Securitization

Securitization is the process of pooling loans or other assets that produce regular payments and turning them into securities that investors can buy. A bank or finance company sells a pool of mortgages, car loans, credit card balances or similar claims to a separate legal entity, which pays for them by issuing bonds. Interest and principal paid by the original borrowers flow through to the bondholders.

The result is usually called an asset-backed security (ABS), or a mortgage-backed security (MBS) when the pool is home loans. Securitization is a core part of shadow banking, because it moves lending off bank balance sheets and into markets. It differs from a covered bond, where the loans stay with the issuing bank, and from a collateralized debt obligation (CDO), which is itself a securitization of other bonds or loans.

Imagine a lender that has made a thousand small car loans. Each borrower will pay a little every month for five years, but the lender wants its money back now so it can lend again. So it bundles all thousand loans into one box, sells the box to a separate company, and that company sells slices of the box to investors. Each month, the borrowers' payments are collected and shared out among the slice holders.

The slices are not all equal. Some investors agree to be paid first and accept a lower return. Others agree to be paid last, so they lose money first if borrowers stop paying, and they expect a higher return for taking that risk. It is a little like a queue at a buffet: those at the front are sure to eat, while those at the back may go hungry if food runs short.

Most deals follow the same steps:

1. Origination. A lender makes loans to borrowers after its own underwriting.
2. Sale to a vehicle. The loans are sold in a "true sale" to a special purpose vehicle (SPV), so they are protected if the lender later fails.
3. Issuance. The vehicle issues notes in several classes, often rated by credit rating agencies, and uses the proceeds to pay the lender.
4. Servicing. A servicer, often the original lender, collects payments and passes them to a trustee, which pays investors in a fixed order called the waterfall.

Deals usually include protection for senior investors, such as more collateral than notes issued, reserve accounts and excess interest. This credit enhancement is what allows the top classes to carry high ratings even when the underlying loans are riskier.

Splitting a deal into classes, or tranches, is what makes securitization attractive to many kinds of investor. Senior tranches are paid first and price at a narrow credit spread. Mezzanine tranches absorb losses after the junior piece is gone. The equity or first-loss tranche takes the first defaults and keeps any money left over. Common types include:

• Residential and commercial MBS. Backed by home loans or loans on offices, shops and hotels.
• Consumer ABS. Backed by car loans, credit card receivables, student loans or equipment leases.
• Collateralized loan obligations (CLOs). Backed by loans to companies, many of them leveraged.
• Asset-backed commercial paper. Short-term notes issued by conduits that hold receivables, which depend on rolling over their funding.

Similar structures appear in Islamic finance as asset-backed sukuk, and in crypto markets as tokens representing pools of real-world assets.

Modern securitization began in the United States in 1970, when the government agency Ginnie Mae guaranteed the first mortgage pass-through security. Fannie Mae and Freddie Mac followed, and by the 1980s the technique had spread to car loans and credit cards. Private-label deals without a government guarantee grew rapidly in the early 2000s.

That growth fed the 2008 financial crisis. Lenders that sold loans on had less reason to check borrowers carefully, a problem known as "originate to distribute." Pools of subprime mortgages were repackaged again into CDOs, insured with credit default swaps and rated far more highly than their losses later justified. When house prices fell, short-term funding for vehicles holding these assets dried up, and banks that had promised to support them took the losses back.

Reforms aimed at the incentives behind those losses. In the United States, the Dodd-Frank Act requires sponsors of most ABS to keep at least 5 percent of the credit risk, a rule known as risk retention, and the Securities and Exchange Commission expanded loan-level disclosure under Regulation AB. In the European Union, the Securitisation Regulation (EU) 2017/2402, in force since January 2019, sets retention, due diligence and transparency rules and creates a "simple, transparent and standardised" (STS) label with lower capital charges. Bank capital rules under Basel III also raised the capital needed to hold securitized exposures.

Supporters say securitization lowers borrowing costs by letting lenders recycle capital, spreads risk to investors who want it and gives insurers and pension funds long-term assets. Critics point out that it separates the lender from the risk, makes chains of ownership hard to follow and relies on short-term funding, which links it to maturity transformation outside the banking system. Regulators now watch it alongside private credit as part of non-bank financial intermediation.

• Government National Mortgage Association (Ginnie Mae)
• Regulation (EU) 2017/2402 (Securitisation Regulation), EUR-Lex