Securitized Products: Definition, Examples, Safety Issues

What Are Securitized Products?

Securitized products broadly refer to pools of financial assets that are brought together to create a new security, which is then divided and sold to investors. Since the value and cash flows of the new asset are based on its underlying securities, these investments can be hard to analyze, but they have their benefits. 

How Securitized Products Work

Securitization describes the process of pooling financial assets and turning them into tradable securities. In theory, any financial asset can be securitized—that is, turned into a tradeable, fungible item of monetary value. In essence, this is what all securities are. However, securitization most often occurs with loans and other assets that generate receivables such as different types of consumer or commercial debt. It can involve the pooling of contractual debts such as auto loans and credit card debt obligations.

The first products to be securitized were home mortgages. These were followed by commercial mortgages, credit card receivables, auto loans, and student loans, among others. Bonds backed by home mortgages are commonly referred to as mortgage-backed securities (MBS), and bonds backed by non-mortgage-related financial assets are called asset-backed securities (ABS). Mortgage-backed securities played a central role in the financial crisis that began in 2007.

Creating a securitized bond looks something like this: A financial institution (the "issuer") with assets it wishes to securitize sells the assets to a special-purpose vehicle (SPV). For legal purposes, the SPV is a separate entity from the financial institution, but the SPV exists only to purchase the financial institution's assets.

By selling the assets to the SPV, the issuer receives cash and removes the assets from its balance sheet, providing the issuer with greater financial flexibility. The SPV issues bonds to finance the purchase of the assets; these bonds can be traded in the marketplace and are referred to as securitized products.

One key feature of securitized products is that they are usually issued in tranches. This means the larger deal is broken down into smaller pieces, each of which has different investment characteristics. The existence of different tranches makes securitized products appealing to a wide range of investors because each investor can choose the tranche that best combines their desire for yield, cash flow, and safety.

Special Considerations 

Internal credit enhancement for securitized products refers to safeguards that are built into the structure of the securitized product itself. Common forms of internal credit enhancement include subordination—where highly-rated tranches receive cash flow priority over lower-rated tranches—and over-collateralization—where the amount of bonds issued by the SPV is less than the value of the assets backing the deal. 

The intended effect of any type of internal credit enhancement is that cash flow shortfalls due to losses in the value of the underlying assets do not affect the value of the safest tranches of bonds. This works well, given the relatively low levels of losses, but the value of the protection is less certain if losses on the underlying assets are substantial.

External credit enhancement occurs when a third party provides an additional guarantee of payment for bondholders. Common forms of external credit enhancement include third-party bond insurance, letters of credit, and corporate guarantees.

The main drawback to external credit enhancement is that the additional protection is only as good as the party providing it. If the third-party guarantor experiences financial hardship, the value of its guarantee may be negligible, leaving the safety of the bonds dependant on the bonds' underlying fundamentals.

Benefits of Securitized Products

As with many other areas of the fixed-income marketplace, the main participants in the securitized products market are institutional investors. Despite these challenges, many individuals invest in securitized products.

Owners of diversified fixed-income mutual funds or exchange-traded funds often indirectly hold securitized products through their funds' holdings. Some individuals also choose to invest directly in securitized products. There are several key benefits that securitization provides to market participants and the broader economy.

Frees Capital, Lowers Rates

Securitization provides financial institutions with a mechanism for removing assets from their balance sheets, thereby increasing the pool of available capital that can be loaned out. A corollary to the increased abundance of capital is that the rate required on loans is lower; lower interest rates promote increased economic growth. 

Increases Liquidity, Lowers Risk

This action increases liquidity in a variety of previously illiquid financial products. Pooling and distributing financial assets allows for a greater ability to diversify risk and provides investors with more choice as to how much risk to hold in their portfolios.

Provides Profits

Intermediaries benefit by keeping the profits from the spread, or difference, between the interest rate on the underlying assets and the rate paid on the securities that are issued. Purchasers of securitized products benefit from the fact that these products are often highly customizable and can offer a wide range of yields. 

High Yield

Many securitized products offer relatively attractive yields. These high returns don't come for free though; compared to many other types of bonds, the timing of the cash flows from securitized products is relatively uncertain. This uncertainty is why investors demand higher returns.

Diversification and Safety

As one of the largest fixed-income security types, securitized products present fixed-income investors with an alternative to government, corporate, or municipal bonds. There are several methods that financial intermediaries use in order to issue bonds that are safer than the assets that back them. Most securitized products have investment-grade ratings.

Drawbacks to Consider

Of course, 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. Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations. But that doesn't help much if the loan holders' default and little can be realized through the sale of their assets.

Different securities—and the tranches of these securities—can carry different levels of risk and offer the investor various yields. Investors must take care to understand the debt underlying the product they are buying.

Even so, there can be a lack of transparency about the underlying assets. MBS played a toxic and precipitating role in the financial crisis of 2007 to 2009. Leading up to the crisis the quality of the loans underlying the products sold was misrepresented. Also, there was misleading packaging—in many cases repackaging—of debt into further securitized products. Tighter regulations regarding these securities have since been implemented. Still—caveat emptor—or beware buyer.

A further risk for the investor is that the borrower may pay off the debt early. In the case of home mortgages, if interest rates fall, they may refinance the debt. Early repayment will reduce the returns the investor receives from interest on the underlying notes.