Question by : Will mortgage securitization pass or fail in the future?
Will securitization of mortgages succeed or fail in the future markets? What are some reasons why or why not?

Thanks
I was asking more about the general process of the secondary mortgage market where there is securitization of mortgages. (mortgages are pooled together with hundreds or thousands of others, where investors can they invest in them).
Also, do you have any idea what an IO trigger is? an advantage and disadvantage of an IO trigger? I’m not really sure what it means?

Best answer:

Answer by Immortal
Are you talking about the CMO and CDO where there are various different tranches to invest in?

Yes, that sounds very much like CDO/CMO investment. In that case, I don’t think anyone who knows about the true nature of CDO/CMO would bother to invest in it, and ultimately cause it to cease to exist.

Why?
Because these kind of securitization is used to reallocate all the mortgages’ risks (prepayment risk, default risk, interest rate risk, etc) into several different tranches. Some of the tranches will overcompensate the investors based on lower-than-average risks, while some other tranches will be undercompensated based on higher-than-average risks. The average that I mean refers to the average risks of the whole mortgages included in the securitization.

For a smart investor, he will invest in the tranches that overcompensate him. In other words, he was supposed to get average return at average risk if there was no segregation of mortgages by tranches, but because there’s segregation based on tranches, this smart investor will buy the tranches that give him higher return at average risk, or average return at lower risk.

That will leave out the other tranches that undercompensate any investors stupid enough not to realize they are being undercompensated. So these investors will take the most brunt in case of defaults. Even though these tranches are undercompensating, those who package the securitization can make them look very attractive to attract ignorant investors. Only then can all the tranches be sold out. Or else you’ll have half of them sold out and the other half unwanted.

When people get more educated about the nature of these kind of investments, they will stay out of the other half that undercompensate them. Then the party that have liability to the unsold securities will have to continue to bear the mortgage risks. That’s not the purpose of securitization in the first place. Securitization comes with the purpose to transfer the mortgage risk to the buyers, both the smart and the stupid.

I don’t know what you mean by IO trigger, but I know IO stands for Interest Only, which means your investment will receive interest payment only. There will not be any principal amortization. And the higher the interest rates, the lower will be the prepayment rate, and the more certain you’ll continue receiving interest payments into the future.

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