Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, such as mortgage-backed securities (MBS), as bad debts can stop these instruments' cash flows.

The risk of bad debt, however, can be apportioned among investors. Depending on how the securitized instruments are structured, the risk can be placed entirely on a single group of investors or spread throughout the entire investing pool.

Key Takeaways

  • Securitization is the process of financial structuring a non-liquid asset or group of similar assets into a security that is sold to investors.
  • Securitization takes many non-liquid assets, usually loans, such as mortgages, bundles them into a security, which is sold to an investor that receives an income stream from the principal and interest payments on that loan.
  • There are two types of securitized assets: those that come as pools and those that have tranches.
  • In a pool securitization, all investors are equal, sharing all of the risks. If there is bad debt on the pooled security, all investors suffer the financial loss.
  • In a tranche securitization, the security is split into different levels (tranches) that are made up of assets with different risk profiles. Lower tranches suffer losses on bad debts first whereas higher tranches are usually unaffected.

Securitization

Securitization is the process of financially structuring a non-liquid asset or group of similar non-liquid assets into a security that can then be sold to investors. The MBS was first created by trader Lew Ranieri in the early 1980s. It became an extremely popular investment in the 1990s and early 2000s. The idea was that the new security could be sold on the secondary mortgage market, offering investors significant liquidity on an asset that would otherwise be quite illiquid. 

Securitization, specifically, the bundling of assets such as mortgages into securities, has been frowned upon by many as it contributed to the subprime mortgage crisis of 2007. However, the practice continues today.

Pools and Tranches

There are two styles of securitization: pools and tranches. Here's how they affect the level of risk faced by investors.

Pools

A simple securitization involves pooling assets (such as loans or mortgages), creating financial instruments, and marketing them to investors. Incoming cash flows from the loans are passed onto the holders of the new instruments. Each instrument is of equal priority when receiving payments. Since all instruments are equal, they all share in the risk associated with the assets. In this case, all investors bear an equal amount of bad-debt risk.

Tranches

In a more complex securitization process, tranches are created. Tranches represent different payment structures and various levels of priority for incoming cash flows. In a two-tranche system, tranche A will have priority over tranche B. Both tranches will attempt to follow a schedule of payments that reflects the cash flows of the underlying loans or mortgages.

If bad debts arise, tranche B will absorb the loss, lowering its cash flow, while tranche A remains unaffected. Since tranche B is affected by bad debts, it carries the most risk. Investors will purchase tranche B instruments at a discount price to reflect the level of associated risk. If there are more than two tranches, the lowest priority tranche will absorb the losses from bad debts.

Tranches can be categorized incorrectly by rating agencies, where tranches are rated investment grade even though they include junk assets, which are non-investment grade.

For a portfolio, investors can choose from securitization investments such as prime and subprime mortgages, home equity loans, credit card receivables, or auto loans. Investors can also choose an index.

The Bottom Line

Securitization is a way for investors to gain access to assets that they would otherwise not have the chance to do so, such as mortgages. It is also a way for companies to reduce their balance sheet and take on more business by selling off assets like mortgages.

Securitization is a way to receive a consistent income stream, though it can be risky as much information about the underlying assets is unknown, such as the case in the subprime meltdown. When bad debts occur in securitization, the loss is shared as there are multiple investors, however, depending on the type of securitization, the loss is shared equally as in pooled securitizations or at different levels as in tranche securitizations.