Glad you asked. Let’s start with the basics of securitization, which is probably one of the most important developments in the financial world. Securitization, as you might have guessed, happens when you take a pool of assets that earn interest, like car loans, mortgages, or credit card debt, and package it into securities.
For example, Wall Street might take $800 million worth of credit card debt from 80,000 different people and package that into credit card asset backed securities (ABS). Whoever invests in this ABS gets paid dividends from the credit card borrowers as they pay their interest and principal. Wall Street gets a fee for overseeing this whole process, and the investor gets a yield-earning asset. Nice! For the most part, the credit card borrowers have no idea of what’s going on, as long as they keep making their payments
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Capital One takes a big pool of credit card debt, securitizes them into credit card ABS, and sells them to other people, like banks, pension funds, hedge funds, and insurance companies. The ABS investor gets the right to the yield, and Capital One often retains the rights to the excess cash flow (or any cash flow left over after the ABS investors are paid). The same process holds for mortgage loans in Countrywide’s case.
The key here is that Capital One only retains a tiny portion of the ABS, so its credit risk is basically gone. This frees up its equity so it can go out and make more credit card loans and then securitize them again. Each time Capital One securitizes loans, it gets the rights to more residual cash flow.
Wal-Mart wants to sell its inventory as quickly as possible, because it earns a small margin on each item sold, and the more times inventory is turned over (sold), the more profit Wal-Mart makes. Similarly, financial service firms like Countrywide also want to sell their inventory of loans several times — via the process of securitization — to improve their returns.
