Mortgage-Backed Securities
Product Overview
Mortgage-backed securities (MBS) represent an investment in mortgage loans. An MBS investor owns an interest in a pool of mortgages, which serves as the underlying assets and source of cash flow for the security. The loans backing the MBS are issued by a national network of lenders consisting of mortgage bankers, savings and loan associations, commercial banks, and other lending institutions.
MBS may be backed by entities such as Government National Mortgage Association (GNMA or colloquially as Ginnie Mae) and backed / issued by Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), and Federal National Mortgage Association (FNMA or Fannie Mae). Ginnie Mae guarantees investors the timely payment of principal and interest on loans originated through the Federal Housing Association (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service (RHS) and Public and Indian Housing (PIH). Freddie Mac and Fannie Mae purchase mortgages forming pools and issue MBS that carry a guarantee of timely payment of principal and interest to the investor. Unlike GNMA, their obligation is not backed by the full faith and credit of the U.S. government.
All MBS are subject to federal, state and local taxes and various securities have different minimum investment amounts. Settlement for MBS depends on the issue and is confirmed on an individual trade basis, but settlement usually occurs within the last two weeks of each month.
Features
a)Attractive yields
•Typically higher yields than government bonds.
•Varies by coupon and term-typically, MBS with higher coupons produce higher yields but carry a greater prepayment risk.
b) Credit quality
•Credit risk is affected by homeowners or borrowers defaulting on their loans. Credit risk is considered minimal for mortgages backed by federal agencies or federally sponsored agencies.
c) High current income
•Investors may receive high payments compared to the income generated by investment grade corporate issues.
•A portion of these payments may represent return of principal, not just interest payments.
d) Liquidity
•The secondary market can be large and relatively liquid, with active trading by dealers and investors.
•Characteristics and risks of a particular security, such as the presence or lack of GSE backing, may affect its liquidity relative to other mortgage backed securities.
Risks
•MBS with higher coupons typically have shorter average lives (defined below) while issues with lower coupons have lengthier average lives.
•Lower interest rates, relative to the rate obtained by the mortgage borrower, may lead some borrowers to refinance their mortgage, while those holding loans with fairly current coupons may not refinance their mortgage.
a) Credit/Default risk
•MBS backed by Ginnie Mae carry no risk of default. There is some default risk for Freddie Mac and Fannie Mae MBS. MBS not backed by any of these agencies generally carry a higher risk of default.
•Pooling mortgages helps mitigate some of this risk.
•Investors considering mortgage backed securities, particularly those not backed by one of these entities, should consider the characteristics of the underlying mortgage pool carefully (e.g. terms of the pooled mortgages, underwriting standards, etc.).
•Credit risk of the MBS issuer may also be a factor depending on the legal structure and entity that retains ownership of the underlying mortgages.
b) Interest Rate risk
•In general, bond prices in the secondary market rise when interest rates fall and visa versa.
•Because of the prepayment risk and extension risk (see below), the secondary market price of MBS will sometimes rise less than a typical bond when interest rates decline, but may drop more when interest rates rise. Thus, there may be greater interest rate risk with MBS than with other bonds.
c) Prepayment risk
•Prepayment risk is the risk that homeowners will pay off more than their required monthly mortgage payments.
•Prepayment is usually precipitated by a decline in interest rates.
•As prepayments occur, the amount of principal retained in the bond declines faster than what otherwise may be expected-thereby shortening the average life of the bond by returning principal prematurely to the bondholder, potentially at a time when interest rates are low.
d) Extension risk
•Extension risk is the risk that homeowners will decide not to make prepayments on their mortgages to the extent initially expected-instead they make only the required monthly payment.
•Extension can be the result of an increase in interest rates. As rates rise, there is little incentive to refinance fixed rate mortgages.
•As the prepayments that were expected do not materialize, the average length of term (average life) originally estimated begins to creep out further along the curve, resulting in a security that is lengthier in term.
Mortgage-Backed Security Issuers
a) Government National Mortgage Association (GNMA or Ginnie Mae)
•A wholly owned government corporation backed by the full faith and credit of the U.S. government.
•Purpose is to ensure that mortgage funds are available throughout the U.S.
•Guarantees certain privately issued mortgage-backed securities.
•Instrumental in eliminating regional differences in the availability of mortgage credit.
•Available in a variety of maturities.
•Minimum denomination for new issue securities is $25,000 with additional increments of $1,000.
•Investments for less than $25,000 may be available by purchasing bonds that are either selling at a discount or have paid back a portion of their principal.
b) Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
•A publicly-owned government-sponsored enterprise not explicitly guaranteed by the U.S. government (see Agency/GSE Product Overview).
•Purpose is to increase the availability of mortgage credit for residential financing.
•Raises most of its funds by developing and maintaining an active secondary market for residential mortgages.
•Issues both mortgage-backed securities and standard corporate coupon bonds, referred to as Government-Sponsored Enterprise (GSE) bonds.
•Securities available in $1,000 increments.
c) Federal National Mortgage Association (FNMA or Fannie Mae)
•A publicly-owned government-sponsored enterprise (see Agency/GSE Product Overview) not explicitly guaranteed by the U.S. government.
•Purpose is to maintain an active secondary market for mortgages.
•Issues both mortgage-backed securities and standard corporate coupon bonds.
•Securities available in $1,000 increments.
Types of MBS
a) Pass-throughs
•In a pass-through MBS, an issuer collects monthly payments from homeowners and then passes on a proportionate share of the collected principal and interest to the investor.
Pass-through MBS have three components of cash-flow:
•Scheduled principal (usually fixed).
•Scheduled interest (usually fixed).
•Prepaid principal (usually variable depending on the actions of homeowners, as governed by prevailing interest rates).
Pass-throughs represent a share of an investment pool consisting of multiple mortgages. Prepayment risk is reduced when the investment is subject to increasingly larger numbers of mortgages because each mortgage prepayment would then have a reduced effect on the total pool. Pass-through securities allow investors to reduce their prepayment risk through diversification rather than a single mortgage investment.
b)Collateralized Mortgage Obligations (CMOs)
•CMOs represent repackaged pass-through mortgage-backed securities, but with the cash-flows directed in a prioritized order based on the structure of the bond. A CMO's objective is to provide some protection against the prepayment risk associated with mortgage investments, above and beyond the protection offered by pass-throughs, while still offering credit quality and high yields.
•CMOs take the cash-flows from pass-throughs and segregate them into different bond classes known as tranches, to provide the investor some level of payment predictability. Tranches are created in an attempt to provide a time frame, or window, during which repayment is expected. The tranches prioritize the distribution of principal payments among various classes and serve as a series of maturities over the life of the mortgage pool.
Average life
•Mortgage securities are often discussed in terms of average life rather than their stated maturity date. The average life is the average time that each principal dollar in the pool is expected to be outstanding, based upon certain assumptions about prepayment speeds. When prepayment speeds are faster than expected, the average life of the CMO is shorter than the original estimate. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life is always a best estimate, contingent on how closely the actual prepayment speeds of the underlying mortgage loans match the assumption.
Liquidity
•CMOs can be less liquid than other mortgage - backed securities due to the individuality of each tranche. Investors need a high level of expertise to understand the implications of tranche-specification. In addition, investors may receive more or less than the original investment upon selling a CMO.
Interest rate risks
•Movements in market interest rates generally have a greater effect on CMOs than other fixed interest obligations because rate movements affect the underlying mortgage loan prepayment rates, and consequently the CMO's average life and yield. Prepayment speeds tend to accelerate in a declining interest rate environment. When rates are rising, prepayments tend to slow down.
CMOs versus traditional mortgage-backed securities
The key difference between traditional mortgage pass-throughs and CMOs is in the principal payment process:
•With Traditional MBS each investor receives a monthly pro rata distribution of any principal and interest payments made by homeowners; a pass-through holder receives some return of principal until the final maturity of a pass-through, when homeowners pay the mortgage in the pool in full. This process results in uncertainty in the timing of principal return because part or all of the debt can be retired early by the borrower.
•CMOs substitute a principal pay-down priority schedule among tranches for the pro rata process found in pass-throughs, which ensures a more predictable rate of principal pay-down.
Product Overview
Mortgage-backed securities (MBS) represent an investment in mortgage loans. An MBS investor owns an interest in a pool of mortgages, which serves as the underlying assets and source of cash flow for the security. The loans backing the MBS are issued by a national network of lenders consisting of mortgage bankers, savings and loan associations, commercial banks, and other lending institutions.
MBS may be backed by entities such as Government National Mortgage Association (GNMA or colloquially as Ginnie Mae) and backed / issued by Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), and Federal National Mortgage Association (FNMA or Fannie Mae). Ginnie Mae guarantees investors the timely payment of principal and interest on loans originated through the Federal Housing Association (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service (RHS) and Public and Indian Housing (PIH). Freddie Mac and Fannie Mae purchase mortgages forming pools and issue MBS that carry a guarantee of timely payment of principal and interest to the investor. Unlike GNMA, their obligation is not backed by the full faith and credit of the U.S. government.
All MBS are subject to federal, state and local taxes and various securities have different minimum investment amounts. Settlement for MBS depends on the issue and is confirmed on an individual trade basis, but settlement usually occurs within the last two weeks of each month.
Features
a)Attractive yields
•Typically higher yields than government bonds.
•Varies by coupon and term-typically, MBS with higher coupons produce higher yields but carry a greater prepayment risk.
b) Credit quality
•Credit risk is affected by homeowners or borrowers defaulting on their loans. Credit risk is considered minimal for mortgages backed by federal agencies or federally sponsored agencies.
c) High current income
•Investors may receive high payments compared to the income generated by investment grade corporate issues.
•A portion of these payments may represent return of principal, not just interest payments.
d) Liquidity
•The secondary market can be large and relatively liquid, with active trading by dealers and investors.
•Characteristics and risks of a particular security, such as the presence or lack of GSE backing, may affect its liquidity relative to other mortgage backed securities.
Risks
•MBS with higher coupons typically have shorter average lives (defined below) while issues with lower coupons have lengthier average lives.
•Lower interest rates, relative to the rate obtained by the mortgage borrower, may lead some borrowers to refinance their mortgage, while those holding loans with fairly current coupons may not refinance their mortgage.
a) Credit/Default risk
•MBS backed by Ginnie Mae carry no risk of default. There is some default risk for Freddie Mac and Fannie Mae MBS. MBS not backed by any of these agencies generally carry a higher risk of default.
•Pooling mortgages helps mitigate some of this risk.
•Investors considering mortgage backed securities, particularly those not backed by one of these entities, should consider the characteristics of the underlying mortgage pool carefully (e.g. terms of the pooled mortgages, underwriting standards, etc.).
•Credit risk of the MBS issuer may also be a factor depending on the legal structure and entity that retains ownership of the underlying mortgages.
b) Interest Rate risk
•In general, bond prices in the secondary market rise when interest rates fall and visa versa.
•Because of the prepayment risk and extension risk (see below), the secondary market price of MBS will sometimes rise less than a typical bond when interest rates decline, but may drop more when interest rates rise. Thus, there may be greater interest rate risk with MBS than with other bonds.
c) Prepayment risk
•Prepayment risk is the risk that homeowners will pay off more than their required monthly mortgage payments.
•Prepayment is usually precipitated by a decline in interest rates.
•As prepayments occur, the amount of principal retained in the bond declines faster than what otherwise may be expected-thereby shortening the average life of the bond by returning principal prematurely to the bondholder, potentially at a time when interest rates are low.
d) Extension risk
•Extension risk is the risk that homeowners will decide not to make prepayments on their mortgages to the extent initially expected-instead they make only the required monthly payment.
•Extension can be the result of an increase in interest rates. As rates rise, there is little incentive to refinance fixed rate mortgages.
•As the prepayments that were expected do not materialize, the average length of term (average life) originally estimated begins to creep out further along the curve, resulting in a security that is lengthier in term.
Mortgage-Backed Security Issuers
a) Government National Mortgage Association (GNMA or Ginnie Mae)
•A wholly owned government corporation backed by the full faith and credit of the U.S. government.
•Purpose is to ensure that mortgage funds are available throughout the U.S.
•Guarantees certain privately issued mortgage-backed securities.
•Instrumental in eliminating regional differences in the availability of mortgage credit.
•Available in a variety of maturities.
•Minimum denomination for new issue securities is $25,000 with additional increments of $1,000.
•Investments for less than $25,000 may be available by purchasing bonds that are either selling at a discount or have paid back a portion of their principal.
b) Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
•A publicly-owned government-sponsored enterprise not explicitly guaranteed by the U.S. government (see Agency/GSE Product Overview).
•Purpose is to increase the availability of mortgage credit for residential financing.
•Raises most of its funds by developing and maintaining an active secondary market for residential mortgages.
•Issues both mortgage-backed securities and standard corporate coupon bonds, referred to as Government-Sponsored Enterprise (GSE) bonds.
•Securities available in $1,000 increments.
c) Federal National Mortgage Association (FNMA or Fannie Mae)
•A publicly-owned government-sponsored enterprise (see Agency/GSE Product Overview) not explicitly guaranteed by the U.S. government.
•Purpose is to maintain an active secondary market for mortgages.
•Issues both mortgage-backed securities and standard corporate coupon bonds.
•Securities available in $1,000 increments.
Types of MBS
a) Pass-throughs
•In a pass-through MBS, an issuer collects monthly payments from homeowners and then passes on a proportionate share of the collected principal and interest to the investor.
Pass-through MBS have three components of cash-flow:
•Scheduled principal (usually fixed).
•Scheduled interest (usually fixed).
•Prepaid principal (usually variable depending on the actions of homeowners, as governed by prevailing interest rates).
Pass-throughs represent a share of an investment pool consisting of multiple mortgages. Prepayment risk is reduced when the investment is subject to increasingly larger numbers of mortgages because each mortgage prepayment would then have a reduced effect on the total pool. Pass-through securities allow investors to reduce their prepayment risk through diversification rather than a single mortgage investment.
b)Collateralized Mortgage Obligations (CMOs)
•CMOs represent repackaged pass-through mortgage-backed securities, but with the cash-flows directed in a prioritized order based on the structure of the bond. A CMO's objective is to provide some protection against the prepayment risk associated with mortgage investments, above and beyond the protection offered by pass-throughs, while still offering credit quality and high yields.
•CMOs take the cash-flows from pass-throughs and segregate them into different bond classes known as tranches, to provide the investor some level of payment predictability. Tranches are created in an attempt to provide a time frame, or window, during which repayment is expected. The tranches prioritize the distribution of principal payments among various classes and serve as a series of maturities over the life of the mortgage pool.
Average life
•Mortgage securities are often discussed in terms of average life rather than their stated maturity date. The average life is the average time that each principal dollar in the pool is expected to be outstanding, based upon certain assumptions about prepayment speeds. When prepayment speeds are faster than expected, the average life of the CMO is shorter than the original estimate. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life is always a best estimate, contingent on how closely the actual prepayment speeds of the underlying mortgage loans match the assumption.
Liquidity
•CMOs can be less liquid than other mortgage - backed securities due to the individuality of each tranche. Investors need a high level of expertise to understand the implications of tranche-specification. In addition, investors may receive more or less than the original investment upon selling a CMO.
Interest rate risks
•Movements in market interest rates generally have a greater effect on CMOs than other fixed interest obligations because rate movements affect the underlying mortgage loan prepayment rates, and consequently the CMO's average life and yield. Prepayment speeds tend to accelerate in a declining interest rate environment. When rates are rising, prepayments tend to slow down.
CMOs versus traditional mortgage-backed securities
The key difference between traditional mortgage pass-throughs and CMOs is in the principal payment process:
•With Traditional MBS each investor receives a monthly pro rata distribution of any principal and interest payments made by homeowners; a pass-through holder receives some return of principal until the final maturity of a pass-through, when homeowners pay the mortgage in the pool in full. This process results in uncertainty in the timing of principal return because part or all of the debt can be retired early by the borrower.
•CMOs substitute a principal pay-down priority schedule among tranches for the pro rata process found in pass-throughs, which ensures a more predictable rate of principal pay-down.
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