Securitization

A securitization begins when an originator or depositor sells a defined pool of loans to a special purpose entity, sometimes called an issuing trust or SPV. The transfer must qualify as a true sale, meaning the assets legally leave the originator's estate and cannot be clawed back by its creditors in insolvency. That legal isolation, together with restrictions on the entity taking on other business or debt, is what makes the vehicle bankruptcy remote.

The SPE funds the purchase by issuing bonds to investors. A servicer continues to collect payments from borrowers, pursue delinquencies and remit cash to the trust, earning a servicing fee off the top. A trustee enforces the documents on investors' behalf, and rating agencies assess the pool and structure. The originator may retain the servicing role and a residual interest, but the credit performance investors face is that of the pool, governed by the transaction documents rather than by ongoing corporate discretion.

Cash collected from the pool is distributed through a contractual payment waterfall. Interest and principal flow to the most senior bonds first, then downward; realised losses are allocated in the opposite direction, absorbed first by the equity or residual piece and then by the mezzanine tranches. This subordination is internal credit enhancement: the senior class can achieve a high rating even though the underlying loans individually could not.

Other internal supports include overcollateralization, the excess of collateral par value over bonds issued; excess spread, the pool's weighted average interest income less bond coupons, servicing and administrative fees; and cash reserve accounts. External enhancement, such as a third-party guarantee or insurance wrap, introduces counterparty risk and caps the rating at the guarantor's. Time tranching is separate from credit tranching: it reallocates the timing of principal, and therefore prepayment risk, among classes that may share identical credit standing.

Residential mortgage-backed securities dominate by size, split between agency paper carrying a guarantee against default and non-agency deals where investors bear credit risk directly. Commercial mortgage-backed securities pool income-producing property loans and typically feature call protection such as lockouts and defeasance, so prepayment behaves differently from residential collateral. Auto loan and equipment ABS amortize predictably over short horizons. Credit card ABS use a master trust with a revolving period during which principal collections buy new receivables, followed by a scheduled or early amortization triggered by deteriorating performance.

Collateralized debt obligations apply the same tranching logic to portfolios of bonds, loans or other securitized paper. Covered bonds are a useful contrast: the cover pool stays on the issuing bank's balance sheet and holders have dual recourse to both the bank and the collateral, which is why covered bonds generally price tighter than comparable securitizations.

Candidates should be able to name each party and state what it contributes, trace a payment through the waterfall, and explain why the senior tranche's rating can exceed the originator's own. Distinguish credit tranching, which reorders loss absorption, from time tranching, which reorders principal timing. Be ready to explain benefits on both sides: originators recycle capital and remove assets from the balance sheet, while investors gain access to loan exposures unavailable in direct form, with a menu of maturity and credit profiles created from one pool.

Understand the risks that survive the structure. Prepayment risk splits into contraction, when falling rates accelerate principal return, and extension, when rising rates slow it. Servicer quality, pool concentration and the reliability of the true sale all matter, and the crisis of 2007 to 2009 demonstrated that structural protection cannot offset systematically poor underwriting in the collateral itself.