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What is Securitization?

Securitization is a complex series of financial transactions designed to maximize cash flow


and reduce risk for debt originators. This is achieved when assets, receivables or financial
Instruments are acquired, classified into pools, and offered as collateral for third-party
Investment. Then, financial instruments are sold which are backed by the cash flow or value
of the underlying assets.

The process of securitization


The securitization process involves a number of participants. In the first instance is the
originator, the firm whose assets are being securitized. The most common process involves
an issuer acquiring the assets from the originator. The issuer is usually a company that has
been specially set up for the purpose of the securitization and is known as a special purpose
vehicle or SPV and is usually domiciled offshore. The creation of an SPV ensures that the
underlying asset pool is held separate from the other assets of the originator. This is done so
that in the event that the originator is declared bankrupt or insolvent, the assets that have been
transferred to the SPV will not be affected.. By holding the assets within an SPV framework,
defined in formal legal terms, the financial status and credit rating of the originator becomes
almost irrelevant to the bondholders. The process of securitization often involves credit
enhancements, in which a third-party guarantee of credit quality is obtained, so that notes
issued under the securitization are often rated at investment grade and up to AAA-grade.

The originator either has or creates the underlying assets, transaction receivables to be
securitized.
Selection of receivables to be assigned
Formation of Special purpose vehicle (SPV)
Special purpose vehicle (SPV) acquires the receivables under a discounted value
The servicer for the transaction is appointed (normally originator)
Servicer collects the receivables (usually escrow mechanism) and pays off the
collection to Special purpose vehicle (SPV)
The Special purpose vehicles (SPV) either pass the collection to the investor (or
reinvest the same to pay off)
In case of default the servicer takes action against debtors as Special purpose vehicle
(SPV)s agent
When only small amount of o/s receivables are left to be collected, the originator
usually cleans up the transaction by buying back the o/s receivables
At the end of the transaction, the originator profit, if retained and subject to any losses
to the extent agreed by the originator in the transaction is paid off.

Figure: Securitization Process

Features of Securitization:
The investors looks at the cash flows of the entity and not the entity itself
hence its also called as assets backed financing.
It is also called structured funding because risk is structured in accordance
with investors needs.
Originators liability is in the form of credit enhancement.

Parties in the Securitization Process:


The primary players in the securitization of any particular pool of assets can vary. The flow
Chart illustrates the roles of and the relationships between the various primary parties in a
typical issue. Each party is addressed below
Originator: The parties, such as mortgage lenders and banks, that initially creates the assets
to be securitized.
Aggregator: Purchases assets of a similar type from one or more Originators to form the
pool of assets to be securitized.
Depositor: creates the SPV/SPE for the securitized transaction. The Depositor acquires the
pooled assets from the Aggregator and in turn deposits them into the SPV/SPE.
Issuer: acquires the pooled assets and issues the certificates to eventually be sold to the
Investors. However, the Issuer does not directly offer the certificates for sale to the investors.
Instead, the Issuer conveys the certificate to the Depositor in exchange for the pooled assets.
In simplified forms of securitization, the Issuer is the SPV which finally holds the pooled
assets and acts as a conduit for the cash flows of the pooled assets.
Underwriter: usually an investment bank, purchases all of the SPVs certificates from the
Depositor with the responsibility of offering to them for sale to the ultimate investors. The
money paid by the Underwriter to the Depositor is then transferred from the Depositor to the
Aggregator to the Originator as the purchase price for the pooled assets.
Investors: purchase the SPVs issued certificates. Each Investor is entitled to receive
monthly payments of principal and interest from the SPV. The order of priority of payment to
each investor, the interest rate to be paid to each investor and other payment rights accorded
to each investor, including the speed of principal repayment, depending on which class or
tranche of certificates were purchased. The SPV makes distributions to the Investors from the
cash flows of the pooled assets.
Trustee: the party appointed to oversee the issuing SPV and protect the Investors interests by
calculating the cash flows from the pooled assets and by remitting the SPVs net revenues to
the Investors as returns.
Servicer: The party that collects the money due from the borrowers under each individual
loan in the asset pool. The Servicer remits the collected funds to the Trustee for distribution
to the Investors. Servicers are entitled to collect fees for servicing the pooled loans.
Consequently, some Originators desire to retain the pools servicing rights to both realize the
full payment on their securitized assets when sold and to have a residual income on those
same loans through the entitlement to ongoing servicing fees. Some Originators will contract
with other organizations to perform the servicing function, or sell the valuable servicing
rights. Often, there are multiple servicers for a single SPV. There may be a Master Servicer, a
Primary Servicer a Sub-Servicer, and a Default or Special Servicer. Each will have
responsibilities related to the pooled assets, depending on the circumstances and conditions

Benefits of Securitization:
There are good reasons why securitization has taken off. The existence of a liquid secondary
market for home mortgages and other financial debt instruments increases the availability of
capital to make new loans. This increases the availability of credit. Securitization also helps
to decrease the cost of credit by lowering originators financing costs by offering lenders a
way to raise funds in the capital market with lower interest rates. Finally, securitization
reallocates risk by shifting the credit risk associated with securitized assets to investors, rather
than leaving all the risk with the financial institutions.
Mechanics of securitization:
Securitization involves a true sale of the underlying assets from the balance sheet of the
Originator. This is why a separate legal entity, the SPV, is created to act as the issuer of the
notes. The assets being securitized are sold onto the balance sheet of the SPV. The process
Involves:
Undertaking due diligence on the quality and future prospects of the assets.
Setting up the SPV and then affecting the transfer of assets to it.
Underwriting of loans for credit quality and servicing.
Determining the structure of the notes, including how many tranches are to be
issued, in accordance to originator and investor requirements
the notes being rated by one or more credit rating agencies;
Placing of notes in the capital markets.

The sale of assets to the SPV needs to be undertaken so that it is recognized as a true legal
transfer. The originator will need to hire legal counsel to advise it in such matters. The credit
rating process will consider the character and quality of the assets, and also whether any
enhancements have been made to the assets that will raise their credit quality. This can
include overcollateralization, which is when the principal value of notes issued is lower than
the principal value of assets, and a liquidity facility provided by a bank. A key consideration
for the originator is the choice of the underwriting bank, which structures the deal and places
the notes. The originator will award the mandate for its deal to the bank on the basis of fee
levels, marketing ability and track record with its type of assets.