Asset-Backed Securities: An Illustration

The diagram illustrates the asset securitization technique. We start with an hypothetical finance company, Finance Company Ltd (FCL). The company provides loans for private automobiles, small delivery vans and trucks, and farm equipment. While the receivables have a reliable payment history, the growth of FCL’s business means that it has strained the limits of its leverage to dangerous levels. Equity capital is scarce, and the owners are not willing to relinquish control by issuing public stock. Issuing a corporate bond would be difficult and costly, particularly since FCL’s financial ratios would not produce a top credit rating.
This company is ripe for asset securitization. Equity capital is scarce and costly, but the assets themselves are sufficiently strong to support a high credit rating without the backing of the originating lender.

While many investors may not have the means to scrutinize and evaluate the assets, one or more rating agencies will do so, as will a specialized, highly rated, financial institution which will provide its own guarantee.

After working with its bankers, the financial guarantee company, the regulatory and rating agencies and the lawyers to structure the deal, FCL establishes the new company, called FCL 1997-A, to buy its hire-purchase receivables and to issue asset-backed securities. This new company or trust has no other purpose and will be dissolved after the securities mature -- hence the term special-purpose vehicle (SPV).

The specially formed vehicle purchases the assets from FCL and sells notes or certificates to investors. The investors’ stake is secured by the assets in the trust, which are held on behalf of investors and are no longer controlled by the originator or its creditors. The investors, however, are getting more than secured claims. They are receiving predictable cash flows from a selected pool of assets that has been screened by the originator, by the rating agency, and in many cases by an independent guarantee company.

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