How does one securitize a pool of mortgages, especially subprime mortgages? What is the process from origination of the loan or mortgage to the selling of debt instruments backed by a pool of those mortgages? What problems creep up in this process, and what are the mechanisms in place to mitigate those problems? This paper seeks to answer all of these questions. Along the way we provide an overview of the market and some of the key players, and provide an extensive discussion of the important role played by the credit rating agencies.

In Section 2, we provide a broad description of the securitization process and pay special attention to seven key frictions that need to be resolved. Several of these frictions involve moral hazard, adverse selection and principal-agent problems. We show how each of these frictions is worked out, though as evidenced by the recent problems in the subprime mortgage market, some of those solutions are imperfect. In Section 3, we provide an overview of subprime mortgage credit; our focus here is on the subprime borrower and the subprime loan. We offer, as an example a pool of subprime mortgages New Century securitized in June 2006. We discuss how predatory lending and predatory borrowing (i.e. mortgage fraud) fit into the picture. Moreover, we examine subprime loan performance within this pool and the industry, speculate on the impact of payment reset, and explore the ABX and the role it plays. In Section 4, we examine subprime mortgage-backed securities, discuss the key structural features of a typical securitization, and, once again illustrate how this works with reference to the New Century securitization. We finish with an examination of the credit rating and rating monitoring process in Section 5. Along the way we reflect on differences between corporate and structured credit ratings, the potential for pro-cyclical credit enhancement to amplify the housing cycle, and document the performance of subprime ratings. Finally, in Section 6, we review the extent to which investors rely upon on credit rating agencies views, and take as a typical example of an investor: the Ohio Police & Fire Pension Fund.

We reiterate that the views presented here are our own and not those of the Federal Reserve Bank of New York or the Federal Reserve System. And, while the paper focuses on subprime mortgage credit, note that there is little qualitative difference between the securitization and ratings process for Alt-A and home equity loans. Clearly, recent problems in mortgage markets are not confined to the subprime sector.

Contents
1. Introduction
2. Overview of subprime mortgage credit securitization
2.1. The seven key frictions
2.1.1. Frictions between the mortgagor and originator: Predatory lending
2.1.2. Frictions between the originator and the arranger: Predatory lending and borrowing
2.1.3. Frictions between the arranger and third-parties: Adverse selection
2.1.4. Frictions between the servicer and the mortgagor: Moral hazard
2.1.5. Frictions between the servicer and third-parties: Moral hazard
2.1.6. Frictions between the asset manager and investor: Principal-agent
2.1.7. Frictions between the investor and the credit rating agencies: Model error
2.2. Five frictions that caused the subprime crisis
3. An overview of subprime mortgage credit
3.1. Who is the subprime mortgagor?
3.2. What is a subprime loan?
3.3. How have subprime loans performed?
3.4. How are subprime loans valued?
4. Overview of subprime MBS
4.1. Subordination
4.2. Excess spread
4.3. Shifting interest
4.4. Performance triggers
4.5. Interest rate swap
5. An overview of subprime MBS ratings
5.1. What is a credit rating?
5.2. How does one become a rating agency?
5.3. When is a credit rating wrong? How could we tell?
5.4. The subprime credit rating process
5.4.1. Credit enhancement
5.5. Conceptual differences between corporate and ABS credit ratings
5.6. How through-the-cycle rating could amplify the housing cycle
5.7. Cash Flow Analytics for Excess Spread
5.8. Performance Monitoring
5.9. Home Equity ABS rating performance
6. The reliance of investors on credit ratings: A case study
6.1. Overview of the fund
6.2. Fixed-income asset management
7. Conclusions
References
Appendix 1: Predatory Lending
Appendix 2: Predatory Borrowing
Appendix 3: Some Estimates of PD by Rating

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