Asset securitization and developing elements

Securitisation is the "issuance of marketable securities backed not by the expected capacity to repay of a private corporation or public sector entity, but by the expected cash flows from specific assets" (OECD 1995). The concept of securitisation is best understood by considering a typical transaction.

In a securitisation, the originator sells receivables to a special purpose vehicle (SPV) established to isolate the receivables and to perform other functions (eg: restructuring of cash flows and the provision of credit enhancement and liquidity support). The SPV is usually structured as a bankruptcy-remote trust or incorporated entity.

The SPV finances the purchase of receivables by issuing securities (usually notes, commercial paper, bills, bonds or preferred stock) to investors. Legal agreements delineate the rights and obligations of all parties to the transaction, including the appointment of an administrator to manage the receivables where necessary.

One or more financial institutions are usually involved in structuring and marketing the securities issued by the SPV. To facilitate investor demand, credit rating agencies assess the likelihood that the SPV will default on its obligations and assign an appropriate credit rating. Credit enhancement and liquidity support is usually obtained by the SPV to ensure a high rating for the securities.

Why securitise assets?

The potential benefits of securitisation to the originator are:

More efficient financing-

For some private sector institutions, securitisation is used to lower the firm's average weighted cost of capital. This is possible because equity capital is no longer required to support the assets and highly rated debt can be issued into deep capital markets with investor demand driving down financing costs.

Improved balance sheet structure

Securitisation can enhance the managerial control over the size and structure of a firm's balance sheet. For example, accounting de-recognition of assets (ie: removal from the balance sheet) can improve gearing ratios as well as other measures of economic performance (eg: Return on Equity). Financial institutions use securitisation to achieve capital adequacy targets, particularly where assets have become impaired.

Securitisation also releases capital for other investment opportunities. This may generate economic gains if external borrowing sources are constrained, or if there are differences between internal and external financing costs.

Better risk management-

Securitisation often reduces funding risk by diversifying funding sources. Financial institutions also use securitisation to eliminate interest rate mismatches. For example, banks can offer long-term fixed rate financing without significant risk, by passing the interest rate and other market risk to the investors seeking long-term fixed rate assets. Securitisation has also been used successfully to give effect to sales of impaired assets.

Securitisation also benefits investors. It enables them to make their investment decisions independently of the credit-standing of the originator, and instead to focus on the degree of protection provided by the structure of the SPV and the capacity of securitised assets to meet the promised principal and interest payments.

Securitisation also creates more complete markets by introducing new categories of financial assets that suit investors risk preferences and by increasing the potential for investors to achieve diversification benefits. By meeting the needs of different market segments, securitisation transactions can generate gains for both originators and investors.

What type of assets can be securitised?

Any type of asset with a reasonably predictable stream of future cash flows can be securitised. The assets that are easiest to securitise are those; that occur in large pools; for which past experience can be used to predict default rates; for which documentation is standardised; for which ownership is transferable.

Residential mortgages are the most commonly Securitised asset. The US market in Mortgage Backed Securities (MBS) is huge with some 55-60 percent of the total US residential mortgage market now securitised. Recent market innovations include Collateralised Mortgage Obligations (CMO's) which provide investors with an improved capacity to deal with pre-payment risk. In the United States. MBS issues are government-guaranteed and hence are classified as a form of government paper (OECD 1995).

In the view of success of the MBS market, financial institutions began experimenting with securitisation of other assets. Asset backed Securities (ABS) is the catch-all nomenclature used to describe non-mortgage backed securitisations. The most widely used collateral for ABS are credit card receivables, automobile loans, commercial mortgages (single properties and pools), leases and trade receivables. The outstanding volume of publicly traded ABS in the United States was recently estimated at $200 billion. (OECD 1995).

In the Australasian market, during 1998, Standard and Poors assigned ratings to $A21.9 billion of MBS and ABS supported by Australian and New Zealand assets.

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A total of $A46.8 billion of rated securities remained outstanding at the end of 1998. Of these 56% were backed by residential mortgage pools; 21% by financial securities; 9% by corporate receivables, with the rest backed by a mix of corporate loans, commercial property, credit card and trade receivables (Standard and Poors 1999).

The accounting environments:

In the private sector, some of the benefits of securitisation (eg: improved balance sheet structure) require off-balance sheet treatment of the securitisation transactions. The most important accounting question, therefore is whether the assets being scrutinised qualify for de-recognition for financial reporting purposes.

Achieving de-recognition requires the securitised transaction to be treated as a sale rather than a financing transaction. The distinction is subtle and depends on the extent of recourse to the originator in the event of failure of the SPV.

Accounting practices can differ in the way in which residual liabilities are valued an reported. Similarly, accounting treatment can vary with regard to the valuation of Z( interests in collateral that have been removed from the balance sheet but which continue to produce earnings. Other accounting issues include the way in which positions of originators (or services) are reported on balance-sheets, and in the way in which originators account for interests in subordinated branches.

The regulatory environment:

The regulatory environment consists of an array of laws and regulations relating to, but not limited to, company formation and governance, trust establishment and the fiduciary duties of trustees, financial reporting requirements and securities law. While regulatory environments differ substantially between jurisdictions, most regimes involve a combination of information disclosure requirements, the imposition of fiduciary duties on trustees and board directors, and the application of capital adequacy and solvency rules.

In some jurisdictions, the regulatory environment (particularly relating to banks) present significant impediments to securitisation through either outright prevention or the imposition of high compliance costs. In recent times, however, there has been a trend in financial market regulation towards less stringent controls and a greater reliance on information disclosure and competition as a means of protecting investors. The cost of complying with regulatory requirements is likely to be a key determinant of he success of securitisation transactions.

The taxation environment:

In the private sector, issues of taxation can be highly significant. Some jurisdictions levy taxes on the transfer of assets and on cash flows (eg: payments by obligors into the SPV or payments by the SPV to investors). Taxes may also be imposed on profits earned by investments inside the SPV.

What is required for a successful asset securitisation?

Two conditions are required for a successful securitisation:

A robust financial infrastructure enabling the efficient transfer of assets from the originator to the SPV while protecting the interests of investors; and

Strong investor demand, which facilitates lower financing costs for the originator. The level of investor demand will depend inter alia on the risk characteristics of the securities on offer, and on the credit rating assigned by the ratings agencies.