Mortgage originators - those companies that help start mortgages and transactions - rarely keep the mortgages they start. Many mortgages are sold to secondary markets because the originators want to take the fees they collected and keep mortgage debts off of their books.

These new mortgages usually become part of mortgage-backed securities (MBS), asset-backed securities, and collateralized debt obligations markets.

This article will look at how securities firms uses new mortgages to structure their securities, as well as the performance assumptions for those securities and how the yield requirements affect interest rates and credit terms available to consumers.

From Originator to Investor

Small originators often sell their mortgages to large originators. Those companies pool mortgages together and make them secure as mortgage-backed securities through Fannie Mae, Freddie Mac, or other private-label securities.

The mortgage-backed securities then are sold to securities dealers, who sell them or use them as collateral in finance securities. Those securities are sold to investors. Many of these mortgage-backed securities will be in structured securities, which also are known as structured finance deals.

The Payment Waterfall Structure of CMOs, ABSs, and CDOs

Payment waterfalls can take a pool of mortgages with lower credit characteristics and make tranches within a deal with higher credit ratings.

A "tranche" describes a specific class of bonds within another finance deal. One way to think of the tranche is to think of a security within a security. Many structured deals may have several tranches. Tranches are designed to have a certain credit rating and certain performance characteristics. Some tranches have higher ratings than the pool of mortgages, and others have lower ratings.

In a typical CMO deal, for example, tranches with higher ratings receive priority over tranches with lower ratings. Lower tranches will absorb payment defaults and higher tranches will be unaffected. Specific rules in the waterfall determine the order in which each tranche will take the losses.

Usually about 80 percent of the tranches in a structured deal will have a higher credit rating than the underlying pool. The other 20 percent tranches are of equal or lower rating.

The Demand for Yield, Complex Models, and Pricing Signals

Different tranches are priced based on their credit ratings and the yield that investors demand.

Dealers and investors use complex models to track the performances of the different tranches with various interest rates and economic environments. These models are important to investors who want to determine the yield where a particular tranche in a structured finance deal could be bought. In turn, that yield is an important pricing signal for credit terms and mortgage rates. That signal is passed from securities dealers to aggregators; the aggregators pass that on to originators. This information directly affects the interest rates and credit terms that customers can be offered.

This is important to understanding how structured finance deals affect the interest rates and mortgage terms that consumers may be offered. If the complex model's assumptions about defaults is correct, the lower priority tranches will protect higher priority tranches. This means that everything in the so-called "mortgage machine" will run smoothly. If model is inaccurate, however, there are several things that could happen in the market.

1. Losses will move up the waterfall structure of certain deals. Tranches with higher credit ratings will start to absorb losses.

2. Investors will demand more yield as the securities' credit ratings drop.

3. Securities dealers will lower their bid prices for mortgages and mortgage-backed securities.

4. Mortgage originators will raise interest rates and tighten credit terms to try to protect their profit margins.

The finance market is smart and covers the profits, consumers may think they are taking advantage of companies when they sign up for a low APR , they've run the numbers and no they will profit in the long run.