Banks and other lending institutions have played a major part in the development of the society throughout the history. People who have excess money can deposit it in a bank for an interest return and the bank in turn lends the funds to individuals or businesses that need the money to finance expenses or business expansion. In short, banks have become the means of the free flow of funds in the economy that brings prosperity.
Decline in the economy decreases business activities resulting to income deterioration of businesses and individuals and increases unemployment rate. As a result, borrowers experience difficulties in meeting interest and principal repayments of their bank loans. Successive economic slowdowns build up non-performing loans in the bank books that create liquidity problems for the banks. Those banks that do not survive go out of business and most often acquired by bigger banks. This has resulted to the growth of mergers and acquisitions in recent years.
In conjunction with mergers and acquisition, banks have devised another way of getting rid of their non-performing loan assets in their balance sheet. This is through securitisation. A special purpose entity (SPE) or special purpose vehicle (SPV) is created by Banks (called the originator) whose sole purpose of existence is to buy the non-performing assets from the banks and issue tradeable securities to the public. An example of these securities is a mortgage-backed security (MBS) which is a security backed by mortgage loans. The return on these tradeable securities depends upon the cash flows coming from the loans backing these securities. SPVs normally issue the securities into smaller denominations and into tranches to make the investments more affordable to smaller investors and more liquid. The originator of the SPV normally issues a credit guarantee in cases there are defaults in the loans which results to a higher credit rating issued by rating agencies to the SPVs. The higher credit rating makes the securities an attractive investment.
The SPV maybe owned by anyone and may not be connected to the originator at all in legal form. However, it can be seen from the securitisation arrangement that the ultimate risks and rewards still remain with the originator because of the guarantee extended by the originator. The guarantee is a form of credit enhancements which makes the SPV’s financial position robust. A credit enhancement can also be in a form of a borrowing or credit line extended by the originator to the SPV.
Securitisation has solved the bank’s problem of clearing off their mounting loans receivables in their balance sheet by converting them into tradeable securities. However, it should be noted that the original pool of loans that have been securitised are still in the same form of loans. Any defaults of these loans are still the responsibility of the banks. In this way, do you think securitisation is just actually a form of window dressing the banks’ balance sheet?
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Yet another informative post. What are the other things banks can do to improve liquidity?
Absolutely.. I agree completely.
SPV’s and SIV’s (as they’re more commonly known in the US) are a perfect example of the inventiveness of modern banks. By using their superior financial knowledge they confuse and deceive the markets and increase their shareholders profits.
However, you say, just because you securitize something and break it up into tranches, that doesn’t necessarily improve it right? Who is going to invest in the lowest tranches, where the default and repayment risk is intensely concentrated. Wouldn’t these be a terrible investment and nearly worthless?
Of course not oh ye of little faith, this is big banks we are talking about!
Here is where things get really creative:
The newest financial product is to set up a SIV, then provide lower than market rate loans to allow people to invest in the products. Isn’t it perfect? Lending money to people to invest in your own bad loans. It creates a perfect circle with which to confuse everyone and make your senior executives and shareholders rich in the mean time!
It’s Off-off Balance Sheet!
The aim is to confuse everybody for long enough, that the market improves and you can cover these minor losses with huge profits generated from other legitimate money laundering enterprises, I mean well thought out strategies.
My conclusion is, these products seems to work pretty well, no ones been caught out so far, (except for some minor banks like Bear Stearns),so as long as my clients have investments in banks, I’m not complaining. (Just so long as they don’t invest in SIV’s themselves)
Hmmmm, could you please make it more comprehensible my laypeople like me?
The banks are tricking you laypeople and stealing your money.
Do you agree Mr 21?
The banks are just doing what they can do to perform their responsibility to the shareholders even though its already tricking the investors! It should be the regulators that should put a limit of what banks can and can do. Although recently most regulators have been doing their part to combat these abuses of banks through the implementation of BASEL 2.
(For lay people, BASEL is pronounced Baal in english)
(Also, Tranch rhymes with Launch)