What is Securitisation?
When a bank combines several illiquid assets and converts them into a security that can be purchased or sold in the financial markets, thus providing liquidity in the market and lower risk.
Process of Securitisation
Financial organisations first list out all the assets that they want to securitize and remove from their associated balance sheets and then gather the details of these assets. All this information (called reference portfolio) is then sold to the issuers who create tradable securities.
The investors can then buy these securities and these reference portfolios can also be divided into smaller sections called tranches which categorise these assets on various factors like rate of interest, maturity date, type of loan, etc. Thus, each branch has a different risk factor and rate of return, so the investors can buy them as per their budget and requirements, thus reducing the liability of the original creditor or lender
Types of Securitised Instruments
By definition, all financial assets can be securitized, but mostly loans and other assets that generate receivables (like commercial or consumer debt) can be turned into a tradeable item of monetary value. Scrutinization helps companies in raising funds and generating additional income using the financial debts or assets which helps banks in lending out more money while the investors diversify their portfolio and get higher returns.
All these instruments can be categorised into two types of securities:
Asset-backed securities
Asset-backed securities include commercial debt, student loans, and similar loans that aren’t backed by a mortgage. These become assets in the books of the financial organisation that is offering the credit. The government has allowed these organisations to go after the personal assets of defaulters who fail to pay the instalments on time.
Mortgage-backed securities
Mortgage-backed securities are bonds that are backed by real estate properties or loans that have collateral in the form of a vehicle, etc. Investors who buy these securities receive the receipt of the interest payments on the concerned debts as often banks tend to ask the borrowers to send the interest amount directly to these investors.
While the investors can expect high returns on such investments, there is also a risk that the loan instalments are not paid on time, thereby resulting in a loss to the investors. So the investors have to put up with high risk in order to get a higher rate of return.
