Securitization is the financial practice of POOLING various types of contractual debt such as
- Residential mortgages,
- Commercial mortgages,
- Auto loans or
- Credit card debt obligations
and selling said consolidated debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to various investors.
Suppose you run a business of selling aircraft (suppose big if we are supposing :/). Some airline companies like Kingfisher, Sahara approach you and ask you to sell the same to them. Your manager (dealing hand) sold them a few units of value totalling 2 billion bucks. Now as they don’t have funds at the moment and as we know that most of the business run on credit, they ask him for credit of 5 years with agreed principal and interest payments and he gave them by accounting their name under the head “Debtors”.
Now you are in need of fund because you are short of working capital. Your manager didn’t even ask those airline companies for at least a few million bucks as down-payment. Now what choices do you have?
- Issue shares – Will dilute the ownership.
- Take loan – Expensive and strong credit rating required and it carries burden of interest payments.
- Yell on manager for not collecting down-payment.
If you think like me you will first do the 3rd one and then the 4th one. The solution is Securitization, if you don’t want expensive loan or dilution of ownership. Here is how it will go –
- You (Originator) will look for the purchaser (Special Purpose Entity/Vehicle (SPE/SPV), also called issuer) of your book debts (here 2 billion bucks).
- You will sell your book debts at the agreed price (taken into consideration the interest on debt and present value).
- Issuer will then issue tradeable securities in the open market or through private placement against the book debts.
Crux is that you just converted your book debts into cash flow. Issuer issued securities in the market backed by your book debts and with that money bought your book debts. This is a type of securitization which is called Mortgage-Backed securities because you sold your mortgage receivables. Assets backed by other receivables apart from mortgage are called Asset-Backed securities. That’s it! As simple as a cup of coffee.