Securitization is a type of structured finance that involves the pooling of assets (or specific types of assets such as receivables) for issuance of securities (on pooled assets). Securitization allows an entity to obtain funding through the sale of assets, as an alternative to obtaining funds in a direct way (by means of loans/ borrowing). In the process, an entity creates a special purpose vehicle (SPV) that issues the securities (typically, asset-backed securities) to the investors. The parties to a securities include, in addition to an SPV, the originator and the investors in the asset-backed securities.
The main functions of securitization include the following:
- Pooling of risk/ diversification: similar to the functions and role of financial intermediaries, e.g., banks, and mutual funds.
- Risk transfer: the separation of loan origination from on balance sheet investments, based on the originate-to-distribute model (when lenders extend loans with the intention of selling them to investors or other institutions, rather than holding these loans through maturity). It allows banks and other financial institutions to change revenue source from net interest margin to fees.
- Risk distribution: creation of securities with different risk-reward profiles. The risk and reward profiles of such securities also different from that of underlying loans/ assets.
- Alteration of default characteristics of tranched products (vis-à-vis underlying asset pool).
