What is Securitization?
Securitization is a financial innovation in which a company pools together its financial assets, usually illiquid assets, forming a Special Investment Vehicle (SIV) that issues interest-bearing financial instruments to third-party investors.
It allows the originator (lender) to issue additional loans to customers, securitizing the existing assets of the loan portfolio, raises more capital, allowing them to provide additional loans to customers, while the investors that purchase the security assume the position of the lender, profiting from interest payments and principal repayments.
The overall process enhances liquidity in the market, freeing up capital for the lenders removing the assets from its balance sheet, and allowing investors to diversify their portfolios, earning a return on investment (ROI) on the securities purchased.
The process of securitizing starts when an originator (lender) identifies the assets it does not want to service anymore, such as mortgages and auto loans, and creates a pool of assets it would like to remove from its balance sheet.
Usually, it is illiquid assets that are pooled and sold, as it would enable the originator to receive capital from an otherwise illiquid asset, improving liquidity in the market.
The originator, which is usually a financial institution that extends credit, then sells these pools of loans to a special-purpose vehicle (SPV), which is a subsidiary company created for the sole purpose of purchasing assets to securitize them but is a separate legal entity to isolate financial risk.
After the SPV purchases these pools of assets and securitizes them, they are then divided into tranches, which are different slices of the security that will be issued. Each tranche is assigned different levels of risk and interest accordingly based on the underlying credit rating of the mortgages in the security.
The least risky tranche, the senior tranche, is repaid first and has the lowest rate of interest, while the riskiest tranche, the junior tranche (also known as a mezzanine) is repaid last, experiences the first losses but also pays the highest rate of interest to compensate for the increased risk.
The tranches are created by slicing up the risks of the consumers defaulting on their loans, which are rated by credit rating agencies. The big three credit rating agencies in the USA are
The loans that have a lower credit rating, meaning the consumer is more likely to default on their obligations, are split into the riskier tranches, while the loans that have a higher credit rating typically belong in the senior tranche, as there is a reduced risk that the consumer will default on their payment.
Learn more about what a tranche is through the following video:
The special purpose vehicle then issues these securities to investors, who decide to purchase them, generating periodic income, also known as dividends, through interest payments as well as principal repayments from borrowers.
Investors that have a higher risk tolerance might opt for securities in the mezzanine tranche, as although it has the highest risk, it will allow the investor to yield the highest return.
It is important to note that the riskier tranches get paid last, while the safer tranches, such as the senior tranche, get paid first.
In theory, it 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 SIV
- Credit rating agencies are paid a fee for rating the mortgage broker and providing advice on rating improvements
A special purpose vehicle, or SPV, is a subsidiary of a company that is bankrupt and remote from the main organization (i.e. protected even if the parent organization goes bankrupt).
The actions of an SPV are usually very tightly controlled, as they are only allowed to finance, buy, and sell assets. One of the most common reasons to set up an SPV is for securitizing loans, in which it is in charge of:
- Purchasing pools of assets from the originator
- Issuing securities to investors
- Collecting payments from borrowers
- Recovering and selling underlying assets from borrowers who have defaulted on their loans
As the SPV contains assets that are generating revenue, investors have a direct claim on that revenue, coming from borrowers' interest payments and principal repayments.
The main benefits of setting one up are:
- Protecting the parent company’s assets and liabilities
- Isolates financial risk
- Minimizing tax expense by setting it up in a tax haven
The main advantage of securitizing is the ease with which retail investors can invest and have direct legal claims on loans and portfolios of mortgages.
It allows them to participate in a market that would otherwise be very difficult and expensive for them to access. In addition, they are able to invest in securities that directly match their risk tolerance, as well as their desired returns.
As investors have a direct legal claim on the portfolios of mortgages in the security, they have a direct claim on the income the security generates, which comes from the interest payments and the principal repayments.
Furthermore, it allows for much more efficient financial markets by increasing liquidity and turning illiquid assets into securities that can be purchased by smaller investors to generate income.
Additionally, the originators or lenders of the assets being securitized are able to turn their illiquid assets into liquid securities, raising additional capital by selling the assets to an SPV who then issues them as securities to investors, and are also able to remove the assets from their balance sheet.
As the process, under accounting purposes, is treated as a sale of assets, and not as a source of financing, lenders are able to raise funds without increasing their firm's book leverage or debt-to-equity ratio.
Another use case is if the originator would like to issue more loans to customers, they can utilize this process, pooling their assets together, raising additional capital, and using that capital to issue more loans to borrowers.
The process also carries benefits for borrowers, where they are able to gain access to more financing at better rates when taking out debt.
The main disadvantage that arises from securitizing assets is the potential loss that investors incur when borrowers decide to repay their obligations early, also known as prepayment risk.
Borrowers who decide to pay their loan off early reduce the length of their loan and by extension, the amount of interest income that investors receive. Prepayment risk may also arise if the borrower decides to refinance their loan at a lower interest rate.
This is common when the overall interest rate reduces in the economy. Investors also bear the credit risk of the loan, which happens when the borrower is no longer able to meet their obligations.
When this occurs, the bank forecloses on the property, selling the home in order to recoup losses, which results in losses to investors in the security, as there are no more interest payments being made from that borrower, not to mention the loss from the principal not being recouped in full.
Another disadvantage of securitizing debts, as seen in the Global Financial Crisis (GFC), is inaccuracy in its risk assessment, or a lack of risk assessment in general, in terms of the credit risk involved in the underlying assets.
An inaccurate risk assessment, or a failure to initiate one at all, might make risky security seem like it is creditworthy.
The GFC refers to the period of worldwide extreme stress in financial markets and banking institutions between 2007 and 2008.
There are many factors that contributed to the crisis, many of which are still debated to this day in terms of their contribution to the economic collapse. Mortgage-backed securities are frequently touted as one of these reasons.
MBS are securities formed by pooling together a bundle of mortgage loans.
What is important about MBS is that the underlying assets, which are mortgages issued to borrowers, were of good credit quality, meaning the borrowers were creditworthy.
Lenders would ensure borrowers were creditworthy by investigating their credit rating, levels of debt, as well as their income, and would ensure that these documents were not falsified.
In the lead-up to the financial crisis, MBS became a popular financial instrument that investors just wanted more of, and backed by a booming housing market, they were making extremely high returns on their investment.
However, most of the customers that were creditworthy already had homes, and so the market turned dry.
In response to the ever-rising demand and the not-so-present supply, banks started to turn to subprime borrowers, which were borrowers that had low credit ratings and possessed a higher risk of defaulting on their loans.
The banks removed many restrictions that were present on mortgage lending and stopped asking for information on the borrower's income, debt, and credit score.
Banks had even reduced the amount of deposit the customer had to put down and sometimes required no deposit at all because they would not bear the risk of the borrower defaulting as they would sell the assets, gain instant profit, and pass on the credit risk to investors who purchase the security from the issuer.
Financial institutions did this to generate more cash flow to lend to borrowers for mortgages, pool more assets together to create securities, and gain more profit, repeating the cycle, which created a housing bubble.
However, as all good things must come to an end, what ultimately led to the housing bubble burst and subsequently contributed to the GFC and created a domino effect, was an increase in interest rates and a fall in housing prices.
Due to increased interest rates, many of the subprime borrowers, who already had a high interest rate due to their increased risk, were not able to meet their repayments, leading them to default on their loans.
In fact, lenders had begun to foreclose on almost 1.3 million properties due to borrowers defaulting in 2007, which rose to 2.3 million in 2008, and 2.8 million in 2009.
This saw investors realize massive losses on the mortgage-backed securities, as borrowers stopped making interest payments, and the principal wasn't recouped, as housing prices had fallen tremendously.
They started to lose their value, and as expected, the banks that held these MBSs as investments saw billions of dollars of value wiped from their balance sheet, requiring a bailout from the federal government to keep the entire banking system from collapsing.
Check out the following video for a brief but informative explanation of the GFC uploaded by ThePlainBagel: