8/4/2019 Securitization Johar Menezes 519

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BANK 

Borrowers

Google

AppleMicrosof 

t

YahooLOANS

Pool of investors

Special Purpose Vehicle

Deposits to purchasesecurities of the companies

Issue of securities

Tranche 1

Tranche 2

Tranche 3

Tranche 4

Tranche 5

SECURITIZATION

8/4/2019 Securitization Johar Menezes 519

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Let’s assume that there is a bank which is into the lending business. Some organizationslike Google, Yahoo, Microsoft, Apple take loans from the bank. In return these borrowers promise to return principal and interest within a specified period. Now since the bank haslent all it’s money to these borrowers it doesn’t have any capital as of now. But there aremany other opportunities coming up for which the bank requires capital. Either the bank 

can refuse to take part in such investment opportunities or devise a method by which theycan provide loans to these upcoming opportunities and get interest in return. Now let’ssay that the money borrowed by each of the borrowers like Google, Yahoo, Microsoft,Apple is locked in for 4, 5, 10 and 2 years. That means the earliest in which the bank canget back their money is 2 years. Now this doesn’t look very favourable to the bank as itwould be out of business for nearly 2 years which may affect its reputation. Now consider a pool of investors who can only invest very small amounts like $1,000, $100 or $10 butcollectively they have a very high net worth. So what banks do is they come out withsecurities in denominations of $1,000, $100 or $10 which add up to the amounts  borrowed by Google, Yahoo, Microsoft, Apple, etc. Thus these securities haveunderlying assets of reputed companies like Google, Yahoo, Microsoft and Apple. This

leads to the securities being sold quickly and banks thus get an immediate inflow of cash. Now the problem with this arrangement is that the deposits of the investors go directly tothe bank which carries a risk as the bank may put this capital in some risky investmentswhich may affect the creditworthiness of the bank and in turn affect the creditworthinessof the assets of the borrowing companies. Hence the bank to allay investor’s fears starts anew company. This company is opened for the sole purpose of handling the assets of the  borrowing companies namely Google, Yahoo, Microsoft, Apple, etc and this newcompany will then issue the securities to the investors. This new arrangement results inthe investors becoming safe as no matter what happens to the bank their investments aresafe with the new company formed. Thus any decisions or actions taken by the bank willnot affect the creditworthiness of the assets of the borrowing companies, Google, Yahoo,Microsoft, and Apple. This new organization which is created simply to safeguard the pool of investors is called a special purpose vehicle. They are only created for the purpose of managing the assets of the borrowing companies. The securities issued by thespecial purpose vehicle are categorized into various tranches like tranche 1, tranche 2,tranche 3, etc. These tranches are classified based on the risk associated with them. Thehigher the risk the more return on the tranche. Thus the investor has the flexibility tochoose a tranche based on his risk versus return appetite. This is the whole process of securitization and the key players here are the borrowers (Google, Yahoo, Microsoft,Apple, etc), the originator which is the bank, the special purpose vehicle and the pool of investors.