Final answer:
Securitization is the process of pooling various loans and selling the consolidated cash flows as securities, not splitting a single loan into smaller loans. It provides benefits by diversifying risk and facilitating loan issuance but also potentially encourages the issuance of riskier subprime loans.
Step-by-step explanation:
Securitization refers to the financial practice where certain types of assets are pooled together so that they can be repackaged into interest-bearing securities. This statement is false as it describes securitization incorrectly. The correct explanation for securitization is that it's not about splitting a single loan into several smaller ones; instead, it's about pooling various loans (such as mortgages, car loans, or credit card debts) and selling the consolidated cash flows as securities to investors.
Securitization offers benefits to banks by diversifying risk. If a bank has a concentration of loans in one geographic area, selling these loans and buying a mortgage-backed security that includes loans from various regions can help mitigate the risk of exposure to a local economic downturn. For homebuyers, local banks do not need to have extensive funds on hand to issue loans, as they intend to sell these loans as part of a financial security.
However, there is a substantial downside to securitization. When banks plan to sell loans, they may be incentivized to care less about the borrower's ability to repay, leading to the increase in subprime loans, which have risky features such as low down payments and minimal income verification. This was notably problematic during the mid-2000s housing bubble, where such practices contributed to the financial crisis.