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Asset Securitization

Asset Securitization

In the U.S., the size of investment assets started to overtake that of deposits sometime in the 1970’s, so this relatively new trend sparked the need for financial institutions to improve the utilization of existing and future assets. In a well a functioning financial market, the information conveyed in prices plays an important role in helping to optimally allocate capital to its most profitable and ultimately most efficient use. When loan demand exceeds deposit growth, a financial institution is forced to consider several options such as raising deposits, sell or syndicate assets, borrow money from another lender, or securitize assets more commonly referred to as asset securitization. Since its development in the late 1980s, asset securitization has become the most desired option for building capital structure of many corporations. Finally, there are many ways in which financial institutions can raise capital, each of these alternatives have some advantages such as raising q!

uick capitol and receiving cash flows, but they also carry disadvantages such as risk for both the seller and investor. Asset Securitization is a tool that maximizes capitol and minimizes risk due to diversification.

Asset securitization over other methods of raising capitol;

Asset securitization differs from traditional bank financing, as the investor relies on cash flows generated from the specific assets being financed rather than the operating cash flows of the company. Securitization is the process of grouping assets in a "pool". This pool is then sold to investors who receive monthly payments of principal and interest from the pool. The investor typically gets a highly liquid investment that offers a yield in excess of most corporate bonds and still maintains a high credit rating. The seller gets capitol that could be used immediately rather then waiting until maturity of the assets that were sold. Moreover, asset securitization is certainly an optimal solution over the alternatives suggested earlier.

Asset Pools, quality, and diversification;

In principal any asset representing a claim to future cash flows can be securitized including non-performing. Asset securitized pools are typically "Mortgage-Backed Securities" containing assets of residential mortgages. Another type is combined "Asset-Backed Securities" containing assets such as credit card receivables, auto loans, or consumer installment loans. Pools containing a large number of securities tend to make the rate at which the principal is repaid more stable. "Asset-Backed Securities" shows little sensitivity to interest rate changes, as compared to "Mortgage-Backed Securities" which are highly sensitive. Mortgage loan backed deals frequently will require a range of $50 to $60 million in order to achieve adequate diversification. The quality of assets which will assemble the pool will determine the amount of credit enhancement. The issuer will need to have adequate financial capacity to support the representations and warranties that are necessary for securitization, so poorly capitalized companies generally are not good candidates for securitization. Small private placements can be executed for as little as $200,000 in out-of-pocket expenses. Larger or more complex deals can exceed 1 million dollars.

Benefits of the seller when considering Asset securitization,

The seller of the assets benefits by liquidating assets while still being able to continue to focus on core competencies rather then trying to compete in areas where they do not hold sterngths. The most important benefit to the seller is that it reduces capital and liquidity requirements, as assets are moved off balance sheets. Asset securitization provides access to a larger base of capital markets and institutional investors to fund assets. It also gives the seller the opportunity to retain the customer relationship and service. This is important since institutions will not have to turn customers away from continuing business. Other benefits include converting non­liquid assets to cash quickly, and it will achieve a cheaper cost of funds compared to traditional sources (this will vary depending on various yield curves). Furthermore, the seller benefits as much as the investor when considering asset securitization.

Benefits of the investor of asset securitization;

The benefits to an investor are access to a secure and senior rated investment which will earn an attractive market rate, and will retain a liquid investment that can be easily marketed again if needed. Asset securitization benefits both parties as, it allows better diversification of risks and the passage of certain risks along to investors more interested in holding them than the parties that created the instruments. It will enhance performance against targets, particularly return on assets and equity, through a combination of reduced capital requirements and a fixed income stream which recognizes income monthly as opposed to an outright asset sale that requires immediate recognition of income. It will also enhance corporate image in the marketplace of the investor as well as the seller.

Disadvantages of asset securitization;

There are several disadvantages of asset securitization ranging from “asset – pool” selection and risk management to a shift of business policies. Transactions are complex, which require a major shift in thinking of on­balance sheet versus off­balance sheet financing. Many financial institutions emphasize rewards based on the size of the balance sheet, which presents a systemic conflict. Initial costs and time requirements may seem excessive to some sellers that have a low volume of assets to sell. High quality credit underwriting, monitoring, and reporting is critical which could require a large amount of capitol to fund. Once assets are securitized in the capital markets it becomes imperative to maintain quality as any default on the pool of assets will lead to significant image problems for the originator (seller) of the asset. Moreover, a badly structured transaction, or a poorly managed deal can waste thousands of dollars in unnecessary legal fees not to mention the market image of the institution.

Risks Management and Asset securitization;

When financial risks become greater, institutions that generate assets must focus more on risk management. Sound risk management practices must be in place at institutions engaging in securitization activities. Institutions should establish and implement an independent audit function to effectively oversee securitization activities. Given the risks presented by these activities, the bank regulatory agencies are actively considering the establishment of regulatory restrictions that would limit or eliminate the amount of certain retained interests that may be recognized in determining the adequacy of regulatory capital. Reported values for retained interests should be reasonable, conservative and supported by objective and verifiable documentation. Institutions should ensure that sufficient capital is held to support the risks associated with securitization activities and are expected to place concentration limits on retained interests relative to equity capital. Unfortunately, there have been a number of failures of securitized assets, and the number has also begun to increase. In an attempt to limit these failures the Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation recently created guidelines and are seeking restrictions to regulate asset securitization. These failures become a problem because of the expense it creates for the FDIC. The assets in many of the failed pools of assets had little to no value. Furthermore, asset securitization improves risk by diversifying over high quality assets.

Asset securitization is a great innovation in that it allows financial firms to package different kinds of cash flows and risks in which they sell off to investors interested in holding them, rather than have the financial institution keep them on their balance sheet. It allows financial firms to specialize in the deal creation rather than asset-liability management. Firms still have an interest in putting together good deals (financing good assets) as these will sell at better prices, but they can now specialize in certain areas with out having to worry about them selves accumulating to much of associated risk. Though, Asset securitization is costly, as stated before, more and more investment institutions are using this strategy their business today.

By securitizing their assets (be it credit cards or mortgages or car loans) then can focus on a particular area and become very knowledgeable and efficient in assembling asset packages in those specific areas without having to worry about diversification because they pass these assets along to sets of other investors interested in diversifying their own portfolios. Thus it allows financial institutions to focus on being middle men rather than risk takers. It is all just another example of how in certain cases capital markets can be superior to old fashion financial intermediation.

. Because of the diversification, asset securitization also has the advantage of allowing financial instruments to be offered to segments of the population that might not otherwise of had access or to others at lower rates than before. For example, high risk borrowers can now obtain credit cards where before they could not because the card provider (financial institution) specializing in this area need not be the one carrying all the risk. This risk can be spread out among the capital market investors. Thus a business in high risk financial transactions can be created allowing firms to specialize in the origination of the deals without having to live with the concentration of the risk.

Asset securitization requires a developed capital market. There needs to be diverse sets of large investors that would be interested in adding some amount of the assets to their portfolio. As financial risks become greater, financial institutions will focus more on risk management. Part of this is diversification in ones asset base and securitization facilitates asset and liability management. Because I do not believe that financial risk will diminish in the future I imagine that asset securitization will continue to grow with the further development of individual country's capital markets. Because of the increasing mobility of capital due to globalization, communications and the internet, shareholder capitalism will be a strong force in the future. The more the corporations depend on the stock market for capital raising, the higher the attention given to shareholders. The ability to move funds around the world is orders of magnitude faster now than 20 years ago. Also because of increased globalization of business the amount of funds moving around the globe has increased dramatically. Generally speaking the free flow of funds is a good thing as it promotes economic efficiency. However, the increased speed and size of capital flows has led to greater dangers, both for investors and borrowers. For countries it has increased the cost of pursuing policies that are unsustainable, because when the dam breaks there is a lot more water behind it. It is also more dangerous for investors because the speed and quantity of information has not keep up with that of capital. Government officials and corporations are just as slow to change policies as 20 years ago. So the end result is that occasionally mis-information flows or excess flows of capital will occur. However, short of re-establishing capital controls or putting limits on international portfolio flows (which would be damaging to investor diversification and countries access to capital, this will remain!

a part of the modern financial life.

securitization is a more active strategy that generates fee income every time the asset turns. A more appropriate way to draw this comparison would be to use a net

present value calculation on the securitized cash flow.

For instance raising deposits involves offering regular or special rates to attract investors. It takes significant effort to raise large amounts of funds and it has become increasingly difficult as depositors shift from traditional deposit vehicles to mutual funds. This option also requires offsetting liquidity deposits. With the Sell or Syndicate Assets option, assets are sold or syndicated to other financial institutions with liquidity. The seller receives a service fee of 25­50 basis points as well as a premium on the difference between book yield and current market yield of the asset sold. The buyer receives the rest of the revenue but assumes all of the credit risk. Borrowing money from another lender, which could in turn earn a margin (likely a lower margin) on funds that are re-deployed. No longer offer loans would essentially shut off the granting of loans. Shutting the door on many new and existing customers which could cause them to move else where for there financi!

al needs. Finally asset securitization would be migrated off the balance sheet and funds raised in the open capital markets. This is becoming the option of choice for many financial institutions today because it can be done quickly and appears to be a less expensive method of dealing with loan demand. Since its development in the late 1980s, asset securitization has become a permanent fixture in the capital structure of many corporations. The degree of utilization of asset securitization in a country seems to go hand in hand with that of financial market maturity.


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