How loan securitization works: Transforming debt into wealth

The Indian securitization market has witnessed remarkable growth, surging by 20% to ₹1.4 lakh crore in the first nine months of this fiscal year. This blog aims to demystify the concept of securitization, a process that might seem complex at first glance but plays a pivotal role in the Indian debt market. 

Banks can effectively free up their balance sheets for more lending by securitizing their current loans into tradable securities. To learn more, continue reading.

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What is securitization of loans?

The process of securitizing loans involves banks or lenders turning their loan portfolios into tradable securities that are then offered for sale to investors. This benefits banks since they receive cash immediately, which can be used to distribute more loans. In essence, the bank separates the loans in its portfolio into units, which it then sells as securities. 

By purchasing these securities, investors have the right to future principal and interest payments from the underlying loans. It also moves the risk of loan default from the bank to the investors who buy these securities. 

By securitizing loans, lenders can manage their credit risk better and maintain a steady flow of lending, while investors get access to new and diverse investment opportunities. This mechanism supports the overall functioning and stability of financial markets by enabling better risk management and funding allocation.

How does the securitization of bank loans work?

Loan securitization converts loans into securities that can be offered for sale to investors. There are multiple steps in this transformation, all aimed at spreading the risk of loan defaults and generating a flow of funds.

First, a financial institution, like a bank, bundles together a group of loans. These could be any kind, even personal loan securitization. After that, a Special Purpose Vehicle (SPV), a distinct legal entity established especially for this procedure, purchases this bundle. The SPV’s role is crucial as it isolates the financial risk of these loans from the bank, making the securities more appealing to investors.

Investors purchase these packaged loans from the SPV as securities.Investors are subsequently given pass-through certificates (PTC) . The ownership of the investors in the loan pool is represented by these certificates. 

These securities pay investors back with the interest and principal payments made by the original loan borrowers. Investors are essentially purchasing the right to these loans’ future payments.

By selling these securities, the SPV raises money, which it uses to pay the bank for the original bundle of loans. This way, the bank gets cash upfront instead of waiting for the loans to be repaid over time. It also transfers the risk of default from the bank to the investors who buy the securities.

There is also another way of securitisation called DA (Direct Assignment) structure. With DA, there is no need for an SPV because investors purchase the pool directly from the lender or originator, and the collections are allocated pari-passu according to a predefined ratio.This means that all investors share the proceeds proportionally, according to a predetermined ratio, ensuring fairness and clarity in the distribution of returns.

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Types of securitization

The following are the main loan categories that can be securitized:

1. Residential mortgage-backed securities (MBS)

These securities are loans secured by residential assets, such homes and apartments. Investors who purchase these securities get their income flow from homeowners’ mortgage payments.

2. Commercial mortgage-backed securities (CMBS)

Comparable to residential MBS, commercial mortgage-backed securities are loans secured by commercial real estate, such as hotels, shopping malls, and office buildings. Investors receive returns from these commercial mortgage repayments.

3. Vehicle loans

Loans made to people or organisations to buy vehicles can also be securitised. The aggregate cash flow from loan repayments for these auto loans is distributed to investors.

4. Collateralized debt obligations (CDOs)

CDOs are an especially complicated kind of asset-backed security. They may consist of a range of debt kinds, including corporate bonds, credit card debt, vehicle loans, and mortgages. CDOs are structured into different tranches, each with a different level of risk and return, catering to investors with varying risk appetites.

5. Asset-backed securities (ABS) for other loans

In addition to the previously stated, ABS are available for various loan categories such as credit card debt, personal loans, and even student loan securitization. These are pooled and securitised in a similar manner, offering another avenue for investors to gain exposure to loan repayments.

RBI’s framework on securitisation, issued in 2021, includes a negative list that restricts certain asset classes from being securitised. This list of non securitized loans is not definitive, though. The RBI keeps an eye on the market’s development and maturity and is willing to change its position if necessary. 

In the event that market conditions change, the regulator is willing to think about permitting the securitisation of assets that were previously prohibited, provided that choices are made thoughtfully and promptly.

Benefits of securitization of bank loans

For lenders:

• Improves liquidity: Through securitization, banks can swiftly turn loans into cash, freeing up funds for additional lending or other purposes.
• Balance sheet management: Banks can better manage their capital and satisfy regulatory requirements by removing loans from the balance sheet, all without having to raise more capital.
• Risk transfer: By transferring the loan default risk to investors, banks can lower their overall risk profile.

For investors:

• Risk-adjusted returns: A new class of assets is made available to investors, oftentimes with attractive returns.
• Diversification: It provides a means of adding diversity to investment portfolios by incorporating assets with varying risk profiles and frequently supported by tangible collateral.

For the debt market:

• Increases liquidity: Securitization increases the total amount of tradable products on the financial markets, improving liquidity overall.
• Market expansion: It broadens participation and support for different kinds of financial assistance by attracting new institutions and investors to the market.

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Bottomline

Loan securitization unlocks capital for banks, offers diverse investments, and boosts market liquidity. While complexities exist, its benefits for lenders, investors, and the debt market make it a powerful tool for financial growth and stability.