What is Securitization?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

Securitization is the process of bundling financial assets into a single package and selling pieces of that package off to investors.

🤔 Understanding securitization

Securitization is a means of turning assets into tradable investments by pooling them together. Issuers repackage these assets and sell them as interest-bearing securities. Buying these securities allows investors to diversify their portfolios compared to investing directly in one of those underlying assets, and may give them access to assets they otherwise could not invest in. Securitization dates back to the 1970s, when US government-backed agencies began to pool mortgage loans and sell them as mortgage-backed securities. Securitization today still often occurs with mortgage loans and other debt, but any financial assets can theoretically be securitized. Institutions often use securitization as a way of transferring their default risk to other entities and investors or to raise cash.

Example

Suppose that the fictional financial institution World Wide Bank issues mortgages and other types of loans. The bank wants to continue to originate loans, but fears that it’s taking on too much risk. Instead of no longer offering new mortgages, World Wide Bank decides to sell off some of the mortgages it already has. Rather than selling each loan individually, the bank securitizes the mortgages into a single mortgage-backed security and offers that to investors. The investors get the perk of the income from the mortgages, while World Wide Bank gets the benefit of reducing some of its risk.

Takeaway

Securitization is like an appetizer combo at a restaurant…

Instead of selling individual appetizers, some restaurants sell a combo that groups together several popular options. The combo basket can be a safer bet for diners. If you don’t like one of the choices, you’ve got others to eat. Similarly, securitization is the practice of bundling different assets together into a diversified security (or a combo basket) to sell to investors. It can be safer for investors than buying individual mortgages, as they don’t lose all of their money if one borrower defaults. Still, investing in asset-backed securities comes with risk, and returns are not guaranteed.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What is securitization?

Securitization is a process through which a company, usually a financial institution, pools together assets into a single security. The bundle of assets becomes a tradable financial instrument, which the company can then sell to investors. Securitization helps creditors reduce some of the risk they take on by lending people money and to improve cash flow. It also gives investors a way to diversify their portfolios and access assets they otherwise wouldn’t be able to buy.

Any financial asset can theoretically become a security. But securitization usually happens with loans and other kinds of debt. The interest and principal payments are passed on to those who buy the securities.

When financial institutions began securitizing assets in the 1970s, they started with mortgages. Bundling mortgage loans together to create a mortgage-backed security is known as mortgage securitization. Starting in the 1980s, issuers began securitizing other debts as well, such as consumer loans. Mortgage-backed securities still make up a large part of the securitization market.

What is the purpose of securitization?

There are two primary reasons a financial institution might choose to securitize mortgage loans or other debts. First, creditors take on risk each time they lend someone money — the risk that the borrower won’t pay back the loan. Securitizing those loans gives financial institutions a way to offload some of that risk.

Another reason a financial institution might choose to securitize assets is to free up some of its cash flow. Outstanding debt, such as mortgages and other loans, count as assets for the originator. But unlike some other assets, these debts aren’t liquid, meaning banks can’t easily turn them into cash. A loan originator might choose to securitize debts when it wants to free up cash flow to spend elsewhere.

How does securitization work?

The securitization process starts with a company that owns outstanding debts or other income-earning assets. The company decides which of these assets it wants to remove from its balance sheet. The institution pools these assets together into something called a reference portfolio and sells the pool to a special purpose vehicle (SPV), an entity created, usually by a financial institution, specifically to purchase these asset bundles.

In the process of securitization, the reference portfolio is divided up into different pieces known as tranches. Each tranche includes assets grouped based on factors like the type of loan, interest rate, and maturity date, and each comes with a different level of risk.

The next step of the process is when the SPV issues these asset pools as tradable securities to investors. Investors then receive either a fixed income or variable income from these securities, depending on the nature of the assets. The loan originator often continues to service the loan and collect payments from the borrowers, but then passes the income along to the SPV or a trustee, which pays investors.

What are some real-world examples of securitization?

Securitization became a topic of public conversation when the financial crisis hit in 2007. Both before and after the crisis, it has been a common practice for mortgage lenders to bundle mortgage loans together into asset-backed securities.

Prior to 2007, the US was in a housing bubble — real estate prices had rapidly grown to an unsustainable level. When the bubble burst, many people suddenly had mortgages that were significantly larger than the value of their homes. It became clear that lenders had been giving mortgage loans to people who really couldn’t afford them. Those lenders had then taken the subprime mortgages (loans given to people with low credit) and securitized them into mortgage-backed securities. Credit rating agencies led investors to believe those securities were less risky than they were. When many homeowners could no longer make their payments, investors lost money.

The securitization of mortgages began in the 1970s. In the next decade, lenders started doing the same for other types of loans, such as car loans, student loans, and credit card debt.

Is securitization good or bad?

Prior to the subprime mortgage crisis that began in 2007, securitization was seen as a relatively positive and low-risk strategy. It benefitted financial institutions by allowing them to free up some cash flow. It was also a plus for investors, who were able to diversify their portfolios and put money into fixed-income securities. Then the financial crisis of 2007 hit, partially as a result of mortgage-backed securities filled with subprime mortgages (mortgages issued to borrowers with a low credit rating).

The events of the financial crisis exposed some of the problems that can emerge with securitization. Specifically, financial institutions lowered their lending standards, then offloaded those risky mortgages onto investors. Lenders may have been less concerned about the outcome of the loans, because they knew they wouldn’t be keeping them.

The financial crisis wasn’t the end of securitization, and the practice is still common today. One result of the crisis was stricter legislation intended to prevent financial institutions from repeating history. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created the Consumer Financial Protection Bureau to protect borrowers from predatory lending and curbed some excessively risky practices among financial institutions.

Ultimately, one can’t say that securitization is either good or bad. As with any investment, there’s a level of risk that investors should be aware of going in. Anytime you invest, you have to balance the chance of losing your money with the chance of growing wealth. A well-diversified portfolio can help to reduce the risk of loss for an investor.

What is the securitization of receivables?

Securitization of receivables is a process in which companies pool together accounts receivable (or money they’re owed) and sell them as an asset-backed security. Those accounts receivable, which generally count as assets, move off the company’s balance sheet. Companies might choose to securitize receivables to create liquidity or get debts off their financial statements.

Companies often securitize receivables by issuing commercial paper, which is a type of short-term debt security. It’s not just financial institutions that securitize this kind of debt — Other companies can do it, too.

Suppose a manufacturing firm wants to liquidate some of its accounts receivable. That company might work with a financial institution, such as an investment bank, to package those debts into a single debt security, which is made available to investors.

What are securitized debt instruments?

Securitized debt instruments are the actual securities that financial institutions create when they pool together debts into a single financial asset. These securities then become available to investors. There are two primary types of securitized debt instruments: asset-backed securities and mortgage-backed securities.

An asset-backed security is a general term to describe any securitized debt instrument. Financial institutions can put many different types of debt into these securities, including residential and commercial mortgage loans, auto loans, student loans, personal loans, credit card debt, and accounts receivable.

A mortgage-backed security is a securitized debt instrument specifically made up of mortgage loans. When loan securitization first became common practice in the 1970s, financial institutions generally used mortgages. Since then securitization has expanded to other debts as well.

What are the pros and cons of securitization?

Securitization has a few key benefits for the financial institutions and companies issuing the securities, as well as for investors. First, securitizing outstanding debts allows companies to reduce their own credit risk. Companies that offer consumer loans, like banks, take on a lot of risk every day. At some point, they might want to offload some of that risk onto other parties.

Another benefit of securitization for issuers is that it allows them to take relatively illiquid assets (those that can’t easily be turned into cash) on their balance sheets and make them more liquid. Outstanding loans and accounts receivable appear as assets on companies’ balance sheets, but they aren’t assets they can use right now. By securitizing those debts, they can turn an illiquid asset into cash.

On the other side of the equation, buying these securities gives investors a way to put their money into a fixed-income investment — one that produces a consistent return each month. It can also allow them to dip their toes into an industry such as real estate without having to buy a property or take on the risk of a single mortgage loan. These investments are fairly liquid and there’s an extra layer of security, given that debts are often backed by an asset, such as a home or car.

But securitization can have its downsides, too. During the 2007-2008 financial crisis, the world saw the result of securitized debt instruments backed by too many high-risk, subprime mortgages. Because lenders knew they could pass on these debts, they may have lowered their lending standards and given loans to people who probably shouldn’t have gotten them. The downfall of these securities led to a global recession and revealed other vulnerabilities of the lending industry.

Like any investment, buying securitized debts comes with its own fair share of risk. While many of these investments are backed by tangible assets, there’s no guarantee the investor will fully recover their money if a borrower defaults. Investors are simply taking on the risk that the bank had. And some securitized debts aren’t backed by assets at all.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

2431560

Related Articles

You May Also Like

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

1771482

© 2022 Robinhood. All rights reserved.
Follow us on

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

1771482

© 2022 Robinhood. All rights reserved.