Investors buy these bonds and receive income through payments derived from underlying assets (such as loan payments).

Thus, refinancing of assets occurs through the securities market: the originator (bank) receives money in advance, and investors receive regular payments in the future.

For banks, securitization is an attractive tool: selling a loan portfolio to a special company allows you to quickly return funds, improve liquidity and extend lending at the expense of the received refinancing. This separation of assets also makes it easier to comply with capital adequacy standards — the bank removes assets from its balance sheet and can increase the volume of new loans.

For investors, securitized securities are interesting because they are backed by a pool of real assets and often have additional protection. In particular, investors are protected from bankruptcy of the originator: the loans transferred to the pool are isolated from possible problems of the bank and are not affected by the credit rating or restrictions of the bank itself.

Structure of the securitization process

Classical securitization involves the participation of several parties and takes place in several stages.

The originator (primary lender, such as a bank) generates financial assets — provides loans to borrowers or forms monetary claim rights for other assets.

These assets are then transferred to a specially created structure — a Special Purpose Vehicle (SPV), which buys out the pool of assets and issues securities backed by them.

Investors buy these securities and subsequently receive payments coming from the underlying pool of assets.

Four key steps

First, the bank issues a loan to the borrower and receives the right of claim.

The bank (originator) sells or transfers these credit assets to a special purpose company (SPV).

The SPV issues asset-backed securities (bonds) and places them among investors.

Borrowers continue to repay loans, and the SPV redistributes these payments to investors to pay interest and repay bonds.

Trenching and Stratification

To meet the different needs of investors, the issuance of securities is often divided into several classes - tranches.

A conventional structure has at least two tranches — senior and junior (subordinated). This distribution is called stratification: different tranches have different levels of risk and profitability.

For example, investors in the older tranche receive payments first and have a lower risk, therefore their returns are lower; the younger tranche takes the first losses from possible defaults, receives payments last, but offers a higher interest rate.

Tranche subordination can increase the reliability of senior securities — losses on the asset pool are first covered by younger tranches.

Credit enhancement

An important part of the structure is the mechanisms for improving the credit quality of the issue. There are internal and external ways of credit enhancement.

Internal mechanisms

Internal mechanisms are provided by the most structured pool - these are, for example, the presence of subordinated tranches, excess collateral (issuance of bonds in an amount less than the value of the assets in the pool) or reserve accounts: such measures create a “financial cushion” so that, even in the event of partial default by borrowers, senior investors tranches got their money.

External mechanisms

External mechanisms involve third parties — for example, insurance or payment guarantees. Specialized companies (monoline insurers, guarantee funds) assume the risk of defaults for a fee, which may allow to assign a higher credit rating to securities.

As a result, the combination of internal and external reliability enhancement methods makes securitised bonds attractive to a wide range of investors — from conservative funds (which buy older tranches with minimal risk) to riskier investors (who are willing to invest in younger tranches with higher yields).

Risks of securitization

Despite the advantages, securitization generates a whole series of risks that must be taken into account.

Credit risk

This is the basic risk of non-payment of debt by borrowers. Investors of securitized bonds depend on the quality of the asset pool: if a significant part of the borrowers do not repay the loans (default), losses will occur.

Credit risk in securitization includes not only the possibility of default risk, but also related aspects — the risk of late payments and the risk of reinvestment.

Prepayment risk (early repayment risk)

Many types of securitized assets, especially mortgages, allow borrowers to repay debts early.

For investors, this creates uncertainty about the timing and amount of payments. If borrowers massively refinance loans or are ahead of schedule, the bonds will be extinguished ahead of schedule.

Reputational risk

In the event of a failed securitization transaction, the originator bank may suffer serious image losses. Reputational losses have long-term consequences: confidence in a financial institution decreases, it becomes more difficult to raise capital in the future.

US Example: Mortgage Securitization and the 2008 Crisis

One of the most famous examples of securitization (and at the same time its risks) was the massive securitization of mortgages in the United States on the eve of the global financial crisis of 2007—2008.

Moreover, the tranches of mortgage bonds formed complex derivatives — CDOs (secured debt obligations), which were also sold to investors. Credit rating agencies have assigned high ratings (AAA) to many of these securities, assuring that they are reliable, despite the questionable quality of the mortgage pool.

In fact, the ratings did not take into account the worst case scenario (the simultaneous fall in housing prices and the solvency of borrowers) and therefore misled investors about the real reliability of the instrument.

The consequences were dramatic: several leading US banks could not withstand the shock. In particular, the investment bank Lehman Brothers declared the largest bankruptcy in the history of the United States.

The Role of Rating Agencies and Conflict of Interest

Rating agencies play a key role in securitization schemes, because they assess the credit risk of issued securities.

Ideally, their role is an impartial, objective assessment of the reliability of each tranche, giving investors a benchmark. Thanks to ratings, institutional investors can determine whether a given paper meets their risk requirements.

Therefore, the issuer's motivation is to get the highest possible rating for their securities.

Our agency's approach to risk assessment

As a rating agency, we pay special attention to the objective assessment of the risks of securitization instruments.

In its rating conclusions, our agency takes into account the quality of each component of the transaction: the creditworthiness of the borrowers, the structure of the tranches, the available credit enhancement mechanisms, the experience and reliability of the service agent, the legal conditions and other factors.

We adhere to the principle of independence and transparency — our analysts use internationally recognized techniques and model scenarios (including stress testing of collateral defaults or mass defaults) to test the sustainability of the asset pool.

Given the lessons of history, we avoid conflicts of interest: the process of assigning a rating is separate from any consulting services, and our remuneration is independent of the rating.

Our goal is to provide investors with an honest and thorough assessment of risks, thereby fostering confidence in Ukraine's new securitization market and laying the foundation for its sustainable development.

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