Securitization and Capital Management
Securitizations have been a core technique for expanding the financing offered by banks under the "originate and distribute" business model. Securitizations were, originally, a technique for financing based on simple mechanisms and economics. A securitization is economically sustainable if assets securitized, net of operating set-up costs of the SPEs (special purpose entities), provide an expected return in line with the expected compensations required by investors in asset-backed notes issues by SPEs. However, being in line does not mean matching. If the loss of the underlying asset portfolio deviates to a lower than expected loss by any amount, such adverse deviation would impair the credit standing for all asset-backed notes. Hence the expected return from the portfolio should be higher than the expected return to investors, creating a safety cushion that would preserve the securitization economics under stressed conditions. Such rationale is very similar to the capital adequacy principle.
Securitizations, which were supposed to provide a better diversification of risk across all investors in SPE vehicles, became a major contagion factor in the 2007 financial crisis. This does not imply that securitization techniques are flawed. Rather it shows that risks were not addressed properly, raising methodology and discipline issues, notably since ratings agencies and banks tends to use different techniques for assessing the resiliency of securitization structures. The wave of securitizations went into an abrupt stop when it appeared that the risk under stressed conditions was vastly underestimated by arrangers as well as rating agencies. However, they should develop again when imposing a more stringent discipline on risk-assessing methodology plus imposing risk sharing between the originating bank and the investors by making it an obligation to the bank to maintain an interest in the securitized portfolio.
This chapter details these mechanisms and the associated techniques. Section 58.1 addresses the variety of securitizations and shows how some simple principles can be used to finance virtually any asset subject to consistent economics of the securitization vehicle. It reminds us of the basic rationales and motivations that fostered the development of this technique, and, finally, the section details the basic ingredients necessary for arranging a securitization. Section 58.2 explains how securitizations can differentiate the risk of the pools of assets securitized from the risk of notes issued in the markets. Such differentiation is obtained by issuing notes with cascading seniority claims on the cash flows generated by assets of SPEs, or the "waterfall mechanism." Section 58.3 details the economics of a securitization through a simplified case study and illustrates the arbitrage mechanism between financing the same assets on balance sheet versus financing in the market. Finally, Section 58.4 addresses issues for assessing the risk and the resiliency of securitization structures. Stress testing rules are factor-push scenarios. But since only portfolio models provides the loss distribution of asset portfolio, and since each tranche can be shows as being a correlation product, portfolio models remain a mandatory technique for assessing the risk of the underlying pool of assets, in addition to factor-push stress tests.