Securitization

Your Role: You apply for a mortgage with a bank, credit union, or mortgage company (the "originator").

What Happens: The lender:

• Evaluates your creditworthiness and income
• Appraises the property
• Underwrites the loan according to specific guidelines
• Creates the mortgage with standardized terms and documentation

Key Point: Even at origination, many lenders plan to sell your loan rather than keep it, so they structure it to meet the requirements of potential buyers.

The First Sale: Within days or weeks of closing, your original lender typically sells your mortgage to a larger entity called an "aggregator" or "sponsor."

Common Buyers:

• Government-Sponsored Enterprises (GSEs): Fannie Mae, Freddie Mac, Ginnie Mae
• Investment Banks: JPMorgan Chase, Bank of America, Wells Fargo
• Specialty Finance Companies: Various private entities that focus on mortgage purchases

What You Experience: You might receive a notice that your loan has been sold, but your payment terms remain the same. Often, your original lender continues to service the loan (collect payments) even after selling it.

Creating the Pool: The aggregator combines your mortgage with hundreds or thousands of similar loans to create a large pool, typically worth $500 million to $2 billion.

Standardization Requirements: Loans in a pool usually share similar characteristics:

• Similar interest rates and terms
• Comparable credit scores and loan-to-value ratios
• Geographic distribution to reduce regional risk
• Compliance with specific underwriting standards

Due Diligence Process: The aggregator (or their agents) reviews each loan to ensure it meets the stated criteria and has proper documentation.

The Transformation: The pool of mortgages is legally transferred to a special purpose entity (usually a trust) that issues securities backed by the mortgage payments.

Tranching Process: The securities are typically divided into different "tranches" or slices with varying risk levels:

Senior Tranches (AAA-rated):

• First priority for receiving payments
• Lowest risk and lowest return
• Typically 70-80% of the total pool
• Attractive to conservative investors like pension funds

Mezzanine Tranches (AA to BBB-rated):

• Second priority for payments
• Moderate risk and return
• Usually 10-20% of the pool
• Purchased by insurance companies and some mutual funds

Subordinate/Equity Tranches (Below BBB or unrated):

• Last to receive payments, first to absorb losses
• Highest risk and potential return
• Often retained by the originator or sold to hedge funds
• Provide credit protection for senior tranches

Credit Enhancement Mechanisms:

• Overcollateralization: The pool contains more loans than the securities issued
• Reserve Funds: Cash set aside to cover potential losses
• Insurance: Third-party guarantees (like PMI) on individual loans
• Subordination: Junior tranches absorb losses before senior tranches

Rating Agency Process: 

Companies like Moody's, S&P, and Fitch analyze the securities and assign credit ratings based on:

• Quality of underlying mortgages
• Geographic and borrower diversification
• Credit enhancement levels
• Historical performance data

 Investment Marketing: Investment banks market the securities to various types of investors:

Domestic Investors:

• Mutual Funds: Offering mortgage-backed bond funds to retail investors
• Pension Funds: Seeking steady income streams for retirees
• Insurance Companies: Matching long-term liabilities with mortgage payments
• Banks: Investing in highly-rated tranches for regulatory capital purposes

International Investors:

• Foreign Banks: European and Asian banks seeking U.S. mortgage exposure
• Sovereign Wealth Funds: Government investment funds from oil-rich nations
• Private Investors: Wealthy individuals and family offices worldwide

 Active Trading: Once issued, mortgage-backed securities trade in secondary markets like stocks and bonds.

Price Discovery: Market forces determine the value of these securities based on:

• Interest rate movements
• Housing market conditions
• Credit performance of underlying mortgages
• Economic outlook and investor sentiment

Liquidity Provision: Market makers and dealers facilitate trading, providing liquidity for investors who want to buy or sell.

 Banks and Credit Unions: Traditional lenders who make loans to consumers 

Mortgage Companies: Specialized lenders like Quicken Loans, loanDepot 

Credit Unions: Member-owned institutions serving specific communities 

 Fannie Mae (Federal National Mortgage Association):

• Purchases conventional mortgages from lenders
• Issues MBS backed by these mortgages
• Focuses on promoting homeownership and liquidity

Freddie Mac (Federal Home Loan Mortgage Corporation):

• Similar mission to Fannie Mae
• Traditionally served savings and loan institutions
• Provides competition and market stability

Ginnie Mae (Government National Mortgage Association):

• Guarantees MBS backed by government-insured loans
• Part of the Department of Housing and Urban Development
• Provides explicit government backing

 Major Wall Street Firms: Goldman Sachs, Morgan Stanley, Citigroup, etc.

• Structure and underwrite non-agency MBS and CDOs

• Provide trading and market-making services

• Connect mortgage originators with global investors

 The Big Three: Moody's, Standard & Poor's, and Fitch

• Analyze and rate mortgage-backed securities

• Provide independent assessment of credit risk

• Critical for investor acceptance and regulatory compliance

 Loan Servicing Companies: May be banks or specialized firms

• Collect monthly payments from borrowers

• Handle customer service and account management

• Manage defaults and foreclosure processes

• Distribute payments to security holders