Securitization is a financial process that involves pooling together financial assets and transforming them into securities that can be traded on the open market.
The securitization process involves turning illiquid assets into liquid assets that can be bought and sold, which increases liquidity in the market and allows for a more efficient allocation of capital.
In this article, we will explore what securitization is, and its types, and provide some examples of securitization in action.
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Definition of Securitization
Securitization is a financial process that involves pooling together various financial assets, such as mortgages, car loans, credit card receivables, or any other type of loan or receivable, and transforming them into securities that can be sold to investors. These securities are then traded on the open market, providing investors with a way to invest in a diversified portfolio of assets.
Types of Securitization
There are different types of securitization based on the type of asset being securitized, the structure of the security, and the risk involved. Some of the most common types of securitization include:
- Mortgage-Backed Securities (MBS) – This type of securitization involves pooling together residential or commercial mortgages and transforming them into securities. Investors can then purchase these securities, which are backed by the underlying mortgages.
- Asset-Backed Securities (ABS) – This type of securitization involves pooling together assets such as car loans, credit card receivables, or any other type of loan or receivable and transforming them into securities. Investors can then purchase these securities, which are backed by the underlying assets.
- Collateralized Debt Obligations (CDO) – This type of securitization involves pooling together different types of debt, such as corporate bonds, and transforming them into securities. Investors can then purchase these securities, which are backed by the underlying debt.
Example of Securitization
To understand how securitization works, let us consider an example of mortgage-backed securities (MBS). A mortgage lender may originate a large number of mortgages with varying interest rates and terms. The lender then pools together these mortgages and sells them to a special purpose vehicle (SPV), which is a legal entity created solely for the purpose of securitizing the mortgages.
The SPV then issues MBS, which are securities backed by the underlying mortgages. These MBS are sold to investors, who receive periodic payments of principal and interest from the underlying mortgages. The cash flows from the mortgages are used to pay interest and principal to the MBS investors.
Conclusion
Securitization is a financial process that has become an essential part of the global financial system. It enables financial institutions to transform illiquid assets into liquid securities, which increases liquidity in the market and provides investors with access to a diversified portfolio of assets. The different types of securitization offer investors a range of investment options with varying levels of risk and return. As the financial industry continues to evolve, securitization will remain a critical tool for managing risk and creating value.
