Streamline Training & Documentation: Securitization of Subprime Mortgage Credit

Thursday, March 12, 2009

Securitization of Subprime Mortgage Credit

One of the most frequently downloaded of the New York Fed's Staff Reports is "Understanding the Securitization of Subprime Mortgage Credit" (pdf), by Adam B. Ashcraft and Til Schuermann.

As you can see from reading the paper's executive summary, Ashcraft and Schuermann organize their explanation of the securitization process around what they refer to as "frictions" among the players involved. These frictions are diagrammed in the figure below, which appears on page 3 of the paper.

The eight types of player involved in the securitization process are:

Mortgagors — property owners who obtain loans, using their property as collateral.

Originators — institutions that underwrite and initially fund and service mortgage loans.

Arrangers (aka issuers) — institutions that purchase pools of mortgages and carry out all the steps required to complete securitization so that the resulting mortgage-backed securities are ready for sale to investors (often with asset managers acting as middlemen — see below).

Credit rating agencies — companies that assess the risk of loss that investors are incurring by investing in any particular security whose issuer has paid to have it rated. The main rating agencies are Moody's Investors Services, Standard and Poor's, and Fitch Ratings.

Warehouse lenders — institutions that fund loans arrangers have not yet sold (i.e., loans that are "warehoused"). Generally, depository institutions do their own funding, but issuers that do not take deposits turn to warehouse lenders.

Investors — individuals and institutions that purchase securities.

Asset managers — purchasers of securities who turn around and sell the securities, or shares in portfolios of the securities, to investors.

Servicers — institutions that handle receipt and disbursement of interest and principal payments remitted by mortgagors. Servicers may, and generally do, require mortgagors to maintain escrow accounts for the purpose of paying property taxes, hazard insurance, etc.

As you can see from the above diagram, there are seven types of friction to which the players in the securitization process are subject. In reading the diagram, keep in mind that each arrow points from a party at risk of harm to the party who presents the risk. For example the first friction involves the potential for predatory lending on the part of an originator. The party harmed by such behavior is the mortgagor, perhaps because the latter is financially unsophisticated and therefore doesn't understand the precise nature of the deal he/she is being encouraged to accept.

Ashcraft and Schuermann outline all seven frictions in their executive summary, and also identify ##1, 2, 3, 6, and 7 as the frictions that caused the subprime crisis we are currently experiencing. Considerable additional detail is provided in the body of the paper, which runs to some 66 pages.

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Labels: Business acumen, Risk management

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