Question

How does loan securitization compare to other means of risk management? Do you think all types of assets held by FI should be securitized? Please explain.

Answer 1

Securitization is the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors, and this process can encompass any type of financial asset and promotes liquidity in the marketplace

This helps the creditors to lower their risk level because of division of ownership of the debt obligations.The investor in such securities takes up the position of the lender when he buys such security which allows the creditor to remove the associated assets from their balancesheets.The investor would get a rate of return on the associated principle and interest payments made by the debtors on their obligation.If the debtors doesnot pay then his asset can be seized and liquidated to compensate the payments.

Securitization process helps to mitigate risk to some extent but then in case of default by the underlying obligator can have a cascading affect in the entire financial chain and disturb the entire financial eco-system like what happened in the 2008 global financial crisis.

To illustrate it easily, here I have prepared a small flow chart to explain the securitization process.

To the second part of the question, should all types of assets held by Financial Institutes be securitized? The answer would be No. Because if all assets are securitized then invariably, the company is taking every asset off balance sheet which would not give the true and fair picture of the financial statements of the company. On the face value , the company's balance sheet may b=look very heathy but the assets are pared under special purpose vehicle which can have very risky assets too.Therefore it's not a good idea from Investor Point of view to securitze all the assets.