why do (or did?) banks securitize their loans? Evidence from Italy. Bank of Italy Temi di Discussione (Working Paper) No. 741, pp 1-30 ALTUNBAS, Y., GAMBACORTA, L., and MARQUES, D, 2007. Securitisation and the Bank Lending Channel. European Central Bank Working Papers Series No 838, , pp. 1-39. SAMANTHA ROWAN, 2005. Construction Loan Securitization Set To Debut. Real Estate Finance and Investment, , pp. 1-1. SIMONSON, D.G., 1995. Securitization and velocity of capital. American Banker Magazine, 105(3), pp. 77-77. UZUN, H. and WEBB, E., 2007. Securitization and risk: empirical evidence on US banks. The Journal of Risk Finance, 8(1), pp. 11-23. Read More