You have probably heard of securitization. It’s a way of turning non-financial assets into liquid securities that investors can buy and sell. Despite its role in the market crash of 2008 and subsequent Great Recession, the process of securitization is not in and of itself a bad thing. Used well it can help ensure greater liquidity in markets that otherwise might slow down. Of course, used poorly it can turn stable markets into casinos. As with all aspects of finance, the trick is finding the right balance. Here’s how it works.
Sometimes there’s a good reason to sink investment dollars into illiquid securities. A financial advisor can help you assess the advisability of such a move.
What Is Securitization?
A security is a tradable financial product. It takes its value from the market and from the underlying properties that it represents. Stocks are the classic example of a security. They can be represented by a stock certificate, but a share of stock is not a tangible thing. It’s value is based on the company it represents and what other traders on the open market will pay for it.
Securitization is the process of creating tradable securities that are backed by and based on groups of existing assets. As a category this type of product is called an asset-backed security, and any individual product is typically named after the underlying assets. For example, a security backed by auto loans might be called an auto-backed security.
Most asset-backed securities are based on debt. Popular products include securities based on mortgages, student loans and even consumer debt. This is not strictly necessary. Any asset with financial value can be turned into a security. However, debt is overwhelmingly the most common form of asset-backed security because of how it generates profit.
Securitization uses pools of assets to create each new product. For example, when a bank creates a mortgage-backed security it will use a large number of mortgages. This portfolio of assets is then sold by shares like any other portfolio or fund-based product. This distinguishes securitized assets from directly purchasing the underlying asset. If an investor wanted, they could simply buy the debt of a single mortgage. By purchasing a share of a mortgage-backed security they purchase a portion of several mortgages all at once.
Typically securitization will pool large numbers of an underlying asset. For example, in the case of mortgage-backed securities, a bank may package hundreds or thousands of individual mortgages into a single portfolio.
How Securitization Works
A securitized investment generates its returns based on the income generated from the underlying asset. This is why most asset-backed securities are built on debt. Contracts such as a mortgage or a student loan have a fixed repayment schedule and a set interest rate, which the investor can build a product around. If a bank securitizes a bundle of mortgages, for example, they can promise a rate of return based on the interest rates and repayment schedules of the underlying mortgages. Investors could examine this promised rate of return in context of the credit ratings involved with the underlying mortgages and decide whether to invest.
It is possible to build securities out of non-debt products as well, so long as they can generate income around which to build the security’s rate of return. Say, for example, you wanted to securitize art. You might build a portfolio out of hundreds of pieces of art. You would sell shares of this portfolio with returns based on how much you can sell each piece for over time. Whether you could attract investors into such a speculative portfolio would be another matter.
Securitization at its most basic is a two-step process. (For a more detailed explanation, see this guide from the IMF here.)
- First: The originator sells its assets.
A company will identify loans or other income-generating assets that it wants to sell off. This company is called the “originator.” It gathers those assets and sells them to the issuer as a single portfolio.
- Second: The issuer sells shares of the portfolio.
The issuer, having now bought the portfolio of assets, will issue tradable shares in it. Those shares will pay a rate of return based on return generated by the collected assets in the portfolio itself. The issuer typically collects a commission or other form of management fee for overseeing the fund.
The Purpose of Securitization
Securitization is a form of risk management for the originator.
In Step One of the securitization process the originator (often a bank) sells the portfolio of assets to the issuer. Once the originator sells these assets, they won’t collect any future profits but they also no longer assume that asset’s future risk.
In the case of loans, which again make up virtually all standard asset-backed securities, the bank may continue to service this debt by collecting payments and adjusting floating interest rates. However, the actual assets have been removed from the bank’s balance sheets. As the IMF writes in its explainer on the topic, “[i]n essence, securitization represents an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risk) from issuers to investors.”
The issuer pays the bank for these loans because it expects to make more money off them in the future. The bank, in turn, forgoes those future profits in exchange for eliminating the risk that its borrowers will default on those loans.
At its best, this securitization process can introduce liquidity into the market. When a bank sells thousands of mortgages to an issuer, for example, it receives payment for those loans. This gives the bank the cash to make new loans while at the same time allowing the bank to make loans more easily because it can offset that risk. The securitization market acts as a form of guarantor, providing a third party who will assume the risk of these loans. This allows the bank to issue more mortgages to more borrowers who want to buy homes.
This also allows investors to profit off traditionally illiquid assets.
The assets that issuers typically build asset-backed securities out of are illiquid in the sense that they do not transfer easily. In order to invest in a mortgage, someone would have to spend the hundreds of thousands of dollars necessary to purchase that entire debt product from the bank. Not only would this require significant up-front capital, but it would take years before they saw a profit.
However, these products are also (at their best) highly appealing to investors. Debt-based contracts can have a strong rate of return, with traditionally excellent repayment rates compared to many other forms of securities.
By turning groups of debt or other assets into a tradable security, the securitization process makes them liquid. Investors can now easily buy and sell shares of mortgages as a fungible asset class, collecting the returns without the high initial costs.
Of course, all of this can have a downside as well. For investors, it is easy to blur the line between pursuing a reliable asset and chasing a no-risk profit. For lenders, securitization can easily slip from acting as a source of liquidity into acting as an ultimate guarantor that takes all risk out of the market. In both cases, when that happens the market can easily begin over-investing in bad assets.
The Bottom Line
Securitization is the process of turning assets like credit card debt, auto loans, commercial mortgages and residential mortgages into a portfolio of securities that you can buy and sell shares of. Investors typically securitize debt, turning contracts into a package of shares with a rate of return based on the future value of the payments. Once these illiquid assets are packaged and sold to third-party investors, those third-party investors are free to trade them.
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