Final answer:
Securitization involves converting illiquid assets like loans into marketable securities. This allows banks to manage risk and free up capital for lending, but may encourage riskier lending practices. The process was central to both spreading risk and contributing to the 2008-2009 financial crisis.
Step-by-step explanation:
Securitization means that illiquid assets are pooled and made into marketable securities. This financial process provides several advantages. For example, if a bank is concentrated in local loans and the local economy falters, the bank could face significant financial risks. By selling these loans and purchasing a diversified mortgage-backed security, a bank can spread its risk across different regions. Additionally, for local homebuyers, securitization means that a bank does not require as much capital on hand to extend a loan since the loan will likely be sold and turned into a security, thereby freeing up funds for additional lending.
However, there is a notable downside. Banks that plan to sell the loans may have less incentive to screen borrowers thoroughly, leading to riskier lending practices such as the infamous "subprime loans." These loans were known for attributes like minimal down payments and less verification of borrower income, culminating in the NINJA loans, which contributed to the 2008-2009 financial crisis. Securitization played a role in this crisis as it enabled the bundling and sale of these high-risk loans as securities, spreading and obscuring the risks they posed.