Tokenized Real Estate Series

From Bank Mortgages to Community-Backed Debt – Who Really Holds the Risk?

January 06, 2025

From Bank Mortgages to Community-Backed Debt – Who Really Holds the Risk?

Most people experience real estate finance through a familiar interface: a 30-year mortgage with a bank or lender. But behind that seemingly simple loan is a complex chain of risk transfer, packaging, and regulation.

As we rethink real estate ownership through tokenization, it’s natural to ask: what if members of the community or other institutions could take on some of the debt risk directly, instead of (or alongside) banks and Wall Street structures?

This post walks through:

  • How a typical mortgage works today.
  • How banks package and move mortgage risk.
  • How tokenized or community-backed debt structures could share or reshape that risk.

1. The Typical Mortgage: From Borrower to Bank

At the front door, a mortgage looks like a simple relationship:

  • A borrower wants to buy a $500,000 house.
  • They put down, say, $100,000 (20%).
  • They borrow the remaining $400,000 as a long-term loan.

Key features:

  • Interest and amortization
    • The borrower pays monthly installments that cover interest plus principal.
    • Early payments are mostly interest; over time, the principal component grows.
    • The loan is secured by the property: if the borrower defaults, the lender can foreclose and sell the home.
  • Underwriting
    • The lender assesses income, credit history, debts, and the property’s value.
    • The goal is to determine: “What is the probability this borrower will repay, and how much could we lose if they don’t?”
  • Regulation and capital
    • Banks must hold capital against the risk of loans on their balance sheets.
    • Regulators set rules that influence how aggressive or conservative lenders can be.

To the borrower, the lender looks like the long-term counterparty. In reality, that’s often not the case.

2. What Banks Do With Mortgages: Hold, Sell, or Securitize

Once a mortgage is originated, the lender has options:

  1. Hold on balance sheet
    • The bank keeps the loan, collects monthly payments, and bears the credit risk.
    • This ties up capital but can be attractive if the loan is high quality and yields are good.
  2. Sell the loan
    • The bank sells the mortgage to another institution (e.g., a larger bank, government-sponsored entity, or investor).
    • The seller gets cash back and can originate more loans; the buyer takes on the risk and cash flows.
  3. Securitize: create mortgage-backed securities (MBS)
    • Many mortgages with similar characteristics are pooled together.
    • The pool’s cash flows are sliced into tranches with different risk/return profiles (senior, mezzanine, equity).
    • Investors buy these tranches; in effect, they are buying exposure to mortgage risk, not to individual loans.

In all cases, the bank’s role is part originator, part risk manager, part intermediary. Over time, mortgages often move away from the originating bank into a broader financial system.

3. Who Ultimately Holds the Risk Today?

In the traditional system, mortgage risk is distributed across:

  • Banks and lenders
    • Hold some loans on balance sheet.
    • Often retain servicing rights (collecting payments, managing escrow).
  • Government agencies / GSEs (in some countries)
    • Provide guarantees or purchase conforming loans (e.g., Fannie Mae/Freddie Mac in the U.S.).
    • Socialize part of the risk in exchange for broader homeownership goals.
  • Institutional investors
    • Pension funds, insurers, hedge funds, and asset managers buy MBS and related products.
    • They seek yield and diversification, accepting varying levels of credit and duration risk.

Local communities and individual investors are largely indirect holders of mortgage risk (through pensions, funds, or taxes), not direct participants in specific homes’ financing structures.

4. Community or Token Holder Participation in Debt Risk

Tokenization opens the possibility that:

  • The same community members or investors who own equity tokens in a property might also own debt tokens linked to the mortgage-like financing on that property.

Imagine the $500,000 house:

  • Instead of a single $400,000 bank mortgage, the financing stack could be:
    • $250,000 senior debt (institutional lender or on-chain credit pool).
    • $150,000 junior/community-backed debt.
    • $100,000 equity (tokenized ownership).

Community members could:

  • Buy junior debt tokens that pay a fixed or variable return, backed by the property’s cash flows.
  • Share in both the upside (through interest income) and the downside (higher risk of loss if the borrower defaults, especially in junior tranches).

5. How Tokenized Debt Could Be Structured

Several patterns are possible:

  1. Simple fractional mortgage
    • A single debt instrument (like a mortgage note) is originated by an SPV or lender.
    • That note is split into standardized tokens representing proportional claims on interest and principal.
    • Token holders receive payments pro-rata; risk is shared equally.
  2. Tranching – community as junior capital
    • Debt is split into:
      • Senior tranche: lower risk, lower return, often funded by institutions.
      • Junior or mezzanine tranches: higher risk, higher return, potentially funded by community members or aligned investors.
    • Losses, if any, hit junior holders first before affecting senior holders.
  3. Shared-equity style structures
    • Instead of pure debt, part of the financing is structured as shared equity or appreciation-linked instruments:
      • Community investors provide funds that reduce the borrower’s monthly payment burden.
      • In return, they receive a share of future appreciation when the property is sold or refinanced.

Tokenization helps by:

  • Making small slices of these instruments accessible.
  • Automating payment flows, tracking balances, and enforcing waterfall rules (who gets paid in what order).
  • Providing transparency into performance (e.g., payment history, LTV ratios).

6. Comparing Bank-Centric vs Community/Institution-Backed Debt

Risk concentration vs distribution

  • Traditional: risk sits with banks, GSEs, and large institutional investors.
  • Tokenized/community: risk can be shared across many smaller holders and local participants, with tranching to match risk appetite.

Alignment with local outcomes

  • Traditional: investors in MBS may have no connection to the community or property.
  • Tokenized/community: neighbors, local institutions, or mission-driven funds can take targeted exposure to the housing outcomes they care about (e.g., supporting stable homeownership or high-quality rentals).

Flexibility of structures

  • Traditional: constrained by standardized products and regulatory templates.
  • Tokenized/community: more room for innovation (e.g., blended interest + appreciation structures, income-adjusted payment schemes), subject to compliance.

Complexity and responsibility

  • Traditional: complex behind the scenes, but simple for borrowers (one lender, familiar mortgage contract).
  • Tokenized/community: potentially more complex governance; more actors share responsibility for funding, restructuring, or loss allocation.

7. Practical Considerations and Risks

Opening debt risk to community members and smaller investors introduces both opportunities and hazards:

  • Regulatory and suitability concerns
    • Debt and structured products are often treated as securities; investor protections and suitability standards matter.
    • Retail investors need clear disclosures and risk education.
  • Liquidity and pricing
    • While tokens can trade, real-world loan performance and default risk are still lumpy and slow-moving.
    • Markets for these instruments may be thin and volatile in early stages.
  • Servicing and workout processes
    • Someone must act as servicer and, if needed, handle delinquency, restructuring, or foreclosure.
    • Clear delegation of authority is needed so that loan management doesn’t get stuck in multi-party governance.
  • Moral hazard and fairness
    • When community members hold debt, there must be safeguards against predatory structures.
    • Ideally, products should be designed to align with borrower stability and community health, not just yield maximization.

8. A Hybrid Future: Banks, Institutions, and Communities Together

The endgame is unlikely to be “no banks.” Instead, a more resilient and inclusive system might look like:

  • Banks and regulated lenders continue to:
    • Originate and service loans.
    • Provide senior capital and compliance infrastructure.
  • Institutional investors continue to:
    • Buy senior and some mezzanine exposures.
    • Provide scale and price discovery.
  • Community members and aligned funds increasingly:
    • Participate in junior or shared-equity layers for properties they care about.
    • Use tokenization to access, monitor, and govern their exposures at a granular level.

For a tokenized $500,000 house, that could mean:

  • A conventional-style senior mortgage layered with:
    • A community-backed mezzanine slice,
    • Plus tokenized equity ownership.

Together, these create a stack where:

  • Risk and return are more finely sliced.
  • Local stakeholders can participate directly.
  • Banks remain critical but no longer the only channel through which mortgage risk flows.

In future posts, we can explore concrete capital stack examples and how they interact with the maintenance, upgrade, and governance frameworks already outlined in earlier entries of this series.