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Securitization is a method that encompasses the pooling and transferring of the ownership of assets that generate cash flow, such as loans or receivables, to a special legal entity. This entity then offers securities, which are underpinned by these assets, to investors. For instance, a bank that has issued multiple home loans can pool these loans together and sell them to a Special Purpose Entity (SPE). The collection of assets is termed as securitized assets, often known as the reference portfolio or collateral. This distinct legal structure then releases securities to investors, which are backed by the pooled assets. The resultant cash flows are employed to cover interest and return the principal to these investors. Securitization establishes a direct connection between investors and borrowers for various loan types and receivables, yielding advantages for issuers, investors, economic systems, and financial marketplaces.
Predominantly used by European banks, these involve designating a specific mortgage loan pool on the bank’s ledger, distinct from other assets. For instance, Deutsche Bank might release bonds supported by home loan pools. If there is a default, investors can leverage the collateral for repayment. These bonds do not fully qualify as securitizations since they remain on the bank’s balance sheet and payments come directly from the bank, not the loan pool’s cash flow.
These embody true securitizations. A distinct legal entity receives assets, removed from the original balance sheet, and issues securities supported by these assets. As an example, a bank might transfer auto loans to an entity which then issues securities to investors. Payments from the asset pool are proportionally distributed across various risk levels.
These securities aim to make payment patterns more consistent by channeling cash flows across predetermined tranches. They use tools like set payment schedules and tranching to cushion against unforeseen payment changes. Additionally, they might incorporate credit enhancements, such as reserve funds or overcollateralization, to further minimize risk.
MBS are ABS sustained by mortgage pools. They are distinct from ABS backed by non-mortgage assets. Tranching determines payment sequences and how losses are managed. For instance, an MBS by Freddie Mac might prioritize a senior tranche for payments and lastly for absorbing losses, while a junior tranche would be the opposite.
Question
Which of the following best describes the purpose of a Special Purpose Entity (SPE) in securitization?
- To offer loans directly to borrowers.
- To issue securities backed by pooled assets to investors.
- To act as an intermediary between banks and borrowers.
Solution
The correct answer is B.
A Special Purpose Entity (SPE) receives pooled assets and issues securities supported by these assets to investors.
A is incorrect: An SPE does not directly offer loans; it handles the pooled assets.
C is incorrect: The SPE does not act as an intermediary but as a distinct legal structure that holds the pooled assets.