Numerous investors are looking to reorganize their portfolios to guard against losses in light of rising interest rates and looming economic uncertainties. One way to do this is through securitised debt instruments (SDIs) like mortgage-backed securities and asset-backed securities. However, for the average investor, the terms used to describe these securities need to be clarified. So that you are familiar with the concept of securitized debt instruments (SDIs) and can make educated decisions regarding what to keep or sell from your portfolio, we will dissect some of the most common jargon and phrasal verbs associated with securitized debt in this article.
Securitization’s ABCs
The financial institution that plans and organizes the securitization deal is the arranger. The arranger oversees the creation of the special purpose vehicle (SPV) and puts together the various parties and assets.
- Securitisation Trust/Special Purpose Vehicles (SPV): A securitisation trust or special purpose vehicle (SPV) is a legal entity created by a company to carry out a specific financial transaction or activity. Because it is independent of the parent company, the SPV is protected from the dangers posed by its operations. Typical uses of an SPV include securitising assets like mortgage loans or bonds, isolating financial risk, and undertaking speculative investments.
- Borrower IRR: The internal rate of return (IRR) calculates the percentage return you would earn from investing. The anticipated cash inflows and outflows over the investment’s lifetime are taken into consideration when calculating IRR. The discount rate that renders those cash flows’ net present value null is known as the IRR. In other words, the return results in a breakeven investment. IRR helps you compare investment options.
- Collateral: Assets provided as a security for the repayment of the bonds issued by the SPV. This collateral can be drawn if the borrower cannot pay the interest and the principal. SDI investors are comforted even more by it.
- Pass-through Certificate (PTC): These securities, which are issued by the SPV, give investors ownership of the trust and enable them to gain exposure to the cashflows generated by the pooled assets. PTC holders receive principal and interest payments from the underlying loans.
- Listed, Rated, and Compliant: PTCs issued by the SPV are rated by a credit rating agency, listed on a stock exchange, and compliant with SEBI and RBI regulations to assure investors. The arranger ensures that these requirements are met in the deal.
- Non-performing Assets (NPAs): Loans in which the borrower has defaulted and missed payments are considered non-performing assets (NPAs). A loan is considered non-performing, according to RBI guidelines, if the principal, interest, and/or installment are not paid on time for more than 90 days. High levels of NPAs reduce the credit quality of the loan pool and must be weeded out by the arranger. After 90 days of non-payment, the loan is categorised as an NPA.
- Originator: The bank or financial institution that originates and owns the assets to be pooled and securitised. The originator transfers the assets to the SPV to get them off its balance sheet.
- Servicer: The entity that manages the loans in the securitised pool. This entails following up with borrowers, managing non-payments, and collecting payments. The servicer provides reports on the loan pool to the SPV and investors.
- Trustee: An independent third party that oversees the SPV to ensure all parties live up to their duties and obligations. Investors who purchase PTCs benefit most from the trustee’s actions. These trustees are registered with SEBI and provide additional security to the investor’s portfolio.A mortgage pool or pool of assets is a collection of mortgage loans that have been bundled together and sold as an investment. The mortgages within the pool are backed by residential or commercial real estate. Investors can purchase shares or securities in the mortgage pool and receive some interest payments on the underlying mortgages.
- Securitization: Financial engineering is used to turn an illiquid asset or group of assets into a security or negotiable financial instrument through securitization. Typically, the cash flows from the underlying assets are redirected to a special purpose vehicle (SPV) that issues securities sold to investors. By distributing the cash flows from the initial assets to security holders, the SPV serves as a servicer for the securities. The goal of securitization is to lower funding costs, increase asset liquidity, and make risk transferable and diversifiable.
