top of page



What it is

Securitisation involves taking assets and using them as collateral for the issuance of bonds. The money raised being used to finance the purchase of the assets involved. In this way banks and building societies can originate loans and use them to obtain funding.

This is a world of “alphabet soup” the nomenclature reflecting the type of asset that has been used. For example, Mortgage Backed Security (MBS), Residential Mortgage Backed Security (RMBS), Commercial Mortgage Backed Security (CMBS), Collateralised Loan Obligation (CLO) and Collateralised Bond Obligation (CBO).


The bank that is responsible for the structure is known as the “originator”. The originator establishes a Special Purpose Vehicle (SPV) or a Trust.  These are legally separate and bankruptcy remote to the originator. They are normally located in countries with suitable tax and legal frameworks. The originator sells or passes title in the securities to the SPV. The SPV then issues bonds. These are sold to investors.

The bonds can be fixed rate or floating rate, have different maturity dates and different credit risks. Investors in these bonds are at risk for both the interest and principal they expect to receive. This is dependent on the performance of the assets in the SPV and any credit enhancement it contains.

In many securitisations, there is a sequential pay process.  Some bonds are senior, they have priority to receive interest and principal. Next come the mezzanine bonds or middle piece and finally there is the first loss or equity portion. These are the lowest in ranking.

Credit losses incurred by assets in the SPV are written off against the tranches. The subordinated bonds incur credit losses first. The first loss piece therefore has the highest risk and return. The senior bonds have the lowest risk and return. For this reason, rating agencies assign higher ratings to the senior debt, typically AAA. The subordinated tranches get lower ratings or may be unrated.

In addition to evaluating the assets held in the SPV the investor needs to understand how the subordination of both principal and interest work, an important feature being the “thickness” of the subordinated tranches. The SPV may also have additional protection by way of overcollateralisation and guaranteed reserve funds. How this works can also be complicated.

Motivation for Issuers

The motivation behind securitisation varies. It offers balance sheet benefits to the originator. Securitisation improves liquidity in-so-much that assets that are generally considered illiquid (loans) can be put into a structure where the resulting bonds can be sold or used in repo transactions. This can include borrowing from the central bank provided certain criteria and haircuts are met. For banks securitisation is an important source of funding. It can also reduce the cost of funding. This is because the investor is buying a bond that has underlying collateral which offers diversification.

The subordination structure also gives senior bond holders additional protection. The interest income earned by assets in the SPV may exceed that paid on the issued bonds. After deduction of any hedging, servicing and administration costs the arranger will obtain funding at a relatively cheap rate.

A further advantage for the issuer is one of risk transfer. Third party investors are taking the credit risk on the contents of the SPV. The extent and nature of this will depend on the structure of the securitisation and whether the issuer retains some of the originated bonds.

Motivation for Investor

For the investor, the attraction is one of choice. After undertaking due diligence there is the opportunity to benefit from credit enhancement via subordination or additional returns from greater credit risk. In theory, the bonds issued also carry an intrinsic value in that they too can be sold or repoed although in practice market conditions may limit liquidity.


If the assets in the SPV become non-performing the investors who purchased the issued bonds are at risk of loss. It is the modelling of such losses and how they are allocated that makes rating agencies able to estimate how risky individual tranches are.

Under certain circumstances it is possible for investors to misprice the risk they are collectively taking. When this happens the cash inflows in terms of interest and principal repayments from the assets in the SPV will exceed the coupon and principal repayments on the bonds issued. As mentioned this can reduce funding cost but equally it may generate fee income for the originator.

If the originating bank does not undertake suitable due diligence on the assets put into the SPV and the bond investors rely on credit ratings without undertaking their own analysis problems may arise. This is why investors are advised to look closely at what they buy.

The crisis of 2007/8 brought this risk home. It transpired that some structures contained assets that were riskier than expected (self-certified loans, loan to value ratios exceeding 100%, fraudulent loans). For this reason, the efficacy of securitisation was questioned.

Liquidity in many securitised issues dried up and investors, including banks, suffered large mark-to-market losses on the bonds they had purchased. Perhaps surprisingly the full effects were felt by banks holding senior tranches. Low regulatory capital requirements meant these portfolios were huge.

Since the crisis securitisation has remained an important funding mechanism albeit the structures have been simplified. There is also more data available on what is contained in the SPV, its performance and the structural integrity. To align interests originators must now retain a portion of the securitisation so they have “skin in the game”.

Master Trusts

Master trusts are used in the UK to securitise mortgage portfolios. The originator transfers title of the mortgages to a trust. This forms the collateral for several different securitisations. The trust has a “funding share” equal to the outstanding debt issued and a “seller share”, the remaining portion.

Each series of residential mortgage backed securities issued has an interest in the trust’s asset pool. The issuer can add new mortgages to the trust provided they meet minimum standards. Provided there is sufficient collateral further issuance can then take place.

The master trust can act like a regular issuance programme. Investors in the issued bonds are exposed to the quality of the pool of mortgages, the structure of any credit enhancement as well as the overall credit risk associated with the UK housing market.

Some master trusts are referred to as “capitalist master trusts” here each issuer under the trust can be affected differently. This means that tranches with the same ratings can perform differently if there are credit losses. Some master trusts are referred to as “socialist master trusts”, here all tranches with the same rating rank parri-passu. Investors need to be aware of individual structural differences like this before they make an investment decision.


Pass-through: Pass through structures are where interest and principal payments go straight through to the investor. There is a single class of bond issued. All payments to bond holders are pro-rata.

Pay-through: This is where modification to the cash flows occurs. It means there is tranched structure where bond holders have different risks and rewards.

Soft bullet: The repayment date of the bond can vary with the speed at which the assets in the SPV amortise.

Hard bullet: There is a known repayment date on the bond. This can be facilitated by over collateralisation or a third-party guarantee.

Prepayment Risk: Loans like mortgages amortise and capital is repaid over a period. But the speed at which this occurs can vary. In particular, for fixed rate loans there is a tendency for borrowers to refinance at lower interest rates should rates fall. Under these circumstances the loan can be repaid earlier than expected. In a falling interest rate environment prepayment of fixed rate loans in the SPV accelerates the redemption bonds issued by the SPV. This means that investors do not fully benefit from owning a relatively high coupon bond. They are short of a call option. The speed at which pre-payment will occur can be estimated but such estimates are notoriously difficult to make.

First Published by Barbican Consulting Limited 2017

bottom of page