Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming it (or them) into a security. The derisive phrase "securitization food chain," popularized by the film "Inside Job" about the 2007-2008 financial crisis, describes the process by which groups of such illiquid assets (usually debts) are packaged, bought, securitized and sold to investors.
A typical example of securitization is a mortgage-backed security (MBS), a type of asset-backed security that is secured by a collection of mortgages. First issued in 1968, this tactic led to innovations like collateralized mortgage obligations (CMOs), which first emerged in 1983. MBS became extremely common by the mid-1990s. The process works as follows.
Forging a Securitization Food Chain
The first step in the chain begins with the simple process of would-be home- or property-owners applying for mortgages at commercial banks. The regulated and authorized financial institution originates the loans, which are secured by claims against the various properties the mortgagors purchase. Mortgage notes (claims on future dollars) are assets for the lenders, but these assets come with clear counterparty risk. The borrower could fail to repay the loan, and so banks often sell notes for cash.
This leads to the second big link in the chain: Individual mortgages are bundled together into a mortgage pool, which is held in trust as the collateral for an MBS. The MBS can be issued by a third-party financial company, such as a large investment banking firm, or by the same bank that originated the mortgages in the first place. Mortgage-backed securities are also issued by aggregators such as Fannie Mae or Freddie Mac.
Regardless, the result is the same: A new security is created, backed up by the claims against the mortgagors' assets. Shares of this security can be sold to participants in the secondary mortgage market. This market is extremely large, providing a significant amount of liquidity to the group of mortgages, which otherwise would be quite illiquid on their own. (For a one-stop shop on subprime mortgages, the secondary market and the subprime meltdown, check out the Subprime Mortgages Feature.)
There are multiple kinds of MBS: pass-throughs, a simple variety in which mortgage payments are gathered and passed through to investors, and CMOs. CMOs break the mortgage pool into a number of different parts, referred to as tranches. This spreads the risk of default around, similar to how standard portfolio diversification works. The tranches can be structured in virtually any way that the issuer sees fit, allowing a single MBS to be tailored for a variety of risk tolerance profiles.
Pension funds will typically invest in high-credit rated mortgage-backed securities, while hedge funds will seek higher returns by investing in those with low credit ratings. In any case, the investors would receive a proportionate amount of the mortgage payments as their return on investment – the final link in the chain.