Why Securitization Is A Good Thing?
What Is Securitization?
In the current financial crisis, you probably must have heard the word securitization many times. So what exactly is securitization? It is a process in which illiquid assets that can generate cash flows are pooled together and sold as securities. The securities are similar to bonds, in that they have regular coupon payments, and are backed by claims against the assets that have been securitized.
What Kind Of Assets Can Be Securitized?
Any asset that is illiquid and can generate regular cash flows can be securitized. This would include mortgages, student loans, car loans, credit card debt, accounts receivables, and even royalty payments. In fact, singer David Bowie securitized the future revenue of 25 of his albums that were released before 1990. The bonds, named Bowie Bonds, were backed by the royalty payments from 25 albums of the singer, which he forfeited for 10 years.
But Why Securitize?
The main reason for securitization is that the holder of an illiquid asset can receive money upfront, which would be otherwise difficult. In David Bowie’s case, the singer received $55 million up front, which, without securitizing would not have been possible. The classic case to understand why assets are securitized is mortgages. Mortgages appear on a bank’s balance sheet as an asset. However, these are illiquid assets. A bank cannot go out and sell individual mortgages on its balance sheet. This is where the securitization market comes in. The bank can pool all the mortgages on its balance sheet and issue them as bonds to investors. The bank receives a payment upfront from the issuance, allowing it to free up capital on its balance sheet. Investors receive regular coupon payments, which is the interest on those mortgages paid by the individuals who have taken out the mortgage. The bonds are backed by the properties for which the mortgage was taken out.
How Does the Securitization Process work?
To understand this, we will again take the example of a bank that has mortgages on its balance sheet. The mortgages that a bank originates appear as assets on its balance sheet. These mortgages are taken out for a time period of 20 or 30 years. Now, if the bank wants to free up capital on its balance sheet by selling these illiquid assets, it would hire an investment bank to sell those assets. The investment bank would buy all the mortgages and pay the bank upfront. The originating bank has freed up a lot of capital. The investment bank will then pool all the mortgages together, and convert them into bonds that it can easily sell in the bond market. The more well known and high rated an investment bank is, the better prices it can get for its bonds. These bonds, which are backed by mortgages, are called Mortgage Backed Securities. The bank will then sell these mortgage backed securities, which are bought by the investors. The mortgage backed securities would pay regular coupon payments, which is the interest paid by the people who have taken out those mortgages in the first place.
So Why Is Securitization A Good Thing?
The whole idea behind securitization is to create a liquid market for assets, which are difficult to sell individually. Securitization was started to free up capital at banks that originate mortgages. A bank has to maintain a certain amount of capital on its balance sheet. If it were to keep all the illiquid assets on its balance sheet, it will limit its lending capability. With Securitization, a bank can free capital on its balance sheet and lend freely. As the markets for securitization developed, bankers started securitizing more and more illiquid assets such as, credit card debt, student loans and even royalty payments. With securitization, the risk is also spread around.
Many people think that the root of the current financial crisis is the securitization market. They are wrong. It is the greed, and irresponsible behavior by bankers, who created complex securities that were backed by low quality mortgages, which instead of spreading the risk around became, to put in Warren Buffett’s words, financial weapons of mass of destruction. The idea of securitization was that a bank should be capable of originating as many mortgages as it can, so more and more Americans could have a home. Unfortunately, banker’s greed has painted a different picture of an otherwise great idea.
