Securitization: Definition, Meaning, Types, and Example

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Securitization is the process of taking illiquid assets or a group of assets and, through financial engineering, transforming them into an investable security. Understanding securitization is crucial for investors and economists alike since it plays a significant role in shaping credit markets and can have far-reaching effects on the global economy, as demonstrated by the 2007 to 2008 financial crisis.

Mortgage-backed securities (MBS) are a classic—if infamous—example of securitization. The original lender sells a group of home loans to another financial institution, which turns the package of mortgages into a package of investible securities. Investors are then paid the interest and principal payments from these mortgages as if they were the bank lending these different homeowners money.

Key Takeaways

• Securitization is the process of transforming a group of income-producing assets into an investable security.
• Investors are paid the interest and principal payments from these securitized assets.
• Securitization increases liquidity and access to credit.
• However, the products created, asset-backed securities (ABS), have been accused of being opaque about their underlying assets.
• Skeptics say securitization encourages banks and other lenders to care less about the quality of the loans they underwrite and more about the quantity.

Securitization, according to those involved, is a win-win. It lets the original lender rid itself of liabilities and make more loans in the class of MBSs while enabling investors to play the role of lender and profit from these activities. Regulators and the public don’t always see it that way. Securitization has been accused of encouraging reckless borrowing and triggering one of the worst financial crises on record—with worries that two decades after the 2007-08 crisis, another set of newly securitized assets could help trigger wider calamities again.

In recent years, securitization has expanded beyond traditional assets, entering what some call a new age of securitization. This trend has seen the creation of tradable securities from a wide range of previously non-tradable assets, including intellectual property rights, music royalties, and cryptocurrency-based assets.

ETFs have effectively taken whole areas of non-exchange-traded goods (commodities, currencies, volatility, etc.) and made shares in them tradable in your investment account. While this expansion offers new investment opportunities, it introduces novel risks and complexities to the stock markets and broader economy. It’s also another indication of the increasing financialization of the American economy.

For investors, securitization is often associated with specific assets: fixed-income instruments sellable as securities made from loans and other assets that have expected future cash flows, like the interest a homeowner pays on a mortgage. Below, we focus on and explore this meaning.

How Does Securitization Work?

Securitization usually occurs as follows:

1. The company holding the assets, otherwise known as the originator, gathers data on the loans or income-producing assets it no longer wants to service (mortgages, personal loans, or something else). It then removes them from its balance sheets and pools them into a reference portfolio.
2. The assets in the reference portfolio are sold to an entity, such as a special-purpose vehicle (SPV), which turns them into a security in which the public can invest. Each security is a stake in the assets from the portfolio.
3. Investors buy the created securities in exchange for a specific rate of return. In most cases, the originator continues to service the loans from the reference portfolio, collecting payments from the borrowers and then passing them on, minus a fee, to the SPV or trustee. The generated cash flows are then paid to the investor.

Usually, the reference portfolio is divided up into different tranches. Each tranche, or section of the portfolio, consists of assets that share something in common, such as similar maturity dates and interest rates.

Investors need to have a rough idea of what each ABS, the end product of securitization, contains and the level of risk they take. Generally, the greater the likelihood of default, the higher the reward.

Important

Any type of asset with a stable cash flow can be grouped together, securitized, and sold to investors.

Why Do Banks Use Securitization?

Securitization gives the original lender the ability to remove the associated assets from its balance sheet, reducing liabilities and freeing up space to underwrite more loans. There are many benefits to this strategy. Other than taking a nice cut from the assets it sells, securitization lets the bank appease customer demand for credit and can help boost its credit rating.

This is a cost-effective way for lenders to raise money, grow their loan book, and expand their business.

1970

The year when the U.S. Department of Housing and Urban Development created the first modern residential MBS. However, the roots of securitization can be traced back to the late 19th century when it was used to help fund the expansion of the U.S. railroad system.

Which Assets Are Commonly Securitized?

Anything that generates an income stream can theoretically be securitized into a tradable, fungible item of monetary value. While securitization started with mortgages, it has since grown to encompass a wide variety of asset classes. In the U.S. and Europe, the securitization market is primarily built on the following:

• Residential mortgages
• Commercial mortgages
• Credit card receivables
• Auto loans
• Consumer loans
• Trade receivables
• Future cash flows (like toll road receipts)

In theory, any asset or entitlement representing a future, predictable cash flow can be securitized as long as it can be effectively transferred to a SPV through a true sale or if the originator is considered “bankruptcy remote.”

This expansion has led to some surprising securitization opportunities. The World Bank’s International Finance Corporation lists the following:

• Tax revenues
• Utility payments
• Intellectual property royalties
• Music catalogs
• Sports team revenues

The key is that these assets must generate a reasonably predictable income stream. Let’s turn, though, to the most commonly securitized assets:

Mortgages

A cluster of different home loans can be combined into one large portfolio, separated into tranches, and sold off to investors as a bond-like product. Buyers of these investments pay whatever the going rate is and, in return, get the interest and/or principal payments from the pool of mortgages in which they hold a stake.

Auto loans

Another common category of ABS is car financing. Like mortgages, auto loans are bundled, split into various groups with different risk profiles, and sold as securities to investors. Owners of these securities then inherit any payments attached to these assets, including monthly interest payments and principal payments.

Credit card receivables

It’s also possible to buy a stake in money due on credit card balances. These types of ABS don’t have fixed payment amounts, and new loans and changes can be added to the pool as balances are paid off. Returns come through interest, annual fees, and principal payments.

Student loans

The money that students borrow to go to college is commonly packaged into ABS. It’s possible to invest in student loans provided by the government and guaranteed by the U.S. Department of Education or, for a slightly higher risk and potentially larger return, student loans from private sources, such as banks.

What Are the Types of Securitization?

Securitization is generally broken down into three types:

• Collateralized debt obligation (CDO): Holding a stake in a bunch of loans backed by collateral gives the investor peace of mind, as it means there is something of value that can be seized and sold off should the borrower default on payments.
• Pass-through securitization: A servicing intermediary collects the monthly payments from issuers, deducts a fee, and then “passes through” what’s left to the holders of the securities.
• Pay-through debt instrument: Investors don’t own the underlying assets directly for this type. This means that the issuer can change the cash flows and deviate from what the underlying assets pay out.

CDOs, pass-through securitization, and pay-through debt instruments each offer different levels of risk and potential returns, catering to various investor preferences and risk tolerances.

What Are the Drawbacks of Securitization?

In theory, securitization should be beneficial to investors, lenders, and the general economy, which should benefit from greater access to credit. However, it doesn’t always work out that way.

For investors

When investing, guarantees are hard to come by. Netting decent returns usually requires taking on risk, and things don’t always go according to plan. For example, if a debt is backed by collateral, you might think there’s no way to lose. That’s not entirely true, though. It is possible that the asset used as collateral falls in value or becomes difficult to offload.

Moreover, with ABS, there’s always the risk that the borrowers repay debts early and interest payments fall to the point where the investor earns less than inflation or what they could earn elsewhere.

Warning

Remember what happened in the mid-2000s? Investors were sold batches of toxic, difficult-to-pay mortgage loans and were none the wiser, having been led to believe that the underlying assets were of a much higher quality. Tighter regulations have since been introduced, though it still pays to be prudent.

For the economy

Several studies have concluded that securitization can lead to poor lending practices and, subsequently, many people defaulting on their debts.

The general view is that if banks can sell the loans they write and move them off their books without much scrutiny, then they will care less about the quality of those loans. Accepting more applications means making more money. And if it turns out that the applicant can’t pay back what is owed, then someone else—the investor—will pick up the tab anyway.

This was a common issue in the run-up to the 2007 to 2008 financial crisis. At one point, lots of unaffordable mortgages were being doled out and then sold on to investors, who had no idea what they were holding.

Did Securitization Cause the 2007-08 Financial Crisis?

It’s widely agreed that MBS paved the way for the devastating financial crisis. In the period leading up to the downturn, home loans with very questionable terms were made available to virtually everyone, including people with little means of paying them back. These loans were then sold to Wall Street banks, which packaged and advertised them as low-risk investments backed by decent credit ratings.

Eventually, interest rates rose and housing prices, which had rocketed because of heightened mortgage activity, started to fall to the point where homes were worth less than what people paid for them. Suddenly, many borrowers started defaulting on their mortgages, and the nature of the loans given out and sold on as MBS became clear. By then, it was too late. The economy was already unraveling.

Wall Street and credit agencies were blamed for not taking a closer look at these products before peddling them to investors. The original lenders were accused of turning a blind eye to a borrower’s ability to repay because they wouldn’t have to deal with the repercussions.

How Do Regulators View the Expansion of Securitization Into New Asset Classes?

Regulators generally approach new forms of securitization with caution. They aim to balance financial innovation with consumer protection and systemic risk concerns. For instance, the U.S. Securities and Exchange Commission has been closely monitoring the securitization of cryptocurrency assets. In Europe, the EU’s Securitisation Regulation of 2019 introduced a framework for simple, transparent, and standardized securitizations to encourage safer structures. As new asset classes emerge, regulators typically develop new guidelines or adapt existing ones to address their risks.

What Trends Are Emerging in Securitization Beyond Traditional Financial Assets?

“Green securitization” is gaining traction, where environmentally friendly assets like solar panel loans or energy-efficient mortgages are bundled. Another trend is the securitization of digital assets, including cash flows from online businesses or cryptocurrency-related assets. Some companies are also exploring the securitization of recurring revenue streams from subscription-based business models.

For Homeowners, Would Their Mortgage Being Securitized Change Anything?

It might change the platform used to pay the mortgage, but not much else. Say a bank grants a homeowner a mortgage and then sells it at a discount for inclusion in an MBS. At that point, a mortgage servicer would manage the day-to-day administration of the mortgage loans within the pool. They are responsible for collecting monthly mortgage payments, managing escrow accounts, handling delinquencies, and scheduling payments for investors.

The Bottom Line

Securitization involves taking a group of illiquid, income-producing assets and turning them into a single product that can be invested in. Anything with a stable cash flow can be securitized and turned into an ABS. Classic examples include auto, student, and home loans.

Securitization is a divisive topic. On one hand, it is lauded for improving credit conditions and allowing smaller investors to profit from financial institution loan books. On the other, just mentioning the word evokes the global financial crisis.

Read the original article on Investopedia.