What it is:
Commoditization refers to a good or service becoming indistinguishable from similar products.
How it works (Example):
An item should satisfy 3 conditions to be considered a commodity: 1) it must be standardized and, for agricultural and industrial commodities, in a "raw" state; 2) it must be usable upon delivery; and 3) its price must vary enough to justify creating a market for it.
Most people understand commoditization when it comes to corn, soybeans, cotton, or other raw materials (i.e., the idea that "it's all the same."). But financial instruments can be commoditized, too.
For example, in the past, every mortgage issued was considered unique -- that is, the terms and conditions of the loans were specialized according to the borrower and the property. But over time, the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (Ginnie Mae) commoditized mortgages by offering to buy almost any mortgage that met a set of conforming standards. By creating a massive market for mortgages, these agencies encouraged banks to streamline and standardize the types of mortgages they offer to consumers.
Why it Matters:
Commoditization makes an asset easier to trade and encourages a more liquid market. In some cases, this can add volatility to the price of the commoditized entity, but in other cases it can spur economic activity.
In the case of the mortgage industry, commoditization allows lenders to receive cash from selling conforming mortgages to government agencies and government-sponsored entities. The banks can then use the cash to issue more loans, theoretically spurring economic growth.