What is securitization?

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Securitization is a process by which banks transfer their risk to public shareholders through the means of an intermediary financial product. For example, assume that you own a city bank credit card on which you have $20,000 that you owe city bank. Just like you there are millions of credit card holders that city bank has, that potentially owe city bank billions of dollars of credit card debt.

Now, credit card debt is a very high risk debt and billions of dollars of high risk debt sitting on a bank's balance sheet is not a good idea. So city bank's analysts will securitize this credit card debt. What that means is – they will take this billions of dollars of credit card debt and they will break it up into much smaller chunks. Maybe they will break it up into $10 million or $5 million chunks and they will break this up based on the credit quality of the borrowers.

They will in term sell these securitized credit card loans to other smaller banks. Maybe Wells Fargo or maybe ICICI or maybe bank of New York Mellon – any of these smaller banks. And this banks in term will securitize them again and sell them to individual investors. So what happens is – city bank has very easily managed to transfer the risk on its balance sheet of billions of dollars to much smaller amounts.

Securitization is very very popular as a concept in the domain of mortgage bad securities or MBS. Securitization is one of the reasons why the mortgage based recession in 2008 had such a drastic effect on the individual shareholder. When large companies like Lehman Brothers and Morgan Stanley they securitized bad loans on their balance sheet, which means they transferred bad loans to their balance sheet to individual shareholders of these securitized assets. So, suddenly when one day the people were supposed to pay back their home loan stopped paying, the entire system collapsed because the individual share holder was also affected.


Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.

A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages. The process works as follows:

First, a regulated and authorized financial institution originates numerous mortgages, which are secured by claims against the various properties the mortgagors purchase. Then, all of the individual mortgages are bundled together into a mortgage pool, which is held in trust as the collateral for an MBS. The MBS can be issued by a third-party financial company, such a large investment banking firm, or by the same bank that originated the mortgages in the first place. Mortgage-backed securities are also issued by aggregators such as Fannie Mae or Freddie Mac.

Regardless, the result is the same: a new security is created, backed up by the claims against the mortgagors' assets. This security can be sold to participants in the secondary mortgage market. This market is extremely large, providing a significant amount of liquidity to the group of mortgages, which otherwise would have been quite illiquid on their own. (For a one-stop shop on subprime mortgages, the secondary market and the subprime meltdown, check out the Subprime Mortgages Feature.)

Furthermore, at the time the MBS is being created, the issuer will often choose to break the mortgage pool into a number of different parts, referred to as tranches. These tranches can be structured in virtually any way the issuer sees fit, allowing the issuer to tailor a single MBS for a variety of risk tolerances. Pension funds will typically invest in high-credit rated mortgage-backed securities, while hedge funds will seek higher returns by investing in those with low credit ratings.

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