Securitization is a mystery to many smart, reasonably well informed people, I realized as I was trying to explain it to my barber. So here’s a simplified explanation. Let’s start with a 10-year mortgage. (It’s easier to see the chart with a 10-year mortgage than a 30-year mortgage, but it works the same way with any maturity.)
The mortgage consists of 12 payments a year, for 10 years. Let’s group the payments together by year, so each box on the following chart constitutes 12 monthly payments.
Now let’s throw four such mortgages together. They look like this:
Now let’s pool those into one. Think of it this way. Each payment is represented by a coupon, like an IOU. The lender has 120 coupons for each mortgage. He throws all the coupons for four mortgages into one box. The he starts sorting the coupons according to the year that the payment will be made.
He takes all of the coupons for payments in the first year, he staples them together, and calls them “Tranche A.” Then he takes all the coupons for payments in the second year, staples them together, and calls them “Tranche B.” In the chart below, each tranche has its own color.
When we started this explanation, before securitization, we thought the natural grouping of coupons was to put all the coupons from one borrower together. However, after securitization, all the coupons for one year are put together. The buyer of this tranche gets coupons from different home-owners, but all the coupons are to be paid in the same year.
This is a highly simplified example, because we haven’t talked about who gets what if the mortgage is paid off early, or what happens if one borrower does not pay. Add these rules, and you have a mortgage-backed security, consisting of 10 tranches. Each tranche can be sold individually.
Why do this? Dr. Frankenstein applies himself to finance? There’s a good reason. Few investors want to buy coupons for the entire life of the mortgage (10 years in this example, but 30 years in most cases).* However, there are folks who want the first year payments (money market funds). There are others who will be very interested in second and third year payments, such as property and casualty insurance companies. Other insurance companies might want fourth and fifth year payments, while university endowments, pension funds, and bond mutual funds might want the longer maturities. Investors are more interested if the specific tranche is tailored to their needs.
When the experts on TV talk about “slicing and dicing” mortgages, this is what they mean.
Was this understandable? Or too basic? Please leave a comment.
* Mrs. Businomics wants to know why few investors want to hold the entire 10 years of coupons, or 30 years of coupons. Well, some folks want a shorter-term investment. That’s easy to understand; they don’t want to tie their money up for too long. Your car insurance company collects your premiums when you mail them a check, but it will be a while before they have to make payments on collisions. In the meantime, they need a short-term investment, but they can’t tie the money up for 10 years.
What about the folks who do want to tie up their money for a long time, like a pension fund or life insurance company? They don’t want to receive money back too early. They would rather keep it working, earning interest. If they get money back, they’ll only have to re-invest it. When they first invested their money, they would not be sure how much they would get back, because future interest rates on the re-invested money are unknown.