Securitization is a process by which financial intermediaries, such as investment banks, create securitized bonds. Such bonds can offer various advantages over more conventional investing instruments and can form a valuable addition to your portfolio. Securitized instruments, however, have unique characteristics that you must understand before investing your hard-earned cash in them.
Understanding the Securitization Process
Securitization involves pooling a large number of loans and passing the resulting payments to bondholders. A bank, for example, might lend money to 1,000 homeowners in the form of 30-year mortgage loans, resulting in $200,000 in monthly proceeds. The bank can then sell 1,000 bonds, the owners of which receive these monthly proceeds, less a fee that goes to the bank.
Since the mortgage proceeds are pooled and then divided by 1,000 before being paid out, the default of any one homeowner would have a small impact on the average bond. And even in case of default, the house would be foreclosed upon and result in some recovery of loaned funds. This recourse to go after assets of borrowers in case of default is the reason such securities are referred to as securitized.
Exploring Common Securitized Bonds
Bonds that are backed by mortgage payments are the most popular type of securitized debt instruments. However, any type of loan can be securitized. Auto loans, backed by the vehicles themselves, are also commonly pooled to create securitized debt instruments.
Although credit card debt and student loans are usually not backed up by a specific collateral, the lender can go after the borrower's assets. Bonds backed by these kinds of personal loans are also popular investment vehicles. To distinguish these bonds from mortgage-backed securities, they are often referred to as asset-backed securities. Keep in mind that any receivable is, technically, an asset.
Use of Risk Tranches
An advantage of pooling receivables is the ability to offer debt instruments with varying degrees of risk and return. Instead of passing the average monthly payment of 100 homeowners to 100 bondholders, the bonds can be divided up into risk tranches.
One class of bonds can receive less money but would not shoulder any of the losses resulting from homeowner defaults up to a certain limit. A second set of bonds would receive more money every month as long as there are no or few defaults, but all of the loss from defaults and resulting foreclosures would hit those bondholders first. Such structuring allows you, the investor, to select the kind of risk level and potential return with which you are comfortable.
No Intermediary Risk
Another advantage of securitized bonds is that they carry no intermediary risk. In simpler terms, you won't suffer a loss if the bank that has sold you the bonds backed by mortgage or car loan payments goes bankrupt. After all, the monthly payments you are receiving come from the homeowner or other individuals who have borrowed money.
This does not mean that securitized bonds are always safe, of course. Should mass defaults occur and seized assets fall far short of the money owed by borrowers, holders of securitized bonds can lose large sums of money, as in the housing crisis of 2007.