What is “real estate,” really? Most people might say it’s the land and/or structures appurtenant to it. I agree with that (I should; I came up with it) but I think owners

Why aren’t mortgage-backed securities (MBS) actually collateralized by the property underlying each mortgage?

The simple answer to your question is that ultimately the mortgage is backed by the real estate but that’s the only simple part. A mortgage backed security is actually a group of mortgages bundled together to create an instrument that can be sold. That instrument returns a “weighted average coupon” based on the interest rates of the mortgages that comprise the bundle so as the mortgages are paid, the investor recoups his principle along with the interest. Everything is great as long as those mortgages are performing as written.

The problem comes when the mortgages stop paying. As a former mortgage banker, this was my worst nightmare. Yes, I can go after the property but let’s see what that looks like:

  1. I make a $100,000 loan on a house worth $100,000. (Very possible with good credit when securitizations were being done). I pay a yield spread premium to the mortgage broker of 2 points so I have funded $102,000 for a $100,000 loan at 100% loan to value.
  2. Loan is sold to Wall Street at a premium of 5 points so they are now invested in this $100,000 for $105,000. (This is where prepayment penalties come in but that’s another chapter.) Loan is bundled and securitized as a mortgaged backed bond. You no longer have a bundle of 20 loans, you have 1 bond that pays a return.
  3. Borrower has nothing invested in the house and 10 months later, he loses his job. He stops making payments on the loan but it’s part of a bigger bundle. Who is going to foreclose on the property? The owner of the bond can’t do it. He hasn’t taken assignment of the lien. Typically, the securitization firm will replace the defaulted loan with another performing loan unless you have thousands of defaulted loans. Thus, the mortgage meltdown of 2008!

Back to the foreclosure – It would be up to the owner of the actual lien to foreclose on the property which in the prior case would be the securitization firm who replaced the defaulted loan. Remember that the basis in the loan now is $105,000.

  1. Loan is accelerated and foreclosure is filed resulting in attorney’s fees. The amount is going to depend upon the state and whether it is a judicial or non-judicial state.
  2. If the homeowner isn’t paying the mortgage, chances are the taxes and insurance are not being paid either. Force placed insurance isn’t cheap and the taxes have to be kept current to protect the lien.
  3. 9 times out of 10, the homeowner files for bankruptcy to forestall the foreclosure so that requires additional attorney’s fee to file a motion to lift stay.
  4. Once the foreclosure is done and the homeowner is evicted, they NEVER leave the property in pristine condition. Usually the property has to be rehabbed to be put on the market. Additional costs!
  5. Then there are Realtor fees of 6% to sell the property.

By the time the property is sold, the owner (former lienholder) will realize about 55 to 60% of the amount previously invested in the loan.

It’s not a pretty picture.