Securitization, or the process of bundling assets such as mortgages into securities, got a bad name after the 2007 financial crisis. Nevertheless, it remains a time-honored practice that began in the 1970s and continues today, with trillions of dollars of outstanding securities. The distinctive characteristics of these securities offer investors and companies opportunities and pitfalls.
How Securitization Works
The securitization process involves four basic steps. In the first step, a company, known as the originator, picks a portfolio of assets that it wishes to sell, or remove from its balance sheet. The originator is often a financial institution that aims to get rid of assets, such as loans and mortgages. In the second step, the "reference portfolio" is transferred to a special purpose vehicle, or SPV, for legal and tax reasons. The SPV then issues interest-bearing securities, such as mortgage-backed securities, which are used to fund the acquisition of the assets. In the final step, investors are paid over the life of the deal from the cash flows generated by the portfolio assets.
Advantages and Disadvantages for Issuers
One of the major allures of securitization for issuers is off-balance-sheet treatment, meaning that the assets included in the reference portfolio are wiped off the originator's financial statements. The benefit to financial institutions is that securitization frees up regulatory capital -- the assets that banks are required to hold by their financial regulators to remain solvent. In addition, securitization can offer issuers higher credit ratings and lower borrowing costs. One of the biggest drawback for issuers is that it's far more complicated to structure a securitization than to structure traditional types of debt, such as a bank loan or a vanilla corporate bond. In addition, the transactions may not always lead to off-balance-sheet treatment, reducing the benefit to financial institutions.
Advantages and Disadvantages for Investors
Many investors flock to securitizations because of their "AAA" credit ratings, meaning that one or more credit agencies, such as Moody's, believe that investors will not lose their money with these investments. These high ratings are made possible through a combination of features, such as bond insurance, letters of credit and senior-subordinate credit structures. Investors also appreciate the diversification that securitization can bring to their portfolios. However, it's not all sunshine, as certain securitizations carry prepayment risk -- the chance that the deal's cash flows accelerate from expectations. For example, a pool of mortgages might prepay from refinancings, returning money to investors in a lower interest rate environment. In addition, some deals simply flop, such as the mortgage-backed securities that soured during the 2007 financial crisis.
The Role of Securitization in an Investment Portfolio
Investors can choose from a wide range of securitization investments, including prime and subprime mortgages, home equity loans, auto loans and credit card receivables. Investors who don't wish to pick individual securities can purchase an index with broad exposure, such as the U.S. ABS Index. Securitization represents an enormous asset class with many buyers, but it's critical that investors evaluate their goals and risk tolerance or seek the advice of a professional financial adviser.
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