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.
CreditDrive, an automobile dealer, decides to securitise $100 million of its loan assets. It sells the loan portfolio to a special purpose vehicle called CD Loan Trust. CD Loan Trust then issues asset-backed securities to investors, who pay $100 million as principal. CreditCollect, a separate entity, acts as the servicer, collecting payments from borrowers and passing them on to CD Loan Trust. CD Loan Trust then disburses the cash flows to the investors.
In this example, CreditDrive is the seller, CD Loan Trust is the issuer, and CreditCollect is 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.
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.
CD Loan Trust issues the following bond classes:
- Senior Tranche: $70 million principal
- Subordinated Tranche A: $20 million principal
- Subordinated Tranche B: $10 million principal
In the event of a credit default, the recovered amount is used to pay off the principal for the tranches in the order of their seniority. For example, if $85 million is recovered, the first $70 million goes to fulfill the obligations to the Senior Tranche holders, followed by $15 million to the Subordinated Tranche A holders. The remaining $10 million loss is absorbed by the Tranche B holders.
Because of this structure, Tranche B will have the lowest credit rating and offer the highest yield of the three bond classes.
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.
Coming up in our next lesson, we’ll be taking a closer look at residential mortgage loans and how they form the foundation for mortgage-backed securities. Stay tuned!