There are many aspects to the housing market that the average American investor is unaware of.
Lately there have been articles, such as the recent ProPublica and NPR piece, “Freddie Mac Bets Against American Homeowners,” that with the proper due diligence would not have been news.
But to understand this fully, a few subjects must be covered. Let’s begin with one of the main cogs of the housing market since 1970.
Definition of Securitization
The process of securitization is a very intricate and delicate system that involves a number of steps and individuals. The first step occurs when a borrower obtains a loan from a lender. These loans can consist of any consumer contract that produces a cash flow through the collection of principal and interest payments, for example mortgages, student loans, car loans and even credit cards.
The lender or originator of the loan then sells the loan to an issuer, and when the borrower begins making monthly payments on their loan, the money is processed through a servicer to the issuer. A number of these loans are pooled together by loan type and risk, and structured into a marketable debt security.
The debt securities can take the form of bonds, pass-through securities or collateralized mortgage obligations. The process of securitization allows illiquid assets, whose value is uncertain and not easily quickly converted into money, to be pooled together and sold to investors. The investors are paid by the principal and interest payments generated by the assets in the pool. Therefore, the assets are characterized as secured because they’re collateralized by the asset.
Securitization Created the Modern-Day Mortgage System
Before securitization, banks had to hold loans until they matured or were paid off. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage’s inherent risk of default and then sell those smaller pieces to investors.
The process creates liquidity by letting smaller investors purchase shares in a larger asset pool. Without the securitization of mortgages, retail investors would not be able to afford to buy into a large pool of mortgages.
Securitization, therefore, has been recognized as a successful financial mechanism that allowed investors to allocate capital more efficiently, to access diverse and cost effective funding sources, and better manage business risks. If managed correctly, securitization is a financial process that can help businesses and investors see a return on investments while showing very little risk on their balance sheet.
Rather than holding whole loans on a balance sheet, companies were encouraged to hold securitized assets such as mortgage-backed securities.
As previously noted, the securitization process began over 40 years ago and was used to pool together a wide array of assets.
For the historical success that securitization enjoyed in the market place, why was it at the center of the current financial crisis?
When taking an in-depth look, the securitization process itself wasn’t the problem. Instead, it was the influx of bad assets into the private mortgage backed securities market.
So stay tuned, as my next article will tackle how securitization factored into the housing bubble and subsequent “Great Recession.”
Good Investing,
Jason Jenkins
Article by Investment U
