Securitization Reborn: Transfer of Credit, Insurance, and Other Risks
Koegel, Davi D., The RMA Journal
Securitization will be reborn as a result of the recent meltdown of credit and investment markets. This rebirth will focus on transparency, hidden risks, and modeling accuracy related to the obligations being securitized. This is part one of a two-part series.
THE VOLATILE ECONOMIC environment has largely shut down the securitization market in the past 18 months. Nevertheless, in the near future, that same environment will present the opportunity for a rebirth of the securitization process--a rebirth that can provide the market with greater levels of transparency, oversight, and reliability of data. Although the recent credit crisis did not arise from the practice of securitization, its misuse in certain cases and the inferior quality of available information were contributing factors. Drawbacks in the securitization process have included insufficient distinctions among accounting treatments for assets having different levels of credit risk, as well as overreliance on rating agencies' valuations.
Securitizations comprise a wide group of financial instruments that are used to transfer risks to third parties. Financial instruments that strip out and isolate the credit risk of underlying assets and transfer it to other parties can be broadly referred to as credit-linked securities (CLS). In a similar fashion, risk to insurers of policyholders making claims for indemnification of insured losses may be transferred in a form broadly referred to as insurance-linked securities (ILS). While conceptually similar to insurance, CLS and ILS are hedging mechanisms and not actual insurance products. This first article in the series will discuss the advantages and disadvantages shared by nearly all securitizations and the efforts already under way to rejuvenate the market for the securitization of CLS. A second article will describe the development of ILS and their expanding role in risk management and investment programs.
What Is Securitization and Why Use It?
The term securitization broadly refers to a financing and risk-transfer technique in which a collection of monetary obligations is transformed into an investment security. The essential function of securitization is to enable an exchange of certain assets for immediate cash that otherwise might not be possible. Securitization is facilitated by reliance on strong historical operating cash flows to support repayment of debt or payment of other financial commitments. Obligations backing the securitization can include mortgage loans, credit card receivables, and leases. For example, mortgage-backed securities (MBS) are securitizations that result in the creation of bonds whose cash flows are linked to and derived from principal and interest payments related to pools of mortgages.
There are several benefits to the originator of obligations subject to the securitization:
* Lower cost of financing.
* Increased liquidity and credit capacity.
* Diversified risk exposure.
* Removal of assets from the balance sheet.
Potential for significant expense savings, easier access to credit, and better spread of risk are three popular attributes of securitization. These benefits, combined with improved financial ratios as a result of moving assets off balance sheet, can all be realized if the transaction is structured properly. The created securities can be sold more easily in the capital markets if they can be rated independent of the originator's financial condition and the actual rating determined largely on the strength of the underlying collateral and factors that may serve to reduce the likelihood of default. As an example, senior auto-loan-backed securities issued by Ford Motor Credit maintained their AAA rating in 2002 even after the company's rating was downgraded. It was the strength of the underlying collateral and other credit enhancements at the time that protected the sacred AAA rating on the securities. …