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Minimizing Risks for Investors

Securitization of mortgage loans involves the lender pooling together home loans and then an investment bank breaking out the receivable cashflows and turning them into a bond. The resulting bond, known as a residential mortgage-backed security (RMBS) can then be purchased by investors.

Loans that have originated under predatory practices have a higher risk of default, in part because the borrowers are usually subprime, meaning they have a marginal credit rating, and also because some of the borrowers may have pushed into a loan they can't afford. Each loan in the pool that defaults would be a loss of cash flow to the investor in the RMBS. Securitization, however, minimizes the risk to the investor.

One way risk is minimized is by dividing up the cashflows from the mortgages into pieces called tranches. Each tranche receives a priority in terms of getting paid. The most senior tranches get paid first, have the highest ratings and price, and lowest risk. The subordinate tranches, which get paid last and have the highest risk, often stay with the originator of the loan. Even with the risk of holding the lowest tranches, the rewards of securitization outweighs that risk. The originator receives cash from the selling the security and has rights to all interest payments over the amount that is paid to investors. Sometimes the originator sells off even the most subordinate tranches and takes on none of the risk of the loans.

Prepayment risk, which occurs when the borrowers pay additional principal on their loans, hurts investors because they are then forced to reinvest at an interest rate lower than the coupon rate of the security.There is some debate as to whether subprime loans prepay more frequently than prime ones but either way investors are protected from this risk too. First, subprime mortgages are more likely to have prepayment penalties so if the mortgage does prepay, the investor gets the money from the penalty. Second, where prime mortgages tend to prepay when interest rates are low, subprime mortgages tend to prepay when the financial situation of the borrower improves which does not necessarily coincide with declining interest rates. This means that if the loans prepay and the investor is forced to reinvest, interest rates are not necessarily lower than the coupon rate of the security.

Securitization's minimizing of the risk to the investor, creates a high demand for mortgage-backed securities from the subprime market. This demand gives lenders no incentive to stop predatory practices. Experts are currently discussing ways of curbing predatory lending because of the negative impact on borrowers and communities. Some cities and states have already put predatory lending laws in place.

SS&C's Portpro provides online bond accounting to financial institutions and handles mortgaged-backed, asset-backed, and CMO securities. CPRs, a unit for measuring prepayment speed assumptions are updated on a 3 month basis.

Sources:

Engel, Kathleen C. and McCoy, Patricia A., Predatory Lending: What Does Wall Street Have to Do With It? Housing Policy Debate, Volume 15, Issue 3

Engel, Kathleen C. and McCoy, Patricia A., "Turning a Blind Eye: Wall Street Finance of Predatory Lending". Fordham Law Review, Vol. 75, 2007

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