Securitization is the method of changing an illiquid asset (or a group of assets) into security employing financial engineering. The term “securitization food chain,” coined by the movie “Inside Job” about the financial crisis of 2007-2008, relates to the procedure through which clusters of illiquid assets (typically loans) are assembled, purchased, securitized, and traded.
A mortgage-backed security (MBS), a form of asset-backed security that is secured by a group of mortgages, is an obvious form of securitization. This strategy, which was first used in 1970, resulted in developments such as collateralized mortgage obligations (CMOs), which were first used in 1983.
By the mid-1990s, MBS had become tremendously popular. The procedure goes like this:
Creating a Securitization Food Chain
The simple approach of potential home- or property-owners filing for mortgages at financial institutions is the first stage in the cycle. The loans originated by a controlled and recognized financial institution and are protected by claims against the numerous properties that the mortgagors acquire. Creditors have investments in the form of mortgage notes (rights on future cash), however, these investments come with an obvious potential loss. Because the borrower may default on the loan, banks frequently sell notes for cash.
It thus leads to the chain’s second significant link: Individual mortgages are grouped into a mortgage pool, which is held in trust as collateral for mortgage-backed security (MBS). A 3rd financial business, such as a big investment banking firm, or the same bank that originally generated the mortgages, can issue the MBS. Aggregators such as Fannie Mae and Freddie Mac also produce mortgage-backed securities.
Whatever the case, the end effect is the same: fresh security is established, supported by claims against the mortgagors’ assets. Investors in the secondary mortgage market can buy and sell shares of this product. This economy is really extensive, and it provides a lot of liquidity to a set of mortgages that would otherwise be fairly stagnant independently.
There are two types of MBS: pass-throughs and CMOs. Pass-throughs are a simple type of MBS in which mortgage payments are collected and passed through to investors. Tranches are used to divide the mortgage pool into distinct portions in CMOs. Parallel to how traditional portfolio diversification functions, this spreads the likelihood of default around. The tranches can be constructed in almost whatever way the issuer deems appropriate, allowing an individual MBS to be customized to a wide range of risk tolerance profiles.
Retirement funds will often invest in mortgage-backed securities with high credit ratings, whilst hedge funds will bet on those with poor credit to maximize profits. In either scenario, as a return on investment, the investors would receive a proportionate share of the mortgage payments – the concluding step in the process.