Securitisation in 1 Best Complete Reading


Securitisation is a financial process by which an owner of an asset, such as a portfolio of loans, receives cash upfront in exchange for the future cash flows from the asset without selling the asset in a normal contractual sales agreement. This process entails pooling the cash flows and selling them to investors via a special purpose vehicle (SPV or structured entity), effectively turning ‘illiquid’ assets that cannot be sold easily into a ‘liquid’ asset that is tradable. If the income is ‘backed’ by underlying assets the securities are called ‘asset-backed securities’.

There are two main reasons for carrying out a securitisation:

  1. to obtain funding, because selling the cash flows allows the seller to bring forward the future income of the assets and use it for immediate reinvestment; and
  2. to move assets off the balance sheet.

In principle, any asset with associated cash flows can be securitised, for example mortgages or loans such as credit cards, commercial loans and student loans. Depending on the underlying asset, the securities carry different names as shown below.

Types of securities

Security name Description
Residential mortgage backed security (RMBS) Backed by mortgages for the purchase of residential real estate. Includes ‘prime’ mortgages, where borrowers have strong credit histories, ‘buy to let’ mortgages, or ‘non-conforming’ mortgages.
Commercial mortgage backed security (CMBS) Backed by mortgages for the purchase of commercial property.
Consumer asset-backed security (Consumer ABS) Backed by personal financial assets such as auto loans, credit cards, student loans and other consumer loans.
Corporate asset-backed security (Corporate ABS) Backed by the cash flows from receivables such as leases on aircraft or other corporate equipment, small and medium enterprise (SME) loans, trade receivables. Also includes ‘whole business’ securities (WBS) based on the cash flows of an entire business unit, such as franchise or brand royalties.
Collateralised debt obligation (CDO) Backed by a mixture of loans/receivables and/or asset-backed securities. Also includes ‘collateralised loan obligations’ (CLO) backed by loans, often to medium-sized corporates.

Control over CMBS issuer Structured entity

Control over CMBS issuer Structured entity is a case on the assessment whether certain stakeholders in a transaction/structure have Securitisationobtained control over a certain entity in the transaction in line with the requirements of IFRS 10 Consolidated financial statements. Only one stakeholder can be in control! [IFRS 10 B16] Or no stakeholder is in control. Or one stakeholder is in control and has to consolidate the investigated entity  in its consolidated financial statements. Here is the case.

THE CASE – Assessing control of an issuer of commercial mortgage-backed securities managed by a third-party servicer acting on behalf of investors Control over CMBS issuer Structured entity

Background and purpose

Commercial mortgage-backed securitisations exist for a number of reasons. A bank that has originated or acquired commercial mortgages may require funding for those assets. The bank may also seek to pass on some of its exposure to loss on the mortgages. Finally, there may be an opportunity for the bank to create marketable securities of a particular risk profile that are attractive to investors and thereby reduce its funding costs and earn fees from its involvement in the transaction.

Note: many commercial mortgage-backed securitisations contain additional features not illustrated here.

Facts Control over CMBS issuer – Structured entity

  • Bank sets up a structured entity (SE) and transfers to it commercial mortgages with a value of C100. The shares of the SE, which are held by independent third parties (a charitable trust), have no decision-making authority due to the rigid contractual arrangements in place. Securitisation
  • The mortgages held by the SE are contractually-specified and do not change over the life of the SE (a static portfolio). SecuritisationSecuritisation
  • The historical, as well as the expected, future default rate of these mortgages is approximately 5%. The likelihood of a default rate of more than 10% is considered remote. 
  • A third-party servicer administers the mortgage portfolio in the SE under a servicing agreement that sets out servicing standards. The servicer will receive management fees of 8bps (that is, 0.08%) of the outstanding principal of loans, which are not dependent on the servicer’s performance. Securitisation
  • SE issues two tranches of debt. A senior tranche of C80 is issued to a dispersed, unrelated group of note-holders in the market that do not constitute a reporting entity and are represented by a trustee. No individual senior debt-holder owns more than 5% of the senior notes. A junior tranche (subordinated liabilities) of C20 is held by the bank. The SE’s liability in respect of both tranches is limited to the collections from the mortgages it holds.If the SE is not able to repay either tranche due to defaults in the underlying mortgages, this does not constitute a legal default by the SE (that is, debt holders cannot take actions against the SE such as seizing its assets, placing the SE under liquidation, etc). Any residual amount in the SE after payment of all parties is allocated to the junior notes upon termination of the SE. Securitisation
  • The servicer assumes the status of the ‘special servicer’ in case of default on one or more of the underlying commercial mortgages. Management fees on the defaulted mortgages are increased from 8bps (0.08%) to 25 bps (0.25%) of the outstanding principal of defaulted mortgages; and a performance-related fee is paid equivalent to 1% of any collections from mortgages that have defaulted.The higher management fees are designed to cover the higher costs of managing the structure, and the performance fees are designed to incentivise the special servicer to maximise collections. The servicer can therefore obtain a minimum fee of 0.25% of the outstanding principal of defaulted mortgages and a maximum of 1.25%. For the purposes of this case, assume that: Securitisation
    • The magnitude of the management fee (between 8bps and 25bps) has been assessed to be insignificant compared to the SE’s much higher overall expected returns on its mortgage portfolio. The magnitude of the performance fee is also expected to be insignificant, as this is only 1% of collections on defaulted mortgages, which in turn are expected to comprise only 5% of the portfolio.
    • The variability of the management fee relative to the SE’s returns has also been assessed to be insignificant, as the fee is based on principal, which is relatively stable. The variability of the performance fee is assessed to be insignificant, as it is only 1% of collections on defaulted mortgages, which in turn are expected to comprise only 5% of the portfolio. Securitisation
  • The servicer’s fee ranks ahead of payments on the junior and senior notes. Securitisation
  • The servicer’s fees are commensurate with the services provided and the remuneration agreement does not include terms or conditions that are not customarily present in similar agreements.
  • The servicer must make decisions in the best interests of all investors (that is, Bank and senior note-holders) and in accordance with the SE’s governing agreements. Nevertheless, if there is a default, the servicer (in its role as special servicer) has significant decision-making discretion.
  • The bank can remove the (special) servicer if a breach of contract occurs. ‘Breach of contract’ includes a return on the senior notes of less than 20%, a condition that is met as soon as any defaults occur. The effect is therefore that the Bank can unilaterally remove the servicer upon default of the underlying receivables. No other party has kick-out rights.
  • It is improbable that none of the mortgages will default at the reporting date. The servicer is easily replaceable.


Analysis under IFRS 10

Does the SE have relevant activities? [

There are two key functions within the SE: servicing of mortgages and, in the event of default, collection. The act of servicing mortgages on a day-to-day basis does not constitute a relevant activity, as this does not significantly affect the returns of the SE and is generally pre-determined by a contractual arrangement. Securitisation

However, collection of receivables on default is a relevant activity because it is the only activity that will significantly affect the SE’s returns. The fact that this right is exercisable only upon default does not prevent this from being a substantive (rather than a protective) right over the relevant activity of the SE [IFRS 10 B53]. Securitisation

An investor who has the ability to direct the activities of the SE after default would potentially have power where activities are pre-determined until default. Securitisation

The SE therefore has relevant activities.

Who controls the SE?

There are a number of factors that need to be assessed in order to identify which party controls the SE and thus consolidates it. Each party is assessed below.

Assessment of being in control by the servicer/special servicer

IFRS 10 Factor



The servicer gains significant decision-making discretion upon default of mortgages. IFRS 10 B53 indicates the servicer has power to direct the relevant activities of the SE.

The Servicer therefore has power over the SE (though it may be using that power as agent – see third factor below).

Exposure to variable returns

IFRS 10 B57(b) says that an example of returns is: “…remuneration for servicing an investee’s assets or liabilities , fees and exposure to loss from providing credit or liquidity support, residual interest in the investee’s assets and liabilities on liquidation of the investee…..”

Although the servicer obtains a fixed management fee, IFRS 10 B56 clarifies that even fixed performance fees comprise variable returns. The servicer receives a variable performance fee that also gives it exposure to variable returns. As such, the servicer is exposed to variable returns.

The ability to use power to affect returns

Based on the principal-agent guidance in IFRS 10, the servicer has wide discretion to manage and renegotiate defaulted assets, which may indicate its role as being more in the nature of principal [IFRS 10 B60(a)].

However, IFRS 10 B65 indicates that when a single party can remove the decision-maker without cause, this on its own is sufficient to conclude that the decision-maker is an agent. The servicing contract states that the servicer can only be removed on breach of contract. However, breach of contract is defined to include a return on the senior notes of less than 20%, a condition that is met as soon as any defaults occur.

The effect is therefore that the Bank has the unilateral right to remove the servicer on a default of the underlying receivables. As explained above, the only relevant activity is managing receivables upon default; and the only time when the servicer can exercise such power is upon default.

At such time, the Bank immediately acquires the power to remove the servicer. Such removal rights are, in substance, equivalent to those unilateral, unconditional removal rights referred to in IFRS 10 B65. The right is also substantive from the Bank’s point of view, as the Bank can benefit from exercising it through recovering more or less on its junior notes.

The Servicer’s remuneration does not need to be considered – it is an agent by virtue of the single-party removal right. However, it is insignificant when compared to the much higher overall returns expected on the SE’s mortgage portfolio

The servicer/special servicer is therefore an agent.


The servicer/special servicer does not control the SE because it is an agent.

Assessment of being in control by junior note-holders

IFRS 10 Factor



The Bank has the power to unilaterally remove the servicer, but this is contingent upon some of the mortgages defaulting, or the servicer otherwise breaching the servicing contract. Such a right is substantive because:

  • there are no barriers in the fact pattern to prevent the Bank from exercising this right [IFRS 10 B23(a)];
  • the Bank does not require any other party’s approval to exercise the right [IFRS 10 B23(b)];
  • the Bank will benefit from the exercise of the rights because it acquires the power to affect the returns from its junior notes [IFRS 10 B23(c)];
  • the right is exercisable when decisions about relevant activities need to be made even though it is not currently exercisable [IFRS 10 B24]. The only relevant activity in this scenario is the management of receivables upon default, and the Bank is able to exercise this right once such default occurs.

Treatment of this right as substantive is also in accordance with IFRS 10 B26, which specifies that not all contingent powers are protective. This substantive removal right allows the Bank to direct the servicer via the threat of removal.

The servicer’s powers are therefore imputed to the Bank for purposes of the IFRS 10 analysis [IFRS10 B59]. As explained above, the servicer has wide powers over the relevant activities.

Based on the above considerations, the Bank has power due to its substantive ability to remove the servicer.

Exposure to variable returns

The bank is exposed to variable returns, as it owns the junior notes, which are expected to absorb the majority of residual variability.

The ability to use power to affect returns

See the assessment in power above.

  • the Bank will benefit from the exercise of the rights because it acquires the power to affect the returns from its junior notes [IFRS 10 B23(c)];
  • the right is exercisable when decisions about relevant activities need to be made even though it is not currently exercisable [IFRS 10 B24].


The Bank therefore controls the SE.

Assessment of being in control by senior note-holders

IFRS 10 Factor



The following factors suggest that the note-holders have opportunities/ incentives to obtain power:

  • The SE is economically dependent on the senior note-holders for financing via the senior tranche [IFRS 10B19(b) (i)]. However, IFRS 10 B19 states that the existence of a single indicator does not mean that the power criterion is met. This is not therefore a conclusive indicator. Further, this criterion is also met for the Bank as well as for every note-holder.
  • The senior note-holders have limited exposure to downside variability through their holdings of senior notes [IFRS 10 B20]. However IFRS 10 B20 also states that the extent of an investee’s exposure in itself does not necessarily result in power.

There are no conclusive indications that any of the senior note-holders have power over the SE. Further, IFRS 10 B16 indicates that only one investor can control an investee. As explained above, there are strong indications that the Bank has power.

None of the senior note-holders therefore has power over the SE.

Exposure to variable returns

The senior note-holders are exposed to variability through their holdings of senior notes, as the SE may not be able to pay off the senior notes in full if the underlying mortgages default.

However, the Bank is exposed to even more variable returns via its holding of junior notes.

The ability to use power to affect returns

N/A the senior note-holders have no power (see factor Power above).


As none of the note-holders has power over the SE, none of the note-holders controls the SE.

Although the note-holders do not control the SE, they hold an interest in an unconsolidated structured entity. The note-holders should therefore make the disclosures required by IFRS 12 24 – 31.

Overall conclusion 

Based on the above analysis, the Bank controls the Structured entity.

Also read: Special purpose vehicle

Something else -   Proportionate consolidation

General model of measurement of insurance contracts


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Something else -   Adjusted net asset method

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