The securitization process is mainly used by banks and other financial institutions to grant more loans to the public. Under the securitization process, the banks and financial institution convert their illiquid assets like loans and advances to liquid assets like bonds and various other securities to increase the cash flow in the bank. Every bank and financial institution has a limit to grant loans to the customers. Once the bank crosses this limit, they cannot further provide loans to the customer. Hence, in order to overcome this problem, banks try to mortgage the property that is illiquid assets to various private investors and increase their liquid assets i.e. their cash flow, so that they can grant more loans and earn more profit. Simply put, it is a way of transforming illiquid assets into liquid assets to free up the capital that has been blocked. This process is not as simple as it seems and the following steps are considered under this process.
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Steps under the Securitization Process:
- When the borrower approaches the bank (originator) for a loan, the bank allows a certain value as a loan in return for some collateral. The originator will then pool their lending as mortgages or accounts receivables into a homogeneous form based on the interest rate, maturity, etc.
- Thus in the second step, the bank will appoint SPV (Special Purpose Vehicle). This SPV will act as an agent on behalf of the bank. SPV will purchase the mortgage that the bank has made to provides loans to the borrowers and in return that SPV will provide cash or liquid assets to the bank so they can grand more loans in the market.
- In the third step, SPV will split the mortgaged property into different types of security according to their interest and maturity.
Now SPV will issue this property through the various instruments of the securitization process.
- Pass through certificate: Under the pass-through certificate, the payment is made to the investor as and when the cash is received from the borrower and it is passed to SPV. In this certificate the payment is received from the assets such as housing loan and the payment of certificate is done as and when they are due.
- Pay through certificate: Under this instrument, various certificates are issued with different maturity structures. As and when the assets mature, the respective investor who is holding the particular certificate will be paid.
- Interest-only certificated: In this instrument, the interest earns from the assets which are securitized will be paid to the certificate holder. As and when the borrowers will the interest the amount will be further paid to the certificate holder.
Now in the fourth step, the SPV will appoint a credit rating agency to know which assets are doubtful for recovery, and which are not. The SPV will then start to issue the above certificates in the market, and the interest provided on this certificate will be decided by the rating given by the credit rating agency. Higher the rating, the lower the interest on such certificates, and the lower the rating higher the interest on such certificates.
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Advantages of the Securitization Process:
- This process provides liquidity of the fund in the market by transferring the illiquid assets to liquid assets and allows the cash flow in the market.
- The risk of various assets that may prove as bad debt in the future is transferred by the securitization process.
- Under the securitization process, the return on investment is made superior if the investors are ready to take more risk they can earn more return, and if the investors are not willing to take more risk the proper amount of return is generated under this system.
- Banks can generate more credit options through the securitization process.
- With better credit rating on the assets financial institution and generate funds on such assets at a lower cost.
- Because of the presence of the money market, this process is more in use nowadays
Disadvantages of the Securitization Process:
- The biggest disadvantage is that the entire process of securitization is very complex involving several parties; as well the assets need to be appropriately combined.
- The SPV may not disclose to investors the full details on the assets used in the securitized bond.
- Failure to repay loans will potentially end up as a loss to investors. The investor then becomes the ultimate risk bearer in the phase.
- Also, disadvantage can be seen from the point of SPV if they provide liquid assets to the bank and if in the market no one is ready to purchase such instruments, then they may suffer a big loss and as a result of this banks cannot get further liquid assets to make more loan in the market and they may lose customers. This not only affects the banks and other financial institutions but the effect of this can be seen on the overall market in long term.
Author: Charmi Mehta
About the Author: Charmi Mehta is currently pursuing an MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.