Securitization is the process of pooling loans together into “mortgage-backed securities” or “MBS”, to sell to investors. MBS is an investment instrument backed by an undivided interest in a pool of mortgages or trust deeds. Income from the underlying mortgages is used to pay interest and principal on the securities. Figure A below is a simplified schematic depicting the general securitization process and some of the parties involved.
Click on image below to enlarge it.
The process begins with Originators, which are the lenders (such as banks or finance companies) that initially make the loans to homeowners. Sponsor/Sellers (or “sponsors”) purchase these loans from one or more Originators to form the pool of assets to be securitized. (Most large financial institutions are both Originators and Sponsor/Sellers.) A Depositor creates a Securitization Trust, a special purpose entity, for the securitized transaction.
The depositor acquires the pooled assets from the Sponsor/Seller and in turn deposits them into the Securitization Trust. An Issuer acquires the Securitization Trust and issues certificates to eventually be sold to investors. However, the Issuer does not directly offer the certificates for sale to the investors. Instead, the Issuer conveys the certificate to the Depositor in exchange for the pooled assets. An Underwriter, usually an investment bank, purchases all of the certificates from the Depositor with the responsibility of offering to them for sale to the ultimate investors.
What’s important to understand is that to effect the securitization process both the note and trust deed (the security interest) must be assigned from the Originator to the Sponsor/Seller, then from the Sponsor/Seller to the Depositor and, finally, from the Depositor to the Securitization Trust. Each assignee, up until it makes an assignment to the next party along the chain of title, is the beneficiary under the trust deed. There is a break in this chain of title where an assignment is not made or is otherwise invalid.
Also worth noting is that almost all Securitization Trusts elect to be treated as “Real Estate Mortgage Investment Trusts” or “REMICS” pursuant to the rules and regulations of Sections 860A-F of the Internal Revenue Code (“IRC”). Consequently, a Securitization Trust must adhere to certain strict and absolute requirements involving transfers of assets into the trust. The IRC 860 outlines these requirements, which include a condition that all loans that are stated to be in the REMIC trust must be acquired on the start-up day of the trust or within three months thereafter. Any other contributions to the REMIC after the start-up date or the subsequent 90 day window are treated as a “prohibited transaction”.
Here is a chart that shows what should have happened as opposed to what normally happens in the securitization process:
A prohibited transaction is catastrophic to a Securitization Trust as it subjects the entire cash flows of the trust to a minimum 100% tax. For this reason, all parties to a Securitization Trust must strictly adhere to the rules of the trust’s Pooling and Servicing Agreement and the Mortgage Loan Purchase Agreement, especially the guidelines regarding conveyances (and assignments) of the assets. For more information about the Securitization Process read Mortgage Loan Instrument or Personal Property; what really got securitized?