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Mortgage-backed securities, also called mortgage-backed bonds, are pools of real estate mortgages that have been securitized by the issuer, and sold to investors. These mortgage pools consist of particular classes of mortgages in regard to interest rate, maturity, and type of property. Usually, the bank that originated the mortgage also services the loan, for which it continues to deduct a small part of the interest payment as its fee. The rest of the monthly payment, both principal and interest is passed to the investors who purchased the securities, which is why they are also known as pass-through securities.
A major type of the MBS are various forms of REMIC securities. Real Estate Mortgage Investment Conduits (REMIC) can be corporations, partnerships, or trusts that issue mortgage-backed securities of different classes, with different principal balances, interest rates, average lives, prepayment characteristics, final maturities, different yields and different risks, thus expanding the market by creating a more diverse set of securities for investors. The legal basis of REMICs was established by the Tax Reform Act of 1986, which eliminated double taxation from these securities. Unlike traditional pass-throughs, the principal and interest payments in REMICs are not passed through to investors pro rata; instead, they are divided into varying payment streams to create the different classes. The assets underlying REMIC securities can be either other MBS or whole mortgage loans. One example of a REMIC security is the collateralized mortgage obligation.
MBSs can be classified according to issuer or guarantor. Most MBSs are proprietary and are issued by private entities, usually banks; a large percentage are back by the government-sponsored entities (GSEs) Fannie Mae, and Freddie Mac, and a small percentage are backed by the government-owned Ginnie Mae.
| The main issuers of mortgage-backed securities for 2006. The top private issuers include Countrywide Financial, Lehman Brothers, and Wells Fargo. |
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| Source: The role of securitization in mortgage lending, by Richard J. Rosen, Chicago Fed Letter |
In 1968, Congress established the Government National Mortgage Association, commonly known as Ginnie Mae, as a government-owned corporation within the Department of Housing and Urban Development (HUD).
Ginnie Mae does not buy or sell loans or issue mortgage-backed securities, but guarantees investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans — mainly loans insured by the Federal Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA). Other guarantors or issuers of loans eligible as collateral for Ginnie Mae MBS include the Department of Agriculture's Rural Housing Service (RHS) and the Department of Housing and Urban Development's Office of Public and Indian Housing (PIH). A Ginnie Mae MBS is the only MBS that is backed by the full faith and credit of the United States Government, so they are as safe as Treasuries.
The main issuers of Ginnie Mae MBS are mortgage banks, savings and loans, and commercial banks. The monthly payments consist of principal and interest, and have a minimum denomination of $25,000.
As with all MBS's, the interest rate paid to investors is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. Ginnie Mae MBS investors receive a pro rata share of the resulting cash flows (after subtracting servicing and guaranty fees).
There are 2 types of Ginnie Maes:
Ginnie Mae I MBS requires all mortgages in a pool to be the same type (e.g. single-family) and have a first payment date no more than 48 months before the issue date of the securities. Each mortgage must be, and must remain, insured or guaranteed by FHA, VA, RHS or PIH. In addition, the mortgage interest rates must all be the same and the mortgages must be issued by the same issuer. The minimum pool size is $1 million; payments on Ginnie Mae I MBS have a stated 14-day delay (payment is made on the 15th day of each month).
Ginnie Mae II MBS allows multiple-issuer pools to be assembled, which in turn allows for larger and more geographically dispersed pools as well as the securitization of smaller portfolios. A wider range of coupons is permitted in a Ginnie Mae II MBS pool, and issuers are permitted to take greater servicing fees — ranging from 25 to 75 basis points. The minimum pool size is $250,000 for multi-lender pools and $1 million for single-lender pools. Ginnie Mae II MBS have an additional 5-day payment delay because issuer payments are consolidated by a central paying agent (payment is made on the 20th day of each month).
Ginnie Mae Platinum Securities provide investors with greater operating efficiency, allowing holders of multiple MBS to combine them into a single platinum certificate. Ginnie Mae Platinum Securities can be used in structured finance transactions, repurchased transactions as well as general trading.
Freddie Mac and Fannie Mae are government-sponsored entities that have the same charters, Congressional mandates, and regulatory structure.
Like Ginnie Mae, Fannie Mae and Freddie Mac do not lend money, but buy mortgages from lenders to repackage into mortgage-backed securities. Both corporations guarantee the payment of principal and interest to the registered owners of the MBS. While neither is backed by the full faith and credit of the United States government, it is generally believed that if there would be losses to investors, the U.S. government would step in to offset those losses, because both of these corporations were chartered by Congress to make housing more affordable for low- and moderate-income groups—a popular political objective.
The Federal National Mortgage Association (Fannie Mae) was a government-owned corporation, created in 1938, to help low- and middle-income people to buy homes. Fannie Mae buys and sells real estate mortgages that are insured by the Federal Housing Administration or guaranteed by the Veterans Administration. It sells unsecured bonds and notes, and mortgage-backed bonds, which are issued at par, pays semiannual interest, and earned interest is taxed. Ironically, interest and principal payments from unsecured notes and bonds have priority over mortgaged-backed bonds.
Privatized in 1968, equity shares of Fannie Mae trade on the New York Stock Exchange.
Freddie Mac, created in 1970, purchases mortgages from across the country that share similar characteristics – payment terms, interest rate, loan term – and yet may have other characteristics that vary. For example, some mortgages may carry greater credit risk than others, based on the type of property or the credit history of the borrowers. The corporation is held in trust by the Federal Home Loan Bank System and its stock is owned by its members, which include savings banks, savings and loan associations, cooperative banks, commercial banks, credit unions, and insurance companies that are active in housing finance.
The MBS payment stream. Each month, the mortgage payments made by homeowners flow to the holders of the mortgage-backed security:
A homeowner sends the monthly mortgage payment to a lender or loan servicer.
If the mortgage had been purchased by Freddie Mac, the lender sends the homeowner's mortgage payment on to Freddie Mac.
Freddie Mac passes the mortgage payment through to the holders of the mortgage-backed security, minus the fee charged for guaranteeing the timely payment to the investor, as well as some additional fees.
Although, when first issued, MBS have a stated term until maturity, mortgage holders frequently prepay to save on interest, or they may pay off their mortgages, either because they sold their house, refinanced, or simply had extra money. All prepayments are passed through to the holders of the MBS, so the terms of MBSs can be considerably shorter than the stated term when first issued. Because the term of a MBS is variable, the actual term of the security, in contrast to its stated term until maturity or last distribution, is referred to as the average life or average maturity, which is the amount of time when half of a mortgage pool’s principal is paid off, which, when issued, is estimated based on previous mortgage pools of the same type.
Prepayments are more apt to happen when interest rates are falling. Thus, there is not only prepayment risk, but also reinvestment risk, because the investor will usually have to reinvest the money when interest rates are lower.
However, even if there is no prepayment, the amount of income from interest will continually decline over the term of the security, because the principal is reduced with each payment, and thus, there is less principal earning interest.
The main advantage of mortgage-backed securities is that they have more attractive yields for very little risk, since these securities have property as collateral. Investors also receive payment every month instead of the semi-annual payments issued by most bonds.
However, for any investor wanting to sell his MBS in the secondary market, a major disadvantage of an MBS is its negative convexity. Convexity is the relationship of the change in the security’s price in the secondary market to the change in prevailing interest rates. Generally, there is an inverse relationship between interest rates and bond prices. When interest rates rise, bond prices drop, when they decline, bond prices increase. The price of a bond that exhibits negative convexity will rise less than a bond with normal or positive convexity when interest rates decline, but will drop more when interest rates rise. Thus, there is a greater interest rate risk with MBS than with other bonds. However, this risk is only real if the investor wants to sell the MBS in the secondary market.
Negative convexity is easy to understand if you remember that the greater the risk of any bond, the greater the yield that the bond has to pay to entice investors, and that yield is inversely proportional to the bond price. Mortgage-back securities exhibit negative convexity because, when interest rates fall, prepayment risk increases, and when interest rates rise, then default risk increases for those mortgage holders who have variable interest rate loans. This causes MBS to rise slower when interest rates fall, and to fall faster when interest rates rise. This also causes greater volatility than a bond with a comparable term and interest rate.
Some defaults are expected, and the main methods to absorb those defaults without affecting bondholders—and to receive their investment grade rating—are subordination, overcollateralization, and excess spread. Subordination is the issuance of MBSs as different classes, called tranches, with different risks and prepayment flows—the lower tranches receive the highest yield, but are the first to suffer losses. Principal repayments are used to retire the top tranche first, then succeeding tranches in order of seniority. These MBSs are called collateralized mortgage obligations. Overcollateralization is the maintenance of a higher principal balance on the mortgage loans over the principal balance in the outstanding MBSs. Since the eventual payment of principal is passed to the holders of MBSs, defaults would prevent some bondholders from receiving their principal if there was no overcollateralization. Excess spread is the interest rate difference between what is received from the mortgage holders minus the loan servicing fees, and what is paid out to the MBS bondholders. Some excess spread is used to cover defaults, and some is saved for future defaults by increasing overcollateralization, frequently by paying off some of the senior bonds. Subordination and overcollateralization are most often used for MBSs based on prime or jumbo mortgages, and excess spread is used for MBSs with underlying subprime and Alt-A mortgages, where interest rates from the underlying mortgages are higher, allowing more profits from the credit spread.
Although overcollateralization and excess spread are effective in absorbing some defaults, their effectiveness is dependent on the expected default rate. If the losses are higher than expected, then some bondholders are going to suffer losses.
This is what is happening currently (2006-2007) with the proprietary MBSs that included a lot of subprime loans, which are loans to less creditworthy people. The very low interest rates that have prevailed during the early part of this decade and the very high rate of mortgage fraud along with low or nonexistant down payment requirements have created a real estate bubble, in which the price of real estate was rising much faster than people's income. Mortgage fraud included the falsification of documents by inflating income or stating less then the true amount of the borrower's debts. The number of mortgage fraud cases reported by the FBI has increased from less than 10,000 in 2003 to more than 30,000 cases in 2006. It was easy to commit mortgage fraud, because many of these loans were stated income loans in which the borrower would simply certify their income by signing the loan documents. Although lenders verified the source of the income, many did not verify the amount. Many mortgage brokers helped in the fraud, since they are compensated based on how many loans they could originate. Many lenders accepted the subprime loans because they had a higher interest rate, and they could pass the risks on to the buyers of the MBSs.
Now many borrowers are defaulting because the interest rate on their variable rate loans are rising, making the monthly payments unaffordable. Compounding the rising interest rates is the falling prices of their homes, which prevents them from refinancing to better terms. And, of course, the falling home prices is the result of falling demand due to rising interest rates and, more recently, stricter lending. Many homes are now worth less than the amount owed on the mortgage. The credit rating agencies have lowered the ratings of many MBS issues, and several large hedge funds have gone under because of the increasing defaults.
Covered bonds are bonds that are collaterarized by commercial or residential real estate mortgages, or by public sector assets, but they are safer because the bonds are covered not only by the collateral, but also by the lenders of the mortgages. Covered bondholders have a claim not only against the assets, but also the lenders in the case of default. Even mortgage-backed securities issued by European lenders are safer because Europe has stricter lending requirements, generally requiring at least a 20% down payment and verification of income. However, covered bonds are only issued in Europe, with Germany and Denmark being the largest issuers. Covered bondholders have priority over the collateral over all others if the issuer goes bankrupt. Covered bonds are safer because they have strict legal requirements—specifically, they must satisfy the requirements of Article 22(4) of Directive 85/611/EEC, Undertakings for Collective Investment in Transferable Securities (UCITS). Because of their safety, European investment funds are legally allowed to hold 25% of their assets from a single issuer—other assets have a 5% limit. Most buyers of covered bonds are funds and asset managers, savings and co-operative banks, central banks, insurers, and pension funds. The issuance of covered bonds in Europe is larger than the issuance of MBSs there—$2.5 trillion compared to $1.1 trillion.
No Market in the Secondary Mortgage Market - 8/2/2007
Because of the recent fallout from the subprime mortgage market, investors have been very reluctant to buy mortgage-backed securities. Only those loans that conform to the standards of Ginnie Mae, Fannie Mae, and Freddie Mac can be sold. Even Alt-A mortgages, most of which are more creditworthy than subprime, are difficult to sell unless they are rated AAA.
Mortgage rates will rise because lenders can't resell their loans in the secondary market, which means they'll have to carry the loans, which leaves less money to lend out for additional loans. Thus, limited supply will raise prices, causing home prices to fall even more than they already have.
Mortgage rate increases will be substantial for nonconforming loans. Usually, the cost of making nonconforming loans is 102% of the loan value, but nowadays 103% is not enough. It is predicted that rates for nonconforming mortgages will be at least 100 basis points higher. Because conforming mortgages have a limit that is lower than many houses in the most expensive areas of the country, it will be more difficult to get loans for more expensive real estate, which will inevitably lead to lower prices.
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