May 29, 2017 | Barcelona, Spain
The next topic I’m going to discuss that relates to the financial crisis is the process of securitization. In securitization, the issuer creates a financial instrument by mixing other financial resources they have and then selling the combination of assets to investors. It can include all types of financial assets and increases overall liquidity in the market. One example of such, discussed above, is mortgage-backed securities. By taking many different mortgages and putting them all together, the issuer of the security can separate the combined group of mortgages into smaller, individual segments based on the risk of default for each mortgage. This generates more liquidity, because more people are able to buy shares as they can afford the smaller segments of the total pool of shares.
Ideally, securitization provides creditors with a tool to lower their total risk by dividing the ownership of their debt obligations amongst many individual assets. They can effectively remove these assets with higher risk from their balance sheets because the investors are essentially acting lenders by buying the security. What differentiates this process is that these are backed by tangible goods, so if a debtor can make payments of their assets, it can be taken and liquidated to compensate the people who hold an interest in the debt.
By definition, securitization seems to make a lot of sense, however it does come with a decent amount of risk. Just like other investment tools, higher risk means higher rate of returns, leading to higher interest rates that less qualified borrowers end up paying. So, even if the securities are backed by tangible assets, there is still no guarantee that the assets will hold stable in the case of a debtor not making payments.
In regards to the credit crisis, securitization is most commonly blamed for the mortgage-backed securities (mentioned above). The MBS were attractive to investors because of the high interest rates they offered. Mortgage lenders at the time took advantage of the system by pooling the subprime mortgages together and sold them securities to investors who did not know better. People were essentially blindly investing money because the lenders placed all these bad mortgages together into a deceivingly attractive package. As the real estate market boomed, more and more of these packages were sold. Eventually, when the bubble burst and people could not pay their loans and all those subprime mortgages began to default leading to the credit crisis we keep referring to.
In my opinion the idea of securitization is a great one. It makes logical sense, to compiling many financial resources to diversify a portfolio. However, just as with all tools of the trade in investments, it needs to be closely monitored and regulated by everyone. The government, investors, and most importantly the banks and other financial institutions are most responsible for creating packages with legitimate chances to succeed in the long run.