Sunday, February 19, 2012

What is securitization ?

A securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a financing company that has issued a large number of auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing loans, but there isn't a liquid secondary market for individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the pool to investors. For the financing company, this raises capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a diversified pool of auto loans, which may be an attractive alternative to a corporate bond or other fixed income investment. The ultimate debtors—the car owners—need not be aware of the transaction. They continue making payments on their loans, but now those payments flow to the new investors as opposed to the financing company.

All sorts of assets are securitized:
auto loans
student loans
credit card receivables
lease payments
accounts receivable
corporate or sovereign debt, etc

Assets are often called collateral,Collateral will typically pose credit risk. For example, people may fail to make their credit card payments, so credit card receivables entail credit risk. This can be addressed with some sort of credit enhancement such as over-collateralization or a third party guarantee. Tranching is also widely used to allocate credit risk among investors.

Credit ratings are often obtained for  securitizations that entail credit risk, and most ratings are investment grade. If a securitization has different tranches, each may receive a different credit rating.

With a securitization, the party underwriting credit risks is not the party taking that credit risk. This opens the door to various abuses. Such abuses, especially with regard to securitizations of subprime residential mortgages, were a primary cause of the 2008 financial crisis.

Standard categories of securitizations are

mortgage-backed securities (MBS), which are backed by mortgages;
asset-backed securities (ABS), which are mostly backed by consumer debt;
collateralized debt obligations (CDO), which are mostly backed by corporate bonds or other corporate debt. 

Let's see the Video below about  securitization.

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