Securitization: Definition, Pros & Cons, Examples

What Is Securitization?

Securitization is the pooling of assets in order to repackage them into interest-bearing securities. The investors that purchase the repackaged securities receive the principal and interest payments of the original assets.

The securitization process begins when an issuer designs a marketable financial instrument by merging or pooling various financial assets, such as multiple mortgages, into one group. The issuer then sells this group of repackaged assets to investors. Securitization offers opportunities for investors and frees up capital for originators, both of which promote liquidity in the marketplace.

In theory, any financial asset can be securitized—that is, turned into a tradeable, fungible item of monetary value. In essence, this is what all securities are.

However, securitization most often occurs with loans and other assets that generate receivables such as different types of consumer or commercial debt. It can involve the pooling of contractual debts such as auto loans and credit card debt obligations.

How Securitization Works

In securitization, the company holding the assets—known as the originator—gathers the data on the assets it would like to remove from its associated balance sheets. For example, if it were a bank, it might be doing this with a variety of mortgages and personal loans it doesn't want to service anymore. This gathered group of assets is now considered a reference portfolio. The originator then sells the portfolio to an issuer who will create tradable securities. Created securities represent a stake in the assets in the portfolio. Investors will buy the created securities for a specified rate of return.

Often the reference portfolio—the new, securitized financial instrument—is divided into different sections, called tranches. The tranches consist of the individual assets grouped by various factors, such as the type of loans, their maturity date, their interest rates, and the amount of remaining principal. As a result, each tranche carries different degrees of risk and offer different yields. Higher levels of risk correlate to higher interest rates the less-qualified borrowers of the underlying loans are charged, and the higher the risk, the higher the potential rate of return.

Mortgage-backed security (MBS) is a perfect example of securitization. After combining mortgages into one large portfolio, the issuer can divide the pool into smaller pieces based on each mortgage's inherent risk of default. These smaller portions then sell to investors, each packaged as a type of bond.

By buying into the security, investors effectively take the position of the lender. Securitization allows the original lender or creditor to remove the associated assets from its balance sheets. With less liability on their balance sheets, they can underwrite additional loans. Investors profit as they earn a rate of return based on the associated principal and interest payments being made on the underlying loans and obligations by the debtors or borrowers.

Benefits of Securitization

The process of securitization creates liquidity by letting retail investors purchase shares in instruments that would normally be unavailable to them. For example, with an MBS an investor can buy portions of mortgages and receive regular returns as interest and principal payments. Without the securitization of mortgages, small investors may not be able to afford to buy into a large pool of mortgages.

Unlike some other investment vehicles, many loan-based securities are backed by tangible goods. Should a debtor cease the loan repayments on, say, his car or his house, it can be seized and liquidated to compensate those holding an interest in the debt.

Also, as the originator moves debt into the securitized portfolio it reduces the amount of liability held on their balance sheet. With reduced liability, they are then able to underwrite additional loans.

Drawbacks to Consider

Of course, even though the securities are back by tangible assets, there is no guarantee that the assets will maintain their value should a debtor cease payment. Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations. But that doesn't help much if the loan holders' default and little can be realized through the sale of their assets.

Different securities—and the tranches of these securities—can carry different levels of risk and offer the investor various yields. Investors must take care to understand the debt underlying the product they are buying.

Even so, there can be a lack of transparency about the underlying assets. MBS played a toxic and precipitating role in the financial crisis of 2007 to 2009. Leading up to the crisis the quality of the loans underlying the products sold was misrepresented. Also, there was misleading packaging—in many cases repackaging—of debt into further securitized products. Tighter regulations regarding these securities have since been implemented. Still—caveat emptor—or beware buyer.

A further risk for the investor is that the borrower may pay off the debt early. In the case of home mortgages, if interest rates fall, they may refinance the debt. Early repayment will reduce the returns the investor receives from interest on the underlying notes.

Real-World Examples of Securitization

Charles Schwab offers investors three types of mortgage-backed securities called specialty products. All the mortgages underlying these products are backed by government-sponsored enterprises (GSEs). This secure backing makes these products among the better-quality instruments of their kind. The MBSs include those offered by:

• Government National Mortgage Association (GNMA): The U.S. government backs bonds guaranteed by Ginnie Mae. GNMA does not purchase, package, or sell mortgages, but does guarantee their principal and interest payments.
• Federal National Mortgage Association (FNMA): Fannie Mae purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Fannie Mae and are not direct obligations of the U.S. government. FNMA products carry credit risk.
• Federal Home Loan Mortgage Corporation (FHLMC): Freddie Mac purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Freddie Mac and are not direct obligations of the U.S. government. FHLMC products carry credit risk.