Software Nerd

Saturday, December 15, 2007

Understanding Mortgage Securitization

This post is a brief explanation of mortgage securitization. It is meant as background to another post coming shortly, about the recent sub-prime rate freeze.

Remote Lenders:
These days, banks making mortgage loans do not remain lenders for long. Instead, they "pool" many similar loans, and re-sell them to others. For instance, a home-owner may borrow $200,000 from the bank, to buy a home; but, within a couple of months, other people buy a share of that loan. People all over the world have been lending to U.S. homeowners, by these indirect means. [E.g. a municipality in northern Norway, lost $82 million on U.S. sub-prime loans.] Simplifying, these "remote" lenders pay the bank the $200,000 principal, and the future interest goes to them. The bank continues to service the loan, for a fee.

Delinquent Borrowers: If a borrower is delinquent, his home can be repossessed and sold, to pay back the loan. Banks don;t like doing this. Often, they cannot recover enough money this way. Therefore, sometimes, a bank will make a deal with the borrower. For instance, the borrower may be allowed to pay a lower rate for a while. The bank might take such a loss if repossession would mean a worse loss.

Delinquencies with Remote Lenders: When the lender is remote -- like a municipality in Norway -- there is no practical way for them either to repossess or to cut the borrower some slack. Therefore, the loan-pooling agreements usually designate certain entities as trustees for the ultimate lenders. Also, they allow the servicing companies some discretion to act as good-faith agents for the ultimate lenders. In general, the servicing company is allowed to make deals that they judge to be in the interest of the lenders, and they are to act according to "reasonable and customary" practices.

The devil is in the details: It's important to note that giving borrowers a break may be reasonable. To know whether such a break is reasonable or not, one has to understand the details of the situation. The recent, U.S. government announcement lays down a specific framework, saying what will be deemed reasonable.

For more details, see this post.


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