Credit Securitization and Banking Risks
Credit securitization refers to the process of transforming individual loans into assets that may be purchased by investors. Banks orchestrate these transactions to reduce their exposure to individual financial risks. Meanwhile, investors covet securitized products as means to diversify their respective portfolios and gain entry into multiple financial markets. Despite theses inherent benefits, abuse of the securitization model may create asset bubbles that inevitably collapse.
Banks begin the securitization process by bundling individual loans together into larger pools, and selling off stakes within those pools to investors. Investors earn returns as borrowers make principal and interest payments upon each debt. Credit card balances, automobile notes and school loans are all debt obligations that may be securitized. Real estate investors, however, may be more so familiar with collateralized mortgage obligations (CMOs). CMO investments represent claims to an underlying pool of mortgages. Banks earn fees and commissions for structuring these securitization deals.
Credit securitization provides liquidity, which effectively reduces and manages banking risks. Liquidity describes access to cash, and securitization generates cash flow from management fees, while also serving as another source of financing. Rather than being limited to lending out their own capital to borrowers, banks can use securitization methods to tap into a larger capital base from investors. Banks then effectively pass default risks onto investors that choose to buy securitized products.
Banks divide their securitized products further into tranches, to attract a diverse mix of prospective investors. Individual tranches feature distinct risk versus reward profiles. For example, Tranche A of a collateralized mortgage obligation may receive principal and interest payments prior to all other tranches. Conversely, Tranche Z would be the last tranche to receive any income.
In this case, investors would pay top dollar to enter the first tranche. Higher acquisition costs, however, lower potential returns for this tranche. Tranche Z features increased default risks, but value-conscious investors that buy into this tranche will earn higher returns, if homeowners successfully make payments on all underlying mortgages.
Banks best employ securitization techniques amidst stable interest rate environments, when investment demand is high for these products. Higher moving interest rates adversely affect returns for existing debt securities. At that point, newly issued fixed income investments offer higher interest rates for investors. Alternatively, interest rate environments that shift lower are not ideal for securitized products, as savvy homeowners may then refinance into new mortgages, and save hundreds of thousands of dollars through the life of the loan. CMO investors would then lose out on future interest payments from the old loans.
Liquidity related to securitization increases the money supply, which effectively lowers overall interest rates for borrowers. Low interest rates may foster credit bubbles and speculative asset prices, as investors abuse their easy access to financing to place high bids on assets. Trading debt through securitization, of course, may mask the weak credit profiles of individual borrowers. Several notable analysts, in fact, have largely blamed the 2008 housing bust upon securitization.