What Is Securitize?
The term securitize refers to the process of pooling financial assets together to create new securities that can be marketed and sold to investors. These pooled financial assets generally consist of different kinds of loans. Mortgages, credit card debt, car loans, student loans, and other forms of contractual debt are often securitized to clear them off the balance sheet of the originating company—the bank—and free up credit for new lenders. The value and cash flows of the new security are based off the underlying value and cash flows of the assets used in the securitization process. They vary according to how the pool is split up into tranches.
- The term securitize is the process of pooling financial assets together to create new securities that can be marketed and sold to investors.
- Mortgages and other forms of contractual debt are often securitized to clear them off the balance sheet of the originating company and free up credit for new lenders.
- Securitization is a great system when lenders give out good loans and ratings firms keep them honest.
- But there can be problems when assets become toxic, as when the subprime mortgage market collapsed, leading to the financial crisis of 2007-2008.
When a lender securitizes, it creates a new security by pooling together existing assets. These new securities are backed by claims against the pooled assets. The originator first selects the debt to be pooled like residential mortgages for a mortgage-backed security (MBS). This pool contains a subset of borrowers. Borrowers with excellent credit ratings and very little risk of default may all be pooled together to sell a high-grade securitized asset, or they can be sprinkled into other pools with borrowers with higher default risk to improve the overall risk profile of the resulting securities.
When the selection is complete, these pooled mortgages are sold to an issuer. This may be a third party that specializes in creating securitized assets or it can be a special purpose vehicle (SPV) set up by the originator to control its risk exposure to the resulting asset-backed securities. The issuer or SPV acts essentially as a shell corporation. The SPV then sells the securities, which are backed by the assets held in the SPV, to investors.
Securitizing is not an inherently good or bad thing. It is simply a process that helps banks turn illiquid assets into liquid ones and frees up credit. That said, the integrity of this complex process depends on banks retaining moral responsibility for the loans they issue even when they are not legally liable, and on ratings firms to be willing to call out originators when they abdicate this responsibility.
The securitization process depends on the moral responsibility of banks for loans they issue and on ratings firms to call out originators.
There are several reasons why lenders may securitize. One of the main reasons is because it lowers costs. A lender, for instance, may repackage debt and sell off asset-backed securities to increase its own credit rating. So a lender with a B-rating may rise in the ranks after securitizing its debt with a AAA-rating. By doing this, other lenders may be more likely to lend at lower interest rates, thereby cutting down the cost of debt. Securitizing also helps banks and other lenders to clear their balance sheets. By pooling the assets together and creating a new security, it becomes an off-balance-sheet item. This means there is no affect from these items on the balance sheet.
Asset-backed securities are attractive for investors. But they're particularly attractive for institutional investors. That's because they are highly customizable and can offer a product tailored to meet these large investors' needs. If these securities have been stripped, the investors can choose between principal- and interest-only in addition to selecting different tranches. The issuer creates the asset-backed security according to the market need, and ratings agencies assign ratings according to the expected ability of the borrowers whose loans make up the product to keep up their payments. And there is a market for every type of loan.
For example, securitized products made from subprime borrowers have a higher overall chance of default and riskier ratings, but those loans also offer more immediate cash flows and, therefore, better returns. So that type of security may fit into a portfolio focused on generating short-term income. But a pool of highly rated borrowers will have lower cash flows, as the borrowers qualify for lower interest rates and have a higher risk of prepayment. Even with these downsides, the resulting security has a better return than most bonds while offering a risk profile that is not that far out of line. That's provided the ratings are accurate.
Example of Securitization
Securitization is a great system when lenders give out good loans and ratings firms keep them honest. But it does have its downsides. When originators start making NINJA loans and ratings firms take their documentation on faith, then bad and potentially toxic assets get sold to the market as being much more sound than they are. That's exactly what happened in one of the worst crashes in history. Mortgage-backed securities were one of the factors that played into the financial crisis of 2007-2008, which led to the failure of several major banks, not to mention the elimination of trillions of dollars in wealth. The effect was so widespread it caused turmoil in the global financial markets.
The whole problem began when heightened demand for these securities, coupled with a rise in home prices led banks and other lenders to relax some of their lending requirements. It got to the point where just about anyone could become a homeowner. But something happened. Housing prices hit their peak and the market crashed. Subprime mortgagors—those who wouldn't be able to normally afford a home—began to default, and subprime MBS began to lose much of their value. It eventually got to the point where these assets were overvalued, and no one was able to unload them. This led to a tightening of the credit market, with many banks on the verge of collapse. Under the Obama administration, the U.S. Treasury ended up stepping in with a $700 billion stimulus package to help the banking system out of the crunch.