Securitization, though it may sound complex, is actually a relatively simple concept. While it is useful for efficient markets, used improperly securitization can also cause meltdowns such as the crisis of 2008 – when toxic mortgage bonds seeped into people’s portfolios causing substantial, unexpected losses for everyday investors. Understanding how securitization works, as well as the ways in which it can be manipulated, can help investors make more fully informed investment decisions.
What is securitization?
On its most basic level, securitization is a process that converts a group of assets into a single financial product. This transfers financial responsibility, as well as any benefit, from seller to buyer. A bank with a large amount of loans, for example, may package the loans together through securitization – offering them for sale to anyone willing to bear the risk of the loans in exchange for receiving the interest income. When securitization becomes more complex, there can be multiple layers of assets offered within one security. These layers, called tranches, contain assets with increasing levels of risk – and as the volume of assets contained in a security increases, the less transparent the security often becomes.
What are the Risks of Securitization?
Ideally, securitization facilitates healthy transactions between companies and investors, offering businesses liquidity in that they receive cash in exchange for their assets, while buyers receive a steady return from a pool of diversified assets. However, the danger of securitization lies in that as products become more intricate, less scrupulous entities can use their opacity as an opportunity to slough off the less-than-savory assets from their balance sheets, often transferring them to unwitting hands. Auto loans, credit card debt, and corporate bonds can all be packaged into saleable products – and securities, particularly complex ones, are difficult to understand and easy to overlook. Likewise, many also assume that any security is a safe investment. Mutual funds, pension, or other retirement funds can attain these risky assets alongside legitimate securities, ultimately at the expense of the people for whom they invest.
Securitization ultimately has one purpose: to facilitate the transfer of ownership, for better or worse. The Securities and Exchange Commission, or SEC, is tasked with the responsibility of maintaining fair and orderly markets and protecting investors. Yet, the complexity and volume of financial products in need of regulation is massive – and history shows that investors can be well served by adding their own due diligence. Having a basic understanding of securitization and being aware of its benefits as well as risks can help ensure a safer financial future for all investors.