Synthetic collateralized loan obligations: risk distillation and redistribution.

• Position: Letter from the Editors

Securitization offers managers of financial institutions a way to originate assets beyond their firm's ability and or willingness to fund the assets. Financial institutions originate home mortgages with the intention of exchanging them on the spot or forward market for mortgage backed securities, which are then either held for investment purposes, or sold to financial institutions that use them as collateral for collateralized mortgage obligations. Leasing companies originate leases and then sell them to a bankruptcy remote subsidiary that in turn sells undivided interests in the leases to a trust in exchange for asset backed securities which are composed of debt and equity interests. The debt will generally be underwritten and distributed in the capital and money markets while the equity interests are retained by the subsidiary. Industrial companies discount pools of revolving trade receivables to a bankruptcy remote subsidiary that in turn exchanges undivided interests in the pool for asset backed securitie s issued by a trust. The asset-backed securities are amortized with the liquidation of the receivable pool. Whether it is mortgages, leases or any other financial assets that are transformed through the process of securitization into marketable securities, capital that was needed to fund the assets can now be reallocated by the originator.

When a firm's balance sheet becomes congested due to limited availability of new capital, diminishing returns on equity or liquidity constraints, management can utilize securitization to liquidate short and long-term assets. Management can extract valuable servicing fees and residual interests from the securitized assets while significantly limiting the amount of capital that is needed to support the assets to the amount needed to fund any residual interests in the assets. Embedded in the residual interests are returns for underwriting loans that perform better than the capital and money markets expect. In other words it is a return on the human capital of the financial institution.

Being able to originate assets beyond the funding capacity of the institution's balance sheet gives managers the ability to remain active in a market without having to use space on the balance sheet to support lending to the sector. For example a manager may forecast profitable future lending opportunities in the commercial real estate market, but at present, allocating space on the balance sheet to this market can not be...