magellan said:
I seem to be a bit out of my element here. I thought the whole point of securitizing the loan was to transfer the risk from the originator of the mortgage to the buyer of the mortgage backed security.
If the borrower fails to repay, it's the security holder that gets caught holding the bag, not the originator. So by my math, the banks hold only 25% of the risk of residential mortgages.
Is that incorrect?
In the interest of clarifying the debate, I think it is time for Securitization 101:
1. Bank or other lender has a pool of receivables that flow cash and they wish to use to raise money. We are talking about mortgages, but you can securitize almost any kind of cash flow: credit card receivables, auto loans, personal loans, commercial mortagges, etc. David Bowie even securitized a stream of royalties on his old albums.
2. Bank sticks these receivables in a special bankruptcy remote trust. The loans are all the trust holds, and if the bank goes bust, it doesn't involve the trust.
3. The trust then sells debt backed by the assets it holds. The debt usually is tiered WRT priority. A very simple structure might have three sets of notes issued: A, B, and C. A would be worth maybe 75% of the assets. This class would have first priority, so if there were problems with the underlying loans, these notes would be the last to be hit. Typically, this is AAA or AA rated debt (very high quality). The B notes might be worth 10 to 15% of the value of the assets. These notes come behind the A notes, but ahead of the C notes. At the outset, these notes would be rated BBB (still investment grade). The C notes are often referred to as the "equity" tranche. They are first in line to soak up the beating if there is a problem with the assets, and they don't get paid until the A and B notes are paid.
4. The A notes are sold to everyone: mutual funds, life insurance companies, banks, individuals, foundations, etc. They are very high quality stuff, so it is easy to sell. Yield might be LIBOR + .5%. The B notes are a little tougher to sell, but there are buyers that specialize in this paper. Yield might be LIBOR + 1.5% or so. The C tranche is usually retained by the nbank, although they can sometimes sell it at the outset or after the deal has "seasoned" for a while.
There are lots of permutations, bells & whistles, and flavors to this, but the above is the basic structure. Given this structure, you can see why banks that deal in junky mortgages might still have most of the risk still on their hands even though they may have sold most of the value of the loans. They still have the first loss piece.