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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
mortgages
credit card
receivables
lease
payments
accounts
receivable
corporate or
sovereign debt, etc.
Assets are often called collateral.
In a typical arrangement, the owner—or "originator"—of assets sells those assets to a special purpose vehicle (SPV). This may be a corporation, US-style trust, or some form of partnership. It is established specifically to facilitate the securitization. It may hold the assets—collateral—on its balance sheet or place them in a separate trust. In either case, it sells bonds to investors. It uses the proceeds from those bond sales to pay the originator for the assets.
Most collateral requires the performance of ongoing servicing activities. With credit card receivables, monthly bills must be sent out to credit card holders; payments must be deposited, and account balances must be updated. Similar servicing must be performed with auto loans, mortgages, accounts receivable, etc. Usually, the originator is already performing servicing at the time of a securitization, and it continues to do so after the assets have been securitized. It receives a small, ongoing servicing fee for doing so. Because of that fee income, servicing rights are valuable. The originator may sell servicing rights to a third party. Whoever actually performs servicing is called the servicing agent.
Cash flows from the assets—minus the servicing fees—flow through the SPV to bond holders. In some cases, there are different classes of bonds, which participate differently in the asset cash flows. In this case, the bonds are called tranches. If the securitization is structured as a pass-through, there is only one class of bonds, and all investors participate proportionately in the net cash flows from the assets.
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When assets are transferred from the originator to the SPV, it is critical that this be done as a legal sale. If the originator retained some claim on those assets, there would be a risk that creditors of the originator might try to seize the assets in a bankruptcy proceeding. If a securitization is correctly implemented, investors face no credit risk from the originator. They also face no credit risk from the SPV, which serves merely as a conduit for cash flows. Whatever cash flows the SPV receives from the collateral are passed along to investors and whatever party is providing servicing.
Depending on the nature of the collateral, it may or may not pose credit risk. For example, people may fail to make their credit card payments, so credit card receivables entail credit risk. On the other hand, many mortgage-backed securities in the United states have little or no credit risk. Ginnie Mae guarantees timely payment of principal and interest on its mortgage pass-throughs. Ginnie Mae is backed by the full faith and credit of the US government, so the pass-throughs are free of credit risk.
If collateral entails credit risk, a securitization will often be structured with some sort of credit enhancement. This may include over-collateralization, a third party guarantee, or other enhancements. Also, by their nature, securitizations diversify the default risk of the underlying assets.
Credit ratings are often obtained for those securitizations that entail credit risk, and most ratings are investment grade. If a securitization has different classes of bonds, each may receive a different credit rating. Credit ratings can be misleading for novices. The fact that a securitization has a AAA rating doesn't mean it is risk free. It only means that the chance of a bond holder incurring a loss attributable to default on the underlying assets is remote. Other risks, which can affect the timing of payments, may be considerable. Also, because valuing the underlying assets is often difficult, there is a risk that an investor will overpay for a securitization the investor is ill-equipped to value on its own.
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.
Each segment of the market offers unique opportunities and risks, reflecting the nature of the underlying assets and market conventions that have evolved over time.
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