Explain the mechanism of Debt Securitization and its advantages?
Answers
Securitization refers to the process of converting debt (assets, usually illiquid assets) into securities, which are then bought and sold in the financial markets. If you notice, the first line calls debt as an asset. This is because debt is a liability for the borrower, but for the lender, it is an asset. One can trade securities (created from securitization) similar to stocks, bonds and futures contracts.
In simple words, securitization is a process where a financial company combines several of its assets into consolidated financial instrument or securities. Then, financial companies issue these securities to the investors, who earn interest.
Such securities are a safe bet as long as the homeowners, whose mortgages were pooled, make their interest payment on time. But, this is not always the case. The 2008 financial crisis is a good example of it.
One disadvantage of securitization is that it may encourage lenders to loan money to high-risk people. This is because, after the securitization, the lender has no money at stake as the risk transfers to the investors.
A similar thing h
Another disadvantage of such securities is that it becomes difficult for the investor to assess the risk in the security. Since ABS consists of many debt instruments, like mortgages, credit card debt, auto loans and more, it can sometimes make it hard for the investor to evaluate the risk properly.