Introduction:
Risks Involved & Inconsistencies
Issue No: 21 Moneta July 2017
Introduction:
Securitization essentially is the process by which certain types of assets( contractual debts) are pooled so that they can be converted into interest-bearing securities. The principal payments and interest are subsequently passed on to investors( purchasers of the securities).
The process which started in the 1980s involves 2 steps:
1 st Step- A Reference Portfolio is made, where assets identified as ones that are intended to be replaced( from the company’ s balance sheets) are pooled. Companies then sell these asset pools to issuers, such as a Special Purpose Vehicle( SPV)- entities that are set up by financial institutions to purchase the assets and realize their off balance sheet treatment for accounting / legal purposes.
2 nd Step- The issuer finances the purchase of the pooled assets by issuing interest bearing securities which are sold to capital market investors. These investors receive fixed / floating rate payments from a
Trustee account funded by the cash flows generated by the portfolio. The company services the loans in the portfolio, collects the payments from the original borrowers, takes their servicing fees, and then directly gives it to the SPV or trustee.
Risks Involved & Inconsistencies
The trenching of pools sold to SPVs, the choice of loans to be pooled / sold, the question why securitized loan pools are homogenous, the contractual nature of securitization( which is yet to be studied), the liquidation efficiency of the system, the legal form of the SPVsthese are major fields that have remained inconsistent and yet to be amplified upon by financial institutions. Also, little is known about the international cross section of securitization.
Other than these, early amortization risk, default risk and currency interest rates fluctuations are the major risks involved.
- Madhavan Saklani NMIMS, PGDM 2017-19
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