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What is 'Securitization'

Securitization is the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors, and this process can encompass any type of financial asset and promotes liquidity in the marketplace.

Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors.

BREAKING DOWN 'Securitization'

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

In securitization, the company holding the loans, also known as the originator, gathers the data on the assets it would like to remove from its associated balance sheets. These assets are then grouped together by factors such as time remaining on the loan, the level of risk, the amount of remaining principle, and others.

This gathered group of assets, now considered a reference portfolio, is then sold to an issuer. The issuer creates tradable securities representing a stake in the assets associated with the portfolio, selling them to interested investors with a rate or return.

Benefits to Creditors and Investors

Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations. The investors effectively take the position of lender by buying into the security. This allows a creditor to remove the associated assets from their balance sheets.

The investors earn a rate of return based on the associated principle and interest payments being made by the included debtors on their obligation. Unlike some other investment vehicles, these are backed by tangible goods. Should a debtor cease payments on his asset, it can be seized and liquidated to compensate those holding an interest in the debt.

Securitization and Risk

Like other investments, the higher the risk, the higher potential rate of return. This correlates with the higher interest rates less qualified borrowers are generally charged. Even though the securities are back by tangible assets, there is no guarantee that the assets will maintain their value should a debtor cease payment.