Securitization

Financial Dictionary -> Investing -> Securitization

Securitization is the process of transforming illiquid assets into securities through financial engineering. In the process, different debt instruments are pooled together in a bundle and sold for cash. In other words, the combined value of all pooled debt instruments is converted into a bond issue that can be purchased by the investors. Usually, the trustee is the first to purchase these bond issues and then sells them to one or several investors.

Debt Instrument Bundles

Debt instruments do not need to be of the same type as to create a bundle. The latter may include various debt instruments including mortgages, credit card loans, and car loans. The only qualifying factor is that the debt instrument should be able to generate income in the form of payments on the principal and the interest charged to the outstanding balance.

A common example of a debt instrument bundle is a mortgage pool. Mortgage companies, banks, and other financial institutions that offer mortgage loans often go through the process of securitization in order to transfer debt to other entities. The process does not actually increase the interest rate on the loan, but it involves the transfer of ownership of the debt as well as the address where the payments are made. This, in turn, creates a mortgage-backed security or MBS.

The advantage of this process is that the investment generally creates regular cash flow which comes from the payments made on the mortgage bundles over a long period of time. Because investors are those who own the debt, they enjoy payments on both, the interest and the principal. The mortgages involved in MBS do not necessarily need to be residential only; they can be commercial mortgages as well.

The Risks

Like any other security, investing in a debt instrument bundle or another securitized product involves a certain degree of risk. Because debt instruments generally form the bulk of the investment, there is a chance that the borrower defaults on his loans, incurring loss to the owner of the security. However, investors who deal with securitized products usually take steps to ensure that potential loss from defaults is kept at a minimum. In many cases, investors include certain terms and conditions in the contract with the seller as to help minimize the chance of incurring loss in this endeavor.

Types

There are four types of securitization: master trust, insurance trust, grantor trust, and owner trust. The first type is intended for handling revolving credit card balances. The second type issues senior/subordinate securities while grantor trusts are used in Real Estate Mortgage Investment Conduits and automobile-backed securities. Owner trusts allocate the interest and principal received to various classes of issued securities.

The Benefits of Securitization

Financial institutions use the process of securitization to lower the risk of going bankrupt. This, in turn, gives them the opportunity to obtain lower interest rate loans with future creditors. If an institution structures the pool of debt instruments correctly, the risk of defaulting is dramatically reduced. In addition, more investors may choose to buy these securitized products. As soon as the financial institution sells the bundles to willing investors, it shares the risks with the buyer, thus improving its financial status, compared to taking the risk on its own.