Debt securitization or securitization of instruments as a whole gained a bad reputation after the financial crisis of 2007-2008. Nevertheless, there are positive economic reasons why banks, companies and investors securitize and trade all securitization assets, such as cheaper financing, balance sheet improvements, higher returns and diversification of credit risk.
How debts are securitized
When a debt obligation is created, the lender assumes the counterparty risk. If the borrower fails to repay the debt, the holder of the note suffers a loss. To combat this risk, the lender may try to sell the note (and, by extension, the counterparty risk) to an investor. Debts are an asset on the lender’s balance sheet; they represent a claim on future income.
Most investors do not take the risk of a single note, so the client packs various debt-based assets and sells them as a portfolio. The logic of this arrangement is that the chance that many borrowers will default simultaneously is much lower than that of an individual borrower. It is another version of portfolio diversification.
Normally, the portfolio is transferred to a vehicle for special purposes and removed from the originator’s balance sheet. The SPV creates and issues debt-based securities to finance the purchase of the portfolio.
Investors who purchase these securities exceed the lifetime of the notes (portfolios are composed of equivalent obligations) from the cash flow generated by loan payments.
Benefits of debt restructuring
Debt certificates are exchanged for a cash equivalent for the originator. This transforms a risky asset into a non-risky asset, which improves the balance in the eyes of regulators and investors.
The diversification of risks has far-reaching economic implications. Capital markets are more profitable and, in many cases, more solvents than before. The reduction in risk also reduces the risk premium on debt contracts; Borrowers can realize a lower interest rate on car loans and mortgages. A 2009 study by Mathias Hoffmann and Thomas Nitschka found that debt sensitization in the mortgage markets created positive benefits for underdeveloped capital markets in poor countries.