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What is Mortgage Securitization?

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  • Written By: J. D. Kenrich
  • Edited By: Angela B.
  • Last Modified Date: 01 September 2016
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Mortgage securitization represents a departure from traditional home lending models in which the financial institution originating a loan retains the promissory note and the risk of default until the obligation reaches maturity. Instead, securitization is a process in which lenders originate mortgages and then sell them to entities able to pool large numbers of mortgage notes into securities products intended to spread credit risk among multiple parties. With originating banks thus freed from the long-term risk presented by a large mortgage portfolio, they effectively have the incentive to make as many loans as possible to generate maximum fees. Gaining widespread popularity in the 1990s, mortgage securitization largely came to a halt in the United States beginning in 2007, when the collapse of the U.S. housing market began to reveal itself.

Risk diversification through securitization entails selling the promissory note to firms with the ability to turn many such notes into a security available for purchase by investors. The mortgage assets are often sold to a special purpose vehicle (SPV), or trust, to ensure investor entitlement to principle and interest payments. The danger of default on the underlying mortgage is thus shifted to the investors and away from the originating bank. The market for these types of securities products has traditionally included individuals, municipalities, corporate entities, and other institutional investors. The loans pooled in this type of process can include residential property loans and commercial loans.

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Mortgage securitization in the United States involving federally sponsored Fannie Mae, Freddie Mac and Ginnie Mae loans is generally accomplished in one of three primary ways. Notes can be pooled and sold as unified, pass-through securities. Alternatively, the interest and principal amounts of the loan pools may be divided and sold as separate streams.

Finally, there is the option of selling collateralized mortgage obligations (CMOs), otherwise known as tranches, which carry varying degrees of risk for investors. The highest tranches are those offering the least risk but more modest returns. Lower tranches are characterized by greater risk but also the potential to generate massive profits.

Proponents of the practice of mortgage securitization often tout the fact that the process permits greater availability of home loans and offers investors a vehicle through which to earn substantial returns. Others believe the mortgage securitization practices prevalent from the start of the housing boom through the end of 2007 significantly deepened the global financial crisis. It is argued by some that the most blame should lie with the credit rating agencies and investment banks, which they believe recklessly pooled risky subprime mortgages and presented them to investors as being much safer than they ultimately proved to be.

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