Wednesday’s Word: Securitization

By Eric Peters, Spring 2018 IAC Student Intern

Securitization is a process that has been developed, essentially, to take various types of debt instruments that were rarely traded and turn them into tradable securities, resulting in greater liquidity.  As such, the goal of the securitization is threefold: 1.) increase the liquidity of debt instruments, 2.) lower the cost of capital to borrowers, and 3.) increase the efficiency of financial markets.

The securitization process developed many years ago with the creation of securities markets for common stock and investment-grade bonds. More recently, it occurred in the junk bond market. Before the junk bond market developed, firms with poor credit were forced to obtain debt financing on a private placement basis, typically from banks.  This made it difficult for firms to shop around various banks for the best rate because lenders who were not familiar with them were unwilling to spend the time and money needed to determine the feasibility of the loan.  On top of that, lenders were concerned about (and subsequently charged a higher rate for) the illiquidity of privately placed debt.  Then, upon Michael Milken’s development of certain procedures for analyzing the repayment feasibility of junk bonds, Drexel Burnham Lambert created a market for them in case a purchaser needed to cash out. After Drexel Burnham Lambert put its reputation on the line and created this market, other investment banks caught on and “securitized” much of the old private placement market for below-investment-grade debt.

Another type of securitization is asset securitization, or “asset-backed securities,” which involves the pledging of specific assets. This process involves the pooling and repackaging of loans secured by relatively homogenous, small-dollar assets into liquid securities. Under this process, several different institutions are involved, each playing a different functional role in the loan process.  For example, a savings and loan institution might originate the loan, an investment bank might pool the loans and structure the security, a federal agency might insure against credit risk, a second investment bank might sell the securities, and a pension fund might supply the final capital.

Another type of asset securitization is the mortgage-backed security. Mortgage-backed securities are created by combining individual home mortgages into pools, and then creating bonds that use the pool of mortgages as collateral.  The securitization of mortgages has created a national mortgage market with many players and has benefited both borrowers and lenders.  Due to the creation of this market, lending institutions are better able to match the maturity of its assets (loans) with its liabilities (deposit accounts) and, thus, are able to lower their costs, resulting in these savings being passed onto borrowers. Today, there are many different types of assets used as collateral for bonds, ranging from auto loans, credit card balances, student loans, and even royalties from David Bowie’s music.

While the trend of securitization has, in general, lowered costs, increased the availability of funds to borrowers, decreased risks to lenders, and created new investment opportunities for many investors, it has not come without risk.  For example, mortgage-backed securities were at the epicenter of the recent 2008 financial crisis. As home mortgage default rates increased due to the bursting of a decade-long housing bubble, mortgage-backed securities’ values plummeted and resulted in enormous investor loss by both individuals and financial institutions. As with any investment, it is important that you, the investor, understand the underlying, real value of any security along with any risk it exposes you to.  Before investing, always make sure you research and understand how the value of the securities you are investing in are derived.  As always, knowledge is the ultimate hedge against risk.  For a more detailed analysis of the current state of securitized assets in the U.S. economy, take a look at FINRA’s Office of the Chief Economist’s “Analysis of Securitized Asset Liquidity” Research Note.

If you would like to learn more, check out: Brigham, Eugene F. and Daves, Phillip R. (2010). Intermediate Financial Management. Ohio: South-Western Cengage Learning.