Financial Risk Manager Part 1

Explanation

Securitization is the process of pooling various mortgage loans into a larger pool, dividing this pool into smaller units, and then selling these units as financial assets to investors. This process is primarily carried out by large banks and financial institutions with the primary objective of transferring the risk associated with these loans to the market. By doing so, these institutions are able to mitigate the potential losses that could arise from defaults on these loans. Furthermore, the process of securitization allows these institutions to free up capital that can be used for issuing more loans, thereby facilitating a continuous cycle of lending and securitization.

Why other options are incorrect:

Choice A is incorrect because securitization is not merely the process of securing a mortgage with a security or collateral which the lender can use in case of default. This explanation confuses securitization with the concept of collateralized loans, where an asset (like a house in case of a mortgage) serves as security for repayment.

Choice B is incorrect because while it's true that securitized financial assets are created from cash flows of underlying assets such as mortgages, loans, auto loans and bonds, this explanation misses out on key aspects like pooling these assets and selling them to investors to transfer risk.

Choice D is incorrect because while setting up a bankruptcy-remote entity (like a Special Purpose Vehicle) is part of the securitization process, it's not the complete definition of securitization itself. The core concept involves the pooling and repackaging of assets into securities.