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What Is Securitization?

By Motley Fool Staff – Jul 16, 2016 at 9:21PM

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Turning assets into tradable instruments has revolutionized the financial industry.

Mortgages are common assets for securitization. Image source: Getty Images.

Some assets are easier to invest in than others. Stocks, bonds, funds, and other securities are easy to trade: They can be bought and sold on recognized exchanges for low commission costs. However, many assets, such as real estate, individual loans, and other cash-flow-producing investments, are far less liquid. Securitization seeks to create tradable investments in these types of assets by pooling various individual assets together into a larger group and then selling fractional interests in the entire asset pool. Buying a securitized investment gives you greater diversification than the individual assets themselves, and the resulting securities are generally more liquid for buying and selling than unsecuritized assets. Although mortgages and other forms of debt are the most common objects for securitization, other assets can also be securitized.

Securitization and mortgage-backed securities

The best-known example of securitization is in the mortgage market. For example, say you lent a homeowner $200,000 toward a mortgage on a home. That would be extremely risky, because you would be exposed to the creditworthiness of one homeowner. If that homeowner defaulted on the mortgage, then you would potentially lose a huge portion of your $200,000 investment.

With that in mind, entities like Fannie Mae, Freddie Mac, and other mortgage-focused agencies securitize mortgages by taking a set of mortgages with similar features and pooling them together. That way, if any single mortgage in the group goes bad, the loss is shared across all investors who bought interests in the securitized pool. For example, if you were one of 100 investors who invested $200,000 in a securitized offering of 100 mortgages at $200,000, and one of those mortgages went bad, then your effective loss would be one-hundredth of $200,000, or just $2,000.

What other assets can be securitized?

Real estate is another common asset that one can securitize, and real estate investment trusts have essentially given investors exposure to asset classes they would have trouble investing in otherwise. Again, investing in a single property requires you to take on a large amount of risk that something could go wrong with that particular property. Having a pooled interest, with small fractions of many different properties, diversifies your portfolio and reduces your risk.

For the most part, any expectation of incoming cash flow can be securitized. For instance, residential solar providers have securitized the expected stream of income from electricity payments and residential energy credits, selling the securities to investors in order to raise capital to expand their businesses more quickly. Any type of debt is available for securitization, allowing multiple investors to spread the risk of a default.

Securitization has greatly enhanced access to capital for many companies, and investors have gained access to investments that were closed off to them in the past. It hasn't always worked perfectly, but securitization still works to expand capital markets and help investors and borrowers alike.

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