Securitize

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, but any type of asset can be securitized.

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 and free up credit for new lenders. The value and cash flows of the new security are based on 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.

Key Takeaways

  • The term "securitize" refers to 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. 
  • The value of a securitized asset is based on the cash flows and risks of the underlying assets.
  • Securitization also provides a liquid market for assets that would otherwise be very difficult to sell.
  • But there can be problems when assets become toxic, as when the subprime mortgage market collapsed, leading to the financial crisis of 2007-2008.

Understanding Securitize

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.

Advantages and Disadvantages of Securitizing

The main advantage to securitizing an asset comes from the additional liquidity of making that asset available to a wider market of investors. Investors who would not ordinarily be able to invest in an asset might be more willing to buy a fractionalized share of that asset.

Moreover, there are also advantages in terms of diversification. Since investing in a small fraction of a thousand similar assets is considered less risky than investing in a single asset, securitizing a pool of assets can allow potential investors to reduce their risk exposure.

The main disadvantages occur due to the regulations surrounding securities issuances. In the United States, the Securities and Exchange Commission has strict rules about the securities that are offered for sale, especially those marketed towards retail investors.

Issuers take a great deal of risk when securitizing assets, and may assume responsibility if the underlying asset fails. Any accidental error or omission of fact in the security prospectus could become the basis for a lawsuit by investors if the securitized asset fails to generate expected returns.

Pros and Cons of Securitizing

Pros
  • Allows a more liquid market for previously illiquid assets.

  • Allows new investment by buyers who would not be able to acquire non-securitized assets.

  • By pooling large numbers of similar assets, securitizing allows investors to reduce their risk exposure.

  • Originator can remove assets from their balance sheets and reduce their risk exposure.

Cons
  • Securities sales are closely regulated and have strict reporting requirements.

  • Issuers may be held responsible for the underperformance of their securitized assets.

  • Asset-backed securities can be complex, requiring a thorough understanding by the investors who buy them.

Types of Securitized Assets

The most well-known securities are stocks, representing fractional ownership of a publicly-traded corporation. However, this is not what we normally mean by securitized assets. In fact, any type of income or cash flow can be bundled with similar assets and sold as securities.

One of the most common types of asset-backed securities are those backed by debt, where the investor earns an income from pooled loans. These can be backed by any type of debt, such as home mortgages, auto loans, or student loans. As the borrowers repay these loans, the owners of the security earn a share of their pooled repayments.

Another innovation uses royalties as the underlying for a securities issuance. In this case, the owner of a song, film, or other artwork sells the rights to future income from their royalties, in the form of a security. In 2022, a subsidiary of KKR issued a royalty-backed security, representing fractionalized royalties from a portfolio of 65,000 different songs.

Special Considerations

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.

Due to their inherent complexity, securitized assets are usually only available to institutional investors or high net-worth individuals.

Securitization and the Great Recession

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.

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. Soon these assets were so overvalued that one was able to sell 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.

Is It Good or Bad to Securitize?

Securitization comes with both benefits and drawbacks to the issuer. On the positive side, it allows the issuer to find a liquid market for assets that could otherwise be difficult to sell. It also reduces investor risk through diversification. On the other hand, securitizing a loan or asset comes with legal obligations on the part of the originator of the security. Any failure to abide by the relevant securities laws, even accidentally, could result in a high cost to the originator.

What Are Securitized Debt Instruments?

Securitized debt instruments are loan obligations that have been packaged and sold as securities. These are usually bundled together with other debt instruments that have similar credit ratings, reducing the buyer's risk exposure should any one of those debts default.

What Is the Purpose of Securitization?

Securitization allows investors to purchase fractionalized shares of an asset or instrument, usually bundled together with similar instruments. This allows more investors to access that type of asset, thereby increasing the liquidity of the market and reducing overall costs.

How Do Banks Make Money From Securitization?

Securitization allows banks to remove assets from their balance sheets, thereby freeing up capital and reducing their risk exposure to those assets.

Article Sources

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  1. Bloomberg. "Songs from Maroon 5, The Weeknd Back KKR's First Music Royalty Bond."

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