More and more the word, securitization, is getting passed around in financial circles. It’s being hailed as a panacea for a lack of cash flow. But what is securitization? And can it truly help your financial institution?
In this article we are going to discuss what securitization is, the key parties involved, and the advantages gained from using securitization. Let’s get started.
Technically, securitization is the structured process whereby interests in loans and other receivables are packaged, underwritten, and sold in the form of asset-backed securities. Basically, it is the ability to bundle a group of loans into securities that can be sold to investors.
This allows loan originators to transfer some of the risks of loan ownership to investors while giving the originators access to broader funding sources at more favorable rates.
The securities involved in securitization are split into tranches, where the assets share similar qualities (e.g., loan classification, interest rate, etc.). This causes different tranches to carry distinct risks and exposure within an investment portfolio.
Tranches offer investors diversity. Some come with greater risk and the opportunity for greater reward while others are safer and offer more reliable, though lesser returns. Tranches enable investors to select the appropriate risk level to generate an acceptable amount of cash flow.
This is a pretty good overview but to really get a good grasp on securitization, you need to understand the players.
Securitization involves multiple parties and several steps. Here is a summary of the steps involved.
Now that we understand securitization better, let’s finally answer the question, “Can securitization truly help your financial institution?” And the answer is yes. Securitization can help financial institutions in several ways. Here are several of the major benefits of securitization.
Securitization enables financial institutions to transfer some of the risks of loan ownership (e.g., early repayment, default, etc.) to investors who are more willing or able to manage them. Selling the loan to an investor reduces liability while still allowing the institution to service the loan.
Securitization also enables financial institutions to access the funding markets at debt ratings higher than corporate ratings. This generally provides access to broader funding sources at more favorable rates. This funding can then be used to run the day-to-day operations and to grow.
By removing assets and supporting debt from balance sheets, financial institutions can save on some of the costs of on-balance-sheet financing while managing potential asset-liability mismatches and credit concentrations.
When accounts are moved off the balance sheet, the interest income for those accounts is converted to fee income for the loan servicer. Securitization reduces costs and creates fee income.
Some entities, due to legal or regulatory requirements, need to limit their amount of capital. Securitization can be used to move assets off the balance sheet. If federal regulators increase the amount of capital an institution is required to hold in case of loss, securitization will allow these institutions to invest their capital to increase their returns instead of holding onto it.
Securitization can make funds available to run operations through assets that would have taken years to generate cash flow. This is especially important in an environment where capital is increasingly difficult to secure through traditional lending options. Plus, institutions can avoid paying higher borrowing rates on capital that is tied up for a long time.
Removing receivables off the balance sheet may help raise an institution’s credit rating, thus allowing it to borrow funds at a lower rate. An institution that is rated BB but uses securitization to maintain assets that are extremely high in quality (AAA or AA) can borrow at significantly lower rates because they can use the high-quality assets as collateral. In addition, the institution is transferring the potential risk of default to investors. If an institution needs to boost their credit rating to secure better funding options, securitization can be a viable solution. It can provide access to better funding options in the present and in the future.
The best thing about securitization is that it enables financial institutions to maintain customer relationships and strengthen them. Institutions can remove assets from the balance sheet but continue to service the debt. Selling the loan to an investor reduces the liability to the financial institution, but the connection with the customer remains strong.
While financial institutions definitely benefit from securitization, investors and borrowers also profit. Investors enjoy a greater chance of having a higher rate of return on revenue-generating assets while gaining access to high-quality assets they normally couldn’t invest in. And borrowers benefit from the increasing availability of credit on terms that lenders may not have been able to provide without securitization.
Want to learn more about how your financial institution can begin using securitization to access funding, optimize capital, and reduce credit risk? GOLDPoint Systems can help. Learn more about securitization on our website or sign up for a free demo to see what securitization can do for you.
“Growth is never by mere chance; it is the result of forces working together.”
James Cash Penney