July 13, 2024

Housing Finance Development

It's Your Housing Finance Development

Definition, Meaning, Types, and Example

What Is Securitization?

Securitization is the process of taking an illiquid asset or group of assets and, through financial engineering, transforming it (or them) into an investable security.

A mortgage-backed security (MBS) is a classic example of securitization. A group of home loans are sold by the original lender to another financial institution, which turns the package of mortgages into one distinct unit that the public can invest in. Investors are then paid the interest and principal payments from these various mortgages as if they were the bank lending these different homeowners money.

Securitization, in theory, is a win-win. It lets the original lender rid itself of liabilities and make more loans, while enabling investors to play the role of lender and profit from these activities. The public doesn’t always see it that way, though. Securitization has been accused of encouraging reckless borrowing and triggering one of the worst financial crises on record.

Key Takeaways

  • Securitization is the process of transforming a group of income-producing assets into one investable security.
  • Investors are paid the interest and principal payments from these securitized assets.
  • Securitization increases liquidity and access to credit.
  • However, the products created, asset-backed securities, have been accused of lacking transparency.
  • Skeptics say securitization encourages banks and other lenders to not care about the quality of the loans that they underwrite.

How Does Securitization Work?

Securitization usually happens in the following way:

  1. The company holding the assets, otherwise known as the originator, gathers data on the loans or income-producing assets that it no longer wants to service (they could be mortgages, personal loans, or something else). It then removes them from its balance sheets and pools them into a reference portfolio.
  2. The assets in the reference portfolio are sold to an entity such as a special-purpose vehicle (SPV), which turns them into a security that the public can invest in. Each security represents a stake in the assets from the portfolio.
  3. Investors buy the created securities in exchange for a specified rate of return. In most cases, the originator continues to service the loans from the reference portfolio, collecting payments from the borrowers and then passing them on, minus a fee, to the SPV or trustee. The generated cash flows are then paid to the investor.

Usually, the reference portfolio is divided up into different tranches. Each tranche, or section of the portfolio, will consist of assets that share something in common, such as similar maturity dates, and interest rates.

Investors need to have a rough idea of what each asset-backed security (ABS), the end product of securitization, contains and the level of risk that they are taking on. Generally, the greater the likelihood of default, the higher the reward.

Any type of asset with a stable cash flow can be grouped together, securitized, and sold to investors.

Why Do Banks Use Securitization?

Securitization gives the original lender the possibility to remove the associated assets from its balance sheet, reducing liabilities and freeing up space to underwrite more loans. There are many benefits to this strategy. Other than taking a nice cut from the assets it sells, securitization lets the bank appease customer demand for credit and can help boost its credit rating.

This method represents a cost-effective way for lenders to raise money, grow their loan book, and expand their business.

1970

The year when the U.S. Department of Housing and Urban Development (HUD) created the first modern residential mortgage-backed security (MBS). However, the roots of securitization can be traced all the way back to the late 18th century. Securitization was used then to help fund the expansion of the U.S. railroad system.

What Are the Asset Types Common to Securitization?

Anything that generates an income stream can theoretically be securitized into a tradable, fungible item of monetary value. Certain types of assets are more commonly turned into ABS, though. They include:

Mortgages

Securitization, as we know it today, began with mortgages. A cluster of different home loans can be combined into one large portfolio, separated into tranches, and sold off to investors as a type of bond-like product. Buyers of these investments, otherwise known as mortgage-backed securities (MBS), pay whatever the going rate is and, in return, get the interest and principal payments from the pool of mortgages in which they hold a stake.

Auto Loans

Another common category of ABS is car financing. Similar to mortgages, auto loans are bundled, split into various groups with different risk profiles, and sold as securities to investors. Owners of these securities then inherit any payments attached to these assets, including monthly interest payments and principal payments.

Credit Card Receivables

It’s also possible to buy a stake in money due on credit card balances. These types of ABS don’t have fixed payment amounts, and new loans and changes can be added to the pool as balances are paid off. Returns come in the form of interest, annual fees, and principal payments.

Student Loans

The money that students borrow to go to college is commonly packaged into ABS. It’s possible to invest in either student loans provided by the government and guaranteed by the U.S. Department of Education or, for a slightly higher risk and potentially larger return, student loans from private sources, such as banks.

What Are the Types of Securitization?

Securitization is generally broken down into three types:

  • Collateralized debt obligation (CDO): Holding a stake in a bunch of loans backed by collateral gives the investor peace of mind, as it means there is something of value that can be seized and sold off should the borrower default on payments.
  • Pass-through securitization: A servicing intermediary collects the monthly payments from issuers, deducts a fee, and then “passes through” what’s left to the holders of the securities.
  • Pay-through debt instrument: Under this structure, the investors don’t directly own the underlying assets. This means that the issuer can change the cash flows and deviate from what the underlying assets actually pay out.

What Are the Drawbacks of Securitization?

In theory, securitization should be beneficial to everyone, satisfying investors, lenders, and the general economy, which should gain from greater access to credit. However, it doesn’t always work out that way.

For Investors

When investing, guarantees are hard to come by. Netting decent returns usually requires taking on risk, and things don’t always go according to plan. For example, if a debt is backed by collateral, you might think there’s no way to lose. That’s not entirely true, though. It is possible that the asset used as collateral falls in value or becomes difficult to offload.

Moreover, with ABS, there’s always the risk that the borrowers repay debts early and interest payments fall to the point where the investor earns less than inflation or what they could earn elsewhere.

Remember what happened in the mid-2000s? Investors were sold batches of toxic, difficult-to-pay mortgage loans and were none the wiser, having been led to believe that the underlying assets were of a much higher quality. Tighter regulations have since been introduced, though it still always pays to be prudent.

For the Economy

Several studies have concluded that securitization can lead to poor lending practices and, subsequently, lots of people defaulting on their debts.

The general view is that if banks can sell the loans they write and move them off their books without much scrutiny, then they care less about the quality of those loans. Accepting more applications means making more money. And if it turns out that the applicant can’t pay back what is owed, then someone else—the investor—will pick up the tab anyway.

This was a common issue in the run-up to the 2007–08 financial crisis. At one point, lots of unaffordable mortgages were being doled out and then sold on to investors, who had no idea what they were holding.

Did Securitization Cause the 2007–08 Financial Crisis?

It is widely agreed that MBS paved the way for the devastating 2007–08 financial crisis. In the period leading up to the downturn, home loans with sometimes-questionable terms were made available to virtually everyone, including people with little means of paying them back, and then sold on to Wall Street banks, which packaged and advertised these loans as low-risk investments backed by decent credit ratings.

Eventually, interest rates rose and house prices, which had rocketed due to heightened mortgage activity, started to fall—to the point where homes were worth less than what people paid for them. Suddenly, lots of borrowers started defaulting on their mortgages, and the nature of the types of loans that were given out and sold on as MBS became apparent. By then, it was too late. The economy was already unraveling.

Wall Street and credit agencies were blamed for not taking a closer look at these products before peddling them to investors. And the original lenders were accused of turning a blind eye to a borrower’s ability to repay because they wouldn’t have to deal with the repercussions.

What is securitization in simple terms?

Securitization is the process of taking a group of income-producing assets and turning them into a single product that can be invested in.

What does it mean for a loan to be securitized?

If a loan is securitized, it was pooled with other similar loans and sold by the original lender to other investors.

What are the benefits of securitization?

Securitization enables lenders to underwrite more loans and investors to get in on the action. It promotes liquidity and access to credit, although the reputation of securitization did take a hit following the 2007–08 financial crisis.

The Bottom Line

Securitization involves taking a group of illiquid, income-producing assets and turning them into a single product that can be invested in. Pretty much anything with a stable cash flow can be securitized and turned into an asset-backed security (ABS). Classic examples include auto, student, and home loans.

Securitization is a divisive topic. On one hand, it is lauded for improving credit conditions and letting smaller investors have a chance to profit from financial institution loan books. On the other, just the mention of the word evokes thoughts of greed, the global financial crisis, and everything that is wrong with Wall Street and the banking sector.

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