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A Primer

Mortgage Backed Securities

In the financial world, there are plenty of ways to grow a portfolio. Mortgage-backed securities are instruments that offer a variety of benefits to those hoping to lend, invest and borrow. Here's a quick introduction to how they work, who might stand to benefit from using them and their greater role in the secondary lending market.

What Are Mortgage-backed Securities?

Securities, or value-bearing financial instruments, serve a variety of purposes. Although their fungible, or interchangeable, nature makes them excellent commodities for brokerage, resale and trade, securities can also be held solely for investment purposes. Mortgage-backed securities, or MBSes, are one such type of instrument.

As their name implies, MBSes derive their value from mortgages. For instance, a bank that wants to lend to customers who don't have many assets might use MBSes to make its portfolios more viable. By acting as an intermediary between an investment company and a would-be homeowner or business borrower, the bank facilitates lending opportunities that might not exist otherwise. Since many banks fund their lending activities by borrowing from enterprises known as warehouse lenders, it's in their best interest to keep their credit free and clear so that they can continue lending money and earning origination fees from borrowers.

Like all securities, MBSes are debt obligations. Although they may differ from other investment vehicles because they're more commonly attached to residential properties instead of investment or commercial assets, they still represent legally valid claims on a borrower's principal and interest payments. Investors typically receive payments on a monthly basis.

Why Do People and Companies Invest in MBSes?

Although MBSes are more complex than other vehicles, they still have a few significant advantages. For instance, their yields are usually significantly higher than those of bonds issued by national treasuries and private corporations. The fact that they come with credit quality ratings is also a definite plus, and MBSes provide far more flexibility than many other fixed-income investment options. The MBS market is also known for its high liquidity, which usually outpaces all other sectors besides U.S. Treasury bonds in terms of transaction volume. The widespread proliferation of advanced analytic mathematical models also makes some investors feel far more confident and knowledgeable about their ventures into the field.

Potential Investment Risks

Of course, no opportunity is flawless. One of the most common risks that investors face with MBSes is what happens when the borrower deviates from the payment plan.

If a borrower prepays their mortgage, or repays it in full before the specified date, then the investor won't receive as much interest as they usually would have. Prepayment can also happen when borrowers refinance their mortgages, which many do when their mortgage interest rates exceed national interest rates due to market fluctuations.

Another risk is known as a credit risk, which is what happens when the borrower doesn't repay the loan. Credit risks not only increase the likelihood that the investor won't get their money but also heighten the chances that the investor will have to spend more cash on collection activities. Although prepayment risks are a bit harder to anticipate, credit risks often correspond to a borrower's credit rating.

What Is a Mortgage Pool?

To mitigate risk and increase their viability as investment vehicles, mortgages can be combined into pools. These are typically sold to investors as a more attractive form of portfolio asset.

Mortgage pools are exceedingly common in the lending industry. Bankers can group mortgages into bundles based on their maturity periods or the kinds of mortgages in question. This may appeal to investors who don't want to sink all of their money into a single loan that might end up going into default. Investing in pools with more substantial collateral amounts is also beneficial for professional investment companies that would rather not hunt down security opportunities individually.

What Is an MBS Pass-through?

There are a few different kinds of mortgage-backed securities. Pass-throughs take the form of trusts that group mortgage payments together and pass them on to investors. Like other forms of trusts that involve pass-through structures, the trustee may be a limited liability company or other entity specifically created to ensure that investor beneficiaries get their money.

MBSes in the Real World

Pass-through MBSes also raise interesting maturity issues. Although a mortgage's maturity date signifies when it's scheduled to be completely paid off, pass-through structures can include different loans with various amortizations, or the amount of time until payoff as per the original repayment plan. This means that even though many MBS pass-throughs start with declared maturities of somewhere between five and 30 years, they may be shorter lived depending on how the mortgages actually get paid off.

Few mortgage-backed securities are created at the time of a loan's origination. Instead, most are the result of non-security mortgages being securitized, or converted into investment vehicles. For example, in the leadup to the 2007 financial crisis, many banks sold mortgages to investors as MBSes to raise lending capital. As investors took notice and demand grew, the increasing prevalence of subprime mortgages, or those issued to bad-credit borrowers, led to overvaluation and inaccurate ratings. Combined with the tendency for such loans to end in nonpayment, these factors directly contributed to the subsequent housing crash and global financial crisis.

The majority of MBSes are pass-through structures. Although this wasn't always the case, changes in how major government-backed issuers operated during the late 20th century resulted in significant increases in MBS issuance and greater housing market stability.

What Is a Mortgage-backed Bond?

Another common type of mortgage-based investment vehicle is the mortgage-backed bond. Like other bonds, these investments provide fixed-income arrangements. Instead of reflecting ownership rights the way other securities do, however, they're secured by liens on the assets of the entity that issued the bond.

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Mortgage-backed bonds can be a bit more predictable than MBSes when it comes to maturity. Since these bonds can't be redeemed early, they may be preferable in certain investment situations, and investors may prefer the reliability of knowing when the maturity date will arrive.

What Are RMBSes?

Residential mortgage-backed securities are supported by the interest and principle from homeowners. These payments can originate from mortgages, home-equity loans and other common forms of residential debt that may appeal to those investing for estate-building purposes.

Residential mortgage-backed securities can include different types of mortgages or pools of financial instruments with distinct interest rate terms, credit qualities and ratings. Although RMBSes were a considerable source of woe leading up to the financial crisis, they still appeal to those who know how to manage their portfolios wisely: Investors often get to have a say in how RMBSes are built and what goes into them. This option can make RMBSes effective vehicles for mitigating risk and managing factors such as the cash flows that investors derive from benefit payouts.

What Is a TBA?

A to-be-announced, or TBA, is a type of trade made for a mortgage-backed security that hasn't yet been designated. Because MBSes are fungible, they can be thought of as interchangeable. This fact means that traders can reach agreements on a few salient details beforehand, such as the maturities of the mortgages, transaction prices and the date of the TBA trade settlement.

How Do TBA Securities Work?

When investors deal in TBA contracts, they don't know which or how many pools their transactions will include. Instead, they get to trade for large lots each worth $1 million, and the securities in question get announced 48 hours before the transaction's agreed-upon settlement date.

Trading in TBA securities carries the risk that the other party might not live up to its end of the bargain. This hazard can be particularly problematic in volatile markets where an investor might not be able to find another party to provide a similar deal. Although there are rules in place designed to mitigate such risks, they don't apply to every investor and might be more relevant to those borrowing on margin accounts where they acquire cash collateral to fund their purchase of securities.

What Is a Mortgage-backed CDO?

Collateralized debt obligations, or CDOs, are a kind of asset-backed security, or ABS. Although most ABSes are backed by pooled assets that don't include mortgages, CDOs can hold mortgages along with non-mortgage assets. They can also feature either option by itself.

Most ABSes gain their value from things like student loans and credit card receivables. Collateralized debt obligations, on the other hand, are formed by trusts and business entities conceived explicitly for such purposes. They can include vehicles like bank loans, bonds or even other CDOs.

CDO Structure

One crucial point to keep in mind is that CDOs typically divide their instruments into three or more groups known as tranches, or risk-based slices. Low-credit-rating mortgages with higher yields fall into the equity tranches, while the more secure, high-credit-rating vehicles are in the senior tranches. The remainder of the instruments are usually grouped in a mid-tier "mezzanine" tranche, but CDOs can be divided even further depending on the needs of the investor.

Even in the midst of the increased regulation brought on by the housing crisis, different banks and financial institutions have unique definitions of which instruments qualify for which tranches. It's important to understand the risk factors and not simply trust a lender that claims to have a great opportunity.

Drawing Distinctions

CDOs differ from collateralized mortgage obligations, or CMOs. Since CMOs only include MBSes, variations like interest rates and prepayment risks have the potential to affect investors even more than they would with diversified alternatives.

Also, remember that CDOs aren't the same as MBSes even though some MBSes can be CDOs. Whereas banks and other originators typically pool MBSes to fund mortgages and make money, CDOs are geared more towards mitigating risks for investors by creating synthetic financial instruments with structured cash flow properties and contractual terms.

How to Trade Mortgage-backed Securities

Mortgage-backed securities offer a range of investment opportunities, and this includes different trading methods. Since investors can purchase them from private, governmental or government-backed enterprises, they satisfy a variety of portfolio goals and needs. Here's a quick introduction to the fundamentals.

How Are MBSes Traded?

A significant number of lenders sell their mortgages to third-party institutions that specialize in investments. These entities are commonly referred to as mortgage aggregators. Such sales typically occur soon after the mortgages are issued because banks don't make much profit by holding onto loans and receiving interest.

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From here, brokers package the loans into MBSes and other structures. Then, they can sell them to wholesalers via mortgage brokers or directly to the public. MBS pools can also be divided into shares prior to sale.

One appealing aspect of MBSes is that they're usually traded like stocks, fixed-income securities and other vehicles, but there are some important distinctions to understand. With stock transactions, share prices are pegged to the value of an instrument at the moment of its trade. With MBSes, sellers usually publish rate sheets that detail how much the devices are worth and stick to these price schemes until new rates get put out. In most cases, lenders issue these sheets in accordance with predetermined pricing changes.

Pricing Factors

MBS prices reflect a wide array of different economic circumstances. For example, news regarding the housing or commercial real estate markets can have a big influence on what brokers and sellers charge. Factors like inflation also have major impacts.

Some investors may be surprised to discover that strong markets don't always bring good tidings. While stock prices typically swell with better economies, MBS and bond prices are known to sink. This trend makes sense considering the fact that increased capital and resource demand mean higher borrowing costs and inflation. The hard-to-predict nature of such factors can make MBS rates extremely sensitive to what seem like relatively minor market adjustments.

In general, MBS price fluctuations coincide with secondary mortgage market demand. As these securities perform better, more investors want in, and sellers tend to charge more in response. Exceptions to this general rule include the fact that some MBSes have higher-than-market-average interest rates that sellers charge premiums for the privilege of purchasing. On the other end of the spectrum, some sellers offer discounts to offset the reduced yields of MBSes that underperform compared to current market rates.

Unfortunately, there's no hard-and-fast rule for anticipating MBS prices. The wide variety of factors that impact the value of mortgages means that it takes a whole lot of advanced math to calculate asking prices that account for inflation, housing market strength and other ongoing realities.

Who Issues Mortgage-backed Securities?

In the U.S., three entities issue the vast majority of MBSes. The Government National Mortgage Association, more commonly referred to as Ginnie Mae, provides mortgages that are fully backed by the U.S. government. The Federal Home Loan Mortgage Corporation, also known as the FHLMC or Freddie Mac, and the Federal National Mortgage Association, also known as the FNMA or Fannie Mae, also offer MBSes. Although these options come with fewer guarantees, they still carry the weight of these entities' power to borrow against U.S. Treasury funds.

The Impacts of MBS Regulation

Although the Federal Housing Finance Agency, or FHFA, doesn't originate or deal in MBSes directly, it's responsible for overseeing Freddie Mac, Fannie Mae and the nationwide Federal Home Loan Bank system. For instance, these government-sponsored enterprises, or GSEs, were placed into conservatorship in 2008, which gave the FHFA the right to make major management decisions and regulate how the companies could manage their MBS portfolios. Since these entities regularly purchase loans from other financial institutions before reissuing them in the form of securities, the FHFA's power to litigate against private enterprises and regulate government entities has a direct impact on the issuance of MBSes and similar investment vehicles.

mortgage backed securities insurance

Private-label Alternatives

Private institutions can also offer securitized mortgages. For instance, a homeowner might obtain a loan from a brokerage firm or bank that later sells it. People who construct their own residential properties using homebuilder financing often discover that their mortgages get sold. These private-label mortgage securities often come with far fewer guarantees, however, and they're not backed by the U.S. government's credit or faith, which may make them riskier.

How to Value or Price MBSes

MBS price analysis can be difficult. For instance, it's not always easy to predict how interest rates will change by the time an investment vehicle matures. Factors like storms and major weather events can also impact the markets by influencing whether people are ultimately able to repay what they owe.

For these reasons, many investors place a higher value on government-backed securities. Because these lenders accommodate borrowers more readily and back their securities, they may be a bit less risk-prone and ultimately worth more attention.

Some critical factors to look at include the interest rates and stated maturities of MBSes. Although each investor has different goals, these parameters are vital to creating a viable portfolio that performs well over time. Other relevant performance indicators include the following:

Coupon Rates

Coupon rates represent the real yearly income earned on the value of a mortgage-backed security. For instance, a $1,000 MBS with an 8 percent coupon rate will pay a total of $80 in interest annually.

Different coupon rates can apply to specific investment situations, such as with MBSes that include mortgages with a variety of interest rates. The gross coupon is the average of all the interest rates in the pool, while the net coupon is what the investor gets after things like servicing fees and guarantees get taken out.

Another critical coupon rate is known as the weighted average coupon, or WAC. Whereas the gross coupon rate is a general average, the WAC represents a total that has been weighted by adjusting each interest rate in the pool according to the size of the accompanying outstanding mortgage. The difference between the net coupon rate and the WAC rate is known as the servicing spread.

Bond issuers get to decide how they'll assign coupon rates based on things like market interest rates and other factors. Since the coupon rate determines how much investors actually receive, it's critical to pay attention to it.

Loan Size

This calculation is relatively simple: It's obtained by dividing the current balance of the pool by the number of loans that have yet to mature. Like other calculations, this average can be weighted to account for which loans make up the bulk of the vehicle.

As might be expected, average loan sizes typically increase with mortgages from areas that have higher housing costs. Loan sizes can also help investors calculate prepayment risks since people with larger loans may be more likely to refinance.

Age and Maturity

An MBS's weighted-average loan age, or WALA, is the average age of the pool's loans. Each loan is weighted by adjusting its dollar amount proportionally to the ratio of the pool's total worth, and the calculation can be made using the stated nominal value or the remaining principal balance.

The weighted-average maturity, or WAM, offers an estimate of how long it will take the security to reach maturity barring prepayments and other developments. As with WALA calculations, the loans are weighted according to their dollar amounts and the portfolio's overall worth. A higher WAM can be a good indicator of sensitivity to interest rate fluctuations.

Collateral Types

Pass-through collateral comes in many forms, so it can be hard to draw distinctions between investment opportunities. Fortunately, lending agencies like the Federal Housing Administration, or FHA, typically group their loans according to factors like whether they're attached to multi- or single-family homes, their original amortization rates, the types of payment schedules they include and their coupon rates. Looking at these differences is a must for investors who want to create structured portfolios for specific purposes.

Built-in Delays

Individual MBSes come with predetermined delays designed to give servicers sufficient time for processing. Investors don't get their money immediately following borrower payments, so it's important to account for this gap period when planning a portfolio.

Other Disclosures

Agencies may include extra information in the descriptions of the pools that they provide. For instance, many specify the credit ratings, type of occupancy and purposes of loans. Other important disclosures, like the loan-to-value ratio, or the current worth of the mortgage compared to the current worth of the asset, can prove essential when investors are trying to steer clear of less-than-stellar opportunities.

What Is a Mortgage Pass-through Certificate?

When an investor puts money into an MBS, he or she receives a mortgage pass-through certificate. This document doesn't mean that they own the security, but it does entitle them to the interest and other income derived from the loan's performance as a financial vehicle. Banks commonly issue them so that they can wash their hands of unusable capital and continue lending money in compliance with Federal Reserve Bank rules regarding institutional liquidity.

Certificate documents are important because they serve as evidence of guarantees and detail when payments will occur. Those issued by federal entities like Fannie Mae also specify critical information, such as the formula for calculating maintenance premiums and conventional risk factors that investors need to recognize.

Which Entity Is a Guarantor of Mortgage-backed Securities?

Only some MBSes are guaranteed, and the nature of the issuer is usually the determining factor. For instance, although Fannie Mae and Freddie Mac both have the power to issue or guarantee MBSes, these assurances lack government backing and are instead linked to the GSEs' organizational performance. While the government backs Ginnie Mae guarantees, the agency primarily sticks to loans insured by entities like the Federal Housing Administration. Ginnie Mae may also serve as the guarantor for securities issued by private issuers that qualify with the agency.

Are FNMA Securities Guaranteed?

Fannie Mae's primary function is to buy mortgages, repackage them as MBSes and sell them. After purchasing loans from secondary sellers that bear the mark of regulatory approval, it typically trades them in the TBA market. These securities come with promises that the investor will receive interest and principal payments in a timely manner, and their assurances are designed to hold true no matter how the underlying mortgages fare.

It's important to understand the nature of Fannie Mae's guarantees and its relationship with the government as a semi-independent corporation. Even though mortgage-backed security certificates from FNMA come with assurances that may be more reliable than those from private sellers, the company doesn't have access to Treasury funds. If the GSE goes bottom up, then the investor loses out.

Key MBS Takeaways

Like many vehicles, mortgage-backed securities offer various ways for investors to make money from other people's debt obligations. The vast majority of home mortgages and many commercial loans end up being sold to investors via the secondary mortgage market. Although there are plenty of regulations in place to keep government enterprises like Fannie Mae and Freddie Mac from buying or selling poorly-rated loans, investors don't always enjoy the same protections. It's vital to be aware of what each opportunity actually entails and create a diversified portfolio that offsets the risks.

Investors also need to recognize the possibility that the secondary mortgage market will continue to evolve. Although federal policies have historically been somewhat hands-off, agencies like Ginnie Mae work towards public goals like increasing market liquidity. As economists and policymakers continue to learn from the housing crisis and other events, the viability of MBS-based strategies is almost certain to change.

Other Reading

  1. JHU MBS Guide
  2. Fannie Mae Jan 1997
  3. Fannie Mae Fixed Rate
  4. FHFA Uniform
  5. CBO 21992
  6. What Is Economics? [vanderbilt.edu]
  7. Department Of Economics [economics.harvard.edu]
  8. Duke University [econ.duke.edu]
  9. Mit Economics [economics.mit.edu]
  10. Economics [econ.columbia.edu]
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