Securitization of debt can be defined as the process of pooling multiple financial products of the same class and then marketing them and then sell them to another financial institution.
So, the securitization of debt follows the same logic. A bunch of the same financial assets are pooled together and converted into one marketable security. Now, these can be mortgages, corporate bonds, or car loans.
In this case, a bunch of receivables credits is pooled into one marketable financial product.
Mortgage-backed securities or MBS are the most famous type of debt-backed securities that are packaged into a special purpose vehicle and then sold to the investors.
Securitization of debt is great for both the originators and the investors. Selling securitized debt which a bank issue allows it to have liquidity, while for the investor, he/ she gets a great asset that pays out regularly.
The securitization also carries with it some risks. These risks are that the securitized are highly complex and the debt that goes in them is highly difficult to track.
This means nobody really knows what’s in them and the other risk is Tranche of Securitization. Even if the high-level tranche is made up of a high-quality investment rate, if the lower tranches, which are usually made up of lower quality investment products, fail, the upper tranches are affected.
The concept behind securitization of debt
The concept behind the securitization of debt is risk management. By pooling the same debt class securities under one marketable financial product, the yield of the securitized debt goes up, but the risk still remains low.
As these securitized assets consist of hundreds of thousands of the same debt class, so if a couple of debt deteriorate majority of the assets are still all right. This also helps in mitigating the credit risk that arises from a single asset.
The securitized assets consist of tranches, higher tranches, and lower tranches. Higher tranches consist of high-quality debt securities and low tranches consist of lower-quality debt securities.
So, if the securitized assets are properly layered, they provide great risk management, which reduces risk but increases the yield of these financial products.
Types of debts that can be securitized
There are multiple types of debts that can be securitized. But, they are divided into four main categories based on the type of credit. All of these are shown in figure 1 below:
Figure 1: Four types of securitized debt
The four main types of debt that can be securitized are car loans, home loans, credit card debt, and student loans. Each one of these debts and how they are securitized is explained in great details below:
Car loans are considered a type of consumer loan. These loans are securitized by bundling together tens of thousands of car loans into one marketable financial security. These types of securitized loans are called ABS or auto-backed securities.
The car loans ABS are divided into high quality and low quality based on the FICO scores and LTV.
The ABS is considered short term security as the car loans are paid in years, instead of decades as is the case for Mortgages.
Mortgage-backed securities are called MBS. These are by far the most widely used debt which is securitized. The MBS got a bad reputation due to the part these securities played in the global financial crisis of 2007-2008.
There were a lot of other reasons what caused the global financial crisis of 2007-2008.
The MBS is a great financial product, as the cash flow is highly predictable and so are the earnings. These are also products that have a timeline of decades. As the financial products which are mortgages are used to issue Mortgage-backed securities.
Credit Card Debt
Credit card debt is one of the most popular types of debt which can be packaged into securitized.
This is because of the phenomenal returns that these securities give and the relatively short amount of time in which it gives these returns.
These are the shortest securities in terms of maturity. It can take, normally, anywhere from a few months to a year for the credit card receivable securities to mature. In this short amount of time, they also provide whopping double-digit returns.
But, the greater returns also come with greater risk, as the underlying receivables can fail as people do not pay their credit card debts.
Student loans backed securities have the second-longest maturity time after mortgage-backed securities. There are trillions of dollars of student loans in the U.S.A alone.
So, these loans provide a huge market for securitization. The student loan securities provide a better return than the MBS, but they are not risky at all.
It is due to the fact that a person cannot get rid of the student loans even in Bankruptcy.
Examples of Securitization of debt
Mortgage-backed securities are one of the examples of debt securitization. A bunch of securities is packed into one marketable financial security.
Then the investor gets a stable and fix return over the lifetime of these securities.
The main advantages of debt-backed securities
The main advantages of debt-backed securities are:
i) Fixed and stable returns are provided.
ii) The risk is diversified.
iii) While the risk is low, the yield on these assets increase.
Main disadvantages of debt backed securities
As there are advantages, there are also many disadvantages associated with debt-backed securities. The main disadvantages of these securities are:
i) These are highly complex products.
ii) It is very difficult to get a hold of the underlying securities.
iii) Very complex product tranche coverage means difficult to assess the risk even if the risk is low.
The securitization of debt is a great way to lower the risk, while also increasing the yield. But, severe complexity must be kept in mind before investing in debt-backed securities.