By Jeff Jones, CFA, CFP, CPA, CMA, CFM

Asset securitization takes place when loans are combined into a pool, and then claims on the cash flows from the loans are sold to investors. In its simplest form, the three main parties associated with the asset securitization process are the loan originator, the special purpose vehicle (SPV), and investors. The loan originator makes the initial loan to the borrower. The loan is then pooled with other loans having similar characteristics and transferred to an SPV. The SPV generates funding to purchase the loans from the loan originators by selling claims on the cash flows to investors.

Asset securitization is beneficial for the loan originator because it provides them with liquidity. The loan originator can sell a loan to the SPV, thereby freeing up capital to originate other loans. Asset securitization is beneficial for investors because it allows them access to an asset class (lending money) that can be invested in using reasonable denominations and that is diversified across many borrowers. For example, absent the securitization process, an investor wanting exposure to home loans would be required to make loans to individual borrowers in very large denominations.

The two general categories of securitized assets are mortgage backed securities (MBS) and asset-backed securities (ABS). MBS is created when a home loan originator, generally a bank or finance company, sells or transfers the loan to an SPV that pools them with similar loans. The defining characteristic of an MBS is that the underlying loans are all home mortgages.

ABS are created in a manner similar to MBS, but the key difference is that the loans underlying an ABS are not mortgage loans. Typical loans from which an ABS is constructed include automobile loans, credit card receivables and student loans. As might be expected, ABS generally carry more risk than MBS, due to the lower quality of the loan collateral.

Investment in MBS and ABS involve three primary risks:

1) Default risk is the risk that the borrowers on the underlying loans will be unable or unwilling to repay the loan.

2) Interest rate risk is the risk that arises when interest rates change and the underlying loans have a fixed interest rate.

3) Prepayment risk is the risk that borrowers will repay the loan before its scheduled maturity, thus depriving the investors in the MBS or ABS of receiving interest on the borrowed funds. Prepayment risk is more of a concern for investors in MBS due to the longer maturities of mortgage loans.

Of course as we saw during the recent financial crisis, the “over-engineering” of MBS and ABS can create substantial problems and unforeseen risks for investors. As such, it is important to have a complete understanding of the security before investing. Despite these past abuses, however, the process of asset securitization provides important benefits for financial markets. Asset securitization provides more liquidity for loan originators, provides investors access to a diversified asset class, and it also leads to overall lower interest rates for borrowers.

Is investing in MBS or ABS right for your portfolio? To decide, talk with your financial adviser.

This article appeared in the August 22, edition of the Springfield News-Leaders and can be accessed online here.

Jeff Jones, CFA, CFP, CPA, CMA, CFM is an assistant professor of finance at Missouri State University. The views expressed in this article reflect those of the author, have been distributed for educational and informational purposes only, and should not be construed as investment advice or a recommendation of any specific security, strategy or investment product.