Securitization of Mortgages

Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment. It involves the selling of financial instruments which are backed by the cash flow or value of the underlying assets.  Securitization typically applies to assets that are illiquid (i.e. cannot easily be sold). It is common in the real estate industry, where it is applied to pools of leased property, and in the lending industry, where it is applied to lenders' claims on mortgages, home equity loans, student loans and other debts.

Any assets can be securitized so long as they are associated with a steady amount of cash flow. Investors "buy" these assets by making loans which are secured against the underlying pool of assets and its associated income stream. Securitization thus "converts illiquid assets into liquid assets" by pooling, underwriting and selling their ownership in the form of asset-backed securities (ABS).

Securitization has evolved from tentative beginnings in the late 1970s to a vital funding source with an estimated total aggregate outstanding of $8.06 trillion (as of the end of 2005, by the Bond Market Association) and new issuance of $3.07 trillion in 2005 in the U.S. markets alone.

How it works?

Imagine getting the NPV of your future cash flows today.  This is what a bank / mortgage company does.  They know with high certainty that they will receive money from the mortgages, so, they sell those future cash flows to investors.  In essence, they get the money today, but loose the right to them in the future (giving up a fee in the process).

The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts.

Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are "credit enhanced," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).

Mortgage-backed securities, and Collateralized debt obligations

Mortgage banks began spreading their risk by issuing mortgage-backed securities (MBS) - bonds whose repayments are tied to a large pool of mortgages. By issuing these securities, lenders were able to free up additional capital on their balance sheets, thus allowing them to make more loans and increase the overall velocity of their lending business. This practice was further driven by significant growth in investor appetite as it effectively provided automatic loan diversification, spreading the damage done by a single default across a pool of thousands of loans.

Subsequently, MBSs were increasingly used as components in structured products sold by Wall Street. The key innovation of these structured products was that rather than spread the risk from these mortgage pools evenly across all bondholders, it would instead distribute losses hierarchically to investors, with status being dependent on expected yield. Because of these structures, the conventional wisdom ran that investment grade loans could be created out of low quality credit pools.

This mentality was given further credence by the national credit rating agencies, which began to see spectacular profits due to the boom in structured product issuances. Recent developments have suggested that the rating agencies may have applied a different scale to tranches of structured products, thus leading investors to believe that the probability of default on their investments was substantially lower than the reality.

Impact on the Developing  world

One of the most important financial innovations has been the securitization of mortgages.  This simple Innovation has had a massive impact on Latin America where it allowed large pools of money to invest in Latin America for the first time.  Before then, the only option for  pension funds, for example, was to invest in the limited number of corporate bonds in Latin America.  But with the innnovation of mortgage backed securities, we saw the mobilization of capital in Latin America for the first time.  Not since the Brady Bonds has there been such an important financial innovation for the financial industry in Lat. AM. 

Links

for more info, visit: http://en.wikipedia.org/wiki/Securitization

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