For the financing company, the tool works to mobilize capital from the markets as the company consolidates all its assets and debt to form a financial instrument that it issues to its investors. So, through the accumulated funds, the company can increase its loan book. Generally, illiquid assets or assets with poor liquidity that cannot be transferred easily such as loans are issued for the purpose of securitization. So, through the process, liquidity in the market is enhanced. For investors, the investment avenue helps to diversify their asset portfolio and earn substantial returns.
Securities that are backed by mortgage receivables are referred as mortgage backed securities are refereed as mortgage backed securities (MBS) while those backed by some other type of receivables are known as asset backed securities (ABS).
In Asset-backed securitization, originator may sell interest in the profit of its loan book on a percentage basis for which the investor pays the price. For the funds mobilized, originator promises to pay the investor the principal sum and interest over time with assets being the collateral for the funds raised as a loan amount from investors.
Rationale of Securitization
Securitization of illiquid assets such as a loan enables the company who is otherwise the owner of the asset or the originator to protect itself against all the risk associated with the asset. As now the interest in the asset is spread among several investors for a cost which the company pays as interest to its investors over a term.
Also, in a case when the company is in need of cash urgently, it can also securitize mortgage-backed assets at a lower profit which otherwise the mortgage holder shall realize in the long run.
The process also enables companies to eliminate liabilities such as loans from its balance sheet. Likewise, all the associated risk with the asset class is now transferred in the hands of the investor, so any loss from the asset has to be borne by the investor in the securitized asset.