Securitization occurs when a loan or pool of loans is transferred into a trust, and the trust then issues bonds that are rated by the large ratings agencies and sold in the bond market. The loans most often associated with securitization are home mortgages, and the bonds sold by these trusts are called mortgage-backed securities (MBS). The individual mortgages are secured by homes and property of the borrowers. The trust holds these collateralized mortgages as collateral for the bonds that these trusts issue.
Years ago, a potential homebuyer applied for a mortgage at a bank or financial institution. The financial institution that approved and funded the loan kept the loan on its own balance sheet until the borrower repaid it. Today, that financial institution is called the “originator” of the loan. The originator of the loan sells the loan to a third party. Some of the well-known third parties are Ginnie Mae, a government agency, Fannie Mae, a government-sponsored entity, and Freddie Mac, also a governmentsponsored entity. The originator may also sell the loan to private sector financial institutions. The third party pools the mortgage with other mortgages and sells the payment rights to investors. The process of packaging a bundle of mortgages and selling the package to investors is called “securitization.”
A bundle of packaged mortgages might take the following form. Suppose an originator has negotiated 500 mortgages averaging $200,000 each. The mortgages are all scheduled for repayment over 30 years at a fixed interest rate of 7 percent. This $100 million bundle of mortgages can act as collateral for 10,000 bonds. Each bond is worth $10,000, matures in 30 years, and pays 6.5 percent interest. Each of these bonds is called a mortgage-backed security (MBS). The interest earned on the bonds comes from the mortgage interest payments on a pass through basis. Payments made on mortgage principals go toward paying down the principal on the bonds. The mortgages charge slightly higher interest than the bonds earn because intermediates charge fees for their services.
From an investor point of view, the MBSs issued by Ginnie Mae, Fannie Mae, or Freddie Mac are safer investments than those sold by private financial institutions, which are more often based on mortgages negotiated with less credit worthy borrowers.
Private financial institutions structure securitization to meet risk-reward preferences of various investors. In the context of securitization, subordination means that issued bonds carry different bankruptcy priorities. In case of mortgage default, the subordinated classes of bonds bear the first losses. A securitization may involve up to six layers of subordination (Rosen, 2007). The senior bonds have priority in bankruptcy. The first defaults are allocated to the lowest layer of subordination. There are two other methods for controlling risk. One is overcollateralization, and the other is widened interest rate spreads between the bonds and the underlying mortgages.
The packaging and sale of an MBS is not necessarily the end of the securitization process. Bundles of MBSs are also packaged and sold. Bonds backed by securitized bundles of MBSs are called collateralized debt obligations (CDOs). CDOs can be backed by MBSs or other CDOs. Similar to the CDO is the structured investment vehicle (SIV). SIVs issue short-term and medium-term debt, whereas CDOs issue long-term debt.
SIVs are also backed by bundles of assets such as MBSs or CDOs.
In 2008, the process of securitization came under scrutiny in the United States. The originators of mortgages had little incentive to be concerned about the prospects for repayment. The credit rating agencies, such as Moody’s and Standard and Poor’s, overrated the credit worthiness of MBSs. The mortgage default rate rose
to high levels. The price of houses sank, undermining the value of the collateral backing the MBSs. Investors in MBSs discovered themselves holding illiquid assets without a measurable market value. Freddie Mac and Fannie Mae saw their stock continue to plummet in 2008 as MBSs lost all credibility. Rather than let two institutions key to home financing go under, the United States Treasury nationalized Freddie Mac and Fannie Mae. The boards of directors of the two institutions sold an 80 percent stake in each entity to the United States Treasury for 0.001 cent per share (Jenkins, 2009, p. A13).
See also: U.S. Financial Crisis of 2008–2009
Jenkins, Holman W. Jr. “Rethinking the Fan and Fred Takeover.” Wall Street Journal (Eastern Edition) March 4, 2009, p. A13.
Penner, Ethan. “The Future of Securitization.” Wall Street Journal (Eastern Edition), July 10, 2008, p. A15.
Rosen, Richard J. “The Role of Securitization in Mortgage Lending.” Chicago Fed Letter, The Federal Reserve Bank of Chicago, Essays on Issues no. 244, November 2007.