Securitisation: Comprehensive Study Notes
Definition and purpose of securitisation
Securitisation creates new securities (ABS) whose income comes from a pool of existing assets that are not themselves securities (typically loans).
The new instrument (ABS) is tradable in organised secondary markets, while the underlying assets (reference portfolio) are not securities and may be illiquid on an individual basis.
Concept of security: a financial instrument tradable in a secondary market; securities are typically issued in large quantities with identical terms (issuer, maturity, interest, payment frequency) enabling secondary trading.
Loans differ: they are tailored to a borrower, are not traded in a broad secondary market, and are usually sold bilaterally rather than via a market.
Securitisation links income from a non‑security asset pool to the new security through a Special Purpose Vehicle (SPV).
SPV isolates the reference portfolio from the originator’s balance sheet, becoming the issuer of the ABS and holder of the income stream.
ABS = asset-backed securities; ABS is used as a general term in the chapter, though media sometimes use ABS to refer to a subcategory (RMBS, CMBS).
The original assets still exist; they are relocated to the SPV to provide the income stream for the ABS.
Benefits: (i) provides an instrument and market access for investments in assets that investors could not directly invest in (e.g., loans); (ii) helps originators sell assets and manage liquidity even where secondary markets for loans are weak.
Subprime crisis impact: securitisation was blamed for the 2007–2008 crisis and its reputation suffered, but securitisation remains a useful mechanism in the financial system.
Australia context: dominant securitisation is residential mortgage loans via long-term bonds issued domestically; RMBS represent about AUD 0.130 billion of AUD 0.162 billion total asset-backed securities (as of March 2022); the long-term bonds account for about AUD 0.150 billion of the total AUD 0.162 billion. Post‑GFC, levels recovered but did not return to 2007 highs (~AUD 0.270 billion).
Other players: ABS on issue come from assets issued by ADIs and non‑ADIs with roughly equal shares.
Structure of the chapter: (1) The process of securitisation; (2) The benefits; (3) The dangers.
The process of securitisation: core concepts
Originator identifies a pool of assets to securitise (often non‑bank lenders like finance companies). It approaches a trustee to create a Special Purpose Vehicle (SPV).
SPV is a separate legal entity, insolvency‑remote from the originator, with its own balance sheet; the trustee in charge of the SPV must not be related to the originator (not a subsidiary).
The securitised pool becomes the SPV’s assets (the reference portfolio/receivables) and the SPV issues asset-backed securities (ABS) as liabilities.
The income from the reference portfolio funds the coupons/principal on the ABS; the ABS are traded in organised secondary markets, while the reference portfolio remains in the SPV.
The term “asset‑backed securities” emphasizes that the ABS’ income comes from the reference portfolio; the SPV’s balance sheet shows both the ABS liabilities and the reference portfolio assets.
Visual/flow interpretation: ABS are represented by a circle in flow‑of‑fund diagrams; reference pool assets do not exhibit a circle because they existed prior to securitisation and are transferred to the SPV.
The flow of funds: investors buy ABS, providing funds to the SPV to purchase the reference portfolio from the originator; the reference portfolio then generates income (interest, royalties, lease payments, etc.) that pays the coupons and principal on the ABS.
Servicing arrangements: borrowers typically pay the SPV (or the originator on behalf of the SPV); servicing fees compensate the originator for administering the loans.
Practical timing: to simplify, the ABS can be issued before the SPV purchases the reference portfolio; the SPV then uses the ABS proceeds to buy the reference pool. In real life, structures may vary (e.g., lines of credit that the SPV can draw on to acquire the pool, repaid later).
Example income paths: interest from loans funds coupons on ABS; other asset types could provide the income (e.g., lessee payments for car leases or royalties for IP-backed securitisations).
In rare cases, securitised assets themselves are already securities (e.g., bonds); the coupons of the original bonds become the income for the SPV’s ABS.
The SPV balance sheet and common misunderstandings
The SPV balance sheet contains two sides: assets (reference portfolio) and liabilities (ABS).
Important correction: the reference portfolio and the ABS are not the same instrument; the reference portfolio is the underlying asset pool, while the ABS are the issued securities backed by that pool.
Common internet myths: some sources wrongly treat the reference portfolio and ABS as one instrument or misname tranches; the SPV holds the assets and issues the ABS separately.
The two‑sided link: ABS provide the funds to purchase the reference portfolio; the reference portfolio income pays the ABS coupons.
In Australia, many spinoffs describe ABS issuance as a flow of funds between SPV and originator, with the SPV holding the reference assets and issuing the securities that investors buy with funds from the market.
1.1 The creation of securities backed by a reference portfolio
Flow: originator identifies assets → trustee appoints SPV → SPV acquires reference portfolio → SPV issues ABS → investors purchase ABS using funds supplied to SPV.
SPV is insolvent-remote from the originator; it is a standalone entity with its own balance sheet.
The reference portfolio is estopped from being re‑absorbed by the originator; once transferred, the assets remain with the SPV for the life of the ABS.
The SPV’s balance sheet shows both asset-backed securities (liabilities) and the reference portfolio (assets).
Servicing: borrowers may continue to pay the SPV (or the originator on behalf of the SPV) in exchange for servicing fees; the SPV may use servicing arrangements to collect income for the ABS.
Two‑sided accounting and the investors’ role: ABS investors provide the funds to purchase the reference portfolio; the SPV uses those funds to acquire the assets from the originator.
Funding and flow notes: Diagrammatic representations (Figure 2, Figure 3) illustrate the flow of funds and the SPV’s funding to purchase the reference portfolio.
1.2 Tranches of asset-backed securities
Early ABS were homogeneous with the same coupon and same priority; all investors were paid equally from the same pool.
Innovation: tranching ABS into multiple layers with different priorities and coupons (e.g., senior, mezzanine, junior). Some deals may have seven tranches.
Structure: all ABS within a tranche are identical, but tranches differ by coupon and seniority (subordination).
Waterfall mechanism: income from the reference portfolio is allocated first to the senior tranche, then to mezzanine, then to junior; this allocation occurs only if the reference portfolio provides sufficient income.
If default events occur, the waterfall ensures the senior tranche is paid first, with the junior tranche at higher risk and often higher coupon.
Ratings: credit rating agencies assess risk, design tranche sizes, and rate them; this adds complexity and fees.
Liquidity: ABS issued in Australia are typically traded over the counter through dealers; investors buy/sell to manage exposure.
Example concept: in a stressed scenario where income is insufficient to pay all promised coupons, the allocation follows the waterfall so that the senior tranche is prioritized, potentially leaving junior tranches under‑funded.
Practical implication: investors can choose tranche risk profiles (senior for lower risk, junior for higher risk and higher coupons).
1.3 Credit Enhancement
Credit enhancement reduces the effective credit risk to ABS investors relative to the reference portfolio risk through several mechanisms:
Internal (structural) mechanisms
Tranching itself: senior tranche generally receives higher credit ratings than the reference portfolio, providing implicit credit enhancement to senior investors; junior tranches carry higher risk.
Over‑collateralisation: the asset value in the reference portfolio exceeds the value of the ABS, creating a cushion and a potential equity buffer below the junior tranche.
Reserve fund: originator provides a reserve fund (deposits) to support coupon payments if asset income is shortfall; this protects investors in downturns.
External mechanisms
Mortgage insurance (for RMBS): SPV can obtain mortgage insurance to cover losses if property values fall; cost of insurance can enable lower coupon rates.
Guarantor arrangements: a guarantor (insurer or originator) may guarantee any shortfall in income to pay coupons or redeem principal; less common in Australia.
2 Benefits of securitisation
The chapter emphasizes that securitisation, despite negative associations with the subprime crisis, provides useful functions in the financial system and for the involved parties.
2.1 Benefits for the originator
Liquidity and balance sheet management: originators with loan portfolios without active secondary loan markets can securitize to remove assets from their balance sheet and access a broad market of ABS investors.
Selling loans and transferring credit risk: securitisation transfers credit risk from the originator to ABS investors; if the originator securitises, the loan pool is no longer on the originator’s balance sheet (the risk moves to the ABS investors).
For banks (regulated institutions): securitisation can decrease risk-weighted assets (RWA) because loans carry positive risk weights while central bank deposits have zero weight; swapping loans for deposits can reduce regulatory capital requirements. Note: this is a simplification of regulatory accounting and depends on regulatory framework.
Self‑securitisation note: some originators may securitize with the intent to hold the ABS themselves to preserve flexibility for future funding needs rather than reducing current risk.
Match‑funding benefit: securitisation can align the life of assets with the liabilities by converting illiquid assets into liquid funding that matches asset lifetimes; this can stabilize refinancing risk and support future lending.
Servicing revenue: originators often continue to service loans on behalf of the SPV and receive servicing fees, contributing to income and potentially boosting equity via profits.
Liquidity for next lending cycle: securitisation provides liquidity for new lending without issuing new liabilities directly on the originator’s balance sheet.
Relative cost of funding: ABS can be a cheaper funding source if the reference portfolio quality is high; however, this argument is nuanced because ABS is not recorded as a liability of the originator in the same way as new debt would be.
2.2 Benefits for ABS investors
Access to loan-level returns: investors gain exposure to loans without needing a lending license, enabling direct exposure to mortgage or SME loans through securitised instruments.
Subset of assets: ABS allows targeting exposure to specific loan pools (e.g., residential mortgages, SME loans) rather than the entire lender’s asset base, reducing cross‑asset risk.
Insolvency remoteness: if the originator experiences trouble, ABS investors are not necessarily affected because the SPV is financially independent and only the reference portfolio income supports the ABS.
Customizable risk profiles: investors can choose tranches that match their risk tolerance (senior = lower risk; junior = higher risk but higher coupon).
Liquidity and secondary markets: ABS provides a tradable instrument with a secondary market, enabling investors to exit easily if desired.
Typical buyers: managed funds, insurers, superannuation funds, and sometimes banks.
2.3 Benefits for the financial system
Risk dispersion: securitisation spreads credit risk across many investors rather than concentrating it in a single lender, potentially broadening funding availability for lending.
For non‑bank originators: securitisation can unlock funding that banks can obtain directly through deposits and other mechanisms; securitisation is particularly valuable for non‑bank lenders seeking diversified funding sources.
Caveat for banks: the funding dynamic for banks is different since loans create deposits; securitisation may not provide central bank deposits and does not function the same as traditional lending while reflecting regulatory mechanics.
3 Dangers of securitisation
The chapter frames three main concerns highlighted by the subprime crisis, with regulatory responses described.
3.1 Increased adverse selection and moral hazard
Originate-and-securitize model incentives: if originators do not bear credit risk (they securitize quickly and sell), they may lower underwriting standards to generate more loan volume, accepting higher default risk.
Adverse selection: lenders may lend to riskier borrowers to boost loan volume, since the risk is transferred away via securitisation.
Moral hazard: servicing fees do not depend on borrower performance (they earn servicing fees regardless of defaults), reducing incentives to monitor performance or to close defaulted loans.
Historical example: subprime crisis saw many lenders offering loans to low‑income or unstable‑income borrowers (NINJA loans – No Income, No Job, no Asset) and misrepresenting risk; defaults rose as teaser rates expired and house prices fell.
Regulatory response: to counter misalignment of incentives, regulators introduced “skin in the game” requirements, compelling originators to retain some exposure to ABS to align incentives with long‑term performance.
3.2 Challenging rating of the tranches
Complexity of tranches: rating agencies faced difficulty pricing multi‑tranche ABS; some AAA senior RMBS tranches defaulted, highlighting modeling and incentives issues.
Conflicts of interest: potential conflicts when rating agencies also provide advisory services to the same issuers; reforms require separation of rating teams and disclosure of methodologies to allow independent checks.
Contagion risk: if a default occurs, risk is spread across multiple investors; cross‑SPV securitisations can complicate the traceability of cash flows and risk attribution.
Traceability challenges: multiple securitisations feeding a reference portfolio can make it hard to trace origin of income and risk, complicating rating and risk management.
3.3 The SPV are not regulated
SPVs generally do not face the same capital requirements as banks; this creates regulatory and risk governance questions since SPVs hold loans and issue liabilities.
4 Conclusion
Securitisation remains a useful tool for the financial system, providing liquidity, risk transfer, and funding opportunities, but it carries notable dangers that require sound regulation and risk governance.
The Australian government has supported securitisation cycles during crises (GFC and COVID‑19) to maintain SME lending and competition among lenders:
GFC: Australian government via AOFM bought AAA‑rated ABS backed by SME loans to sustain liquidity (AUD 20 billion program).
COVID‑19: Structured Finance Support Fund (SFSF) with AUD 15 billion, where AOFM bought ABS backed by SME loans.
5 References (contextual, not exhaustive)
Australian Securitisation Journal (2011–2022) semi‑annual publication by Australian Securitisation Forum.
Goumenis, S. and Jinks, A. (2020) Structured finance and securitisation in Australia: overview from Clayton Utz for Thomson Reuters Practical Law.
6 Appendix: When the originator is a bank
Different configurations of SPV and investors’ banking relationships affect where central bank money flows during securitisation:
Case 1: SPV and ABS investors have accounts in a different bank from the originator; central bank money increases in the securitising bank when the SPV issues ABS, funded by investors paying for ABS; SPV’s transaction account decreases accordingly.
Case 2: SPV and ABS investors are both customers of the same bank; central bank deposits do not increase from securitisation; bank deposits on the liabilities side decrease (internal shifting among accounts).
Case 3: SPV is a customer of the securitising bank, but ABS investors are not; the sale of the pool reduces SPV’s deposits if SPV holds an account at the securitising bank; funds to the SPV involve central bank money transfers to the securitising bank.
Case 4: Mixed cases where some ABS investors are customers and others are not; effects on central bank money vary; in some scenarios, the net central bank money may increase, decrease, or remain unchanged.
Overall point: securitisation cannot be treated as a guaranteed or always available source of money for the originator; the money flow depends on the bank relationships and settlement configurations.
Key formulas and concepts to reinforce
Waterfall allocation (illustrative, generic):
Let CS, CM, C_J be the promised coupons for Senior, Mezzanine, and Junior tranches, and I be the total income from the reference portfolio available to pay coupons.
PaidS = \min(CS, I)
I1 = I - PaidS
PaidM = \min(CM, I_1)
I2 = I1 - Paid_M
PaidJ = \min(CJ, I_2)
If I >= CS + CM + C_J, all coupons are fully paid; otherwise, payments are allocated in order of priority (senior first, then mezzanine, then junior), with possible pro‑ration within each tranche if needed.
Credit enhancement mechanisms in brief:
Internal: over‑collateralisation, reserve funds, tranche structure (senior rating uplift for protection), junior risk premium.
External: mortgage insurance, guarantor arrangements.
Key players and terms:
SPV (Special Purpose Vehicle): insolvency‑remote entity owning the reference portfolio and issuing ABS.
Reference portfolio: pool of assets providing income to the SPV/ABS.
ABS: asset‑backed securities; the instrument issued by the SPV.
Servicing: ongoing management of the underlying loans; payable as servicing fees by the SPV to originator.
Important regulatory and governance notes:
Skin in the game requirements to align originator incentives with long‑term performance.
Rating agencies: separate rating processes and disclosure to mitigate conflicts of interest.
Real‑world relevance and implications
Securitisation supports non‑bank lenders by providing liquidity and access to capital markets; it also enables risk transfer and funding diversification for the lender.
The structure creates multiple layers of risk and reward (tranches) that must be understood by investors, regulators, and risk managers.
The Australian experience shows securitisation as a significant funding mechanism for residential mortgage lending and SME finance, with government interventions during crises to maintain liquidity and competition.
Ethical and practical implications include ensuring proper underwriting, maintaining incentives for supporting borrowers, and managing the systemic risk that can arise from routing large pools of securitised assets through multiple SPVs and cross‑SPV collateral chains.
Quick glossary (in place for quick revision)
ABS: Asset‑Backed Securities.
SPV: Special Purpose Vehicle, an insolvency‑remote entity that isolates the reference portfolio and issues ABS.
Reference portfolio: the pool of underlying assets (e.g., auto loans, residential mortgages) that generates income for the ABS.
Tranches: layered ABS with different seniority and coupon characteristics (e.g., Senior, Mezzanine, Junior).
Credit enhancement: mechanisms (internal/external) that improve the rating/credit quality of ABS relative to the reference portfolio.
Waterfall: the order in which income from the reference portfolio is allocated to ABS tranche payments.
Skin in the game: regulatory requirement for originators to retain some risk exposure to align incentives with long-term loan performance.
Notation reminders for exam prep
Distinguish between the asset pool (reference portfolio) and the issued securities (ABS).
Remember the role of the SPV as the issuer and the asset holder separate from the originator.
Be able to explain how a waterfall works and why senior tranches are protected at the expense of junior tranches.
Understand the difference between internal credit enhancement (e.g., over‑collateralisation, reserve funds, tranching) and external credit enhancement (e.g., insurance, guarantors).
Be able to discuss why securitisation is useful (liquidity, risk transfer, funding diversification) and what risks it introduces (adverse selection, mispricing, regulatory gaps, systemic risk when cross‑asset/ cross‑SPV structures appear).
Formula references for quick recall
Flow-of-funds relationships involve the SPV using ABS proceeds to acquire the reference portfolio, while the portfolio income funds the coupons of the ABS:
Income to ABS from reference portfolio: I
ABS coupon payments: CS, CM, C_J (Senior, Mezzanine, Junior)
Waterfall allocation (illustrative):
PaidS = \min(CS, I)
I1 = I - PaidS
PaidM = \min(CM, I_1)
I2 = I1 - Paid_M
PaidJ = \min(CJ, I_2)
Additional notes
The material includes several Australian‑specific statistics and regulatory discussions; be prepared to discuss how government interventions have supported securitisation during crises, and recognize the ongoing debates about the role of SPVs and servicers in risk management.