Securitization: Definition, Theory & Process Video

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  • 0:06 Defining…
  • 2:01 How Securitization Works
  • 3:09 Advantage of Securitization
  • 3:32 Disadvantage of Securitization
  • 4:24 Lesson Summary
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Lesson Transcript
Instructor: Noel Ransom

Noel has taught college Accounting and a host of other related topics and has a dual Master's Degree in Accounting/Finance. She is currently working on her Doctoral Degree.

This lesson examines the meaning of securitization and its usefulness in financial markets. Securitization and the securitization process are defined and outlined.

Defining Securitization and Assets

Securitization is the process of turning assets into securities. More specifically, specific assets are pooled together and repackaged as interest-bearing securities. Securities are financial or investment vehicles that are bought and sold in financial markets similar to how stocks and bonds are traded. The purchasers of the new, repackaged interest-bearing securities receive interest and principal payments.

Let's also define assets. Assets can be converted into cash, some easier and quicker than others. An asset that can be converted into cash quickly is called a liquid asset. An asset that takes longer to convert to cash and will likely sell for a price lower than market value is called an illiquid asset.

For example, a money market account is an account at a bank used to store cash. It usually pays a small rate of interest based on the amount of money on deposit in the account. If the owner of the account wants to withdraw all or a portion of the money, he can simply use a withdrawal form at the bank to take money out immediately. A money market account is an example of a liquid asset.

However, if a person who owns a home decides to sell the house, it could take days or months before the house sells. The owner needs to put the house up for sale, advertise or use a real estate agent, and find a buyer for the house. Once the owner finds a buyer willing to purchase the home, it's not guaranteed that the owner will receive the full value of the home, and it can take days or even months to complete the transaction. A house is an example of an illiquid asset.

From the bank's perspective, a mortgage loan is considered an asset because the bank receives interest and principal payments from the borrower each month for a specific length of time (usually between 10 to 30 years). However, the mortgage asset carried on the bank's balance sheet is considered an illiquid asset because the mortgage is tied to the borrower's home, which is also an illiquid asset.

How Securitization Works

Securitization turns illiquid assets, like mortgages, into liquid assets. First, a bank or financial institution compiles hundreds or thousands of mortgages into a pool. Think of a 'pool' of mortgages as a large grouping of mortgages. The bank divides the pool into pieces called shares and sells the shares to investors and other companies in the form of what are called securities. Remember, the securities are made up of hundreds or thousands of mortgages.

For example, John purchases a piece or share of the pool. John has purchased the right to receive a portion of the mortgage payments made by all the hundreds of thousands of homeowners whose mortgages were pooled together to form the securities. The securities that are made of mortgages are called mortgage-backed securities.

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