Who Bears the Risk of Bad Debts in Securitization?

Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, such as mortgage-backed securities (MBS), as bad debts can stop these instruments' cash flows. The risk of bad debt, however, can be apportioned among the investors. Depending on how the securitized instruments are structured, the risk can be placed entirely on a single group of investors or spread throughout the entire investing pool.

Securitization is the process of financially structuring a non-liquid asset or group of similar non-liquid assets into a security that can then be sold to investors. The MBS was first created by trader Lew Ranieri in the early 1980s. It became an extremely popular investment in the 1990s and early 2000s. The idea was that the new security could be sold on the secondary mortgage market, offering investors significant liquidity on an asset that would otherwise be quite illiquid. 

Securitization, specifically, the bundling of assets such as mortgages into securities, has been frowned upon by many as it contributed to subprime mortgage crisis of 2007. However, the practice continues today.

There are two styles of securitization. Here's how they affect the level of risk faced by investors.

A simple securitization involves pooling assets (such as loans or mortgages), creating financial instruments, and marketing them to investors. Incoming cash flows from the loans are passed onto the holders of the new instruments. Each instrument is of equal priority when receiving payments. Since all instruments are equal, they all share in the risk associated with the assets. In this case, all investors bear an equal amount of bad-debt risk.

In a more complex securitization process, tranches are created. Tranches represent different payment structures and various levels of priority for incoming cash flows. In a two-tranche system, tranche A will have priority over tranche B. Both tranches will attempt to follow a schedule of payments that reflects the cash flows of the underlying loans or mortgages. If bad debts arise, tranche B will absorb the loss, lowering its cash flow, while tranche A remains unaffected. Since tranche B is affected by bad debts, it carries the most risk. Investors will purchase tranche B instruments at a discount price to reflect the level of associated risk. If there are more than two tranches, the lowest priority tranche will absorb the losses from bad debts.

For a portfolio, investors can choose from securitization investments such as prime and subprime mortgages, home equity loans, credit card receivables, or auto loans. Investors can also choose an index such as the U.S. ABS Index.

Many investors are attracted to securitizations because they carry a "AAA" credit rating, which means that credit agencies, such as Moody's, believe them to be safe investments. Bond insurance, letters of credit, and senior-subordinate credit structures back these high ratings.

But some securitizations carry prepayment risk—cash flows can exceed expectations returning money to investors when lower interest rates are lower. In addition, some deals simply fail, such as the MBS in 2007.

Securitizations are a popular asset class, but investors should evaluate their risk tolerance or consult the advice of a professional financial advisor.