In securitization, financial professionals take illiquid assets and convert them into interest-bearing securities. This process started in the 1970s and requires two steps. The first features asset holders determining what in their portfolio they want converted into securities. They then put these items into a “reference portfolio,” which is bought by a new entity created exclusively to purchase the “asset pool.” The entity funds this project by selling interest-bearing securities to capital market investors who acquire money from the cash flow earned by the reference portfolio.
Securitization is particularly popular in the mortgage industry. In this process, a financial institution creates mortgages secured by claims against the property. The firm combines many of its mortgages into a “pool” that can be used as collateral for a mortgage-backed security. At the end of this process, the mortgagor receives a new security backed by its own assets. Many firms will sell this security to companies involved in the secondary mortgage market, thus transforming otherwise illiquid assets into liquid investments.