What is a securitization product?
Securitization products broadly refer to the combination of financial asset pools to create new securities, which are then divided and sold to investors. Since the value and cash flow of the new asset is based on its underlying securities, these investments may be difficult to analyze, but they have their advantages.
- Securitization products are securities composed of an asset pool that constitutes a new security, and the asset pool is split and sold to investors.
- Securitization products are valued based on the cash flow of related assets.
- Mortgage loans (residential and commercial), credit card accounts receivable, auto loans, student loans, etc. can all be brought together to create securitization.
- The underlying asset of securitization is usually placed in a special purpose vehicle (SPV), which is a separate entity (for legal purposes).
- Securitization products are usually sold in batches; each file has different characteristics and attracts different types of investors.
How do securitization products work
Securitization describes the process of pooling financial assets and turning them into tradable securities. In theory, any financial asset can be securitized—that is, it can be turned into a tradable and fungible item with monetary value. In essence, this is all securities. However, securitization most often occurs on loans and other assets that generate accounts receivable, such as different types of consumer or commercial debt. It may involve consolidation of contract debts, such as car loans and credit card debts.
The first securitization products are mortgage loans. Followed by commercial mortgages, credit card accounts receivable, auto loans and student loans. Bonds backed by mortgage loans are usually called mortgage-backed securities (MBS), and bonds backed by non-mortgage-related financial assets are called asset-backed securities (ABS). Mortgage-backed securities played a central role in the financial crisis that began in 2007.
Creating a securitized bond looks like this: A financial institution (“issuer”) that owns the asset that it wants to securitize sells the asset to a special purpose vehicle (SPV). For legal purposes, SPV is an entity independent of financial institutions, but SPV exists only to purchase assets of financial institutions.
By selling assets to SPVs, the issuer obtains cash and removes the assets from its balance sheet, thereby providing the issuer with greater financial flexibility. SPV issues bonds to finance the purchase of assets; these bonds can be traded on the market and are called securitization products.
A key feature of securitized products is that they are usually distributed in wholesale banks. This means that larger transactions are broken down into smaller parts, each with different investment characteristics. The existence of different grades makes securitization products attractive to a wide range of investors, because each investor can choose the grade that best combines their income, cash flow, and security needs.
Mortgage-backed securities are backed by a pool of mortgage loans. Asset-backed securities (credit card ABS, auto loan ABS, student loan ABS, etc.) are backed by other assets.
special attention items
The internal credit enhancement of securitization products refers to the safeguard measures built into the structure of securitization products. Common forms of internal credit enhancement include subprime (the cash flow of the high-rated part takes precedence over the low-rated part) and overcollateralization (the number of bonds issued by the SPV is lower than the value of the assets supporting the transaction).
The expected effect of any type of internal credit enhancement is that the shortage of cash flow due to the loss of the value of the underlying asset will not affect the value of the safest part of the bond. Given the relatively low level of loss, this is effective, but if the loss of the underlying asset is large, the value of protection is uncertain.
External credit enhancement occurs when a third party provides bondholders with additional payment guarantees. Common forms of external credit enhancement include third-party bond insurance, letters of credit, and company guarantees.
The main disadvantage of external credit enhancement is that the quality of additional protection depends on the party providing it. If a third-party guarantor encounters financial difficulties, its guarantee value may be insignificant, and the security of the bond depends on the fundamentals of the bond.
Benefits of securitization products
Like many other areas of the fixed income market, the main participants in the securitization product market are institutional investors. Despite these challenges, many people still invest in securitized products.
Owners of diversified fixed income mutual funds or exchange-traded funds usually hold securitized products indirectly through their fund holdings. Some individuals also choose to invest directly in securitized products. Securitization provides several key benefits for market participants and the wider economy.
Free up capital and lower interest rates
Securitization provides a mechanism for financial institutions to remove assets from their balance sheets, thereby increasing the pool of available capital that can be loaned out. An inevitable result of the increase in capital adequacy ratio is lower interest rates required for loans; lower interest rates promote economic growth.
Increase liquidity and reduce risk
This action has increased the liquidity of various previously illiquid financial products. Pooling and allocating financial assets can improve the ability to diversify risks and provide investors with more choices to decide how much risk they hold in their investment portfolio.
Intermediaries benefit by keeping profits from the spread or difference between the interest rate of the relevant asset and the interest rate of the issued securities. Buyers of securitized products benefit from the fact that these products are usually highly customizable and can provide a wide range of benefits.
Many securitization products provide relatively attractive yields. However, these high returns are not free. Compared with many other types of bonds, the timing of cash flow generation from securitization products is relatively uncertain. This uncertainty is why investors demand higher returns.
Diversity and safety
As one of the largest types of fixed-income securities, securitization products provide fixed-income investors with alternative options for government, corporate, or municipal bonds. Financial intermediaries use a variety of methods to issue bonds that are safer than the assets that back them. Most securitization products have investment grade ratings.
Disadvantages to consider
Of course, even with tangible asset-backed securities, there is no guarantee that if the debtor stops paying, the asset will maintain its value. Securitization provides a mechanism for creditors to reduce their related risks through the division of ownership of debt obligations. However, if the default of the loan holders and the sale of their assets are almost impossible to achieve, it will not help much.
Different securities—and parts of these securities—can take on varying degrees of risk and provide investors with different returns. Investors must pay attention to the debt behind the products they buy.
Even so, the underlying asset may lack transparency. During the financial crisis from 2007 to 2009, MBS played a toxic and accelerating role. The cause of the crisis was that the quality of loans for the products sold was distorted. In addition, there are misleading ways of packaging debt into further securitized products—in many cases, repackaging them. Since then, stricter regulations regarding these securities have been implemented. still-Buyer conceited——Or beware of buyers.
Another risk facing investors is that borrowers may pay off their debts early. In the case of mortgage loans, if interest rates fall, they may refinance the debt. Early repayment will reduce the return investors receive from the interest on the underlying bill.