Banks and other financial institutions can convert a batch of debts into marketable securities backed—securitized—by the original debts. Banks may securitize debt for several reasonsincludingrisk management, balance sheet issues, greater leverage of capital, and in order to profitfrom origination fees. Securitization is the process of pooling various forms of debt—residential mortgages, commercial mortgages, auto loans, or credit card debt obligations—andcreating a new financial instrument from the pooled debt. The bank then sells this group of repackaged assets to investors.
Securitization is useful because it offers opportunities for investors and frees up capital for originators, both of which promoteliquidityin the marketplace.
Benefits of Securitization
One of the most significant advantages of securitizing debt is the benefit that banks may receive from moving the default risk associated with the securitized debt off their balance sheets to allow for more leverage of their capital. By reducing their debt load and risk, banks can use their capital more efficiently.
The securitized instruments created by pooling the debt are known as collateralized debt obligations (CDOs). The securitization process creates additional liquidity for debt instruments. While it is unusual for individual investors to own CDOs, insurance companies, banks, investment funds, and hedge funds may trade in CDOs to obtain returns greater than simple Treasury yields.
How Securitized Debt Is Sold to Investors
Different levels of the debt, known as tranches, are sold to investors. The tranches are grouped together by different factors, including the level of risk for the tranche or the maturity of the payments due. Tranches are often given ratings that denote their perceived risk. The tranche rating determines the amount of principal and interest investors receive for buying that level of debt. Riskier tranches require higher interest rates, while tranches with higher ratings pay less interest.
Defaults on subprime mortgages included in many CDOs are often cited as one of the reasons for the 2008 financial crisis.
Even though investing in a company's debt can be somewhat complex, doing so can generate strong returns. Individual investors can get in on a portion of these returns by investing in a bond or investment fund that purchases various forms of securitized debt.
