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Securitization is a financing process in which a corporate entity moves assets, to an ostensibly bankruptcy-remote / low risk vehicle, in order to obtain lower interest rates from potential lenders. This is obtained because the assets cannot be seized in a bankruptcy proceeding, the risk is less for lenders and they are willing to offer a lower rate. The technique comes under the umbrella of Structured Finance as it applies to assets that typically are illiquid Contracts (i.e. assets that cannot easily be sold). It 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. Alternate but similar definitions are: ''Securitization is the process of homogenizing and packaging financial instruments into a new Fungible one. Acquisition, classification, collateralization, composition, pooling and distribution are functions within this process'' Black's Law Dictionary (7th ed) ''Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors. Investors buy the repackaged assets in the form of securities or loans which are collateralized (secured) on the underlying pool and its associated income stream. Securitization thereby converts illiquid assets into liquid assets.''Mark Fisher & Zoe Shaw, eds., Euromoney Books, London 2003 HISTORY OF SECURITIZATION "Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets). But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the Credit Risk , and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well.""Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of National Banks, 1997. In February 1970, the U.S. Department Of Housing And Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae ) sold securities backed by a portfolio of mortgage loans. "Asset-Backed securities in Germany: the sale and securitization of loans by German credit institutions", Deutsche Bundesbank Monthly Report July, 1997. To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence."Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of National Banks, 1997. This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1)."Hearing before the U.S. House subcommittee on Policy Research and Insurance in “Asset Securitization and Secondary Markets” (July 31, 1991), page 13 The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows."Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of National Banks, 1997. As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995-2004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion. "Common Structures of Asset-Backed Securities and Their Risks”, Tarun Sabarwal, December 29, 2005 At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases. "Common Structures of Asset-Backed Securities and Their Risks”, Tarun Sabarwal, December 29, 2005 WHAT IS SECURITIZATION? In the article "Asset Securitization Controller's Handbook", there is a very concise and straightforward definition of securitization. "Asset securitization is the structured process whereby interests in loans and other receivables are packaged, underwritten, and sold in the form of “asset-backed” securities.""Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of National Banks, 1997. Another handbook states that "In essence, securitization is the open market Selling of Financial Instruments backed by asset cash flow or asset value. It is characterized by
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. However, it cannot demand early repayment on the leases and so cannot get its money back early if required. If, however, 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 company originating the debts (the leasing company in our example) is a bank or other organisation that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts. In vanilla structures, the credit derivative is used to change the credit quality of the underlying portfolio of leases so that it will be acceptable to the final investors. The diagram below describes a typical transaction with this separate company (usually referred to as a Special Purpose Vehicle or as a Special Purpose Entity [SPE ).
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