Securitization is the process of pooling or bundling various types of debt instruments for the purpose of selling the instruments for cash. As part of the process, the combined value of the bundle of debt instruments is used to convert the pool into a bond issue that can in turn be purchased by investors. Generally, a trustee makes the initial purchase of the bundle, then sells the bond to one or more investors.
The type of debt instruments involved in securitization do not have to be similar debts in order to be included in the bundle. A securitization deal may include such varied debts as mortgages, car loans, or credit card debt. Essentially, the main qualification for inclusion is that the debt instruments included in the bundle will continue to generate income from the payments received on the principle of the debt as well as any interest that is applied to the outstanding balance.
A mortgage pool strategy of this type is relatively common. Banks, finance companies, and investor consortiums often engage in the process of securitization. For the individual debtors, a transfer in the ownership of the debt may be completely transparent, or require nothing more than changing the address where the payments are remitted. Generally, a securitization project does not lead to an increase in interest rates.
The beauty of using a process of securitization to create an MBS or mortgage-backed security is that the investment will generate a regular flow of revenue over an extended period of time. The investors receive this cash flow from the payments on the interest and principal made by borrowers. The MBS may involve both residential and commercial mortgages.
As with any asset-backed security, there is some degree of risk to the investor. Because the bond issues are backed with debt instruments, there is always the chance that one or more debtors will default on the loans, mortgages, or credit card debt. However, investors who regularly include securitization investments as part of their business practices usually take steps to minimize the potential loss from a default, sometimes including some sort of assurance on the part of the trustee in the terms and conditions that apply to the sale. This can help to minimize the chances of holding an illiquid asset and incur a loss on the venture.