Introduction to Finance

Securitization
is the process of pooling and packaging mortgage loans into debt securities. A 
mortgage-backed security
is a debt security created by pooling together a group of mortgage 
loans whose periodic payments belong to the holders of the security. Some mortgage-backed 
securities “pass through” the interest and principal payments to the owners of the securities. 
Payments on the underlying mortgages are made to the fi nancial institution that created the 
mortgage-backed security. The institution, in turn, pays or passes through the payments to the 
investors or owners of the securities. In some mortgage-backed securities, the issuer separates 
or “strips” the interest and principal payment streams into separate securities. Cash fl ows 
from interest and principal payments are dependent on continued mortgage payments by the 
fi xed-rate mortgage 
fi xed interest 
rate with a constant periodic 
payment over the real estate 
loan’s life
adjustable-rate mortgage (ARM) 
interest rate and periodic payments 
that vary with market interest rates 
over the real estate loan’s life
securitization 
process of pooling 
or packaging mortgage loans into 
debt securities
mortgage-backed security 
debt 
security created by pooling together 
a group of mortgage loans

---

184
C H A PT E R 7 Savings and Investment Process
borrowers on the underlying mortgage loans. The uncertainty of mortgage payments is further 
increased when mortgages are prepaid during periods of declining interest rates.
Credit Ratings and Scores
A 
credit rating
indicates the expected likelihood that a borrower will miss interest or prin-
cipal payments and possibly default on the debt obligation in the form of a loan, mortgage, 
or bond. Credit ratings are prepared by private organizations on individuals, fi nancial institu-
tions, business fi rms, and government entities.
A credit rating for an individual is typically expressed in terms of a 
credit score
, which is 
a number that indicates an individual’s creditworthiness or likelihood that a debt will be repaid 
according to the terms that were initially agreed to. Creditworthiness refl ects an individual 
borrower’s capacity to pay, his or her character, and the collateral or security to the lender. 
Some borrowers have the capacity to pay but may not be suffi
ciently trustworthy for certainty 
that they will pay. Credit scores are based on an individual’s credit history, as refl ected in 
credit report information (e.g., payments on credit cards, auto loans, mortgages) and public 
records (e.g., bankruptcies, tax liens).
While there are many diff erent credit score systems in use, they each attempt to diff eren-
tiate among high quality, moderate quality, and low-quality borrowers. For example, a credit 
scoring system may range from 500 to 1,000 points in 100-point increments. Mortgage loans 
issued to borrowers with credit scores above 700 might be viewed as prime mortgage loans. A 
prime mortgage
is a home loan to a borrower with relatively high credit worthiness, indicating 
a relatively high likelihood that mortgage payments will be made when due. Of course, the 
higher the credit score, the higher the borrower’s credit quality, with scores above 900 refl ect-
ing the highest credit quality classifi cation.
Mortgage loan borrowers with credit scores of 700 or below, for example, might be considered 
to be subprime borrowers. A