After the sub-prime mortgage crisis, just about everyone heard of securitization. Following the crisis, investors shied away from securitized financial instruments. But securitized debt obligations continue to be common financial instruments. If you are considering purchasing securities created through securitization of a debt obligation—or are considering making an illiquid asset more liquid through securitization— it may help to speak with a securities lawyer from the Priori network.
Securitization is a way to transform an illiquid asset (or group of illiquid assets) into a security. A group of contractual debt obligations -- e.g. a mortgage, auto loan, or credit card debt obligation -- is pooled together and the cashflows resulting from these underlyings is resold to investors as a security. Examples of securitized securities include bonds, pass-through securities, or collateralized debt obligations.
The Securitization Process
The securitization process has two basic steps. First, a creditor pools assets from its balance sheet into a portfolio and sells it to a special purpose vehicle (SPV) or other issuer (for example, a trust). The asset originator is therefore removed from the equation and has no legal interests in the securities created.
Next, the cashflows from the underlying assets are converted into tradable securities and sold to investors. Usually, this portfolio is divided into tranches, which reflect differing levels of risk. The most secure tranches, called senior tranches, carry the least risk, but also receive the lowest returns. Junior tranches conversely carry the most credit exposure and receive the highest returns. Between these tranches lie mezzanine tranches which carry a moderate amount of risk for moderate returns. The SPV is financed by the purchase of such securities within the tranches (which is also called a cash flow waterfall), and the profits from the underlying assets are delivered to investors.
Why Securitization Is Done
Securitization has become a popular tool for financial institutions, because it introduces liquidity into the market. Creditors can remove assets from their balance sheets or borrow against them to refinance. By pooling assets through securitization, these purchases become more appealing to investors than a single bond. Furthermore, risk of default is borne by a larger pool of investors, which makes any single default less damaging.
Mortgage-Backed Securities and Other Securitized Assets
Many types of debt-based assets are securitized. Credit card balances, automobile loans and student loans are commonly securitized. Perhaps the most common type, even after the financial crisis, is mortgage-backed securities. In a mortgage-backed security, mortgages issued to people with high credit ratings are packaged into senior tranches, while debtors with lower credit ratings are packaged together for more junior tranches.
Is securitization bad for the economy?
Not necessarily. Securitization in itself is simply a way of making the market more efficient. The problems with the mortgage backed securities implicated in the subprime crisis began with the underlying quality of the assets. Because of high appetite for these securities, banks extended mortgages to borrowers who either should not have been able to qualify for a mortgage or should only have qualified for a smaller loan. Improved regulation at the lending and securitization level has reduced the risk profile of these product