Securitization is the process of converting a batch of debts into a marketable security that is backed, or securitized, by the original debts.

Most debt securities are made up of loans such as mortgages made by banks to their customers. However, any receivables-based financial asset can support a debt security. Other forms of underlying assets include trade receivables, credit card debt, and leases.

Key Takeaways

  • Debt securitization is the process of packaging debts from a number of sources into a single security to be sold to investors.
  • Many such securities are batches of home mortgage loans that are sold by the banks that granted them.
  • The buyer is typically a trust that converts the loans into a marketable security.

An investor who purchases stock in a company has a claim to the company's assets and future cash flows. Similarly, an investor who purchases a securitized debt product has a claim against the future repayment of the underlying debt instruments.

From the viewpoint of the investor, the debt is an asset.

Understanding Debt Securitization

There are always at least four parties involved in the debt securitization process. The first is the borrower, who took out a loan and promised to repay it. The second is the loan originator, which is the bank that approved the loan.

That loan originator, or bank, has the initial claim to the borrower's repayments. But the bank might want to realize its profit from the loan much faster than the 20-year or 30-year term of the loan permits.

The bank can cash in immediately by selling this loan and others in its possession for face value or close to it to a third party. That third party is usually operating as a trust.

The trust makes money by securitizing a number of the loans and repackaging them as a newly-minted asset. The asset is then sold to investors, who make up the fourth party in the chain.

If you follow the chain, the securitized debt product eventually delivers loan repayments to the fourth party in the form of investment returns.

A Short History of Debt Securitization

The first mercantilist corporations served as vehicles of sovereign debt securitization for the British Empire during the late seventeenth and early eighteenth centuries.

According to researchers at Texas Christian University, Great Britain restructured its debt by offloading it to its wealthiest corporations, which in turn sold shares backed by those assets.

This process was so pervasive that, by 1720, the South Sea Company and the East India Company held nearly 80% of the national debt. The corporations essentially became special purpose vehicles (SPVs) for the British treasury.

Eventually, worries over the frailty of those corporate shares led the British to stop securitizing and focus on a more conventional bond market to raise money.

The Revival of Debt Securitization in the 1970s

The debt security market was virtually non-existent for the next 200 years. In 1970, the secondary mortgage market began to see the first mortgage-backed securities (MBS) in the United States.

The debt securitization market took off in 1983 when Fannie Mae introduced the first collateralized mortgage obligations.

This process could not have existed without the Government National Mortgage Association (Ginnie Mae), which guaranteed the first mortgage pass-through securities.

Prior to Ginnie Mae, investors traded individual loans in the secondary market. Since they were not securitized, very few investors were interested in buying them.

Government-backed pass-throughs became a revelation to secondary mortgage traders. They were then viewed as safe investments. Ginnie Mae was soon followed by two other government-sponsored corporations, Fannie Mae and Freddie Mac.

Fannie Mae fueled the fire when it issued the first collateralized mortgage obligations (CMOs) in 1983. Congress doubled down on CMOs when it created the Real Estate Mortgage Investment Conduit (REMIC) to facilitate the issuance of CMOs.

By 2000, the trade in mortgage-backed securities has become a $6 trillion market. It bore a great deal of the blame for triggering the 2008-2009 financial crisis when many of those underlying mortgages went into default. After about five years in no man's land, the market for mortgage-backed securities came roaring back. By 2018, the total was close to $10 trillion.