Mortgage-Backed Securities - Pools of Mortgages

Part 2: Pools of Mortgages

The creation of a pool of mortgages begins with a mortgage originator who grants mortgage loans to homebuyers. Assuming that the mortgage meets the agency’s criteria (please see Part 1 of this article series), the agency then either buys the mortgages or extends guarantees for them. The pool of mortgages is then purchased by a securities firm which subsequently resells “undivided interests” in the pool to investors. An undivided interest means that the investor who purchases a 5% interest, for example, in the pool owns 5% of 100% of the mortgages in the pool, as opposed to owning 100% of 5% of the mortgages in the pool. This is an important distinction. Let’s look an example of how this structure operates.

Assume a loan originator makes ten 30-year $100,000 8% fixed-rate qualifying mortgages, which are sold to an agency. The agency extends its credit guarantee to the mortgages, for which it receives a fee (generally around 0.5% per year of the outstanding principal balance). The mortgages are then sold to a securities firm which, in turn, sells interests in the pool of mortgages to investors. These interests are called participation certificates. Let’s say that this pool was sold to five investors who purchased percentages of the pool in the following amounts: Investor A made a $500,000 investment for a 50% ownership share of the pool; Investor B invested $250,000 for a 25% ownership share; Investor C bought in with a $150,000 investment for a 15% ownership share; Investor D invested $75,000 and owns 7.5 percent of the pool; and Investor E made a $25,000 investment and acquired a 2.5% ownership share. As a result of these investments, the capital that’s loaned to the homebuyers has ultimately come from these investors, having passed through two intermediaries: namely, the originator and the agency.

After the loans close, the homeowners begin making their monthly payments to the lender. The lender collects and records the payments, sends any late notices, maintains escrow accounts, and executes foreclosure proceedings as necessary. These collective services, which are known as servicing the mortgages, can also be provided by another entity if servicing is handled by a third party. The lender (or third-party servicer) then passes on the mortgage payments, minus its servicing fees (which are usually around 0.5% of the outstanding balance) to the agency. The agency subtracts its fee for providing its credit guarantee, and then distributes the payments to the investors on a prorated basis, according to each investor’s percentage of ownership. Therefore, Investor A receives 50% of the interest and principal that the agency can pay out, Investor B gets 25%, and on down the line according to each investor’s ownership percentage.

The homeowners pay off a portion of their loans each month as part of their mortgage payments. The investors, therefore, receive back a portion of their invested principal every month. If any of the homeowners pay off their loans early, the principal that’s paid off is, again, distributed on a prorated basis to the investors.

This structure allows investors to invest in mortgages without having to devote any time or incur any of the expenses of originating and servicing the loans. It also frees them from the credit risk of mortgage investments. In the previous example, the investors received a 7% return on their investments, paying the other 1% of the mortgage rate to the loan servicer and the agency. The cost of eliminating those problems associated with mortgage investments is, according to many investors, money well spent.

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