What Is Securitization?
Securitization is the procedure by which an issuer designs a negotiable financial instrument by merging or grouping various financial assets into a single group. The issuer then sells this pool of repackaged assets to investors. Securitization provides opportunities for investors and frees up capital for new companies, which promote liquidity in the market.
In theory, any financial asset, that is, a consumable and consumable item of monetary value, can be securitized. Basically, this is what all values are.
However, securitization occurs more frequently with loans and other loan-generating assets, such as various types of commercial or consumer debt. It may involve the pooling of contractual debts, such as car loans and credit card debt obligations.
How Securitization Works
For securitization, the company that owns the assets, known as the originator, collects the details of the assets it wishes to draw from their related balance sheets. For example, if you were a bank, you might be dealing with a variety of mortgages and personal loans that you no longer want to pay. This group of pooled assets is now considered a benchmark portfolio. The promoter then sells the portfolio to an issuer who creates marketable securities. The securities created represent a portion of the portfolio’s assets. Investors will buy the created securities for a specified rate of return.
The reference portfolio, the new securitized financial instrument, is often divided into several sections, known as tranches. Tranches consist of individual assets grouped by various factors, such as the type of loan, its maturity date, its interest rates, and the amount of principal remaining. As a result, each tranche carries different degrees of risk and presents different returns. There is a correlation between higher risk levels and higher interest rates charged by less qualified borrowers on the underlying loans, and the higher the risk, the higher the potential rate of return.
Guaranteed Mortgage Security (MBS) is a great example of securitization. After combining the mortgages into a large portfolio, the issuer can divide the pool into smaller pieces based on each mortgage’s risk of default. These small pieces are then sold to investors, each packaged as a type of bond.
When buying a stock, investors effectively accept the position of the lender. Securitization allows the original lender or creditor to remove related assets from its balance sheets. With fewer liabilities on their balance sheets, they can get additional loans. Investors benefit from a rate of return based on principal and related interest payments made by borrowers or borrowers on the underlying loans and obligations.
The mortgage securitization process usually involves the following:
In general, the mortgage securitization process exists to allow mortgage brokers to sell mortgage loans and use the money to obtain more loans from homeowners. This process allows lenders to continue recycling homeowners’ loan money without retaining loan assets from their books. Unfortunately, this has led to predatory tactics and some finance companies are taking advantage of buying MBS in the secondary mortgage markets.
Benefits of securitization
The securitization process creates liquidity by allowing retail investors to purchase shares in instruments that would not normally be available to them. For example, with MBS, an investor can purchase portions of the mortgage and receive periodic returns, such as interest and principal payments. Without a mortgage securitization, small investors may not be able to afford a wide variety of mortgages.
In addition, as the originator transfers the debt to the securitization portfolio, it reduces the amount of liabilities on its balance sheet. With reduced liability, they can get additional loans.
Hard to judge
Of course, while securities are backed by tangible assets, there is no guarantee that the assets will maintain their value if a debtor fails. Securitization provides a mechanism for creditors to reduce their risk by sharing ownership of debt obligations. But this is useless if creditors do not comply and there is little that can be done by selling their assets.
Different securities and tranches of these securities may have different levels of risk and offer different returns to the investor. Investors should be careful to understand the underlying debt of the product they are buying.
However, there may be a lack of transparency regarding the underlying assets. MBS played a toxic and precipitating role in the financial crisis of 2007-2009. Before the crisis, the quality of the loans underlying the products sold was distorted. In addition, other securitized products had misleading packaging (in many cases, repackaging) of the debt. Since then, stricter regulations on these values have been implemented. Still, caveat emptor, or buyer beware.
Another risk for the investor is that the borrower may pay off the debt early. For home mortgages, if interest rates drop, they can refinance the debt. Early redemption will reduce the returns received by the investor for the interests of the footnotes.
Examples of real securitization
Charles Schwab offers investors three types of mortgage-backed securities called specialty products. All of the mortgages underlying these products are backed by Government Sponsored Enterprises (ESAs). This secure backing makes these products one of the best quality instruments of their kind. MBS includes offers for:
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