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Primer
Mortgage-backed securities
Ivo Kolev
Research Assistant
Financial Policy Forum
July 29, 2004
One of the greatest
innovations in US credit markets in the past 30 years was the creation of the
mortgage-backed securities (MBS) market.
The securitization of mortgages brought new capital and led to more
liquid assets and more efficient market pricing of mortgages. It also led to specialized intermediation of
the mortgage market. Together, these
improvements lowered mortgage rates for borrowers, broadened homeownership and
eliminated regional disparities in the deployment of capital for home mortgage
lending.
From investors’ point
of view, the MBS securitization process converted non-rated, illiquid loans
into securities that are highly liquid, have low credit risk and offer
competitive rates of return. With daily
trading volume exceeding $200 billion and outstanding debt more than $5.3
trillion in 2003, the US mortgage-backed securities market today is one of the
most liquid in the world.[1] MBSs offer higher yield than Treasury notes
and corporate bonds.[2] This higher
yield compensates partially for the higher credit risk, market risk and
especially the embedded prepayment option.
The mortgage
securitization process also helped to stabilize the US housing finance system
by shifting the interest rate risk of mortgages from banks and thrifts to
numerous investors. Furthermore, much
of the credit risk is now held by enterprises like Fannie Mae and Freddie
Mac. These large corporations are
highly capable of diversifying credit risk because they package mortgages from
across the whole nation, compared to most local banks and thrifts who deal
primarily with mortgages from their region.
This
primer will provide an overview of the several different types of MBS, the MBS
market and its unique and unprecedented development. Further on, it will discuss the structure of MBS and the three
major types of residential MBS: mortgage pass-through securities,
collateralized mortgage obligations and stripped mortgage-backed securities.
HISTORY
The
major issuers of mortgage-backed securities are Ginnie Mae, Freddie Mac and
Fannie Mae. The Federal National Mortgage Association, now known as Fannie Mae, was
created by Congress in 1938 to add new capital and liquidity to the US mortgage
market. It was initially owned by the
federal government through the Reconstruction Finance Corporation (RFC). In 1968, Fannie Mae was split into two
corporations: Ginnie Mae, which stayed associated with the government, and
Fannie Mae which became a private stockholder-owned corporation.[3]
The role
of Ginnie Mae, since 1968, is to provide a secondary market for
government-insured mortgages; it is on the federal budget and its programs are
backed by the full faith and credit of the US government. Through Ginnie Mae, the federal government
made its initial foray into mortgage-backed securities in 1970.
The Federal Home Loan Mortgage Corporation, also
known as Freddie Mac, was established by Congress in 1970 to be a secondary
market in mortgages for the savings and loans industry. It was privatized in 1989 into a private
stockholder-owned corporation.
Fannie
Mae and Freddie Mac are not backed by the full credit and faith of the US
government. Both institutions were
created by the federal government and have federal corporate charters. The market perceives an implicit guarantee
by the US government, because like other giant financial institutions, such as
Bank of America, the government is unlikely to let these institutions fail in
the event of financial problems. As a
result, these institutions pay low credit risk premiums when they borrow in
private capital markets.
The
first MBS was brought to market by Ginnie Mae in 1970. Throughout the 1970s and early 1980s the
major type of MBS security was the pass-through security (discussed in details
below). A major innovation for the MBS
market occurred in 1983 when Freddie Mac issued the first Collateralized
Mortgage Obligations (CMOs). These new instruments appealed to investors with
special maturity and cash-flow requirements.
However, the first CMO issues faced complex tax, accounting and
regulatory obstacles. Much of those
legal issues were resolved with the passing of the Tax Reform Act of 1986 which
included the Real Estate Mortgage Investment Conduit (REMIC) tax vehicle. After 1986 the issuance of CMOs grew
enormously. The new tax law also
allowed for the creation of other mortgage instruments such as STRIPs, floaters
and inverse floaters (discussed in details below).
TERMINOLOGY
Before
discussing the different mortgage-backed securities and how they work, the key
terms need to be clearly defined. These
features are common for all MBS and will help the reader understand how the
whole mortgage market works.
·
Mortgage issuer or initial lender is a mortgage lender,
usually a bank, thrift or a mortgage banker.
The issuer lends money to the homeowner who is the borrower.
·
Guarantor guarantees the timely payment of interest and principal on the
mortgage. In the case of Ginnie Mae,
this guarantee is backed by the full faith and credit of the US
government. Fannie Mae and Freddie Mac
guarantee mortgages based on their own creditworthiness.
·
Mortgage servicer: The
main function of the servicer is to collect monthly payments from the mortgage
borrowers and pass the cash flow to the mortgage pool or other mortgage
purchaser.
·
MBS issuer is the institution that issues the mortgage-backed security. It forwards the cash flow to the ultimate
investor.
·
Primary market is where new capital is raised . In the case
of mortgages it is when the mortgage is first issued. In the case of MBS is
when the securities are first brought to market.
· Secondary market is where the title of the asset is transferred,
i.e. where existing mortgages or
existing MBS are traded between investors. In the case of mortgages, there is secondary mortgage market where whole mortgages are sold to
investors or enterprises such as Fannie Mae and Freddie Mac. In the case of
MBS, the MBS secondary market is
where the mortgage-backed securities are traded between investors.
Individuals,
Pension Funds, Insurance co.s, trusts, endowments,
banks and thrifts, Fannie
Mae, Freddie
Mac
Pass-THROUGH
SECURITIES
The
pass-through or the “participation certificate” (PC) is the most common
structure for mortgage-backed securities.
The MBS issuer acquires mortgages from original mortgage lenders. The agency then examines the mortgages to
ensure that they meet the credit-quality guidelines. Loans with similar characteristics (yield and maturity) are
pooled together and the servicer “passes through” a pro rata share of all
interest and principal payments to the investors. For example if an investor owns 2% of the pool, she would receive
2% of all the payments of interest and principal received by the pool less
fees. The actual packaging or “pooling”
can be done by the government sponsored enterprises: Ginnie Mae, Fannie Mae and
Freddie Mac, or by private enterprises.
Payments to investors are made on a monthly basis.
Since
not all the mortgages in a pool have the exact same mortgage rate and maturity,
a weighted-average coupon (WAC) is calculated for the pool of mortgages backing
the pass-through. However, investors
receive what is called net coupon which is the WAC less the fees that the MBS
issuer charges for guaranteeing the issue.
Prepayments
One
of the features that distinguishes mortgage-backed securities from other
fixed-income instruments is the embedded prepayment option. Borrowers may prepay their mortgages for a
wide variety of reasons, such as moving, default or refinancing to take
advantage of lower rates. If the
borrower relocates or defaults on the loan, the house is sold and the whole
mortgage is paid back (Ginnie Mae also allows for the mortgage to be
assumed). The borrower might also
choose to refinance if mortgage rates fall significantly lower than their
contract rate. Furthermore, borrowers
can choose to overpay their monthly bills, called curtailments, so as to save
by retiring their debts early. In all
cases, the prepayment results in a reduction of the outstanding balance of
principal of the mortgage pool.
There
are many models that try to predict prepayment behavior, but the most popular
one is the model published by the Public Securities Association (PSA). It starts with the assumption of .2%
prepayment rate the first month and rises by .2% each month, until it levels
off at 6% at 30 months from the beginning of the mortgage contract. Prepayment speed is usually expressed as a
percentage of the PSA model. For
example, 100% PSA means the speed of prepayment is .2% until the 30th
month, while 200% PSA suggests twice as fast speed of .4% monthly increase
until it reaches 12% by the 30th month, where it remains until
maturity.
What
makes mortgage-backed securities much more difficult to price than conventional
bonds is that the mortgage investor holds a short option on prepayment. Homeowners hold, and should hold, a long
option position, because this allows for more flexibility in decisions. It makes moving to another location less
difficult. It also gives the chance to
refinance.
Credit Risk
Like
any debt instrument, mortgages involve credit risk. Credit risk arises from uncertainty over whether the borrower
will perform as required to fulfill interest and principal payments. In order to reduce that risk on mortgages,
the conventional mortgage contract, which was developed by Fannie Mae in the
1930s, requires borrowers to put down 20% of the house price as
downpayment. This is expressed as 80%
loan-to-value ratio when value refers to the market price of the home. Thus the collateral for the mortgage, the
value of home, amounts to 125% of the debt principal. Mortgage insurance is provided by several federal government
programs as well as by private mortgage insurance companies.
The
Federal Housing Administration (FHA) was created under the National Housing Act
of 1934. It insures mortgages of low-
and moderate-income families to promote ownership for those people. The FHA insurance covers the whole amount of
the loan, but there is a limit to what the size of the loan could be. If the borrower with FHA insurance defaults
insurance, the FHA has two options. It
can pay the lender the insured amount and let the lender take the title of the
house. The FHA can also reimburse the
lender for the entire loan amount and take the title of the house.
The
Department of Veterans Affairs (VA) offers insurance on mortgages for
veterans. Unlike the FHA, the VA insurance
covers only a certain percentage of the loan, up to 25%.
The
Rural Housing Service (RHS) offers limited insurance to single-family houses on
farm properties.
Most
loans are not insured by government agencies like FHA, VA or RHS. These are called conventional mortgages.
Private lenders investing in these mortgages often require private
mortgage insurance (PMI) if the loan-to-value ratio exceeds 80% (that is, if
the home buyer puts down less than 20%).
Such insurance can be obtained from a mortgage insurance company
(MIC). The MIC industry was created in
1920s but collapsed in the 1930s. It
gained popularity again in the 1950s.
Recently, private insurers have been accused of abuses such as repeated
sale of PMI insurance policies to borrowers with enough equity to not require
mortgage insurance.
Investors
in MBSs do not want to hold credit risk on the underlying mortgages, so MBS
issuers provide guarantees. When Fannie
Mae and Freddie Mac issue MBSs, they charge a guarantee fee that is currently
between 20-30 basis points. This is
taken from the gross yield on the loan so it is netted to the investor. These corporations are able reduce their
risk of mortgage default by diversifying their large portfolios across the
nation. Investors in these MBS thus
have not the individual borrower, but Fannie Mae and Freddie Mac as a counter
party to their credit risk. Therefore
the credit risk of mortgage-backed securities issued by Fannie Mae and Freddie
Mac reflects the credit rating of those corporations.
Pass-through programs
Ginnie Mae
Ginnie
Mae offers three pass-through programs: Ginnie Mae I, Ginnie Mae II and Ginnie
Mae Platinum. These programs are backed
by the full faith and credit of the US government. Therefore, they have virtually the same risk as US treasury
securities except for the prepayment risk.
Ginnie Mae pass-throughs are backed by newly originated FHA and VA
insured mortgages and their credit is further enhanced by Ginnie Mae’s
guarantee. Ginnie Mae I has the lowest
servicing spread with 6 basis points for guarantee fee and 44 basis points for
servicing fees. The majority of Ginnie
Mae pass-throughs are issued under Ginnie Mae I, where the securities are
backed by single-family fixed-rate 30- or 15-year mortgages and one-year
adjustable rate mortgages.
Freddie
Mac
Freddie
Mac offers a pass-through program that offers full and timely payment of
interest and principal. Like Freddie
Mac notes and bonds, these pass-throughs are not guaranteed by the full faith
and credit of the US government.
However, some market participants view them as similar in credit
worthiness to Ginnie Mae pass-throughs.
Freddie Mac’s pass-through pools consist of conventional mortgages as
well as those from FHA and VA mortgages.
Freddie Mac charges guarantee fee under 25 basis points and a servicing
fee between 25-37 basis points[4]. Freddie Mac has implemented a contract
feature that adjusts the guarantee fee up or down relative to the current level
of security price spreads.[5]
Fannie
Mae
Fannie
Mae offers a pass-through program which, like Fannie Mae notes and bonds, is
not backed by the full faith and credit of the US government. Fannie Mae’s pass-through pools consist of
conventional mortgages as well as those from FHA and VA mortgages. Fannie Mae’s have similar fees as Freddie
Mac’s: guarantee fee under 25 basis points and servicing fee of 25 to 37 basis
points.[6] In 2003, the average effective guarantee fee
that Fannie Mae reported was 20.2 basis points.[7]
COLLATERALIZED MORTGAGE
OBLIGATIONS (CMOs)
Pass-through
securities became a popular instrument by the early 1980s, but they held some
major drawbacks to investors. The first
and most important was that pass-throughs did not offer complete certainty of
cash flow. Depending on the actual
prepayment from borrowers, investors might end up with a security with
different maturity than expected.
Furthermore, pass-throughs did not fully address the different needs of
investors for instruments with various maturities. While pension funds and life insurance companies looked for
securities with long maturity, banks and thrifts wanted to invest in shorter
term instruments. As an answer to those
drawbacks and the demands of different types of investors, Collateralized
Mortgage Obligations (CMOs) were created.
CMOs provided less uncertainty as to the average life of the investment,
and they offered a full spectrum of maturities that appeal to investors with
different perspectives.
First
issued by Freddie Mac in 1983, CMOs are in essence multiclass securities backed
by a pool of pass-throughs or by mortgage loans. The mortgage cash flows are distributed to investors by the MBS
issuer based on a set of predetermined rules.
Some investors will receive their principal payments before others
according to the schedule.
The
issuer structures the security in classes, called tranches, which are retired sequentially. With the payments from the underlying mortgages, the CMO issuer
first pays the coupon rate of interest to the all investors in each
tranche. After that, all the principal
payments are directed first to the bond class with the shortest maturity. When the first bond class is retired, the
principal payments are directed to the bond class with the next shortest
maturity. This process continues until
all the tranches are paid fully and if there is any collateral remaining, the residual may be traded as a separate
security. In the figure below class A
is the class with the shortest maturity.
After class A is retired, principal payments go to class B. The last class D has the longest
maturity. The above described CMO is
known as sequential pay or plain vanilla CMO.
Another
CMO which was developed after the plain vanilla CMO is the Z-bond. This bond is usually the last tranche in a
CMO deal, and it does not receive any interest until its principal payment
starts. However, interest is accrued
and added to the principal balance.
Z-bonds help stabilize the cash flow of earlier classes, because the
interest that should have been paid to the Z-bond is used to pay the other
tranches.
PACs and
TACs
Planned Amortization Class (PAC) and Target
Amortization Class (TAC) were created to reduce the prepayment risk of
investors. The PAC is structured so that
investors receive a predetermined principal cash flow under a range of possible
prepayment scenarios using a mechanism similar to a sinking fund. The investor will receive a fixed amount of
principal no matter whether the prepayment rate increases or decreases, as long
as it stays within the specified range, which is usually called prepayment band or PAC band. However, the additional stability of the PAC
bonds is achieved by creating a less stable support
bond also known as companion bond or
non-PAC bond. The companion bond absorbs prepayments when prepayments are
higher than expected, and it defers principal payments when prepayments are
slower than expected. Because the
average life variability is higher for companion bonds, they usually pay a higher
yield. TAC bonds provide call protection only if prepayment speed
increases from the projected, while reverse
TAC bonds give protection only against slowdown of prepayments.
Floating-rate bonds
Floating
rate CMOs or “floaters”, first issued
in 1986, offer to pay a variable interest rate tied to an index, usually the
London Interbank Offer Rate (LIBOR).
This type of instrument is usually attractive to European and Japanese
institutional investors and US commercial banks. In order to ensure that the cash flow from the collateral is
sufficient to make the coupon payments on the floaters, MBS issuers also offer “inverse floaters”, which as the name
suggests are inversely indexed to LIBOR.
The floater and the inverse floater combined give the return of a
fixed-rate instrument. Inverse floaters
are attractive instruments for the purpose of hedging against interest rate
risk.
STRIPPED
MORTGAGE-BACKED SECURITIES
Stripped
MBSs, first issued in 1986, are created by dividing the cash flows from the underlying
mortgages or mortgage securities into two or more new securities. Each stripped security receives a percentage
of the underlying security principal or interest payments. For example, the cash flow of a 6%
pass-through can be used to make two new stripped securities, one with 4%
coupon and another with 8% coupon, by directing more of the interest to the
security with higher coupon. Stripped
securities can be partially stripped, meaning that each investor receives some
combination of principal and interest payments, or completely stripped. Strips can also be structured to be an
Interest-Only (IO), which receives only interest from the underlying
securities, and Principal-Only (PO), which gets only the principal payments
without any interest. Both IOs an POs
show substantial price volatility in an environment of changing mortgage
rates.
Principal-Only
Principal-Only
(PO) securities are traded at a substantial discount to par value. The return from the PO strip depends on the
prepayment rate. Higher prepayment rate
would mean higher return, since the investor purchased the PO at a discount and
gets back the face value faster. In an
environment where mortgage rates decline, we expect to see faster prepayment
rate, which will cause the PO price to increase. Conversely, if mortgage rates rise, the price of PO will
fall.
Interest-Only
The Interest-Only (IO) securities are
structured so that investors receive only interest on the amount of outstanding
principal. Therefore, the return on IOs
is inversely related to the speed of prepayments. When prepayments are made, the total amount of interest received
will be less, due to the decline in outstanding principal. When mortgage rates decline, prepayments are
expected to accelerate, which will lower the cash flow for the IO
security. Therefore in an environment
of declining interest rates, the price of IOs tends to decline. Conversely, when mortgage rates rise, prepayments
slow down. This means that investors
will receive interest payments for a longer time, which tends to result in a
higher price of the IO (as long as slower prepayments outweigh higher discount
rates). However, as interest rates keep
increasing, prepayment speeds will eventually level off, and the effect of the
discount rate starts to dominate, which brings the price of IO down.
CONCLUSION
The
securitization of mortgages through the issuance of mortgage-backed securities
have come to play an important role in the US housing finance system over the
past 30 years. The government played an
essential role in the development of this securitization process. The government owned Ginnie Mae and the government-sponsored
enterprises Freddie Mac and Fannie Mae made the issuance of the first
pass-throughs and CMOs possible. The
MBS have provided investors with new classes of liquid assets, and in doing so
it has helped raise more capital and at a lower costs so as to help American
homeowners borrow at a lower interest rate.
A good understanding of the MBSs is therefore essential for comprehending
the US mortgage market today.
REFERENCES
Davidson, Sanders, Wolff, Ching. “Securitization: Structuring and
Investment Analysis”, Wiley, 2003.
Fabozzi, Dunlevy. “Real Estate-Backed Securities”, Frank J. Fabozzi Associates, 2001.
Fannie Mae News Archive, http://www.freddiemac.com/news/archives/investors/2003/mvsrelease_102403.html
Fannie Mae 2003Annual Report.
Hayre, Lakhbir. “Salomon Smith Barney Guide to Mortgage-Backed and
Asset-Backed Securities”, Wiley, 2001.
Hu, Joseph.
“Basics of Mortgage-Backed Securities”, 2nd ed. Frank J.
Fabozzi Associates, 2001.
Kelman, Andrew. “Mortgage-backed Securities & Collateralized Mortgage
Obligations: Prudent CRA Investment Opportunities”, Community Investments, March 2002.
Kendall, Fishman. “A Primer of Securitization”, MIT Press, 1996.
“Mortgage Backed Securities” < http://www.iadb.org/exr/bs/0603/KYoshinari.ppt>
The Bond Market Association, < http://www.bondmarkets.com>
, 2004.
Zipf, Robert.
“How the Bond Market Works”, 2nd ed., New York
Institute of Finance, 1997.
“An Investor’s Guide to Pass-Through and
Collateralized Mortgage Securities”, The Bond Market Association, New York, 2002.