What are Securitized Debt Instruments?
Securitized debt instruments are financial securities that are created by securitizing individual loans (debt). Securitization is a financial process that involves issuing securities that are backed by a number of assets, most commonly debt. The assets are transformed into securities, and the process is called securitization. The owner of the securities receives an income from the underlying assets; hence, the term asset-backed securities.
Securitized debt instruments come with various advantages over conventional forms of investing and are more valuable to a portfolio. One of the most common types of securitized debt is mortgage-backed securities. Securitized debts can lower interest rates and free up capital for the bank, but they can also encourage lending for reasons other than making a profit.
Pros and Cons of Securitized Debt Instruments
One of the main advantages of securitized debt instruments is that they allow banks to offer bonds at different levels of risk. The bonds can be divided into risk tranches where one class of the bonds receives less money but will not suffer any consequences should the homeowner default on the loan payments.
In addition, a second bond class will receive a higher payment but will face a loss in the case of foreclosure of the home. The different bond class offerings allow investors to choose the level of risk they want to invest in.
One drawback of securitized debts is that they create a complex financial system. When a securitized debt is pooled and sold, it becomes difficult to identify who owes money and to whom they owe it to. It results in economic problems that can affect the entire financial system.