Securitization

Updated on January 5, 2024
Article byKosha Mehta
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Securitization Meaning

Securitization is the process of financing or refinancing income-generating assets by transforming them into a form that can be traded through the issuance of bonds or other types of securities. It makes it possible for originators to dispose of assets in a time- and cost-effective manner and get a more advantageous financing profile and improved funding conditions.

Securitization

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It also allows investors to participate in assets they would not otherwise have access to. As a result, the amount of highly rated bonds made available to investors has significantly increased. Therefore, securitization is a handy instrument for investors and originators to diversify their portfolios. It has also been instrumental in the growth and expansion of other markets.

Key Takeaways

  • Securitization is a risk management method for the company that originated the loan.
  • Securitization is a process of transforming illiquid assets into liquid assets by transforming cash flows with longer durations into cash flows with shorter durations.
  • The need of the originator to seek out financial leverage in the case of sudden demand is removed from the originator due to securitization’s ability to unblock blocked funds to maintain liquidity.
  • The returns on a securitized investment are calculated based on the revenue generated by the asset it is backed by.

Securitization Explained

Securitization implies the transformation of an illiquid asset or combination of illiquid assets into a security. This transformation is accomplished via the use of financial engineering. The process by which groups of such illiquid assets (typically debts) are bundled, bought, securitized, and sold to traders is satirically described by the phrase “securitization food chain,” which was popularized by the film “Inside Job,” which was based on the financial crisis that occurred in 2007-2008.

A mortgage-backed security is an example of a typical form of asset-backed security guaranteed by a pool of mortgages and serves as a good illustration of securitization. Initially implemented in 1970, this strategy was the driving force behind the development of innovations such as collateralized mortgage obligations, which appeared for the first time in 1983. Around the middle of the 1990s, MBS reached its peak prevalence.

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Types

Let us have a look at the major types of securitization.

Types of Securitization

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#1 – Assets Backed Securities

The bonds whose value is derived from the underlying value of other financial assets. Credit card debt, college tuition, loans secured against the equity in a home, vehicle loans, and other types of loans are among the receivables that can be converted into ABS.

#2 – Mortgage-Backed Securities

There are two types of mortgage-backed securities, residential mortgages and commercial mortgages. Residential mortgage bonds are composed of various mortgages on real estate, land, houses, jewelry, and other valuable items. Commercial mortgage bonds are created when various commercial assets, such as office buildings, industrial land, plants, factories, and so on, are mortgaged together and bundled together.

#3 – Collateralized Debt Obligations 

CDOs, or collateralized debt obligations, are bonds created by re-bundling individual loans to sell to potential investors on the secondary market.

#4 – Securitization Of Future Cash Flows

A debt receivable in the future is used as collateral for the issuance of these instruments by the corporation. Even if these liabilities are secured against the company’s future receivables, the firm can satisfy the principle and interest payments through its regular business activities.

Examples

Let us look at some securitization examples to understand the concept better:

Example #1

Let’s imagine a company having 10,000 home loans, each with a balance of $100,000, for a total of $100,000,000 in outstanding debt. If they only kept the home loans for themselves, they would be forced to incur a loss if one of the home loans went into default.

Let’s imagine, however, that they convert the loans into two separate securities: Suppose they allocate any losses on the home loans to B first. Security A has a balance of $90 million, while Security B has a balance of $10 million. Again, assuming they assign any deficits on the loans to B first. When viewed in this light, Security A has a lower risk than Security B.

The collateral, which in this case is the home loans, is analyzed by rating agencies, and a transaction model is constructed. This helps the agencies determine the levels at which they will assign an A rating to the securities. If this is the case, then it is likely that investors such as pension plans can purchase shares in them. Through investment banks, these ABS bonds are promoted and sold to investors in public and private markets with comprehensive transparency regarding collateral and home loans.

Example #2

In an article published by Global Capital, the author shows how the US securitization market has not yet found its footing on ESG. Investors consider more than the numerous transaction parties when investing in the securitization market. Such as the originator and servicer, but also the collateral of the securitization pool. Individual investors are the ones who ultimately decide whether or not a transaction meets environmental, social, and governance (ESG) norms because there is no actual consensus on a framework.

Investors wonder if any financial gain exists for issuers who tout higher environmental, social, and governance credentials. The report concludes that there is still a long way to go until the method to define securitizations is established. Nevertheless, there is still promise for development in assets that qualify as green regardless of whether frameworks are in place.

Advantages And Disadvantages

Let us look at the advantages and disadvantages of securitization to understand the concept better.

Advantages

  • The goal of securitization is to free up the blocked money. Although thus, the originator may pursue other exciting prospects, the originator stands to earn the most from the process.
  • Management of risk is better. For example, the financial institution lending cash can securitize its receivables to shift the risk of bad debts.
  • Securitized bonds are significantly distinct from other types of securities. Hence, an investor can get a highly diversified portfolio by integrating these types of bonds.
  • Securitization frees up the blocked capital to retain liquidity. Thus, the originator is relieved of the obligation to seek financial leverage in the event of sudden requirements.

Disadvantages

  • Transparency is absent. Investors may not be provided with all the information on the assets included in a securitized bond.
  • Handling it can be difficult as the entire securitization process involves several parties. Also, the assets must be blended intelligently.
  • Compared to floating shares, a securitized bond is often rather expensive. This cost includes underwriting, legal, administrative, and rating expenses.
  • The investor bears the risk. If the obligations owed by the borrower are not repaid, the investors will suffer a loss. As a result, the investor is the only person at risk during the process.

Securitization vs Factoring

  • Factoring is a financial institution’s acquisition of a firm’s book debts and payment to the company against receivables. At the same time, securitization is transforming illiquid into liquid assets by shifting long periods of cash flows into shorter-term.
  • Factoring involves the bank and the corporation, whereas securitization involves many investors who engage in the securitized asset.
  • Factoring is helpful for short-term account receivables ranging from one month to six months. At the same time, securitization is helpful for the company’s long-term receivables.
  • While factoring is with or without recourse, securitization does not have recourse.
  • Because factoring includes the bank and the firm, there is no need for a credit rating. In contrast, securitization involves multiple investors and hence requires a credit rating before proceeding with receivables securitization.

Frequently Asked Questions (FAQs)

What does securitization mean?

Converting an asset, often a loan, into marketable securities is known as securitization. This is often done to generate cash by selling the securities to other investors.

What is securitization of debt?

The practice of bundling loans from a variety of different sources into a single security and then selling that security to investors is known as debt securitization. Many of these securities are bundles of house mortgage loans first given by banks and then resold by those institutions. In most cases, the buyer is a trust responsible for transforming the loans into marketable security.

What is asset securitization?

Asset securitization refers to the organized process through which interests in debts and other receivables are organized, underwritten, and marketed as “asset-backed” securities. Accordingly, this procedure is referred to as “asset-backed” securities.

This article has been a guide to Securitization and its meaning. Here, we explain its types, examples, advantages and disadvantages, and difference with factoring. You may also find some useful articles here –

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