 Hi guys, it's MJ and in this video, we're going to be talking about Securitization so previous video we looked at interest rate derivatives, which were quite complicated and difficult to price Now we're going to be looking at something known as Securitization now Securitization, I think it's one of the greatest financial inventions ever made. Remember, this is me studying out loud Videos are unedited very much opinion-based So, you know rather consult a textbook if you want just facts, but I'm going to go on record. It's saying that securitization is a fascinating Invention and is very good for the financial markets. I'm actually got a paper pending On securitization and the blockchain and I'll maybe discuss that a little bit But I just want to say securitization is a good thing Okay, it's a good thing. I know it kind of caused the world recession and almost wiped out the you know the world's economy and You know financial Armageddon, but that's because people, you know abused it and that that wasn't the right thing to do How it was working is banks would Sell houses to people who had no income No jobs, no assets. Otherwise known as ninjas No income, no job and no assets So they sold these houses to these ninjas and What they would do is they would take these bonds Securitize them chop them up into nice little tranches Get a credit rating agency who are we don't like rating agencies. They're bad Confused them with some really fancy mathematics and you know copulars two-dimensional Distributions, ooh, so they got a triple a rating and were able to sell these two big pension funds Around the world which then gave them enough money to purchase more houses to give to more ninjas And it was this terrible cycle that went in on each other Some smart individuals bought things known as credit What are they credit derivatives of swaps? Are they called transfer to swaps? Yeah, sorry credit default swaps credit default swaps and These guys then took a bet against this and then vented this instrument Because they saw that this financial system was unsustainable and they made a lot of money from it That's from that movie The long short or the short long. I don't know that movie that Steve Corral's in We're gonna be talking about credit default swaps a lot tomorrow So tune in for that video and more about say the credits crunch and the world recession But just know that Securitization was used and abused in this instance, which is unfortunate because it's now got a bad name And it's actually a brilliant invention. What does Securitization do well That's gonna be the point of this video and the great thing about Securitization is that it provides business owners or just people in the economy with an alternative form of raising capital other than loans or equity Remember loans you get some money from a bank and if you fail to make the repayment they come and they take your assets away And it's a traumatic experience Equity is you give some control over to an investor You have to give him a dividend in forever as long as the business is alive Which kind of sucks and you're giving him some control So if he doesn't like the way you're managing it He can call the other directors together and they can vote you out of your managerial position So both loans and equity have got these disadvantages Securitization provides a way an alternative way that doesn't have these downsides. It doesn't give over control it doesn't give over control and Doesn't need collateral Okay, very very important. So how does securitization work then well Let me explain What you do is with securitization. Let's say you have a business or you have any sort of income stream Hey, you've got an income stream other from selling beer selling chocolate Getting fees from a service. It could be a hairdresser anything can be securitized as long as it's got this income stream And then what you say is we're going to be let's say getting a hundred grand every day Okay, now what we could do is and let's say we are a hairdresser. Okay hairdresser with our little saloon If we took it alone and we didn't make the hundred grand every day The saloon would bank would take away the saloon if we sold equity shares Then they might you know kick us out as management We would still all hold the percentage that we already have but we won't be able to be say the lead hairdresser or something like that What securitization does It says what we're going to do is we're going to take this hundred grand every day this revenue stream And we are going to crystallize it In a sense what we're going to do is we're going to take this hundred grand every day hundred grand every day And we're almost going to form a security or a bond hence the name securitization We're going to turn it into a bond sell it off to an investor and get cash up front. So i'm going to trade my income stream for a lump some payment Now as a hairdresser, I might want to do that because now I can build another salon I can get another fancy scissors or I don't know get some assets or I can just I don't know there's lots of different reasons why you'd want a lump sum payment Uh, what's also cool about securitization? It doesn't have to be the full amount I mean you could just say 50 grand of the hundred so 50 percent goes And that's quite a nice way for a hairdresser to To realize their wealth Without diluting ownership in their own business Now why would an investor Be interested in a securitization compared to say a loan or equity Well, this is why investors like it because it offers a big diversification benefit Because what you're basically doing is you're getting pure exposure To the revenue model to how how many people are cutting their hair with equity What first has to happen is you're getting exposure also to the operating Risks of the business because you take that revenue you take away Expenses your takeaway tax you take away all those other things and then you only get your dividend With securitization you get your payment straight away. It's at the top of the revenue So that's a benefit for for investors also The duration Can be tailored So what you can do is you can say is tailor's built like that or is it built like that? I don't know I think it's anyway, that's not important Important thing is that the duration can be tailored. So securitization can be for five years three years one year Which is great for when it comes to say matching your assets first liabilities, which we'll look at later in asset liability modeling now So securitize it. Yeah, it has these diversification benefits and it has this duration It does have the weakness in the sense that it's maybe not as liquid. It's not as marketable as shares or loans So that does need to be considered but that also depends on various other other factors So what but anyway, let's get Back to sorry my my mind's jumping all over the place. I'm very excited about talking I'm very excited to be talking about securitization Let's get back into some of the theory so what was What is securitization mainly used for it's mainly used for mortgages and it's also used for credit card repayments The reason being is that these things are massive And securitization does require a lot of admin a lot of auditing a lot of certification You know trust that they actually are there's a lot of your trust required Auditing and a lot of expenses to set it up Hence why it is only mainly used for very big deals such as mortgages or credit card repayments Where we're talking, you know billions of dollars compared to say a hairdressing salon, which is might not even worth $100,000 However, new technology more preferably the blockchain Can change all of that blockchain can reduce the administrative burden of issuing securities While incorporating the same level of trust that an administrative Procedure would give and that's actually something I've written about. Hopefully it will be published soon And yeah, I'll provide a link or just look out for that That little document of mine. Maybe it'll win the the Nobel prize in economics. I'm joking But blockchain is a big technology that can help Securitization be accessible to the general public and can be a great way of unlocking a whole bunch of capital. Anyway For the test or for the exams, we need to look at Securitization the way it's applied to mortgages and credit card repayments and maybe a few other scenarios The two things that we are very much interested when it comes to securitization It is predictability And sustainability Okay With our hairdresser example, we kind of made that hundred-rand Fix and we made it forever. So we may basically simplified both of these dimensions For in order to explain the concept but these are important Predictable is it going to be a hundred grand all the time or is it going to be 99 is going to be 88 Technically what we would do is we would securitize say 50 percent So we would say you're getting 50 50 50 50 and it would be fixed the predictability is Is important though is whether you'll be able to pay it. So you might get 198 88 but if this goes to say below 45 then there's going to be a default So you do need to be able to predict it to make sure that your default risk Is low or to make sure that the coupons that you're paying out on your securitization Is enough or can be met The other thing is and this is where actuaries can actually add a lot of value Yay for actuaries Is in sustainability and this is something that you don't really get taught in other financial courses And that is that income streams die okay Income streams just like how a stream in the real world dries up So financial streams dry up They dry up and they die and this is where we can use our actuarial Techniques where we look at you know, say mortality We can look at what is the probability that an income stream dies that it, you know Degenerates and all these various things. So actuaries do have an advantage in this area Okay, what can cause an income stream to dry up? Well, it could be competition Which depends on say barrier to entry But a lot of the time it also comes down to say demand Maybe people don't want to get their hair cut anymore Or maybe supply gets altered in the sense that more hairdressers are setting up And if there isn't say a license to cut hair then that's a very low barrier to entry So forth so forth like that But I mean you could spend an entire Video or an entire textbook on trying to determine the sustainability Of an income stream and it will vary for every single one And hence why that does actually add to the cost of setting up a securitization Or at least in evaluating it So predictability and sustainability I mean so when you're looking at say the mortgages you'll look at say the lease terms the rental prospects With credit cards you will maybe look at what is the current default? What is market confidence look at all those type of things? I mean another thing you can get quite technical into like the structuring and security issuance treasury management Probability of default is there any chance of recovery? The statistics of early repayment all those various things But I just want to talk about one last thing That's mentioned in the notes and it says that a major difficulty Insecuritization and I don't think it's a difficulty at all think the notes are being really dumb here But they say in the choice of the discount rate Choice of discount rate Okay, now the reason why I think that is done is because What we get told in the textbook is that risk can either be interpreted as Reducing the cash flow so they say there's a hundred grand every day But there's a 95 chance that that might not be paid then instead of saying a hundred we say 95 Okay, that's the smart way to deal with risk the dumb way to deal with risk Which the textbook also gives is to increase the interest rate And that's dumb So the idea is that if it's certain to get a hundred grand every single day, it would be say at 5% But if there's a 95% chance will be repaid rather use another interest rate What interest rate maybe 6% maybe 7% depending on the duration and all these other things It's quite difficult to calculate what that percentage should be Another reason why this is dumb is because when I want to analyze two projects And I'm seeing the one at you know 7% interest rate and the other ones at an 8% interest rate It's very difficult to try and comprehend. Well, how much a risk Is in that 1% is different and say if we had to look from 1% to 2% does that mean it's double the risk or is that the same amount of risk being added at say 8% to 9% You know, they both got the difference of 1% But is it an absolute or is it relative? I mean interest rates are They're bad so I don't see this as a problem because I see it as Set your interest rates the same for every single asset which you're valuing and rather reduce the cash flow or Express your risk in the cash flow amounts Rather than fiddling with the interest rates, which like I said on a they are made up. So the central bank could change it the next day And then you have to redo all your calculations. Whereas With this one, you're just changing one amount because you've expressed the risk in the in the cash flows rather than the interest rate So I don't see that as a problem They do make a big fuss of it in the notes So you could probably get a mark by mentioning that in the exam But just know that there is a better way of doing it You can maybe even get another mark for for saying what's done That'll impress the examiners Anyway, that is the end of my video on securitization I'm very excited about this topic. I do a little bit more research into it So I do apologize if I was a little bit, you know, blabbering and stuttering as I try to contain myself talking about the subject It's much better when I write about it Then just talk about it because there's so much to mention and I seem to jump all over the place So I do apologize for that Tomorrow's video will be better tomorrow's video is on credit default swaps and it's fascinating because they're not actually swaps well Yeah, maybe let me let's talk about it more in tomorrow's video, but it's going to be quite interesting So I hope you tune in for that and otherwise. Thanks for watching. Cheers guys