UNIT-5

Asset securitization works through a Special Purpose Vehicle (SPV). The SPV acts as a crucial link in the
securitization chain, intermediating between the primary market for the underlying asset and the
secondary market for the asset backed security. Following are the steps involved in the securitization
process:
Origination:
Assets are originated by a company, and funded on that companys balance sheet. This company is
normally referred to as the Originator.
Asset Identification and Pooling:
The asset to be securitized by the institution is identified, which comprises of the loans advanced by the
institution. The identification of the assets is done in such a manner as to ensure an optimum mix of
homogeneous assets having the same maturity.
Security Creation:
Securities of uniform maturity are created out of the assets that are identified. These are then passed on to
another institution called Special Purposes Vehicle (SPV). The SPV is a trust. Which like an investment
banker, manages the issue of securities to investors. These securities are known as pay or pass through
certificates. The SPV becomes liable to the investor for principal repayment and interest recovery.
SPVs Task:
The SPV engages itself in the task of enhancing its credibility in order to make the issue attractive. For
this purpose, the SPV obtains an insurance policy to cover the credit losses, or arranges a credit facility
from a third party lender to cover delayed payments.
Security Issue:
The SPV issues trade able securities to find the purchase of assets. The performance of these securities
is directly linked to the performance of the assets, and there is no recourse (other than in there event of
breach of contract) back to the originator.
Security Purchase:
Investors purchase the securities, because they are satisfied (normally by relying upon a rating) that the
securities will be paid in full and on time from the cash flows available in the asset pool. A considerable
amount of time is spent considering the different likely performances of the asset pool, and the
implications of default by borrowers. The proceeds from the sale of the securities are used to pay the
originator.
Receipt of Benefits:
The SPV agrees to pay any surplus which arises during its funding of the assets back to the originator.
This means that the originator, for all practical purposes, retains its existing relationship with the
borrowers and all the economies of funding the assets [i.e. the originator continues to administer the
portfolio, and continues to receive the economic benefits (profits) of owning the assets].
Rating and trading:
The SPV gets the securities rated by some reputed credit rating agencies so as to enhance the
marketability of the securitized assets. In addition, credit rating increases the trading potential of the
certificate in a secondary market, thus augmenting its liquidity potential.
Redemption:
On maturity of the security, the investors get a redemption amount from the issuer along with interest due
to the amount.
Purposes:
Following are the purposes served by the securitization process:
1. To improve the return on capital, since securitization normally requires les capital to support than
traditional on balance sheet funding
2. To raise finance when other forms of finance are unavailable (in a recession banks are often unwilling
to lend, and during a boom, banks often cannot keep with the demand for funds).

3. To improve return on assets, since securitization can be a cheap source of funds. The attractiveness of
securitization, for this reason, is dependent primarily on the costs associated with alternative funding
sources.
4. To diversify the sources of funding which can be accessed, so that dependence upon banking or retail
sources of funds is reduced
5. To reduce credit exposure to specific assets (for instance, if a particular class of lending becomes large
in relation to the balance sheet as a whole then securitization can remove some of the assets from the
balance sheet).
6. To match fund certain classes of asset mortgage assets are technically 25 year assets, a proportional of
which should be funded with long term finance; securitization normally offers the ability to raise finance
with a longer maturity than is available in other funding markets.
7. To achieve a regulatory advantage, since securitization normally removes certain risks which can cause
regulators some concern. There can be a beneficial result in terms of the availability of certain forms of
finance (for example, in the UK building societies consider securitization as a means of managing the
restriction on their wholesale funding abilities).
Advantages & Disadvantages of Securitization for Issuers & Investors
How Securitization Works
The securitization process involves four basic steps. In the first step, a company, known as the originator,
picks a portfolio of assets that it wishes to sell, or remove from its balance sheet. The originator is often a
financial institution that aims to get rid of assets, such as loans and mortgages. In the second step, the
"reference portfolio" is transferred to a special purpose vehicle, or SPV, for legal and tax reasons. The
SPV then issues interest-bearing securities, such as mortgage-backed securities, which are used to fund
the acquisition of the assets. In the final step, investors are paid over the life of the deal from the cash
flows generated by the portfolio assets.
Advantages and Disadvantages for Issuers
One of the major allures of securitization for issuers is off-balance-sheet treatment, meaning that the
assets included in the reference portfolio are wiped off the originator's financial statements. The benefit to
financial institutions is that securitization frees up regulatory capital -- the assets that banks are required
to hold by their financial regulators to remain solvent. In addition, securitization can offer issuers higher
credit ratings and lower borrowing costs. One of the biggest drawback for issuers is that it's far more
complicated to structure a securitization than to structure traditional types of debt, such as a bank loan or
a vanilla corporate bond. In addition, the transactions may not always lead to off-balance-sheet treatment,
reducing the benefit to financial institutions.
Advantages and Disadvantages for Investors
Many investors flock to securitizations because of their "AAA" credit ratings, meaning that one or more
credit agencies, such as Moody's, believe that investors will not lose their money with these investments.
These high ratings are made possible through a combination of features, such as bond insurance, letters of
credit and senior-subordinate credit structures. Investors also appreciate the diversification that
securitization can bring to their portfolios. However, it's not all sunshine, as certain securitizations carry

prepayment risk -- the chance that the deal's cash flows accelerate from expectations. For example, a pool
of mortgages might prepay from refinancings, returning money to investors in a lower interest rate
environment. In addition, some deals simply flop, such as the mortgage-backed securities that soured
during the 2007 financial crisis.