Securitization is the pooling of monetary assets with predictable cash flows and sale of said assets to a specially created third party, which has borrowed money to finance the purchase.
What does this mean? I suck at ASCII art, so you shall have an ordered list:
- A company decides that it doesn't have enough cash on hand, and wants to get rid of some illiquid receivables quickly. Illiquid = not liquid = not easily converted into cash. Receivables = accounts receivable.
- The firm then creates a Special Purpose Vehicle, or SPV, which is designed to manage the assets that the company no longer wants.
- The firm gathers together all of the assets of a certain type it no longer wants, and sells them to the SPV for cash.
- The SPV sells shares of this asset pool to investors for cash and manages the assets, channeling all cash flows from the assets to the investors in the form of dividends.
The term securitization was first used in The Wall Street Journal in 1977, in a column entitled "Heard from the Street." Ann Monroe, the reporter who authored the column, was at a loss for a better term, and submitted "securitization" as a name for the practice of pooling receivables to sell as a group. WSJ printed the term under protest, whining about proper English and that "securitization" wasn't a proper English word and couldn't Ms. Monroe do any better than that? Wall Street felt differently, and the term caught on quickly.
Securitization is about as close to a win-win situation as the market will ever get. The company frees up cash to invest elsewhere, and the investor acquires the dependable cash flows of the asset pool while minimizing the risks of the individual receivable account (default/non-payment). The investment banking community has a whole new product line to start hawking. And what a product line; everything is being securitized these days, from mortgages and home-equity loans to credit card receivables and junk bonds. Anything with a cash flow is being grabbed, repackaged, and sent back out to the market.
For more information about the process of securitization, and a short account of the history of securitization, please go here.
For more information about the concept of pooling individual risks to minimize overall risks, please start reading about this.
Bibliography
BROOKS, Donald E., and HERZ, Robert H. Guide to Financial Instruments. Third Ed. New York: Coopers & Lybrand, 1994.
FABOZZI, Frank J. Issuer Perspectives on Securitization. New Hope, PA: Frank J. Fabozzi Associates, 1998.
FISHMAN, Michael J., and KENDALL, Leon T. A Primer on Securitization. Cambridge, MA: MIT Press, 1996.
HAYRE, Lakhbir. Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities. New York: John Wiley & Sons, 2001.