by Arushi Sharma
Securitization is the process of turning illiquid assets into marketable securities and increasing liquidity in the market. There are two types of assets- liquid assets and illiquid assets. Liquid assets are the assets which can be quickly converted into cash. For example bank balance; it is very easy for a person to withdraw money from his bank account within minutes. On the other hand, there are assets which cannot be easily and quickly converted into cash (without losing some value); such assets are illiquid assets. For example a house is an illiquid assets because it could take an owner months or years to sell one. It is also possible that in the process, the owner loses some value of his property due to undervaluation.
In securitization, such illiquid assets are ‘pooled together’ and packed as interest bearing security which is purchased by interested investors in the financial markets. Those who purchase such securities then become entitled to both the interest and the principal repayment amounts (and of course the risk associated with it). This way the risk is transferred to the purchasers. Securitization can be used to issue different bonds (called tranche) each of which is associated with a different level of risk and credit ratings. Securitization makes it easier to sell off the illiquid assets since these securities are tradable (unlike their underlying assets). A typical example of securitization is mortgage- backed securities (MBS) which is a type of asset-backed security (ABS) that is secured by a collection of mortgages.
To put the process of securitization in simple words, consider a bank which wants to sell certain assets. In this case, the bank becomes the originator (the entity whose assets are being securitized). The bank pools all such assets into what is called a reference portfolio and sells to an issuer. The issuer is a company that is specially set up for the purpose of realizing the value of the reference portfolio and is known as special purpose vehicle (SPV). Creation of SPV separates the reference portfolio from the bank’s other assets. This ensures that if the bank goes bankrupt, the assets transferred to SPV are not affected. Now that the assets are sold to SPV, the credit ratings of the bank become irrelevant; hence it becomes easier for the issuer to sell the asset pool by issuing tradable, interest-bearing securities in the financial market. The investors receive interest payments funded by the cash flows generated by the reference portfolio. Hence securitization is an alternative way of financing through a transfer of risk from an issuer to an investor.
Some of the obvious benefits of securitization are-
- It creates liquidity in the capital market.
- An alternative form of financing for issuers.
- Allows the originator to wipe off the assets (included in the reference portfolio) from their balance sheets.
- Can offer issuers higher credit ratings and lower borrowing costs.
However, securitization comes with its own package of troubles. In dearth of sufficient regulations and valuation methods, securitization brings in instability in the economy. This could severely hurt a country’s economy and even other countries through a domino effect. The scale of this damage could be fathomed if we take a look at the Great Recession of 2008.
The Great Recession of 2008, which hit the US economy is considered to be the worst period of economic slowdown, the likes of which had never been witnessed before. The unemployment rates reached historic levels with a double digit figure and managed to bring down several giant financial institutions which had withstood many cyclic fluctuations. One of the factors contributing to this downward spiral of the economy was the subprime mortgage crisis.
Subprime mortgage is a type of mortgage issued by a lending institution to a borrower with a low credit rating. Since the borrower has a lower credibility, the lending institution faces a greater risk of a default by the borrower. To cover up for the greater risk they assume, these institutions extend loans to such borrower at higher interest rate. So what triggered the subprime mortgage crisis?
The securitization of mortgages led to the US housing bubble of 2000-2007. Before 2000, the banks would only extend home loans to those with good credit histories. However during the US housing bubble, the banks relaxed their loan requirements and started extending mortgages to people without verifying their income statements -even to those with poor credit histories (subprime loans). The banks did so because they had already securitized the mortgages and thereby transferred the default risk on investors. Also, through securitization of such mortgages, they obtained funds to grant new mortgages and continue this process. Thus relaxed loan requirements kept the demand for such mortgage loans up. As a result, house prices escalated quickly during 2000-2007. Even if a borrower had defaulted on the mortgage, homes kept appreciating over time, so foreclosures did not harm banks and investors. Banks and investors foreclosed homes that soared in value. However, when the economy entered the recession, all the subprime borrowers started defaulting in record numbers on their loans and turned the subprime loans into ‘toxic’ loans. When the investors noted large number of defaults in such mortgage loans, they stopped investing in securitized debts. Consequently, banks were left with a plethora of unsold reference portfolios. If the banks accumulate too many bad mortgages, then they become insolvent which was the scenario in the US.