Securitization is the process by which an illiquid asset is transformed into a real security through financial engineering processes. A credit, which itself is not marketable, is made salable and exchangeable through securitization.
The most common example of securitization concerns mortgage-backed securities, ie securities backed by assets which are themselves secured by a set of mortgages.
The securitization process works as follows:
First, a regulated and licensed financial institution issues a variety of mortgages, which are secured through claims on the properties that borrowers purchase. Then, all of the individual mortgages are put together into a mortgage pool within a fund as collateral for a mortgage-backed security. These can be issued by third party finance companies, such as to a large investment banking firm, or by the same bank that issued the mortgages.
The result of the securitization materializes in the creation of a new asset, guaranteed by the credits owed by the borrowers. This asset can be sold to participants in the secondary mortgage market. This market is extremely large and provides a significant amount of liquidity to mortgages, which would otherwise be quite illiquid on their own.
Also, during the process of creating mortgage-backed securities, the issuer often chooses to fragment the mortgage pool into multiple parts, called tranche. These tranches can be structured in any way the issuer sees fit, thus allowing each security to be tailored to a variety of market participants’ risk tolerances.
