Securitization (Asset-Backed Securities and Structured Financing)

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Book Chapter

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Practising Law Institute




What is securitization? As the title of this chapter suggests, securitization has many names, and, as the following pages demonstrate, securitization has many descriptions, it spawned new complex structures, and its use has grown. However, its fundamental features have remained the same.

Securitization is a flexible form of intermediation—a channel through which savers transfer money to borrowers and receive the cash flow from the aggregate borrowers’ obligations. Thus, securitization converts illiquid loans into tradable securities that are backed by these loans. That is why the securities are called “asset-backed securities”1 and the process is called “securitization.” This form of intermediation also offers a unique form of financing. That is why, for those who focus on raising funds, the process is called “financing.” Securitization is a technique of structuring cash flow; this cash flow, derived from illiquid loans or debt, is divided into different cash streams. That is why the process is sometimes called “structured financing.”

The disagreements about the definition of securitization stem mainly from four issues. First, because the process breaks traditional intermediation into many discrete activities, it can be described by one or more of these activities. Second, because it can involve many actors, each with his own motivation, securitization can be described by its utility to the actors. Third, it is hard to define securitization in the terms of the traditional forms of intermediation or the financial system because securitization has changed these forms of intermediation and thereby the quality and structure of the whole financial system.3 Fourth, securitization can take a number of forms, all resulting in the conversion of illiquid financial instruments into securities. That is why people disagree about its predominant features. Indeed, one commentator used the proverbial three blind men defining an elephant to describe the various definitions of securitization, including my own.4 Since the failure of sub-prime securitized mortgages in 2008 and its effect on the failure of large banks and the financial system, the process underwent a thorough review followed by stricter regulation than in the past. Securitization has taken mainly two forms. In one form, a large loan is divided into small standardized parts that can be traded. This process is usually called “participation.” It has been used by banks for decades and is not a focus of much attention in 2014. The second form is the most prominent form of securitization. In this form an entity is created—Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE)—to receive illiquid loans, and the SPV issues standardized obligations that can be traded. In this chapter we deal with this process of securitization.

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