Securitization: Costs and Benefits - Coursework Example

Running Head: Securitization: Costs and Benefits Securitization: Costs and Benefits [Institute’s Securitization: Costs and Benefits “Securitization is a process that converts illiquid assets into liquid and tradable securities” (Sellon, pp.92-103, 2002). An illiquid asset turned into separate units of securities that represent an ownership interest in the underlying asset is securitization of the asset. The process involves creating securities out of a pool of debts and turning them into a structure that replicates bonds. Various categories of debt including mortgages, credit card loans, car loans and personal loans are bundled together. Securitization of these instruments helps convert illiquid debt into liquid tradable securities in secondary markets. Therefore, enhancing the liquidity of these debt instruments is one benefit of securitization. Pooling of assets for securitization can follow different methodologies. One way is to create a pool of varied assets and securitize them, while another method used is the pooling of similar debt instruments such as a bundle of several mortgages and securitizing those instruments only. A benefit of the pooling process is that it adds diversification to the pool, an individual investor holding a single mortgage debt instrument is highly prone to credit default risk and may lose all his money in case of a default (Haensel, pp. 121-125, 2007). However, the pooling process spreads the credit risk between a large number of participants holding several varied mortgages or debt instruments. Securitization has become an important tool for raising money for new ventures by corporations. Especially large corporations with established market position prefer to securitize their own assets and issue corporate bonds to investors rather than obtaining those funds through a financial intermediary such as a bank. This reduces the cost of debt for these corporations as they pay lower rates of return on these instruments, which they would have had to pay to a bank. It is important to note that securitization is using two distinct forms of asset structures in this process. One structure is to convert the already existing pool of debt such as mortgages and convert them into securities, which involve a change of hand between the creditors. While the other structure involves the conversion of assets into debt instruments in order to raise money for the asset owners themselves. Asset securitization is used by firms to increase the worth of the assets as they might be worth more outside the firm than within (Haensel, pp. 121-125, 2007). Normally, each asset of a company has a risk equal to the company risk, as it is part of the company itself. The process of securitization separates the asset from the company by the use of a special purpose vehicle that can have its own legal identity, thereby reducing the risk factor considerably. A reduction in the risk of an asset implies that it requires lower return due to lowered risk premium for the investors. Securitization in the case of mortgage securities reduces the cost of debt by increasing the liquidity and reducing the associated risk by diversification (Jorion, pp. 174, 2007). The investors are attracted for putting their money into the product by offering them higher rates compared to other liquid securities as after securitization mortgage-backed securities are indistinguishable from other types of bonds. However, appearances can turn deceptive and have serious consequences for investors in case they fail to understand the risks associated with these innovative financial products. Mortgage-backed securities still hold considerable risk due to their longevity, as it is more predictable for a mortgagee to go bankrupt over the next thirty years as compared to a person holding short-term loan. Therefore, to an extent, the diversification provides some protection but that does not imply reduction in default risk on an individual basis. During the recent financial crisis, the economy suffered due to subprime loans and mortgages pooled and securitized together to meet investors rising demand for mortgage-backed securities. As these securities provided comparatively higher return than other available corporate bonds in the market and retained the liquidity features of bonds, they were very attractive for investors (Jorion, pp. 174, 2007). As the demand for mortgage-backed securities continued to increase originators of these securities fell short of supply. Increasing demand and scarce availability certainly provided an opportunity for originators of these securities to earn a higher fee and increase their volumes. This led to a largely increasing focus of investments banks in the creation of mortgage-backed securities including sub-prime loan securities. At the same time, stable and low interest rate environment, encouraged banks to issue a large number of mortgages and the government policies induced them to relax the lending restrictions. This accompanied by the real estate boom resulted in the creation of a large number of mortgages. Many mortgages were highly speculative attempts by banks trying to take an indirect position in the real estate sector. One such product was a mortgage that required no down payment by the mortgagee and the mortgagee had the option to be able to pay interest on a deferred basis. A large number of mortgages were sub-prime loans where it was clear that the mortgagee would not be in a position to pay back. An increasing default risk for the mortgage-backed securities accompanied a paradox of decreasing or stable interest rates on these mortgages. This was due to investor interest and rising demand for these securities. As the financial crisis began and a substantial number of individuals lost jobs the subprime crisis began even worse and a huge number of mortgage-backed securities revealed their unknown risk factors by going into default. Accompanied by falling interest rates to induce investment in the economy the creditworthy mortgage holder decided to use their option to reschedule their mortgage debts at the lower interest rates. Poor mortgages turned into non-performing loans and the profitable mortgages rescheduled at lower rates. This double hit to the banks and to the owners of mortgage-backed securities resulted in the bankruptcy of many major banking institutions in the United States and around the world. In some way, this also led to the liquidity crisis because the financial community lost trust in the creditworthiness of most banks and counterparty risk became high enough that banks were not willing to lend at the federal funds rate. Financial intermediaries had also facilitated the securitization of large amounts of accounts receivables of many organizations. The emergence of the financial and economic crisis implied that a large number of there securitized account receivable will go in default and never be recovered as firms face bankruptcy. Similarly, credit card loans were available to almost everyone who was working and individuals in United State being highly driven by consumption forces were used to spending a few months of their expected future income on their credit cards in advance (Herring, pp. 422-431, 2009). As the economic crisis, set in millions lost their jobs and were never able to pay their credit card dues. Therefore, a large amount of securitized credit card loans went into default. Car loans were also in trouble once the economic crisis set-in and the banks resorted to sell those cars in order to recover their principal and dues. However, unfortunately when there is little purchasing power in the economy and a large number of banks selling cars they could not obtain fair prices for the cars and suffered substantial losses. Most of these losses got written-off the balance sheets of these financial institutions in the next few quarters in order to clean up the accounts. There was chaos in the financial markets but this situation cannot be termed as a reason to derail the securitization process itself. Results would have certainly been very different with securitization of low risk assets. Little or no due diligence of loans and mortgages by the banks and over-securitization by the originators to meet the demand for mortgage-backed securities contributed largely towards an extended economic crisis. Securitization has certain benefits for the corporations including a lowered cost of capital, reduction in the assets from balance sheets and nondisclosure of certain assets. The cost of debt reduces resulting in the weighted average capital for a corporate to go down (Kothari, pp. 1684-1693, 2006). In addition, lowered assets mean that the company reports higher return on assets compared to the previous structure where it did not use securitization. A higher return on asset helps the company to retain a competitive advantage over other firms. However, securitization process has certain upfront and lump sum costs for a corporation included as fees for originators and investment bankers. After securitization, investors of the corporation or shareholders can benefit from higher return on assets (Davidson, pp. 211-213, 2003). Investors of these securities can also benefit from superior returns and higher liquidity. This does not only provide diversification but also reduces the probability of facing the worst-case scenario by lowering event risks. The securitization process also results in certain intricacies for investors in the form of increased legal costs. In addition, the collateral associated with asset-backed securities is usually more complex and the investors need to access the associated risks accordingly. Many securities have unique risks involved as mortgage-backed securities have a prepayment risk. Securitization has potential benefits for an economy as a whole which include the development of secondary and capital markets, the availability of alternative sources for financing and funding of projects and more possibility to finance residential homes and make ownership of housing more prevalent in the economy (Davidson, pp. 211-213, 2003). Also, lowered costs to borrowers means that more projects will have a positive net present value for investors and thus increase economic development. Increased funding availability for infrastructure development can also facilitate economic development through securitization of assets. Certain costs associated with securitization include the interest cost of issued debt, the costs of origination and increased legal and accounting costs. Securitization also involved costs for credit enhancement such as the creation of a special purpose vehicle to separate the legal identity of assets (Kiff, pp. 65-68, 2008). The issuers will also face costs in the form of fees charged by rating agencies, the time senior management will spend in the securitization process and the costs of changes in the systems already in place at the corporation. Securitization also involves substantial fees for obtaining guarantees or issuing credit default swaps. The idea is simple, if benefits associated with the securitization of a certain asset exceed the costs associated to the company for securitization, than the process is worth pursuing for the corporation. In the context of the economy, the securitization process results in more efficient markets and provides a lot of benefits to the society and must be pursued in the larger interest of the society keeping the risks into account. A sustainable approach towards securitization would be the key to the success of the product. Only, assets or debt of high quality and low credit risk should be securities after carrying out proper due diligence. References Davidson, Andrew. (2003). Securitization: Structuring and investment analysis. John Wiley and Sons. Haensel, Dennis. (2007). Does credit securitization reduce bank risk? Evidence from the European CDO market. Bank of International Settlement. Herring, Richard. (2009). Prudent lending restored: Securitization after the mortgage meltdown. Brookings Institution Press. Jorion, Philipe. (2007). Financial Risk Manger Handbook. John Wiley and Sons. Kiff, John. (2008). European securitization and the possible revival of financial innovation. Internation Mutual Fund. Kothari, Vinod. (2006). Securitization: The financial instrument of the future. John Wiley and Sons. Sellon, Gordon. (2002). the changing US financial system: some implications for the monetary transmission mechanism. Federal Reserve Bank of Kansas. Read More