Securitization - Essay Example

Securitization Investing in Asset backed bonds is beneficial from the point of an investor, because they are based upon actual, non liquid assets, such as real estate mortgages and other such receivables which therefore provide excellent security in the event of a default by borrowers. They offer a form of secured investment with a low level of risk. The issues that A must consider before taking up the purchase of such bonds is to examine how the transfer of the bonds should be arranged. When the transfer is effected through a true sale, the advantages will be that the investor receives the title to the assets and the ownership to the receivables may be valid and enforceable in his favor. By issuing the bonds, the SPV which is securitizing the asset is also in a position to be able to provide the investor a valid title and ownership of the assets. The disadvantages however are that there may be issues related to conflicts of laws, especially when investors and originators are from different countries and such an arrangement for transfer of portfolios may not be recognized under the law of either country. There is the danger that such a transfer of portfolios may be considered as a form of secured financing. This gives rise to the issue of re-characterisation of the assets, since it is equivalent to the originator of the securities borrowing from the investor in order to secure cash by using the mortgages as collateral for the loan. The validity of such a transaction may be struck down in the courts due to a lack of registration, as per Section 395 of the Companies Act. This was also the issue in the case of In re George Inglefield Ltd1 where the issue of recharacterisation of the assets arose and were deemed to be outright sales which could not be sustained under Section 395. This was also the case in Lloyds & Scottish v. Cyril Lord Carpets2 and Welsh Develop. Agency v. Export Finance Co.3 In the case of Agnew v. Cmr of Inland Revenue4, the Court held that it was necessary to clarify the intention of the parties to determine the extent of the rights and obligations that would accrue, however the determination of whether the assets constitute security rights is not dependent upon intentions and would constitute recharacterisation of assets. This principle was also upheld in the cases of Smith (Admin. of Cosslett (Contractors) Ltd v. Bridgend CBC5 and National Westminster Bank v Spectrum Plus.6 In view of the above, synthetic securitization may be the preferable option here in order to avoid such issues resulting from the conflict of laws and the recharacterisation of assets and to ensure that the investor benefits without any obstacles that may stand in the way of such transfer. In the event of synthetic securitization however, there are some risks that arise, which must be taken into consideration. It must be noted that by investing in asset bonds through securitization, the investor is taking upon himself the risk associated with the assets and the possibilities of default. He becomes responsible for the administration of the assets without gaining legal title through a true sale, hence the intervening interests of third parties and debtors must also be taken into consideration. Such claims (for example claims from debtors under SE Section 8)could impact upon the effective value of the receivables and diminish protection for the investor on debts recoverable from the seller. Additional risks may be posed by the originator’s insolvency, since the liquidator may claim that these assets were sold at an undervalue and should therefore be returned (as under Section 238 of the Insolvency Act of 1986). Additionally, the liquidator may claim that the transfer of assets was not a true sale, therefore these risks have to be counterbalanced by additional protection from the originator. Since asset based bonds are long term investments, the possibility of insolvency of the bond issuer arises and this is in general, covered through warranties provided by the originator. Synthetic securitization offers the investor the facility of a derivative transaction whereby the investor assumes the risk over defaults on the securities but both investor and originator have the option of protection from insolvency through the recovery of the proceeds. There is also the added facility available to the SPV of trading the securities in the open market in order to raise funds against them. Therefore, there is the option to transfer the risk on the securities without coming in conflict with the statutory and contractual restrictions that would hinder an actual transfer of the assets through a true sale process. Synthetic securitization offers the facility of transferring the risk and gaining the benefits of a low risk, secured long term investment without the attendant problems with transfer of assets through real sale. Therefore an investor is protected by the fact that a temporary insolvency or liquidity crunch on the part of either the SPV or the originator can be offset by issuing the securities in the open market to raise funds and by a transfer of the risk of default over a wider base. Additional protection afforded to an investor in asset based securities is through credit enhancement. While securitization provides an opportunity for financial institutions to sell off fixed income portfolios, the investors/SPV may also be benefited through over-collatereralization, whereby the originator transfers a higher proportion of receivables to the investor than what he is investing. In this way, the investor is able to absorb a certain element of risk through the cushioning of the extra assets without suffering any undue harm, thereby lessening the possibility of insolvency. The excess collateral just sweeps back to the asset seller on maturity, and if the securities issued by the SPV exceeds the assets that are being funded, then there could be early amortization if creditworthiness of the asset portfolio diminishes. These are significant aspects in protecting the investor. Such securities are rated high in terms of credit value and provide an encouragement for investors to take up such securities which may be classed as low risk investments with a high credit rating. Over collateralization may also assume other forms such as spread accounts, interest swap rates or liquidity facilities. This arrangement may also be beneficial to the seller because it helps to consolidate an originator’s position by increased liquidity and availability of funds for investment or clearing up other debts. There is however some risk retention on the part of the originator which is designed to protect the investor, for example by providing a line of credit if the cash flow from the securitized assets is inadequate to service the securities. There may also be facilities offered by the originator for repurchase of the assets, in order to maintain their credit worthiness. In any case, it helps both originator and investor to adjust and manage their finances in such a manner that the risk is spread between them and protects both of them. In the case of synthetic securitization, such retention of credit risk by the originator is common and enhances protection available to an investor.. Read More