Credit Risk Management Practice Exam

What happens to assets during a true securitization?

1. The assets are kept on the originator's balance sheet

2. The assets are sold at a premium rate

3. The assets are removed from the originator's balance sheet

4. The assets are transformed into equity

The correct answer is: The assets are removed from the originator's balance sheet

In a true securitization, the essential process involves the transformation of illiquid assets into tradable securities. This process typically includes the creation of a special purpose vehicle (SPV) or special purpose entity (SPE) that purchases the underlying assets from the originator. When this occurs, the assets are effectively removed from the originator's balance sheet. This transfer of assets allows the originator to reduce its leverage and risk exposure, enabling it to free up capital for other uses. By offloading the assets onto the SPV, the originator can improve its financial ratios, such as return on assets and debt-to-equity ratios, as those assets are no longer part of its financial position. In contrast, keeping the assets on the originator's balance sheet would imply that they still bear the associated risks and leverage impacts. Selling at a premium rate or transforming assets into equity are not typical outcomes of true securitization; those processes don’t align with the fundamental objective of securitization, which is to package and sell the cash flows generated by the assets to investors. Thus, the removal of assets from the originator's balance sheet is a defining characteristic of true securitization, validating the correct choice.