Securitization

Securitization is a financial process in which illiquid assets, such as mortgages, loans, or receivables, are pooled and converted into securities. The assets are typically sold to a legally separate special purpose vehicle (SPV) or special purpose entity, which issues the securities to investors. The SPV is designed to be bankruptcy-remote so the assets remain dedicated to the securitization.

Payments on the underlying assets are passed through to investors according to a predetermined waterfall. The issuer creates tranches with different risk and return profiles; senior tranches have first claim on cash flows, while junior tranches absorb losses. Credit enhancements, such as overcollateralization, reserve accounts, subordination, or guarantees, are used to improve credit quality and enable higher ratings for some tranches.

Several roles exist: the originator or sponsor who initially owns the loans; a servicer who collects payments; a trustee who enforces terms; and rating agencies or investors who assess credit quality and buy the securities. The process aims to convert illiquid assets into tradable securities while transferring a portion of credit risk to investors.

Common asset types include RMBS (residential mortgages), CMBS (commercial mortgages), auto loan ABS, credit card receivables, and student loan ABS. Synthetic securitization also exists, using credit derivatives to transfer risk without transferring the underlying assets.

Securitization can provide liquidity to lenders, diversify funding sources, and enable capital-relief strategies, but it can be complex and opaque, potentially creating incentives that affect underwriting. Regulation since the mid-2000s has emphasized transparency and risk retention by sponsors.