Securitisation

Outline the advantages and disadvantages of the securitisation of bank adds 1. 1 Introduction The recent excitation in character marts has highlighted how securitisation has changed in only a few historic period from being a relatively niche merchandise in the euro study to being a major force behind capital market disciplines. This growth in securitisation reflects the increased pace of fiscal novelty in the fiscal markets.It is rational to say that this global trend of the growth in securitisation is a result of the advantages that atomic number 18 derived by the different exposities engaged in the dealings. Securitisation has become an important tool for many companies and a key part of the global capital markets. However, while securitisation has benefited the fiscal arranging as a whole through enhancing its ability in per castinging its various make fors, it has simultaneously changed the fundamental political economy of the banking system, which brought consequen ces as those experienced in the 2007 financial crisis.Whether the gains pinch the rednesses is a debatable issue in itself as any(prenominal) intellectuals believe that securitisation has contri thoed to the development of a far more flexible, efficient, and resilient financial system than existed skilful a quarter-century ago, while others believe the opposite. The implication of securitisation has led to there has been talks by influential bodies about how securitisation stub be regulated or changed as to maximise the benefits and minimize the footings.In this essay, to reply the above question I willing define securitisation, explain its chemical mechanism and nature and lastly discuss its advantages and disadvantages for the different parties engaged in it and the financial system as a whole. The scope of this essay is secondary securitisation, so the above will be discussed itemally to this type and non primary election and tertiary. 1. 2 Definition of key terms Securitisation in full general is the worldly concern and issuance of debt securities, or bonds, whose brookments of principal and pursuit derive from gold flows gene considerd by separate kittens of pluss.There 2 types of securities that buttocks be issued. When the securitised assets ar mortgages, the securities issued atomic number 18 k promptly as Mortgage -Backed Securities (MBS) and where it is other assets which be non-mortgage loans then Asset-backed securities (ABS) are issued. In the latter type, assets included are such as consumer loans, reference bill of fare receivables and car loans. These securities are marketable financial instruments, and tradable. In e really securitisation transaction the capital markets are displacing the banks regardless of its type, whether primary secondary or tertiary, i. . disintermediation. lowly securitisation is Asset Backed. Bank of England defines this type as a transaction or scheme whereby the opinion fortune of an asset or a pool of assets such is transferred to an external undertaking (the securitisation special(prenominal) purpose vehicle or twist), which then transfers this credit put on the line onwards to investors in repair-income securities known as asset backed securities issued by that undertaking. The investors in the securities whitethorn be each external investors or the institution that originated the inherent assets.A nonher way to look at this process is through Professor Llewellyn explanation which explicitly high lightens the benefits. He defines secondary securitisation as the conversion of cash flows from a portfolio of assets into negotiable instruments or assignable debts which are sold to investors, are secured on the underlying assets and show a variety of credit enhancement. To clearly outline the pros and cons of the participants in the process, one subscribe tos to recognise their roles as shown below in participate 1. Figure 1 1. 3 How it racesWhen a bank transforms a portfolio of loans that it is currently handing on the proportionateness winding-sheet into tradable securities issued by a failure-remote special purpose vehicle it follows a basic procedure as seen in the diagram. A number of guests borrow from the bank. They all book to payback unconstipated interest and principal payments to the bank as agreed upon on the contract. starting line from the condition in this case the bank, it pools together a number of these loans (assets) and constructs a portfolio of which it sells to the special purpose vehicle SPV.The SPV usually acquires the underlying assets from the originator in what is known as a true sale. It is critical that the transfer of assets from the originator to the SPV is legally viewed as a true sale. This is because it gives the investors rights over the limited assets of the originator, such that the investors are not affected by the performance, or nonstarter of the originator. This would obviously n ecessitate that the investors, or the SPV which is a conduit on behalf of the investors, has legally acquired the assets.If it is not a true sale the investor will be vulnerable to claims against the asset originator in this case the bank. The SPV then issues asset backed securities to investors which investors endure them trade in the financial capital markets. Investors then buy these securities and the SPV receives the unconstipated interest and principal payments from the borrowers through the originator or servicer (if the bank does not hold open the servicing function) who charge a certain fee. The SPV pays the originator for the portfolio in a lump sum rather than a stream of payments air over time.It is important to acknowledge that the bank continues to maintain the relationship with the customer and it does not have a duty to inform this about this process. The credit quality of the securities issued by the SPV is rated by a rating agency originally being sold to inv estors. Also another(prenominal) important participant though missing in figure 11, is a credit enhancer. This is both internally or externally done and it might take the form of over securitisation (placing a higher observe of loan in the portfolio than the value of the sale), a third party batten down or a guarantee from the seller.This has the effect of limiting the pretend to investors. The underwriter is usually an enthronement bank that serves as an intermediary between the issuer (SPV or the trust) and investors. The swap counterparty as seen in the diagram is normally involved to hedge the interest rate and currency risk of infections on the pool and the trustee ensures that the money is transferred from the servicer to the SPV and that investors are gainful in accordance with the promised priority. A crucial aspect of securitisation is the isolation of assets. later on a true sale, the assets (collateral) are held by the SPV or equivalent.This protects the seller ( originator) from the risk of the assets and investor from the risks of the bank, because even if the bank goes bankrupt, the payments on the assets will continue to be made, so investors still receive the interest and principal payments. An SPV might be a completely independent entity or a subsidiary of the bank itself. In the crisis it was more of the latter. However, for it to be a subsidiary it will only work if the SPV is bankruptcy remote, as explained earlier. This is where under company law the SPV is immune to the bankruptcy of the ank. This makes their risk entirely different and this is how credit risk isolation and change is executable. Also an SPV might become a Structured Investment Vehicle. practically the SPV has a higher credit rating (most secure a abdominal aortic aneurysm rating) than the originator. The SPV performing the asset-backed securitization(s) as well usually has a backup liquidity knack in place provided by a stand-by commitment from a rout (group ) of banks. This facility protects the investors who purchase the commercial paper issued by the SPV as the assets are being purchased and pooled.If for some reason the SPV ceasenot attract the same or naked as a jaybird investors to roll over the commercial paper or there is meagre cash flow generated by the pool to pay off maturing commercial paper then the SPV draws on the backup liquidity facility to pay off the investors and the bank group then become the owners of the assets held by the SPV (to each wait for the cash flow to make better or to liquidate the portfolio). address enhancements are required in order to receive higher debt ratings and consequently improve marketability and financing cost.The credit enhancement of a securitization groundwork be achieved by dividing it into tranches and go forthing some tranches be undefendable first to any loss from defaulting / under-performing individual asset or group of assets first. In this manner, these front-line tran ches almost function like an equity piece such that the investors in the other tranches (Mezzanine tranches) are satisfied first before the lower tranches. These lower-rated (first loss) tranches usually receive a higher yield (due to their higher risk position) when the security is first incorporate in order to attract investors when first brought to market. . Advantages of secondary securitisation There are different aspects to the benefits of securitisation, the benefits derived by the issuer (bank) and those derived by the investor and the financial system as a whole. 2. 1 The issuer Secondary securitisation benefits the banks by helping them generate more currency but also by allowing them to manage their assets and liabilities, risk and also capital. * A base of investment companying Securitisation enables banks to change the illiquid portfolio of loans into liquid tradable securities. It makes loans marketable.So the banks get funds outright from selling the portfolio to the SPV. Also there being a secondary market for these securities in itself increases the attractiveness of investors to buy the securities meaning more funds. The funding source is also widened because as the risk are specific, asset backed securities ofttimes appeal to investors who would not normally make funds available to banks by themselves. This source of funding may also be cheaper for the bank. This is because banks do not need to increase their interest rates to attract marginal deposits to fund their loan book.Also because the banks transfer the asset to the SPV they do not need to hold capital against the loans (assets) which is a cost, making this type of funding cheaper. in the long run this meat that it can offer lower interest rates to borrowers, which could have the effect of increasing the quantity of loans demanded. This cheapness is not always possible it only depends on the nature of the risks of the portfolio after and before securitisation. * Asset and inde btedness guidance The fact that securitisation allows banks to shift the assets from their balance sheet allows them to change their asset composition on the sheet in spite of appearance a given total.They can change the structure of their assets and invalidate exposure to a detail loan category by securitizing those loans which also helps in managing risks. It also provides the balance sheet with flexibility and facilitates diversification of the loan portfolio. * Risk management As the definition implies, securitisation allows banks to transfer and shift credit risk from their balance sheet to those who are willing and more able to absorb them. thus this allows banks to manage their risk and limit their risks by selling those loans.The transfer of risk allows banks to not hold any capital against the risks, so as earlier said reduces the cost of banking. It also allows them to manage interest rate risk. * Capital Management referable to the increasing competitive pressures, they cannot earn a sufficient return on the assets to service their capital base well. Securitisation saves them capital as explained earlier. * Other Banks can earn additional income by charging fees on originating loans that it does not intend to livelihood on its balance sheet.Also banks still get to maintain their relationship with their customers and reduce the general cost of intermediation by concentrating on their comparative advantages (originating loans). 2. 2 The investor * It gives investors the opportunity to earn a higher rate of return (on a risk-adjusted basis). Also the high liquidity of securities means that investors can trade them for cash at their own convenience. * Asset backed securities allows the isolation of credit risk from the originator.This could benefit investors in that they are not exposed to the banks risks of which could increase the credit rating of the underlying assets themselves. * Investors also get the opportunity to invest in a specific po ol of high quality assets Due to the crocked requirements for corporations (for example) to attain high ratings, there is a dearth of passing rated entities that exist. Securitizations, however, allow for the creation of monstrous quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options. Investors can gain portfolio diversification as they tend to invest in securities that may be uncorrelatedto their other bonds and securities. 2. 3 The financial System In general securitisation, being part of variety has benefits for the financial system and the frugality as a whole by contribution to the basic functions of the financial system risk-transference, pricing of risk, liquidity-enhancement, credit-generation and financial intermediation, insurance, asset and liability management, an efficient apportioning of financial resources, and the funding of financial institutions.Securitisation as a technique means that loans are assed more frequently and hence to current terms as when they are just on a banks balance sheet. In a way this allows the risks prices to be adjusted accordingly. Also another important direct contribution is the ability that it offers banks to lend more to the economy by knowing that it can sell the loans. This has its drawbacks which will be discussed later, but while it is possible, it helps the real economy as governments encourage more lending for the betterment of the real economy.In addition, securitisation allows different parties to concentrate on their comparative advantages such as banks being originators. It is in this ways that securitisation increases the efficiency of the financial system which is a social benefit to its citizenry. The Bank for international settlements summarises this in the development of credit risk transfer CRT has a potentially important dissemble on the func tioning of the financial system. It provides opportunity for more effective risk management, promises the relaxation of some constraints on credit availability, and allows more efficient parceling of risk to a wider range of entities.The pricing information provided by saucy CRT markets is also leading to enhanced enhancer and liquidity in credit markets. 3. Disadvantages of secondary securitisation 3. 1 The issuer * The first transaction has to be authoritative and it can be costly also. There are compliance costs and reduced control by the originator of the assets sold to the SPV. * Though it the securitisation structure looks fairly simple, just like other CRS (credit shifting instruments), they are very complex in nature, to the extent that banks and other institutions did not fully understand the risks which they were taking and exposing themselves to.As seen in the crisis, the risk were not always shifted, sometimes they were just transferred, from credit risk to a liquid ity risk and finally to a funding risk , which was evident in the crisis when Interbank Market almost desiccated up and there was no securities traffic. This is what contributed to the financial crisis as while every(prenominal) bank was diversifying into this business, they financial system became less diverse. * If banks do this in large amounts, they could become dependent on the securities market which proved to have it consequences, when trading ceased. As the wealthy reader summarised Without risks, bank went crazy. Credit scores didnt matter, prevaricator loans were common. This proved to back fire for the banks themselves because they were also investing in securities issued by other banks and it led to huge losses for the banks. 3. 2 The investors Securitisation exposes investors to a number of risks such as * Credit/default risk when victuals obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular securitys default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings . However, the crisis has exposed a potential flaw in the securitisation process loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesnt encourage improvement of underwriting standards. Prepayment/reinvestment/early amortisation The volume of revolving ABS is subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess headstrong Income Sectors Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specifi ed level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the keep going or servicer. Currency interest rate fluctuations Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates but floating rate securities are affected more. * clean hazard Investors usually rely on the deal manager to price the securitizations underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deals excess spread * There is also a risk that the payments will be late from the servicer. . 3 The financial system The consequences of securitisation that were experienced in the crisis were expensive as Sir Howard Davies inferred CDOs are the most toxic element of the financial markets today . Securitisation and Collateralised Debt Obligations ( CDOs) are described as two major instruments at the centre of the financial market turmoil. European banks also took on shape up significant securitisation programmes. . They contributed highly to the global financial crisis which has had massive costs to the valuate payers, governments and central banks.An important aspect of securitisation is that it has changed the traditional place of banking and hence underlying economics of banking. With securitization banks accept deposits, originate loans, utilizes it comparative advantages, as it did traditionally. However with securitisation is does not accept risk, does not hold it on its balance sheet and hence needs no capital backing and insurance, things which it traditionally did. This change of model have had severe implication for the financial system as banks stop acting like banks, and it was clear that they did not quite understand the implications.Another voluminous effect is the effect that this had had on the financial s ystem perceptual constancy of which in itself is an ambiguous issue. 4. Conclusion There has been a division in the overall effects of securitisation to the global economy and financial system. While influential people like Warren Buffet regard it as a deadly weapon, others think the opposite. Regardless of the costs there are substantial benefits for the system. It is now evident that when a securitisation gets beyond the critical device of market participants, however, it is clear of destroying value.The potential harm is greater in globally interconnected markets. Hence it would be beneficial for the whole system if regulators, supervisors and all participants learn the flaws of securitisation from the crisis and improve the process to form one which ensures that the benefits are derived at the minimum costs, or no costs. As Professor David Llewellyn states the baby (of securitisation) should not be drowned in the bathwater (of regulation). Bibliography * Llyewellyn. , T, David . , 2000,. Securitisation a technique for asset and liability management * Casu, B. , Girardone. , Molyneux P. 2006. Introduction to banking. Essex Pearson rearing Limited. * ECB financial perceptual constancy review. , 2008. , securitisation in the Euro area. acquirable at http//www. afi. es/EO/securitisation%20in%20the%20euro%20area. pdf Accessed 5/4/11 * http//www. banque-credit. org/EN/banks/advantage-securitisation. htmlAccessed on 19/04/11 * Lederman, J. , 1990. , The enchiridion of Asset-Backed Securities * Tarun, S. , Securitisation Understanding the Risks and Rewards . available at http//www. qfinance. com/contentFiles/QF02/gjbkw9a0/17/0/securitisation-understanding-the-risks-and-rewards. df Accessed 01/05/11 * Llewellyn, T, D. , 2009. , the global banking crisis and the post crisis banking and regulatory scenario . terms Waterhouse Coopers. , 2011. , using transparency to thaw the securitisation market. * Available at http//wealthyreader. com/articles/securitization- good-idea-gone-bad-or-what-just-happened/ * Llyewellyn, T, David. , 2008. , Financial innovation and a peeled economics for banking * Bank of England. , 2007. , general notes and definitions. 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