I have a bit of an idea of what it includes and some of its features, but if someone asked me what it meant I’d have no answer for them.
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Much appreciated guys. This was very helpful!
In: Economics
Could you be a little more specific? There are a lot of topics that this could conceivably cover.
It means what is sounds like – making something into a security. Usually that something is a bunch of IOUs (loans, mortgages, receivables). The advantage of securitization for the lawyers and bankers is they can originate loans beyond what they have the capacity or desire to hold on their books. The advantage for the investor is they can invest in a pool of hundreds or thousands of loans without needing the infrastructure to be able to originate hundreds or thousands of loans. The securities usually trade more often than the underlying assets – which everyone likes. The most notable downside is that there isn’t perfect alignment of incentives between those originating the deals and those who own the risk.
Securitization is turning assets into tradable financial instruments. Take a mortgage for example. One bank owns it, and they can sell it. Someone else can buy a bunch of mortgages and bundle them together into a financial instrument and stick a price on it.
This was very popular in the early 2000s and was a major player in the 2008 crash. But that doesn’t mean all securitization is bad.
The lawyers get involved because they have to draw up the contracts that describe the security, enumerate everyone’s duties and rights, and ensure the instrument they have created complies with securities trading laws wherever they are operating.
A loan can be “secured” or “unsecured” meaning it has collateral, a house loan is “secured” against the house, if the borrower doesn’t pay, they take the house and sell it.
An unsecured loan is like a credit card. There’s no guarantee over the “word” or credit of the borrower.
Given a large enough bank they have a requirement to keep at least a percentage of the money on hand ( not loaned out at all) to cover when some one wants to make a withdrawal, and at least a certain amount as loans “secured” by actual property. The rest the bank can invest on unsecured loans. If a bank makes too many “unsecured loans” it could fail if they all went bad, so the bank might sell or trade some loans for a loan that is less risky or “secured”.
Imagine you have a piggy bank, but instead of filling it with coins, you fill it with promises from your friends that they’ll give you some of their allowance money. Each promise is based on the fact they get an allowance every week, so you’re pretty sure you’ll get some money from them. Now, imagine you have a lot of these promises, but you want to buy a big toy now, and you don’t want to wait to collect all that allowance money over time.
Here’s what you do: You take all these promises, put them together in a big box, and then you tell other people, “Hey, if you give me money for the big toy I want now, I’ll share the allowance money from these promises with you over time.” People who give you money are now partly owning the promises in your box. This process of putting all the promises together and getting money from others by promising them a share of the future allowances is kind of like what “securitization” is.
Now, why do lawyers and bankers care so much about this?
Lawyers: They’re like the rule-keepers or referees. When you’re putting all these promises in a box and then telling people they can get some of the allowance money, there are a lot of rules to follow. These rules make sure everything is fair and that no one is lying about the promises they have. Lawyers help write the rules for the box of promises (the contracts) and make sure that when people trade money for promises, everyone is doing it right and fairly.
Bankers: They’re like the experts in knowing which promises are good to put in the box and how to find people who want to buy into it. They help collect the promises, figure out how much money they’re probably going to make, and then find people who want to share in those promises. They’re interested because they can make money from setting up the box of promises and from managing the money that comes in and out.
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