Globalization of corporate activities along with the expansion of financial markets have paved the way for the development of debt securitization, which is an innovative financial instrument for fund enrichment. As per Investopedia, "Securitization is the process of creating a financial instrument by combining other financial assets and then marketing them to investors." In other words, securitization is a process by which loans and receivables are converted into negotiable instruments to raise debt. In this process, an illiquid asset is transformed into a liquid security with a secondary market.
Through securitization, a firm can convert its existing assets and further cash flows into marketable securities. The conversion of existing assets into marketable securities is known as asset-backed securitization and the conversion of future cash flows into marketable securities is known as future-flow securitization. The traditional lending process required a bank to hold assets till maturity. Securitization can be considered as a way of unlocking these locked-in funds.
The loans given to customers are its assets. The funds of this bank are locked up in their loans. To unlock the locked-in funds, securitization can be applied. Securitization starts with an originator taking a pool of financial assets from an entity, such as a bank or finance company. For a clear understanding, consider XYZ Ltd., to be a bank, originator. The originator sells the pool of assets to a trust called Special Purpose Vehicle (SPV). The pool of assets needs to be homogenous in terms of the underlying assets, maturity and risk profile. The SPV will take the role of an intermediary, which divides the assets of the originator into marketable securities. |
