Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Commoditize

What it is:

Commoditize means to homogenize a product or security.
 

How it works (Example):

To be considered a commodity, an item must satisfy three conditions: It must be standardized (and for agricultural and industrial commodities, it must be in a "raw" state); it must be usable (i.e., have a shelf life) upon delivery; and its price must vary enough to justify creating a market for the item.

When a product becomes indistinguishable from similar products, it is considered commoditized. Most people understand the concept when it comes to orange juice, potatoes or other raw materials (i.e., the idea that "they're all the same.") But financial instruments can become commoditized, too. One example is mortgages. In the past, every mortgage issued could have been considered unique -- that is, the credit risk of the borrowers, the value of the real estate, and even the terms involved might have been very specialized. However, Federal National Mortgage Association (Fannie Mae), the Federal National Mortgage Association (Freddie Mac), and other agencies have helped commoditize mortgages because they buy them from lenders and use them to create mortgage-backed securities (which they then sell to the public). Their act of creating a market for mortgages has encouraged banks to streamline and conform the types of mortgages they offer in order to then sell those mortgages to Fannie Mae, Freddie Mac, etc.

Why it Matters:

When we commoditize a security, we make it easier to trade and thus more liquid. In some cases, this can add volatility to the price of the commoditized entity, and in other cases it can spur economic activity. In the case of the mortgage industry, commoditization allows lenders to receive cash from selling their mortgages, use that cash to issue more loans, and therefore spur economic growth through more home purchases.

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