The Role of Securitization in Mortgage Lending;

Home , Jumbo mortgage, Securitization, Share (finance)

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK NOVEMBER 2007 OF CHICAGO NUMBER 244

Chicag o Fed Letter

The role of securitization in mortgage lending by Richard J. Rosen, senior economist and economic advisor

Recent media coverage on the problems in the subprime mortgage market has featured an alphabet soup of abbreviations, such as MBS, CDO, and SIV. What do these terms stand for? And how do they ﬁ t into the mortgage ﬁ nancing process?

In this Chicago Fed Letter, I discuss the the mortgage—the parties that provide sources of fi nancing for mortgages. My the funding—can be many steps removed focus is on the role of securitization in from the originator of the mortgage. fi nancing mortgages, which includes The process by which most mortgage mortgage-backed securities (MBSs), loans are sold to investors is referred collateralized debt obligations (CDOs), to as securitization. In the mortgage and structured investment vehicles (SIVs). market, securitization converts mort- I fi rst outline the process by which a mortgages to mortgage-backed securities.1 gage becomes part of an MBS, touching An MBS is a bond whose payments are on the role of Ginnie Mae, Fannie Mae, based on the payments of a collection and Freddie Mac (secondary market of individual mortgages. The initial sales lenders, described in detail later). I then of the bonds are put together either by explain how MBSs are repackaged into the two GSEs or by private fi nancial in- CDOs and SIVs. The process by which stitutions, such as Countrywide Financial, Mortgage origination and securitization Lehman Brothers, or Wells Fargo (all most mortgage loans are among the top six private issuers in Thirty years ago, if you got a mortgage sold to investors is referred 2006).2 The MBS origination process from a bank, it was very likely that the typically begins when the issuer purchases to as securitization. bank would keep the loan on its balance a collection of mortgages from the orig- sheet until the loan was repaid. That is inators. As payments are made on the no longer true. Today, the party that mortgages, they are passed through the you deal with in order to get the loan trust to bondholders. (the originator) is highly likely to sell the loan to a third party (see fi gure 1). As an example of an MBS issuance, The third party can be Ginnie Mae, a assume that an issuer has collected government agency; Fannie Mae or 1,000 mortgages, each worth $100,000 Freddie Mac, which are government- with a 30-year maturity and a fi xed in- sponsored entities (GSEs); or a private terest rate of 6.50%. This $100 million sector fi nancial institution. The third pool of mortgages can be used to back party often then packages your mortgage 10,000 bonds, each worth $10,000 with with others and sells the payment rights a 30-year term and a fi xed coupon rate to investors. This may not be the fi nal of 6.00%. Each bond shares the same stop for your mortgage. Some of the coupon rate and other features, and investors may use their payment rights importantly, each has a similar claim on to your mortgage to back other securities all payments. The MBSs are structured they issue. This can continue for additional so that interest payments on the mort- steps. In effect, the eventual buyers of gages are at least suffi cient to cover the loans that back private sector MBSs are 1. Mortgage funding process jumbo loans; such loans are issued to high-quality borrowers, but they are too large to meet the conforming loan size Funding Funding limit of the two GSEs. Bank Third party intermediary Homeowner Loan Loan sale Alt-A loans are issued to borrowers that appear to have good credit, but these loans do not meet the defi nition of prime Loans Funding or conforming. Often, Alt-A loans are issued to borrowers with limited or no income and asset verifi cation. In recent

CDO? Bonds years, the Alt-A sector has increasingly More securitization? Investors MBS included loans for which the loan-to- SIV? Funding value ratio was too high. The share of MBSs backed by subprime and Alt-A mortgage loans increased NOTES: MBS means mortgage-backed security. CDO means collateralized debt obligation. SIV means structured investment vehicle. rapidly in the last decade. From 1996 through 2006, the share of subprime interest payments due on the bonds of MBSs issued in 2006. They purchase and Alt-A MBSs rose from 47% to 71% (plus the fees of the intermediaries). what are known as conforming mort- of total private sector MBS issuances. Principal payments (either scheduled gages from originators. Conforming The structure of securitizations payments or prepayments) on the mortgages are those that meet certain mortgages are used to pay down the borrower quality characteristics and loan- The illustrative example of a securitization principal on the bonds. to-value ratios and are smaller than the backed by mortgages given previously conforming loan size limit ($417,000 as has a much simpler structure than the Since investors can invest in MBSs directly of January 1, 2007). These GSEs use typical securitization issued by a private or indirectly (e.g., through mutual these conforming loans to back the MBSs sector fi rm. The basic pass-through nature funds), these asset-backed securities they issue, adding guarantees that prin- of most MBSs is the same: Interest pay- allow a broad investor base to help cipal and interest on the mortgages ments on the underlying mortgages are fund home mortgages. In part for this will be paid.3 used to pay interest on the bonds, and reason, an increasing share of home principal payments are passed through mortgages have been securitized, with The remaining 56% of MBSs issued in to pay down the principal on the bonds. the ratio of MBSs to total mortgages now 2006 were packaged by private sector However, the structure of a typical issue over 50% (see fi gure 2). fi nancial institutions. Most of these MBSs is much more complicated. In part, the included securities backed by high- complications are there to more fi nely Participants in securitization quality (prime) loans, subprime loans, allocate the risks of the underlying In addition to private fi rms, the partic- or “Alt-A” loans. The problems with mortgages to investors. ipants in the mortgage securitization pro- mortgages in recent cess are the government agency Ginnie months have been 2. MBS share of total mortgage debt outstanding Mae and the government-sponsored largely confi ned to the percent entities Fannie Mae and Freddie Mac. subprime and Alt-A 60 sectors, and it is the Ginnie Mae facilitates the securitization MBSs backed by pools of home mortgages backed by federally 50 of these loans that have insured or guaranteed loans, such as had the most problems. those issued by the Federal Housing 40 Administration (FHA) or the U.S. The difference between 30 Department of Veterans Affairs (VA). prime and subprime

Ginnie Mae guarantees the timely pay- mortgage loans hinges 20 ment of mortgages’ principal and inter- on borrower quality. est, thereby reducing the risks for MBS A prime loan indicates 10 investors. That said, it guaranteed the that the borrower has mortgages underlying only 4% of all a good credit rating (an 0 MBSs issued in 2006. “A” grade), while the 1980 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 2000 ’02 ’04 ’06 subprime borrower has NOTE: MBS means mortgage-backed security. The GSEs Fannie Mae and Freddie Mac SOURCE: Inside Mortgage Finance Publications Inc., 2007, The 2007 Mortgage Market a lower credit rating. Statistical Annual, 2 vols., Bethesda, MD. accounted for a more substantial 40% Many of the prime 3. Sample six-pack structure for jumbo mortgage-backed security example, some MBSs can include multiple classes of bonds backed by jumbo that differ in the order in which they Bond class Percent of total pool Rating loans use a “six-pack” are repaid (these classes are typically A 94.15 AAA structure, with six referred to as “tranches”). For example, B1 2.00 AA layers of subordina- all principal payments could be allocated 4 B2 1.50 A tion (see fi gure 3). to the A bonds until those are completely repaid. Then, principal payments would B3 1.00 BBB The fi rst default start being allocated to the B bonds. The B4 0.65 BB losses are allocated MBSs broken up in this fashion are called B5 0.40 B to the most junior collateralized mortgage obligations. B6 0.30 Not rated class of bond (B6 in the example in fi g- SOURCE: Mark Adelson, 2006, “MBS basics,” Nomura Fixed Income Research, March 31. Resecuritization ure 3) until that class Mortgage-backed securities are not the is exhausted; then end of the line. Pools of MBSs are There are three major risks to MBS losses move up the line. The A class does sometimes collected and securitized. investors. The fi rst is interest rate risk, not suffer from default losses until all Bonds that are themselves backed by and it is common to all bondholders. the B classes are completely written down. pools of bonds are referred to as col- If interest rates change, the value of a Because of this, ratings are higher for the lateralized debt obligations. The CDOs bond changes in the opposite direction. more senior classes. Early prepayments can look like MBSs, except that the assets The second risk is prepayment risk. are allocated to the A class (to keep the are bonds or other assets.5 In recent Many mortgages in the United States other classes around as loss buffers). years, a number of CDOs have purchased can be prepaid without penalty. Pre- Of the MBSs issued by private fi rms in MBSs and the securities of other CDOs. payments introduce timing risk, since 2006, 93% had subordination (accord- The issuers of CDOs were the major investors do not know when their bonds ing to the Inside Mortgage Finance buyers of the low-rated classes (similar will be repaid (thereby eliminating future MBS Database). interest payments). Additionally, pre- to the B classes in the previous exam- 6 payments are generally larger when inves- The MBS issuers also use overcollateral- ple) of subprime MBSs in 2006. Many tors want them to be smaller. That is, ization and excess spread to provide a de- recently issued CDOs contained mort- when the interest rates on new mort- fault buffer. Overcollateralization refers gage securities (e.g., 81% of those issued 7 gages fall, investors like the fact that they to the difference between the principal in 2005 did). balance on the loans in the pool and the continue to receive the old, higher in- Structured investment vehicles are sim- principal balance on the outstanding terest rates on existing MBSs. But this is ilar to CDOs. The difference between MBSs; excess spread is the difference precisely when borrowers are most likely SIVs and CDOs is essentially in the type to prepay loans by refi nancing their between the interest payments coming mortgages. Interest rate risk and pre- in (loan payments minus servicing fees) and the weighted average payments going payment risk are common to all MBSs. Charles L. Evans, President; Daniel G. Sullivan, to bondholders. They are related in Senior Vice President and Director of Research; Douglas The third risk faced by MBS investors is that excess spread can be used to build Evanoff, Vice President, fi nancial studies; Jonas Fisher, default risk—that is, the risk that home- Economic Advisor and Team Leader, macroeconomic up overcollateralization. The fi rst use of policy research; Richard Porter, Vice President, payment owners will default on the mortgages excess spread is to cover default losses. studies; Daniel Aaronson, Economic Advisor and that back the MBS. As noted earlier, If any excess spread is left, it can be used Team Leader, microeconomic policy research; William Testa, Vice President, regional programs, and Economics Ginnie Mae, Fannie Mae, and Freddie to build up a cushion against future Editor; Helen O’D. Koshy, Kathryn Moran, and Mac offer guarantees against default risk. losses (e.g., one way to do this is to pay Han Y. Choi, Editors; Rita Molloy and Julia Baker, Production Editors. Private sector MBS issuers may obtain down the principal on senior bonds). direct insurance against default, but often Chicago Fed Letter is published monthly by the Excess spread varies by deal, but it aver- Research Department of the Federal Reserve they structure their MBSs to allocate de- aged 2.5% for subprime MBSs in 2006 Bank of Chicago. The views expressed are the fault risk toward parties willing to bear it. (according to Bear Stearns). Overall, authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Among the tools used to distribute de- 61% of MBSs issued by private fi rms in Reserve System. fault and payment timing risk are sub- 2006 were overcollateralized (according © 2007 Federal Reserve Bank of Chicago to the Inside Mortgage Finance MBS Chicago Fed Letter articles may be reproduced in ordination, overcollateralization, and whole or in part, provided the articles are not excess spread. Subordination refers to Database). Traditionally, subordination reproduced or distributed for commercial gain a securitization that issues multiple classes is more common in prime (jumbo) and provided the source is appropriately credited. MBSs, while subprime and Alt-A MBSs Prior written permission must be obtained for of bonds that differ in bankruptcy priority. any other reproduction, distribution, republica- Some bonds are senior, while others are more often structured to include tion, or creation of derivative works of Chicago Fed signifi cant excess spread. Letter articles. To request permission, please contact are subordinated. Senior bonds have Helen Koshy, senior editor, at 312-322-5830 or priority in bankruptcy, meaning that as The MBSs can be structured also to allo- email [email protected]. Chicago Fed Letter and other Bank publications are available mortgages default, the fi rst losses are cate the timing of payments. An MBS on the Bank’s website at www.chicagofed.org. taken by the subordinated classes. For ISSN 0895-0164 of debt they issue. The SIVs are struc- Conclusion to investments in U.S. subprime mortgage tures backed by pools of assets, such as When subprime mortgages started to ex- loans or subprime-loan-based securities. MBSs and CDO bonds. The SIVs issue perience problems, a variety of organiza- As a result, news reports began to feature short- and medium-term debt rather tions that supported or owned CDOs and terms such as MBS, CDO, and SIV. This than the longer-term debt of most CDOs. SIVs began to suffer losses. A number of article demystifi es these terms by explain- The short-term debt is referred to as hedge funds and banks (including many ing what the abbreviations stand for and 8 asset-backed commercial paper. non-U.S. banks) reported losses related how these fi nancial instruments work.

1 For a discussion of why assets such as 3 Fannie Mae and Freddie Mac also purchase 6 Jody Shenn, 2007, “Overlapping subprime mortgages are securitized, see Ronel Elul, and sell MBSs in secondary markets. exposure mask risks of CDOs, Moody’s says,” 2005, “The economics of asset securitiza- Bloomberg, April 4. 4 All privately issued securitizations are rated tion,” Business Review, Federal Reserve Bank by the bond rating agencies. A rating is 7 David E. Vallee, 2006, “A new plateau for the of Philadelphia, Third Quarter, pp. 16–25. based on the agencies’ assessments of the U.S. securitization market,” FDIC Outlook, For mortgages, both liquidity and regula- risk of the particular bond, so different Fall, pp. 3–10. tory arbitrage play a role in the popularity classes of bonds in the same structure can of securitization. 8 Commercial paper (CP) is short-term debt have different ratings. (maturity not more than 270 days) that can 2 The MBSs backed by mortgages guaran- 5 The CDOs are issued as different classes of only be purchased by sophisticated investors. teed by Ginnie Mae are issued by private bonds, with subordination, overcollateral- Asset-backed commercial paper is CP backed sector ﬁ nancial ﬁ rms. ization, and excess spread. by pools of assets rather than a general claim on the issuer.