Securitization: Definition, Pros & Cons, Example

Securitization is the financial alchemy of taking not-easily- or nontradable assets, pooling them together, and selling tradeable shares in that pool to investors. Broadly, securitization could be taking any assets, as with bitcoin or ether for crypto exchange-traded funds or properties and related assets for real estate investment trusts, and selling securities related to them.

However, we focus here on its primary meaning for investors and regulators: when an issuer designs a marketable financial instrument by merging financial assets, normally mortgage loans and consumer or commercial debt. Investors who buy these securities receive the principal and interest payments for the underlying assets.

We'll take up the nuts and bolts of how securitization works, exploring its mechanics through a step-by-step example. We'll examine the potential benefits securitization offers to both lenders and investors, such as improved liquidity, risk diversification, and more efficient capital allocation. Meanwhile, we'll grapple with the significant risks and downsides of securitization, including reduced transparency, misaligned incentives, and the potential for systemic instability.

How Securitization Works

In securitization, the company or the originator that holds the assets determines which assets to remove from its balance sheets. A bank might do this with mortgages and personal loans it no longer wants to service or raise capital for additional loans.

This gathered group of assets is now considered a reference portfolio. The originator then sells the portfolio to an issuer who creates tradable securities with a stake in the assets in the portfolio. Investors buy the new securities for a specific rate of return and effectively take the position of the lender.

Securitization allows the original lender or creditor to remove assets from its balance sheets to underwrite additional loans. Investors profit as they earn a rate of return based on the associated principal and interest payments made on the underlying loans and obligations by the debtors or borrowers.

Steps In Securitization

Securitization is a complex process that involves several steps:

1. Asset origination: The process begins with a lender, such as an investment bank, issuing loans to borrowers. These loans can be in business lines of credit, mortgages, auto loans, credit card receivables, or other types of credit.
2. Create asset pools: The lender selects a pool of loans with similar characteristics, such as loan type, maturity, and credit quality. This pool of loans will serve as collateral for issuing securities.
3. Create the special purpose vehicle (SPV): The lender establishes a separate legal entity called an SPV) or a special purpose entity. The SPV is designed to be bankruptcy-remote, meaning that if the lender goes bankrupt, the assets held by the SPV won't be affected.
4. Transfer the assets: The lender sells the pool of loans to the SPV, effectively removing the assets from its balance sheet. In return, the SPV pays the lender for the assets, often using funds raised from issuing securities.
5. Tranching: The SPV divides the pool of loans into different risk classes, known as tranches. Each tranche has a different level of risk and return, catering to different investor risk appetites. The tranches are typically considered senior, mezzanine, and junior (or equity).
6. Credit enhancement: The SPV may use various credit enhancement techniques to make the securities more attractive to investors. These can include over-collateralization (i.e., putting more collateral in the pool than the value of the securities issued), reserve accounts, or third-party guarantees.
7. Rating: The SPV hires credit rating agencies to assess the creditworthiness of each tranche. The rating agencies assign ratings to the tranches based on their perceived risk, with the senior tranches receiving the highest ratings and the junior tranches receiving the lowest.
8. Marketing and sale: The securities, now backed by the pool of loans, are marketed and sold to investors through investment banks. Investors can invest in different tranches based on risk tolerance and investment objectives.
9. Distribute cash flows: As borrowers of underlying loans make payments, the cash flows are collected by a servicer and distributed to the investors according to the terms of the securities. The senior tranches get priority over junior tranches in receiving payments.
10. Monitoring and reporting: Throughout the life of the securities, the servicer monitors the performance of the underlying loans and provides regular reports to the investors.

Types of Securitization

There are several types of securitization, each with its own structure and characteristics. The most common types include pass-through securitization, pay-through debt instruments, and collateralized debt obligations (CDOs).

Pass-Through Securitization

Pass-through securitization is the most basic form of securitization. In this structure, the cash flows from the underlying pool of assets are transferred to investors. The SPV issues securities, known as pass-through (or flow-through) certificates, which represent an undivided interest in the pool of assets (i.e., there are no tranches). As borrowers make payments on the underlying loans, the cash flows are collected by the servicer and distributed to the investors pro rata.

MBS issued by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac are examples of pass-through securitization.

Pay-Through Debt Instruments

Pay-through instruments, also known as collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits, are a more complex form of securitization. For these, the cash flows from the underlying pool of assets are used to pay interest and principal on the securities issued by the SPV, but the securities themselves are structured as debt obligations.

The securities are divided into tranches with different maturities, risk profiles, and payment priorities. The cash flows from the underlying assets are allocated to the tranches based on a preset structure, with the senior tranches receiving payments before the junior tranches.

Collateralized Debt Obligations (CDOs)

Collateralized debt obligations (CDOs) are a type of securitization that involves pooling together a diverse range of debt obligations, such as corporate bonds, loans, or even other securitized products like MBS or ABS. The pool of assets is then divided into tranches, each with its own risk and return characteristics.

Upping the ante, CDO-squared and CDO-cubed have underlying assets of CDOs and CDO-squared, respectively. These played a significant role in the 2007 to 2008 global financial crisis. Many of these securities were backed by subprime mortgages and experienced significant losses when the housing market collapsed. The complexity and lack of transparency in these structures made it difficult for investors to understand the true risks involved, leading to a loss of confidence in the securitized product market.

Advantages and Disadvantages of Securitization

Securitization creates liquidity by allowing retail investors to buy shares in instruments that would be unavailable to them. An MBS investor can buy portions of mortgages and receive regular returns from interest and principal payments.

Unlike other investments, many loan-based securities are backed by collateral. In addition, as the originator moves debt into the securitized portfolio, it reduces the liability on its balance sheet, allowing it to underwrite further loans.

Although the securities may be backed by tangible assets, there is a risk of default. Moreover, early repayments will cut the returns the investor receives on the underlying notes. There may also be a lack of transparency about the underlying assets. Misrepresented MBS infamously played a toxic and precipitating role in the financial crisis of 2007 to 2008.

Example of Securitization

The investment company Fidelity offers MBS that give investors a monthly distribution of principal and interest payments made by homeowners. For this example, Fidelity offers an MBS issued by various GSEs or agencies:

• Government National Mortgage Association (Ginnie Mae): Ginnie Mae does not purchase, package, or sell mortgages but does guarantee their principal and interest payments.
• Federal National Mortgage Association (Fannie Mae): Fannie Mae purchases mortgages from lenders, then packages them into bonds and resells them to investors.
• Federal Home Loan Mortgage Corporation (Freddie Mac): Freddie Mac purchases mortgages from lenders, then packages them into bonds and resells them to investors.

When an investor purchases these securities, they are essentially buying a share in a pool of mortgages. As homeowners make their monthly mortgage payments (principal and interest), the cash is collected by the GSEs or agency and distributed to MBS investor pro rata.

Investors in MBS benefit from the regular cash flows from the underlying mortgages, as well as the potential for capital appreciation if interest rates fall (as the value of fixed-income securities generally rises when interest rates decline). However, they also face prepayment risk, which is the risk that homeowners may refinance or pay off their mortgages earlier than expected, altering the cash flow profile of the MBS.

By investing in these MBS, investors are exposed to the risks and returns associated with the underlying mortgages. These MBS are backed by the full faith and credit of the U.S. government, making them among the safest fixed-income investments. These are called agency MBS, as opposed to non-agency (private) MBS, which make up but a small part of the market.

The Bottom Line

Securitization pools or groups debt into investable portfolios to make marketable financial instruments. Investors can profit from the interest and principal paid on the underlying assets. Both mortgage-backed securities and asset-backed securities are created through securitization and include mortgages, consumer, and commercial debt.