Credit Securitization and Financial Risks
Credit securitization works to convert individual loans into liquid assets. Banks orchestrate these transactions to reduce their exposure to individual financial risks. Meanwhile, investors may covet securitized products as means to diversify their respective portfolios and gain entry into multiple financial markets. Abuse of the securitization model, of course, 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 benefit as borrowers make principal and interest payments upon underlying debt. Credit card balances, automobile notes and school loans are all debt obligations that are often securitized. Real estate investors may be more so familiar with collateralized mortgage obligations (CMOs) that represent asset claims above home loans. Banks earn fees and commissions for structuring these securitized deals.
Credit securitization improves liquidity, or the ability to convert assets into cash throughout the financial system. 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 into these 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 higher prices 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 may not be ideal for securitized products. In the case of collateralized mortgage obligations, homeowners will exploit lower interest rates to refinance into new mortgages that charge lower interest rates. The 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 often underpin asset bubbles, as investors leverage cheap money to speculate. Asset bubbles inevitably crash, when markets reorder themselves back to reality. At that point, the domestic economy may slog through a recession lasting eighteen months.