Academic journal article Journal of Real Estate Portfolio Management

Securitization Demystified

Academic journal article Journal of Real Estate Portfolio Management

Securitization Demystified

Article excerpt

Executive Summary.

The concept of securitization can be standardized by focusing on its effect on investment characteristics rather than its effect on assets. The effect on investment characteristics impacts asset value. Although recent advances in securitization technology apply to the securitization of fixed-income assets, securitization has long been the primary investment banking function. Wide variation in securitization methodology reflects wide variation in asset investment characteristics.

Financial engineering has developed into a complex and sophisticated subject in the last fifteen years, and securitization is almost certainly its most exciting and dynamic area. This represents a major shift in perspective within the financial community: although the concept of a financial security has been familiar to investors for more than 150 years, the concept of securitization was arcane and unfamiliar to most financial professionals as recently as twenty years ago.

Securitization has become a financial buzzword in the last fifteen years, yet most investors and investment managers find it difficult to describe precisely what securitization is. Most are also unable to distinguish the actual investment attributes of securitized investment products from the advertised attributes.

These issues are more relevant today than in the past because of the basic tenet of Modern Portfolio Theory (MPT): in reasonably efficient liquid markets, diversification lowers investment risk more than it lowers investment return. It follows from the basic tenet that portfolio managers generally-although not always-improve the risk/return profiles of investment portfolios by diversifying the portfolios to the maximum feasible extent.1 As a result, highly diversified portfolios have come to serve as benchmarks throughout the investment industry for evaluating the on-going performance of investment managers.

Investment regulators, courts and legislators have embraced the basic tenet of MPT as a guiding principle that financial fiduciaries ignore at their peril. For example, in the extreme case of pension fund regulation, fund fiduciaries can be held personally liable for any suboptimal performance of pension fund investments if they fail to ensure strict adherence of the pension fund investments to the basic tenet of MPT.

It follows that investment bankers have a guaranteed demand side clientele in markets for any new investment banking products that securitize assets with well-identified investment characteristics not replicated by existing financial products. This ensures the continuing attention of the financial industry to securitization research and applications. In particular, the financial industry-and the corporate sector in general-has incentive to comprehend the meaning and scope of the securitization concept.

One problem with new concepts is that the original definition may not constitute the best description for purposes of fostering related innovations. In this case, the first definition was a working description of the process for generating mortgage-backed securities, which is essentially how securitization is still perceived by many practitioners and academics. This is a highly significant and visible application in the current economy, which may partially explain why the original working definition has not been replaced with a definition that is more conceptual, despite the boost to new product design that could result.

The present study introduces a definition of securitization that shifts the focus of the process from its effect on specific assets to its effect on the specific investment characteristics of assets in general. This shift achieves two disparate objectives: it provides a unifying framework for several types of financial applications that were not viewed previously as related, and it enables an economic connection to be established from the effect of securitization on assets to the effect of securitization on asset value. …

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