top of page
  • CommercialLawGuides


By Jamie Johnson

What is securitisation?

Securitisation is where a collection of assets are put into a tradeable asset (a security). The underlying assets in the tradeable asset usually provide some flow of income (receivables). The main example of securitisation is the securitisation of mortgages, where mortgages are bundled together to create mortgage-backed securities.

Who is involved in securitisation?

There are four main actors involved in securitisation: the originator, the issuer, investors and the arranger.

The originator is the actor who creates the initial assets. For example, the originator may be the bank who offers mortgages that then undergo securitisation.

The issuer is a special purpose vehicle (SPV). This entity will have a different legal identity to the originator and will isolate the receivables that then provide payments.

Investors are actors who actually purchase the security from the issuer so that they can get the receivables. These investors might be financial institutions, insurance companies, pension funds, hedge funds and so on.

The arranger is the actor who ensures that the securitisation is structured in the most efficient way for the originator. They will also mitigate any risks involved from the security.

How is securitisation structured?

Typically, securitisation uses a SPV, as mentioned above. This SPV will issue bonds for the company to investors. The SPV will use the money raised from this bond issuance to buy the assets from the original owner of the assets to be securitised. The SPV will then pay the purchase price for these assets. Then the SPV will use the income from the assets they have bought to repay investors who bought bonds in the SPV.

How are the risks of securitisation mitigated?

From the originator’s perspective the main risk is that there will not be much demand for their securities whereas from the investors’ perspective there is a risk that the security is not worth purchasing. Consequently, there is a need for the arranger to reduce the risks for both parties. There are four main ways that the arranger mitigates the risks involved in securitisation: they conduct tranching, they do credit enhancement, they take out liquidity support and they hedge.

Tranching is where the securities are divided into different categories depending on their risk profile. More senior tranches will have a lower interest rate attached but will also have a greater priority of payment.

Credit enhancement is where the credit rating of the securities involved is improved so that investors who have a low risk tolerance (such as pension funds) are willing to purchase the security.

Liquidity support is where the originator or a third party will create a loan facility to the SPV. This is to avoid any liquidity risks for the SPV. These risks could arise because, for example, the receivables that the SPV is expecting are paid late. In order to meet the SPV’s payment schedule, it could then take out debt to ensure that investors are paid what they are owed.

Hedging is necessary because the receivables may be denominated in one currency. If this currency depreciates relative to the currency that investors want, they may risk losing money. Thus, the SPV will normally hedge using derivatives.

What are the advantages of securitisation?

There are three advantages of securitisation: it provides lenders with more liquidity, it allows the original creator of the assets to remove them off their balance sheet and it can provide investors with a less risky source of income.

Securitisation provides lenders with more income because it allows them to make previously non-tradable assets into tradable ones. Thus, they are able to raise capital from a greater range of investors. Importantly, this means that lenders have a greater capacity to make loans. In practice, this means that everyday borrowers will experience lower interest rates, as banks are more willing to lend out more capital.

The fact that original assets can be removed from the balance sheet also means that lenders avoid having a significant amount of exposure to the assets in question. Thus, they take on less risk and can potentially underwrite more loans.

Securitisation also may be less risky for investors because of the nature of the assets to be securitised. Generally speaking, mortgage repayments provide a more reliable source of income than things such as dividends.

What are the disadvantages of securitisation?

There are three main disadvantages of securitisation: there is a risk of a default on any underlying loans associated with the security, there can be a lack of transparency around the assets and it can be an expensive way of raising capital.

There can be a risk on defaults on the underlying loans associated with a security if there is a general economic downturn. A downturn may mean that, for example, people default on their loans and so the SPV will be unable to repay investors.

There can also be a lack of transparency around the quality of the underlying assets, as the investors in the SPV will not have made the original loans underlying their investment. Importantly, this means that they might be exposed to an extremely risky investment. This is particularly the case because banks making the loan may have an incentive to make riskier loans, as they are not as exposed to the risk of those loans once they have securitised them.

Securitisation may be an expensive way of raising capital if the assets involved are particularly complex. This is because there could be particularly high legal fees involved in setting up the SPV.

Case study

Before the global financial crisis, banks actively securitised mortgages which had poor (subprime) credit ratings. This meant that there was a great deal of exposure for investors who purchased the bonds of SPVs. Once the default rate in the US increased, the receivables for investors declined. Ultimately, this helped to reduce the amount of liquidity for banks, as they had taken on a great deal of exposure to the mortgage market (Lehman Brothers for example had purchased over $100 billion in mortgage-backed securities in 2007). The resulting loss of liquidity for financial institutions was part of the cause of the global financial crisis.

43 views0 comments

Recent Posts

See All

By James Dugdale Overview Despite the effects of the pandemic and continued lockdowns on the world economy, 2020 saw the number of initial public offerings (IPOs) on the US stock market more than doub

By Chloe Rana What is a bond? A bond is a fixed income instrument that represents a loan between an investor (bondholder) and a borrower (bond issuer). They are most commonly used when a company or go

By Kathleen Wang What are investment funds? Investment funds are collective funds where investors supply capital (money) that is used to purchase securities. An investment fund draws on the inherent

bottom of page