Securitization and Its effect on Auto Loans

This article is made to have some specific discussion about securitization for a financial institution which is specialized on auto loans.  Now we need to get answer about some specific questions relating to this issue. Those are-

·         Importance of securitization?

Securitization is a financial process where an entity having large amount of receivable from a valid source sale a pool of such receivable to a special purpose entity who issue securities against such pool of assets. At the maturity of the security cash flow from receivable directly flow to the investor of the security.

Now as we know the process of securitization, we need to analyze the probable benefits from this process.

Ø  Liquidity benefit- The entity creates receivable known as originator (in this case the financial institution issuing auto loans) does not need to wait until it receive payments from receivables (auto loans) for flow of funds to the business. Because funds flow from sale of pool of receivables (pool of auto loans). These funds can be used by the company for generating more receivables. Hence this process provides liquidity.

Ø  Better Representations of financial status- The process of securitizations managed to offset receivables by cash in the balance sheet. So it provides a better look of the financial situation to attract more investors.

Ø  Benefits of the interest spread – Auto loans are amortizing assets. Therefore a payment of auto loans normally includes interest and principle. Now the security issued in securitization process normally carry a lower interest rate than that of the auto loans. Hence, originator gets the benefits of this interest rate spread.

Ø  Asset-Liability Management- Some financial institutions are not in position to raise long term international borrowings due to various limitations including the size of the institution. Securitization helps in improving the rating for particular deal much above the institution’s. This rating enables institution to raise funds for a longer period. Hence this facilitate in matching the tenure of the liabilities and assets.

Analyzing the above benefits we can say that the competitor company has followed securitization in order to achieve liquidity which is one of the most important concerns for a financial institution. Additionally this spread the ownership of risk associated with recovery of auto loan.

·         What are the potential benefits of securitizations to Issuer, Investors and Borrowers?

Issuer: - Issuer is a special purpose entity (SPE) usually created pursuant to a trust agreement between originator and the entity. Securitization provides several benefits to an issuer such as-

Ø  Most securitization process is to structure the transactions that will result in “off-balance-sheet” treatment for the existing assets. If securitization is a sale, cash from sale will be added to the assets and the sold assets will be taken out of balance sheet.  This will provide a better leveraged position as compared to issue of any other security. 

Ø  As security issued in securitization is secured against a pool of assets, it is more secure as compared to other security. Hence this provides an oppournity of improved rating.

Ø  As security issued in securitization is more secured as compared to other securities, it normally attract more investors, hence coupon   rate of this security is relatively less than other. So, it is a low in cost also.

Investors buying ABS: - The main participants in the ABS are institutional investor. Main benefits of investing in ABS are-

Ø  Diversification of funds – Diversification of funds is the most intended by an investor because it reduces risks. As ABS is backed by a pool of assets, it provides investor a chance to invest in diversified portfolio.

Ø   Safety – As return from ABS is backed up the cash flow from a pool of assets, it is more secured as compared to other security. Hence it is relatively safe for the investor.

Further benefit of investing in ABS backed up by auto loan is that it provides an oppournity of monthly redemption as it is backed up by monthly payment of auto loan interest and principle. Hence, it can perform the function of a mutual fund also. 

Borrowers: - Securitizations provides borrowers a better access to the market. Following are major benefits of it for the borrowers-

Ø  Reduction in interest rates- Rate of interest gets high because of risk. Securitization spread out ownership risks associated with the loan. Therefore there is a high chance of reduction in interest rate of the loan.

Ø  Reduction in borrower’s principle – Securitization provides a way to flow of funds. Hence it provides liquidity which could give chance for borrower for reduction in principle.

Impact of ABS to the Auto Loan market-

Auto loan origination is categorized as being direct and indirect. In the direct lending channel customer goes to lender directly for an auto loan, whereas indirect channel involves dealers as intermediary. Loans are given based on borrower’s credit quality. Credit quality can be of mainly of three types. Those are prime, non-prime, and subprime. This categorization has been done based on credit ability of the borrower. ABS is the process of issuing of security by backing up of this auto loans. The major impact of ABS on this market are-

Ø  ABS provides liquidity to the market as fund stars flow easily. This provides a chance for the lenders to issue loan at a lower interest rate which provide chance to a less credit quality borrower to borrow funds. However, if it is not monitored properly it could lead to a disaster situation. Because increase in poor quality borrower will increase the risk of defaulter and if defaulter amount of loan increases more than a certain proportion, it could lead to break down of the entire system and market in turn. Latest example of this could be Lehman brothers break down which lead to economic recession. Hence, one should consider its risk appetite for issuing loans to non-prime and subprime borrowers.

The graph above illustrate subprime of auto ABS by vintage year based cumulative net losses. Although relatively stable, graph shows that there is some variability in loan performance for subprime ABS over last 12 years. Not unexpectedly there is some deterioration in the performance in between 2006 to 2008, a typical recession period.

   

Ø  The use of capital can be optimized by reconfiguring portfolios to satisfy risk weighted capital adequacy norms better.

Ø   Securitization directly rewards better credit quality by reducing cost of credit enhancement and cost of funds. This serves as an incentive to the institution to improve the quality of loan generation.

Ø  The rate of asset turnover in the economy increases. For example, HFCs with excellent asset origination skills may have an insufficient balance sheet size to absorb the entire risk but can securitize loans in excess of what they feel comfortable with.

Ø  The debt market as a whole attained greater depth. This fact has been borne out by the experience in other countries. The capital markets can participate more directly in infrastructure.