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Account for why securitization is undertaken and what it offers.

FRM® Part II · Credit Risk Measurement and Management · An Introduction to Securitisation · FRM2.CR.23.d

The idea

Originators securitize to turn illiquid loans into cash, diversify funding away from deposits or unsecured debt, and in some cases obtain regulatory capital relief or lower funding costs, because senior tranches are rated more highly than the originator itself. It can also free balance sheet capacity for new lending and earn servicing fees. Investors gain access to diversified pools of loans they could not originate, with tranches that offer a chosen risk and return through seniority. Benefits depend on genuine risk transfer. If the originator keeps the first-loss piece or offers implicit support, most of the expected loss stays with it and capital relief should be limited. Adverse selection is the standard concern, since an originator knows its loans better than investors do. That is why retained risk and disclosure matter. Securitization moves and reshapes risk. It does not make it disappear.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a principal benefit of securitization to an originating bank?

  1. It eliminates all credit risk, even where the bank retains the first-loss trancheWhy not: Retained first-loss exposure keeps most of the pool's expected loss with the bank.
  2. It automatically lowers the interest rate that each borrower in the pool paysWhy not: Borrower rates are set at origination; securitization changes the bank's funding, not the borrower's rate.
  3. It removes any need for the bank to monitor or underwrite its borrowersWhy not: Underwriting quality still matters, as investors and rating agencies scrutinize it and the bank usually retains exposure or reputation risk.
  4. It converts illiquid loans into cash, diversifying funding and possibly providing regulatory capital relief - correct

Securitization gives liquidity and funding diversity and, if risk is genuinely transferred, capital relief. It does not remove credit risk that the bank retains.

A harder one

A bank sells USD 600 million of loans with a risk weight of 100% into a securitization. It retains a USD 20 million equity tranche that is deducted in full from capital. Required capital is 10% of risk-weighted assets. Ignoring other effects, the net capital freed is closest to:

  1. USD 60 millionWhy not: Counts the capital released on the sold loans but ignores the deduction for the retained equity tranche.
  2. USD 40 million - correct
  3. USD 80 millionWhy not: Adds the retained tranche to the capital released instead of subtracting it.
  4. USD 20 millionWhy not: Counts only the retained tranche and ignores the capital released on the sold loans.

Capital released = 600 x 100% x 10% = 60. Deducting the retained equity tranche of 20 gives net capital freed of 40 million.

The hardest tier

A securitization holds USD 100 million of loans with a weighted average coupon of 7.0%. The notes are USD 85 million of senior at 4.5%, USD 10 million of mezzanine at 6.5% and a USD 5 million equity piece that receives the residual. The servicing fee is 0.5% of the pool. Assuming no losses, the annual return on the equity piece is closest to:

  1. 50.5%Why not: Omits the servicing fee of 0.5 million, which is paid ahead of equity.
  2. 44.5%Why not: Applies the senior coupon of 4.5% to the mezzanine tranche as well.
  3. 2.0%Why not: Expresses the residual of about 2.0 million as a percentage of the pool of 100 rather than of the equity piece of 5.
  4. 40.5% - correct

Interest 7.0 - senior 3.825 - mezzanine 0.65 - servicing 0.5 = 2.025 million. Divided by the equity of 5 million this is 40.5%, which shows how leverage amplifies the equity return.

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