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 mutual funds. 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.
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* 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.
Extremely helpful for a classroom discussion. Thanks.
Posted by: JTapp | October 01, 2008 at 08:32 AM
With the graphs, it's simple to understand. Thanks for the info.
Posted by: Iris | October 01, 2008 at 10:01 AM
Really useful, thanks.
And if you feel like taking it to the next step with a little more detail, that would be even better!
Posted by: Skill | October 08, 2008 at 02:53 PM
it is good, but you have not stated why the tranches are sold and whether they are sold at a higher price. here the simplicity of the flow breaks for the barber's understanding. pls continue from the " each tranche can be sold individually ..."
Posted by: M M Joshi | October 09, 2008 at 05:57 PM
agree with MM Joshi. If the first year of payments are sold separately then a buyer of years 2thru 30 doesn't get year one and the interest on it. So what is the appeal to the pension funds, etc since, it would seem all that has happened is to increase the risk of default or prepayment??
Posted by: tom mclaughlin | October 10, 2008 at 02:29 PM
For Joshi and Tom, here's some elaboration.
The earlier tranches have shorter maturity and less risk; both of these result in low interest rates. The buyers of these tranches will receive interest at a rate lower than the overall mortgage rate.
The later tranches will pay progressively higher interest rates, for reasons of both risk and maturity. In addition, the later tranches need higher interest rates because the buyers expect refinancings to work against them. If interest rates fall, the homeowners will refinance and the investors suddenly have to reinvest their money at low rates. If, however, interest rates rise, then the investors are locked into their investment at just the time when they'd like to jump onto another, higher rate investment.
So why be an investor in the later tranches? The return seemed to compensate for the risk. Remember that most of the deals were closed before foreclosures became a significant problem, so risk seemed low.
The higher tranches also have the advantage of no cash flow early on. See my last two paragraphs of explanation for Mrs. B.
Posted by: Bill Conerly | October 13, 2008 at 10:25 AM
Dr. Conerly,
This is a wonderful explanation. Up to this point I hadn't even attempted to understand mortgage-backed securities, but this article makes it easy. We can only hope that as more people understand what they are, we can find a way out of this financial mess we are in.
Posted by: D. Sean | February 02, 2009 at 11:36 AM
Thank you for making it simple and easy to understand
Posted by: Pankaj | June 15, 2009 at 12:50 PM
i was having a hard time to understand what it is.. your explanation made me understand clearly. Thank you
Posted by: Vitus | October 02, 2009 at 03:02 AM
This is an amazing example,
thank u very much
Posted by: Huda El-Akkad | May 05, 2010 at 07:22 AM
This is a very gud example. Can u elaborate on the process please.
Thanks
Monica
Posted by: Monica | November 29, 2010 at 10:07 AM
you literally just helped me understand 50% of my university assignment. No other resource on the internet can simply it this well.. Thanks!
Posted by: steve | May 07, 2012 at 04:48 AM