The Securitization Process
Securitization involves transferring ownership of assets from original owners (usually individual borrowers) to a special legal entity, and this entity in return issues asset-backed securities backed by these transferred assets. The pool of securitized assets from which cash flows are generated is known as collateral.
Advantages of Securitization
Securitization allows investors to have more direct legal claims on loans and portfolios of receivables. Also, due to disintermediation (lessening the role of intermediaries), the costs paid by borrowers can effectively be diminished. Banks can improve their profitability by increasing loan origination and fees.
Investors can easily access securities matching their risk, return, and maturity needs. For example, a pension fund with a long-term horizon can have access to long-term real-estate loans.
Securitization also allows for the creation of tradable securities with much liquidity and results in more efficient financial markets.
Many sovereign governments have also embraced securitization. For example, the Italian government has used securitization for privatizing public assets. In emerging markets, companies and banks have used securitization to lower their funding costs.
A major benefit of securitization is:
A. Providing lower interest rate risk
B. Providing transparency in the markets
C. The creation of tradable securities with better liquidity
The correct answer is C.
Securitization allows for the creation of tradable securities with better liquidity resulting in more efficient financial markets.
Option A is incorrect. Securitization in itself does not reduce reduce interest rate risk, but it does helps investors access securities matching their risk, return, and maturity needs.
Option B is incorrect. The securitization process does not provide more transparency. In fact, asset-back securities can sometimes be quite opaque as seen from the 2007-2008 financial crisis.
Reading 45 LOS 45a:
Explain benefits of securitization for economies and financial markets