A hypothetical financial institution, BCG Bank, decides to raise a $100 million loan by securitizing loans rather than issuing corporate bonds. The company sets up a legal entity, Loan Trust, to which it sells the loans. Such legal entity is called a special purpose entity (SPE) or special purpose vehicle (SPV).
The ultimate owner of the loan, Loan Trust, is considered bankruptcy-free from the seller of the loans. The loans backed by asset-backed securities are accepted to be safe within the SPE, and creditors of the BCG don’t have any claims on these assets.
BCG sells $100 million of loans and receives $100 million in cash. In turn, Loans Trust issues and sells securities that are backed securitized loans (represents collateral) and receives cash. Periodic cash payments that are received from the collateral, for instance, monthly mortgage payments made by borrowers, are used to make periodic cash payments to security holders, i.e. the investors who bought the asset-based securities. These investors are often large pension funds.
Parties Involved in the Securitization Process
In our example, the money flows in the following manner:
- Individual borrowers contract loans with BCG Bank.
- BCG Bank, the originator, then sells these assets to the SPV, Loans Trust. This reduces BCG Bank’s liabilities portion of its balance sheet.
- Investors such as mutual funds invest in the SPV in exchange for promised monthly mortgage payments.
Some other parties are also involved in the securitization process: independent accountants, lawyers, trustees, underwriters, rating agencies, financial guarantors, liquidity support, etc.
A significant amount of legal documentation is required to create a special purpose entity. The purchase agreement is signed by the seller of the collateral and the SPE. Another important legal document is the prospectus which describes the structure of a securitization such as the priority of payments to be made to parties.
Which of the following parties is likely to be referred to as the originator in the securitization process?
A. Grand American Bank
B. Jim Blank, an individual mortgage borrower
C. Rogers Mutual Fund
The correct answer is A.
The originator of the loan is usually a financial institution providing mortgage loans to individual borrowers. However, it is important to note that the securitization process does not always have to based on mortgage loans.
Reading 53 LOS 53b:
Describe securitization, including the parties involved in the process and the roles they play