What is securitization?
Securitization is a process through which a financial service provider, like financial institutions or other lenders, pool their various assets in the form of debts and mortgages and issues securities to the investors backed by this pool of assets.
What is securitization in finance?
Securitization is a financial management technique used by a lender to maintain liquidity. Usually, after lending to a borrower, the funds of such financial institutions are blocked for a considerable period. Therefore, to leverage their activities, they resort to such techniques to maintain liquidity, increase their lending activities, and create new investment avenues.
Process of securitization
The steps involved in a securitization process are:
- Creating a pool of assets: This is the first step of the securitization process, where a lender creates a pool of assets by segregating assets backed by similar types of mortgages. This may include similar maturity, rates of interest, or other similar terms.
- Transfer of assets to SPV: This is not a mandatory step. A separate body or organisation may be created for the purpose of securitization known as a Special Purpose Vehicle (SPV). The pooled assets are then transferred in the name of SPV.
- Sale of securities: Based on the assets and their specifications, securities are designed. This may be done by either the lender itself or the SPV specially created for this purpose. The securities designed are then sold to the investors. These securities may be either Asset-Backed Securities (ABS), Mortgage-Backed Securities (MBS), Collateralised Debt Obligations (CDO) and may take the form of Pass-Through Security (PTS) or Pay-Through Certificates (PTC).
- Administration: This is regulating and administering the whole process before and after the securities are issued.
The Great Recession (2007-08)
During the Great Recession in the US in 2007-08, the securitization process played a key role. The securities that were created and sold to the investors were backed by sub-prime mortgages. Sub-prime mortgages were the ones where the mortgages were created against the loans given to households with poor credit histories. As the defaults by such households increased, Mortgage-Backed Securities (MBSs) became worthless as there were no repayments. The Federal Reserve had to step in to inject liquidity into the economy by purchasing such MBSs.
Therefore, securitization is a common practice that plays a vital role in financial management systems. When making any mutual fund investment decision or considering the different avenues available, like stocks, mutual funds, fixed deposits, Exchange Traded Funds, etc., it is essential to do these calculations to get an idea of the stock market today.
With that being said, it is imperative to know that financial advice needs to be taken from experts before making any investments.
Q: What is its benefit to investors?
A: Earnings generated by a financial institution in the form of interest payments are passed on to the investors along with the principal repayment at the end.
Q: How can we trust security?
A: These securities are given credit ratings by recognised credit rating agencies.
Q: What is the difference between ABSs and MBSs?
A: ABSs and MBSs are different primarily because ABSs include different types of debts within their ambit such as auto loans, mortgages, credit card loans, other debts, etc., while MBSs are backed only by mortgage debts.