What are securitized products?
Securitized products generally refer to poolsfinancial assetswhich are combined to form a new security which is then distributed and sold to investors. Because the value and cash flows of a new asset are based on its valueunderlying securitiesThese investments can be difficult to analyze, but they have their merits.
Key Teaching Points
- Securitized products are securities made up of pools of assets that create a new security that is broken down and sold to investors.
- Securitized products are valued based on the cash flows associated with the underlying assets.
- Mortgages (residential and commercial), credit card debt, car loans, student loans, etc. they can be combined to form a securitization.
- The assets underlying the securitization are usually placed in a special purpose vehicle (SPV), which is a separate entity (for legal purposes).
- Securitized products are usually broken down and sold in separate tranches. each tranche has different characteristics and appeals to different types of investors.
How securitized products work
Securitydescribes the processpoolfinancial assets and convert them into securities. In theory, any financial asset can be securitized, i.e.replaceablean item of monetary value. That's basically all the implications. However, securitization usually occurs with loans and other money-generating assetsamounts remaining to be collectedsuch as various types of consumer or commercial debt. It can include consolidating conventional debt, such as car loans and credit card debt.
The first securitized products wereresidential mortgages. The following positions were commercial mortgages, credit card debt, auto loans, and student loans. Bonds backed by residential mortgages are commonly referred to as "bonds".Mortgage Backed Securities (MBS)and bonds secured by non-mortgage financial assets are redeemableasset backed securities (ABS).Mortgage-backed securities played a key role in the financial crisis that began in 2007.
Creating a securitized bond goes something like this: a financial institution (the "issuer") that owns the assets it wants to securitize sells to an investorspecial purpose vehicle (SPV). For legal purposes, the SPV is a separate entity from the financial institution, but the SPV exists solely to purchase the assets of the financial institution.
By selling the assets to the SPV, the issuer receives cash and removes the assets from its balance sheet, giving the issuer greater financial flexibility. SPVissues bondsto finance the purchase of assets; These bonds can be traded in the market and are called securitized products.
An important feature of securitized products is that they are usually issued inecstasy. This means that a larger transaction is broken down into smaller parts, each with different investment characteristics. The existence of different tranches makes securitized products attractive to a wide range of investors, as each investor can choose the tranche that best combines their expectations in terms of profit, cash flow and safety.
Mortgage-backed securities are backed by pools of mortgage loans.Asset-backed securities (Credit Card ABS, Car Loan ABS, Student Loan ABS, etc.) are backed by other assets.
Internal credit enhancement for securitized products refers to the collateral built into the structure of the securitized product itself. Typical forms of internal credit enhancement include:submission– where highly rated tranches have cash flow priority over lower rated tranches – andover security— when the amount of bonds issued by the SPV is lower than the value of the assets securing the transaction.
The intended effect of any form of domestic credit enhancement is that cash flow shortfalls caused by the impairment of the underlying assets do not affect the value of the safer bond tranches. This works well given relatively low losses, but the hedging value is less certain if losses to the underlying asset are significant.
Externalcredit increaseoccurs when a third party provides an additional repayment guarantee to bondholders. Typical forms of external credit support involve third partiesbond insurance, letters of credit and corporate guarantees.
The main downside to outside credit enhancement is that the extra protection is only as good as the party offering it. If the external guarantor faces financial difficulties, the value of his guarantee may be negligible, which means that the safety of the bond depends on the basic parameters of the bond.
Benefits of securitized products
As in many other sectors of the fixed income market, these are the main participants in the market for securitized productsinstitutional investors. Despite these challenges, many people invest in securitized products.
Holders of diversified fixed income securitiesInvestment fundsor listed funds often own securitized products indirectly through their fund assets. Some people also choose to invest directly in securitized products. There are many important benefits that securitization offers to market participants and the wider economy.
Frees up capital, lowers interest rates
Securitization provides a mechanism for financial institutions to remove assets from their institutionBalance, increasing the pool of available loanable capital.The consequence of the increased abundance of capital is lower interest on loans. Lower interest rates favor greater economic growth.
Increases liquidity, reduces risk
This action increases liquidity to some earliersomethingFinancial products. The pooling and distribution of financial assets provides greater opportunity to diversify risk and gives investors more choice as to the level of risk they want to retain in their portfolios.
It offers profit
intermediariesbenefits in the form of retained earnings resulting from the spread or difference between the interest paid on the underlying and the interest paid on the securities issued. Buyers of securitized products benefit from the fact that these products are often highly customizable and offer a wide range of returns.
Many securitized products offer relatively attractive returns. However, these high profits are not free. Compared to many other types of bonds, the timing of cash flows from securitized products is relatively uncertain. This uncertainty is why investors demand higher returns.
Differentiation and security
As one of the largestfixed rate securityTypes of securitized products offer fixed income investors an alternative to government, corporate or government bondsmunicipal bonds. There are various methods used by financial intermediaries to issue bonds that are safer than the underlying assets. Most securitized products doinvestment qualitydegrees.
Disadvantages to consider
Of course, although the return securities are tangible fixed assets, there is no guarantee that these assets will retain their value in the event of a debtor's default. Securitization provides creditors with a mechanism to reduce risk by distributing ownership of debt obligations. However, it won't help much if the borrowers go bankrupt and you can't make a profit from selling your assets.
Different securities – and tranches of those securities – may involve different levels of risk and offer different returns to the investor. Investors should ensure they understand the debt underlying the product they are purchasing.
However, there may be a lack of transparency about the underlying assets. MBS played a toxic and precipitating role during the 2007-2009 financial crisis. In the pre-crisis period, the quality of the loans underlying the products sold were falsified. There was also deceptive packaging - in many cases repackaging - of claims into further securitized products.Since then, stricter rules have been put in place for these securities. Yet-warning pump-or buyer beware.
An additional risk for the investor is the possibility of early repayment of the debt by the borrower. In the case of mortgages, if interest rates fall, they can refinance the debt. Early redemption will reduce the return the investor will receive from interest on the underlying bonds.