Securitization: Definition, Pros & Cons, Example

What Is Securitization?

Securitization pools assets and repackages them into interest-bearing securities. An issuer designs a marketable financial instrument by merging financial assets, commonly mortgage loans or consumer or commercial debt. Investors that purchase these securities receive the principal and interest payments of the underlying assets.

How Securitization Works

In securitization, the company or the originator that holds the assets determines which assets to remove from its balance sheets. A bank might do this with mortgages and personal loans it no longer wants to service.

This gathered group of assets is now considered a reference portfolio. The originator then sells the portfolio to an issuer who creates tradable securities with a stake in the assets in the portfolio. Investors buy the new securities for a specified rate of return and effectively take the position of the lender.

Securitization allows the original lender or creditor to remove assets from its balance sheets to underwrite additional loans. Investors profit as they earn a rate of return based on the associated principal and interest payments made on the underlying loans and obligations by the debtors or borrowers.

Tranches

The new securitized financial instrument may be divided into different sections called tranches. The tranches consist of individual assets grouped by factors such as loan type, maturity date, interest rate, and remaining principal. Each tranche carries different degrees of risk and offers different yields.

Mortgage-backed securities (MBS) or asset-backed securities (ABS) are examples of securitization and can be divided into tranches. Asset-backed securities (ABS) are bonds backed by financial assets, such as auto loans, mobile home loans, credit card loans, and student loans. After combining debt into one portfolio, the issuer can divide the pool into smaller pieces based on the inherent risk of default. These smaller portions are sold to investors, each packaged as a type of bond.

Advantages and Disadvantages of Securitization

Securitization creates liquidity by allowing retail investors to purchase shares in instruments that would be unavailable to them. An MBS investor can buy portions of mortgages and receive regular returns from interest and principal payments.

Unlike other investment vehicles, many loan-based securities are backed by collateral. Additionally, as the originator moves debt into the securitized portfolio, it reduces the liability on its balance sheet, allowing it to underwrite additional loans.

Although the securities may be backed by tangible assets, there is a risk of default. Additionally, early repayment will reduce the returns the investor receives on the underlying notes. There may also be a lack of transparency about the underlying assets. Misrepresented mortgage-backed securities played a toxic and precipitating role in the financial crisis of 2007 to 2008.

Example of Securitization

Fidelity offers mortgage-backed securities that provide investors with a monthly distribution of principal and interest payments made by homeowners. These investments may be backed or issued by:

• Government National Mortgage Association (GNMA): The U.S. government backs bonds guaranteed by Ginnie Mae. GNMA does not purchase, package, or sell mortgages but does guarantee their principal and interest payments.
• Federal National Mortgage Association (FNMA): Fannie Mae purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Fannie Mae and are not direct obligations of the U.S. government. FNMA products carry credit risk.
• Federal Home Loan Mortgage Corporation (FHLMC): Freddie Mac purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Freddie Mac and are not direct obligations of the U.S. government. FHLMC products carry credit risk.

The Bottom Line

Securitization pools or groups debt into investable portfolios to make marketable financial instruments. Investors can profit from the interest and principal paid on the underlying assets. Both mortgage-backed securities and asset-backed securities are created through securitization and include mortgages, consumer, and commercial debt.