- What is Loan Securitization?
- February 3, 2012
- Law Firm: EV Law Group LLC - Chicago Office
Securitization is a process by which various types of contractual debt are pooled together and consolidated as bonds, pass through securities, or collateralized debt obligations (CDO) to investors also called Mortgage Backed Securities (MBS).
Before the securitization process, a bank would issue a loan to a borrower. The same issuing bank collects the loan payments for the life of the loan. The same bank also services the loan with the borrower until the borrower fully pays off the loan.
This process limited the banks ability to issue new loans without new capital or borrower deposits. Hence,Fannie Mae and Freddie Mac.
If the borrower defaults then the full losses from a defaulting loan is borne by the issuing bank. If too many of the banks loans go into default, the bank's financial status may be jeopardized resulting in a shutdown by federal and state regulators or forced acquisition by larger banks.
In the 40s post depression era, in order to increase home ownership, the US Government formed Fannie Mae to recapitalize banks after issuing mortgage loans, by purchasing those mortgage loans from the banks. For the banks to be recapitalized, the government and regulatory authorities instituted strict lending guidelines for loans, and banks to qualify borrowers to prevent abuse and mass defaults.
Securitization, otherwise afforded banks the opportunity to completely remove all risks of default arising from issuing loans to borrowers.
For instance, any time a loan or a revenue-producing asset (i.e. leases, credit card debts) are created, these assets are ripe for securitization. Accounts receivable are also an example of assets that can be securitized.
The originator of the securitized asset anticipates a regular flow of payments and by combining several assets together, the influx of payment will support interest and principal payment on other securities. The idea of securitization is to spread the risk of default across hundreds if not thousands of loans so that in the event of a borrower defaulting the aggregate of the "pool" will continue making payments offsetting the loss in payments and profits arising from default. Risks of losses from defaulting borrowers were further minimized through various types of Credit Default Swaps and Derivatives.
Security Rating agencies such as Morningstar, Moody's and Standard & Poors, viewed the minimization of risk through securitization, and distribution of borrower credit worthiness throughout the pool as Triple AAA security. Triple AAA rating is as strong and as high as US Treasury securities and bonds, with higher rates of returns.
These ratings were valid so long as the proposed rate of borrower defaults remained less than 2%-3%. When that increased in 2008, the illusions supporting the ratings of Mortgage Backed Securities came crashing down. Because they no longer carried value to be purchased in the secondary market. SeeDevaluations of Mortgage Backed Securities.