A CASE ON SECURITIZATION

Assume Bank XYZ needs funds to grow and expand its business : $ 900 million.

How to finance the growth?

Assume, in currents environment Bank XYZ can issue debt at 6.0%. As a consequence of new debt the bank will increase investment in mortgages from $ 900 to $ 1800 at 10% interest rate. BUT, by doing so, the bank will be required by the regulator to increase its capital to comply with regulations about capital requirements. So, if Bank XYZ wants to grow and expand its business must take a debt at 8% and increase capital according to regulations. Cost of Equity is 15%.

How much additional capital is required?

Capital adequacy ratio (CAR) is defined as banks equity divided by risk weighted assets. Equity is adjusted to reflect capital according to regulations. So some items are previously deducted from Equity according to rules. Assume capital adequacy ratio must be equal or greater than 10%., and that the regulator establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 150% risk weighting, and all other types of assets have a 200% risk weighting.

Bank XYZ's CAR after new debt and investments is calculated as follows: Cash 100 x 0.0 = 0 Investment in mortgages 1800 x 1.5 = 2700 Risky Weighted Assets : 2700 Capital Adequacy Ratio (CAR): 200/2700 = 7.41% < 10%

FINANCIAL IMPACT OF SECURITIZATION

Now suppose that at 6 per cent, the present value of those mortgages is $ 925 million. Also, at 6 per cent there are institutional investors (pension plans, mutual funds, hedge funds, insurance companies, etc) . Cost of structuring the securitization is $ 5 million

Whats the financial impact of securitization on Bank XYZ