[1] Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing.
Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock.
Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.
The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.
This increases the likelihood that the investors will receive the cash flows to which they are entitled, and thus enables the securities to have a higher credit rating than the originator.
Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).
Each tranche has a different level of credit protection or risk exposure: there is generally a senior ("A") class of securities and one or more junior subordinated ("B", "C", etc.)
If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched.
But if the assets are income-based transactions such as rental deals one cannot categorise the revenue so easily between income and principal repayment.
In addition to subordination, credit may be enhanced through:[6] A servicer collects payments and monitors the assets that are the crux of the structured financial deal.
Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller.
[7][9] A controlled amortization structure can give investors a more predictable repayment schedule, even though the underlying assets may be nonamortising.
[7] Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.
[6] Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits).
Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.
[10] In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities.
Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs.
Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be.
While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet.
Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.
[12] For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus.
Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
[7] Contractual agreements Moral hazard: Investors usually rely on the deal manager to price the securitizations' underlying assets.
Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.
[7] Among the early examples of mortgage-backed securities in the United States were the farm railroad mortgage bonds of the mid-19th century which contributed to the panic of 1857.
A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.
This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market.
After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.
[16] Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe.
This activity grew to nearly $15bn (~$21.8 billion in 2023) of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX.