Securitization

Table of Contents

Securitization
What Is securitization?
Understanding securitization
Working of securitization
Advantages and disadvantages of securitization
Example of securitization
Frequently Asked Questions

Securitization

Securitization allows an issuer to finance certain assets, mortgage loans and/or consumer debts and transform them into bonds or other forms of debt security that can then be traded or sold to a trader for a certain sum that can be used by the company to invest in itself or to expand the company.

What Is securitization?

Securitization is a process that allows a company to pool all of its assets and transform them into bonds or securities that can bear interest. Investors can now purchase these bonds for a certain amount, and in return they will receive the principal and the interest amounts. A mortgage-based security is one fine example of securitization.

Understanding securitization

Take mortgage-based security loans for example. The original lender will sell a bunch of home loans to a bank or any other financial institution that in turn will turn these loans into a single unique investment package. The bank will then allow the public to invest in the package, for which they will receive principal and interest amounts from the various loans inside the package.

How much the public receives in the form of interest and principal will be in proportion to the amount they invest in it. Unlike other investments, it’s a win-win situation for every party involved. The investors get paid in the form of principal and interest amounts, while the original lender gets to clear out any liabilities that often arise in these situations. This is one of the reasons why the public isn’t as enthusiastic about it as they once were.

The public believes that securitization often leads to unnecessary borrowing and debt, especially after the 2008 economic crisis.

Working of securitization

Securitization is a process that begins when the original lender sells a bunch of assets to a financial institution. Here’s a detailed breakdown of how the securitization process works.

The original lender who is in possession of certain assets that it no longer needs may decide to sell them. This not only allows them to get rid of unnecessary assets but also helps them avoid any liability from the assets. They will then pool the assets into a reference portfolio, ready to be sold. These assets can be anything from mortgage loans to personal loans.

The original lender will then sell the reference portfolio with all its assets to a financial entity such as a bank or private lender. The financial entity will then turn the assets into a security where the public can invest in. Once an investor invests in the assets, he will in return receive principal and interest payments proportional to the stake they bought. The higher the securities you buy, the higher your stakes will be in that reference portfolio.

Potential investors purchase these securities at a certain rate of return. The original lender receives all the payments, which will be then transferred to the bank apart from a small fee. The bank will then pay the investors from that.

Advantages and disadvantages of securitization

Here are the advantages of securitization:

The original lender, also known as the originator, is in possession of a bunch of assets that he is unable to sell. Securitization allows him to sell these assets and free up the money blocked in those assets. This allows him to focus on other investment options.
The financial entity can shift the risks by securitizing its receivables.
The financial entities get to diversify its portfolio by bringing in securitized securities. These bonds are a lot different than any other form of security.
The originator can also gain some financial leverage from the financial entities. This can certainly help when the originator is in need of some cash.

Here are some disadvantages of securitization:

There’s very little to no transparency between an investor and the bank. That means an investor has very little knowledge of the kind of assets that are involved in the said bond.
The securitization process involves multiple parties and handling everything can be a difficult process.
There are a lot of processes involved in securitization, including legal proceedings, administrative and underwriting, among others. This increases the cost of securitized bonds.
The investors are the ones at the highest risk and the originator gains the most.

Example of securitization

Here are a few examples of securitization:

Government National Mortgage Association (GNMA)
Federal National Mortgage Association (FNMA)
Federal Home Loan Mortgage Corporation (FHLMC)

Frequently Asked Questions

What are the types of securitization?

Securitization involves the financing of multiple types of assets into a singular unit. Here are the 5 asset types of securitization:

Mortgages: In mortgages, securitization happens with home loans that are combined into one large portfolio before it is sold to financial institutes.
Auto loans: Auto loans or car financing is a form of ABS securitization that is initially combined together but later split into multiple groups according to their risk profiles. They are then sold to potential investors.
Credit card receivables: It’s also a form of ABS securitization and it involves buying a certain stake from the credit card balance.
Student loans: Student loans are provided to students who require loans to finish graduation from college. It’s a great opportunity for investors as these are protected by the US Department of Education.

What is the difference between securitization and factoring?

Securitization and factoring are two different ends of the spectrum. Securitization is the process of financing and refinancing existing assets into one single unit, which the public can invest in. While factoring refers to the process of selling receivable accounts in a bid to increase the flow of cash.

What is meant by securitization of debt?

It refers to the process of pooling certain assets, such as debt securities, into bonds that can be later sold to financial entities/investors. These bonds are also called collateralized debt obligations or asset-backed securities.

What is asset securitization?

It is the process of financing the assets into a bond or a security debt that can be sold or traded for a certain sum. The investors who buy them gain the principal and the interest amount.

What Is the difference between an MBS and an ABS?

MBS refers to mortgage-backed security, whereas ABS refers to asset-based security. Mortgage-based security pools in mortgage loans as assets, while asset-based security pools in student loans as assets. These assets are non-mortgagable assets in nature.