Securitization: A Tool for Issuers to Reallocate Credit Risk and Widen the Investor Base
Issuers in the Latin America and the Caribbean region are often unable to access a broader and more diversified investor base because, among other reasons, of the investors’ risk appetite. Many would be very interested in participating in those projects, but the potential risk levels make it difficult for them to do so.
One really useful tool to deal with this problem is securitization: it is the process of pooling various types of cash-flow generating assets, such as mortgages or loans, repackaging them and selling them as securities and, most importantly, offering different level of risk to buyers.
With this tool, issuers can better manage their balance sheets and diversify its funding sources, reducing their dependency to banking funding and being able to access capital markets. Investors can broaden the types of assets and countries they can invest in. The idea is that each investor assesses the amount of risk it can take.
IDB Invest’s solution supports these securitization transactions to finance initiatives with a positive development impact. These initiatives can be directly linked to the portfolio of assets being securitized or the use of proceeds generated by these transactions can be deployed towards other highly developmental projects that are core to IDB Invest mission in the region.
There are several advantages to using this tool for issuers and investor:
- Securitization allows investors to diversify their risk across a broad portfolio instead of a single issuer.
- It can provide access to capital for issuers that may not be available through traditional lending channels especially in a situation of scarcer and costlier financing available to issuers in the LAC region. This can be especially useful for small and medium-sized enterprises (SMEs) in the region across various economic sectors, since they can access financing with longer tenors in different currencies, while obtaining greater visibility in the market.
- It can improve efficiency and credit availability. In the case of financial institutions, by transferring portfolio risks and selling off their assets as securities, they can free up capital that can be used to extend new loans, improving credit availability for borrowers.
- It can provide standardization and transparency, helping to improve the overall functioning of financial (capital) markets in the region.
An interesting aspect is the diversity of assets that can be securitized and the ability to tranche the debt considering the investors’ risk appetite. Securitization structures are highly adaptable to features of the underlying assets and the specific needs of investors with different risk-reward appetites.
These techniques can be applicable to a wide range of private sector projects and clients, spanning from corporate and financial institutions to infrastructure, and help reinforce IDB Invest’s commitment in financing sustainability through capital markets.
Although being less developed than in other regions, we see securitization transactions being key in the development of local capital markets and the mobilization of private capital towards the development of the LAC region. These type of transactions are therefore highly developmental in relation to the projects generated through such funding but as well through the development of local capital markets and the investors it attracts.
As client preferences differ on multiple matters, from liquidity to capital relief for banks, the structure can be adapted in many formats to adjust to the client and investor needs. Dividing securities issued into different risk categories is called tranching: investors can choose to invest in the tranche that aligns with their desired level of risk and return.
Investors can benefit from this in several ways:
- Customized risk and return: Tranching allows investors to choose the level of risk and return that aligns with their investment objectives. This can help investors better manage their portfolio risk and diversify their investments.
- Higher potential returns: The tranches with higher risk may offer higher potential returns, allowing investors to potentially earn higher returns on their investments.
- Enhanced transparency: Tranching provides investors with greater transparency into the underlying assets in the securitization, allowing them to make more informed investment decisions.
- Improved liquidity: Tranching can help improve the securities’ liquidity, as investors have the option to sell their investments in the secondary market.
- Credit risk management: Some tranches, such as senior tranches, might have lower risk of default thanks to structuring techniques.
Securitization can be seen as a relatively complex product and imply a cumbersome execution process for first-time issuers. The key is in working with clients throughout that process, before and after the issuance of securities.
Prior to the issuance, this can be done through assessing their readiness for issuing such product, advising on all aspects of the operation, structuring the best product for the client including alternatives products like a warehousing line or a structured loan ahead of a future securitization issuance, and establishing a long-term partnership with the originating entity.
IDB Invest participation in the issuance could be in the form of a direct investment in the issued securities at different level of risks and mobilizing other investors. The role can be extended to providing a credit guarantee on the securities issued, therefore reducing the securities’ risk profile for the benefit of other investors, and contributing to reduce the cost of capital for the issuer.
In short, there are certainly many benefits to using securitization and tranching for both investors and issuers. Recent deals with companies ranging from Mexico’s fintech Konfio to Chile’s insurer AVLA are a testament to that.
If those benefits are combined with the right regulations, securitization can be an efficient and powerful tool for promoting economic growth and capital market development in emerging and developing markets. We’ll look into more details on how this can work in a future publication as well.
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