When most people think about the process of obtaining a mortgage, they assume that the bank is lending them the money to purchase their home. However, what many people do not realize is that the promissory note they sign at closing is not actually being used as collateral for the loan they receive. Instead, banks are taking these promissory notes and bundling them into securities that trade on the market under a CUSIP number. This practice, known as securitization, has become increasingly common in the mortgage industry over the past few decades. While securitization can provide benefits for investors, there are serious concerns about how this process is being used by banks to maximize their profits and exploit homeowners.
The Mechanics of Securitization
To understand how securitization works, it’s important to understand the basics of the mortgage process. When a borrower obtains a mortgage, they sign a promissory note promising to repay the loan. This promissory note is a legal document that represents the borrower’s obligation to repay the loan. The mortgage itself is a separate document that serves as collateral for the loan. In other words, if the borrower defaults on the loan, the bank can foreclose on the mortgage to recover their money.
In the securitization process, banks take these promissory notes and bundle them together into a pool. This pool of mortgages is then sold to investors in the form of mortgage-backed securities (MBS). These MBS are typically sold to institutional investors such as pension funds, insurance companies, and mutual funds.
The MBS are divided into tranches, or layers, with each tranche representing a different level of risk. The top tranche, or senior tranche, is the least risky and has the highest credit rating. The bottom tranche, or equity tranche, is the most risky and has the lowest credit rating. Investors in the senior tranche receive the first payments from the mortgage pool, while investors in the equity tranche receive the last payments.
Once the MBS are sold, they trade on the market under a CUSIP number, just like stocks and bonds. Investors can buy and sell these securities on secondary markets, such as the New York Stock Exchange or Nasdaq.
The Risks and Rewards of Securitization
Securitization can provide benefits for both investors and borrowers. For investors, securitization allows them to invest in a diversified pool of mortgages, which can provide a higher return than traditional investments such as bonds. Securitization also allows investors to trade their securities on secondary markets, which provides liquidity and flexibility.
For borrowers, securitization can make it easier to obtain a mortgage, since banks are able to sell the mortgages they originate to investors. This can also lead to lower interest rates for borrowers, since banks are able to pass on some of the risk associated with the mortgages to investors.
However, securitization also comes with risks. One of the biggest risks is that the mortgages in the pool may default, which can lead to losses for investors. This is especially true for investors in the equity tranche, who are the last to receive payments from the pool.
Another risk of securitization is that the original lender may not have properly underwritten the mortgages in the pool. This can lead to a higher risk of default and can also expose investors to legal risks, since borrowers may challenge the validity of their loans.
The Dark Side of Securitization
While securitization can provide benefits for investors and borrowers, there are serious concerns about how this process is being used by banks to maximize their profits and exploit homeowners.
One of the biggest concerns is that banks are not properly disclosing the risks associated with securitization to borrowers. In many cases, borrowers are not even aware that their promissory note is being securitized. This lack of transparency can lead to borrowers being unaware of who actually owns their mortgage and can make it difficult for them to negotiate with their lender if they run into financial difficulties.
Another concern is that banks are not sharing the returns from securitization with all investors. While investors in the senior tranche receive regular payments from the mortgage pool, investors in the equity tranche may never receive any payments. This is because banks often use the equity tranche to hedge their own positions or to create synthetic securities. In these cases, the bank is essentially betting against the mortgage pool and may stand to make a profit if the pool performs poorly.
There have also been cases of banks engaging in fraudulent activities related to securitization. In 2011, the Department of Justice sued Bank of America for allegedly defrauding investors in mortgage-backed securities. The lawsuit alleged that Bank of America had made false statements about the quality of the mortgages in the pool and had failed to disclose the risks associated with securitization.
The Impact on Homeowners, Especially Minority Communities
The impact of securitization on homeowners, especially minority communities, cannot be overstated. In many cases, these communities were targeted by predatory lenders who offered them subprime mortgages with high interest rates and unfavorable terms. These loans were then securitized and sold to investors, leaving homeowners with little recourse if they ran into financial difficulties.
Minority homeowners have also been disproportionately affected by foreclosures related to securitization. A study by the Center for Responsible Lending found that African American and Latino borrowers were more likely to receive subprime mortgages than white borrowers, and were more likely to lose their homes to foreclosure as a result.
What Can be Done?
There are several steps that can be taken to address the concerns associated with securitization. One solution is to increase transparency in the securitization process, so that borrowers are aware of who owns their mortgage and investors are aware of the risks associated with the pool. Another solution is to hold banks accountable for fraudulent activities related to securitization, so that they are deterred from engaging in such behavior in the future.
Another solution is to provide more support for homeowners who are struggling to make their mortgage payments. This can include programs to help homeowners refinance their mortgages at more favorable rates or to modify their loans to make them more affordable.
Conclusion
Securitization has become a common practice in the mortgage industry, providing benefits for investors and borrowers alike. However, there are serious concerns about how this process is being used by banks to maximize their profits and exploit homeowners. Minority communities, in particular, have been disproportionately affected by securitization-related foreclosures.
To address these concerns, increased transparency, accountability, and support for struggling homeowners are needed. By taking these steps, we can ensure that securitization is used in a way that benefits everyone, rather than just a select few.
Sources:
- “The Promissory Note and the Mortgage – What’s the Difference?” by Investopedia: https://www.investopedia.com/mortgage/promissory-note-and-mortgage-whats-difference/
- “Mortgage-Backed Securities (MBS)” by Investopedia: https://www.investopedia.com/terms/m/mbs.asp
- “Securitization of Mortgages” by Federal Reserve Bank of St. Louis: https://www.stlouisfed.org/publications/regional-economist/january-2008/securitization-of-mortgages
- “Mortgage Securitization” by National Bureau of Economic Research: https://www.nber.org/papers/w18609
- “Foreclosure Disparities Continue in 2019” by Center for Responsible Lending: https://www.responsiblelending.org/research-publication/foreclosure-disparities-continue-2019
- “The Securitization Process” by Fannie Mae: https://www.fanniemae.com/resources/file/ir/pdf/basics_of_securitization.pdf
- “Understanding the Securitization Process” by The Balance: https://www.thebalance.com/what-is-securitization-3305857
- “The Mortgage Meltdown, Financial Regulation, and Securities Law” by University of Chicago Law Review: https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=5269&context=uclrev
- “Securitization and the Global Financial Crisis” by European Central Bank: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1232.pdf
- “Mortgage Securitization: Securitization of a Residential Mortgage Loan or Package of Loans” by Securities and Exchange Commission: https://www.sec.gov/smallbusiness/guides/mortgage-securitization.htm
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