Demystifying securitisation for online lenders

By Phil Toth on Monday 22 January 2018

Opinion

Phillip Toth of Oberon Securities makes the case for securitisation in online lending.

Introduction

Mortgage Backed Securities (“MBS”), Collateralised Debt Obligations (“CDOs), Collateralised Loan Obligations (“CLO’s), Asset-backed Commercial Paper (“ABSCP”) and other types of securitised products are largely responsible for the Subprime Crises in 2008. These financial instruments created massive financial losses and large-scale damage to the economy overall. A great deal of negative press followed demonising certain industry participants and the use of financial engineering. Best-selling books like Too Big to Fail and The Big Short along with countless congressional testimonies drew even more attention to the subject.

With all the media attention came a fair amount of misinformation. For decades now, securitisations have funded large consumer purchases including automobiles and homes. It also fueled the credit card industry and the expansion of consumer credit. Securitisations fund small to large businesses and countless other aspects of the United States and world economy. Yet, for many it is a relatively new phenomenon that they may not completely understand or even mistrust.  

More recently, internet lenders brought an entirely new buzz to the securitisation market. Their more customer-centric model to lending resulted in explosive growth. So much so, the original peer-to-peer funding model was largely replaced by the efficiency of the securitization market. According to Bloomberg/Peer IQ, total securitisation of marketplace loans is now close to $90 billion up from less than $50 million at the end of 2013.

What is securitisation?

Securitisations or more specifically asset-backed securities (“ABS”) are pools of loans such as residential and commercial mortgages, auto loans, consumer loans, leases, trade receivables, or other assets packaged in security form. The loan pools often separate into different securities with varying levels of risk and return. Lower risk, lower interest tranches receive the loan payments first, with the holders of the higher-risk securities receiving payments thereafter. The securities sell as new issues and subsequently may trade in the secondary securities market. Public offerings of ABS require registration with the SEC.

Securitisation is like secured lending in many ways. Secured lenders require borrowers to pledge specific assets as collateral for a loan. Cash flows from the borrower and the assets pledged as collateral back the loan in the case of default. In a similar way, the loan pool in the securitisation trust acts as collateral for a security. In a securitisation of secured loans, assets that collateralise the loans in the pool also flow through the trust in case of a loan loss and subsequent liquidation. The holder of the security has a rightful claim to the cash flows of the loan pool including principal and interest payments, loan sales and recoveries from any defaults.

Essentially, securitisation is the process of taking a group of homogenous assets and transforming them into a security. The assets are pooled together and repackaged into a single security, which is then sold to investors. The security entitles them to the incoming cash flows and other economic benefits generated by the asset pool.

A Simplified Overview of the Securitisation Process

From FDIC.gov website

How did securitisation begin?

The modern history of securitisation began in 1970s when Government Sponsored Enterprises (“GSE’s) including the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Corporation (“Freddie Mac”) issued the first residential mortgage-backed securities. These first issuers pooled residential mortgage loans and used them as collateral for securities. The market was significantly expanded by the Emergency Home Finance Act of 1970 which authorised Fannie Mae and Freddie Mac to buy and sell mortgages insured or guaranteed by the federal government. Along with credit enhancement of the government guarantee came an entire industry of creating newly issued bonds and trading securities in the secondary market. By 1977, Bank of America issued the first non-government sponsored security in the form of a private label (non-government backed) residential mortgage pass-through bond.

Securitisation evolved over the decades, as different methods and products developed from the process. A critical component was the Tax Reform Act of 1986. The Tax Reform Act eliminated the double taxation of income earned at the corporate level by issuers and dividends paid to securities holders. It also allows for Real Estate Mortgage Investment Conduits (“REMICs” or “Conduits”). The REMIC was an important distinction for balance sheet lenders as they were then permitted to structure a security offering as a sale of assets. The ability to package assets off-balance sheet offered regulatory capital relief for lenders and greatly increased capital available to fund growing consumer loan demand. Mortgage securitisations then led to new types of asset securitisation including auto loans, credit card receivables and others. As the United States paved the way other advanced countries soon followed with their own ABS.

By the 1990s the securitisation market exploded. New rules in the United States by the SEC along with REMIC legislation made the process more efficient. Global consumer culture clamouring for access to credit paired with the expansive growth of institutional managed money seeking new investment opportunities was the perfect combination. Consumer credit was now available to purchase everything from houses and cars to consumer electronics and higher education. 

The need for business credit also expanded during this time. The 1990s saw the introduction of commercial mortgages backed securities (“CMBS”), collateralised loan obligations (“CLOs”), Franchise ABS, Equipment Leasing Securitisations and other structures designed to finance business.   

Growth of Securitisation (1970–2008)

*Securitisation and Fractional Reserve Banking Nov 12, 2009  Nikolay Gertchev

What are the benefits of securitisation?

For the Issuer Securitisation is Cost Efficient. It allows a company to issue low cost senior debt independent of the company’s rating and fund itself less expensively than it could on an unsecured basis. The strategic use of securitisation enables a company to grow its business and earnings without additional equity capital and/or enhance return on equity. These benefits derive primarily from the capital efficiency of securitisation. Depending on the structure, securitised assets can be supported with less equity capital than on balance sheet assets primarily due to the transfer of asset-related risks to investors.

Securitisation Transfers Asset Related Risks. Firms that specialise in originating new loans and have difficulty funding existing loans may use securitisation to access more liquid capital markets for funding loan production. In doing so, the originator or finance company also transfers risk. These risks generally include interest rate risk, basis risk, liquidity risk, prepayment risk and credit risk. While in some transactions the issuer may retain most of the economic credit risk associated with securitised assets, the credit risk of certain asset types may be small compared with these other risks. In addition, securitisation can create opportunities for more efficient management of the asset ability duration mismatch generally associated with the funding of long-term loans, for example, with shorter term bank deposits.

Diversification for Investors. Investors seek diversification of investments for the benefit of their overall portfolio. Securitisations offer unique investment opportunities and attractive risk-return profiles compared to other asset classes such as government and corporate bonds. Securitisation also allows the structuring of securities with differing maturity and credit risk profiles from a single pool of assets that appeal to a broad range of investors.

Risk Sharing and Liquidity. Securitised products allow institutional investors opportunities to participate in consumer and corporate assets that cannot be found elsewhere. With securitisation, investors may invest in various consumer and business loans without having to develop in-house origination and servicing capabilities required to procure loans, collect payments and managed defaults and liquidations. In this way, investors benefit from the sourcing and servicing expertise of originators freeing money for more efficient capital deployment. Finally, the conversion of basically illiquid banking assets into tradeable capital market instruments often gives investors the opportunity to sell securities in the secondary market and obtain liquidity.

Securitisation Provides Market Driven Pricing Discipline. Securitisation can provide a market driven pricing discipline by highlighting the market price for risks transferred to investors and, thereby, providing pricing benchmarks to judge the profitability of a business.

How do the regulators look at securitisation post-crisis?

Despite a major setback in 2008, securitisation continues to be the primary alternative to bank financing. Securitisation transfers trillions of investment dollars into the economy. The regulatory authorities in the United States recognise the systematic importance of the capital markets to the real economy. In a report to Congress in 2010 by the Federal Reserve (“The Fed”), the Fed states, “the securitisation markets are an important link in the chain of entities providing credit to U.S. households and businesses, and state and local governments. When properly structured, securitisation provides economic benefits that can lower the cost of credit.” That exact phrase was reiterated in 2014 in a joint agency report by the US Treasury, SEC, OCC, HUD, The Fed, FHFA and FDIC regarding risk retention for securitisations.

Comments like this from the regulatory bodies lead most people to believe that securitisation is here to stay. Transforming illiquid typical bank assets into tradable securities is an important way to channel cash to borrowers and fund economic growth. While new regulation calls for increased scrutiny of deals it recognises the importance securitisation plays in the overall economy. New measures such as better documentation and risk retention are now in place. The rules call for issuers to retain an economic interest or so-called “skin-in-the-game” on deals they bring to market. This makes for a better alignment of interest, stronger transactions and increased transparency. In that way we are better than ever before.  

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