Securitization

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Avinash Patil

Securitization describes a process in the financial industry in which assets that can't easily be bought or sold (illiquid assets) are packaged in a way that makes them easy to trade - usually by turning the assets into collateral for third-party investment. The assets are backed by cash flow or by their underlying value, and they are acquired, grouped into pools, and then offered to investors - the securitization process allows assets that usually cannot be easily sold to be liquid equity that can be traded.

Securitization is common in the real estate industry, where leased properties are pooled and offered to investors. It is also common in the lending industry, where it is applied to claims on mortgages, home equity loans, student loans and other debts.^[1]

When assets are securitized, investors "buy" them - but essentially they are making a loan to the party that issued the security. The loan is secured against the underlying value of the securitized assets, and the cash flow associated with these assets. If the underlying cash flow is reduced (such as in the subprime lending crisis when borrowers stopped making their mortgage payments), then the investor must write down the value of the asset and take a loss on the loan (the purchase of the securities).

Mortgage-backed securities are an example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors.

The process creates liquidity by letting smaller investors purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

1. ↑ Wikipedia.org, "Securitization"