Securitization

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. 

1. 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. 

1. 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. 

1. 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