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A Company can issue bonds to investors secured on the future profits expected to arise from part of its existing life business.

When a pool of financial assets (such as car finance, home or commercial mortgages, corporate loans, royalties, leases, non-performing receivables, and contractually pledged operating revenues) are structured and transferred to a ‘special purpose vehicle or entity’ (SPV or SPE), it is known as a Securitisation transaction.

Types of Securitisation transaction

Usually with securitisation transactions, the transfer of rights to assets can take one of two main forms, true sale or synthetic securitisation.

1. True Sale securitisation

In a true sale securitisation, the originator (for instance a bank selling mortgages) sells the assets to the Issuer. The assets are serviced by the servicer who happens to be the Originator, with respect to say the mortgages sold to the Issuer. The originator continues to collect the principal and interest from the borrowers on behalf of the issuer on such mortgages and see to all default mortgages as well.

The significance of true sale is that the first-tier sale of the assets from the originator to the SPV is structured as a “true sale” such that the assets are removed from the originator’s bankruptcy or insolvency estate and cannot be recaptured by any trustee. Thus, the issuers are usually incorporated as insolvency remote entities; and may not engage into any transactions other than those necessary to effect the securitisation what is known as “limited purpose-concept” by which virtue the SPV will not be allowed to issue any additional debt or enter into mergers or similar transaction.

2. Synthetic Securitisation

In a synthetic securitisation transaction, the originator does not sell any assets to the Issuer and therefore does not obtain any funding or liquidity under the transaction. The originator enters into a credit swap with the issuer in respect of an asset or pool of assets, transferring the originator’s risk to the issuers. Under this contract, the issuer pays the originator an amount equal to any credit losses suffered in respect of such assets or pool of assets. The Issuer’s (SPV) income streams in a synthetic transactions are the fixed amounts paid by the Originator under the credit default swap and interest amounts received on the collateral. These transactions are typically undertaken to transfer credit risk and to reduce regulatory capital requirements.

3. “Whole-Business” Securitisation

Apart from the main two forms above,”whole business” securitisation is sometimes used to finance a stake in private or management buyout of the Originator. This type of securitisation originated in the United Kingdom. It involves the provision of a secured loan from an SPV to the relevant Originator. The SPV issues bonds into the capital markets and lends the proceeds to the Originator. The Originator services its obligations under the loan through the profits generated by its business. The Originator grants security over most of its assets in favour of the investors.

Cash flow types in securitisation transactions:

1. Collateralized Debt: This is similar to traditional asset-based borrowing. The debt instrument need not match the cash flow configuration of any of the assets pledged.
2. Pass-Through: This is the simplest way to securitise assets with a regular cash flow. It involves selling participation in the pool of assets, i.e. an ownership interest in the underlying assets, with principal and interest in the underlying assets collected given to the security holders.
3. Pay-Through Debt Instrument: This is a borrowing instrument and not participation. Investors in a pay-through bond are not direct owners of the underlying assets but simply investors.

Restrictions on SPVs

Unlike ordinary operating companies, SPVs have limited powers that are necessary for the purpose of the securitisation transaction. They only have the power to purchase specific receivables, issue related capital market securities, and make payments on them.

Risks in Securitisation

Securitisation is based on underlying assets being securitised. Rating agencies spend a lot of time estimating the credit risk for all underlying assets in a securitisation transaction. Other risks considered include prepayment risk and third-party risk.

Financial Risks

Financial risks include interest rates, foreign exchange rates, devaluation risk, and inflation risks. These risks can affect securitisation negatively if not accounted for in the transaction deal.

Political Risk

There is a risk that the issuer might default on payment due to cross-border transactions where assets generate cash flows in the domestic currency while the securities backed by those assets are denominated in foreign currency. Political risks, such as expropriation risk, nationalisation, convertibility risk, and change of law, could impact the transaction.

Conclusion

Securitisation involves the transfer of financial assets to an SPV or SPE. There are different types of securitisation, including true sale, synthetic securitisation, and whole-business securitisation. Cash flow types in securitisation transactions include collateralized debt, pass-through, and pay-through debt instruments. SPVs have limited powers to accomplish the purpose of securitisation. Risks in securitisation include financial risks, political risks, and third-party risks. Rating agencies play a crucial role in estimating the credit risk for underlying assets in securitisation transactions.
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Ihab Salloum