Securitized Profits

EXECUTIVE SUMMARY

Securitizations in the mortgage industry are collateralized with home or commercial mortgage loans and are packaged into mortgage-backed securities (MBS) that are sold to institutional investors seeking to realize higher returns on investment-grade debt instruments compared with other securities of similar credit quality.

Mortgage banks generate revenue through interest income, the sale of loans and loan servicing income. Loan sales are usually structured as whole loan sales, loans securitized and accounted for as a sale, and loans securitized and accounted for as financing.

A gain on sale of loans can be either a cash gain or a non-cash gain. When the sale is accounted for as financing, no gain is recognized. When loans are securitized and accounted for as financing, a company recognizes interest income on the mortgage loans and interest expense on the debt securities (as well as ancillary fees) over the life of the securitization, instead of recognizing a gain or loss upon closing of the transaction.

In recording a gain on the sale of loans securitized and accounted for as a sale, two accounting estimates need to be made: (1) the value of the retained interest and, if applicable, (2) the value of the mortgage servicing rights. Both require the projection of future cash flows that are derived from loans that underlie the MBS. The fair values of each of these assets are based on a series of key assumptions that can significantly impact their fair value and are determined by management judgment.

In the recent past many banks followed a business model of originating mortgage loans and then passing all or most of the risk to the capital markets. This model is now less popular, but securitization is by no means dead. The segregation of risk to allow a greater degree of leverage is what the world of finance is all about and will continue to be in the future, albeit in potentially different forms.

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