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.
A Little More on What is Securitization
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 company’s 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 Investor’s 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.
References for Securitization
Academic Research for Securitization
Securitization without risk transfer, Acharya, V. V., Schnabl, P., & Suarez, G. (2013). Journal of Financial economics, 107(3), 515-536. This paper scrutinizes asset-backed commercial paper conduits, particularly the ones that engaged in shadow-banking during the onset of the financial crisis in 2007. Commercial bank assets worth $1.3 billion were securitized by way of conduits during the process of insuring the securitized assets by employing explicit guarantees. The paper concludes that conduits were set up mostly because of regulatory arbitrage.
Understanding the securitization of subprime mortgage credit, Ashcraft, A. B., & Schuermann, T. (2008). Foundations and Trends® in Finance, 2(3), 191-309. This paper offers an insight into the subprime mortgage securitization process and provides an understanding of the seven principal informational frictions that are usually associated with such securitization. It also describes the influence of market participants in reducing such frictions. Finally, the authors describe the principal structural attributes of a conventional subprime securitization and record the process of assigning credit ratings to mortgage-backed securities.
Did securitization lead to lax screening? Evidence from subprime loans, Keys, B. J., Mukherjee, T., Seru, A., & Vig, V. (2010). The Quarterly journal of economics, 125(1), 307-362. This paper conducts an empirical analysis of the subprime crisis and attempts to scrutinize the notion that securitization reduces the incentives of fiscal intermediaries to meticulously screen borrowers. The authors analyze data pertaining to securitized subprime mortgage loan contracts. The paper concludes that existing securitization practices have a profound negative impact on the screening incentives of subprime lenders.
The alchemy of asset securitization, Schwarcz, S. L. (1994). Stan. JL Bus. & Fin., 1, 133. This article provides an insight into the concept of asset securitization and demonstrates the direct and indirect benefits that it offers to businesses. One of the most important advantages of using asset securitization is an access to lower cost capital market funding, which offers a significant reduction in financing costs to businesses.
Securitization, Minsky, H. P., & Wray, L. R. (2008). Securitization (No. 08-2). This paper is an evaluation of Hyman P. Minsky’s writings pertaining to securitization and provides valuable insight into the late author’s concept of money manager capitalism – a particularly unstable form of capitalism that owes its origins to several long-term market forces. According to Randall Wray, Minsky advocated major institutional reforms to address this systemic problem that transcends the realms of subprimes and real estate.
Bank funding modes: Securitization versus deposits, Greenbaum, S. I., & Thakor, A. V. (1987). Journal of Banking and Finance, 11(3), 379-401. This paper scrutinizes a bank’s options pertaining to the loans it originates. These are: Funding these loans by emitting deposits. Selling the loans to investors. The authors invalidate both options as irrelevant. They contend that securitization of high quality assets and funding of low quality assets is inevitable, given that there is zero government intervention.
Wealth effects of asset securitization, Lockwood, L. J., Rutherford, R. C., & Herrera, M. J. (1996). Journal of Banking & Finance, 20(1), 151-164. The authors scrutinize businesses that securitize assets and assess variations in wealth for such businesses. They make the following observations: Finance companies displayed an increase in wealth. Banking institutions displayed a decrease in wealth. There was no discernible change in wealth for industrial and automobile businesses. The paper concludes that the announcement of an asset securitization potentially increases wealth for stronger banks, while it reduces wealth in the case of weaker banks.
Special purpose vehicles and securitization, Gorton, G. B., & Souleles, N. S. (2007). In The risks of financial institutions(pp. 549-602). University of Chicago Press. This paper scrutinizes securitization in the context of special purpose vehicles (SPVs). The authors contend that the primary function of SPVs is to reduce bankruptcy costs. They substantiate that argument by using unique data on credit card securitization as evidence. The process involved in the reduction of bankruptcy costs offers an insight into the appropriate approach to evaluating bank risk.
Securitization of mortality risks in life annuities, Lin, Y., & Cox, S. H. (2005). Journal of risk and Insurance, 72(2), 227-252. This paper evaluates mortality-based securities such as mortality bonds and swaps, and offers pricing strategies for such products. The authors are primarily focused on individual annuity data. However, quite a few of the modeling approaches described in this paper can be incorporated in various other forms of annuity or life insurance.
Credit card securitization and regulatory arbitrage, Calomiris, C. W., & Mason, J. R. (2004). Journal of Financial Services Research, 26(1), 5-27. This paper scrutinizes off-balance sheet financing of credit card receivables by banks and explores three related issues: The magnitude of the impact of securitizations causing the transfer of risk out of the originating bank. The magnitude of the impact of securitizations allowing banks to economize on capital by circumventing minimum capital requirements. The negative effect of banks’ circumvention of minimum capital regulation via securitization.
Special purpose vehicles and securitization, Gorton, G., & Souleles, N. (2005). National Bureau of Economic Research. Assets are often transferred to special purpose vehicles (SPVs) in order to facilitate off-balance sheet financing. SPVs serve as effective tools to avoid bankruptcy. In the event that a business incurs high bankruptcy costs, it can resort to off-balance sheet financing. This paper concludes that notwithstanding legal and accounting restrictions, it is possible for investors in special purpose vehicles to bail out their investments.
• Securitization of life insurance assets and liabilities, Cowley, A., & Cummins, J. D. (2005). Journal of Risk and Insurance, 72(2), 193-226. This article provides an insight into the concept of securitization as an indispensable innovation of modern finance. Securitization isolates a pool of assets or rights to a set of cash flows and the repackaging of the assets or cash flows into tradable securities. It also facilitates the unbundling and segregation of cash flow streams so they can be traded as discrete financial instruments.