In the mortgage market, mortgage originators rarely hold onto the portfolio of mortgages they help transact. Most mortgages are sold into the secondary mortgage market shortly after origination. A major reason for this is that they simply want to take the fees generated and keep the debts off their books.

Once sold into the secondary market, these newly originated mortgages frequently become part of the mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized mortgage obligations (CMO) and collateralized debt obligations (CDO) markets.

In this article, we'll take a look at how securities firms use pools of newly originated mortgages to structure such securities, the performance assumptions in those securities, and how the yield requirements by securities investors affect future interest rates and credit terms offered to consumers.

From Mortgage Originator to Mortgage Investor
Smaller mortgage originators will often sell their mortgages to large scale originators or aggregators, which pool mortgages together and securitize them into mortgage-backed securities (MBS) through Fannie Mae, Freddie Mac or as private-label securities.

The resulting MBSs are then sold to securities dealers, which sell them to investors or use them as collateral in structured finance securities such as CMOs, ABSs and CDOs. These are then sold to investors. A large percentage of these MBSs end up in structured finance securities, also known as structured finance deals. (To explore the secondary mortgage market further, see Behind The Scenes Of Your Mortgage and What is the difference between a CMO and a CBO?)

The Payment Waterfall Structure of CMOs, ABSs and CDOs

Using what is known as a payment waterfall, it is possible to take a pool of mortgages with lower credit characteristics and create tranches within a CMO, ABS or CDO deal with higher credit ratings than the pool of underlying mortgages. (To read more about tranches, see What is a tranche?)

"Tranche" describes a specific class of bonds within a structured finance deal. A tranche might be thought of as a security within a security. Most structured finance deals have several tranches. Each tranche within a deal is designed to have certain performance characteristics and a certain credit rating. Logic tells us that some of the tranches in a deal have a higher credit rating than the overall pool of underlying mortgages, some tranches in the deal must a have an equal or lower credit rating than the overall pool of underlying mortgages.

For example, in a typical CMO deal, according to a payment waterfall, higher-rated credit tranches are given priority over lower-rated credit tranches on cash flow from the underlying pool of mortgages. In other words, the lower-rated credit tranches will absorb payment defaults in the underlying pool of mortgages so the higher-rated credit tranches will be unaffected by those defaults. The rules of the payment waterfall dictate the order in which each tranche in the deal will absorb losses.

In general practice, about 80% of the tranches in a structured finance deal will receive a higher credit rating than the underlying pool of mortgages. The remaining tranches will have an equal or lower credit rating than the pool of underlying mortgages. (To learn more about this, see Profit From Mortgage Debt With MBS.)

The Demand for Yield, Complex Models and Pricing Signals
The different tranches within CMO, ABS and CDO deals are priced based on their credit rating and the yield demanded by investors.

Securities dealers and investors use complex models to plot the performance of the various tranches of a deal under varying interest rates and economic environments. These models are very important to investors in determining the yield at which a certain tranche of a structured finance deal might be purchased. In turn, that yield is a very important pricing signal for mortgage rates and credit terms offered to consumers. The yield is the pricing signal that is passed back through securities dealers to mortgage aggregators, then mortgage originators and then goes on to directly affect the interest rates and credit terms that are offered to consumers.

This is the key to understanding how structured finance deals affect interest rates and mortgage terms offered to consumers. If the model's assumptions about the number of defaults in the underlying pool of mortgages of a deal prove to be correct (the lower priority tranches protect the higher priority tranches in the waterfall structure as planned), everything in the originator to investor mortgage machine runs smoothly. But, when the model assumptions prove to be inaccurate, or if a low probability economic event takes place, several things are likely to happen very quickly. (Learn how to protect your portfolio when the economy does the unexpected, see Can You Predict The Future?)

  1. Losses start to move up the waterfall structure of CMO, ABS and CDO deals. In other words, higher-rated credit tranches start to take losses.
  2. Investors demand more yield as the credit ratings on their securities drop.
  3. Securities dealers lower their bid prices for the mortgages and/or MBS they purchase to structure deals.
  4. To preserve their profit margins, mortgage originators raise interest rates and tighten credit terms to consumers.

Conclusion
CMO, ABS and CDO structured finance deals are based on complex modeling with many rules and assumptions. Deal structurers, credit rating agencies and investors make decisions based on these models. If the assumptions and/or rules in those models prove to be inaccurate, or if a low probability event such as a severe economic downturn takes place, the lower-rated credit tranches in a structured finance deal fall in price (the yield demanded by investors rises). In addition, as the probability rises that all the tranches in the deal will be affected, the higher-rated credit tranches also fall in price (the yield demanded by investors rises).

These pricing signals work their way back through the mortgage supply chain from the investor, then to the securities dealer, on to the originator and finally to the consumer in the form of tighter credit requirements and higher interest rates.

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