Securitisation is a type of structured finance that has been overcomplicated in the market. The most important element is receivables flowing from pools of economic assets. An example of these underlying products may be bonds or mortgages.
What is a ‘pool’ in terms of securitisation and how are they determined?
A pool is a specific type of economic asset, such as a sub-prime mortgage, or a particular bond, which are grouped together to form a ‘pool’. Pools can be securitised, i.e., bundled up and sold as bonds to sophisticated investors or institutions, perhaps aiming to yield returns.
How are pools categorised?
Pools are tranched (or categorised) depending on the different levels of risk, which are set against different asset pools.
The aim of this type of structured finance is the repackaging of risks with the intention of creating safer asset pools that will pay a lower yield and riskier pools; advancing higher interest levels.
It is very important to understand what is at the core of a structured product. As was seen in the downfall at the 2007 crises, many of the securities were actually a lot riskier than once thought or advertised. When risk is packaged up into perceived safety, it can lead to many problems.
Opining on the securities is the role of the ratings agencies. The default risks on these securities and pricing should be correlated, but this is not always the case.
An example of these types of financial instruments is collateralized debt obligations (CDOs) and a financial structure of this type means that discrepancies or problems can be overlooked or are not automatically obvious in the underlying pool.
Small imprecisions can mean large default risk and incorrect pricing of instruments. The products and their locations underlying the instruments are also difficult to find or pin point. Therefore it is important for one to understand what the underlying fundamentals are when compared to corporate bonds.
The main ratings agencies are Standard and Poor’s, Moody’s and Fitch.
The creditworthiness of a product is distinguished by having a rating scale, which may be anything from AAA, AA, A, BBB etc. In America (2007); there were 37,000 top rated structured finance issues in the U.S. With the increase in issues, there was a loosening of criteria and pricing in some areas and this was widely seen as a reason for the financial downfall. An example of the potential problems was the mortgage crises around this time; where CDO’s were used to create securities that were rated at AAA. However, the underlying asset may not have been triple AAA rated. This meant that economic issues and unexpected defaults not previously priced in had a big impact.
The tranched system should be clear, that if a bucket is likely to default and it is high risk then similar rated securities will default at the same time. This will pay a higher coupon to an investor. As the pools are lower down the risk curve, they will pay a lower level of coupon or interest.