Everything You Need to Know About Securitization

Securitization is the process of combining a group of illiquid assets and transforming them into interest-bearing securities through financial engineering. These assets can be sold in the financial market, providing lower risk and liquidity in the market. It makes it possible for issuers to dispose of assets in a cost-effective manner and get better funding conditions along with a beneficial financing profile. 

An issuer creates a marketable instrument by merging several financial assets, commonly loans, consumer debts, or loans. Investors who purchase these underlying financial instruments receive a principal along with interest payments on the assets. 

Moreover, it also allows investors to purchase assets that they normally don’t get access to. Due to securitization financing, the amount of highly rated bonds available to investors has significantly increased. That being said, securitization of debt is a useful instrument for the growth and expansion of the market. It also helps investors and originators to diversify their portfolios. 

Are you intrigued by securitised assets and products? You’re in the right place. In this blog, we will discuss securitisation, its pros and cons, and types of securitization, with relevant examples. 

Securitization Explained

Securitization can be defined as transforming illiquid assets or transforming illiquid assets into a security. This transformation is achieved through the use of financial engineering. The process of bundling, buying, and securitizing up illiquid assets like debt and mortgages and being sold to traders is described as a “securitization food chain’. The term was made famous by the film ‘Inside Job’ which depicted the financial crisis of 2007-08. 

In theory, securitization is a useful process and is a win-win. It allows the original lender to get rid of liabilities and make more loans. It also allows investors to become the lender and profit from these activities. However, the process of securitization is seen in bad light by the public. In fact, it has been accused of increasing reckless borrowing and triggering one of the worst financial crises in the history of the United States of America. 

One of the best examples of Securitization is mortgage-backed security(MBS). A group of home loans or mortgages are sold to another financial institution by the original lender, turning the package of loans into a distinct unit that the public can invest in. Investors who invest in the unit get paid premiums along with the interest payments from the various mortgages as if they were banks. 

Types of Securitization

Securitization can generally be categorised into four types. Let’s take a look at the major types of securitization- 

Asset-Backed Securities

Asset-backed securities are bonds whose value is estimated from the underlying value of other financial assets. Credit card debt, college tuition, loans secured against the equity in a home, vehicle loans, and other various types of loans are some of the receivables that can be converted into asset-backed securities. 

Mortgage-backed Securities

Mortgage-backed securities can in turn be classified into residential mortgages and commercial mortgages. Commercial mortgage bonds are created when various commercial assets are bundled together and mortgaged. Examples include office buildings, industrial land, manufacturing plants, factories, etc. 

Residential mortgage bonds are created by bundling together various mortgages on assets like real estate, houses, land, jewellery, and other valuable assets. 

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Collateralized Debt Obligations(CDO)

Collateralized Debt obligations also known as CDO are bonds created by bundling individual loans that can be sold to investors on the secondary market. 

Securitization of Future Cash Flows

These instruments are issued by the corporation by using a debt receivable in the future as collateral. Even if the liabilities are secured by the company’s future receivables, the firm can complete the principal and interest payments through day-to-day business activities. 

How Does Securitization Work?

The process of securitization happens in the following steps- 

Step 1: The company that holds the assets(also known as the originator) gathers information on the loans or income-producing assets that it no longer wants to service. These include mortgages, personal loans, home loans, or something else. The company removes these instruments from its balance sheets and pools them into a reference portfolio. 

Step 2: The assets in the reference portfolio are sold to an entity like the Special Purpose Vehicle(SPV) which turns these assets into securitized products that the public can invest in. Each securitized product represents a stake in the assets from the portfolio. 

Step 3: Investors buy the securitised assets in exchange for a specified rate of return. The originator continues to service the loans from the reference portfolios, collecting payments from the borrower and passing them on to the SPV or trustee. The generated income is paid to the investor. Keep in mind that the originator deducts a fee before passing the amount to the SPV. 

The reference portfolio is divided up into sections called ‘tranches’. Each tranche or section of the portfolio consists of assets that have something in common. In most cases, the common factor is maturity dates or interest rates. 

Before investing in securitised assets, investors must have a basic understanding of asset-backed mortgages(ABS), the end securitised product and must be familiar with the level of risk they are taking on. Usually, the greater the likelihood of default, the higher the returns. 

Why Do Banks Use Securitization?

Securitization allows the original lender to remove the associated assets from its balance sheet and transfer them into the reference portfolio. This helps in reducing liabilities and makes more room to underwrite more loans. This strategy poses many advantages. Besides taking a commission from the assets it sells, the banks can cater to customer demand for credit and improve their credit rating. 

Securitization Financing helps lender to raise money in a cost-effective way, grow their loan book, and ultimately expand their business. It is not a new concept and the roots of securitization can be traced back to the late 18th century when it was used to help fund the expansion of the U.S. railroad system. In 1970, the U.S. Department of Housing and Urban Development(HUD) created the first modern residential mortgage-backed security. 

What are Securitized Assets?

Theoretically, anything that generates an income can be securitized into a tradable item of monetary value. However, there are certain types of assets that are more commonly transformed into asset-backed securities- 

Mortgages

Securitization began with mortgages way back in 1970 when the U.S. Department of Housing and Urban Development created the first modern residential mortgage-backed security. A group of different home loans or mortgages can be combined into a portfolio, classified into tranches, and distributed to investors as a bond-type product. Investors who purchase these products (also known as mortgage-backed securities), pay whatever the rate is and receive the interest and principal payments from the pool of mortgages in return. 

Auto Loans

Car Financing or Auto Loans is another common instrument that is transformed into asset-backed securities. Auto loans are bundled together, split into various tranches with different risk profiles, and sold to investors as securities. Owners of these securities receive any payment attached to these assets, including principal payments and monthly interest payments. 

Credit Card Receivables

Now you can also buy a stake on money due on credit card balances. These types of ABS don’t have any fixed payments and new loans and changes can be made to the mortgage pool as previous balances are paid off. Investors receive Interest, annual fees, and principal payments in the form of returns.

Student Loans

One of the most common types of asset-backed security is student loans. The money that students borrow to complete their education is bundled into an ABS. Moreover, it is also possible to invest in student loans guaranteed by the U.S. Department of Education and provided by the government or if you want slightly higher returns(with higher risk), you can also invest in student loans from private sources, like banks and credit unions. 

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Advantages and Disadvantages of Securitization

Securitization creates liquidity by allowing retail investors to buy shares in a financial instrument that would otherwise be not available to them. A mortgage-backed investor can buy parts of mortgages and receive regular returns in the form of monthly interest and principal payments.

Moreover, unlike other investments, most loan-based securities are backed by collateral. As the originator moves debt into the portfolio, it reduces the liability on the balance sheet, allowing it to underwrite more loans. However, even though securities are backed by tangible assets, there is always a risk of default. Moreover, early repayment reduces the returns of the investors. There may also be a lack of transparency about the underlying assets. 

Now that you understand the basics of securitization and how it works, let’s take a look at the pros and cons of securitization financing. 

Advantages of Securitization

High-Income Potential: The primary objective of securitization is to free up blocked money. Although the origination may pursue other exciting prospects, they stand to earn the most from the process of securitization. 

Better Risk Management: Securitization offers better management of risk. The originator lending cash can securitize its receivables and shift the risk of bad debt. 

Highly-Diversified Portfolio: Securitized bonds are clearly distinct from other types of financial securities. By integrating these types of bonds, an investor can effectively diversify their portfolio. 

Financial Leverage: Securitization frees up the blocked money to retain liquidity. The originator is relieved of the responsibility of seeking financial leverage in case of immediate requirement. 

Disadvantages of Securitization

Lack of Transparency: One of the drawbacks of securitization is that it lacks transparency. Generally, investors are not able to access all the information on the assets included in securitized products. 

Difficulty in Handling: It can be difficult to handle securitized bonds as the process involves several parties. Moreover, the assets must be blended intelligently. 

Expensive: Compared to traditional floating shares, securitised assets can be rather expensive. It includes various costs like underwriting, legal expenses, administrative fees, and rating fees. 

Investors Bear Risk: In case the borrower is unable to make repayments, the investors suffer significant losses. The investor is the only individual who bears any risk during the process. 

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Was Securitization Responsible for the 2007-08 Financial Crisis?

It is widely believed that mortgage-backed securities(MBS) played a key role in in the devastating financial crisis of 2007-08. In the period leading up to the crisis, home loans with questionable terms were made accessible to almost everyone, including individuals who didn’t have the income or assets to make repayments. These loans were sold off to Wall Street banks, which packaged and advertised them as low-risk investments. 

Eventually, interest rates rose and house prices that had skyrocketed due to increased mortgage activity, started to fall. The house prices fell to such an extent that homes were worth less than what people paid for them. Due to this, lots of borrowers started to default on their mortgages, and the nature of the loans that were sold as mortgage-backed securities became quite clear. By then, the damage had been done and the economy was already on the verge of collapse. 

Credit agencies and Wall Street were held responsible for not evaluating these products before distributing them to the investors. The original lenders were blamed for turning a blind eye to the borrower’s ability to repay these loans so they wouldn’t have to face the consequences. 

Securitization vs. Factoring

• Factoring can be referred to as a financial institution’s acquisition of a company’s book debts and payment to the company against receivables. Whereas, securitization is the process of transforming illiquid assets into liquid by shifting long-period of cash flows into short-term. 
• While securitization involves many investors who interact with a securitised asset, factoring primarily only involves the bank and the corporation. 
• Factoring is helpful for short-term account receivables ranging from a month to six months whereas securitization is helpful for the firm’s long-term receivables. 
• Securitization is exclusively without a recourse while factoring may or may not have a recourse. 
• As factoring includes the bank and the firm, there is no requirement for a credit rating. On the other hand, securitization involves multiple investors and needs a credit rating before proceeding with the securitization of debt or products. 

Key Takeaways

• Securitization is the process of transforming illiquid assets into liquid by altering the cash flows of long-term receivables into short-term cash flows. 
• It is a risk management method for the company that started the loan. 
• Investors are paid the principal payment and interest payments from the securitised assets. 
• Securitization is useful in increasing liquidity and access to credit. 
• The returns on a securitized investment are determined on the basis of revenue generated by the assets it is backed by. 
• The need of the originator to seek out financial leverage due to sudden demand is removed from the originator due to securitization’s ability to unblock blocked funds. 
• Some skeptics have accused the securitized products, asset-backed securities of lacking transparency. 
• According to some skeptics, securitization encourages banks and other lenders to not care about the quality of the loans they underwrite. 
• Mortgage-backed securities are backed by home loans issued to consumers. Asset-backed securities are backed by auto loans, mobile home loans, student loans, personal loans, and various other types of loans. 
• Some individuals also blame securitization for the devastating financial crisis of 2007-08.
• The roots of securitization can be traced back to the 18th century when it was used to fund the expansion of the U.S. railroad system. 
• There are typically four types of securitization- mortgage-backed securities, asset-backed securities, collateralized debt obligations, and securitization of future cash flows.

Final Words

Securitization is the process of transforming illiquid assets into liquid by taking a group of illiquid, income-producing assets and bundling them into a single securitised product that can be invested in. Any financial instrument with a stable cash flow can be securitized and turned into an asset-backed security(ABS). Most common examples include personal loans, auto loans, mortgages, student loans, and literally any other type of loan. 

It is a diverse topic and has its pros and cons. It is often termed useful for improving credit conditions and letting smaller investors have a chance of profit. On the other hand, it is also widely regarded as the factor responsible for the catastrophic financial crisis of 2007-08. 

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