Introduction

In the intricate landscape of credit risk transfer mechanisms, securitization plays a pivotal role. This chapter delves into the multifaceted process of securitization, where financial institutions package and sell pools of assets as securities to investors. This mechanism not only assists in risk management but also contributes to liquidity in the market. Additionally, we’ll explore the concept of Special Purpose Vehicles (SPVs), the entities responsible for holding and managing the securitized assets. Lastly, we’ll analyze the risk associated with different business models employed by banks for securitized products.

Securitization Process

Securitization is a financial technique that involves pooling together a portfolio of assets, such as loans, mortgages, or credit card receivables, and converting them into tradable securities. These securities are then sold to investors, thereby transferring the credit risk associated with these assets. The process typically involves several steps:

• Asset Pooling: Financial institutions gather a diverse set of assets with similar characteristics, such as home mortgages or auto loans, and pool them together.

• Creation of Special Purpose Vehicle (SPV): An SPV, also known as a special purpose entity (SPE), is created to hold the assets. The SPV is separate from the originating institution, reducing the risk of bankruptcy affecting the securitized assets.

• Issuance of Securities: The SPV issues securities backed by the pooled assets. These securities are classified based on their risk profile and expected returns.

• Credit Enhancement: To attract investors, credit enhancements like subordination (tranching) are often used. This involves creating different classes of securities with varying levels of risk and priority in receiving cash flows.

• Sale to Investors: The securities are sold to investors in the market. The cash flows generated by the underlying assets are used to pay interest and principal to the security holders.

Special Purpose Vehicle (SPV)

An SPV is a legal entity established to isolate financial risk from the sponsoring firm. It holds the securitized assets and issues securities to investors. The SPV’s sole purpose is to manage and administer these assets, ensuring their isolation from the originator’s balance sheet. This segregation helps protect investors from potential bankruptcy of the originating institution. For example, a bank might create an SPV to hold a portfolio of mortgages, issuing mortgage-backed securities (MBS) to investors.

Risk Assessment in Securitized Products

Different business models determine the structure and risk profile of securitized products. Two common models include the “Pass-Through” model and the “Pay-Through” model.

• Pass-Through Model: In this model, cash flows generated from the underlying assets are directly passed through to the investors. The SPV collects payments from borrowers and distributes them to investors. This model is simpler but exposes investors to prepayment risk and interest rate fluctuations.

• Pay-Through Model: Here, the SPV uses cash flows to make interest and principal payments to investors according to a predetermined schedule. Even if borrowers default, investors receive payments as long as the SPV has sufficient cash flow. This model offers more predictable payments but can lead to liquidity risk for the SPV.