Securitisation Techniques In Financial Markets Finance Essay - Free Essay Example

Sample details Pages: 9 Words: 2574 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? Introduction Securitisation is a structured finance technique that allows for credit to be provided directly to market processes rather than through financial intermediaries. Securitisation describes the process and the result of converting regular and classifiable cash flows from a diversified pool of illiquid existing or future assets of similar type, size and risk category into tradable, debt and equity obligations (liquidity transformation and asset diversification process). Securitisation was first started in United States after the housing market collapsed in early 1930s. Don’t waste time! Our writers will create an original "Securitisation Techniques In Financial Markets Finance Essay" essay for you Create order There are three government sponsored agencies which are involved in creation of mortgage back securities, known as Ginnie Mae (GNMA) Fannie Mae (FNMA) and Freddie Mac (FHLMC) (A.Saunders, M. Cornett, 2008 p.815) In simple securitisation is a process where pool of illiquid assets such as long term loans, mortgages, and other illiquid assets are transferred into liquid assets by selling them to outside investors. Securitisation has become very popular with the banks worldwide as it helps the financial institutes to write off the illiquid assets of their balance sheet, helps to reduce the taxes, frees the capital for further investments, and reduces risk. Different researchers have given different definitions to securitisation, (Y. Altunbas, et.al) defines Securitisation as the process whereby individual bank loans and other financial assets are bundled together into tradable securities, which are sold onto secondary market. The other definition given by (C. Cardone-Riportella, et.al ) is Securitisation is a financial technique that allows a batch of illiquid assets to be transformed into a liquid tradable instrument with a known flow of income payments. Whereas (S. Saunderson, 1997 p.359) defines securitisation as a framework in which some illiquid assets of a corporation or a financial institution are transformed into a package of securities backed by these assets, through careful packaging, credit enhancement, liquidity enhancement, and structuring. The other definition given by (Cox, 1990 p.2 and Kendall, 1996 p.1-2) securitisation is the process where pools of individual loans, receivables or debt instruments are packaged in the form of securities, the credit status or rating of the securities are enhanced and distributed to investors in simple we could explain securitisation as a mechanism of pooling of a group of loans and selling them to the investors in the secondary market. This paper aims to understand the process of securitisation, its advantages and disadvantages, and then we will look onto some cases on financial institutes which did failed for too much dependence on securitisation, Northern Rock Bank was one of the bank which collapsed in UK due to overdependence on Securitisation and short term funds. Until 2007 Securitisation was the most favourable process used by banks and different financial institutions but too much dependence on it lead many financial institutes to collapse. Process of Securitisation There are a number of participants in Securitisation process, firstly there is an Originator- which is usually a financial firm, or a bank, the assets of the originator such as mortgages, credit card receivables, automobile loans, etc are pooled together to securities for writing off those assets from the Originators Balance sheet. In second step there is an Issuer- often called as Special Purpose Vehicle (SPV). The SPV is a company or it can be another Bank which is specially set up for the purpose of securitisation. The SPV holds the securities, which are the sole owners of the securitised assets, the SPV issues the notes/bonds to the investors which are backed by the pool of assets, but before the notes/bonds been issued there are several other parties are involved during this process, such as the credit scoring companies, Trustees, Servicer. The rating agency advices the originator on assets, examines the credit quality of the pooled assets, and rates the assets to AAA, or AAB, etc. before the bonds been issued to investors. In some cases the underwriters are involved as well during this process. A servicer in many instances is an originator. The servicer is responsible to collect the interest/instalments on loans/mortgages deriving from the pooled assets and pays it to the Trustees. Servicer entitles for a fee for the timely collection of instalments. Trustees act on behalf of investors and looks onto the performance of the other parties involved in the process, reviews periodic information on the pooled assets and takes any legal action on defaults to protect the investors. The large purchasers of the securities are insurance companies and pension funds. These bonds issued are very much favourable to the investors as they are less risky compared to any other investments. These bonds are protected against the default risk. For e.g. a bond is issued by a mortgage backed security and the property price goes down or the buyer defaults then the bondholders w ould be at risk unless been insured by the external guarantor, or even if the originator went bankrupt then too the bonds are safe, as the bonds are insured and are low on credit risk. Originator (e.g. Bank creates mortgages on Balance Sheet) Sale proceeds (payments) Asset Pool SPV Class A Notes Investors (life insurance, pension funds) Note issue Class B Notes Class C Notes The above chart demonstrates the process of securitisation in simplest mode. As we can see the originator pools the assets and transfers them to a SPV and then the notes/bonds are sold in the secondary market. The sale proceeds are transferred to the originator and can be reused to create new mortgages. (A. Teesdale, 2003, A. Sayman) Case Study To simplify the process of securitisation, we can take one case study of a ABC commercial bank established in the European union. ABC bank is involved in retail and corporate banking sector, and also provides loans to housing consumer sector, special financial services, and investment fund management. The main business of bank is to provide housing finance. ABC bank intends to expand, for which it requires additional finance but banks liability consist of long term B rated debt which it intends to replace with less expensive process and even wants to free a part of regulatory capital. So it could expand in to BB-rated country. The bank could achieve this by two processes. We will look at the initial position of Bank Balance sheet ASSET 1000 Housing Loans 605 Securities 245 Cash at hand 30 Interbank Placement 120 LIABILITIES 1000 Retail Deposits 662 Interbank Deposit 68 BB rated Loans 225 Shareholders Equity 45 The Bank has two option on funding first by taking a collateralised Loan or by Securitisation. Bank wishes to raise Euro 200 million in both the cases. Collateralised Loan: In this the Bank takes a collateralised loan of Euro 200 million whose interest rate is 9.5% which is less expensive then the B rated Bonds. By doing this the Banks asset side of the Balance sheet remains unchanged. A new liability is shown on the Banks Balance sheet. The net interest income is improved as cost of funding is decreased. The bonds proceeds are replaces by a loan. But this process is not that favourable compared to securitisation. The other method which Bank could take is securitisation. In this process the Bank pools the low risk housing loans together and sells them to XYZ company which is a special purpose vehicle (SPV). The ABC Bank has set up a XYZ SPV to implement the securitisation transaction. To min imise the initial capital and tax burden the SPV is registered in Lichtenstein. The borrowers of the loan continue to pay the loan instalments to the originator i.e., ABC company and ABC company then passes them to the SPV. SPV issues either Bonds/ Notes and sells them to investors in the secondary market. The SPV pays the sale proceedings to the originator. So now the Banks Balance sheet has changed. ASSETS 1000 Housing Loans 405 Securities 245 Cash at hand 230 Interbank Placement 120 LIABILITIES 1000 Retail Deposits 662 Interbank Deposit 68 BB rated Loans 225 Shareholders Equity 45 The Balance sheet of XYZ Company appears as; ASSETS 201 Housing Loan 200 Cash 1 LIABILITIES 201 Securities 200 Equity 1 So from the above procedure we could see Securitisation procedure is favourable as it takes off the long term assets from its Balance sheet and makes quick availability of cash and transfers risk to other parties. There are many more advantages to securitisation which are given below. Advantages of Securitisation Securitisation is very much favourable to many of the financial institutes and is accepted worldwide. Banks securitise their assets to free the long term investments and reduce risks. Different researchers have given different advantages to Securitisation, (A. Jobst, 2006, H. Shin, 2008, D. Barnes, N. Warman, 2000, www.rbnz.govt.nz, www.rbidocs.rbi.org.in) like securities which are issued by securitisation have a good credit rating as they are backed by assets and are scored by credit rating agencies, so these securities get sold quickly in the secondary market. The cost of raising fund via securitisation is a cheaper mode then borrowing money on interest, or depending on deposits. The other benefit to the Banks is it helps to reduce or pass on risk to other parties, Banks face many different risks on the loans, such as interest rate risk that the interest rate will move on diverse side and it will affect the Banks profitability or make loss. Liquidity risk that the Bank wont have enough cash to pay its depositors. Credit risk that the borrower will default and wont be able to pay the debt. So securitisation is preferred by the Banks as it helps to reduce or pass on risk to other parties. Securitisation helps Bank to covert the illiquid assets in to liquid funds very quickly which could be reinvested and helps to raise the turnover of the assets on Banks Balance sheet. It also gives regulatory advantage. As per the rules set by Basel II pillar I minimum Capital requirement Banks do need to hold minimum Capital to risk weighted asset ratio. (www.bis.com) By securitisation process the assets are taken off the Banks Balance sheet which helps to reduce the minimum Capital holding requirement which in turn improves the leverage ratio and further improves the Return on Equity. The Income of the Financial Institutes is improved as the Banks charges onetime fee on loans it processes and by retaining the responsibility to service them the Banks income of loan charges are unaffected by any change in interest rates. It even builds up confidence for the Financial Institutes in the financial market. It helps Financial Institutes to diversify to loans portfolio beyond few companies, industries, or geographical location and can increase their sources of fees and interest income. It also helps to invest in to different lines of business and avoid single type of credit risk. Further easy available of funds help the Financial Institutes to compete and even benefits the borrowers to borrow at low rate of interest. Disadvantages of Securitisation Along with the advantages given above there are some disadvantages as well which are given by many researchers. Until 2007 securitisation was the very much acceptable and favourable process used by many Financial Institutes worldwide (H.Shin, 2009) says there are two pieces of received wisdom concerning securitisation one old and one new. The old role emphasise a positive role played by securitisation but the subsequent credit crises has somewhat tarnished the positive image. Easy and cheap available money has motivated the borrowers and companies to borrow and lend more than they should. Many researchers as, (H Shin, 2009. D. Rakesh have argued that the main reason for the subprime crisis was the securitisation, over dependence on it has nailed the fianacial system in many countries. Securitisation is a very complex process with many different parties involved in it such as SPV, credit rating agencies, underwriters, Trustees, etc. So it is difficult for Banks to ensure that all risks arising from securitisation are appropriately managed. The Securitisation process is expensive when the assets to be securitised are not large. The other disadvantage is that Banks would securities all their best assets, thereby lowering the overall quality of assets on Balance sheet, Since the better quality of assets are more likely to be suitable for securitisation. Securitisation Failure Until 2007 Securitisation was the most preferred process used by financial institutes for their growth, but after 2007 due to the credit crunch and too much dependence on securitisation lead the financial institutes to collapse, we could see this from the figures in Europe the total volume of securitised assets grew from 78.2 billion Euros in 2000 to 711.3 billion Euros in 2008, but later it dropped to 414.1 billion euros in 2009, due to freezing of credit market and loss of confidence on asset backed securities. From the current sub-prime crisis we have learned the lesson that even too much dependence on securitisation could even lead the companies to failure, so was the case with northern Rock bank in U.K. it was the first bank in U.K. which experienced a bank run and had to rush to Bank of England as a lender of last resort. Securitisation was the central part of the Northern Rocks overall business strategy (D. Llewellyn, 2008) The main business of Northern Rock was to lend mort gages, and to fund these mortgages it depended heavily on securitisation and short term funding. Northern Rock pooled it mortgages and sold them in the secondary market in form of Mortgage Back Securities (MBS). These MBS were purchased by banks around the world. Securitisation and Colateralized Debt Obligation (CDO) were the two major instruments of the financial market turmoil. Easy availability of funds via securitisation motivated the financial institutes to lend money to sub-prime buyers with low income, credit ratings, etc. (H.Shin, 2009) says As Balance sheet expands new borrowers must be still need to expand, then Banks have to lower their lending standard in order to lend to subprime borrower. The seed of the subsequent downturn in the credit cycle are thus sown. When the interest rates went high almost 80% of the borrowers defaulted which led many banks go bankrupt, further led property markets go down and affected the whole economy. This is when the credit market freezed up especially for asset backed securities, MBS, CDOs. As a result of this there was a loss of confidence on asset backed securities throughout the globe. Although Northern Rock was not exposed to US sub-prime mortgage it become caught up in all this because of its business model: securitisation as a central strategy and reliance on short term money market funding. (D. Llewellyn, 2008) Due to loss of confidence on ABS and freeze in capital made Northern Rock to suffer, as it could not securities its mortgage loan in the funding market and had to hold the assets on its balance sheet. Majority of the assets of Northern Rock were long term residential mortgages so had little scope to reduce the Balance sheet in a flexible way once the crisis struck (H. Shin, 2008) like northern rock there were many different companies worldwide which did collapsed due to overdependence on Securitisation. Conclusion The aim of this article was to indicate how Securitisation process works, what are the advantages and disadvantages of securitisation. A case study is presented to better understand the securitisation process. The example of Northern Rock failure is been highlighted in this article to understand that overdependence of securitisation could lead to failure. From the current sub-prime crisis Basel committee has made some efforts to improve the banking capital structure by increasing the percentage of minimum capital requirement. Besides the current financial crisis Securitisation will continue to play a significant role in future for banks to grow.