Key Insights
Securitization pools assets and repackages them into interest-bearing securities. An issuer designs a marketable financial instrument by merging financial assets, commonly mortgage loans or consumer or commercial debt. Investors that purchase these securities receive the principal and interest payments of the underlying assets.
Key Takeaways
- Securitization pools or groups debt into portfolios.
- Issuers create marketable financial instruments by merging various financial assets into tranches.
- Securitized instruments provide investors with income from interest and principal.
- Mortgage-backed securities (MBS) and asset-backed securities (ABS) are common examples.
How Securitization Works
In securitization, the company or the originator that holds the assets determines which assets to remove from its balance sheets. A bank might do this with mortgages and personal loans it no longer wants to service.
This gathered group of assets becomes a reference portfolio. The originator then sells the portfolio to an issuer, who creates tradable securities with a stake in the assets. Investors buy these new securities for a specified rate of return, effectively taking the position of the lender.
Securitization allows the original lender or creditor to remove assets from its balance sheets, freeing up capital to underwrite additional loans. Investors profit from the rate of return based on the associated principal and interest payments made on the underlying loans by borrowers. This process also promotes liquidity in the marketplace.
Tranches: Understanding the Building Blocks
The new securitized financial instrument may be divided into different sections called tranches. The tranches consist of individual assets grouped by factors such as loan type, maturity date, interest rate, and remaining principal. Each tranche carries different degrees of risk and offers different yields.
Mortgage-backed securities (MBS) and asset-backed securities (ABS) are examples of securitization and can be divided into tranches. ABS are bonds backed by financial assets such as auto loans, mobile home loans, credit card loans, and student loans. These bonds are divided into smaller portions based on the inherent risk of default and are sold to investors, each packaged as a type of bond.
Pros and Cons: Weighing Your Investment
Securitization creates liquidity by allowing retail investors to purchase shares in instruments that would otherwise be unavailable to them. An MBS investor can buy portions of mortgages and receive regular returns from interest and principal payments.
Unlike many other investment vehicles, loan-based securities are often backed by collateral. As the originator moves debt into the securitized portfolio, it reduces the liability on its balance sheet, thus being able to underwrite additional loans. However, there are risks, including potential defaults and early repayment, which may reduce the investor’s returns.
Pros
- Turns illiquid assets into liquid ones
- Frees up capital for the originator
- Provides income for investors
- Small investors can participate
Cons
- Investor assumes creditor role
- Risk of default on underlying loans
- Lack of transparency regarding assets
- Early repayment can harm investor’s returns
Real-World Example: How Fidelity Works with Securitization
Fidelity offers mortgage-backed securities that provide investors with monthly distributions of principal and interest payments made by homeowners. These investments may be backed or issued by:
- Government National Mortgage Association (GNMA): Bonds guaranteed by Ginnie Mae, backed by the U.S. government. GNMA does not purchase, package, or sell mortgages but guarantees their principal and interest payments.
- Federal National Mortgage Association (FNMA): Fannie Mae buys mortgages from lenders, packages them into bonds, and sells them to investors. These bonds are guaranteed solely by Fannie Mae and are not direct obligations of the U.S. government.
- Federal Home Loan Mortgage Corporation (FHLMC): Freddie Mac purchases mortgages from lenders, packages them into bonds, and sells them to investors. These bonds are guaranteed solely by Freddie Mac and are not direct obligations of the U.S. government.
Regulatory Oversight: Ensuring Market Stability
Regulatory oversight is provided by entities such as the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, Inc. (FINRA). These organizations ensure compliance and protect investors’ interests.
Understanding Investor Returns: MBS and ABS
Mortgage-backed securities (MBS) and asset-backed securities (ABS) are bonds backed by various loans. MBS are specifically backed by home loans, whereas ABS are backed by auto loans, mobile home loans, credit card loans, and student loans.
Pass-throughs and collateralized mortgage obligations (CMOs) are two types of MBS. Pass-throughs are structured as trusts where mortgage payments are collected and passed to investors with stated maturities. CMOs consist of multiple pools known as tranches with varying credit ratings that determine the rates returned to investors.
The Final Word: The Power of Securitization
Securitization is a powerful financial process that pools or groups debt into investable portfolios, creating marketable financial instruments. Investors can earn profits from the interest and principal payments made on the underlying assets.
Related Terms: financial instruments, investments, collateral, Securities and Exchange Commission (SEC), liquidity.
References
- Fidelity. “What Are Mortgage Backed Securities?”
