The Hindu Business Line : ‘Securitisation, a (sub)prime option’

We have seen ‘securitised assets’ of poor credibility wrecking havoc in the global financial markets in the past year. So, what is securitisation? In simple terms, it is a mode of raising capital by banks/financial institutions. It is a process where a financial entity converts its assets into securities and sells them to investors. The cash flow from the asset then becomes the return on the investment for the holder of the security.

A win-win situation?

When banks (or other financial institutions) need funds, they convert their assets (advances/loan given) into marketable securities (bonds) by transferring them to an entity (Special Purpose Vehicle-SPV) formed for this purpose. The SPV does the job of detaching these assets from the holder and converting them into securities. Backed by assets, these securities are called “asset backed securities” and are also referred as pass-through certificates (PTC). The banker gets the needed funds, the investor gets the promised returns and the SPV too gets a fee for the service — the difference between the interest the borrower had agreed to pay and the return the investor is promised. Does this look like a win-win situation for all parties? On the face of it, yes. But there are hidden risks. .

Leverage to banks

The entire cycle explained above revolves around the borrower . His promise to repay is the guarantee for return to the investor. . His default will disturb the entire cycle.

A slowdown in real-estate demand in the US and the subsequent fall in their prices completely washed off the mortgage banks that lent to the high risk sub-prime borrowers and investment companies that had put money in those securitised bonds.

Hence, the credit worthiness of the borrowers and the credibility of the instruments in which the banks invest assume significance. Also, any concern on the lower-than-expected return from the investment made by banks (from the money got through PTCs) will impact the return promised to the investor.

If properly structured, securitisation could however give the benefit of leverage to banks and also help higher credit disbursal.

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