Securitization, a financial process aimed at converting illiquid assets into tradable securities, finds its prime examples in Mortgage-backed securities (MBS) and asset-backed securities (ABS). These instruments, integral to modern financial markets, serve as mechanisms for pooling various types of loans and debts. In the case of MBS, home mortgages serve as the underlying assets, while for ABS, a broader range of financial assets such as auto loans, mobile home loans, credit card loans, and student loans, back the securities. Both MBS and ABS can be further segmented into tranches, each representing a different level of risk and return for investors.
The process of securitization involves bundling cash flows from underlying assets and transforming them into tradable securities. For instance, in mortgage-backed securities, the cash flows come from the mortgage payments made by homeowners. These payments are then packaged into securities and sold to investors. Similarly, in asset-backed securities, cash flows are derived from the various underlying assets mentioned earlier, providing investors with exposure to a diversified portfolio of debts.
One of the key benefits of securitization is its ability to diversify risk. By pooling together various assets, securitization spreads risk across a broader spectrum, reducing the impact of defaults on individual loans or debts. Moreover, securitization enhances liquidity in financial markets by creating tradable securities from otherwise illiquid assets, thus allowing investors to buy and sell these securities more easily. This liquidity facilitates capital formation and enables lenders to continue providing credit to borrowers.
(Response: An example of securitization is Mortgage-backed securities (MBS) or asset-backed securities (ABS), which involve pooling various types of loans and debts into tradable securities, such as bonds. These securities, divided into tranches, represent different levels of risk and return for investors.)