Securitization is a financial innovation that allows debt to be pooled together and for anyone to buy a claim on a portion of that debt.
Securitization allows individual mortgages to be pooled together into large bundles ($100 million to $10 billion or more), the loans are then restructured and credit enhanced to be given a higher debt rating by the ratings agencies and then investors can buy claims on the debt.
Debt pools are split into 'tranches', which are all assigned different levels of risk and interest accordingly. The least risky tranche (senior) is repaid first and pays the lowest rate of interest, whilst the most risky tranche (mezzanine) is repaid last, experiences the first losses but also pays the highest rate of interest.
In theory, securitization is a fantastic idea for all parties because:
- Homeowners get access to credit and are able to buy a house
- Mortgage brokers receive upfront fees for securing the customer
- Originators receive a fee for selling the loan
- Investment banks are paid for structuring and distributing the securitization
- Credit rating agencies are paid a fee for rating the mortgage broker and providing advice on rating improvements
- Investors receive attractive yields compared to other investments
- Collateralized Debt Obligation (CDO)
- Investment Bank (IB)
- Interest Rate (IR)
- Junior Tranche
- Junk Bond
- Mortgage Backed Security (MBS)
- Ratings Agency
- Senior Tranche