Securitization: The Making of an Exchange Traded Derivative
The modern financial system is all about innovation. The system and its proponents believe that financial jugglery can solve almost any problem. With this belief in mind, modern day America witnessed the rise of a new asset class. This new asset class was based on real estate. However, unlike real estate this was not sold on the streets. This new asset class was traded on stock exchanges across America and the world. Also, this new asset class did not have a big ticket size like real estate does. Anyone with a few dollars in their pockets could purchase and sell these securities that mimicked the return on real estate markets.
This metamorphosis of real estate from a capital intensive illiquid asset to a small denomination highly liquid asset class took place through a process called securitization. In this article, we will discuss this process in more detail.
The Problem with Real Estate: Lack of Liquidity
During the early 2000s real estate was providing highest returns in the American market. Banks and investors had the opportunity to make more and more mortgage loans, benefit from the prevailing low interest rates and make a good return in the process. However, there was a problem with real estate. Loans once made would not be repaid for three decades. Banks had to hold these loans on their books. The holding of these loans would block up precious capital and banks were wary of this.
This was when the need was felt to use some financial magic to transform a highly illiquid asset into a highly liquid one.
The problem was that banks were forced to hold these assets on their books. Even though the returns were lucrative the banks still wanted more. On the other hand, retail investors and pension funds would be glad to hold these investments for years. The rate of returns provided by real estate was more than that provided by bonds and as such it was a favorable investment. Hence, a new solution was found out. This solution was called securitization.
The process of securitization has provided a method to created exchange traded derivatives from illiquid assets. However, it still needs to be refined to get rid of the negative consequences.
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