CFM3304 - Understanding loan relationships: debt assets

Securitisation

Instead of selling its debt assets, a company could generate further funds from the debt assets without selling them.

Where a company has debt assets which are generating a flow of income, the company could use this flow of income to back the issue of further securities.

A credit card company has a continuous flow of income – the payments from credit card holders. If it wants to raise further funds now it could issue securities in the market meeting the interest and capital repayments it needs to make on these new securities with the payments coming from the credit card holders. In cash flow terms, the credit card company has acquired new funds, but will be using the income from its old lending to fund the new borrowing.

A mortgage company holds large numbers of debt assets which produce a steady stream of income. While they produce income the repayment term may mean that there will be a long wait before further capital comes into the mortgage company to enable it to make further loans. (In addition banking regulations restrict the amount a company can lend by reference to its capital base.) In the 1980s it was common for mortgage companies to bundle up large numbers of individual residential mortgages. The bundles of mortgages would be sold to a special purpose vehicle (SPV) which issued securities to fund this purchase. The SPV would meet the interest and capital repayments on its own borrowings by using the interest and capital repayments received on the residential mortgages. As a result:

• new money has come to the mortgage lender from the transfer of the loans
• the SPV holds the mortgages and uses the income from the loans to fund its own borrowing
• the borrowings of the SPV will be secured on the assets and therefore will carry a lower rate of interest than unsecured borrowings.
• the possible risks in the original mortgage lending are removed from the mortgage lender
• the mortgage company has reduced its lending exposure and is thus permitted by banking regulations to make further loans.

The mortgages, some of which may have been likely to default, have been transformed into tradable securities.

Securitisation is not limited to debts. Wherever there is a fairly certain stream of income, it may be possible to securitise it. So, a landlord with a stream of rental income might be able to issue marketable securities backed by the income stream from the rented properties. A pop star about to embark on a world tour might be able to issue marketable securities, backed by the anticipated income stream from the ticket sales for the tour.