Table of Contents
- In a simple model of securitized bonds
- Complex models involve third parties
- Types of securitization instruments
- Benefits of securitized bonds
Securitized bonds are bonds where coupon and interest payments come from a collection of other underlying assets. For example, a bank pools its mortgage into debt securities. This security is what we call securitized bonds.
In a simple model of securitized bonds
From the issuance of the bonds, the bank gets fresh money. They can use it to issue new mortgages or other types of loans.
On the other hand, banks use mortgage payment money from debtors to pay coupons and principal holders of bonds. In other words, the mortgage debtor indirectly pays the bondholders. Therefore, banks transfer risk from their balance sheets to debt markets through the sale of securitized bonds.
That contrasts with conventional bonds, which banks pay with internal cash sources. In this bond, insufficient internal cash can cause banks to default.
Conversely, in securitized bonds, the risk of bad credit mortgages can lead to a default on bonds. In extreme cases, banks may not have enough internal cash. However, it does not cause default while the debtor is still smoothly paying the mortgage installments.
Complex models involve third parties
The above section is the simplest model of how securitized bonds work. The way securitization works are more complicated. Financial institutions as issuers or originator (for example, banks) do not directly issue bonds. It involves a third party, namely the Special Purpose Vehicle (SPV).
SPV is a separate entity and stands for buying assets from financial institutions. They are specialized entities that handle asset securitization. Two of the oldest and most famous examples of SPV are Fannie Mae and Freddie Mac in the United States.
The bank sells assets to SPV and receives cash. It transfers assets from its balance sheet to SPV, which will structure it into a bond. SPV issues these bonds to raise funds. They use the funds to pay the purchase of bank assets.
Types of securitization instruments
The issuer can use any asset as long as it generates cash flow. The most common example is a mortgage. Mortgage securitization is known as mortgage-based securities (MBS).
Not only mortgages, but issuers can also use cash inflows from several assets. Examples are car loans, student loans, toll-road revenues, accounts receivable, credit card financing, equipment rental, etc. Bonds with underlying non-mortgage assets are called asset-backed securities (ABS).
Benefits of securitized bonds
Securitized bonds allow originators to increase their operational leverage. The originators’s cash flow does not decrease since it does not pay bondholders using internal cash instead of from installments of mortgage loans.
By transferring assets and receiving cash flow, the originator’s liquidity increases. Therefore, they can provide loans at lower interest rates. Cheaper loans ultimately encourage increased economic growth.
Meanwhile, for intermediaries such as SPV, they benefit from the spread, which is the difference between the interest rate incurs when buying assets from a bank and the interest rate on bond issuance.
For investors, securitized bonds offer alternative diversification. They obtain a fixed source of income other than conventional fixed income sources, such as government bonds and corporate bonds.