Understanding Securitization Securitization is a commonly used term

Understanding Securitization

Securitization is a commonly used term in the world of investments. So what is “Securitization” all about?

Typical definitions are quite complicated to comprehend. So we are attempting to explain the concept using a simple example. We’ll be glad if our explanation helps you to get, at least, a conceptual understanding of this term.

Let’s say Raju has a large house worth Rs. 100 crores in a posh locality. He decides to give his house on rent to a wealthy family. They agree to pay him Rs. 5 lacs every month.

All of a sudden Raju is in need of money. He approaches his friend Ramesh and offers his house. Ramesh agrees to buy out the house but does not have all the money for the same. So he approaches a bank for a loan of Rs. 80 crores.

Although the bank provides Rs. 80 crores to Ramesh as a home loan, the bank itself decides to reduce its risk by passing on risk to interested investors. For doing this it divides the asset (the home loan is an asset for the bank) in smaller parts called securities by the process of securitization.

Now let’s understand how does it go about securitizing the asset?

The bank first consults a rating agency and gets the home loan rated. Since the house is located in a posh area, its condition is immaculate, all papers are clean and the tenants are good people paying their rents regularly, the rating agency gives a high rating.

Now the bank armed with the rating, divides the Rs. 80 crores home loan into 10, 000 papers (documents) of Rs. 80, 000 each. This process of dividing one large asset document or paper into smaller and affordable units is known as securitization.

Securitization as you’ll see makes the asset more liquid and available to the retail customers who individually would not be in a position to own the asset but who can gladly own the asset collectively.

After securitization the bank starts to market the units (securities) to retail customers as an alternate asset class which is not only backed by a valuable asset but also one that is rated by a rating agency. The bank thus recovers the Rs. 80 crores from retail investors (in fact if the demand is high the bank may even be able to recover more than the Rs. 80 crores and make an additional profit).

Thus, the risk which was earlier owned by a single entity is now with 10, 000 retail investors. Retail investor is thus lured into this offer due to asset and rating backing of the securitized paper.

To reiterate this splitting of asset into smaller units is what is commonly referred to as “securitization”.

This of course is a conceptual explanation. In a real life scenario, there would be several other complexities involved in this process. But the objective of this explanation is to provide readers with a conceptual clarity and hence we have kept the explanation simply simple.

Hope you have understood the concept of Securitization Please give us your feedback at professor@tataamc. com

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