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Sunday, December 28, 2008

Understanding the Role of Securitization in Mortgages

As most everyone Fannie Mae and Freddie Mac have come under a great deal of criticism (to put it mildly). In fact, they have come under so much criticism that some may not realize the very vital role they play in the mortgage process, mortgage securitization

A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments
are typically made monthly over the lifetime of the underlying loans.[1][2]

To understand why securitization is so important we need only to look at the current market. Right now, it's possible for an individual borrower to get rates as low as 5% and have those rates be fixed for 30 years.

Now, a layman might ask how a bank could afford to guarantee such a low rate for such a long period of time. After all, while money is cheap now it won't necessarily be cheap forever. As such, what happens when money is more expensive to get for the bank. If it starts to cost the bank, 3, 4, and 5% to get the money, how could they possibly afford to continue to only receive a rate of 5%?

What the process of mortgage securitization does is removes all of this risk from the bank. What these banks do is bundle millions of loans together and sell them to Fannie/Freddie. Then, Fannie/Freddie bundle these same loans together and turn those loans into bonds at the current market rate. Then, those loans are sold to investors.

Those that invest in bonds are essentially making a bet that current interest rates will be more than future rates. Let's look at an example to illustrate. Let's say I receive a Fannie Mae bond at 5%. Then, six months later Fannie Mae bonds only pay 4%. Of course, my bond is then more valuable because my bond receives a higher rate than the current market rate. What's important to understand is that those that invest in bonds can afford to take a risk on interest rate. Banks, on the other hand, are not in the business of taking interest rate risks. At their core, all banks ever want to do is loan money at a higher rate than they get it at. The process of mortgage securitization takes this risk away from the bank and moves it to bond investors, where it is more appropriate.

The other thing that mortgage securitization does is it creates liquidity in mortgages. While over the long term, a bank would make more money by collecting the monthly mortgage payment for the full 30 year term, it would also leave banks with less money in the short term to lend to new borrowers. By relieving banks of the loans immediately, banks have money to lend to a new person immediately. As such, the process of mortgage securitization allows banks to lend to far more people than without it.

The travails of Fannie/Freddie should not minimize their vital role in the process. In fact, quite the opposite should be seen. Because mortgage securitization is so vital, it is that much more vital that this process not be corrupted. These two companies are a virtual monopoly and they are fully funded by the government making their profits private while their losses are covered by the tax payers. This has perverted this very important process. The failure of both make it that much more vital that the process of mortgage securitization be done in a free market and private system.

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