What are Mortgage and Asset-backed Securities? (Explained)

The mortgage is a loan used for financing the homes. The lender charges a certain rate of interest on the amount of the loan. Mostly, the interest payments are regular, and the property acts as collateral for the security of the loan. The mortgages can of different types that include fixed-rate mortgages and variable-rate mortgages. The variable rate mortgage is when the rate of interest fluctuates in line with the market rate. On the other hand, the fixed rate of interest does not change with the changes in the market rate.

On the other hand, the asset back securities are issued against the pool of the mortgage assets. This helps the lender to get additional financing for their operations. Let’s discuss how a mortgage works and any connection between the mortgage and the asset back securities.

How a mortgage works?

The person looking for a home or some investments in real estate approaches the financial institutions for financing. The proceeds of the mortgage loan can be used to purchase the property or land. Usually, these types of loans are long-term in nature. However, the duration might be different for the different types of loans.

The greater advantage of the mortgage for the lender is that they have peace of mind regarding the security of the disbursed funds. They are aware that their disbursed funds have been invested in the real estate, and they have obtained the purchased property as collateral. So, they have peace of mind regarding the loan’s security to perform or be backed in the form of collateral.

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On the other hand, the advantage for the borrower is that they become an owner of the property by paying installments instead of paying the tenancy expenses. Usually, these loans have a larger duration which means there is no need to worry about the massive size of the payment. The greatest advantage for the borrower is full ownership of the property once they are done with the payments. This is one of the best news for the borrowers fed up with regular payments of the tenancy expenses.

Characteristics of the mortgage loan

Following are the characteristics of mortgage loans.

  1. The rate of the interest on the mortgage loan is comparatively lower than other loans prevailing in the market.
  2. There are multiple options available for the pricing of the mortgage loan. For instance, the rate of the interest may be fixed, variable, or mixed, etc.
  3. Once all of the payments are made for the loan, the liability is eliminated and the property is fully transferred in the name of the borrower.
  4. This type of loan is available for longer tenure as well. Hence, it’s one of the easiest ways for the person to get ownership of the property.

How asset-backed securities work?

The financial institutions disburse different types of the loan to the people. These institutions issue loans against some security. A time comes when they are left with no money to approve further and disburse the loans but a mortgage asset pool.

The shortage of funds restricts the financial institution from approving and disbursing additional loans as they have limited funds. However, they appoint the special purpose vehicle- SPV to raise the finance. The financial institutions agree with the SPV to arrange funds for them based on the pool of the mortgages.

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The SPVs get ratings of the pool of mortgage assets, and trenches are made for a security to be issued against the pool. The SPVs issue security in the market, collect funds against issuance and remit to the financial institution. Hence, by way of securitization, the financial institutes convert illiquid assets into liquid assets or cash. So, the bank/financial institution can use these liquid assets to run their operations further smoothly.

Characteristics of the securitization

Following are the characteristics of the securitization process.

  1. The illiquid pool of the assets is converted to liquid resources.
  2. The process of securitization involves multiple parties like the borrower, financial institution, special purpose vehicles, credit rating agencies, and buyer of the securities backed with the pool of the mortgages.
  3. Asset-backed securities are considered to be the more secured type of investment.
  4. High risky trenches produce a higher return. On the other hand, lower risky trenches of the pool produce lower income. These trenches are organized based on the credit rating of the securities in the pool of the assets.

How mortgages and securitization processes are connected

There is a certain connection between mortgage loans and asset-backed securities. The securitization cannot be completed without the pool of the mortgages, as securitization is the issuance of the security based on the pool of the mortgaged assets. Hence, securitization is only possible when the financial institution has obtained a pool of mortgages.

Conclusion

The mortgage loan is considered one of the easiest ways to finance the purchase of the property. This type of loan is usually disbursed for the greater tenure. The property purchased under the mortgage serves as collateral. It’s like security provided to the lender for approval and disbursement of the loan. Once all the installments and interest are paid on the mortgage loan, the property is free, and the borrower owns it.

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On the other hand, securitization is when an illiquid pool of assets is converted into liquid cash or resources. The financial institutions/banks have limited capacity to disburse the funds. Once the capacity is reached, they are out of the funds, but there is a pool of the assets he obtained against the disbursement of the loans. The financial institutions issue the securities against the pool of the mortgages and get funds from the investors. It means the illiquid pool of the assets has been converted into liquid cash resources, and the process is known as securitization.

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