Securitization

A bank or other lender that has made many loans can sell them to a special company set up for the purpose. That company finances the purchase by issuing securities to investors, who receive payments from the interest and principal paid by the original borrowers.

Securities backed by mortgages are called mortgage-backed securities. Those backed by other assets, such as car loans, credit card balances, student loans or equipment leases, are called asset-backed securities. The securities are often divided into tranches with different levels of risk and return.

For example, a bank might bundle thousands of car loans into a pool and sell securities backed by that pool to pension funds and insurers. The bank receives cash it can use to make new loans, while investors earn returns from the borrowers' payments.

Securitization can make credit more widely available, spread risk across many investors and give investors access to new types of assets. However, it can also weaken lending standards if lenders sell loans on rather than keeping the risk themselves. Securitizations of poor-quality US mortgages were central to the 2008 financial crisis, leading to reforms such as requirements for issuers to retain part of the risk.