How Securitisation Works | CFA Level I Fixed Income

Let’s dive into the fascinating world of asset-backed securities! These fixed-income instruments are created through a process called securitisation. In this lesson, we’ll explore the securitisation process and learn about the benefits it brings to economies and financial markets.

Securitisation Process and Benefits

Securitisation is a process where assets are transferred from their original owners to a separate legal entity called a special purpose vehicle (SPV). The SPV then issues securities backed by these assets and sells them to investors. The cash flows generated by the assets are used to pay both interest and principal owed to the investors.

Here are some key benefits of securitisation:

• Reduces intermediation costs, resulting in lower funding costs for borrowers and higher risk-adjusted returns for investors.
• Investors have a stronger legal claim to the assets, as they are marked as collateral for the asset-backed securities (ABS).
• Increases liquidity for banks, enabling them to lend more.
• Diversification and risk reduction benefits, as the risk is spread across multiple borrowers in the asset pool.
• Financial innovation, allowing investors to invest in securities that better match their preferred risk, maturity, and return characteristics.

Parties Involved in Securitisation

Typically, three parties are involved in a securitisation transaction: the seller, the issuer (or trust), and the servicer.

Special Purpose Vehicle (SPV)

SPVs are essential to the securitisation process, as they protect the assets from the creditors of the originating company. The SPV allows the creditworthiness of the ABS to be evaluated based on the quality of the collateral and cash flows, rather than the creditworthiness of the originating company.

Tranching

To improve the creditworthiness of the ABS, the issue can be segregated into multiple classes of securities, each with a different claim to the cash flows of the collateral. There are two forms of tranching: credit tranching and time tranching.

Credit tranching involves segregating the ABS into senior and subordinated tranches, with the subordinated tranches absorbing credit losses first. This is also known as a waterfall structure.

That concludes our lesson on the securitisation process and its benefits. In the upcoming lessons, we’ll delve deeper into different types of asset-backed securities, starting with the most common type, mortgage-backed securities.