Securitization

What Is Securitization?

Securitization is the process of turning many similar debts, such as home loans, auto loans, or credit card balances, into tradable securities. A lender or other institution gathers a large group of these loans into one pool and then sells securities backed by that pool. Each security gives its holder a claim on a share of the payments borrowers make, so investors receive interest and principal as the debts are repaid. When the underlying loans are home mortgages, the result is called a mortgage-backed security. Securities backed by other kinds of debt are generally called asset-backed security|asset-backed securities.

How the Process Works

The process usually involves several steps. The institution that originally made the loans, called the originator, transfers them to a separate legal entity, often a special purpose vehicle. This structure is designed to keep the loans separate from the originator's own finances. The vehicle then issues securities in several layers, known as tranches, which differ in their order of payment and their level of risk. Senior tranches are paid first and generally carry lower yields, while junior tranches absorb losses first and usually offer higher potential returns. credit rating agencies often assign ratings to these layers to indicate their expected credit risk.

Example

Consider a bank that has made several thousand auto loans to its customers. Rather than holding all of them until they are repaid, the bank groups them into a pool and sells them to a special vehicle, which issues securities to investors. The bank receives cash it can use to make new loans, while investors buy securities whose returns depend on how well the borrowers keep up with their payments.

Benefits and Risks

Securitization can help lenders free up capital and fund additional lending, and it can give investors access to kinds of debt they might not hold directly. The structure also adds complexity. Investors depend on the quality of the underlying loans and on how cash flows are divided among tranches. When lenders plan to sell their loans, they may have less incentive to check borrowers carefully. Weaknesses in securitized home-loan markets contributed to the late-2000s financial crisis, which is why many investors review the loan pool, the tranche structure, and the issuer's disclosures before evaluating these securities.