Who Bears the Risk of Bad Debts in Securitization?

Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, such as mortgage-backed securities (MBS), as bad debts can stop these instruments’ cash flows.

The risk of bad debt, however, can be apportioned among investors. Depending on how the securitized instruments are structured, the risk can be placed entirely on a single group of investors or spread throughout the entire investing pool.

Key Takeaways

• Securitization is the process of structuring a non-liquid asset or group of similar assets into a security that is sold to investors.
• Securitization bundles many non-liquid assets, usually loans such as mortgages, into a security, which is sold to an investor who receives an income stream from the principal and interest payments on that loan.
• There are two types of securitized assets: those that come as pools and those that have tranches.
• In a pool securitization, investors are equal and share all of the risks. If the pooled security has bad debt, all investors may suffer financial loss.
• In a tranche securitization, the security is split into different levels (tranches) made up of assets with different risk profiles. Higher tranches carry less risk than lower tranches, meaning lower tranches have a higher risk of suffering losses on bad debts first.

Securitization

Securitization is the process of financially structuring a non-liquid asset or group of similar non-liquid assets into a security that can then be sold to investors. The MBS was first created by trader Lew Ranieri in the early 1980s. It became an extremely popular investment in the 1990s and early 2000s. The idea was that the new security could be sold on the secondary mortgage market, offering investors significant liquidity on an asset that would otherwise be quite illiquid. 

Securitization, specifically, the bundling of assets such as mortgages into securities, has been frowned upon by many as it contributed to the subprime mortgage crisis of 2007. However, the practice continues today.

Pools and Tranches

There are two styles of securitization: pools and tranches. Here’s how they affect the level of risk faced by investors.

Pools

A simple securitization involves pooling assets (such as loans or mortgages), creating financial instruments, and marketing them to investors. Incoming cash flows from the loans are passed onto the holders of the new instruments. Each instrument is of equal priority when receiving payments. Since all instruments are equal, they all share in the risk associated with the assets. In this case, all investors bear an equal amount of bad-debt risk.

Tranches

In a more complex securitization process, tranches are created. Tranches represent different payment structures and various levels of priority for incoming cash flows. In a two-tranche system, tranche A will have priority over tranche B. Both tranches will attempt to follow a schedule of payments that reflects the cash flows of the underlying loans or mortgages.

If bad debts arise, tranche B will absorb the loss, lowering its cash flow, while tranche A remains unaffected. Since tranche B is affected by bad debts, it carries the most risk. Investors will purchase tranche B instruments at a discount price to reflect the level of associated risk. If there are more than two tranches, the lowest priority tranche will absorb the losses from bad debts.

For a portfolio, investors can choose from securitization investments such as prime and subprime mortgages, home equity loans, credit card receivables, or auto loans. Investors can also choose an index.

Important

Tranches can be categorized incorrectly by rating agencies, where tranches are rated investment grade even though they include junk assets, which are non-investment grade.

Issuer Risk

In addition to investor risk, securitized assets also pose risks to the issuer. Along with credit and liquidity risk, which investors share, issuers also face capital, reputational, and operational risks.

If the securitized market is full of bad debt—as occurred during the subprime mortgage crisis—this can lead to significant capital risk if the bottom falls out of the market. Financial firms must have sufficient capital to cover their losses arising from credit or market shocks.

A negative reputation can severely impact a financial institution’s ability to acquire credit and customers. Due to the public’s prevailing negative perception of securitized assets, banks that engage heavily in the securitized market must have plans in place to counter the negative perception.

Securitized assets are complex financial products and, as such, require significant capital and operational knowledge to create and market. Financial firms that want to sell securities assets must have appropriate underwriting, collection, and monitoring processes and expertise to profit from these assets while also mitigating risks.

What Are the Major Risks Associated With Securitization?

There are four major risks associated with securitization; credit risk, interest rate risk, prepayment risk, and liquidity risk. Credit risk is the risk that investors will not recoup their investment, while interest rate risk refers to the risk that interest rate changes will affect the price of the securitized asset. Prepayment risk is the risk that the principal will be returned prematurely, leading to lost future income, while liquidity risk is the risk that investors will not be able to sell bad assets on the open market.

What Are Examples of Securitized Assets?

Securities assets are assets that pool together numerous financial products to create a new security. Examples include mortgage-backed securities, collateralized debt obligations (CDOs), and asset-backed securities (ABS).

How Does Securitization Work?

Securitization happens in several phases. First, loans are issued to consumers. Next, banks and other financial institutions pool those various loans into a trust. These assets are then securitized and sold to investors as a pool or in various tranches with various interest rates and risk profiles. Investors receive interest payments, and banks selling the assets receive cash flow, which they use to fund other projects and — eventually — pay back their investors.

The Bottom Line

Securitization is a way for investors to gain access to assets that they would otherwise not have the chance to do so, such as mortgages. It is also a way for companies to reduce their balance sheet and take on more business by selling off assets like mortgages.

Securitization is a way to receive a consistent income stream, though it can be risky as much information about the underlying assets is unknown, such as the case in the subprime meltdown. When bad debts occur in securitization, the loss is shared as there are multiple investors, however, depending on the type of securitization, the loss is shared equally as in pooled securitizations or at different levels as in tranche securitizations.