What it means
Financial products are rarely sold in the exact form in which they are created. A pension fund might want a steady income and a particular credit rating, which the underlying bonds do not offer.
A bank can repackage those bonds into a note that pays what the fund wants, and earns a fee for doing so. Common examples include asset-backed securities, in which loans or receivables are pooled and sold as bonds, and structured notes, which combine a bond with other features such as a link to a stock index.
In some cases the repackaging is done through a special purpose vehicle (SPV), a separate legal company that holds the original assets so that investors have a claim on them and not on the bank. The economics are simple.
The arranger receives income from the underlying assets, pays investors a return on the new product, and keeps the difference as a fee. The investor gains a product that fits their needs, while the original holder may free up capital by selling the assets.
Repackaging can improve the efficiency of markets, but it has a darker side. Complex structures can hide the true risk of the underlying assets, and investors may rely on credit ratings or assumptions that turn out to be wrong.
The financial crisis of 2007 to 2009 showed how repackaged mortgage securities could spread losses widely. Finance professionals should therefore ask what sits inside a repackaged product, who bears the first losses, what fees are charged and how easily the product can be sold.
If these questions cannot be answered clearly, the product is probably too complicated to buy. Transparency and simple structures are the best defences.
In practice
Real-world examples.
Example
A bank buys a group of corporate bonds and places them in a trust. It then issues a single note backed by the bonds that pays a fixed income with a simple credit rating. Insurance companies buy the note because it meets their investment rules.
Example
A car finance company pools thousands of customer loans and sells bonds backed by the repayments. This repackaging lets the lender recover cash quickly and make new loans. Investors receive returns from the customer payments, and the lender removes the loans from its balance sheet.
Example
A wealth manager buys a government bond and combines it with an option on a stock index to create a capital-protected note. The client receives the full bond repayment plus a share of any index rise. The manager charges a fee built into the price of the note.
Formula
Calculation
Repackaged yield = Underlying yield - Structuring and servicing costs
Arranger income = Underlying income - Income paid to investors
Suppose an arranger holds $10,000,000 of bonds paying 6% a year, which is 10,000,000 x 0.06 = $600,000 in annual income. It repackages them into a note that pays investors 5.5%, which is 10,000,000 x 0.055 = $550,000. The arranger keeps the difference of 600,000 - 550,000 = $50,000 a year, which covers its structuring costs and profit. The investor's yield is 0.5 percentage points lower than the underlying bonds in return for the features of the new note.Case study
Seen in the real world.
Coastal Trust Bank is an illustrative, fictional lender that held $200,000,000 of small business loans. Its finance team wanted to free up capital for new lending and decided to repackage the loans into bonds for sale to investors.
The bank created three layers of bonds: a senior layer of 80% of the pool, a middle layer of 15% and a junior layer of 5% that would absorb the first losses. It kept the junior layer on its own books to show that it still had a stake in the quality of the loans.
Investors bought the senior and middle layers, giving the bank $190,000,000 in cash to lend again. The illustrative lesson was that repackaging works best when the arranger keeps some risk and discloses clearly what is inside.
Watch out
Common mistakes.
- Believing that repackaging removes risk, when it only redistributes it among different holders.
- Relying on a credit rating for a repackaged product without understanding the underlying assets.
- Ignoring fees and costs, which are often built into the price and reduce the investor's return.
Questions
People also ask.
Why do banks repackage assets?
They can free up capital, earn fees and create products that match what particular investors want to buy.
What is a special purpose vehicle?
It is a separate legal entity set up to hold the original assets, so that the repackaged securities are backed by those assets and not by the bank itself.
Is repackaging the same as securitisation?
Securitisation is a common form of repackaging in which loans are pooled and sold as securities, but repackaging also covers other restructurings of existing securities.
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