Securitize

Securitize refers to the process of pooling financial assets together to create new securities that can be marketed and sold to investors. The financial assets being pooled are generally types of loans. Mortgages, credit card debt, car loans, student loans and other forms of contractual debt are often securitized to clear them off the balance sheet of the originating company (the bank) and free up credit for new lenders. The value and cash flows of the new security are based off of the underlying value and cash flows of the assets used in the securitization process and vary according to how the pool is split up into tranches.

To securitize an asset, the originator — usually a bank or a finance company — selects the contractual debt that is to be pooled. Generally this selection process focuses on a certain type of debt, like residential mortgages being selected for a mortgage-backed security. The pool will contain a subset of borrowers. The borrowers who have excellent credit ratings and very little risk of default may all be pooled together for the purpose of selling a high-grade securitized asset, or they can be sprinkled into other pools with borrowers with higher default risk to improve the overall risk profile of the resulting securities. When the selection is complete, these pooled mortgages are sold to an issuer. This may be a third party specializing in creating securitized assets or it can be a special purpose vehicle (SPV) set up by the originator to control its risk exposure to the resulting asset-backed securities. The issuer or SPV acts essentially as a shell company. The SPV will then sell the securities, which are backed by the assets held in the SPV, to investors.

Asset-backed securities are attractive for investors and particularly so for institutional investors. This is because they are highly customizable and can offer a product tailored to meet these large investors' needs. If the asset-backed securities have been stripped, the investors can choose between principal only and interest only in addition to selecting between different tranches. The issuer creates the asset-backed security according to the market need, and ratings agencies assign ratings according to the expected ability of the borrowers whose loans make up the product to keep up their payments. And there is a market for every type of loan. For example, securitized products made from subprime borrowers have a higher overall chance of default and riskier ratings, but those loans also offer more immediate cash flows. So that type of security may fit into a portfolio that is focused on generating short-term income. On the other hand, a pool of highly rated borrowers will have lower cash flows, as the borrowers qualify for lower interest rates and will have a higher risk of prepayment.

Of course, securitization was also involved in one of the worst crashes in history. It is a great system when lenders are giving out good loans and ratings firms are keeping them honest. When originators start making NINJA loans and ratings firms take their documentation on faith, then bad and potentially toxic assets get sold to the market as being much more sound than they are. Securitizing is not an inherently good or bad thing. It is simply a process that helps banks turn illiquid assets into liquid ones and frees up credit. That said, the integrity of this complex process depends on banks retaining moral responsibility for the loans they issue even when they are not legally liable, and on ratings firms to be willing to call out originators when they abdicate this responsibility.