Securitization is a crucial financial process that has fundamentally transformed capital markets and enabled greater access to credit. By converting illiquid assets into tradable securities, securitization provides numerous benefits to both lenders and investors.
For issuers, it serves as an alternative funding source and frees up capital that can be lent to new borrowers. The ability to remove assets from their balance sheets also allows issuers to manage risk. For investors, securitization offers access to diversified cash flow streams and the ability to tailor exposures based on risk preferences. Both issuers and investors benefit from increased liquidity. But what is securitization and how is it helpful?
This article covers everything you need to know about securitization and its implications.
What is securitization in finance?
Before understanding the types of securitization assets, it is essential to know what is securitization.
Starting with what is asset securitisation, it is the financial process of pooling various types of contractual debt obligations and packaging those debt obligations into securities that are sold to investors.
This allows the holders of those loans, which would otherwise be illiquid investments, to raise capital by selling them on secondary markets. The pooled assets serve as collateral for the asset-backed securities issued. Investors receive scheduled payments on the securities from the cash flows generated as borrowers make payments on the underlying debt obligations.
Securitization enables lenders to convert an illiquid asset into a tradable security and replenish their funds. It also provides investors access to investment-grade securities backed by diversified asset pools.
What are securitized assets?
Now that you know what is securitization, it is time to understand the securitized assets. Any type of asset with a stable money flow can be grouped, securitized, and sold to investors. Although certain types of assets are more commonly turned into asset-backed securities (ABS). They include:
1. Mortgages: Bundling together groups of home loans and selling portions to investors originated with the creation of mortgage-backed securities in the 1970s. This remains one of the largest securitization markets globally.
2. Auto loans: Similar to mortgages, auto loan contracts are structured into securities with varying risk-return profiles and sold to investors seeking exposure to consumer credit.
3. Credit card receivables: Investors can purchase securities derived from pooled credit card balances. These tend to allow more flexibility as new debt and payments continuously modify the underlying pool.
4. Student loans: Loans issued to students by private lenders and government programs are securitized to meet investor demand. These provide exposure to the education financing sector.
What are the types of securitization?
After understanding what is securitization, here are the different types of securitization:
1. Collateralised debt obligation (CDO)
Collateralised Debt Obligations (CDOs) bundle loans and other debt instruments together and issue securities backed by this diversified pool of credit assets. CDOs provide investors collateral protection since identified assets can be liquidated if borrowers default.
2. Pass-through securitization
These involve an intermediary collecting payments on the underlying loans in a securitization pool, retaining a small fee, and passing the residual cash flows directly to investors. This allows investors to gain targeted exposure to the interest and principal repayments generated by the assets.
3. Pay-through debt instrument
Under this, investors own securities backed by the asset pool but not the loans themselves. This provides more flexibility for the issuer to alter payment flows and terms based on the underlying credits rather than directly passing cash flows to security holders. The pool acts more as collateral than a defined source of cash flows.
What is a securitization example?
As discussed, securitization involves the pooling of various assets. But what is a securitization example?
Here’s one: when a credit card company bundles together thousands of credit card balances owed by its customers into a pool. These balances serve as the underlying assets. The credit card company then sells this pool of assets to a financial institution, such as an investment bank.
The investment bank, acting as the originator, structures the pool into securities called asset-backed securities (ABS). These ABS are then sold to investors in the financial markets. Investors receive returns based on the payments made by credit card holders, while the credit card company continues to service the accounts, collecting payments and passing them through to the investors after deducting a fee.
This process allows the credit card company to free up capital for further lending, while providing investors with an opportunity to invest in a diversified pool of credit card debt.
What are the benefits of securitization?
Securitization can benefit your investment strategy in several ways:
1. Diversification
By investing in securitized products, you can expand your portfolio beyond conventional assets like stocks and bonds. These products cover various underlying assets such as mortgages, auto loans, and future cash flows from royalties or intellectual property, spreading risk across different asset classes and potentially boosting overall performance.
2. Risk management
Securitized products offer diverse risk and return profiles, enabling investors to tailor their exposure based on risk tolerance and objectives. Some products offer higher yields with increased credit risk, while others provide stable cash flows with lower returns, allowing for effective risk management.
3. Enhanced yield potential
Particularly those backed by mortgages or consumer loans, securitized products can yield higher returns compared to traditional fixed-income securities in low-interest-rate environments, appealing to investors seeking greater income generation.
4. Liquidity
Many securitized products trade in liquid markets, facilitating easy buying and selling. This liquidity enhances portfolio flexibility, enabling investors to adjust asset allocations in response to market changes or new investment prospects.
Parting words
Understanding what is securitization and its process is essential for investors and lenders. Securitization plays a vital role in providing liquidity, enabling risk sharing, and fostering credit availability within financial markets. By understanding its mechanics and benefits, market participants can utilize it optimally.
If you are looking for financial assistance, Tata Capital is a trusted source to avail of loans against securities. We offer attractive loan against securities interest rates and no prepayment charges. With minimal documents required for a loan against securities, we provide quick funding against your shares and bonds. Get hassle-free loans against your investments today with Tata Capital!
Visit the Tata Capital website or download the Tata Capital App for more information!
The details mentioned in this blog may change from time to time and from vendor to vendor or government policies.
11 March 2024
6 mins read
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