Financial Intermediaries: Securitizers

Financial intermediaries perform an important market function when they securitize assets by buying them, placing them in a pool, and selling ownership securities in the pool. Through securitization, new financial products are created that enable investors to indirectly own assets they would otherwise not be able to purchase. Residential mortgages are one type of asset that are frequently repackaged by banks and investment firms and sold as securities. The payments from the underlying assets are passed through to investors regularly.

Why do you think residential mortgages are a logical choice for securitization?

Incorrect.

Correct!

Investors that are not big enough to obtain the diversification benefits by purchasing a large number of mortgages can turn to mortgage-backed securities for this purpose. The default and repayment characteristics are more predictable for a larger pool of loans than a small one, suggesting that these securities are easier to value and trade, which increases market liquidity. Investors have an array of high-return-producing investment options available, so that is not the reason why mortgages are a commonly securitized asset.

Mortgage banks pool loans from originating lenders. Typically, these mortgages are included in the bank's assets, and the securities they create appear as liabilities. However, a corporation or trust called a __special purpose entity__ or __special purpose vehicle__ can be formed to buy the loans and issue the securities. This allows the intermediary, the bank, to avoid including the assets and liabilities on its balance sheet. In what way do you think special purpose entities benefit investors in the market for securitizations?

Incorrect.

Exactly!

Financial intermediaries do not only securitize mortgages. They also repackage such things as auto loans and bank loans, and the instruments they create are referred to as _asset-backed securities_. Regardless of the securitization they are creating, intermediaries frequently develop classes of securities called _tranches_ that have different rights to the asset pool's cash flows. Tranches that are senior have predictable cash flows and junior tranches are relatively risky. The harder it is to predict the investment's cash flows, the tougher it will be to value it.

If your manager were to ask you whether the most senior or junior tranches of an asset-backed security offer the highest return potential, how might you respond?

Incorrect.

That's right!

The more senior a tranche is, the greater will be its chances of having a predictable cash flow stream, making the task of assigning it a valuation much easier. Less risk generally translates into lower returns, so the senior tranches will not have the greatest return potential. Junior tranches are given a disproportionate amount of the pool's risk, so their cash flows are much less predictable. Valuations for junior tranches will be lower, offering greater potential for disproportionately higher, and lower, returns.

To summarize: [[summary]]

With the assets off the intermediary's balance sheet, they will not be caught up in a bankruptcy proceeding. The special purpose entity will function as a stand-alone company that exists for the sole purpose of passing through payments to investors. Their benefit does not lie in the ease with which they are understood.

Because other types of securities, such as stocks and bonds, may not offer satisfactory returns for investors

Because these securities offer investors exposure to the housing market without having to purchase properties or service individual loans

Special purpose entities are more easily understood, allowing for better analysis of the investment

Special purpose entities protect investors' interests if an intermediary were to declare bankruptcy

Senior tranches offer the greatest return potential, since they are the most desirable tranche for investors

Junior tranches have subordinated claims to an asset pool's cash flows, so the cost to buy them should be lower and the potential return higher

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