Securitisation (and the resultant ABS, CDOs etc.) has long been touted as harmful to market stability and as the bringer of the credit crunch. It is true, these instruments certainly exacerbated the issuance of toxic debt during the crash. But, with correct use and legislation, structured products could be used to create financial health and stability within many sectors and markets.
What Is Securitisation?
Securitisation of assets can provide a business with risk management, liquidity and financing. The cash flows from aggregated pools of assets (mortgages, bonds, engine leases, etc.) are securitised to form the basis on which securities are sold. Investors buy these securities and receive coupons (whose value is dependent on the underlying assets performance).
Priority of payment (when underlying mortgages default) allows several investor tranches to be created, each with their own credit rating (credit enhancement). The most senior tranche will have a higher credit rating than that of the underlying asset pool, and vice versa for the most junior tranche. The business can then invest the received monies into R&D, growth, etc.
In a special case, capital that is non-existent can also be securitised. This is done in life assurance and is called value of in-force securitisation. It is based on the future cash flow potential of an insurance portfolio.
Trump And Dodd-Frank
A boom in asset-backed securities (ABS) issuance was seen this September as banks, and funds rushed to complete deals before the ABS ‘risk retention rules’ come into play on Christmas Eve.
These rules form a small part of the 2010 Dodd-Frank Act which President-Elect Donald Trump has stated he seeks to dismantle. This rule aims to improve underlying asset quality. Under it, the asset-backed security issuer, and sponsors (the originators of the underlying assets) cannot simply offload all credit risk to investors, they must retain at least 5% of it.
Fannie And Freddie
Two government-sponsored enterprises in the US – Fannie Mae and Freddie Mac – have for about four years been offloading the credit risk of their risky junk bonds (mortgages underlying) away from the taxpaying public and on to yield-hungry private investors, using ‘credit risk transfers’.
These are synthetic bond securities (STACR and CAS) that investors can buy. They are synthetic because the default on any of the underlying mortgages is secured by the investor’s principal and coupon payments. In essence, the coupons investors receive are premiums that Fannie and Freddie pay investors for the provision of credit default swaps (the product is similar to a ‘synthetic CDO’). Investors can gain up to 8% yield on this debt, before risk adjustment.
Some banks now offer bespoke tranching, where clients select the desired risk level and have a portfolio of underlying assets created around their needs, as opposed to buying traditional pre-made asset-backed securities. Some banks even offer online customisation and purchase of structured notes by brokers for their clients.
Application In Aviation
Securitisation in aviation started in the 90s, typically based on securitising the cash flows from aircraft or engine leasing. It is a growing industry which helps the aviation sector by providing it with the financing it requires. Aircraft leasing allows cheaper testing and changing of routes and strategies, as aircraft purchases are incredibly expensive and can pose a solvency risk.
The airline industry is volatile: Delta and American Airlines filed for bankruptcy in 2005 and 2011, respectively. This year, the chief of British Airways, Willie Walsh, stated parent company IAG may look to leasing 777s and A380s in an effort to lower costs. Also this year, Emirates gained four leased A380s from an Investec subsidiary. For airlines to remain competitive and keep up with the air traffic demand of the future, securitisation could prove integral.