What is securitization?

By Chris Gallant AAA
A:

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.

RELATED FAQS

  1. What is the difference between a hedge fund and a private equity fund?

    Learn the primary differences between hedge funds and private equity funds, both of which are utilized by high net worth ...
  2. How do hedge funds determine what assets to own?

    Learn about the various types of investments that hedge fund managers use, and explore basic hedge fund management trading ...
  3. Where does a hedge fund get its money?

    Learn how a hedge fund is structured and how the managing partner of the fund goes about the process of finding and soliciting ...
  4. What is the purpose of a hedge fund?

    Find out what a hedge fund is, how it is set up and why it is different than other forms of investment partnerships like ...
RELATED TERMS
  1. Steve Cohen

    A trading magnate also referred to as the Hedge Fund King and ...
  2. David Tepper

    A legendary investor who specializes in distressed debt and manages ...
  3. David Einhorn

    Known for his short selling strategy, activist investor David ...
  4. Subprime Meltdown

    The sharp increase in high-risk mortgages that went into default ...
  5. Collateralized Loan Obligation - CLO

    A security backed by a pool of debt, often low-rated corporate ...
  6. Volcker Rule

    The Volcker rule separates investment banking, private equity ...

You May Also Like

Related Articles
  1. Investing Basics

    The Most Popular Bitcoin Mining Software

  2. With stocks surging, financial advisers and their wealthy clients are asking why they should continue to bother with poorly performing alternatives.
    Professionals

    Are Advisors Off Alternatives?

  3. Investing Basics

    Putting Your Retirement Eggs in Several ...

  4. bitcoin
    Investing Basics

    Medici, The Blockchain Stock Exchange

  5. Investing Basics

    The 5 Most Important Virtual Currencies ...

Trading Center