Asset-Backed Securities (ABS)
Asset-backed securities are the primary categories of securitised assets. Both residential mortgage-backed securities (MBS), and commercial mortgage-backed securities are sub-categories of asset-backed securities (ABS).
Asset-backed securities are securitised financial assets and debt instruments that are backed by some collateral. These securities are generated by pooling together similar asset-backed loans and are then run through the process of securitisation to be sold on the stock market through special purpose vehicles.
The underlying assets may be residential or commercial properties for mortgage-backed loans or some other asset for non-mortgage-backed loan assets.
Residential Mortgage-Backed Securities (MBS)
As mentioned above, residential mortgage-backed securities are a type of asset-backed securities that derive from loan pools with residential properties such as houses & residential estates & properties as collateral. In some instances, borrowers can even offer jewellery and other personal valuables as loan collateral.
Commercial Mortgage-Backed Securities (CMBS)
Another significant type of asset-backed security, commercial mortgage-backed securities, are derived from loans secured by commercial assets mortgage. Borrowers put some of their business or commercial property at stake to get a loan. Typical commercial mortgages are business assets such as machinery, buildings, plants, factories, etc.
Collateralised Debt Obligations (CDO)
Collateralised debt obligations (CDOs) are unique kinds of asset-backed securities. They are intricate financial products designed by restructuring and re-pooling personal loans as securities to be sold. The value of these obligations is obtained from the underlying assets of the debts, which become the collateral in case of any default.
Collateralised debt obligations are akin to derivatives; their value is derived from underlying financial assets. Banks create CDOs by gathering & repackaging several assets that generate cash flow, such as mortgages, bonds, home & auto loans, credit card debts, etc., grouping them into distinct tranches and selling them per investor credit risk tolerance levels.
Those CDOs then become security tranches with labels that refer to the underlying asset or collateral.
Future Flow Securitisation
A unique and innovative type of securitisation, Future flow securitisation aims to secure future cash flows from future debt obligors. Simply put, the marketed securities are based on future cash flow receivables. A financial institution securitises the receivables from debt instruments in a future period but pays investors from its current business activities.
Advantages of Securitisation
Securitisation involves multiple parties, chief among them being the originator, the SPV, and the investor.
Originators are primarily lending institutions that securitise assets from their books. SPV (Special Purpose Vehicles) are special legal entities that buy the assets from the originator’s books, bundle them and sell them to the secondary market. It is the prime mover of all critical structures and moves assets to the SPV for the process of securitisation, and receives the funds after the sale. SPVs also act as risk management bodies for originators. And finally, we have investors who buy from a pool of securities and receive interest payments & principals as per the agreed terms & conditions.
Securitisation poses numerous significant benefits to both originators & investors.
Benefits for the Originator
1. Unblocks Capital:
Banks, NBFCs, and micro-financing entities can free up their capital by applying the process of securitisation to their debt assets. Securitisation offers capital relief, lowers capital requirements, and unblocks capital for future lending & other projects.
2. Provides Liquidity:
Banks and lending institutions securitise illiquid assets, generating income for them. The liquidity, thus obtained, helps lenders underwrite more loans and generate more assets.
3. Lowers Funding Cost:
Securitisation of illiquid assets offers capital relief and generates a funding source other than traditional debt & equity securities, such as bonds, debentures, & shares. As a result, asset securitisation substantially enhances the business’s liquidity and brings down funding costs.
4. Risk Management:
Securitisation is an effective way to manage the risks within one’s asset portfolio. The lender secures its portfolio risk by running a pool of assets through the securitisation process. It transfers those assets off its sheets to be pooled, securitised, and sold on the market, thereby sharing, re-balancing, and redistributing its risks.
5. Overcoming Profit Uncertainty:
Assets with uncertain obligatory behaviour are a perpetual risk to lenders. Securitisation helps secure the lender’s profit or return from such investment by redistributing that risk to investors.
6. Reduces Need for Financial Leverage:
Securitisation frees up capital, boosts liquidity, and allows lending institutions to carry on their business & engage in new projects without additional financial support.
Advantages Offered to an Investor
1. Quality Investment:
Attractive returns from different types of asset-backed securities are the primary motivators for individual and institutional investors. In addition, securitised assets promise a fixed income for mid-term and long-term investments.
Securitisation is structured financial instruments with features & benefits aligning closely to investor needs. As a result, investors can diversify their investment portfolio and generate substantial & consistent returns from their quality investments.
2. Less Credit Risk:
Asset and mortgage-backed securities, CDOs, and associated asset classes showcase better credit resilience. As a result, defaults in these asset classes & securitisation tranches are typically low. Moreover, the assets being securitised possess high creditworthiness and value & are considered separate from the borrower as they are considered collateral.
The rate of default recoveries for asset securitisation has been significantly higher than that of debt securities such as corporate bonds. Thus, the credit risk of securitised assets remains comparatively low, and interest rates remain much less volatile.
3. Better Returns:
Attractive rates of returns are THE primary incentive for investors. An investor’s return generally depends upon their risk tolerance and the extent of their portfolio diversification. Securitised assets offer much high than most conventional security instruments. The yields associated with debt securities are significantly higher than corporate or government bonds.
4. Diversified Portfolio:
Investing in different asset-backed securities boosts diversity in one’s investment portfolio. In addition, the higher reliability & lower defaulting probability and creditworthiness of underlying financial assets make asset securities an excellent choice for portfolio diversification.
5. Benefit Small Investors:
A wide array of asset-backed securities, mortgage-backed securities, and other types of securitisation are available for investors to put their money in. In addition, there are loads of options for small investors, who invest a small amount of money securely and get prominent, assured yields routinely.
As the loans associated with asset-backed securities, mortgage-backed securities, and CDOs generally have lower chances of defaulting and are backed by underlying financial assets, they are much less volatile than their traditional security counterparts. This makes them an excellent choice for small and low-risk investors.