Real Estate
Mortgage Securitization Explained
Securitization is the process of converting assets, in this case mortgages, into negotiable instruments which can be sold in financial markets. The proceeds from the sale of the securitized assets then provide additional capital for lending institutions to finance new loans. Securitization has provided a new source of funding in many industries for assets that were once illiquid.
Unlike the value of stocks and other equity instruments, mortgage-backed assets are often more difficult to both value and risk profile. The concepts of risk profiling and valuation are closely related. An inaccurate risk profile will lead to an imprecise valuation. Unlike corporate stock issuances where financial information is provided in a direct manner, investment banks must rely on several layers of disclosures by originators, appraisers, and others to accurately value the underlying assets in mortgage-backed securities. This asymmetry of information as well as instrument complexity, leads to an inability to create reliable risk analysis and valuations. Auditing all the involved actors is costly and cumbersome for investment banks.
The trend toward mortgage securitization can be traced to the period following the Great Depression. During this time, Congress enacted legislation to increase the liquidity of mortgage instruments through government-sponsored institutions, now known as Ginnie Mae, Fannie Mae and Freddie Mac. Today, these entities continue to purchase loans and oversee the origination process. However, Fannie Mae and Freddie Mac both have origination rules requiring conformance with strict standards before they will purchase mortgages for securitization.Loans purchased must have a high loan to value ratio, full documentation, fall below a maximum debt to income ratio, and contain qualified appraisals which cannot be “broker ordered.” These steps insulated Fannie Mae and Freddie Mac from many of the losses associated with private subprime mortgage securitization.
During the late 1970’s, private entities began to see value in mortgage securitization. Private sector financial institutions packaged mortgages from a pool of borrowers and then sold the income stream to investors. The pooling and securitization of the mortgages creates a secondary mortgage market through sale of the mortgage-backed security instrument. A mortgage-backed security is a bond that bases its payments to investors on the loan payment income from the underlying borrowers whose mortgages were pooled. The private issuers of mortgage-backed securities consist of investment banks and other financial institutions such as Countrywide Financial and Wells Fargo. Finally, investment banks may also pool the mortgage-backed securities themselves to create a collateralized debt obligation (CDO). CDOs theoretically provided an additional layer of diversification to protect investors.
Another major player in the securitization process is the rating agencies. The main national rating agencies are Standard and Poor’s, Moody’s, and Fitch Investment Company. Investors value rating agencies because they create a benchmark in order to differentiate between different securities. Comparison between different bonds without regard to the sector allows investors to evaluate instruments in a uniform manner. Investors’ key concern for mortgage-backed securities is to obtain assurances that the issuers accurately represent the quality and value of their mortgage-backed securities. Rating agencies insist that their analysis amounts only to an opinion. Nonetheless, in the structured finance arena, investors treat ratings with much greater weight when making their investment decisions.
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