Mortgage-backed security
A
mortgage-backed security (MBS) is similar to a
bond whose cash flows are backed by
mortgage payments. In the
United States, residential mortgage loans may usually be
prepaid in whole or in part
at any time. This means that the duration of the cash flows is unknown, which makes an MBS more interesting than plain vanilla bonds. An MBS is an
asset-backed security where the assets are mortgages. Mortgage loans secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, industrial properties and other commercial sites) 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.
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 an arbitrage between the originating credit spread 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.
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, that prepay goes up when interest rates go down, because they can
refinance at a lower
fixed interest rate (fixed rate). In commercial MBS, this risk is mitigated by 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.)
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 a faster turn over 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 less attractive.
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 deteriotating credit ratings never would. (An example of "
Adverse selection".)
|
Risk, Return, Rating & Yield relate |
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
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.
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*
Securitization*
Structured finance*
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.Software
*
Fast Computation of the Expected Tranche Loss of Credit Portfolio
