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Collateralized mortgage-backed securities are debt instruments that are produced by pooling together a number of mortgage loans. Typically, creating collateralized mortgage-backed securities entails a special process that involves several parties such as a loan originator, an investment bank and a rating agency. After issuing mortgages to various parties, the loan originator sells the loans to an investment bank. The rating agency appraises and rates the underlying mortgages and gives them different ratings that reflect their risk levels. Depending on their ratings, the investment bank divides the mortgages into different classes and then sells them to investors who collect a regular payment for a given period.
Typically, the process of creating collateralized mortgage-backed securities is called securitization. This process involves loan originators, investment banks, rating agencies and others. After the collateralized mortgage-backed securities have been created, they are sold to investors who get paid interest regularly. The loan originator might be a commercial bank, a mortgage banker or another type of entity that specializes in issuing mortgages. These mortgages normally are for the purchase of residential and/or commercial real estate.
A rating agency makes necessary analysis to assess risks associated with the underlying mortgages. Such risks include the likelihood of default, which is when the borrower is not able to repay his or her loan. After assessing the different loans in the pool, the rating agency will appropriately grade the different mortgages using a scale that typically ranges from a high of AAA to a low of CCC. Mortgages graded AAA to BBB are considered to be investment-grade, whereas those graded BB and under are thought of as below investment-grade.
The investment bank classifies the mortgages into different "tranches” according to their grades. Basically, tranches are slices of the pool of mortgages that have different risk and return levels. That is, a tranche is a part of the larger pool, and it might have features different from the other parts. For instance, AAA-rated mortgages make up the AAA tranches, which are the safest in the entire pool, and because they are relatively safer, they produce lower returns than riskier tranches. Tranches are sold to investors, and those who are averse to risk will usually opt for AAA tranches, whereas those who are comfortable with risk will buy riskier ones, such as CCC-rated tranches.
Essentially, when the parties who have acquired mortgages from the originator make principal and interest payments, the money will flow to investors. In a typical fashion, the payments might flow in a top-to-bottom type of system. That is, AAA-rated securities are at the top of the scale, AA rated follow in line, and all the way down to CCC. Thus, investors who hold the AAA-rated securities get paid first, and after they have been fully covered, then B-rated investors get paid next, all the way down to CCC-rated investors, who get paid last. Conversely, when payments can't be met, such as in the event of defaults on certain underlying mortgages, the securities are affected in reverse order, from CCC-rated all the way up to AAA.
Collateralized mortgage-backed securities transactions might involve what are known as servicers. Normally, the servicer's main job is to collect mortgage payments, watch for late payments and perform all necessary tasks when defaults occur. Also, the servicer will deal with a trustee, who ensures that investors who purchased the collateralized mortgage-backed securities are paid, among other responsibilities.