Securitization: Definition, Pros & Cons, Example

What Is Securitization?

Securitization pools assets and repackages them into interest-bearing securities. An issuer designs a marketable financial instrument by merging financial assets, commonly mortgage loans or consumer or commercial debt. Investors that purchase these securities receive the principal and interest payments of the underlying assets.

Key Takeaways

  • Securitization pools or groups debt into portfolios.
  • Issuers create marketable financial instruments by merging various financial assets into tranches.
  • Securitized instruments provide investors with income from interest and principal.
  • Mortgage-backed securities are backed by home loans issued to consumers. Asset-backed securities are backed by auto loans, mobile home loans, credit card loans, and student loans.
Securitization: The pooling of assets in order to repackage them into interest-bearing securities.

Investopedia / Xiaojie Liu

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.

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 specified 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.

Securitization frees up capital for originators and promotes liquidity in the marketplace.

Tranches

The new securitized financial instrument may be divided into different sections called tranches. The tranches consist of individual assets grouped by factors such as loan type, maturity date, interest rate, and remaining principal. Each tranche carries different degrees of risk and offers different yields.

Mortgage-backed securities (MBS) or asset-backed securities (ABS) are examples of securitization and can be divided into tranches. Asset-backed securities (ABS) are bonds backed by financial assets, such as auto loans, mobile home loans, credit card loans, and student loans. After combining debt into one portfolio, the issuer can divide the pool into smaller pieces based on the inherent risk of default. These smaller portions are sold to investors, each packaged as a type of bond.

Advantages and Disadvantages of Securitization

Securitization creates liquidity by allowing retail investors to purchase 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 investment vehicles, many loan-based securities are backed by collateral. Additionally, as the originator moves debt into the securitized portfolio, it reduces the liability on its balance sheet, allowing it to underwrite additional loans.

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

Pros
  • Turns illiquid assets into liquid ones

  • Frees up capital for the originator

  • Provides income for investors

  • Small investors can participate

Cons
  • Investor assumes creditor role

  • Risk of default on underlying loans

  • Lack of transparency regarding assets

  • Early repayment damages investor's returns

Example of Securitization

Fidelity offers mortgage-backed securities that provide investors with a monthly distribution of principal and interest payments made by homeowners. These investments may be backed or issued by:

  • Government National Mortgage Association (GNMA): The U.S. government backs bonds guaranteed by Ginnie Mae. GNMA does not purchase, package, or sell mortgages but does guarantee their principal and interest payments.
  • Federal National Mortgage Association (FNMA): Fannie Mae purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Fannie Mae and are not direct obligations of the U.S. government. FNMA products carry credit risk.
  • Federal Home Loan Mortgage Corporation (FHLMC): Freddie Mac purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Freddie Mac and are not direct obligations of the U.S. government. FHLMC products carry credit risk.

Which Agencies Regulate Securitization?

Companies that engage in securities or investment activities are regulated by the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, Inc. (FINRA).

How Are Investors Paid by Investing in Mortgage Based Securities?

Two types of MBS included pass-throughs and collateralized mortgage obligations (CMO).

Pass-throughs are structured as trusts in which mortgage payments are collected and passed to investors with stated maturities of 5, 15, or 30 years. CMOs consist of multiple pools of securities known as tranches with varying credit ratings that determine the rates that are returned to investors.

What Is the Difference Between an MBS and an ABS?

Mortgage-backed securities are bonds backed by home loans issued to consumers. Asset-backed securities are bonds backed by auto loans, mobile home loans, credit card loans, and student loans.

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.

Article Sources
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  1. Fidelity. "What Are Mortgage Backed Securities?"

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