Fixed Income
Loan Securitisation and How Credit Is Transformed
Loan securitisation is often introduced as a technical financing process. In reality, it is a way of transforming illiquid loans into tradable securities. What begins as a series of individual loans held on a bank’s balance sheet becomes a pool of cash flows sold to investors.
Because securitisation affects risk transfer, funding, and financial stability, it is a core topic in fixed income, credit analysis, and financial reporting.
What Loan Securitisation Really Is
Loan securitisation is the process of pooling loans and converting them into marketable securities.
Instead of holding loans until maturity, the originator transfers them to a separate structure. Investors then receive payments derived from the underlying loan cash flows.
The loans do not disappear. Their risk is redistributed.
Why Institutions Use Securitisation
Banks and lenders securitise loans for practical reasons.
They may want to:
- free up capital
- improve balance sheet flexibility
- manage credit and liquidity risk
- generate funding without issuing new equity
Securitisation allows lending activity to continue without expanding the balance sheet indefinitely.
Role of the Special Purpose Entity
A Special Purpose Entity typically sits at the centre of the process.
The loans are transferred to this separate entity, which then issues securities backed by those loans. The legal separation helps isolate the assets from the originator’s broader risks.
For exams, the key question is whether risk and control have truly been transferred.
How Cash Flows Reach Investors
Borrowers continue to make loan payments.
These payments flow through the securitisation structure and are passed on to investors after fees and expenses. Different classes of securities may receive cash flows in different orders, depending on seniority.
This structure allows investors with different risk preferences to participate.
Risk Transfer and Credit Enhancement
Securitisation is designed to reallocate risk, not eliminate it.
Credit enhancement mechanisms—such as subordination or excess spread—are used to protect senior investors. Losses are absorbed in a predefined order.
Understanding this loss allocation is central to securitisation analysis.
Impact on Financial Statements
From an accounting perspective, securitisation raises a key issue: has the loan truly been sold?
If the originator retains significant risk or control, the loans may remain on the balance sheet. If risk transfer is substantive, derecognition may be allowed.
Exams often test this substance-over-form principle.
Benefits and Limitations
Securitisation can improve funding efficiency and broaden access to credit.
At the same time, it can reduce transparency if structures become overly complex. Misaligned incentives and weak underwriting standards have historically amplified risks during periods of stress.
Balanced interpretation is expected in exam answers.
Common Student Misunderstandings
Many students think securitisation removes risk from the system. It does not.
Others assume all securitised loans are off-balance-sheet. They are not.
Some forget that investors ultimately bear credit risk tied to borrower performance.
These misunderstandings often appear as exam traps.
Closing Reflection
Loan securitisation reshapes how credit moves through the financial system. It converts loans into securities, shifts risk across investors, and changes how institutions fund themselves. For CFA and FRM preparation, the key is understanding why securitisation is used, how risk is transferred, and when accounting recognition changes. Once those principles are clear, securitisation-related questions become far easier to reason through.
