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

A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages. The process works as follows:

First, a regulated and authorized financial institution originates numerous mortgages, which are secured by claims against the various properties the mortgagors purchase. Then, all of the individual mortgages are bundled together into a mortgage pool, which is held in trust as the collateral for an MBS. The MBS can be issued by a third-party financial company, such a large investment banking firm, or by the same bank that originated the mortgages in the first place. Mortgage-backed securities are also issued by aggregators such as Fannie Mae or Freddie Mac.

Regardless, the result is the same: a new security is created, backed up by the claims against the mortgagors' assets. This security can be sold to participants in the secondary mortgage market. This market is extremely large, providing a significant amount of liquidity to the group of mortgages, which otherwise would have been quite illiquid on their own. (For a one-stop shop on subprime mortgages, the secondary market and the subprime meltdown, check out the Subprime Mortgages Feature.)

Furthermore, at the time the MBS is being created, the issuer will often choose to break the mortgage pool into a number of different parts, referred to as tranches. These tranches can be structured in virtually any way the issuer sees fit, allowing the issuer to tailor a single MBS for a variety of risk tolerances. Pension funds will typically invest in high-credit rated mortgage-backed securities, while hedge funds will seek higher returns by investing in those with low credit ratings.

For more on structured finance, check out Profit From Mortgage Debt With MBS.

  1. How does securitization increase liquidity?

    Securitization involves taking an illiquid asset (or group of assets) and consolidating with other assets in an effort to ... Read Full Answer >>
  2. What role did securitization play in the U.S. subprime mortgage crisis?

    The securitization of subprime mortgages into mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) ... Read Full Answer >>
  3. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  4. Are hedge funds regulated by FINRA?

    Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>
  5. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  6. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  2. Professionals

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  3. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  4. Home & Auto

    5 Mistakes That Make House Flipping A Flop

    If you're just looking to get rich quick, you could end up in the poorhouse.
  5. Entrepreneurship

    Top 10 Features Of a Profitable Rental Property

    Find out which factors you should weigh when searching for income-producing real estate.
  6. Financial Advisors

    Are Alternatives Right for Your Portfolio?

    Alternative investments are increasingly making their way into retail investors' portfolios. Are they a good fit?
  7. Bonds & Fixed Income

    Credit Default Swaps: An Introduction

    This derivative can help manage portfolio risk, but it isn't a simple vehicle.
  8. Fundamental Analysis

    Investment Banks: Not a Good Bet Right Now?

    Investment banks might appear safe to investors at the moment, but they're probably more dangerous than advertised.
  9. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  10. Professionals

    Common Interview Questions for Investment Bankers

    Explore some of the most commonly asked questions in an interview for an investment banking position, along with suggestions for winning answers.
  1. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  2. Investment Banking

    A specific division of banking related to the creation of capital ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based ...
  4. Investment Banker

    Someone working at an institution raising capital for companies, ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through ...

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center