Why does Securitisation exist?
The first securitisation transactions began in the 1970s. The early transactions were rather simple pass-through mortgage structures, which passed through all the cash flows on the underlying mortgages to the investors. Since the deals were backed by the United States Agencies, credit risk was not concern.
The pass-through structures migrated to more complex structures and have become known as Collateralised Mortgage Obligations (CMOs). Subsequently, the US tax law that established the Real Estate Mortgage Investment Conduits (REMICs) rules made mortgage structures tax efficient and enhanced the ability to reallocate cash flows from the assets to one or more tranched securities. In today’s market, there are many types of tranched investments issued, including Planned Amortisation Certificates (PACs), Interest Only (IO), Principal Only (PO), Companion and Targeted Amortisation Class Bonds (TACs) to name just few. Derivatives, financial guarantees and revenue funds and also enhance cash flows broadening the investor base and participants in the marketplace. Residual Interests are more akin to equity interests.
The marketplace participants began to look at other financial assets, such as automobile loans (leases), and credit and balance became the most significant asset classes securitised that are not home mortgages.
In the late 1980s, a new type of structure emerged: the Collateralised Debt Obligation (CDO) and the Collateralised Loan Obligation (CLO). Like a REMIC a CDO issues tranched debt securities, usually in the form of notes and equity securities. However, CDO equity is typically in the form of preferred stock, income notes or limited partnership interests. Furthermore, such equity in funded transactions is generally more than a nominal amount. Proceeds from the securities are used to purchase financial assets from the secondary market (arbitrage CDO) or from an originator or owner of financial assets (balance sheet CDO). In a synthetic CDO, the owner of assets may enter into a credit default swap or total return swap with the CDO linked to the asset portfolio. Debt issued may be funded or unfunded.