Investing and Financial Markets
Home Equity and Refinancing

What is securitization?


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Securitization is the process of transforming collateral or obligations into traded securities. An easy way to understand this is through example. The mortgage backed securities market is one of the largest and most liquid in the United States. Through the process of securiization, mortgages are transformed into bond-like securities. Assume a bank has made 100 mortgage loans ranging from $150,000 to $350,000 each to new homeowners this month. The homeowners have agreed to pay interest rates from 6.00% to 6.50% for 30 years on their various mortgages. Instead of holding 100 different mortgage loans of different sizes and coupons, and having risk to the credit of these homeowner on their balance sheet, the bank can use expected cash flows on the mortgages to securitize the mortgages into a mortgage-backed-security (a bond backed by the cash flows of the mortgages). In this case, assume the average loan size was $200,000, and the average interest rate was 6.25%. The 100 loans could be packaged together to create a $20,000,000 security paying 6.25%. Such a security would have a prospectus, which outlined the terms of the bond, and also would get a credit rating. The process of securitization transforms those smaller loans into a larger, more uniform, liquid security. This security could then be sold to an investor, such as a hedge fund, insurance company, mutual fund, or even another bank.