1. Securitization: A transaction with
endless possibilities
Thought Paper
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2. Securitization: A transaction with
endless possibilities
What does a bank which has a fine portfolio of markets, it has evolved, taken various shapes
assets with assured cash flows do to expedite and forms, appeared in many different avatars
them to the present day and improve its and is still growing world-wide. Along the way
liquidity? What does a lending institution with securitization was part of many a scandal in
a slightly lower credit rating do to borrow at a different economies at different points of time
better rate which is usually reserved for an which could have slowed down its spread,
institution with a higher rating? What does an but did not. The financial significance and
insurance company which wants to correct implications of securitization are so integral
the asset-liability mismatch in its books usually and essential to the world of finance that it
look to do? And finally what does a government continues to thrive as time goes by. There is an
which is debt-ridden do to improve its economy? estimated outstanding amount of 2.1 trillion
If there has to be one common answer to Euros in the European securitization market as
this, it will be in the form of a financial of 2011 end. And in the US market this amount
instrument – Securitization. is estimated at 10.04 billion.
Since the 1970s, when the first form of
securitization appeared in the US home mortgage
The underlying principles
The basic principle of a securitization transaction then sold to investors. The payments on the
is pooling together a large amount of similar securitized collateral are then received by these
risk rated or similar obligations such as loans investors. In short, securitization is selling of
or mortgages that are backed by a collateral, future cash flows which otherwise would have
financial papers or instruments and any form accrued over a long period of time.
of receivables, to create a new security which is
Who can opt for securitization?
Banks irrespective of size and nature, specialized role of a SPV, called the issuer, is often varied.
lending agencies including government agencies, It ranges from being the executor of the
corporates, and micro-lenders are the main transaction to being just an intermediary. They
players in the securitization business. The would sometimes be involved in reinvesting
securitized products often referred to as bonds or re-adjusting the cash flows and related
are traded in the marketplace and bought by activities depending on the end objectives of
various investors in including banks, financial the securitization transaction. The issuers often
institutions, mutual funds, institutional investors issue the securitized products in tranches in
and corporates. There is another entity in this order to improve its marketability. This is done
cycle – often referred to as the Special Purpose on the basis of yield, cash flows, the underlying
Vehicle (SPV) or Special Purpose Company. The asset quality or safety.
02 Thought Paper

3. The benefits
As a financial instrument the benefits that • Reduces cost of capital: As liquidity improves
securitization transaction provides to the with lower risks, so does the cost associated
various participants is enormous and varied. It with it. Securitization enables justified costs
is therefore not at all surprising that the as it manages to lower illiquidity and also
instrument has grown in leaps and bounds over a offers a wide range of yields to the investors
period of time. associated with it.
• Improves liquidity: The factor that fuels • Ensures safety: Many securitized products
every market, liquidity! This is the constant are fully backed with assets and often earn
benefit afforded by securitization, as it a high investment grade when traded in the
provides a conduit to banks to convert their markets. The products are sometimes built
locked assets to liquid ones. with internal standards. Apart from this,
issuers also fortify the products with external
• Diversified Risk: Very few instruments give
aspects such as a built-in insurance features
investors such as wide choice of diversifying
or corporate guarantees.
their risk portfolio as securitization. As assets
are pooled and then distributed it gives
investors the choice of diversifying their risk
across a wide range of portfolio of their choice.
How securitization benefits the economy?
Apart from benefiting every participant in the Traditionally, the lending market is imperfectly
securitization transaction, it also has deeper, competitive which results in limited options
greater implications on the financial system. Most for financing. This imperfection is corrected by
importantly securitization provides additional securitization where creativity abounds when
links in the financial transaction chain. An it comes to product configuration. Issuers
obvious proof of this is the mortgage-backed thrive in creating a wide ranged menu when
securitization market in the United States which it comes to securitized products and this
propelled the growth of the housing sector improves the spread of products on offer. The
and enabled housing for a large section of result – a move towards an efficient, sophisticated
the population. and perfect market.
Thought Paper 03

4. Further, being an instrument that provides the transaction shows that the issues were
sufficient amount of information up-front in with the system and not with the instrument.
terms of the risk, collateral and cash-flows, Wrong market practices such as toxicity of the
securitization fuels efficiencies in the process of underlying instruments, over-rated credit rating
capital formation. This increases standardized to instruments and a high default rate of
practices in the lifecycle and encourages best underlying securities have crept into the system.
practices in the areas of legal, contracting and But that has not slowed down market growth.
the like. All the above benefits have culminated On the positive side these crisis events have
into growth of capital markets in securitization- increased demand for market transparency,
friendly countries of the world. improved regulatory balance and brought the
market under the focus of policy makers.
However, there is also a downside. But a quick
check on real-world failures associated with
Regulation in the securitization framework
As in all other products and sub-products, the in the transaction. This is about 5% in many
securitization world also needs an efficient set countries. They also provide investors with
of regulatory conduct to enable and normalize access to all relevant underlying data including
the participants. Most of these regulations focus exposures, collateral and cash flows and in some
on the need to strengthen the nature of countries, even loan-level data. Further, issuers
involvement of market participants in order will have to carry out rigorous due diligence,
to deepen their relationships in transactions. stress tests and ongoing monitoring on their
The issues for instance are guided with securitized holdings with failure to comply
regulations revolving around increased attracting severe penalties.
disclosures with respect to the level of retention
How technology can enable securitization?
It is impossible to ignore the role that technology possible only due to the ease of transaction
has played in the securitization transaction. It supported by technology. Technology has also
has provided limitless capabilities to the many contributed to increased complexity, diversity,
processes that abound the securitization lifecycle proliferation and most importantly creativity in
transaction. This ranges from pool selection this industry. So as we see the instrument of
and designing, pricing, rating, loan and trust the future – securitization evolve in its various
accounting, monitoring, reconciliation, bond avatars we may not know whom to thank for
administration and analytics. The entire industry it, but surely do know what to thank for
has seen a turnaround when it comes to easing its growth!
the administration of such large volumes
Anuradha Mallya
Principal Consultant, Product Strategy, Infosys
04 Thought Paper

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