'Securitization' is explained in detail and with examples in the Banking edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Securitization is a financial engineering procedure. In this process, sponsors take an asset or group of assets that is illiquid and turn them into a saleable security. Mortgage backed securities are common instruments that result from securitization. These MBS products are backed by assets. The security that underlies them are a group of mortgages.
The securitization process works in a series of steps. It begins with a bank or other financial institution originating a number of mortgages. The mortgages themselves are backed up by the specific properties the home buyers purchase. Next, these single mortgages become combined together into what is known as a mortgage pool. The pool of mortgages remains in trust for the MBS collateral.
MBS are sometimes put together in the securitization process by an investment bank or other third party independent financial firm. They could also be issued by the original bank that underwrote the mortgages in the beginning. Large aggregators like the government sponsored entities Freddie Mac, Fannie Mae, and Ginnie Mae put together many of these mortgage backed securities themselves.
Whichever group undertakes the effort, the end result is identical. Securitization creates a new financial security that is underpinned by the legal and financial claims on the assets of the mortgagors. Sponsors then take the new security and sell it investors or other interested parties in the secondary mortgage market. This proves to be a very large and liquid market. It offers substantial tradability to the securitized mortgages that would have little to no liquidity as stand alone investments.
When these mortgage backed securities are being created through the securitization procedure, issuers have options. Many times they decide to break up their pool of mortgages into a group of different components. They call these tranches. With tranches the issuers are able to put together the security however they would like.
This means they can craft one MBS into a range of tolerance for risk. Some buyers like pension funds are only interested in investing in mortgage backed securities with high credit ratings. Other investors like hedge funds have a higher tolerance for risk. They will be willing to take on tranches with lower credit ratings in exchange for higher returns.
Individual investors who want to participate in these mortgages have several choices. They can take a participation certificate share in a pool of mortgages. This pass through participation provides a pro rated share of interest and principal payments that come back into the pool when the issuers obtain the borrowers’ monthly payments. There are also pools of such pass through mortgages called CMOs collateralized mortgage obligations.
Many individuals would like to become involved in mortgage investing but are unsure of all the research involved with the various kinds of MBS. An ideal way to participate without having to understand the detailed mechanics is through mortgage mutual funds. These funds could invest in a single kind of MBS like a Ginnie Mae issued one.
Still other funds are comprised of a range of mortgage backed securities as part of a group of holdings in government bonds. Mutual funds provide a better diversification in loan holdings than individuals might afford on their own. They also offer the ability to reinvest all payments of principal and interest into other MBS. This helps to reduce the risks of changing interest rates and prepayments. It also permits investors to receive yields that vary with current interest rates.