How does securitization increase liquidity?

Securitization involves taking an illiquid asset (or group of assets) and consolidating with other assets in an effort to create a more liquid asset that can be sold to another party. Liquidity describes the degree in which an asset can be readily sold without affecting its price; a large, well-established market with high trading volume is considered to be a liquid market. Transforming illiquid assets into assets than can be readily sold on a market thereby increases liquidity.

For example, a bank can use securitization to convert a portfolio of mortgages (which individually are illiquid assets) into cash (a very liquid asset). When a bank underwrites a mortgage, it owns the rights to the future stream of income provided by the borrower repaying the loan. Effectively, it creates an asset on its balance sheet.

However, a mortgage is a relatively illiquid asset for the bank. The repayment of principal and interest occurs over long periods of time, often 15 to 30 years for residential mortgages. Further, it is difficult to attract a market of buyers looking to purchase a single mortgage due to the risk of the borrower defaulting on the loan. If the bank wanted to liquidate this asset, it would have to offer a substantial discount to compensate for the higher degree of risk.

The bank could avoid a deep discount on selling its assets to improve liquidity through securitization. If the bank pooled its mortgage assets, combining many existing mortgages into one stream of income, it would mitigate the risk of default and make the asset more attractive to a larger market of prospective buyers. It could then divide up and sell the rights to the future stream of income from this pool of mortgages for cash.

This process improves the bank's liquidity position by reducing its position in illiquid assets (in this example, the portfolio of mortgages) and increases its position in a more liquid asset (cash, in this example).

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