Mortgages are loans issued by a bank to its customers, generally for acquiring and maintaining land, buildings, and other fixed assets, requiring regular payments and backed by collateral. As part of securitization, the individual mortgages are bundled with others into large pools, and securities on this bundled pool are issued and sold to the investors who receive the payment of interest and repayment of the principal amount. Thus, investors effectively loan money to homeowners and get repaid through the mortgage payments of the homeowners.
Let's look at an example of an MBS in action to understand this better. Assume that a bank Banana Ltd. has lent loans to residents of community A to buy property in the said community. Realizing that it needs money faster than the repayment schedule, it decides to sell this portfolio of loans to a third-party investor. However, no investor is willing to take on the entire portfolio which runs into more than $100 million in size. The bank then decides to issue securities against the entire pool and issue the same to various willing investors, who can now own various quantities of the debt instrument, having risk-return characteristics not much different from that of a bond. This is a simplified example of what the securitization process looks like and the securities issued to investors is what is called an MBS.
Mortgage-backed securities are classified into two classes based on the characteristics of the underlying asset:
- Residential MBS - created from the securitization of mortgages related to residential properties
- Commercial MBS- created from the securitization of mortgages related to office buildings, rented properties, hotels, malls, etc.
In the United States, MBSs issued are divided into three types based on the nature and backing of the issuer :
- Those issued and backed by federal agencies such as Ginnie Mae, backed by the full faith and credit of the US Government.
- Those issued and backed by Government-sponsored enterprises (GSE) such as Fannie Mae and Freddie Mac.
- Securities that are neither guaranteed by federal agencies nor GSE's and issued by private entities such as institutions, commercial banks, etc.
Those securities guaranteed by either federal agency or GSE's are referred to as agency RMBS (Residential Mortgage-Backed Securities) while the others are called nonagency RMBS.
Agency RMBS are those RMBS that are constructed by a government agency. This government agency can either be a federal agency or a government-sponsored agency, and the difference between them is explained below.
An example of a federal agency is Ginnie Mae, which due to its virtue of being a part of the US Department of Housing and Urban Development carries the full faith of the US government ensuring that the investors are made timely payments of interest and principal amount.
Securities issued by government-sponsored enterprises such as Fannie Mae and Freddie Mac do not carry the full faith of the US government behind them. However, they are insured to reduce credit risk in exchange for a fee paid by the investors. Furthermore, a loan issued by them must meet certain underwriting standards such as the maximum size of the loan, loan documentation required, loan-to-value ratio, etc., before being securitized and sold to the investors. The loans which meet these criteria are called 'conforming loans' while the ones that don't are called 'non-conforming loans'.
Non - Agency RMBS
Non - agency RMBS refers to securities issued by institutions, commercial banks, and other private entities. This works best when the loans are "non - conforming" and therefore cannot be securitized to sell to investors. As private entities have no such restrictions, they can pool these "non - conforming" loans for securitization and issue securities against them to investors.
As these are not backed by the faith of the US government, they possess a significant amount of credit risk. Further, an absence of any standards on the underlying loans makes it that much harder to ascertain the exact nature and amount of credit risk.
Pass-through securities are securities that pay the investor a percentage of interest and principal equal to the size of their investment in the pool of underlying assets. The MBS is one of the most common types of pass-through securities. Investors in pass-through securities (and by extension MBS) receive interest and principal payments each month based on a repayment schedule, as well as prepayments of principal if any.
Since the investors are not directly involved in collecting the monthly payments from borrowers, service and administrative fee is charged to them for these services, which is deducted from their monthly cash receipts from the securities. As a result, the interest rate on pass-through securities is always lower than the mortgage rate on the underlying assets.
For example, the interest rate on security issued on a mortgage pool with a mortgage rate of 6.7% on the underlying assets will always be less than the mortgage rate of 6.7%. Assuming an interest rate of 6% on the said pass-through securities, the cash flows corresponding to the difference of 0.7% (6.7% - 6%) are charged as the cost of providing administrative services such as collecting the monthly payments, sending payment notice to the customers, charging penalties in case of overdue, sending foreclosure notice and tax information to borrowers when required, etc.
Since not all loans in the underlying mortgage pool originated on the same date with the same maturity, a weighted average of mortgage rate and maturity are determined for the pool of loans.
Collateralized Mortgage Obligation (CMO)
Collateralized Mortgage Obligations are a type of MBS formed by pooling different subordinate asset classes into various tranches based on their risk-return pattern, as well as the prepayment risk associated with them. CMOs were primarily created to appease the institutional investors concerned with the prepayment risk of the mortgage loans due to fluctuations in the interest rates. Some CMO structures are as below:
Sequential pay CMO structure
The sequential pay CMO structure retires each tranche in sequence with the highest tranche being retired first, followed by its subordinated tranche, and so on. The principal portion of the payment is first allocated to the first tranche, also called the senior tranche. Only when the principal value of the first tranche becomes zero are the principal payments made to the subsequent tranches.
The highest tranches are usually less risky as they are paid first with the risk increasing the lower the tranche is, and the riskiest being the junior tranche. The interest payments are made based on outstanding principal payments for each tranche. If the principal payments for the tranche are completely paid off, the investors stop receiving the interest payments for the concerned tranche. As a result, the highest amount of risk and return is allocated to the junior-most tranche, which receives payment on its principal at the very end.
CMO structure using planned amortization class (PAC) and support tranches
PACs are used to limit prepayment risk (both extension and contraction) to its investors by transferring it to accompanying support tranches that absorb any fluctuation in the rate of prepayments. The interest payments are made based on the principal outstanding as with other CMO structures. Prepayment risk is addressed by the structure as follows:
- In case of contraction risk (when the principal is prepaid faster than schedule), the support tranche receives the prepayments first, to the extent, it is ahead of schedule. This ensures the principal tranche (PAC) receives the interest and principal payments as per the predetermined schedule, with virtually no risk.
- In case of extension risk (when the principal is prepaid slower than scheduled), the PAC receives the prepayments first, to the extent it is scheduled to receive it, and only when there is any excess are the support tranches paid their share of principal repayments.
Other CMO structures
There is no limit to the number and types of CMO structures that can be created. For example, a CMO can be structured to have some tranches with floating rates, and also can be made to replicate the payoffs and risks associated with other asset classes.
Another example is a floater tranche that pays its investors a higher rate when interest rates go up while an inverse floater pays a lower rate when the interest rate goes up. They are generally used in combination as the payoff is inversely related.
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Commercial Mortgage-Backed Securities (CMBS)
Commercial Mortgage-Backed Securities are formed when the mortgages on income-producing properties (also called commercial properties) such as office buildings, industrial properties, malls, and healthcare facilities are pooled together and securitized.
Since CBMS, like other MBS, are non-recourse loans, the lender cannot claim properties/assets of the borrower other than the ones under mortgage to recoup the outstanding principal. The loan to value ratio (LTV) and the debt service coverage (DSC) ratio are used to measure the potential of the underlying mortgage portfolio to meet its monthly payment schedule. The higher the LTV ratio, the greater is the chance that the mortgage loan will be paid off, and lower the credit risk.
The debt service coverage is a ratio of a property's annual net operating income to its annual principal and interest payments. The higher the debt service coverage ratio, the greater is the borrowers' ability to pay off the loan using cash flows generated from the commercial property. These metrics only measure the ability to pay and not the willingness.
The risk involved with the repayment principal of a mortgage loan is called its prepayment risk. It is one of the most important risks affecting the payoff in an MBS. As the interest rate environment changes, the borrowers of mortgages may choose to repay their loans faster or slower which drastically affects the various tranches. The junior-most tranche is negatively affected in case of extension risk (as there are lower chances of repayment of principal), while the senior-most tranche is negatively affected in case of contraction risk (as the principal is paid off first, leading to lower returns). The primary factor that directly contributes to the level of prepayment risk is a change in the interest rates. Illustrated below are the effects of interest rates on both types of prepayment risks.
- When the interest rates are low, the mortgage loan owners refinance their loans at a lower rate. As a result, the prepayments are higher than anticipated and the maturity of the mortgage bond declines. This results in an increase in contraction risk.
- When the interest rates are high, the borrowers keep hold of loans with the lower mortgage rates. As a result, the maturity of mortgage bonds increases and the borrowers choose to delay their payments. This results in an increase in extension risk.
Measuring Prepayment risk
Two key metrics to measure prepayment risk are the monthly mortality rate (SMM) and conditional prepayment rate (CPR). Illustrated below are brief definitions and the formulae used to calculate both of them.
Monthly mortality rate (SMM)
The monthly mortality rate is the percentage of monthly mortgage prepayments as compared to the ending mortgage balance outstanding had the prepayments not taken place.. Prepayments are undesirable as it means foregone interest and principal payments, and hence, investors look for mortgage-backed securities that have a low or declining SMM.
Conditional prepayment risk (CPR)
Conditional prepayment risk (CPR) is the percentage of mortgage amount that will be prepaid ahead of schedule in the fiscal year. If the CPR is 7.5%, it means that 7.5% of the total mortgage amount will be prepaid ahead of schedule in the given year. CPR can be derived by substituting the value of SMM:
A higher CPR means a higher rate of prepayment, which negatively impacts the investors' return.
PSA prepayment model
The PSA prepayment model is a prepayment scale developed by the Public Securities Association for analyzing American MBS. It is the most commonly used prepayment model used to estimate prepayment risk. This model assumes that the prepayment rate increases steadily for the initial 30 months of a mortgage and then remains constant for the period after. The standard model, called 100 PSA, assumes that the prepayment increases at the rate of 0.2% every month until it reaches 6% at the end of 30 months, after which it remains stable at that rate. There are many other variations of the same using varying rates of prepayment increases and terminal rates.
Use of MBS
MBS are mainly used for the following benefits:
- Investment-grade MBS could be created out of a pool of lower-rated securities (this practice has been discontinued since the 2008 financial crisis), which increased opportunities for institutional investors who were restricted to only dealing with investment-grade debt, to invest in lower grade credit instruments structured to have lower market risk.
- Securitization of mortgage loans helps banks to take mortgages issued by them off their books, and thus increases their lending power to new customers, thereby giving borrowers easy access to debt (which may not be a good thing as the 2008 financial crisis showed us).
- With a pool of mortgages that have the backing of collateral as the underlying for MBS, they form a relatively safe source of investment for investors in the debt market with regular monthly payments.
The 2008 financial crisis
MBSs were at the forefront of the 2008 financial crisis. The GSE's such as Freddie Mac and Fannie Mae were aggressively securitizing subprime loans in the leadup to the crisis (since 2006), which pushed the prices of the housing market higher and higher while deteriorating the quality of the debt market by having high LTVs. When the subprime borrowers started to default on their loan payments, it had a rippling effect on other homeowners as well. The price of the housing market fell and a lot of people abandoned their houses to avoid paying mortgage loans on the depreciated houses.
As a lot of financial institutions were heavily involved in dealing with the subprime MBSs, many of them collapsed, most notably Lehman Brothers, or suffered heavy losses. The recovery to the crisis saw the increase in regulation on such off-balance securities followed by a steady increase in the size of the MBS markets.
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- Collateralized Debt Obligation (CDO)
- Interest Rate (IR)
- Junior Tranche
- Ratings Agency
- Senior Tranche