Securitization
Securitization is the financial process of transforming assets, particularly debts, into tradable securities—financial instruments that can be bought and sold. This practice gained prominence in the 1970s and 1980s, primarily through the creation of mortgage-backed securities, allowing financial institutions like banks to sell bundled debts to investors rather than holding them until maturity. By pooling various debts, such as mortgages or credit card debts, originating firms can mitigate risk, as the likelihood of all borrowers defaulting is lower compared to a single debt holder. These pooled debts are issued as securities, commonly referred to as asset-backed securities, which are often rated by credit agencies to inform investors about the associated risks.
Securitization has significantly impacted the global economy by increasing the availability of credit, enabling banks to lend more freely to a broader range of borrowers. However, it also has potential downsides, as seen during the financial crisis of the late 2000s when overvalued securities led to widespread defaults and market instability. Although securitization remains a vital component of financial systems, it has prompted ongoing discussions about regulatory measures to prevent future economic crises related to risky lending practices.
On this Page
Subject Terms
Securitization
Securitization is the process of changing an asset, such as debt, into a security. A security is a financial instrument that can be bought and sold. The securities created from securitization are often created, sold, and traded by financial institutions, such as banks. Securitization started in the 1970s and 1980s when banks began buying and selling mortgage-backed securities, which were similar to bonds because they could be sold and traded. Securitization has become very important to the world economy since the 1980s. The economic downturn that began in the United States in the late 2000s was due in part to securities that were overvalued.
Background
The term securitization first began to be used in the 1980s, and the practice of securitization began in the 1970s. Before that time, debt was usually taken on by one individual company, such as a store, or an institution, such as a bank. That company or institution kept that debt the entire time the person who took out the debt paid it back. If a person could not pay their debt, the company or institution that loaned that person money would suffer. Furthermore, banks that gave out mortgages had to wait many years to see a return on their investment when they owned mortgages for their entire lifetimes. In the 1970s, the finance sector realized they could bundle illiquid assets and turn them into assets they sell or trade. Illiquid assets are those that are not easily turned into cash, such as real estate. The bankers turned the illiquid assets into something like bonds. These bonds could be traded or sold. Investors could make money from them, and banks could make money from selling them. Securitization quickly became an important part of the world economy.
Overview
The process of securitization begins with an originating firm. An originating firm is generally a financial institution, such as a bank. Other original firms could include an auto company that leases cars, a credit card company that has credit card debt, or another merchant offering credit. The originating firm creates debts by giving credit to a consumer. The next step in the process is that the originating firm pools together a number of debts. The pooled debts are then sold. When debts are purchased from the original firm, that firm is paid for the debt and no longer owns the debt. The debt has been transferred away from the originating firm, and the originating firm no longer carries the risk of those debts. If the debts go unpaid, the firm that owns them will lose money. However, if the debts are paid in full with interest, the firm that owns them will make money. The debts are pooled together so that the firm that owns them has less risk. Owning only debt could be very costly if that one person does not pay their debt. However, when a firm owns many debts that are pooled together, the debt is less risky, as it will likely include many people who do pay off their debts and only a few who do not.
Once the debts are pooled, the owner turns them into securities by issuing bonds whose worth is supported by the debts. The bond is like an "I owe you," which tells the owner that the bond has a particular value. The value of the bond comes from the value of the pooled debts that the trust owns. If the debts generate more money, the bond becomes more valuable. If the debts lose money, the bond becomes less valuable. The bonds could become almost worthless if they lose enough of their value. Therefore, the people who buy the bonds could potentially lose the money they invested in the bonds. The bonds are called asset-backed securities. Some bonds have other names depending on the type of debt used to create the bonds. For example, bonds created from mortgages are called mortgage-backed securities.
In the United States and other countries, asset-backed securities are rated to tell investors how likely they are to make money by investing in them. These ratings help investors make educated investment decisions based on the security’s risk assessment. The world's three most important credit rating agencies that rate securities include Standard & Poor's (S&P), Moody's, and Fitch Group, sometimes called The Big Three. These agencies rate securities and put them into groups called tranches based on the likelihood of investors making a profit. AAA (called "triple A") rating is the best rating a security can have because it indicates that a security is a low-risk investment, which means investors will most likely make back their money and earn a profit. The other tranches are AA ("double A"), BBB ("triple B"), and Unrated. Securities in the AAA tranche are the most likely to be invested in, and investors who are willing to take on risk will invest in securities in the AA and BBB tranches. Often, the securities in the Unrated tranche are not purchased because they are considered very high-risk investments.
Banks often create securities. To create a security, Bank A sells a customer a loan for $100,000. Then, the bank bundles that debt into a pool with other debts. The bank sells all the debts for more money than the loans themselves are worth. For example, the bank might receive roughly $110,000 for the original $100,000 loan. The debt, which is now bundled with other debts, is worth more than the original amount because the person paying the mortgage will pay interest. The bank benefits from this situation because the bank does not have the risk of the individual debts, and it receives money immediately from the sale of the debts. In the past, banks had to wait decades to make money from the mortgages they gave out. Securitization can also be beneficial, as banks have become more likely to give out mortgages and other types of credit to customers who they might not have lent to in the past because of concerns about being paid back. Although this can be useful for some customers, some original firms, such as mortgage brokers, can take this practice too far. They can become predatory lenders and convince people to purchase mortgages they cannot actually afford. Since the originating firms rid themselves of the risk of the debt through securitization, originating firms can be motivated to sell credit to people who will be unable to pay it back. This process helped contribute to the financial crisis of the late 2000s and early 2010s.
After the first asset-backed securities were created in the 1970s and 1980s, the banking industry became reliant on them. The banks made money quickly from selling securities, and they did not have to wait years to see a profit from the mortgages they made. Asset-backed securities became even more popular in the 1990s. By 2003, securitization had become a $6.6 trillion industry. By that time, securitization was a common practice that was making money for many Wall Street investors. However, some of the bonds that were being traded, such as mortgage-backed securities, were overvalued. In the early 2000s, the Big Three credit rating firms were giving all types of mortgage-backed securities very high ratings. However, some of these mortgage-backed securities were created from debts that were not very reliable.
Predatory mortgage brokers convinced people to purchase mortgages they could not afford. As people bought more homes and took out mortgages, the prices of homes increased. The predatory lenders used the home price increase to convince even more people to buy homes and even second homes, claiming the real estate would be a good investment. Even more people who could not afford the homes bought them. As time passed, some of the mortgages that were turned into securities went unpaid. Then, more and more people failed to pay back their mortgages. As people failed to pay their mortgages, many people went into foreclosure, which is the process of the bank taking back a home from an individual who failed to pay the mortgage. This process caused home prices to fall. It also caused the securities to become worth much less than they were supposed to be worth. Many securities that had been rated AAA by the Big Three failed during the financial crisis.
Although mortgage-backed securities were a major contributor to the financial crisis of the early twenty-first century, they continue to play an important part in the world economy. Many governments, including the United States, took steps to better regulate asset-backed securities after the financial downturn. Some people believe that the government did not go far enough, however, and asset-backed securities could again cause problems for the world economy.
By the 2020s, investors began the securitization of digital assets like cryptocurrency and revenue from subscription-based services. Green securitization also rose in popularity in the twenty-first century, with investors bundling residential rooftop solar panel loans or energy-efficient home mortgage loans. In organizations, green securitization refers to any asset-backed security that raises funds for green infrastructure, including water management, energy generation, or transport infrastructure.
Bibliography
Chen, James. "Securitization: Definition, Pros & Cons, Example." Investopedia, 14 June 2024, www.investopedia.com/terms/s/securitization.asp. Accessed 6 Jan. 2025.
Finney, Denise. "Credit Rating Agencies: Overview and History." Investopedia, 13 Nov. 2023, www.investopedia.com/articles/bonds/09/history-credit-rating-agencies.asp. Accessed 6 Jan. 2025.
Fligstein, Neil, and Adam Goldstein. "The Transformation of Mortgage Finance and the Industrial Roots of the Mortgage Meltdown." University of California, Oct. 2012, sociology.berkeley.edu/sites/default/files/faculty/fligstein/The%20Transformation%20of%20Mortgage%20Finance2.pdf. Accessed 6 Jan. 2025.
Frank Fabozzi, et al. "Where Does Securitization Stand?" Yale Insights, 26 Aug. 2010, insights.som.yale.edu/insights/where-does-securitization-stand. Accessed 6 Jan. 2025.
"Green Securitisation: Unlocking Finance for Small-Scale Low Carbon Projects." Climate Bonds Initiative, www.climatebonds.net/files/files/March17‗CBI‗Briefing‗Green‗Securisation.pdf. Accessed 6 Jan. 2025.
Jobst, Andreas. "Back to Basics: What Is Securitization?" International Monetary Fund, 2008, www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf. Accessed 6 Jan. 2025.
Liberto, Daniel. "Securitization: Definition, Meaning, Types, and Example." Investopedia, 10 Oct. 2024, www.investopedia.com/ask/answers/07/securitization.asp. Accessed 6 Jan. 2025.
Merritt, Cam. "What Is the Meaning of Securitization?" Hearst Newspapers, 19 Dec. 2018, www.weekand.com/home-garden/article/meaning-securitization-18037144.php. Accessed 10 Jan. 2025.
Schwarcz, Steven L. "Securitization and Post-Crisis Financial Regulation." Cornell Law Review Online, vol. 10, no. 1, 2015, scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6249&context=faculty‗scholarship. Accessed 10 Jan. 2025.
"Securitisation: It's Back." Economist, 11 Jan. 2014, www.economist.com/leaders/2014/01/11/its-back. Accessed 10 Jan. 2025.
"What Is Securitization?" Motley Fool, 22 Nov. 2024, www.fool.com/terms/s/securitization. Accessed 10 Jan. 2025.
Zhang, Hannah. "How a New Asset Class Is Growing Out of Subscription Revenue." Institutional Investor, 25 Jan. 2022, www.institutionalinvestor.com/article/2bstlvcy8lgwuff6rbx8g/corner-office/how-a-new-asset-class-is-growing-out-of-subscription-revenue. Accessed 6 Jan. 2025.