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What is securitization?
In finance, it seems like nearly anything can be traded for profits.
Securitization is the process of taking groups of assets, packaging them together, and selling them as interest-earning securities on the secondary market.
These securities are similar in nature to bonds, since the investor receives both principal payments as well as interest, and they are typically traded among financial institutions. For example, investment banks sell mortgage-backed securities to institutional investors like insurance companies and hedge funds.
Securitization has many advantages: It’s one way for an institution to reduce their credit risk, since with each trade they are literally removing the securitized assets from their balance sheets. Issuers like them because they are a more cost-effective way to raise cash than taking out loans or issuing corporate bonds, plus securitized assets usually have different regulatory standards than their underlying assets that are often less costly.
Investors, in turn, find securitized assets favorable because they provide a chance to earn a higher rate of return as well as a larger pool of investment options to choose from, which results in increased market liquidity.
But along with every opportunity comes risk. Investors of every rank paid dearly for the rampant speculation that surrounded millions of subprime loans during the Financial Crisis of 2007–2008. These risky home loans were securitized into collateralized debt obligations and other mortgage-backed securities and traded around the world, leading to losses in the trillions when beleaguered homeowners failed to make their mortgage payments, rendering their securitized assets worthless.
What are some types of securitized assets?
There are several kinds of securitized assets, and most are based on debt. In truth, nearly any kind of asset with a stable cash flow can be securitized, but a few of the most well-known are:
- Asset-backed securities, which is a broad term for securities that are composed of collateralized assets, such as consumer loans, student loans, mortgages, or leases
- Mortgage-backed securities, which are solely backed by home loans
- Collateralized debt obligations, which consist of mortgages but could also include other assets, such as credit card debt
- Synthetic asset-backed securities, which are structured vehicles that merely contain the credit risk associated with their underlying assets
Securitization first occurred in the 1850s, as much of the railroad boom in the Western U.S. was financed by Wall Street bond issues.
After World War II, banks simply could not keep pace with the demand for housing and sought alternate sources of mortgage funding. Ginnie Mae, an offshoot of the U.S. Department of Housing and Urban Development, whose mandate was to make affordable housing widely available, developed the first mortgage-backed security in 1970.
How does securitization work?
The entity that holds the assets is known as the originator. It gathers these assets into a group, which is called the reference portfolio. In the case of mortgage-backed securities, the reference portfolio might contain pools of hundreds or even thousands of mortgages.
The originator then sells the reference portfolio to an issuer, who securitizes it by issuing tradable shares, offering a rate of interest based on the return generated by the portfolio. This comes in the form of monthly payments that can either “pass through” (are made directly available to investors) or are “structured” (have set guidelines often based on demand).
The securitized assets are then divided into categories, known as tranches, which means “slices” in French. A collateralized mortgage obligation, for example, could have as many as 50 tranches, each being investible, segmented by aspects like home values or homeowner credit scores. The issuer designates how much principal and interest will go into each tranche.
Next, credit ratings agencies, such as Standard & Poor’s, Fitch Ratings, and Moody’s, assign each tranche a grade based on the income generated by underlying assets, with AAA-rating being the highest. In the case of mortgage-backed securities, a AAA-rating would mean that the mortgage holders are capable of meeting all of their financial commitments. The lowest grade, D, signifies that they are currently in default.
The lowest yields are assigned to the best, or most senior tranches, because they are the least risky. Investors in senior tranches usually get paid first. The highest yields are attached to junior tranches, and investors in these tranches get paid last, since they carry the greatest possibility of default.
How did securitization contribute to the Financial Crisis of 2007–2008?
During the housing boom of the early 2000s, Lehman Brothers was profiting doubly from the mortgage market: It traded derivatives based on subprime loans and even got into the mortgage origination business. This guaranteed a near-endless supply of mortgages it could securitize and trade—so long as the underlying mortgage holders made their monthly payments.
Tragically, many subprime loans contained adjustable rates of interest, which increased by hundred dollars a month when prevailing interest rates rose. By the end of 2007, as the Fed funds rate increased from 1.0% to 5.25%, millions of subprime mortgage holders defaulted on their loans, causing credit ratings agencies to downgrade 90% of mortgage-backed securities to a grade of D, or “junk” status, erasing trillions in value.
In September 2008, Lehman Brothers reported a $3.9 billion quarterly loss as its stock plummeted more than 80%. It reached out to the Federal Reserve for an emergency bailout, but because it was so overleveraged—it had a leverage ratio of 40:1, which meant that for every $40 in assets it had, there was only $1 to cover liabilities—the Fed said its hands were tied.
Lehman declared bankruptcy on September 15, 2008, sending global markets into a tailspin on fears of widespread financial contagion and ushering in the Great Recession, a two-year economic crisis that would be second only to the Great Depression in terms of its severity.
How is securitization regulated?
One tough lesson that came out of the Financial Crisis of 2007–2008 was that securitized assets were hardly receiving any regulation at all.
Collateralized debt obligations, considered at the time to be an emerging investment, were not very well understood. Credit ratings agencies received criticism for using inadequate valuation methods to assign their ratings, often operating on erroneous assumptions that the tranches they were rating contained far less risk.
In addition, loan originators faced flak for granting subprime loans to unqualified customers, who had little to prove they would make their payments on time, let alone at substantially higher rates.
When the smoke cleared, reforms like the Dodd-Frank Wall Street Reform and Consumer Protection Act made it illegal for banks to trade risky derivatives like collateralized debt obligations. It also required mortgage originators to do their due diligence and verify that borrowers would indeed be able to repay their loans.
