In this essay, I will write a reflection on the topic of asset-backed

securitization in week 7 that I have learnt from the Financial Market

Institutions course of teacher Lee Edward

IN THE CLASS

To begin with, in summary of what I have learnt through this lecture,

securitization is when banks underwrite contracts and sell them to other
investors. I understand that the process is more complicated than this but to
simplify, bank have 3 steps to securitize a loan. A bank making loans or a
corporation extending credit to customers creates a pool of debt-based assets.
Then, the pool of assets is sold to a separate legal entity, referred to as a
special purpose entity. Finally, the SPE issues fixed-income securities
supported by the cash flow from the collateral. As a result, securitization of
bank assets created new financial markets structures where the risk was
“wrapped” into tranchés for investors with varying types of risk appetite.
These ABSs are purchased by investors, such as pension funds or fixed-
income funds, that deem the risk/reward of the underlying collateral to be
attractive. All in all, Securitization connects the owners of capital with those
that require capital and removes the originating bank or corporation from the
intermediation process. This allows the bank to allocate more funds to
profitable activities such as lending or other investments, which improve
liquidity. Banks can use securitization to sell illiquid loan portfolios, thereby
operating more efficiently from a risk/return perspective.

On the other hand, for the investor, they can invest in securities
matching their preference and diversify their portfolios. Through
securitization, investors can access the collateral pool without having the
specialized resources and expertise necessary to provide loan origination and
loan servicing functions. Additionally, ABSs are liquid securities that can be
sold to other investors more easily than the underlying collateral. In
conclusion, I think that this is a win-win situation for both parties to invest
and liquidate their assets.

EXAMPLE

I will illustrate the basic structure of a securitization transaction with

this simplified, fictitious example of Fred Motor Company. Fred Motor
Company (Fred) sells most of its cars on retail sales installment contracts (i.e.,
auto loans). The customers buy the automobiles, and Fred loans the customers
the money for the purchase (i.e., Fred originates the loans) secured on the
autos and receives principal and interest payments on the loans until they
mature. Fred is also the servicer of the loans (i.e., collects principal and
interest payments, sends out delinquency notices, and repossesses and
disposes of autos if customers do not make timely payments) through a
subsidiary established by Fred to perform financial services. Fred has 50,000
auto loans totaling $1 billion that it would like to remove from its balance
sheet and use the proceeds to make more auto loans. It accomplishes this by
selling the loan portfolio to an SPE called Auto Loan Trust for $1 billion
(Fred is called the seller or depositor). The SPE, which is set up for the
specific purpose of buying these auto loans and selling ABSs, is referred to as
the trust or the issuer. The SPE then sells ABSs to investors. The loan
portfolio is the collateral supporting the ABS because the cash flows from the
loans are the source of the funds to make the promised payments to ABS
investors. An SPE is sometimes also called a special purpose company or
special purpose vehicle (SPV). The SPE is a separate legal entity from Fred.

AFTER THE CLASS

After this class, I totally understood the basic concept that the teacher
wants to convey about the concept of financial engineering in pooled
investments, the securitization and financial products, also how risks are
shifted and the role of regulators. But based on what I've learned, there are
many questions that still need to be answered.

RELATIVITY OF KNOWLEDGE

There are a lot of types of securitizations, based on their underlying

assets, in general we have RMBS, CMBS, Solar ABS, CMO, CLO, CBO,
synthetic CDO, each have their own different risks and terms of contract
based on their issuers’ credit worthiness, assets. To protect its investor,
internal credit enhancement can be applied in the contract like
overcollateralization, excess spread or subordination. To evaluate the value of
this bond, instead of using discounted cash flow to value their NPV, we can
use its yield and yield spread to measure by using duration, convexity, matrix
pricing. We can also use quantitative and qualitative factors to evaluate
business models like Porter’s 5 forces, CAPM pricing, macro, micro and
hybrid approach.
 If that is so, then where is the risk of this type of securitization? By
pooling various loans, the risk associated with individual loans is reduced.
Securitized products are often divided into tranches, each with different risk
and return profiles. Senior tranches have priority in receiving payments and
carry lower risk, while junior tranches absorb losses first and offer higher
returns. It often involves creating SPVs to hold the underlying assets. This
isolates risk from the originating institution, protecting it from potential losses
related to the securitized assets. Investors are exposed to a diversified
portfolio, which mitigates the impact of any single default. Through these
mechanisms, securitization effectively redistributes risk among various
stakeholders, including banks, investors, and insurance companies, allowing
for more efficient capital allocation in the financial system. However, it can
also lead to complexities and systemic risks if not managed properly, as seen
in the financial crisis of 2008. The main risk of this type of investment I think
is credit risk and prepayment risk. The risks to investors in ABSs are twofold,
the cash flows from the collateral to the ABS investors are uncertain and can
vary in timing and size. The credit risk of the collateral is passed through to
investors in the ABS. Systemic buildup of credit risk in ABSs can create risks
for the financial system. In addition to those backed by mortgages, there are
ABSs backed by various types of financial assets including business loans,
accounts receivable, or automobile loans. In fact, any asset that generates a
future stream of cash flows could be used as collateral for securitization. Each
of these types of ABS has different risk characteristics, and their structures
vary to some extent as well. Based on what I have learned and know,
investments like this create liquidity and help the market operate more
efficiently, but at the same time, its risks are highly contagious and when
problems occur, it can involve many financial institutions as well as
individuals.
 Through this lecture, I have revised a basic knowledge of asset-backed
securitization but still cannot dive deep into this topic. There are more
questions to cover, like how many types of ABS are there, what is the
difference, what is their factor to determine tranche, interest rates for the
bond, is there a specific process to prevent a crisis from happening and to
standardize and legalize the investment process to fully understand this type
of investment. One session seems not enough, but for a good topic like this,
for me, this lecture is not effective in fully conveying the essence of this type
of investment