Securitization and Securitization of Assets

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Description

Securitization is the financial process of pooling various types of contractual debt such as mortgages, car loans, or credit card debt obligations and selling their related cash flows to third-party investors as securities. These securities are known as Asset-Backed Securities (ABS). It allows financial institutions to remove these assets from their balance sheet, enhance liquidity, and manage risk better.

Key Features of Securitization

• Conversion of illiquid assets into liquid, tradable securities
• Improves liquidity and capital adequacy for originators
• Investors receive predictable cash flows from pooled assets
• Involves a Special Purpose Vehicle (SPV) or entity to handle asset transfer
• Reduces credit risk for financial institutions

5 Mathematical Examples

1. Example 1:
   A bank securitizes home loans worth ₹100 crore with expected interest inflows of ₹12 crore annually. What is the annual return for investors if the SPV issues securities worth ₹90 crore?
   Solution: Return = ₹12 crore / ₹90 crore = 13.33%
2. Example 2:
   If the SPV pays ₹2 crore annually in fees and costs from a ₹10 crore cash flow, how much net is available to distribute?
   Solution: ₹10 crore - ₹2 crore = ₹8 crore
3. Example 3:
   A pool of car loans totaling ₹50 crore generates monthly EMI payments of ₹1 crore. How long will it take to fully repay the principal through securitization cash flows?
   Solution: ₹50 crore / ₹1 crore = 50 months
4. Example 4:
   Securities worth ₹80 crore are backed by loans of ₹100 crore. What is the over-collateralization ratio?
   Solution: ₹100 crore / ₹80 crore = 1.25 or 125%
5. Example 5:
   Suppose investors demand a return of 10% on a securitized product. If the cash flow from assets is ₹11 crore annually, what is the maximum value of securities that can be issued?
   Solution: ₹11 crore / 10% = ₹110 crore

10 Multiple Choice Questions (MCQs)

1. What does securitization primarily involve?
   a) Issuing new equity shares
   b) Pooling and selling financial assets
   c) Merging with other financial institutions
   d) Creating credit derivatives
   Answer: b
2. Which entity is created to manage the securitized assets?
   a) RBI
   b) Clearing Corporation
   c) Special Purpose Vehicle (SPV)
   d) Asset Management Company
   Answer: c
3. Securitized instruments backed by mortgages are known as:
   a) Treasury Bills
   b) Mortgage-Backed Securities (MBS)
   c) Commercial Papers
   d) Debentures
   Answer: b
4. Which of the following is a benefit to the originator in securitization?
   a) Lower risk-weighted assets
   b) Higher cash reserve ratio
   c) Fixed returns
   d) Increased asset base
   Answer: a
5. Over-collateralization in securitization provides:
   a) Higher interest payments
   b) Additional risk
   c) Credit enhancement
   d) Regulatory burden
   Answer: c
6. Which risk is transferred to the investors in securitization?
   a) Market risk
   b) Operational risk
   c) Credit risk
   d) Political risk
   Answer: c
7. The originator of a securitized asset is:
   a) The investor
   b) The government
   c) The entity that creates the SPV
   d) The institution that owns the original assets
   Answer: d
8. Which financial instrument is commonly used in securitization?
   a) Bond
   b) Share
   c) Asset-Backed Security (ABS)
   d) Option
   Answer: c
9. Which of these is a drawback of securitization?
   a) Enhances liquidity
   b) Regulatory complexity
   c) Risk diversification
   d) Credit rating benefit
   Answer: b
10. Tranching in securitization refers to:
    a) Loan repayment structure
    b) Risk-based segmentation of securities
    c) Dividend distribution
    d) Taxation of ABS
    Answer: b