Securitization is the process of grouping financial instruments together to create a distinct security called an asset-backed security. That resulting security then can be sold to investors as a distinct unit.
This article will define securitization, discuss the process, provide examples, point out pros and cons, and explain why securitization occurs.
Definition and Examples of Securitization
Securitization is the process of creating what are known as asset-backed securities. Many underlying assets are pooled together and sold as a package to investors. The purpose of securitization is to pool illiquid financial assets—often some type of loan such as a mortgage, credit card debt, or accounts receivable—to create liquidity for the issuing firm.
For example, mortgage-backed securities are the result of securitization. In the 1970s, the U.S. government sponsored the process in which financial lenders could sell groups of their mortgage loans as individual securities.
Securitization creates liquidity for the financing institution because the resulting asset-backed securities can be sold to investors. This process provides the institution with new capital that can be used to make loans to other customers.
Raising capital through securitization of illiquid loans can often be more cost-effective than borrowing. The securities are liquid for the investor as well because they can be traded on the open market, unlike the underlying instruments they are created from.
How Does Securitization Work?
Securities may be bundled together according to their term, interest rate, credit rating, or type of loan. For example, an asset-backed security may be created by bundling long-term loans. Another security may be created by packaging together accounts receivable.
Once the financial instruments are bundled together, they will often be divided into separate securities with varying degrees of risk. This process of dividing the securities by risk is called subordination, and these risk segments are called tranches.
Since the source of return of an asset-backed security is the cash flow from underlying loans, the associated risk is the possibility of defaulting on those loans.
The securities with the highest risk will pay the highest rate of interest and provide the highest expected return, while the lower risk slices will provide lower rates of interest.
Forming asset-backed securities in this way allows an investor to choose a security that is best suited for their investment objectives.
Types of Asset-Backed Securities
Securitization can create many different types of asset-backed securities. Often, a distinction is made between asset-backed securities backed by pools of mortgages and other asset-backed securities created from other types of loans.
Mortgage-backed securities, or MBS, are a specific type of asset-backed security created by packaging together real estate loans. The investor's return comes from the payments on the underlying mortgage. The source of risk in mortgage-backed securities is the possibility that the borrowers won’t repay their loans.
Pros and Cons of Securitization
Provides liquidity to financial institutions
Gives investors access to new investments
Lowers financing cost for institutions
Investors may not fully understand the risks
May cause institutions to make riskier loans
Securitization can create liquidity for financial institutions because they can free up assets on their balance sheets and raise new capital when those assets are packaged and sold. This allows them to make loans at a greater scale. Investors also gain access to investments that they otherwise may not be able to hold directly without securitization.
There are some drawbacks to securitization as well. Investors may not always understand the risk of investing in asset-backed securities, and may experience unexpected losses. During the subprime mortgage crisis, many investors were exposed to greater default risk than they realized, because assets that were below investment grade were given investment-grade ratings, often AAA, after they were securitized.
Securitization has also been said to create a moral hazard in the loan origination process. If the institution that originates the loan does not plan to keep it, but plans to transfer the liability through securitization, then it may decide to make riskier loans that it otherwise would, because the risk of default is passed on to the investors.
- Securitization is the process of packaging together many different illiquid financial assets to create asset-backed securities to sell to investors.
- Securitization can provide liquidity to financial institutions and expand capacity to make additional loans.
- Investors that purchase asset-backed securities are able to access a greater selection of investments, but may not always understand the risk involved.
- Mortgage-backed securities are a type of asset-backed security, and their risk played a key role in the subprime mortgage crisis.