Loan Securitization

This is a complex subject that is probably beyond the interests of most visitors to this website.

Loans, commercial and residential are rarely kept by the originators. This includes most of the major banks. They only retain the servicing rights. Instead they are packaged with similar loans and sold on Wall Street. The package of loans can be “sliced and diced” into various risk categories. This is the main function of Fannie Mae and Freddie Mac ®. Hence the term, conforming loans.

For example, take a package of new 30-year loans at 8% p.a. interest totaling $30 million. The total cash flow will be $220,129 per month. But this income stream is not the same as buying a 30-year bond.

First of all, every month there is a repayment of principal as the mortgage amortizes. Secondly there is the pre-payment risk.

Mortgages are pre-paid or paid off for several reasons, including:

  • People moving
  • Foreclosures
  • Refinancing

Refinancing is a particular problem. If interest rates go down, people refinance and you have to place your money into another investment, which will earn a lower rate of return. On the other hand, this is a one-way street. If interest rates go up, people will NOT refinance and you will be stuck with the investment even though you could now earn more elsewhere.

Professionals generally estimate that the average 30-year mortgage will be paid off in 7 years.

The income stream is often sold off into Interest-only (IOs) and Principal-only (POs) securities. As interest rates rise, prepayments will drop and the value of the IOs will increase. Likewise if interest rates drop, prepayments will increase and the value of the IOs will fall. The opposite is true for the POs.

As you can see, this is a complex subject. If you are interested in further study, we recommend the book “Basics of Mortgage Backed Securities” by Joseph Hu, Ph.D., which is available from our Bookstore