Securitization - How Does It Work And Its Benefits?

What Is Securitization?

Essentially, securitization refers to the process of creating asset-backed securities (ABS). By doing so, it pools the illiquid assets of a finance company (such as leases, loans, mortgages, and credit card debts) and converts them into highly liquid securities for sale to investors.

It is theoretically possible to securitize any financial asset — that is, to convert it into a tradable, fungible item with a monetary value. This is essentially what all securities are. As a result, the financing companies can raise additional capital at cheaper rates than they could obtain through their commercial banks. They do this by releasing cash from assets on their balance sheets. In addition, this increases their loan book by lending their capital back to new borrowers.

How Does Securitization Work?

The process of securitization generally has two steps.

Step one:

A company with loans or other income-producing assets (called “the originator”) identifies the assets they wish to remove from its balance sheets and puts them into a portfolio referred to as the reference portfolio. They then sell this asset pool to an issuer, such as a special purpose vehicle (SPV). SPVs are created, typically by financial institutions, to purchase assets and realize their off-balance-sheet classification for legal and accounting purposes.

Step two:

To finance the acquisition of the pooled assets, the issuer issues and sells tradable, interest-bearing securities to investors in the capital markets. Investors receive fixed, or floating rate payments from a trust fund backed by the cash flow generated by a reference portfolio. The originator, in most instances, manages the loans in the portfolio, collects the payments from the original borrowers, and passes them on to the SPV or trustee of the portfolio. In essence, securitization is an alternative and diversified source of financing that involves the transfer of credit risk from issuers to investors (as well as the interest rate and currency risks).

Benefits of Securitization

When assets are packaged and sold, securitization may create liquidity for financial institutions by freeing up assets on their balance sheets and raising new capital. The resulting liquidity enables them to make loans at a grander scale. On the other hand, as a result of securitization, investors gain access to investments that they otherwise would not be able to hold directly. For example, small investors may be unable to afford to invest in a large pool of mortgages without securitization. In the case of mortgage-backed securities (MBS), an investor can buy portions of mortgages and receive regular returns in the form of principal and interest.

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