What securitization is and the main structures

The core idea

A bank or company that has made many loans holds a stream of future payments: interest and principal from borrowers. Securitization turns that stream into tradable bonds. The lender gathers similar loans into a pool, sells the pool to a newly created legal entity, and that entity issues securities to investors.

The pool goes by several names: the securitized assets, the reference portfolio or the collateral. The securities are asset-backed securities (ABS): bonds backed by, and paid from, that specific pool rather than from the original lender's general business.

The entity in the middle is the special purpose entity (SPE), also called a special purpose vehicle (SPV) or special purpose company. It buys the assets, issues the ABS and passes the borrowers' payments on to investors in a predetermined way. Because it redistributes the pool's cash flows by fixed rules, a securitization creates a whole new ranking of claims on that pool.

• Step 1: originate loans or receivables (the original source of assets).
• Step 2: pool assets with similar features.
• Step 3: transfer the pool to the SPE.
• Step 4: the SPE issues ABS to investors, who are repaid from the pool.

Securitization creates a direct link between the people who borrow (car buyers, homeowners, businesses) and the investors who fund them, with the SPE as a pipe in between.

Three structures, from simple to complex

Covered bonds are the simplest form. The issuer, typically a European bank, earmarks a pool of mortgage loans on its own balance sheet and keeps it separate from its other assets. The bank then issues bonds with that pool as collateral (the "cover"). Investors are paid by the bank itself; if the bank defaults, they can turn to the pool.

Because the assets never leave the bank's balance sheet and no independent SPE is involved, a covered bond is not a full securitization. And investors' payments come from the bank, not directly from the cash the pool generates.

Pass-through securities are true securitizations. The pool is removed from the balance sheet and placed in a separate, independent legal entity, which issues securities. Borrowers' interest and principal are passed through to investors proportionally, so what investors receive varies with the pool's credit performance and payment pattern.

Bonds with structural enhancements add rules on top of a pass-through. Cash flows are redistributed across specified tranches according to a preset schedule, which makes payments more predictable and softens the effect of defaults, prepayments or payment extensions. Lower tranches are subordinated and take more of those risks, and further credit enhancements can be added to cut investors' risk further.

MBS versus other ABS

Mortgage-backed securities (MBS) are ABS whose collateral is a pool of mortgages. In the US it is common to separate MBS from ABS backed by non-mortgage assets. Both families come in several sub-types; the details are the subject of the next two modules.

Exam shortcut: a CMO redistributes a mortgage pool's cash flows across tranches by a preset schedule, so it sits at the complex end. A covered bond sits at the simple end.