SECURITIZATION

Borrowers

Google

Yaho o LOANS BANK

Microsof t

Apple

Tranche 1 Tranche 2 Tranche 3 Tranche 4 Special Purpose Vehicle Issue of securities Tranche 5

Deposits to purchase securities of the companies

Pool of investors

Lets assume that there is a bank which is into the lending business. Some organizations like 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 has lent all its money to these borrowers it doesnt have any capital as of now. But there are many 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 they can provide loans to these upcoming opportunities and get interest in return. Now lets say 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 can get back their money is 2 years. Now this doesnt look very favourable to the bank as it would 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 but collectively they have a very high net worth. So what banks do is they come out with securities in denominations of $1,000, $100 or $10 which add up to the amounts borrowed by Google, Yahoo, Microsoft, Apple, etc. Thus these securities have underlying 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 to the bank which carries a risk as the bank may put this capital in some risky investments which may affect the creditworthiness of the bank and in turn affect the creditworthiness of the assets of the borrowing companies. Hence the bank to allay investors fears starts a new 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 new company will then issue the securities to the investors. This new arrangement results in the investors becoming safe as no matter what happens to the bank their investments are safe with the new company formed. Thus any decisions or actions taken by the bank will not 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 the special 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. The higher the risk the more return on the tranche. Thus the investor has the flexibility to choose 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.