Securitization
What is Securitization?
Securitization is the practice of pooling illiquid loans into a trust and selling investors tradable securities whose payments come from the pooled loans.
A lender that holds a loan to maturity ties up capital and carries all of the credit risk itself. Securitization breaks that link: the loans are sold to a special purpose vehicle, which issues bonds in tranches that are paid in a fixed order, so senior tranches absorb losses last and can carry a higher credit rating than any single loan in the pool. The originator gets cash back to lend again, and investors get exposure to loan cash flows they could never underwrite one by one. The model works when the pool is large, the loans are similar enough to model, and defaults are close to independent of each other. It breaks when defaults become correlated, because the diversification the senior tranche relies on disappears at exactly the moment it is needed, and it also weakens the originator's incentive to screen borrowers whose loans it does not intend to keep.
Securitization: a worked example
A trust buys a $100 million pool of auto loans and issues three tranches: an $80 million senior piece, a $15 million mezzanine piece and a $5 million equity piece. Losses on the pool come to 8 percent, or $8 million. The equity tranche has no subordination beneath it, so it takes min(max(8 - 0, 0), 5) = $5 million, a total loss. The mezzanine has $5 million beneath it, so it takes min(max(8 - 5, 0), 15) = $3 million, a 20 percent loss on its $15 million. The senior has $20 million beneath it, so min(max(8 - 20, 0), 80) = $0: the pool lost 8 percent of its value and the senior tranche lost nothing.
The mistake students make with securitization
Students call the senior tranche safe because the pool is diversified, then apply that reasoning to a pool of loans that all depend on the same thing, such as house prices in one region. Diversification only thins the tail when defaults are close to independent; raise the correlation between borrowers and the pool starts behaving like one big loan, so the senior tranche can take losses its rating never contemplated. The other frequent slip is treating securitization as simply selling loans. In a securitization the buyer is a bankruptcy-remote vehicle that reissues the cash flows as ranked claims, which is what creates the different risk levels.
Securitization questions
What is a tranche?
A tranche is one slice of the bonds a securitization issues, defined by where it sits in the payment order. Senior tranches are paid first and take losses last, while junior and equity tranches are paid last and absorb the first losses. Every tranche is backed by the same pool of loans, so they differ in risk and yield rather than in what stands behind them.
Why do banks securitize loans instead of holding them?
Selling the loans returns cash and moves credit risk off the balance sheet, which frees up regulatory capital and lets the bank originate more lending on the same equity base. It also converts illiquid, hard-to-value contracts into securities that a wide range of investors can buy and trade. The cost is a weaker incentive to screen and monitor borrowers whose loans the bank will not be keeping.
Does securitization always make the financial system riskier?
No. Spreading loan risk across many investors can make individual lenders safer and lower borrowing costs, and plain securitizations of well-underwritten prime loans have performed as designed for decades. The damage comes from opaque pools, ratings built on assumptions of low default correlation, and originators paid on volume rather than on how the loans perform. The structure divides risk among investors; it does not destroy it.
Formula / Example
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