In finance, securitization is the process of pooling and repackaging of cash flow producing financial assets into securities that are then sold to investors. The name “securitization” is derived from the fact that the financial asset is converted into a security.
The economic securitization process in the United States typically begins with the identification of a pool of eligible assets. These assets are generally loans or receivables that have been originated by financial institutions and then sold to investors. The pool of assets is then securitized, which involves the creation of a special purpose vehicle (SPV) that issues securities backed by the pool of assets. The securities issued by the SPV are typically divided into two tranches: a senior tranche and a junior tranche. The senior tranche is typically rated AAA by one of the major credit rating agencies, and as such, is the first to receive principal and interest payments from the pool of assets. The junior tranche is typically unrated, and as such, is the last to receive payments from the pool of assets. The proceeds from the sale of the securities are used to purchase the pool of assets from the financial institutions that originated them. The financial institutions are then free to use the capital thus freed up to originate new loans, which can help to stimulate economic activity. The securitization process has been criticized for a number of reasons. First, it can be difficult to value the securities issued by the SPV, as they are often not traded on public markets. This lack of transparency can make it difficult for investors to know what they are buying. Second, the SPV structure can create incentives for the originators of the assets to sell loans that are likely to default, as they are not typically on the hook for any losses incurred by the investors. This can lead to a build-up of risk in the system that can eventually lead to a financial crisis. Despite these criticisms, securitization remains a popular way for financial institutions to raise capital, and it has played an important role in the development of the US financial system.
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