Historically, banks were almost entirely reliant on deposits to raise funds. But in the past few decades banks have found alternative sources of funding. One of those sources is securitization.

Securitization is the process of bundling illiquid financial assets and then creating securities that are backed by the cash flows from the pool of financial assets. The financial assets can be packaged in such a way that each bundle of assets has a different risk profile.

Many banks securitize mortgages, for example, which creates a mortgage-backed security (MBS). A mortgage-backed security is a financial instrument that derives its cash flows from a pool of mortgages. You can have residential mortgage-backed securities (RMBS) or commercial mortgage-backed securities (CMBS).

Mortgage-backed securities are a special type of asset-backed security (ABS) where the underlying asset is a mortgage. Asset-backed securities can also be backed by credit card receivables, car loans, student loans, equipment loans, etc.

Valuing mortgage-backed securities and asset-backed securities is difficult because the cash flows are uncertain. This is due to:
• interest rate risk
• prepayment risk
• default risk

Some banks use Monte Carlo simulations to estimate the value of MBS or ABS.

Securitization has several advantages:
• It removes risky, illiquid assets from the bank’s balance sheet
• It reduces the bank’s regulatory capital requirements
• It raises cash and increases liquidity so the bank can underwrite more loans

The investors buying the securities benefit from being able to invest in mortgages (or credit card debt, car loans, etc.) without having to originate or service the mortgages.
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