Securitization: Definition, Theory & Process

What Is Securitization?

What is securitization? The securitization definition is the financial strategy of combining debt obligations and selling them to investors. Debt like mortgages, credit card balances, and auto loans can be organized into financial assets and sold as securities. Investors who buy these securities can earn passive income by cash payment on the debts. The securitization meaning is the transferring of non-investment debt vehicles into investment debt vehicles through financial securities.

It is important for investors to understand that assets are the items that have debt obligations, while securities are the collection of these items that individuals can invest. There are two different types of assets, liquid and illiquid.

• Liquid assets include any debt item that can be easily transferred to cash. Here are some liquid asset examples: mortgages, auto loans, any on-hand cash, business loans, or any form of investments

• Illiquid assets are items that are very difficult to convert into cash or cannot be transferred to cash at all. Some common illiquid assets are property or homes, collectibles, vehicles, and private business holdings.

Securitization Process

The securitization process commonly works in two main steps:

1. A financial institution pools up debt obligation assets in its portfolio.

2. Divide the new assets into investment vehicles for investors to purchase.

The most common type of asset pooling is through mortgage-backed securities (MBS). MBS are investment securities used for pooling numerous real estate mortgages together and placing them into a security. Once this is done, investors can buy the security and make money through the cash flow process of mortgage payoff. Financial institutions that hold mortgages and want to split them up in securities can divide the securities even further into shares to sell to investors.

The securitization theory is held strong by having assets that are backed by something real, like MBS are backed by real estate. Securitization also helps individuals, who have lower credit scores, receive some financial loan assistance from a bank.

Advantages of Securitization

There are several advantages of securitization, and it has become very popular in the last couple of decades.

For issuers of asset-backed securities can receive the following benefits:

• Offers new ways to generate revenue.

• Can reduce borrowing costs from other loans or through conversion of illiquid assets into cash quicker.

• Lower capital requirements allow organizations to take out more loans if needed.

• Debt-assets are not on business balance sheets, meaning these types of investments do not add to "liabilities" or debt obligations.

For investors, there are several advantages as well:

• Securitization offers investors an opportunity to receive higher-than-average returns.

• Investors can use these types of securities to diversify their portfolios and get involved in real estate investing.

• They have access to usually pretty safe, highly rated investments in large amounts of debt securities.

Disadvantages of Securitization

Issuers face some disadvantages in securitization:

• Could damage the quality of the investment portfolio.

• Securitization comes with high costs in managing the assets, legal costs, ongoing administration of the pool of assets, and other fees.

• Any issuer of debt-asset securities faces a large amount of risk because of low credit individual's chance of default, prepayment of loans, and bankruptcy.

One of the largest mishaps of securitization occurred during the 2006-2008 market crash. All centered around mortgage-backed securities, banks and other financial institutions were offering mortgage loans to very low credit, high-risk borrowers that were prone to default on loans. Starting in 2006 and bleeding into 2007, thousands of these high-risk borrowers defaulted or failed to pay off their home loans, which sent a shock wave through the financial world and caused an economic crisis.

This chart shows the beginning of the sub-prime market crash that led to a global economic crisis. Mortgage-backed securities were very popular in the financial sector in the early 2000s but experienced a large decrease at the end of 2006 and beginning of 2007.

Investors in securitization also see these disadvantages:

• Debt-asset securities are usually expensive because of high management costs and legal fees, eating away at any returns they may have gained.

• Default risk - If a group of loans defaults on payments, investors could lose out on their invested money.

• Variable interest rates can cause an investor's holdings in securitization funds to have wide swings in value.

Common Securitization Solutions

Common Securitization Solutions (CSS) is a financial technology (FinTech) company that creates a platform for the issuance and management of mortgage-backed securities - the most popular of securitization assets. Companies like the CSS help facilitate the process of securitization in the financial world. Common Securitization Solutions is a Government-Sponsored Enterprise that helps the flow of business through Fannie Mae and Freddie Mac. Both Fannie Mae and Freddie Mac are government enterprises that support the mortgage market in the United States.

Prior to 2009, the Federal Reserve, the U.S. central banking system, did not hold any mortgage-backed securities (red line) and only held government treasury notes(blue line). Because of the global financial crisis, the Fed began buying up mortgage securities to help mitigate the fallout.

CSS helps issuers of MBS monetize their debt assets to sell to investors. Their technology support software takes residential mortgages that are pooled together and places them in mortgage-backed securities. Then, these MBS are sold to investors. CSS claims that because of their services, financial institutions are able to raise liquid assets in order to offer more mortgages to individuals.

Lesson Summary

Securitization is the process of collecting debt assets like home mortgages and pooling them into securities that can be sold. Assets are items that individuals or businesses have loans for, like homes, vehicles, and businesses. Securities are investment vehicles like stocks and bonds. Securitization investment vehicles can have two types of assets combined in them: liquid assets and illiquid assets. Liquid assets are items that can be quickly turned into cash, like car loans and home loans. Illiquid assets are items that are more difficult to transfer to cash, like house property.

The securitization process takes two steps: the pooling of assets into a security and then offering these securities for investors to invest. Securitization theory states that there are some profit opportunities and lower cost advantages for issuers of securitization investments, but there are also some risks like loss of investment value and higher costs or more regulation. The Great Recession saw the worse of securitization when mortgage-backed securities, the most popular securitization method, were being held up by loans that were given to high-risk borrowers. Once the loans began to default, the value of all the MBS portfolios tanked and set off a financial tumble for over a year. Post-2008, government and private organizations worked together to manage better and facilitate the securitization market. Common Securitization Solutions (CSS) is one of those companies that help create a platform to facilitate the issuance of mortgage-backed securities better.