how securitization works
in securitization the company or the originator that holds the assets determines which assets to remove from its balance sheets a bank might do this with mortgages and personal loans it no longer wants to service or raise capital for additional loans this gathered group of assets is now considered a reference portfolio the originator then sells the portfolio to an issuer who creates tradable securities with a stake in the assets in the portfolio investors buy the new securities for a specific rate of return and effectively take the position of the lender securitization allows the original lender or creditor to remove assets from its balance sheets to underwrite additional loans investors profit as they earn a rate of return based on the associated principal and interest payments made on the underlying loans and obligations by the debtors or borrowers securitization frees up capital for originators and promotes liquidity in the marketplace steps in securitizationsecuritization is a complex process that involves several steps 23types of securitizationthere are several types of securitization each with its own structure and characteristics the most common types include pass through securitization pay through debt instruments and collateralized debt obligations cdos 3the new securitized financial instrument may be divided into different sections called tranches the tranches consist of individual assets grouped by loan type maturity date interest rate and remaining principal each tranche carries different degrees of risk and offers different yields pass through securitization is the most basic form of securitization in this structure the cash flows from the underlying pool of assets are transferred to investors the spv issues securities known as pass through or flow through certificates which represent an undivided interest in the pool of assets i e there are no tranches as borrowers make payments on the underlying loans the cash flows are collected by the servicer and distributed to the investors pro rata mbs issued by government sponsored enterprises gses like fannie mae and freddie mac are examples of pass through securitization 4pay through instruments also known as collateralized mortgage obligations cmos or real estate mortgage investment conduits are a more complex form of securitization for these the cash flows from the underlying pool of assets are used to pay interest and principal on the securities issued by the spv but the securities themselves are structured as debt obligations the securities are divided into tranches with different maturities risk profiles and payment priorities the cash flows from the underlying assets are allocated to the tranches based on a preset structure with the senior tranches receiving payments before the junior tranches 5asset backed securities abs are a general term for securitization backed by a pool of nonmortgage assets such as auto loans credit card receivables student loans or equipment leases the cash flows from these assets are used to pay interest and principal on the securities issued by the spv like other types of securitization abs can be structured with different tranches each with its own risk and return profile collateralized debt obligations cdos are a type of securitization that involves pooling together a diverse range of debt obligations such as corporate bonds loans or even other securitized products like mbs or abs the pool of assets is then divided into tranches each with its own risk and return characteristics upping the ante cdo squared and cdo cubed have underlying assets of cdos and cdo squared respectively these played a significant role in the 2007 to 2008 global financial crisis 67 many of these securities were backed by subprime mortgages and experienced significant losses when the housing market collapsed the complexity and lack of transparency in these structures made it difficult for investors to understand the true risks involved leading to a loss of confidence in the securitized product market 8advantages and disadvantages of securitizationturns illiquid assets into liquid onesfrees up capital for the originatorprovides income for investorssmall investors can participateinvestor assumes creditor rolerisk of default on underlying loanslack of transparency regarding assetsearly repayment damages investor s returnssecuritization creates liquidity by allowing retail investors to buy shares in instruments that would be unavailable to them an mbs investor can buy portions of mortgages and receive regular returns from interest and principal payments unlike other investments many loan based securities are backed by collateral in addition as the originator moves debt into the securitized portfolio it reduces the liability on its balance sheet allowing it to underwrite further loans although the securities may be backed by tangible assets there is a risk of default moreover early repayments will cut the returns the investor receives on the underlying notes there may also be a lack of transparency about the underlying assets misrepresented mbs infamously played a toxic and precipitating role in the financial crisis of 2007 to 2008 example of securitizationthe investment company fidelity offers mbs that give investors a monthly distribution of principal and interest payments made by homeowners 9 for this example fidelity offers an mbs issued by various gses or agencies 