A:

Banks may securitize debt for several reasons including risk management, balance sheet issues, greater leverage of capital and to profit from origination fees. Debt is securitized by pooling certain types of debt instruments and creating a new financial instrument from the pooled debt. The types of debt instruments used may include residential mortgages, commercial mortgages, car loans or credit card obligations. The banks receive fees for selling the new debt security.

Banks may benefit from moving the default risk associated with the securitized debt off their balance sheets to allow for more leverage of their capital. By reducing their debt load and risk, banks can use their capital more efficiently. The securitized instruments created by pooling the debt are known as collateralized debt obligations (CDOs). The securitization process creates additional liquidity for debt instruments. While it is unusual for individual investors to own CDOs, insurance companies, banks, investment funds and hedge funds may trade in CDOs to obtain returns greater than simple Treasury yields.

Different levels of the debt, known as tranches, are sold to investors. The tranches are grouped together by different factors, including the level of risk for the tranche or the maturity of the payments due. Tranches are often given ratings that denote their perceived risk. The tranche rating determines the amount of principal and interest investors receive for buying that level of debt. Riskier tranches require higher interest rates, while tranches with higher ratings pay less interest. Defaults on subprime mortgages included in many CDOs are often cited as one of reasons for the 2008 financial crisis.

(For related reading, see: Who bears the risk of bad debts in securitization?)

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