Securitization

Securitization ⇒ refers to a process by which financial assets (e.g., mortgages, accounts receivable, or automobile loans) are purchased by an entity that then issues securities supported by the cash flows from those financial assets. The primary benefits of the securitization of financial assets are (1) a reduction in funding costs for firms selling the financial assets to the securitizing entity and (2) an increase in the liquidity of the underlying financial assets.

Consider a bank that makes mortgage loans to home buyers and retains and services these loans (i.e., collects the mortgage payments and performs the necessary recordkeeping functions). To gain exposure to a bank’s mortgage loans, investors traditionally could only choose among investing in bank deposits, bank debt securities, or the common equity of banks.

Compared to this traditional structure, with the bank serving the function of financial intermediary between borrowers and lenders, securitization can provide the following benefits:

• Securitization reduces intermediation costs, which results in lower funding costs for borrowers and higher risk-adjusted returns for lenders (investors).
• With securitization, the investors’ legal claim to the mortgages or other loans is stronger than it is with only a general claim against the bank’s overall assets.
• When a bank securitizes its loans, the securities are actively traded, which increases the liquidity of the bank’s assets compared to holding the loans.
• By securitizing loans, banks are able to lend more than if they could only fund loans with bank assets. When a loan portfolio is securitized, the bank receives the proceeds, which can then be used to make more loans.
• Securitization has led to financial innovation that allows investors to invest in securities that better match their preferred risk, maturity, and return characteristics. As an example, an investor with a long investment horizon can invest in a portfolio of long-term mortgage loans rather than in only bank bonds, deposits, or equities. The investor can gain exposure to long-term mortgages without having the specialized resources and expertise necessary to provide loan origination and loan servicing functions.
• Securitization provides diversification and risk reduction compared to purchasing individual loans (whole loans)