Banks can securitize take on debt for a number of reasons, including risk management, balance sheet issues, increased capital leverage, and to profit from origination fees. Securitization is the process of pooling various forms of debt – residential mortgages, commercial mortgages, auto loans, or credit card debt obligations – and creating a new financial instrument from the pooled debt. The bank then sells this group of refurbished assets to investors.
Securitization is useful because it provides opportunities for investors and frees up capital for originators, which promotes liquidity on the market.
Benefits of securitization
One of the most significant advantages of debt securitization is the benefit that banks can derive from the transfer of default risk associated with securitized debt off their balance sheets to enable better leverage of their capital. By reducing their leverage and risk, banks can use their capital more efficiently.
Securitized instruments resulting from the pooling of debt are called debt-backed bonds (CDOs). The securitization process creates additional liquidity for debt securities. Although it is unusual for individual investors to own CDOs, insurance companies, banks, investment funds, and hedge funds can trade CDOs to earn returns above simple Treasury yields.
How securitized debt is sold to investors
Different levels of indebtedness, called slices, are sold to investors. Tranches are grouped according to various factors, including the risk level of the tranche or the timing of the payments due. Tranches are often given ratings that indicate their perceived risk. The tranche rating determines the amount of principal and interest investors receive for purchasing that level of debt. Riskier tranches require higher interest rates, while tranches with higher ratings pay less interest.
Default on subprime mortgages included in many CDOs are often cited as one of the reasons for the 2008 financial crisis.
Although investing in corporate debt can be somewhat complex, it can generate strong returns. Individual investors can take advantage of some of these returns by investing in a bond or investment fund that buys various forms of securitized debt.