Illiquid assets

GLOBAL INVESTOR 1.15 — 60 The bank then bundles a number of home loans –
How does securitization work?
The following illustrations show how loans can be turned into tradable securities:
1
When a bank grants a mortgage to a borrower,
the bank earns an interest income.
2
both risky and less risky – into a pool of mortgages.
3
The bank places these pools of mortgages
into a trust. The trust then sells bonds, which
are secured by the mortgages.
4
The return and the risk of the bonds depend on the
riskiness of the mortgages which secure the bonds.
To create different risk categories of bonds, the
bank divides the mortgages into risk groups called
tranches. Rating agencies such as Standard &
Poor’s or Moody’s then often rate the tranches to
reflect the risk of default. The bank is required by
regulation to keep a tranche of the highest risk
category.
5
The newly created bonds are sold to private and
institutional investors and even central banks.
Thus, the bank has earned a fee for originating
mortgages, but sold the risk and rewards of these
mortgages to investors through the process of
converting them into tradable securities (bonds).