When making investments in the stock market, it’s an excellent idea to get a good handle on common terms used by market participants and professionals. Familiarity with these terms allows you to research potential investments and understand the workings of the stock market with less risk of confusion and misunderstanding. It’s easy to mix up “security” and “securitization,” but you should know what these terms mean before you dive in to the next stock or bond prospectus.
The term "security" essentially means an investment. In purchasing a security, you transfer money to another party and in return receive certain ownership rights and financial claims that the security represents. Common stocks, for example, are one form of security, as are corporate bonds or U.S. Treasury bonds. In addition, a partnership in a company is considered by law to be a security. A security may or may not entail a written contract or an interest in tangible goods.
Security has a second and very different meaning: property or tangible goods a borrower offers to guarantee that he will repay a lender. A house, for example, provides security for a mortgage; if the loan goes into default, then the lender has the right to repossess the house. Pawnshops also deal in secured loans; the property you offer as security is subject to seizure by the shop unless you repay the loan it extends. Loans can be secured or unsecured; a common form of unsecured loan is a credit card account. Lenders who make unsecured loans are risking a total loss of the money lent; as a result, unsecured loans carry a higher rate of interest.
Securitization is the process of turning a financial asset, such as a loan, into a security. Mortgage companies, banks and brokerages securitize home loans by bundling them together and then selling them to investors, who gain a stream of income from the mortgage or loan payments made by multiple borrowers. Auto loans, student loans and credit card accounts may also be securitized in this way.
Advantages and Risks
The securitization of assets offers several advantages to loan originators. The securitization process allows them to convert their loans to cash and transfer their risk in the asset to individual investors. It allows them to reinvest that cash into new loans or a different asset altogether. Investors must be aware of the risks of securitized assets, including the possibility that borrowers will repay the loans early (ending the income stream) or default altogether, an action that renders the securitized loan worthless.