What Is Securitization?
Securitization is how an issuer creates a marketable financial instrument by combining or pooling many financial assets into a single entity. This group of repackaged assets is then sold to investors by the issuer. Securitization provides chances for investors while also freeing up cash for originators, both of which help increase market liquidity.
Any financial asset can theoretically be securitized and converted into a tradeable, fungible monetary object. This is, in essence, what all securities are.
On the other hand, securitization is most commonly associated with loans and other assets that create receivables, such as various types of consumer and commercial debt. It may entail the consolidation of contractual debts such as vehicle loans and credit card debt.
How Does It Work?
The corporation owning the assets, known as the originator, obtains data on the purchases it wants to remove from its related balance sheets in securitization. For example, if it were a bank, it might be doing this with a range of mortgages and personal loans that it no longer wants to service. This collection of assets is now referred to as a reference portfolio. Subsequently, the portfolio is sold to an issuer, who will turn it into trading securities. Securities are created to represent a share of the portfolio’s assets. For a specific rate of return, investors will purchase the newly minted securities.
The reference portfolio, a new securitized financial product, is frequently broken into tranches. Individual assets are divided into tranches based on various characteristics, including the type of loan, maturity date, interest rate, and amount of remaining principal. As a result, each tranche bears varying levels of risk and offers varying returns. Less-qualified borrowers of the underlying loans are charged higher interest rates due to higher risk, and the higher the risk, the higher the potential rate of return.
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A perfect example of securitization is mortgage-backed security (MBS). Following the consolidation of mortgages into a single large portfolio, the issuer might divide the pool into smaller sections based on the risk of default inherent in each mortgage. These smaller amounts are subsequently sold to investors in the form of bonds.
Investors effectively take up the role of the lender by purchasing the security. Thanks to securitization, the linked assets can be removed from the original lender’s or creditor’s balance sheets. They can underwrite more loans with less responsibility on their balance sheets. Investors profit because they gain a rate of return based on the debtors’ or borrowers’ payments of principal and interest on the underlying loans and obligations.
Securitization generates liquidity by allowing regular investors to buy shares in securities that would otherwise be out of reach. An MBS, for example, allows an investor to purchase shares of mortgages in exchange for regular interest and principal payments. Small investors may not be able to afford to buy into a big pool of mortgages without securitization.
Unlike some other investment vehicles, many loan-based securities are backed by tangible assets. If a debtor stops making payments on a loan, such as a car or a house, the asset might be seized and sold to recompense individuals who have an interest in the debt.
In addition, by moving debt into the securitized portfolio, the originator reduces the number of liabilities on their balance sheet. They can then underwrite more loans because their liability has been lowered.
Consider the Drawbacks
Even while actual assets back the securities, there is no guarantee that the assets will retain their value if the debtor stops paying. Through the split of ownership of debt obligations, securitization provides creditors with a tool to reduce their related risk. But that won’t assist much if the loan holders default and only a small portion of their assets can be sold.
Different securities—and different tranches of these securities—can have varying levels of risk and give varying yields to investors. Investors must be aware of the debt that underpins the goods they purchase.
The investor also faces the risk of the borrower paying off the debt early. If interest rates fall on home mortgages, they may be able to refinance the debt. The interest earned on the underlying notes will be reduced if the notes are repaid early.
Securitization in the Real World
Specialty products are three types of mortgage-backed securities offered by Charles Schwab to investors. Government-sponsored businesses back all mortgages that underpin these products (GSEs). Because of this solid foundation, these instruments are among the highest quality in their class. Among the MBSs are those provided by:
Fannie Mae is the Federal National Mortgage Association, which buys mortgages from lenders, packages them into bonds, and resells them to investors. These bonds are only guaranteed by Fannie Mae and are not directly backed by the United States government. Credit risk is associated with FNMA products.
Freddie Mac (Federal Home Loan Mortgage Corporation) buys mortgages from lenders, packages them into bonds, and sells them to investors. These bonds are only guaranteed by Freddie Mac and are not directly backed by the United States government. Credit risk exists with FHLMC products.
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