Securitization of debt is a very important concept as far as banking and some derivative instruments are concerned.
Securitization and Swaps are the main causes that lead to the sub-prime crises in the United States.
To understand what exactly a sub-prime crisis is we will first have to understand the process of securitization of debt.
Let’s take a look at a bank’s (Hypothetical) balance sheet.
Liabilities
|
Amount
|
Assets
|
Amount
|
Equity Capital
Deposits from Public(NDTL)
|
1000
500
|
Fixed Assets
CRR(6% of NDTL)
SLR(24% of NDTL)
Loans given to public
Housing Loan
Car loan
Personal Loan
Net current Assets(incl.Cash)
|
600
30
120
120
70
160
400
|
Total
|
1500
|
Total
|
1500
|
As we can see the total deposits from the public is 500 and 30% of the deposits has been kept aside as reserve requirements. The remaining 70% which is 350 can be used for lending. The bank has a portfolio of housing, car and personal loans. The bank earns profit from the spread of lending and borrowing rates.
Let's assume the Borrowing rates to be 10%
and lending rates as follows:
Housing Loans : 12%
Car Loan : 15%
Personal Loan :18%.
Income statement (hypothetical)
Particulars
|
Amount
|
Interest from lending
Housing
Car
Personal
Total Income
Expenses
Interest on borrowed funds
Other Expenses
Total expenditure
Net profit
|
14.4
10.5
28.8
53.7
50
1
51
2.7
|
As we can see there is no scope for the bank to earn more money unless the deposit base is increased or the bank borrows from the market and lends. Let's assume the quantum of deposit to be constant and also it is not in favor to borrow from the market and lend (i.e. it is not interested in increasing the size of the balance sheet).
Now the bank sees a great opportunity to earn profit in credit card lending (lending rate 20%). But since it has no more funds to lend it cannot tap that credit card loan markets. The only option is to get off the existing portfolios of loans (i.e. to en-cash the loans).The encashment of loans is done by selling off the portfolio of loans to the SPV (explained later). The Car loans and personal loans will be recovered in a relatively short period of time when compared to housing loans which range from a tenure of 5 - 25 years.
Divesting from the current loan portfolio is called SECURITIZATION OF DEBT.
These loans are colloquially called debt in the financial arena.
The process of Securitization follows:
An entity called a SPECIAL PURPOSE VEHICLE is created (which is usually a trust). The bank then sells off its debt (in this case the housing loan worth 120) to this SPV and in return gets the said amount in cash. The SPV in turn issues securities (just like a debt instrument) called COLLATERALIZED DEBT OBLIGATION (CDO) for a fixed interest. The retail investors then subscribe to these CDO’s and become the owner of the debt to the extent they hold the amount of CDO. As and when the housing loan holder pays off his debt with the interest, the CDO holders get their fixed interest payment promised by the SPV.
This process can be better understood with the help of a diagram.
This Securitization Leads to the following changes in the balance sheet
1) Bank
Liabilities
|
Amount
|
Assets
|
Amount
|
Equity Capital
Deposits from Public(NDTL)
|
1000
500
|
Fixed Assets
CRR(6% of NDTL)
SLR(24% of NDTL)
Loans given to public
Car loan
Personal Loan
Net current Assets(incl.Cash)
|
600
30
120
70
160
520
|
Total
|
1500
|
Total
|
1500
|
Now the bank has an extra cash of Rs.120 to lend towards credit card loans on which it can earn a higher amount of interest which would ultimately lead to increase in its Net Interest Margin.
2) Special Purpose Vehicle
Liabilities
|
Amount
|
Assets
|
Amount
|
CDO’s Issued
|
120
|
Housing Loan
|
120
|
Total
|
120
|
Total
|
120
|
As and when the loan holder pays their EMI’s the CDO holders get their promised interest and at the end of the tenure of the housing loans the Debt holders will get their principal back.
This is a simplistic model of an SPV there are many variants which can be looked into.
Conclusion:
The Securitization process leads to liquidity to the banks and gives the banks an avenue to offload their less interest bearing Loans and invest in more interest bearing Loans.
And as far as the investors are concerned they get an opportunity to invest in the securities which earns more income than the conventional Fixed Deposits and debt instruments.
Although this seems to be very much beneficial to the banks as well as investors it is a double edged sword if not handled properly would lead to situations like the Sub-Prime crises that took the whole economy to a toss in the USA.
The mechanism and consequence of improper use of this facility is explained as follows
Banks which used to lend to the creditworthy borrowers only now would become lax and would start lending to the people whose credibility is questionable i.e. their payback capacity won’t be strong as the banks know that they have a safer exit option from these loans via securitization. And investors who are not fully aware of the portfolio of the loans take a hit. This is where the onus lies on the credit rating agencies which give ratings to the CDO’s Issued by the SPV. The Portfolio if not properly evaluated which happened in case of USA would cause pain to the investors having the CDO’s as their money could be wiped off if the Loan holder default.
