Who Owns Your Loan if It Is Securitized?

Loan originators have two big problems. The first is that it might take a long time to be repaid, in effect tying up their cash for perhaps months or years. The second is the risk that some borrowers won’t repay their loans. When a borrower defaults on a loan, the lender might be able to sue in court and seize collateral that they can sell to repay the loan partially or fully – a costly and time-consuming process. However, lenders often prefer to sell their loans for cash to third parties who repackage the loans in a process called securitization.

Securitization is a process in which an agency or private company (the securitizer) purchases loans, pools them with similar loans and sells the pool's cash flow in the form of bonds known as asset-backed securities (ABS). The assets backing the securities might be composed of car loans, student loans, credit card debt or mortgages. Mortgage-backed securities (MBS) form the largest market for securitized loans.

A good example of securitization is the residential mortgage-backed securities (RMBS) market. Investors buy residential mortgage-backed securities to receive the interest and principal that flow into the loan pools from mortgage payments. If you viewed a securitization process diagram, you’d see that the procedure requires several steps performed by multiple parties:

1. Banks and other originators make mortgage loans to homeowners.
2. The mortgage originators sell their loans to a securitizer, which can be a government agency (the Government National Mortgage Association, or Ginnie Mae), a government-sponsored entity (the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or Freddie Mac), or a private financial company (a “private label” securitizer).
3. The securitizer assembles similar mortgages into pools.
4. The securitizer transfers the mortgage pools to a tax-exempt trust. The trust might be a r_eal estate mortgage investment conduit_, (REMIC) or a grantor trust. The trusts are pass-through vehicles that pass mortgage payments along to residential mortgage-backed securities investors without triggering corporate taxes.
5. The trust creates residential mortgage-backed securities and sells them to investors. Each issuance corresponds to pools of residential mortgages with shared characteristics, such as term, yield and credit rating.
6. The trust can sell the mortgage servicing rights to a master servicer that has the overall responsibility to administer the mortgages, collect payments and forward them to the trust.
7. Investors collect monthly principal and interest payments from the trust’s underlying mortgage pools (after any fees are extracted).

The example clarifies the question of who owns your loan when it is securitized. The answer is that the trust established by the securitizer owns the loan. The residential mortgage-backed securities investors own the beneficial rights to your loan, but not the loan itself. Beneficial rights are the rights to receive principal and interest cash flows from the underlying mortgage pools. The loan securitizer assumes the risk that homeowners might default on their mortgages and usually guarantees payments to investors even when defaults occur.

Loan servicers are the points of contact with borrowers. As a borrower, you send your monthly payments to the loan servicer, without necessarily knowing who actually owns your loan. Normally, borrowers don’t need to know the identity of the loan holder. However, the need might arise for various reasons, such as renegotiating the terms of the mortgage. As an example, there are several ways for homeowners to find out who owns their mortgages:

• Contact your mortgage servicer. It might be as easy as making a phone call. You can make a more formal qualified written request for information from the servicer that requires a response within 30 business days.
• Run a check on the MERS (Mortgage Electronic Registration System) website. Many mortgages are registered on the MERS system. The system is a national database that tracks mortgage servicing rights and beneficial ownership interests.
• Visit the Ginnie Mae, Fannie Mae and Freddie Mac websites to use their loan lookup tools. If one of these agencies owns your mortgage, it will show up on their tool.

Homeowners are fairly indifferent to securitization, since they deal with the loan servicer no matter who owns their loans. However, securitization does offer several advantages to loan issuers and investors:

• Risk transfer: A loan issuer not only faces credit risk that the borrower will default on the loan. It also must deal with prepayment risk because when a borrower repays the loan earlier than expected, the loan issuer loses some interest income. Liquidity risk arises from the fact that lenders recover their lent money over the term of the loan, which ties up some of their cash and makes it harder to finance additional loans. Loan issuers can shed all these risks by selling their loans.
• Certainty: A lender locks in its return when it sells its loans. For many companies, a return that is certain is more valuable than the potential for higher returns by holding the loans.
• Lower funding costs: A company might have a lower bond rating than the ratings on the debt it owns. For example, asset-backed securities cash flows backed by car loans might have an AAA rating even if the finance company has a BB rating. By issuing asset-backed securities on the high-rated debt, the finance company can pay a lower interest rate than if it tried to sell corporate bonds.
• Higher rate of return: On a risk-adjusted basis, investors can potentially earn a higher rate of return from asset-backed securities than from corporate bonds. Investors can also control their risk/return tradeoffs by investing in specific pools of assets.
• Isolation of credit risk: Another benefit to investors is that the securitization trust is a separate entity from the company that purchased the loans (normally, the “parent” company of the trust). That means the trust should survive even if the parent company goes bankrupt, because the trust cash flows do not depend on the parent company.
• Diversification: Investors can increase the diversity of their holdings by purchasing asset-backed securities. In general, diversification reduces the overall risk of an investment portfolio.

Investing in asset-backed securities does involve some risks and limitations, including:

• Prepayment and credit risk: Investors will collect less interest when borrowers prepay their loans. Worse, investors will lose interest and possibly principal when borrowers default on their loans. The mortgage meltdown of 2007-2008 revealed a credit risk mismatch. Namely, the mortgage originators made risky loans that they then sold off to investors. The mortgage originators had a strong incentive to make risky loans because they never bore those risks. Instead, the default risk on the loans accompanied the purchase of the loans by securitizers and by investors.
• Sensitivity to interest rates: As with all bond investors, asset-backed securities investors can suffer losses (at least on paper) if prevailing interest rates rise after they purchase their securitized loans. That’s because the interest paid by the asset-backed securities will seem relatively puny, causing their prices to fall. Even if asset-backed securities investors hold their bonds until maturity, they still lose out on the higher returns available from newer securities.
• Potential conflicts of interest: The company managing the asset-backed securities deal usually earns a fee based upon the price of the underlying assets. This is an incentive to overvalue the underlying assets in order to increase fees. This will cause asset-backed securities investors to earn smaller returns.