Secure Loans And Repay Capital Example For Free - Free Essay Example

Sample details Pages: 7 Words: 2103 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? The concept of securitisation has developed over recent years predominantly as a means of removing assets from the balance sheet, creating liquidity and aiding the process of risk management. Securitisation as defined by David T Llewellyn is a technique that transforms or repackages a pool of assets on the balance sheet of a bank into securities that can be resold to investors in the capital market. The trend therefore to securitisation has been a product of both changes in the market and economic environment, and shifts in the relative efficiency of bank and capital markets. Don’t waste time! Our writers will create an original "Secure Loans And Repay Capital Example For Free" essay for you Create order The growth of securitisation implies a potential decline in the demand for services traditionally provided by banks, especially for the corporate sector. Mechanics of securitisation The basic structure and workings of securitisation are displayed in the diagram below taken from D T Llewellyns lecture notes. Simple securitisation structure Borrowers Receive loan Pay back interest and principle Asset seller/originator Pools the assets and sells them to the SPV Collects payments made by borrowers to pass them to SPV SPV To pay for the assets issues securities backed by the cash flow from the assets Rating agency Credit Enhancer Analyses the credit quality of Enhances the credit the securities quality of the securities Servicer Only if the seller does not retain the servicing function Investors in asset backed securities Stage 1 The first stage of securitisation for a bank is the decision to remove selected loans from its balance sheet. Once it has decided which loans it wishes to remove it collectively repackages the loans that are of a common nature, and forms a security. Stage 2 The bank then establishes a bankruptcy-remote SPV (Special Purpose vehicle). This is usually a company set up especially to fund the purchase of these assets. It is important that the SPV is independent from the originator (bank) otherwise selling to the SPV would not remove the assets from the originators balance sheet. If the bank was to become bankrupt, as the name suggests, the SPV is unaffected. Stage 3 Before the securities are sold by the SPV to investors, a number of procedures are carried out: A credit enhancement may also be added to the security. This involves an independent organisation endorsing the security, and in the event that the borrowers default and the bank cannot pay the repayments of the security, then the endorser assumes responsibility for repayment. As the endorser provides increased liquidity and credit quality, they charge a fee for the service. A rating agency assesses the quality of the securities and provides a grade. Aspects such as the value of the collateral are investigated, as well as the structure of the cash flows from the securitised assets. An assessment of the quality of the endorser is also provided and the SPV is checked to see if they are adequately bankruptcy-remote from the selling bank. The rating is used to act as an incentive for the bank to behave well. Stage 4 The asset security is then sold by the SPV into the capital market to an investor. Once the security is sold, the bank continues to retain responsibility for repayments from the original borrowers. Interest earned is then passed onto the SPV. These payments are used to service the securities the SPV bought from the bank. During the securities maturity period, the original loans are still administered by the bank and a bank-customer relationship is maintained. Types of securities that may be issued There are different types of securities which are issued by the SPV: A floating rate note is a type of security that is characterised by a variable rate of interest. Asset backed commercial paper is often used to attract short term funding, which in terms of securitisation would be to cover the receivables on the balance sheet. Asset backed interest bonds are issued with a fixed rate of interest. The rate may be changed at certain times between issue and maturity if specified on the original contract. A change every six months is common. The choice of security issued depends largely on the composition of the loans in the portfolio. The aim of the SPV is to limit risk, so it will normally try to match the type of assets in the portfolio. They will try to create a security with an interest rate similar to those in the portfolio as well as matching the maturity times. D T Llewellyn explains that Whatever instrument is issued, three servicing alternatives are available. The SPV may choose to use a revolving method which uses the flow of income from its assets to buy more assets (loans), which will, extend and continue the duration of income from the securities. A second alternative could be the bullet principal payment method. In this situation, it is agreed that the buyer of the security will only receive payment once the security has fully matured. The final method is known as the Amortisation method. Here the income from the security payments is used to cash in the security. Reasons for Banks securitising loans Asset Motive Firstly, banks will securitse its assets due to the asset transformation motive, which refers to the banks ability to manage the level of risk it is exposed to on the balance sheet. If a bank believes that it holds too many loans in a particular area of its business, then it may choose to create a portfolio of loans and then securitise the portfolio. 147s and sell the assets off relieving some of its exposure on the balance sheet. Securitisation therefore allows banks to use this method as a risk management strategy and the result of securitisation is a shift of risk from the bank to others in the capital market. Again with respect to risk management, a bank may want to diversify its asset portfolio but may be constrained by its capital available for lending. In these circumstances a bank may securitize existing assets in unwanted sectors and use the capital gained from this process to fund investments in assets in different fields. Some existing loans in a ba nks portfolio may also offer small profit margins. The bank may decide to sell off these existing loans in exchange for new more profitable loans again through the process of securitisation. A bank may in more general terms require liquidity to finance other projects or to pay for unforeseen costs. It may be that banks require funds to pay shareholders. Securitisation allows for quick availability to cash that assets in the form of individual loans cannot provide. Investors in asset-backed securities choose a specific risk (e.g. mortgages) rather than share in the overall portfolio risk of the selling bank. This, to them, is the attraction. Funding motive As the banking market becomes more competitive, the rate of return on many banks assets is becoming more tightly squeezed, to such an extent that they even become unprofitable to hold. Securitisation can be a method that can actually bring in new sources of funds without having an effect on that banks capital ratio and balance sheet. A bank selling an asset backed security is a major attraction to investors looking to invest in something with a specific risk. An investor making a deposit in a bank is effectively exposing itself to the complete portfolio of assets the bank holds. For some investors, this may not meet their risk requirements. A security issued by the bank offers a particular type of asset with a specific risk. This product provides increased funds to those who would not normally invest in the bank. As David T Llewellyn highlights there are a number of reasons an investor may choose to invest in a security rather than making a deposit. The investor may be undert aking a hedge transaction. This would not be possible with an exposure to the banks complete portfolio. the investor may already be at its credit limit to banks Some investors prefer the flexibility that comes with a security. They are marketable and therefore liquid unlike a bank deposit. When a bank segments funds into securitised packages it can also lower the marginal cost of attracting new funding. If a bank wishes to attract new deposits it has to pay a higher interest rate to all the existing depositors as well as the new ones. With a security there is a lower marginal loss when issuing new assets. Its can increase funds without having to increase its interest payments on its existing depositors. Again as is pointed out in securitisation as a technique of asset and liability management the fact that the assets have been removed from the balance sheet through securitisation, alleviates the need to hold capital against the assets which the bank once held. This again reduces costs to the bank. Fee income motive Securitisation also provides the opportunity for banks to make a continuous fee income. Because banks benefit from a comparative advantage in originating and providing loans, it is possible for them to create loans with the intention of securitising them for a profitable income stream. It is the integrated service of providing a loan that the bank charges for and makes money from. These charges include general admin costs, monitoring costs and search costs to name a few. It is these aspects of loan creation that the banks carry a comparative advantage so can confidently provide loans at the most competitive rate with the intention of securitising. Balance sheet constraint motive This other motive allows a bank to use securitisation as a means of dealing with an existing interest rate or maturity mis-match. However, for some banks, securitisation is a clear sign that they have some unprofitable assets on their balance sheets. Why repay capital to its shareholders? As mentioned in the banks asset transformation motive, banks will carry out securitisation as a means of removing risk from themselves and passing it on to a SPV. When banks create loans, this creates excess capital- not more which is often a common mistake. So, if banks believe that the rate of return on some assets is set to be too low they have to act. Shareholders may have a clear idea of the rate of return they require on their equity. Very often shareholders require a minimum of price/ equity multiplier which can be seen below: The equation above shows that at a certain level when prices/ assets falls then shareholders will repay some capital to its shareholders. This is necessary because of how competitive the market is; if the shareholders become unhappy then they will sell their shares and the overall value of the bank will fall. As a result of securitising, it means all that is left on the balance sheet are those assets which do generate the high rate of return which i s required. A company called Madura Coats planned capital reduction to repay public shareholders in August 2003. They were a multinational company in India who wanted to go private but were faced with some stubborn shareholders who refused to part with their holdings even after the stock had been delisted. They chose to go for a capital reduction programme that forced the return of capital to the public shareholders who still held on to their shares. Under the provisions of Section 100 of the Companies Act, a company has the right to extinguish any of its shares that is in excess of its wants. This is one extreme case to repay shareholders that a bank may opt for in some circumstances (highly unlikely but still a possibility). Conclusion In conclusion, banks basically securitise to pass on any risk they are associated with and to remove bad assets from the balance sheet. Recently, the guardian newspaper asks whether, banks are doomed as a result of the current financial crisis? With the securitisation of mortgages originally seen as a triumph, because it shifted risk to financial markets, while taking deposits and making and monitoring loans the purview of traditional banks was regarded as narrow and old-fashioned. By contrast, modern banks would seek finance mainly in the interbank market and securitise their loan portfolios. Northern Rock faced problems because it was securitising everything and then was lending money to the SPV it relied on. It is necessary for banks to securitise but caution must be exerted when choosing the SPV and how many assets are been securitised. It is necessary for banks to repay capital to shareholders to show strength and to give encouragement for the future. With the market been so competitive banks must try and keep existing customers and gain more so they do not fall behind.