Street-Smart Guide to Securitization: The Basics

What is securitization?

Securitization is simply borrowing money from the public (through Wall Street) to complete a financial transaction.  The "financial" transaction, in turn, is a mere buy/sell transaction in which the buyer does not have enough money to pay cash for the item being sold, so a third party is needed to put up the money ("finance" the purchase). That third party, however, does not put up its own money, but borrows it from the public through Wall Street (and calls such borrowing "securitization") to facilitate the transaction and make a profit.

Let's say Joe P. Buyer what's to buy a house for $100,000.00, but only has $10,000 in cash.  Joe might go to the Bank (or the Bank's agent) and ask to borrow the missing $90,000.00 to complete the purchase.  The Bank will say, well, I'll lend you the $90K, but you'll have to repay it with interest, by regular monthly payments, and within 30 years at the max... Pretty simple.

Then, the Bank says: "well, why should I give this Joe $90K of my own money? After all, Joe's middle name is Poor (that's what the 'P' stands for), plus, as a bank, I'm already overextended out of my pants! I will just find a bunch of the same 'Joes' (but who are already retired, etc.) through Wall Street, and use their money.  They will be the investors.

I will tell the investors I have a bunch of Joe P. Buyers who will work their butt off for the next 30 years to generate income and make regular monthly payments to me.  I will then take those investors' money and give them back (or their 401k fund managers) a piece of paper called a 'bond' in return. The bond (also called a 'debt instrument') will be a promise (like a promissory note) to repay to the investors their money with interest (say, at 5%)."

The Bank continues: "out of the money so raised from the public, I will give Joe P. Buyer his $90K needed to complete the purchase, and will put him in a sub-prime loan at 9%. I will keep the difference in the interest rate ('spread') for as long as Joe pays. Also, I will get my appraisers to inflate the appraisals in the entire neighborhood so that Joe buys a house for his $100K that is actually worth $60K.  That way I will charge higher fees for all the house purchases across the board, including Joe's. I will do the same with the 'appraisers' who rate my bogus bonds (rating agencies), so that the public investors part with their money faster."

The Bank continues: "yeah, I know that Joe may default on an overpriced loan for an overpriced house in spite of his hard work, but who cares?  I raised the money from the public, so let those public investors deal with the problem if Joe defaults.  After all, I told them that there are risks and that past performance does not guarantee future results.  Additionally, the government guarantees over 50% of the loans. So if all hell breaks loose, the same Joes, as Buyers on one side and as Investors on the other, will pick up the tab as taxpayers.  Whatever happens, I, as a bank, can't lose."

Isn't it a great system to call yourself a bank whether or not you are broke, to call borrowing money "financing" and "securitization," and then duping just about every player in the financial system by functioning as a transaction broker/middleman and scuttling away with all the profit...