Asset Securitization in a Changing Environment

Article excerpt

Asset securitization has received much negative publicity since the onset of the recession in 2008. Securitization can provide a company with lower borrowing costs and a way to share financial risks. Although these financial transactions have been abused over time, the underlying reasons for their use persist Because the use of securitization is unlikely to cease in the near future, accounting and financial professionals must understand them, as well as the evolving rules in this area. These financial transactions will continue to change in order to meet the demands of society, and accountants must remain up-to-date.

Background

Securitization is the process of transforming loans receivable into securities. It is similar to a sale of receivables or to a secured borrowing using the receivables as collateral. Instead of transferring the actual loans, the loans are first grouped into a pool and then reconstructed into various debt securities, which are more liquid than the bans themselves. These securities are backed by the cash flows from the pooled assets and can be readily traded.

Securitization was first applied to home mortgages in the 1970s. In more recent years, billions of dollars of loans have been securitized annually, representing a substantial portion of all new debt issuances. The scope of assets being pooled has expanded to include credit card receivables, vehicle and machinery loans, student loans, and mortgages.

Securitization is an important topic for professionals in accounting and finance because it can be a highly advantageous approach to acquiring capital and sharing risk. If used correctly, securitization has the potential to benefit financial markets instead of causing harm. The misuse of securitization, however, contributed to the 2008 financial crisis and subsequent economic downturn; thus, it is important to understand how securitizations are put together, along with the related benefits and risks. This understanding will help CPAs ask the right questions before a company or individual invests.

How Securitization Works

As mentioned earlier, securitization transforms loans receivable into new securities. For example, assume that 100 investors invest in a group of 50 home mortgages. Each investor effectively owns 1% of 50 different mortgages. If a single homeowner defaults, each investor loses only a small portion of the amount invested because of diversification.

A key feature of the securitization process is that an additional step is taken. Again, assume cash flows are being received from 50 mortgages. In securitization, the cash flows are collected together into a group. Multiple classes of debt securities are then created, which pull cash flows out of this collected group. These new classes are sometimes referred to as tranches (French for "portions"). In order to create the tranches, estimates are formulated about how much cash will come in. Based on these estimates, at least one of the new classes is created to have minimal risk; consequently, at least one class has high risk.

Exhibit 1 demonstrates a basic example of tranche creation using three loans receivable. Each loan will result in an uncertain cash flow between 6 and 10; if the cash flows of the three receivables are collected together into a pool, the total expected cash inflow is between 18 and 30. Two classes of securities - low-risk and highrisk security - are created. In this case, the low-risk class could be promised a certain cash flow of 18. Whether it could be promised a higher amount, such as 19 or 22, depends upon probabilities of uncertain future events.

The low-risk class in a securitization is highly demanded by investors. Creation of low-risk securities is generally the primary purpose of the securitization process; some securitizations create a single category of low-risk securities, while others have various classes. The highest-risk, lowest-credit quality security is often called a "residual interest" It can almost be thought of as an equity piece, whereas other securities resemble debt pieces. …