Introduction to Structured Finance

CHAPTER 4

Basic Principles of Securitization

Securitization is a well-established practice in the global debt capital markets. It refers to the sale of assets, which generate cash flows, from the entity that owns them to another entity that has been specifically set up for the purpose, and the issuing of notes by this second entity. These notes, backed by the cash flows from the original assets sold to the second entity, are referred to as asset-backed securities. The technique was introduced initially as a means of funding for U.S. depository institutions starting in 1969 and is the major reason for the development of the strong U.S. housing finance market. Subsequently, the technique was applied to other assets such as credit card payments and auto loan receivables. It has also been employed as part of asset/liability management in order to manage balance sheet risk for financial institutions.

Securitization allows institutions such as banks, other financial entities such as insurance companies and finance companies, and nonfinancial corporations to convert assets that are not readily marketable—such as residential mortgages, car loans, or lease receivables—into rated securities that are tradeable in the secondary market. The investors that buy these securities gain an exposure to these types of original assets that they would not otherwise have access to.

In this chapter, we discuss the motivation for securitization from the issuer's perspective, the basic mechanics of a securitization, ...