Securitization and its Role in Creating Toxic Assets
June 2014
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).
Securitization has evolved from its beginnings in the late eighteenth century to an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to control the company. (Hill, 2002)
The originator initially owns the assets engaged in the deal. This is typically a company looking to raise capital, restructure debt or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates. (Sabarwal, 2005)
A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or "SPV" (the issuer), a tax-exempt company or trust formed for
References: 1. Hill, C. - “Whole Business Securitization in Emerging Markets”, Duke Journal of Comparative and International Law 12:2 (2002) 2. Sabarwal, T. - "Common Structures of Asset Backed Securities and Their Risks”, 2005 3. Financial Accounting Standards Board (FASB) Statement No. 140 - "Accounting for transfers and servicing of financial assets and extinguishments of liabilities—a replacement of FASB Statement No. 125", 2000 4. Dwight Asset Management Company – “Fixed Income Sectors: Asset-Backed Securities – A primer on asset-backed securities”, 2005 5. Kim, M. ; Hessami, A. ; Sombolestani, E. - Cash Flow Waterfall [Video file]. URL: http://www.youtube.com/watch?v=Dw_z56HmLYs, June 17th, 2014 6. Reis-Roy, C. - Journal of International Banking Law 13 (9): 298–304, 1998 7. Lederman, J. - "The Handbook of Asset-Backed Securities", 1990 8. Longstaff, F.; Myers, B. – “How does the market value toxic assets?”, 2009, http://www.krannert.purdue.edu/faculty/mfaccio/LongstaffMyers.pdf, June 17th, 2014