Securitization is a term used to describe a legal and financial process in which certain assets, such as mortgages, debts, loans and receivables of a business, can be combined into a single security, making it easier to raise money, set prices, and measure risk and reward.
This financial alchemy turns a group or collection of similar yet separate assets into a single security or group of securities. The securities are then bought by major financial institutions such as banks and brokerages and sold to institutional and individual investors, just like any stock or bond. This allows the original owners of the assets to sell them, raise fresh capital, creating a liquid market where other investors can trade the securities.
How securitization works
First, the originator evaluates the assets that it plans to sell, grouping those with similar qualities. This is known as the reference portfolio. These assets will be sold to another financial entity, which will turn them into securities that can be traded on a secondary market. The securities will have qualities similar to bonds—they’ll be subject to interest rate risk, repayment and prepayment risk, and they’ll be graded for quality by a credit rating agency, such as Standard & Poor’s or Moody’s.
Securitization in various industries
Securitization is used by a host of different industries. Some of the more well-known include:
- Auto loans: Many consumers buy cars by financing them. The company that extends them credit owns the loans of thousands of borrowers. Those loans are graded and analyzed for credit quality and other characteristics. The stream of money that flows from the borrowers to the finance company is an asset that has a tangible value. Securitization makes it possible for those auto loans and the cash stream they generate to be pooled together into one security, making it possible to buy and sell the entire package of loans, just as you would any other bond.
- Credit card receivables: Many consumers carry balances on their credit cards and the routine monthly payments create a steady stream of cash for the card issuer. In the same way that auto finance companies can securitize auto loans, the card issuer can package the receivables into a security for sale in the secondary market.
- Mortgages. Mortgages come in different flavors, though the most common tend to be for residences and commercial properties. Mortgage originators either bundle the loans themselves or sell them to other businesses specializing in the legal and financial details of creating and marketing the securities. This process has created one of the largest markets for securitized assets, and the way these assets were further securitized into collateralized debt obligations (CDOs) combined with leverage, played a major role in the 2008-2009 financial crisis.
A similar process can be used for all sorts of other financial assets that generate flows of cash—equipment rentals and leases, student loans, royalties on entertainment, highway tolls, and even fees.
Example of securitization
Here’s an example of how securitization can work in practice..
A company is in the business of leasing equipment to mining companies. These huge pieces of expensive machinery can cost more than $3 million apiece. Rather than owning the equipment, the mining company enters into a lease agreement. The mining and leasing companies agree to payment terms. The right to these lease payments can now be combined with the rights to other equipment lease payments, even from other leasing companies.
Now suppose the leasing company wants to raise additional money for expansion. The company can sell stock to the public, but that would dilute current owners. The company might consider selling a bond, borrowing from bond investors, with terms and agreed-to covenants and disclosures. But that means the company would be directly liable for the payments. In addition, depending on the size of the company, there might not be a large market for its bonds.
Securitization might be the least onerous and most profitable path to raising the money. In return for the stream of lease payments, the leasing company receives a lump sum payment today. Plus, if the mining company (or any of the leasing company’s other customers) isn’t able to make its payments, the leasing company isn’t liable and has no stake in the ownership of the security. In this way, the leasing company has transferred the risk of non-payment to investors, and is able to raise capital without taking on any additional obligations or risks.
From the investors’ perspective, the potential risk is theoretically dispersed or diversified among all the components of the security because one stream of payments is bundled with other payment streams to form the security.
Benefits of securitization
- Turning illiquid assets into liquid ones. Securitization allows an issuer to turn a relatively illiquid asset into one that is liquid and tradeable. Imagine a mortgage lender, such as a bank, makes 30-year fixed-rate loans to home buyers. The lender can wait three decades to get its money back as borrowers repay their loans month-by-month. Or it can use the process of securitization to sell the 30-year stream of payments and receive money today, albeit with a discount for the potential risk of either prepayment or non-payment.
- Generates capital for growth. Securitization makes it possible for a company to pocket future cash flows today. The money received for selling the securitized assets can be used to make additional loans, creating yet another stream of payments that can be packaged and sold on.
- Doesn’t dilute ownership. Raising money via securitization doesn’t dilute current ownership the way that selling stock does. That comes with advantages such as: maintaining control of the company’s strategic business model, control over what assets are packaged. It’s also a boon to lawyers, accountants, bankers and other finance professionals because of the fees associated with a securitization.
- Higher yields for investors. In the current environment of historically low interest rates, securitizations may also be attractive to investors because they offer a higher yield, as the price of the bundle of assets may reflect the risk of repayment or prepayment. Indeed, in some cases the quality of the loans or leases may be questionable. In that case, the riskier the borrower, the higher the interest rate. Those higher rates can lead to enhanced yield for the entire package of loans. They can also lead to higher risk.
Downsides of securitization
- Complexity. Securitizations have been around since the 1980s, but as the market has grown so has the complexity of the assets that are bundled into these new securities. That reflects not only the financial industry’s ability to create and innovate different types of loans, but also big technology changes that have made it easier to track, measure, and service loans. In good times, complexity may be an edge, but complexity can also be an Achilles heel when markets are roiled by outside forces.
- False safety from credit ratings. Just as credit ratings agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings, are paid to rate bonds according to a variety of criteria, they also play an essential role in the world of securitizations. The 2008-2009 Financial Crisis was precipitated by a feeling of safety. Investors perceived the packaged assets as creditworthy, because they sported good credit ratings. However, these packages of assets could receive an overall rating much higher than some of the riskier assets in the pool, leading many investors to not recognize the potential for parts of the package to influence overall confidence in the security. Computational models had shown that the potential return from the riskier assets more than compensated for the additional risk. But that nuance could hardly be expressed in a single rating.
- Potential illiquidity. Securitizations that trade rely on the same concept of price takers and price givers that exists for stocks, bonds, commodities, or any other financial instrument. The prospect of profits combined with investor demand helps to bolster liquidity. The more market participants, the deeper that pool of liquidity grows, along with a greater ability to determine price. The reverse is also true. When investors lose confidence, markets can seize as participants withdraw, taking liquidity and price discovery with them.
- Leverage and increased risk. Leading up to the 2008-2009 financial crisis, securitizations had become so popular that they have been used as collateral for additional loans, which would then purchase more securitized assets, and so on. When markets seized up, that pressure on investors who were facing margin calls which started a cascade of unwinding leverage that caused prices to fall even further.
The bottom line
Securitization is a process in which individual loans, debts, or other legally binding agreements and contracts that involve a payment stream are bundled together into one security. It expands the market for credit assets.
Securitization offers companies greater access to credit, a lower cost way to raise capital while lowering their overall risk. It benefits borrowers because there is greater demand for their payment streams, leading to more loans being offered. It also gives investors access to a large pool of yield-producing securities, along with the ability to trade the securities in a deep, highly developed market.