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Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages. The process works as follows:
First, a regulated and authorized financial institution originates numerous mortgages, which are secured by claims against the various properties the mortgagors purchase. Then, all of the individual mortgages are bundled together into a mortgage pool, which is held in trust as the collateral for an MBS. The MBS can be issued by a third-party financial company, such a large investment banking firm, or by the same bank that originated the mortgages in the first place. Mortgage-backed securities are also issued by aggregators such as Fannie Mae or Freddie Mac.
Regardless, the result is the same: a new security is created, backed up by the claims against the mortgagors' assets. This security can be sold to participants in the secondary mortgage market. This market is extremely large, providing a significant amount of liquidity to the group of mortgages, which otherwise would have been quite illiquid on their own. (For a one-stop shop on subprime mortgages, the secondary market and the subprime meltdown, check out the Subprime Mortgages Feature.)
Furthermore, at the time the MBS is being created, the issuer will often choose to break the
Clear as mud, don't you think???? The underlying assumption is that the illiquid asset has a known risk level (low) and a certain return (passed on the payments for the original asset).
I'm very glad you posted this because I had a real misunderstanding in this area. What I am still missing though is, what is the relationship between securitization and commodification?
ReplyDelete--Tommy Turner
My response to this is quite simple. One of Warren Buffett's rules for investing is to only invest when you understand what you are investing in and how it makes money? An everyday investor would have absolutely no idea what they were investing in if they are buying securitized assets like MBS.
ReplyDeleteSpeaking of the ordinary citizen, approximately half of the sub-prime mortgages that were issued were not necessary. Those people were eligible for less risky loans.
I think this illustrates how little people actually understand anything to do with their money. No one in their right mind should be investing in these securitized vehicles because they are so complicated to understand.
Speaking more to the process of securitization, isn't the success based on the market for the original illiquid asset not undergoing radical shifts? Fundamentally, it seems to me that these cannot work unless the risk level of the securitized asset is near zero, which does not seem like a reasonable scenario.
Maybe I'm crazy, but the whole thing seems like a big inescapable mud puddle from the get go.
So according to this article the ratings of these mortgage backed securities have a large influence on those who invest in them. During the mortgage crisis I thought I remember hearing that these ratings were manipulated by the underwriters and and were not properly measured (higher ratings were given to make the investment seem more appealing). So aside from being a very complicated investment vehicle to begin with why were they so easily manipulated?
ReplyDeleteCheck out my glossary of terms. It should be helpful.
ReplyDelete