What are Securitized Debt Instruments?
Securitized debt instruments are financial securities that are created by securitizing individual loans (debt). Securitization is a financial process that involves issuing securities that are backed by a number of assets, most commonly debt. The assets are transformed into securities, and the process is called securitization. The owner of the securities receives an income from the underlying assets; hence, the term asset-backed securities.
Securitized debt instruments come with various advantages over conventional forms of investing and are more valuable to a portfolio. One of the most common types of securitized debt is mortgage-backed securities. Securitized debts can lower interest rates and free up capital for the bank, but they can also encourage lending for reasons other than making a profit.
The Process of Securitization
Securitization is a complex process that includes pooling a large number of loans and transferring the resulting payments to the security holders. The process begins with the entity that holds the assets, the originator, selling the assets to a legal entity, the special purpose vehicle (SPV). Depending on the situation, the SPV issues the bonds directly or pays the originator the balance on the debt that is sold, which increases the liquidity of the assets.
The debt is then divided into bonds, which are sold on the open market. The bonds represent different amounts of risks that correspond to different yields for the bondholder. In the case of a mortgage-backed security, if the owner defaults, the house would be foreclosed and result in some recovery of the loaned funds. The action of going after the assets when someone defaults on the loan is the reason why the securities are called securitized.
Common Securitized Debt Instruments
Bonds that are backed by mortgage payments are the most common type of securitized debt instruments. However, any type of asset that is backed up by a loan can also be securitized. For example, a person that takes out an auto loan that is backed by a vehicle is also referred to as a securitized debt.
The loan is often pooled to create securitized debt instruments. Other assets that can be securitized include commercial debt or bank loans to businesses. Credit cards and student loans are also referred to as securitized debt, and although they are not backed up by a certain asset, the bank is allowed to go after the owner’s personal asset in the case of a default on a loan. To differentiate between such types of securities and those backed by mortgages, they are often referred to as asset-backed securities.
1. Mortgage-backed Securities (MBS)
Mortgage-backed securities (MBS) are bonds that are secured by homes or real estate loans. They are created when a large number of such loans are pooled together (they could be as large as $10 million), and then the pool is sold to a government agency like Ginnie Mae, Fannie Mae, or to a securities firm who will use it as collateral for another mortgage-backed security.
2. Asset-backed Securities (ABS)
Asset-backed securities (ABS) are bonds that are created from consumer debt. When consumers borrow money from the bank to fund a new car, student loan or credit cards, the loans become assets in the books of the entity (usually a bank) that is offering them this credit. The assets are then sold to a trust whose sole purpose is to issue bonds that are backed by such securities. The payments made on the loan flow through the trust to the investors who invest in these asset-backed securities.
Pros and Cons of Securitized Debt Instruments
One of the main advantages of securitized debt instruments is that they allow banks to offer bonds at different levels of risk. The bonds can be divided into risk tranches where one class of the bonds receives less money but will not suffer any consequences should the homeowner default on the loan payments. In addition, a second bond class will receive a higher payment but will face a loss in the case of foreclosure of the home. The different bond class offerings allow investors to choose the level of risk they want to invest in.
One drawback of securitized debts is that they create a complex financial system. When a securitized debt is pooled and sold, it becomes difficult to identify who owes money and to whom they owe it to. It results in economic problems that can affect the entire financial system.
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