What is securitization?
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.
What Does Securitization Mean?
The process through which an issuer creates a financial instrument by combining other financial
assets and then marketing different tiers of the repackaged instruments to investors. The process can
encompass any type of financial asset and promotes liquidity in the marketplace.
Investopedia explains Securitization
Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one
large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's
inherent risk of default and then sell those smaller pieces to investors.
The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool.
Using the mortgage-backed security example, individual retail investors are able to purchase portions of a
mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to
afford to buy into a large pool of mortgages.
What Does Asset-Backed Security - ABS Mean?
A financial security backed by a loan, lease or receivables against assets other than real estate and
mortgage-backed securities. For investors, asset-backed securities are an alternative to investing
in corporate debt.
Investopedia explains Asset-Backed Security - ABS
An ABS is essentially the same thing as a mortgage-backed security, except that the securities backing
it are assets such as loans, leases, credit card debt, a company's receivables, royalties and so on, and
not mortgage-based securities.
