The modern financial system is all about innovation. The system and its proponents believe that financial jugglery can solve almost any problem. With this belief in mind, modern day America witnessed the rise of a new asset class. This new asset class was based on real estate. However, unlike real estate this was not sold on the streets. This new asset class was traded on stock exchanges across America and the world. Also, this new asset class did not have a big ticket size like real estate does. Anyone with a few dollars in their pockets could purchase and sell these securities that mimicked the return on real estate markets.

This metamorphosis of real estate from a capital intensive illiquid asset to a small denomination highly liquid asset class took place through a process called securitization. In this article, we will discuss this process in more detail.

The Problem with Real Estate: Lack of Liquidity

During the early 2000’s real estate was providing highest returns in the American market. Banks and investors had the opportunity to make more and more mortgage loans, benefit from the prevailing low interest rates and make a good return in the process. However, there was a problem with real estate. Loans once made would not be repaid for three decades. Banks had to hold these loans on their books. The holding of these loans would block up precious capital and banks were wary of this.

This was when the need was felt to use some financial magic to transform a highly illiquid asset into a highly liquid one.

The Solution

The problem was that banks were forced to hold these assets on their books. Even though the returns were lucrative the banks still wanted more. On the other hand, retail investors and pension funds would be glad to hold these investments for years. The rate of returns provided by real estate was more than that provided by bonds and as such it was a favorable investment. Hence, a new solution was found out. This solution was called “securitization”.

• Sale of Mortgages: The securitization process began with the sale of loans by the banks to a third party. This meant that if a bank made a loan of $100 and expected to be repaid $150 with interest, they would sell out the rights to collect those loans at $130 to a third party. The bank got $130 today and the third party would benefit from the interest that can be received over the lifetime. This third party that would purchase these investments would usually be an investment bank.

• Slicing and Dicing the Mortgages: The investment bank would then slice and dice this mortgage. This meant that if there was one mortgage with $100, the investment bank would create 100 different bonds that worth $1 each. This example is an oversimplification. However, the idea is to explain that the cash flow from the mortgages was being redirected to the bonds. In effect, the bondholders were paying the bank for making the loans and were receiving an income in the form of interest from the mortgage holders. Thus it was not a single bank that was making the mortgage. Rather thanks to the financial jugglery, millions of people from across the world were pumping in money into the American mortgage market.

• Tranching: The next step in the process of creation of what was called “tranches”. This meant prioritizing the level of default. If mortgage owners defaulted, the risk would hit the bondholders who were holding bonds from the lowest tranche. Only after the defaults had completely wiped out that tranche would the next tranche be affected. Doing so enabled investment bankers to sell the higher tranche bonds at a remarkable premium. However it also led to a concentration of risk in the lower tranches. At that moment it did not seem like a big deal since real estate was considered to be an inherently safe investment. However, in 2008, this would pose a big problem.

• Selling It on the Exchange: The last step in the process was to list these derivative securities on the exchanges and sell them as exchange traded derivatives. This meant that there was an active market for all of these securities. People who purchased the bonds were not required to hold them until maturity. Instead they could sell them off to other investors as and when the felt like. Also, since this transformation had made risky real estate investments into safe pension fund grade investment securities, there were buyers from as far as Europe and Japan that had huge exposure to the American mortgage markets.

The Result

• Positive Effect:

  What was achieved by the process of securitization was nothing sort of remarkable. It was as if the model has been taken out from an economics textbook and could be used to define perfect markets. All the borrowers and lenders had the opportunity to cash in and leave when they felt like. It was and is still considered to be a perfectly liquid market. The success of these mortgage backed securities created many imitators. Over a period of time car loans and even corporate receivables were being securitized. It seemed like financial engineers had figured out the solution to the problem of liquidity and exchange traded derivatives seemed to be the perfect solution.

• Adverse Effect:

  The process of securitization also created many adverse effects. To begin with it created a system with no accountability. Since no one was going to hold the mortgage for long, no one exercised caution while giving out these mortgages in the first place. A lot of bad mortgages and therefore bad bonds made their way into the market leading to the spectacular collapse of the market which ended up wiping out Lehman Brothers and bring the entire financial world to a standstill.

  Also, since bonds were made in small denominations and were highly liquid they were purchased by a lot of foreign governments as well foreign private investors. This created a situation that a local mortgage market bust in the United States caused a global meltdown and recession.

The process of securitization has provided a method to created exchange traded derivatives from illiquid assets. However, it still needs to be refined to get rid of the negative consequences.