Consider this scenario, LendCo is an entity in the financial services space which lends money to businesses. LendCo creates various products such as car loans, mortgages, credit card loans and leases. These loan products have receivables in the form of principal repayments and interest payments, which the borrowers commit to settling over the agreed loan period, which can range from short-term, under a year, to long-term, five years. LendCo has committed all its capital to the loans and doesn’t have sufficient liquidity to create new loans. The options available to LendCo include inviting its shareholders to inject additional equity capital or borrowing by issuing debt. Another fundraising option available to LendCo is Securitization.
What is Securitization?
Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to investors who purchase the securities. This process is used to raise funds by issuing securities backed by the underlying assets, which can include mortgages, car loans, student loans, and credit card receivables.
Role of Securitization
The role of securitization in financing is to provide liquidity to financial institutions such as LendCo and to allow them to free up capital that can be used for new lending. This is achieved by turning illiquid assets into securities that are sold to investors. The process of securitization also allows for the transfer of risk from the originator of the assets to the investors who purchase the securities.
A special purpose vehicle (SPV) is created to hold the underlying assets. The SPV issues securities that are backed by these assets, which are then sold to investors. The proceeds from the sale of the securities are used to create other loans, repay existing loans or enhance the lending company’s equity position.
- Reduce funding costs – an SPV usually has an excellent credit rating. Its only business is holding quality assets which enhance its credit rating,
- Free up capital for the originator,
- Off-balance sheet financing – the liability does not appear on the lender’s balance sheet,
- The SPV is entirely separate from the originating business,
- Shareholders can maintain undiluted ownership of the company,
- Turns illiquid assets into liquid ones,
- Provides income for investors,
- Non-recourse transaction. Repayment is only based on proceeds from the securitized receivables and no other source.
- In securitization, an originator pools or groups debt into portfolios which they sell to issuers,
- Issuers create marketable financial instruments by merging various financial assets into tranches,
- Investors buy securitized products to earn a profit,
- Securitized instruments furnish investors with good income streams,
- Products with riskier underlying assets will pay a higher rate of return.
By Steve Ogada, Principal InVhestia Africa.