What Is a “Mortgage-Backed Security” Anyway?

Kegler Brown Litigation Newsletter

We hear about "toxic assets"-mortgage-backed securities gone bad-practically every day now. Sometimes we see references to the "CMBS industry," "CMBS" being shorthand for "Commercial Mortgage-Backed Securities." But what do these terms mean? What is a "mortgage-backed security" anyway?

Well, every mortgage-backed security starts with a group of mortgage loans. In a typical transaction, the bank that made the loans (or sometimes a later purchaser of them) groups the loans together into a "pool." This pool is offered for sale as a whole and, instead of being purchased by a single purchaser, the pool is "securitized."

When a pool of loans is "securitized," it is transferred to a trust, which is administered by a trustee who is responsible for servicing the loans. Investors purchase shares in the trust, called "certificates," similar to purchasing shares in a company. However, not all shares are identical. A range of certificates is generally created, with varying rates of return and varying degrees of risk associated with the various classes of certificates. Prior to the transfer into the trust, credit rating agencies (such as Fitch, Moody’s and Standard & Poors) look at the loans and rate the various certificate classes. AAA-rated certificates, for example, represent the lowest risk, while certificates with a B- rating would represent a higher-risk.

The loans in the pool are not associated with any specific class of certificates. Each certificateholder owns a piece of the entire loan pool. However, the various certificate classes are arranged in such a way that, when the pool incurs a loss (for example, as a result of a defaulted loan), the certificate class with the lowest rating (that is, the highest risk certificates) will get hit with that loss. The most risky certificate classes will absorb all losses until those certificates are worthless, before the less-risky classes see any losses. Because the most risky classes bear any losses in the pool assets first, those investors typically conduct due diligence on the loans prior to the securitization and are given an opportunity to "kick-out" loans they dislike from the pool.

When the economy is humming along, all the investors in a pool of securitized mortgage loans might be very happy-particularly those holding the most risky certificates, which bring with them the highest returns. But, in the current economic climate, the most risky certificates in, for example, a trust of securitized residential mortgage loans, could become worthless in a hurry.

Given all of the above, it is not surprising that the commercial-backed securities industry is seeing significant amounts of litigation recently. Suits include claims against the rating agencies, the banks involved in making and securitizing the loans, and the pool trustees, among others. It is difficult to predict when this trend will reverse. Should you need assistance in this area, the litigation attorneys at Kegler Brown are ready to help.