Securitization is the fancy title for the selling of a pool of assets to a trust, which turns around and finances the purchase by selling securities to the market. These securities are backed by the original assets.
An investor who purchases company stock 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 (which is an asset in this case).
Most debt securities are loans, which normally form the paper assets of most banks. However, any receivables-based financial asset can support a debt security. Other forms of underlying assets include trade receivables, credit card receivables or leases.
There are always a minimum of four parties in the debt securitization process. The first is the borrower, who originally took out a loan and promised to repay. The second is the loan originator, who receives the initial claim to the borrower's repayments. The loan originator is able to realize, immediately, most or all of the value of the loan contract by selling it to a third party, usually a trust. The trust is financed by securitizing the loan contract and selling it to investors, who are the fourth party. If you follow the chain, a securitized debt product eventually sends loan repayments to a fourth party in the form of investment returns.
The 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. Research from Texas Christian University (TCU) showed how Britain restructured its debt by offloading it to corporations with political backing, which in turn sold shares backed by those assets.
This process was so pervasive that, by 1720, the South Sea Company and East India Company held nearly 80 percent of the country's national debt. These corporations essentially became special purpose vehicles (SPVs) for the British treasury. Eventually, the worry about the frailty of those corporate shares led the British to stop securitizing and focus on a more conventional bond market.
The Revival of Debt Securitization in the 1970s
The debt security market was essentially non-existent between 1750 and 1970. During 1970, the secondary mortgage market began to see the first mortgage-backed securities (MBS) in the United States. This process would have been unthinkable without the Government National Mortgage Association (GNMA or Ginnie Mae), which guaranteed the first mortgage pass-through securities.
Prior to Ginnie Mae, investors traded whole loans in the secondary market. Since these mortgages were not securitized, very few investors were willing to accept the risk of default or interest rate fluctuations. This caused the market to be generally illiquid.
Government-backed pass-throughs became a revelation to secondary mortgage traders. Ginnie Mae was soon followed by two other government-sponsored corporations, Fannie Mae and Freddie Mac. By 2000, the MBS market was six trillion dollars strong, and continued to climb to over 10 trillion dollars by 2016.
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.