Contemporary Finance

14Securitization and Structured Product Risk

14.1 Introduction to Securitization

14.1.1 Function and Design of Securitization

Securitization is the issuance of securities backed by a collateral pool of underlying assets, such as mortgages or consumer debt. The securities are typically tranched, forming a capital structure of securities ranking their contractual claims on interest, principal, prepayments, or other cash flows from the pool.

Securitizations are distinguished by the type of asset backing them, the liabilities issued, and the way they are structured. Bonds backed by mortgage loans are called residential or commercial mortgage-backed securities (RMBS and CMBS). Agency MBS are the most common type of RMBS and of securitization generally. Bonds backed by consumer debt are called asset-backed securities (ABS). Claims created in synthetic credit derivatives form, or from pools of bank or corporate debt, are called structured credit products. Collateralized debt obligations (CDOs) are a broad category of structured credit products, with collateral pools consisting of bonds, bank loans, or tranches of other securitizations. Collateralized loan obligations (CLOs), issued in large volumes in recent years, are backed by bank loans.

Securitization and structured credit carry out several important intermediation functions. They are a means to pool and diversify credit risk similar to banks and investment funds. Investors can own claims on a granular pool of obligors rather ...