Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly.
Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities.
- Borrower can either go directly to a bank or through a mortgage broker to get a loan.
- Bank, after due diligence, originates the loan.
- The loan would be either an Agency eligible loan or a Non‐Agency Loan.
- The bank at that point has the option to either put that loan in its own portfolio or sell it.
- If the bank decides to sell the loan then the process of getting it off their books is different depending onthe type of loan originated.
For Agency eligible loans: The loans are sold to the Agencies ( Fannie Mae, Freddie Mac or Ginnie Mae).
When the Agencies buy the loans from the banks they have the option to put some loans directly intotheir portfolio (as raw loans) or securitize them and sell them. Ginnie Mae as yet cannot portfolio them.
The Securitization Process can take 3 basic shapes:
1. The Agencies group similar types of loans into large pools, put their guarantee on it, and can sellthem off (with the help of Wall Street) as Pass‐Through securities (also called TBAs).
2. They may occasionally instead also decide to break up the interest and principal payments of theselarge pools and sell the two cash flow streams as separate bonds (similar to Treasury Strips). Thisdepends on demand from investors as relayed to them via Wall Street.
3. They can also use the large pools to create bonds called CMOs (Collateralized Mortgage Obligations)with the help of Wall Street. The bonds are also referred to as “tranches” in a CMO deal and canvary in maturity, coupon and prepayment protection. Wall Street takes the 30 year stream of cashflows from a pool of mortgages and structures the type of bonds (tranches) that it knows it can sellto investors.
The securitized agency pools are direct obligations of the Agencies while the Strips and CMOs are set upas bankruptcy remote Trusts. The assets of the Trusts are the pools and the liabilities are the bonds.Whenever legal entities are set up lawyers and accountants get involved and so they are an integral partof the process. Since the Agencies have an implicit ‘AAA’ rating their securitizations do not involve therating agencies.
For Non‐Agency Loans: The Non‐Agency Loans are securitized and sold as CMOs with the help of Wall Street Broker/Dealers.
The bonds (tranches) in a non‐agency CMO deals are also structured keeping investor demand in mind.
The CMO trusts are also set up just like the Agency CMO trusts except in this case they carry the name ofthe issuer (like JPMorgan Chase) or of a Wall Street Dealer (like Goldman Sachs).
One glaring difference between Agency CMO deals and Non‐Agency CMO deals is that the bonds in aNon‐Agency CMO deal need to be rated usually by at least 2 rating agencies.
A Non‐Agency CMO deal will have bonds ranging from ‘AAA’ down to junk. The ‘AAA’ segment of thedeal is tranched out like an agency deal while the below ‘AAA’ bonds (called subordinated bonds or subsfor short) are left as pro‐rata bonds which pay down like collateral or absorb losses should there be any. So, the bank gets its money back with some profit by offloading its loans either to the Agencies or through CMO deals with Wall Street’s help.
The Agencies further follow their own securitization mechanisms to gettheir money back by selling TBAs or CMOs also with Wall Street’s help. Ultimately, it’s the end investor thatis financing the loan to the borrower and paying for the fees/profit that this whole securitization mechanismentails.
This would include paying the mortgage brokers, the Bank/Lender, the Agencies, Wall Street,lawyers, accountants, the Rating Agencies and even the Prospectus Printer and Fedex.
How did we get into trouble?
Everybody is talking about “Bad Loans” and loose lending practices. How did that come about ? First, in2003 we got down to 1% Fed Funds and so we had a really low interest rate environment. Second, in 2004,the SEC allowed Investment Banks to determine their own risk limits (i.e. leverage). The availability of cheaplevered money brought about the creation of several hedge funds and CDO managers.
The exponential risein demand for mortgage assets from that investor base drove Wall Street to create more bonds to feed thismonster. Since all good borrowers had already refinanced by 2003, the mortgage broker/originatorcommunity and banks started to look further down the credit spectrum and through 2004 and 2005 lendingstarted to relax gradually to keep the origination pipelines going. By 2006, they had to take more desperatemeasures to keep up with the demand and we saw the advent of “Affordability products” like Pay‐OptionArms, Interest‐Only Mortgages and 40 year loans. All geared towards making the monthly paymentaffordable enough for anyone to qualify and on top of that we got the NINJA loans (no income, no asset andno job verification) loans.
All of these were recipes for disaster. The business model was working well foreveryone: the brokers got paid hefty commissions, the banks sold off the loans at a profit, Lawyers andaccountants got paid, the Rating Agencies got paid, Wall Street took their cut and the levered investors gottheir bonds. All was good until home prices started to go down and the weak loans started to default. Andas the economy started to weaken and the unemployment rate ticked up the default rates on the 2006 and2007 originated mortgages have climbed at an alarming rate exposing the weaknesses in the underwriting.
Who is to blame?
Everyone along that securitization chain shares in the blame plus the Fed and the SEC. To bash Wall Streetmay be fashionable but not entirely correct. OFHEO (now FHFA), the Fannie/Freddie watchdog allowedthem to grow their portfolios without proper oversight and allowed them to relax standards on loans theycould purchase or guarantee. They were doomed. The Rating Agencies who were supposed to be thegatekeepers for the non‐agency stuff failed miserably at their job. Now, we see the same rating agenciesdowngrading bonds to CCC in one fell swoop, the same bonds that they ascribed a AAA rating not even 2years ago. People who lied on their loan applications, the greedy mortgage brokers who corralled eagerhome buyers, the banks who underwrote those loans and the Investors who bought the garbage are allequally culpable.
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