What is meant by securitization of loans?

Securitization of loans means a bank or lender, such as an NBFC, converting its loan portfolio into securities or units and selling these units to investors. For example, take Bank A. It has a portfolio of loans of Rs 100. It has given these loans to its customers. Now it divides this portfolio into 100 units. Each unit represents 1 unit of the portfolio. It then sells these units or securities to investors. The interest & principal that is paid on the loans in the portfolio will now go to the investors who have bought the securities of the bank’s loan portfolio.

The purpose of securitization of loans

What has the bank achieved by securitizing the portfolio of its loans? It has transferred the credit risk from its balance sheet to the investors who bought the securities. Credit risk is the risk that the customers to whom it has given the loans will default on their interest and loan payments when they become due. The bank gets immediate cash from securitizing the loan portfolio and selling them to other investors. The credit risk is now transferred to the investors who have bought the securities.

What do investors in securities issued against loans get?

What do the investors who have bought the securities against the loan portfolio of the bank, gain? The investors have taken the credit risk by buying the loan backed securities from the bank. To compensate for this credit risk, the bank will sell them the units at a price lower than the face value of the unit. In our example, the face value of each unit is Rs 1. So the investors will buy it at a price that is less than Rs 1 – say 90 paisa. If the borrowers pay their principal and interest in full, then investors will make a profit on this investment. If they default, then investors may face a loss.

Securitization of any type of loan can be done

Securitization of gold loans, business loans, personal loans or any type of loan can be done by banks or lenders. The term securitization came into wider notice when 2008 global financial crisis happened. The crisis started with large scale defaults on mortgage backed securities (MBS) in United States. MBS are securities issued against home loan mortgages.