Securitization is the financial alchemy of taking not-easily- or nontradable assets, pooling them together, and selling tradeable shares in that pool to investors. Broadly, securitization could be taking any assets, as with bitcoin or ether for crypto exchange-traded funds or properties and related assets for real estate investment trusts, and selling securities related to them.
However, we focus here on its primary meaning for investors and regulators: when an issuer designs a marketable financial instrument by merging financial assets, normally mortgage loans and consumer or commercial debt.1 Investors who buy these securities receive the principal and interest payments for the underlying assets.2
Key Takeaways
Securitization pools or groups debt into portfolios.
Issuers create marketable financial instruments by merging various financial assets into tranches.
Securitized instruments provide investors with income from interest and principal.
Mortgage-backed securities (MBS) are backed by home loans issued to consumers.
Other asset-backed securities (ABS) are backed by auto loans, mobile home loans, credit card loans, and student loans.
We’ll take up the nuts and bolts of how securitization works, exploring its mechanics through a step-by-step example. We’ll examine the potential benefits securitization offers to both lenders and investors, such as improved liquidity, risk diversification, and more efficient capital allocation. Meanwhile, we’ll grapple with the significant risks and downsides of securitization, including reduced transparency, misaligned incentives, and the potential for systemic instability.
Securitization: The pooling of assets in order to repackage them into interest-bearing securities.
Investopedia / Xiaojie Liu
How Securitization Works
In securitization, the company or the originator that holds the assets determines which assets to remove from its balance sheets. A bank might do this with mortgages and personal loans it no longer wants to service or raise capital for additional loans.
This gathered group of assets is now considered a reference portfolio. The originator then sells the portfolio to an issuer who creates tradable securities with a stake in the assets in the portfolio. Investors buy the new securities for a specific rate of return and effectively take the position of the lender.
Securitization allows the original lender or creditor to remove assets from its balance sheets to underwrite additional loans. Investors profit as they earn a rate of return based on the associated principal and interest payments made on the underlying loans and obligations by the debtors or borrowers.
Securitization frees up capital for originators and promotes liquidity in the marketplace.
Steps In Securitization
Securitization is a complex process that involves several steps:23
Asset origination: The process begins with a lender, such as an investment bank, issuing loans to borrowers. These loans can be in business lines of credit, mortgages, auto loans, credit card receivables, or other types of credit.
Create asset pools: The lender selects a pool of loans with similar characteristics, such as loan type, maturity, and credit quality. This pool of loans will serve as collateral for issuing securities.
Create the special purpose vehicle (SPV): The lender establishes a separate legal entity called an SPV) or a special purpose entity. The SPV is designed to be bankruptcy-remote, meaning that if the lender goes bankrupt, the assets held by the SPV won’t be affected.
Transfer the assets: The lender sells the pool of loans to the SPV, effectively removing the assets from its balance sheet. In return, the SPV pays the lender for the assets, often using funds raised from issuing securities.
Tranching: The SPV divides the pool of loans into different risk classes, known as tranches. Each tranche has a different level of risk and return, catering to different investor risk appetites. The tranches are typically considered senior, mezzanine, and junior (or equity).
Credit enhancement: The SPV may use various credit enhancement techniques to make the securities more attractive to investors. These can include over-collateralization (i.e., putting more collateral in the pool than the value of the securities issued), reserve accounts, or third-party guarantees.
Rating: The SPV hires credit rating agencies to assess the creditworthiness of each tranche. The rating agencies assign ratings to the tranches based on their perceived risk, with the senior tranches receiving the highest ratings and the junior tranches receiving the lowest.
Marketing and sale: The securities, now backed by the pool of loans, are marketed and sold to investors through investment banks. Investors can invest in different tranches based on risk tolerance and investment objectives.
Distribute cash flows: As borrowers of underlying loans make payments, the cash flows are collected by a servicer and distributed to the investors according to the terms of the securities. The senior tranches get priority over junior tranches in receiving payments.
Monitoring and reporting: Throughout the life of the securities, the servicer monitors the performance of the underlying loans and provides regular reports to the investors.
Types of Securitization
There are several types of securitization, each with its own structure and characteristics. The most common types include pass-through securitization, pay-through debt instruments, and collateralized debt obligations (CDOs).3
Tranches
The new securitized financial instrument may be divided into different sections called tranches. The tranches consist of individual assets grouped by loan type, maturity date, interest rate, and remaining principal. Each tranche carries different degrees of risk and offers different yields.
Pass-Through Securitization
Pass-through securitization is the most basic form of securitization. In this structure, the cash flows from the underlying pool of assets are transferred to investors. The SPV issues securities, known as pass-through (or flow-through) certificates, which represent an undivided interest in the pool of assets (i.e., there are no tranches). As borrowers make payments on the underlying loans, the cash flows are collected by the servicer and distributed to the investors pro rata.
MBS issued by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac are examples of pass-through securitization.4
Pay-Through Debt Instruments
Pay-through instruments, also known as collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits, are a more complex form of securitization. For these, the cash flows from the underlying pool of assets are used to pay interest and principal on the securities issued by the SPV, but the securities themselves are structured as debt obligations.
The securities are divided into tranches with different maturities, risk profiles, and payment priorities. The cash flows from the underlying assets are allocated to the tranches based on a preset structure, with the senior tranches receiving payments before the junior tranches.5
Asset-backed securities (ABS) are a general term for securitization backed by a pool of nonmortgage assets, such as auto loans, credit card receivables, student loans, or equipment leases. The cash flows from these assets are used to pay interest and principal on the securities issued by the SPV. Like other types of securitization, ABS can be structured with different tranches, each with its own risk and return profile.
Collateralized Debt Obligations (CDOs)
Collateralized debt obligations (CDOs) are a type of securitization that involves pooling together a diverse range of debt obligations, such as corporate bonds, loans, or even other securitized products like MBS or ABS. The pool of assets is then divided into tranches, each with its own risk and return characteristics.
Upping the ante, CDO-squared and CDO-cubed have underlying assets of CDOs and CDO-squared, respectively. These played a significant role in the 2007 to 2008 global financial crisis.67 Many of these securities were backed by subprime mortgages and experienced significant losses when the housing market collapsed. The complexity and lack of transparency in these structures made it difficult for investors to understand the true risks involved, leading to a loss of confidence in the securitized product market.
