Securitization

Securitization is the procedure whereby an issuer designs a financial instrument by merging various financial assets and then markets tiers of the repackaged instruments to investors. This process can encompass any type of financial asset and promotes liquidity in the marketplace.

The process of securitization creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. It can involve the pooling of contractual debts such as auto loans and credit card debt obligations, or any assets that generate receivables. Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the pool into smaller pieces based on each mortgage's inherent risk of default and then sell those smaller pieces to investors. With a mortgage-backed security, individual retail investors can purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

In securitization, the company holding the loans, also known as the originator, gathers the data on the assets it would like to remove from its associated balance sheets. These assets are then grouped together by factors, such as the time remaining on a loan, the level of risk, the amount of remaining principal and others. This gathered group of assets, now considered a reference portfolio, is then sold to an issuer. The issuer creates tradable securities representing a stake in the assets associated with the portfolio, selling them to interested investors with a rate of return.

Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations. The investors effectively take the position of lender by buying into the security. This allows a creditor to remove the associated assets from their balance sheets.

The investors earn a rate of return based on the associated principal and interest payments being made by the included debtors on their obligation. Unlike some other investment vehicles, these are backed by tangible goods. Should a debtor cease payments on his asset, it can be seized and liquidated to compensate those holding an interest in the debt. Like other investments, the higher the risk, the higher potential rate of return. This correlates with the higher interest rates less qualified borrowers are generally charged. Even though the securities are back by tangible assets, there is no guarantee that the assets will maintain their value should a debtor cease payment.