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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

NOVEMBER 2007
NUMBER 244

Chicago 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 fit into the mortgage financing process?

In this Chicago Fed Letter, I discuss the
sources of financing for mortgages. My
focus is on the role of securitization in
financing mortgages, which includes
mortgage-backed securities (MBSs),
collateralized debt obligations (CDOs),
and structured investment vehicles (SIVs).
I first outline the process by which a mortgage becomes part of an MBS, touching
on the role of Ginnie Mae, Fannie Mae,
and Freddie Mac (secondary market
lenders, described in detail later). I then
explain how MBSs are repackaged into
CDOs and SIVs.

The process by which
most mortgage loans are
sold to investors is referred
to as securitization.

Mortgage origination and securitization

Thirty years ago, if you got a mortgage
from a bank, it was very likely that the
bank would keep the loan on its balance
sheet until the loan was repaid. That is
no longer true. Today, the party that
you deal with in order to get the loan
(the originator) is highly likely to sell
the loan to a third party (see figure 1).
The third party can be Ginnie Mae, a
government agency; Fannie Mae or
Freddie Mac, which are governmentsponsored entities (GSEs); or a private
sector financial institution. The third
party often then packages your mortgage
with others and sells the payment rights
to investors. This may not be the final
stop for your mortgage. Some of the
investors may use their payment rights
to your mortgage to back other securities
they issue. This can continue for additional
steps. In effect, the eventual buyers of

the mortgage—the parties that provide
the funding—can be many steps removed
from the originator of the mortgage.
The process by which most mortgage
loans are sold to investors is referred
to as securitization. In the mortgage
market, securitization converts mortgages to mortgage-backed securities.1
An MBS is a bond whose payments are
based on the payments of a collection
of individual mortgages. The initial sales
of the bonds are put together either by
the two GSEs or by private financial institutions, such as Countrywide Financial,
Lehman Brothers, or Wells Fargo (all
among the top six private issuers in
2006).2 The MBS origination process
typically begins when the issuer purchases
a collection of mortgages from the originators. As payments are made on the
mortgages, they are passed through the
trust to bondholders.
As an example of an MBS issuance,
assume that an issuer has collected
1,000 mortgages, each worth $100,000
with a 30-year maturity and a fixed interest rate of 6.50%. This $100 million
pool of mortgages can be used to back
10,000 bonds, each worth $10,000 with
a 30-year term and a fixed coupon rate
of 6.00%. Each bond shares the same
coupon rate and other features, and
importantly, each has a similar claim on
all payments. The MBSs are structured
so that interest payments on the mortgages are at least sufficient to cover the

loans that back private sector MBSs are
jumbo loans; such loans are issued to
high-quality borrowers, but they are too
large to meet the conforming loan size
limit of the two GSEs.

1. Mortgage funding process

Funding

Funding
Bank
Homeowner

Third party
intermediary

Loan sale

Loan

Loans

Funding

Bonds

CDO?
More securitization?

Investors

SIV?

MBS
Funding

NOTES: MBS means mortgage-backed security. CDO means collateralized debt obligation. SIV means structured investment vehicle.

interest payments due on the bonds
(plus the fees of the intermediaries).
Principal payments (either scheduled
payments or prepayments) on the
mortgages are used to pay down the
principal on the bonds.
Since investors can invest in MBSs directly
or indirectly (e.g., through mutual
funds), these asset-backed securities
allow a broad investor base to help
fund home mortgages. In part for this
reason, an increasing share of home
mortgages have been securitized, with
the ratio of MBSs to total mortgages now
over 50% (see figure 2).
Participants in securitization

In addition to private firms, the participants in the mortgage securitization process are the government agency Ginnie
Mae and the government-sponsored
entities Fannie Mae and Freddie Mac.
Ginnie Mae facilitates the securitization
of home mortgages backed by federally
insured or guaranteed loans, such as
those issued by the Federal Housing
Administration (FHA) or the U.S.
Department of Veterans Affairs (VA).
Ginnie Mae guarantees the timely payment of mortgages’ principal and interest, thereby reducing the risks for MBS
investors. That said, it guaranteed the
mortgages underlying only 4% of all
MBSs issued in 2006.
The GSEs Fannie Mae and Freddie Mac
accounted for a more substantial 40%

of MBSs issued in 2006. They purchase
what are known as conforming mortgages from originators. Conforming
mortgages are those that meet certain
borrower quality characteristics and loanto-value ratios and are smaller than the
conforming loan size limit ($417,000 as
of January 1, 2007). These GSEs use
these conforming loans to back the MBSs
they issue, adding guarantees that principal and interest on the mortgages
will be paid.3

Alt-A loans are issued to borrowers that
appear to have good credit, but these
loans do not meet the definition of prime
or conforming. Often, Alt-A loans are
issued to borrowers with limited or no
income and asset verification. In recent
years, the Alt-A sector has increasingly
included loans for which the loan-tovalue ratio was too high.
The share of MBSs backed by subprime
and Alt-A mortgage loans increased
rapidly in the last decade. From 1996
through 2006, the share of subprime
and Alt-A MBSs rose from 47% to 71%
of total private sector MBS issuances.
The structure of securitizations

The illustrative example of a securitization
backed by mortgages given previously
has a much simpler structure than the
typical securitization issued by a private
sector firm. The basic pass-through nature
of most MBSs is the same: Interest payments on the underlying mortgages are
used to pay interest on the bonds, and
principal payments are passed through
to pay down the principal on the bonds.
However, the structure of a typical issue
is much more complicated. In part, the
complications are there to more finely
allocate the risks of the underlying
mortgages to investors.

The remaining 56% of MBSs issued in
2006 were packaged by private sector
financial institutions. Most of these MBSs
included securities backed by highquality (prime) loans, subprime loans,
or “Alt-A” loans. The problems with
mortgages in recent
months have been
2. MBS share of total mortgage debt outstanding
largely confined to the
percent
subprime and Alt-A
60
sectors, and it is the
MBSs backed by pools
50
of these loans that have
had the most problems.
40
The difference between
prime and subprime
mortgage loans hinges
on borrower quality.
A prime loan indicates
that the borrower has
a good credit rating (an
“A” grade), while the
subprime borrower has
a lower credit rating.
Many of the prime

30
20
10
0
1980 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 2000 ’02 ’04 ’06
NOTE: MBS means mortgage-backed security.
SOURCE: Inside Mortgage Finance Publications Inc., 2007, The 2007 Mortgage Market
Statistical Annual, 2 vols., Bethesda, MD.

3. Sample six-pack structure for jumbo mortgage-backed security
Bond class

Percent of total pool

Rating

A

94.15

AAA

B1

2.00

AA

B2

1.50

A

B3

1.00

BBB

B4

0.65

example, some MBSs
backed by jumbo
loans use a “six-pack”
structure, with six
layers of subordination (see figure 3).4

BB

The first default
losses are allocated
B5
0.40
B
to the most junior
B6
0.30
Not rated
class of bond (B6 in
the example in figSOURCE: Mark Adelson, 2006, “MBS basics,” Nomura Fixed Income Research, March 31.
ure 3) until that class
is exhausted; then
There are three major risks to MBS
losses move up the line. The A class does
investors. The first is interest rate risk,
not suffer from default losses until all
and it is common to all bondholders.
the B classes are completely written down.
If interest rates change, the value of a
Because of this, ratings are higher for the
bond changes in the opposite direction.
more senior classes. Early prepayments
The second risk is prepayment risk.
are allocated to the A class (to keep the
Many mortgages in the United States
other classes around as loss buffers).
can be prepaid without penalty. PreOf the MBSs issued by private firms in
payments introduce timing risk, since
2006, 93% had subordination (accordinvestors do not know when their bonds
ing to the Inside Mortgage Finance
will be repaid (thereby eliminating future MBS Database).
interest payments). Additionally, prepayments are generally larger when inves- The MBS issuers also use overcollateralization and excess spread to provide a detors want them to be smaller. That is,
fault buffer. Overcollateralization refers
when the interest rates on new mortgages fall, investors like the fact that they to the difference between the principal
balance on the loans in the pool and the
continue to receive the old, higher interest rates on existing MBSs. But this is principal balance on the outstanding
precisely when borrowers are most likely MBSs; excess spread is the difference
between the interest payments coming
to prepay loans by refinancing their
in (loan payments minus servicing fees)
mortgages. Interest rate risk and prepayment risk are common to all MBSs. and the weighted average payments going
to bondholders. They are related in
The third risk faced by MBS investors is that excess spread can be used to build
default risk—that is, the risk that home- up overcollateralization. The first use of
owners will default on the mortgages
excess spread is to cover default losses.
that back the MBS. As noted earlier,
If any excess spread is left, it can be used
Ginnie Mae, Fannie Mae, and Freddie
to build up a cushion against future
Mac offer guarantees against default risk.
losses (e.g., one way to do this is to pay
Private sector MBS issuers may obtain
down the principal on senior bonds).
direct insurance against default, but often
Excess spread varies by deal, but it averthey structure their MBSs to allocate deaged 2.5% for subprime MBSs in 2006
fault risk toward parties willing to bear it.
(according to Bear Stearns). Overall,
61% of MBSs issued by private firms in
Among the tools used to distribute de2006 were overcollateralized (according
fault and payment timing risk are subto the Inside Mortgage Finance MBS
ordination, overcollateralization, and
Database). Traditionally, subordination
excess spread. Subordination refers to
a securitization that issues multiple classes is more common in prime (jumbo)
of bonds that differ in bankruptcy priority. MBSs, while subprime and Alt-A MBSs
are more often structured to include
Some bonds are senior, while others
significant excess spread.
are subordinated. Senior bonds have
priority in bankruptcy, meaning that as
mortgages default, the first losses are
taken by the subordinated classes. For

The MBSs can be structured also to allocate the timing of payments. An MBS

can include multiple classes of bonds
that differ in the order in which they
are repaid (these classes are typically
referred to as “tranches”). For example,
all principal payments could be allocated
to the A bonds until those are completely
repaid. Then, principal payments would
start being allocated to the B bonds. The
MBSs broken up in this fashion are called
collateralized mortgage obligations.
Resecuritization

Mortgage-backed securities are not the
end of the line. Pools of MBSs are
sometimes collected and securitized.
Bonds that are themselves backed by
pools of bonds are referred to as collateralized debt obligations. The CDOs
can look like MBSs, except that the assets
are bonds or other assets.5 In recent
years, a number of CDOs have purchased
MBSs and the securities of other CDOs.
The issuers of CDOs were the major
buyers of the low-rated classes (similar
to the B classes in the previous example) of subprime MBSs in 2006.6 Many
recently issued CDOs contained mortgage securities (e.g., 81% of those issued
in 2005 did).7
Structured investment vehicles are similar to CDOs. The difference between
SIVs and CDOs is essentially in the type

Charles L. Evans, President; Daniel G. Sullivan,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; Jonas Fisher,
Economic Advisor and Team Leader, macroeconomic
policy research; Richard Porter, Vice President, payment
studies; Daniel Aaronson, Economic Advisor and
Team Leader, microeconomic policy research; William
Testa, Vice President, regional programs, and Economics
Editor; Helen O’D. Koshy, Kathryn Moran, and
Han Y. Choi, Editors; Rita Molloy and Julia Baker,
Production Editors.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2007 Federal Reserve Bank of Chicago
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Prior written permission must be obtained for
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ISSN 0895-0164

of debt they issue. The SIVs are structures backed by pools of assets, such as
MBSs and CDO bonds. The SIVs issue
short- and medium-term debt rather
than the longer-term debt of most CDOs.
The short-term debt is referred to as
asset-backed commercial paper.8

Conclusion

When subprime mortgages started to experience problems, a variety of organizations that supported or owned CDOs and
SIVs began to suffer losses. A number of
hedge funds and banks (including many
non-U.S. banks) reported losses related

to investments in U.S. subprime mortgage
loans or subprime-loan-based securities.
As a result, news reports began to feature
terms such as MBS, CDO, and SIV. This
article demystifies these terms by explaining what the abbreviations stand for and
how these financial instruments work.

1

3

Fannie Mae and Freddie Mac also purchase
and sell MBSs in secondary markets.

6

4

All privately issued securitizations are rated
by the bond rating agencies. A rating is
based on the agencies’ assessments of the
risk of the particular bond, so different
classes of bonds in the same structure can
have different ratings.

Jody Shenn, 2007, “Overlapping subprime
exposure mask risks of CDOs, Moody’s says,”
Bloomberg, April 4.

7

David E. Vallee, 2006, “A new plateau for the
U.S. securitization market,” FDIC Outlook,
Fall, pp. 3–10.

8

Commercial paper (CP) is short-term debt
(maturity not more than 270 days) that can
only be purchased by sophisticated investors.
Asset-backed commercial paper is CP backed
by pools of assets rather than a general
claim on the issuer.

2

For a discussion of why assets such as
mortgages are securitized, see Ronel Elul,
2005, “The economics of asset securitization,” Business Review, Federal Reserve Bank
of Philadelphia, Third Quarter, pp. 16–25.
For mortgages, both liquidity and regulatory arbitrage play a role in the popularity
of securitization.
The MBSs backed by mortgages guaranteed by Ginnie Mae are issued by private
sector financial firms.

5

The CDOs are issued as different classes of
bonds, with subordination, overcollateralization, and excess spread.


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