Mortgage-backed security
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A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.
Since residential mortgagors in the United States have the option to pay more than the required monthly payment, with the additional payment reducing the remaining loan principal, the monthly cash flows are not known in advance. This advance payment of principal is known as prepayment and is an additional risk for MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
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[edit] Reasons for issuing mortgage-backed securities
There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities
- transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments.
- allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
- can be used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).
- are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
- allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
- allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk-based capital standards.
[edit] Finding the theoretical fair value
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure. The MBS adds a third risk: early redemption (prepayment). The number of homeowners in residential MBS securitizations who prepay goes up when interest rates go down. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection.
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution exists. In models of this type numerical methods provide approximate theoretical prices. These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.
[edit] Real-world Pricing
Most traders and money managers use Bloomberg and Intex to analyze MBS pools. Intex is also used to analyze more esoteric products. Some institutions have also developed their own proprietary software. Tradeweb is used by the largest bond dealers ("primaries") to transact round lots ($1 Million+).
For "vanilla" 30-year pools (FN/FG/GN) with coupons of 4.5% - 7% one can see the prices posted on a Tradeweb screen by the primaries called To Be Announced (TBA). This is due to the actual pools not being shown - only the issuing agency, coupon and dollar amount are revealed. A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" depending on characteristics.
Another factor which influences pricing is prepayment speed. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases. This is usually measured in units of CPR or PSA.
However, it may be advantageous to the holder for the borrower to prepay: if the pool was bought at a discount. This is due to the fact that when the borrower pays back the mortgage he does so at "par." So if the investor bought a bond at 95 cents on the dollar, as the borrower prepays he gets the full dollar back and his yield increases.
This is unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.
If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every dollar that's prepaid, possibly significantly decreasing the yield.
This is likely to happen as holder of higher-coupon MBS have good incentive to refinance.
Loan Balance is yet a third factor in pricing. The average loan balance for a pool is calculated by dividing the Current Amount (or face amount) by the number of loans.
Low Loan Balance: <85k Mid Loan Balance: Between 85k - 150k High Loan Balance: >150k
[edit] The link between interest rates and loan prepayment speed
Mortgage prepayments are most often made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). Hence the term: prepayment risk.
To compensate investors for the prepayment risk associated with these bonds, they trade at a spread to government bonds. This is referred to as an Option Adjusted Spread.
There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, for instance:
- Economic growth, which is correlated with increased turnover in the housing market
- Home prices inflation
- Unemployment
- Regulatory risk; if borrowing requirements or tax laws in a country change this can change the market profoundly.
- Demographic trends, and a shifting risk aversion profile, which can make fixed rate mortgages relatively more or less attractive.
[edit] Credit risk
The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high because:
- The mortgage originator will generally research the mortgage taker's ability to repay, and will try to lend only to the credit-worthy.
- Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against homeowner default risk. This issuer's guarantee is itself considered very solid because it is considered to be implicitly guaranteed by the US Federal Government.
- Pooling many mortgages with similar default probabilities creates a bond with a much lower probability of total default, in which no homeowners are able to make their payments (see Copula). Although the risk neutral credit spread is theoretically identical between a mortgage ensemble and the average mortgage within it, the chance of catastrophic loss is reduced.
- If the property owner should default, the property remains as collateral. Although real estate prices can move below the value of the original loan, this increases the solidity of the payment guarantees and deters borrower default.
If the MBS was not underwritten by the original real estate & the issuer's guarantee the rating of the bonds would be very much lower, because borrowers with improving credit ratings would opt-out of their mortgage to refinance at a lower credit risk, but those with deteriorating credit ratings never would. (An example of "Adverse selection".)
[edit] The MBS market
The high liquidity of most mortgage-backed securities means that any investor wishing to take a position need not deal with the difficulties of theoretical pricing described above; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than speculation) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing) and certain predatory lending schemes.
Total market value of all outstanding U.S. MBS at the end of the first quarter of 2006 was approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger than the market value of outstanding asset-backed securities. The MBS market overtook the market for US Treasury notes and bonds in 2000.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
- 2005: USD 967 billion
- 2004: USD 1,019 billion
- 2003: USD 2,131 billion
- 2002: USD 1,444 billion
- 2001: USD 1,093 billion
[edit] Types of MBS
Any bond ultimately backed by mortgages is classified as a MBS. This can be confusing, because securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that 'vanilla' designates an option with no special features.
Mortgage-backed security sub-types include:
- Pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
- Residential mortgage-backed security (RMBS) - a pass-through MBS backed by mortgages on residential property
- Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by mortgages on commercial property
- Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
- Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
- Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments.
- Principal-only stripped mortgage-backed securities (PO) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
Varieties of underlying mortgages in the pool:
-
- Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assests), stong credit scores, etc.
- Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
- Subprime: weaker credit scores, no verification of income or assests, etc.
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as set by FannieMae.
[edit] Covered bonds
In Europe exists a type of asset-backed bonds called "covered bonds" (commonly known by the German term Pfandbriefe). Pfandbriefe were first created in 19th century Germany when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated since the creation of a law governing the securities in Germany in 1900. The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep those loans on their books. This means that when a company with mortgage assets on its books issue the covered bond its balance sheet grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities payments.
Sources: GT News -- Covered Bonds: a European Experience and Bond Basics: Everything You Need to Know About Bonds
[edit] See also
[edit] External links
- FannieMae's Mortgage-Backed Securities page, including an MBS locator by CUSIP, Pool or Trust Number
- Court filing. Pages 3-10 describe CMBS, and detail the roles of the various parties: Borrower, Seller, Underwriter, Depositor, Certificateholder (including high and low-risk investor), Servicer, Special Servicer, Trustee, S&P, SEC, IRS, Controlling Class.
