Securitization is defined as a method of hedging financial bets by bundling assets and selling bonds backed by current and future revenue from these assets. More simply, securitization is the process of converting assets, most commonly accounts receivables, into marketable securities. Corporations use this method primarily to raise fast cash. Rather than recognizing revenue over the long term (e.g., as receivables are amortized), companies sell bundled assets as bonds backed by both the receivable and its corresponding collateral. Companies also use securitization to control annual income. If regular accounts receivable payments produce an adequate annual income, securitization is typically avoided. If such income is inadequate, assets will be sold so that the longterm revenue can "pull forward," or be recognized during the current fiscal year.
The securitization market began in the early 1970s with the issuance of bonds backed by mortgage loans. Previously, the U.S. government had subsidized the mortgage industry by offering tax breaks to mortgage companies. Unlike banks, which can draw on liquid deposits when funds are needed quickly, companies that focus on lending have no way to raise quick capital. The only revenue such companies generate is through closing costs and amortized monthly payments. So, in the early 1970s, the government created secondary mortgage markets like the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (FNMA, or Fannie Mae) to give mortgage companies a way to increase the liquidity of their business, especially during economic downturns.
Around 1975, shortly after the development of a secondary mortgage market, Sperry Corporation decided to securitize its computer lease receivables. The market spread like wildfire. Car loans were securitized beginning in the early 1980s. Over a short span of about 20 years, the secondary securities market has grown into a billion-dollar industry.
The securitization industry has two categories. The first is mortgage-backed securities (MBS), which groups together firstmortgage loans, termed home-equity loans, home-equity lines of credit, and tax liens placed on residential property. The second type encompasses all other receivable assets, including automobile loans, outstanding credit card balances, student loans, small-business loans, lawsuit settlements, and future revenue generated by royalties. The kinds of assets that can be securitized are broad. In 2004 the outstanding issuance of securities totaled seven trillion dollars. Growth for 2005 is estimated at an astounding $750 billion.
The mechanics of the securitization process are simple. The originator pools together a diverse group of receivables of varying durations, maturities, interest rates, and risk ratings, and moves them to a special purpose entity (SPE), or trust, established by the originator for this specific purpose only. The SPE, in turn, issues asset-backed securities (ABS) or MBSs, depending on the collateral corresponding to the receivable to investors on the open market. The ABS/MBS is divided into different classes (Class A, B, Z), which dictate the priority of repayment.
When the receivable security is removed from the balance sheet of the originator to a SPE, the asset value does not change. Once the security is issued by the SPE, the asset will increase in value. This is because the assets of the originator are worth more outside the company, to investors, than within it. It is crucial for the originator to know the relationship between external and internal value before entering into the securitization.
Once the SPE receives the asset from the originator, the asset is immediately considered off-balance sheet, and, therefore, bankruptcy-remote. Being "bankruptcy remote" protects the asset from the creditors of the originator. In the event of a bankruptcy, the assets would be protected from the bankruptcy estate. …