Securitization is the transformation of financial assets into securities. Securitization is used by financial entities to raise funding other than what is available via the traditional methods of on-balance-sheet funding.
This device that originated in the mortgage markets in the USA in 1970 and became popular in the 1980s as banks would try to take advantage of regulatory arbitrage possibilities. Regulatory arbitrage existed in that the regulatory capital requirements for securitized assets were much lesser than those in case of assets on the balance sheet. The development of accounting standards – FAS 77/ FAS 125 in the USA also greatly contributed to the development of securitization, by generally enabling off balance sheet treatment even if there were significant recourse obligations and retention of residual returns by the sellers. Thus, off balance sheet became easy way of doing banking business whereby banks will keep more assets off the balance sheet than on it.
During the period 2002-2006, securitization grew very rapidly, as subprime mortgage lending picked up. Bouyed by the low default rates with increasing housing prices, subprime lenders picked up excellent spreads, parcelled the loans in the market, and report handsome profits with limited risks. All this collapsed in 2007 as the subprime crisis set in. Several people blame securitization for the crisis – while the jury is out on this question, it is surely clear that leverage levels went to inordinate levels due to securitization.
Securitization appears to be reviving during 2012- 2013. It is apparently growing faster outside of USA than in USA lately. Securitization has now re-emerged as a refinancing instrument and is even being used by non-traditional entities such as furniture rental startups.