Securitization - Explained
What is Securitization?
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Table of ContentsWhat is Securitization?How Does Securitization Work?Advantages of Securitization to Creditors and InvestorsRisks Involved in Securitization (from an Investors Point of View)
What is Securitization?
Securitization is a financial procedure that involves the distribution of default risk by an issuer who groups or merges financial assets such as mortgages into a pool and then sells the cash flows backed by this pool. Securitization is applicable to a wide range of financial assets such as residential and commercial mortgages, automobile loans and even credit card debt balances.
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How Does Securitization Work?
Securitization boosts liquidity in the market by fostering the participation of smaller investors in the purchase of equity in large asset pools. This is made possible by dividing large asset pools into smaller, more marketable pieces before offering them to investors. One of the most prevalent forms of securitization is a mortgage-backed security that enables individual retail investors to acquire parts of a larger mortgage in the form of bonds. The process of securitization involves an originator, which is a company that holds the loans. The originator is responsible for collecting data pertaining to the assets that are due to be securitized. Several criteria such as current remaining principal loan balance, risk levels as well as the remaining period of loan repayment need to be considered while group assets together in a pool. This pool of grouped assets is then earmarked for sale to an issuer. Such a pool is also known as a reference portfolio. The issuer associated with the reference portfolio creates a number of tradable securities with each security representing a stake in the assets that make up the reference portfolio. Interested investors can purchase stakes at predetermined rates of return.
Advantages of Securitization to Creditors and Investors
In general, securitization creates liquidity in the marketplace. It also segregates debts into different tranches, with each being associated with a different level of risk. Securitization also promises several benefits to creditors and investors. They are:
- Creditors get access to an instrument that lowers their associated risks by splitting up the ownership of the debt obligations. Besides, creditors are also able to dispose of unmanageable assets from their portfolios, which may actually raise the companys credit rating.
- Investors who purchase portions of the security practically become the lenders, earning stipulated rates of return that are calculated on the associated principal and interest payments receivable from the included debtors on their obligation.
- Securitized assets provide a higher level of safety compared to many other investment vehicles. This is primarily because any form of securitization is backed by tangible assets that can be seized and liquidated in the event of a default (or a series of defaults) on the part of the debtor.
Risks Involved in Securitization (from an Investors Point of View)
As with any other form of investment, securitization also involves certain risks to the investor. These are:
- The risk of default, which is the inability of the borrower to pay his interest payments.
- Events risks that are associated with prepayment, reinvestment and early amortization.
- Risks that arise from fluctuations in interest rates.
- Risks associated with moral hazards such as conflicts of interest.
- Risks associated with an insolvent servicer.