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Securitization Process

Securitization in relation to structured products is the undertaking and pooling of bundles of debt which may include commercial mortgages, residential mortgages, and other debt obligations such as credit cards. It is under the branch of structured finance which relates to the management of leverage and the risk and serves as a very large source of financing across economies around the world. Securitized products such as Mortgage-backed securities allow investors to get paid from principal and interest cash flows which are usually collected from underlying debt and collateral and then paid back based upon the capital structure of the the security, whether it be in relation to mortgages and real estate, or any other debt products that can be financed in this way. Securitized products also provide a huge source of financing in economies and funds more than 50% of US household debt. The securitization process follows a waterfall model which is divided into tranches and pays investors based upon the level of riskiness their investments hold. Securities with lower risk are usually paid first and are considered investment grade investors which invest in bonds that usually have a “AAA rating” with subprime securities having lower credit ratings such as “BBB”.

In order to originate and structure these products, the securitization process employs a special purpose vehicle technique so that a separate company is created in which the securitized debt in formed as a limited liability venture, so it can carry large mortgages with varying levels of riskiness without having to deploy this capital on their own balance sheets.

COVID-19 Implications

In light of the COVID-19 pandemic, structured products saw a major increase in their prices including products such as Commercial Mortgage-backed securities, Residential Mortgage-backed securities, Collateralized loan obligations, and other esoteric asset backed securities due to the federal reserve significantly lowering interest rates. More significantly, Bonds and the credit market react this way due to being contra-cyclical with interest rate decreases having the opposite affect on bond prices. In recent times however, in order to control extremely high levels of inflation, the fed has raised interest rates leading to the price of the bond marker and the structured products within them falling significantly, however paying a much higher rate of yield to investors like asset managers, hedge funds, and investment banks who buy these products.

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