Securitization, an intricate process in the world of finance, is a strategic approach to boost liquidity by converting an illiquid asset or a pool of assets into an investable security. This financial engineering technique is crucial for markets, enabling them to operate efficiently by increasing liquidity and access to credit. But it's not all sunshine and roses, as securitization has been linked to several potential pitfalls, including alleged lack of transparency and incitement of reckless borrowing.
Before delving into the advantages and potential issues associated with securitization, let's understand how it works. The quintessential example of this process is a mortgage-backed security (MBS). Here, a group of home loans, initially extended by a lender, are sold to another financial institution. This institution then consolidates these mortgages into a singular, distinct unit, making it an attractive investment opportunity for the public.
Investors in an MBS essentially step into the shoes of a lender, receiving the interest and principal payments from these various mortgages. This not only allows investors to profit from these activities but also enables the original lender to offload liabilities and free up capital to make additional loans, thereby boosting overall liquidity in the financial system.
By allowing assets to become securities, securitization transforms an asset, which otherwise would not be a liquid, tradable security, into one. Besides mortgages, several other assets like credit card debts, college loans, and car loans can also be securitized. Such securitized assets are typically referred to as Asset-Backed Securities (ABS) or Collateralized Debt Obligations (CDOs), depending on the type of underlying asset.
While the potential benefits of securitization are plentiful, the mechanism has attracted criticism. Securitization has been accused of lacking transparency and encouraging lenders to underwrite loans without a thorough evaluation of their quality, leading to systemic financial risk. This is because, in securitization, the lenders who originally extended the loans (now securitized) are no longer exposed to the default risk associated with them. They can wash their hands of these loans and pass the risk to investors.
This shifting of risk has led to allegations that securitization emboldens lenders to issue loans to borrowers who may not be financially stable. It's worth noting that this same process was at the heart of the 2007-2008 financial crisis, when an avalanche of defaults on subprime mortgage loans (securitized into MBS) led to a global economic downturn.
Securitization, despite its potential issues, remains an integral part of financial systems worldwide. By transforming illiquid assets into tradable securities, it boosts liquidity, encourages credit expansion, and allows for risk diversification. However, it is vital to note the potential pitfalls associated with this process and underscore the need for responsible lending practices and robust regulatory oversight to mitigate these risks and ensure financial stability.
Summary
Securitization is to turn an asset which would otherwise not be a liquid, tradable security, into one.
Simply put, securitization turns assets into securities.
The most common example when discussing securitization is mortgage-backed securities, in which the cash flow of interest and principal payments on mortgage loans has been pooled, cut up, and distributed for sale in the form of marketable securities which can be held by an everyday investor. The bank or institution who sold the mortgage-backed securities receives cash which they can loan out to more home-buyers.
As far as the first mortgage goes, they no longer have any cash at stake, and they have passed the default risk off to the investors who bought the mortgage-backed securities. This can cause a problem when many lenders are competing to make loans to individuals who may not be financially stable, and then the lenders pass off that risk to third party investors.
Securitization refers most often to situations like this where an illiquid asset is made liquid, with the help of financial engineering. Other assets such as credit card debt, college loans, and car loans can also be securitized and are referred to as Asset-Backed Securities or Collateralized Debt Obligations (CDOs).
Ownership interest in a company is securitized and called stock.