Why securitization is bad

These high ratings are made possible through a combination of features, such as bond insurance, letters of credit and senior-subordinate credit structures. Investors also appreciate the diversification that securitization can bring to their portfolios. However, it's not all sunshine, as certain securitizations carry prepayment risk -- the chance that the deal's cash flows accelerate from expectations.

For example, a pool of mortgages might prepay from refinancings, returning money to investors in a lower interest rate environment. In addition, some deals simply flop, such as the mortgage-backed securities that soured during the financial crisis. Investors can choose from a wide range of securitization investments, including prime and subprime mortgages, home equity loans, auto loans and credit card receivables.

Investors who don't wish to pick individual securities can purchase an index with broad exposure, such as the U.

The financial crisis illuminated the dark side of securitisation. When the housing bubble burst, investors suffered significant losses and lost confidence and interest in securitisation. Moreover, stringent regulatory responses to address the shortcomings in securitisation markets have rendered these transactions costly for banks to engineer.

Minimal investor interest coupled with tougher regulatory requirements has had a detrimental impact on securitisation. The volume of securities that were issued shrank substantially in the post-crisis period, especially in Europe. But, today, ten years after the crisis, European policymakers are eager to revive it. They say that a well-functioning securitisation market will provide significant benefits to European growth.

However, there is little empirical evidence supporting this claim. Securitisation modified the traditional banking business model, where banks keep loans until maturity. It is a complex financial mechanism that enables banks to sell otherwise illiquid loans to third parties. The proceeds of the sale are then used to finance additional lending and this cycle may be followed repetitively.

Since the financial crisis, a large body of work has investigated the negative effects of securitisation. It is also a way for companies to reduce their balance sheet and take on more business by selling off assets like mortgages.

Securitization is a way to receive a consistent income stream, though it can be risky as much information about the underlying assets is unknown, such as the case in the subprime meltdown. When bad debts occur in securitization, the loss is shared as there are multiple investors, however, depending on the type of securitization, the loss is shared equally as in pooled securitizations or at different levels as in tranche securitizations.

Investing Essentials. Alternative Investments. Fixed Income Essentials. Real Estate Investing. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.

We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Key Takeaways Securitization is the process of financial structuring a non-liquid asset or group of similar assets into a security that is sold to investors.

Securitization takes many non-liquid assets, usually loans, such as mortgages, bundles them into a security, which is sold to an investor that receives an income stream from the principal and interest payments on that loan. Naturally, no investment is risk-free. If you read our book The Big Gamble , there can be no doubt left about that fact. Meanwhile, how do we get the markets restored and money flowing again? We believe the markets can be recreated with a higher degree of discipline on the part of each of the players.

What is needed is to restore the practice of securitizations in an honest forthright manner. We are not saying that Wall Street bonuses and incentives are bad; they are necessary.

But no more rewards for blatant manipulation and dishonesty. There are three important elements that should be considered while recreating the markets: simplicity, transparency, and fairness.

The final goal should be to allow borrowers to get credit on fair terms and to make it possible for investors to truly evaluate the inherent risks before investing.

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