Securitization
What is it?
Securitization is a process. More specifically, it's a way of creating tradeable bonds (also known as asset backed securities) based on the future cash flows created by a pool of assets.
Those cash flows can be generated by anything from credit card debts (card users will have to pay those debts off) to student loans and mortgages. Mortgage-related securitizations create mortgage backed securities. Anything that involves a commitment to repay debts or that will create a cash flow in the future can be securitized.
David Bowie, for example, used securitization to raise money on his back catalogue - he knew that he'd sell a lot of copies of Space Oddity in the future, but he wanted the cash immediately. He therefore sold 'Bowie Bonds' to investors, who were in return given a share of the future royalty payments generated by Space Oddity and his other hits.
In the securitization process, the first step is to create a special purpose entity or special purpose vehicle, which purchases the assets to be securitized and ring-fences them from their original owner. This entity then issues asset backed securities based on the cash flows created by the assets.
What's it got to do with the financial crisis?
Securitization is blamed for creating the conditions which led up to the credit crunch.
In the years preceding the crunch, securitization of US residential mortgages went through the roof. In 1990, there were around $1.4 trillion of mortgage backed securities outstanding, according to the US Bond Market Association. By 30 June 2007, this had risen to $6.9 trillion. By 2009, however, the market had come to a near-standstill as the credit meltdown sent banks into hiding.
It's argued that securitization encouraged reckless mortgage lending: lenders who knew that the loans they made were going to be sold for securitization purposes were allegedly willing to extend debt to people they would never have lent to had they been forced to keep the loans on their own books.
A tremendous amount of the world's credit depends on securitization. Citigroup has estimated that $8.7 trillion of assets are currently funded by securitization and that between 30% and 75% of credit in various US industries came from securitization.
The US Treasury proposed rules in June 2009 to 1) force lenders to take on more of the risk in the loans that they securitize and 2) end accounting rules that made the securitization boom an attractive profit center.
Last updated on 7 September 2009.
