Securitisation - Coursework Example

Securitisation The expression securitisation refers to the creation of securities that are asset backed. Thesedebt securities are usually backed by a cash flows stream. Here the person who borrows issues securities to the debt as well. These debt securities are repaid by utilisation of the cash flows mentioned only. Those assets set aside for the purpose of securitisation are initially disposed to SPV (Special Purpose Vehicle) and this helps in isolating a borrower from having a chance to place any repayment claims. Subsequently, the SPV issues debt instruments or bonds and then it utilises the amount of money raised by the way of issuance of debt securities so as to pay for the assets of the ultimate borrower. Thus, the borrower is able to raise money without putting assets to risk besides those that the SPV holds and the SPV gets a lump sum to cater for this. It ends up losing some cash flows or assets in return for the cash. This debt also not reflected in the bane sheet of the ultimate bower. Therefore, securitisation can be viewed as a method of disposing off a cash flows stream. Besides the impact on the borrower, securitisation benefits investors as well. It increases the variety of choices of investments available. The securities that are asset-backed by way of securitisation can be easily analysed since investors need only to undertake an evaluation of cash flows from a very small assets pool. This saves them from having to evaluate the entire complex business. The most commonly securitised assets are loans of a single kind or another type which when pooled becomes an investment of low risk. Also, it means that in the context of the issuer, it is often a borrowing way that’s very cheap. (Moneyterms.co.uk, 2009). This is a study set out to discuss this issue of securitisation and to this there will be a vivid answering of the questions “what is securitisation?” and “why do banks choose to securitise some of their loans?” Securitisation is an expression that has become more common in usage and it’s usually used the numerous mechanisms of transferring risks between the parties involved. It usually includes the description of the scale or disposal of risk assets in an absolute manner or the synthetic transfer of particular risk aspects. It is used in several contexts and among various parties who indulge in contracts. More comprehensively, it’s defined as the process via which receivables, loans or other relevant assets are put together. The cash flows that go with the assets and also the economic values deployed to aid payments of the securities related. The related securities are issued in both private and public markets by issuers or on their behalf, which use the process of securitisation to finance their firms operations. In a general perspective the securities in this context are known as asset-backed securities. Most of the transactions in a securitisation process are used to isolate the financial assets which aid flows of payments of the involved ass-backed securities. The securitised assts pooled are often enhanced of internal structural measures/ with the aid of outside players from a credit view. Fundamentally, this concept of securitisation is applied in any sort of asset that has reasonable verifiable values or that which can prove to generate future in come. The market of Europe has witnessed securitisation flows of significance through the market of conduit. Here some originators “club” together in an effective manner, under one sponsored program of issuance. Originators in a contract of securitisation may include mortgage originators, banks, asset managers, cooperates among others. (Fabozzi and Choudhry, 2004 pp 9-11) Basically the major reason behind the issue of banks taking part in securitisation is the need for them to realise value (that’s, from their balance sheet assets). Normally the assets in the context are corporate loans, residential mortgages, and the retail loans like credit card debt. Some of the major reasons or driving forces behind banks securitisation of some loans are; firstly, scenarios where the banks need to obtain a cheaper source of funding- here, frequently, the amount of interest that’s supposed to be paid upon asset-backed securities is favorably below the amount payable on the loans underlying. Through this a surplus of cash is created for the originating party. Secondly, the amount of capital needed to ensure support to the balance sheet will be made lower. This may lead to savings in terms of costs or in allowing the allocation of capital to other more profitable functions of the business to the institution involved. Lastly, the level of income received from the asset rims unfluctuated, but the assets size has reduced. This leads to a rise in the Return on Equity (ROE) ratio. Therefore, the banks use securitisation to ensure risk management as well as transfer of credit risk, management of balance sheet capital and the funding of its own assets. In the management risk, when asset in this context are securitised the exposure to credit risk upon the assets for the originating bank is considerably decreased. The bank doesn’t also retain a capital piece of first-loss, it’s entirely removed. The reason to this is that the assets have been disposed to the Special Purpose Vehicle. Securitisation can also aid a bank to do away with non-performing assets from its balance sheets. A double advantage situation is struck be removing the credit risk as well as removing a possible negative sentiment from the bank’s balance sheet. There is a positive side realized through securitising assets, where any of the assets starts to perform again, or there is a recovery value from the defaulted assets. The originator will also receive any surplus gains made by the Special Purpose Vehicle. While managing balance sheet capital, securitisation is used to improve the process. Through this, there’s provision of relief of economic capital, diversified capital sources, and relief of regulatory capital. As per the stipulation of BIS- Bank of International Settlements, banks have to ensure maintenance of a certain minimum amount of capital for their assets so as to cater for the risk of the assets. Basel 1 requires that, for every US $ 100of assets that are risk-weighted a bank has to hold a minimum of US $ 8 of capital. However the assets risk-weighting designation is restrictive. The predicaments raised by this are usually addressed by Basel II which was effected from the year 2007. Basel I’s rules were put in place in 1988 and they became effective in year 1992. Basel I’s rules are also another driver of the process of securitisation. A Special Purpose Vehicle isn’t often a bank and it’s not subjected to the rules of Basel and requires only the capital that’s required economically by the related assets. This is not a defined amount, but it is significantly less than 8% which is the amount mostly required by banks. Even if an originating bank doesn’t get a 100% regulatory capital relief, the time it disposes assets from the balance sheet to a Special Purpose Vehicle, its charge for the regulatory capital is made less by a big magnitude subsequent to the process of securitisation. By making less the level of capital that has been utilised to support the pool of the assets, a bank can as well raise its ROE, this is usually an incentive to the shareholders. Lastly, under funding the process of securitisation is utilised in several ways by the banks. It’s used to diversify the mix of funding as well as reduction of the funding cost, assist in a quick asset growth, and decrease the mis-matches of maturity. The asset-backed secunties market is big with an approximated size of us$ 1000 billion which is invested in asset-backed securities issue globally per year of the estimate US$ 1,000 billion, US$ 150 billion is attributed to the European market. Access to the securitisation source of funding by banks enhances the banks to grow their loans at a faster rate unlike the way it would have been if they relied on the traditional sources of funding. For instance, in the UK northern Rock Plc, has at one point utilized securitization to back it increasing share of mortgage market in the UK it helps banks diversify their sources of funding and by this it reduces the risk levels to the bank. In the bid by banks to mix inter bank, retail and wholesale funding sources, securitisation plays a very significant role in this mix. It aids the bank in decreasing the cost of funding by de-linking the rating of notes issued. Mostly, the notes issued by special purpose vehicles are higher rated than those bonds issued courtesy of the originating bank. In the case of security mismatches, the business of ALM-Asset-liability management is recurrently that of mis- match of maturity. Due to the fact that banks fund long-term assets like residential mortgages, with short-assets liability like deposits to bank accounts or inter bank funding, the issue of mismatch maturity arises. By way of securitisation, the problem is solved, where the originating, bank disposes assets and the economic maturity of the notes issued usually matches the assets; (Choudhry, 2004 pp 297-300) From this perspective securities have many merits over loans from bank. The most essential merit of the merits involved is that securities can be traded with and they are very liquid. Loans on the other hand have been known to be highly illiquid while holding a security, a person can witness conditions changing and new information flowing in and move eye catching investments can come across. If one needs money by the way of disposing securities it’s usually easy since they can be sold in the prevailing market price. Thus, one can rapidly receive cash for a given asset even if it has a long maturity. Some of the assets with long term maturity and for which one can enjoy quick cash through securitisation are bonds with a 30-year maturity or perpetual bonds. Historically, before usage of securitisation one could only get cash by way of repayment also the owner of the loan at any time in point couldn’t guess right the time the real worth of an asset these is since while the real value of a security debt can be determined dairy by the way of market the loan value is highly subjective. Securities are also advantageous to investors since they can be a security portfolio which is according to their own appetite bank loans as a port folio can only be set as per the serving of a customers needs. Therefore, may be the most merited advantage of the process a securitisation is because of its cost effectiveness securitisation of an asset is very cost effective than would be placing the same asset in a balance sheet of a bank putting of bank loans in its balance sheet is often an expensive deal because of the bank regulation way as well the economic model they utilise (Bryan & Farrel, 1996 p 65) The principal documentation utilised in securitisation are funding documentation for example the syndicated bank loan or an issue of a commercial paper an agreement proposal of receivables to the special purpose vehicle must be full and final true disposal so as to ensure legal requirements are wholly met regulators accounting rules and the rating agencies it mustn’t be re-characterised by way of a direct loan to an originator as its secured upon the receivables as well as there mustn’t be any liability of he involved originator to assist the special purpose vehicle where the receivable are realised to be insufficient. (Wood, 2007) While concluding and in the answering of the questions, “Why do banks choose to securitise some of their loans one can see that securities are better than loans their major merit is that security are market value determined thus securities are market value determined thus securitisation is highly performed by both banks and investors alike. Work cited: Bryan, Lowell L. and Farrell, Diana. Market unbound: unleashing global capitalism. John Wiley and Sons, 1996. p 65. Choudhry, Moorad. Corporate bonds and structured financial products. Butterworth- Heinemann, 2004. pp 297-300. Moneyterms.co.uk. Securitisation. 2009. Retrieved April 23, 2009http://moneyterms.co.uk/securitisation/ Fabozzi, Frank J. and Choudhry, Moorad. The handbook of European structured financial products. John Wiley and Sons, 2004. pp 9-11. Wood, Philip R. The Law and Practice of International Finance Series. Sweet & Maxwell, 2007 Read More