Securitization
The process of securitization is complicated, and is highly dependent on the jurisdiction upon which the process is conducted.
First, mortgage loans are purchased from banks, mortgage companies, and other "originators".
Secondly, these loans are assembled into collections, or "pools". While a residential mortgage-backed security (RMBS) is secured by primarily single-family real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multifamily properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites. A CMBS is usually structured differently than a RMBS.
Thirdly, these pools are securitized through various legal methods dependent on the type of MBS and jurisdiction. This securitization is done by government agencies, government-sponsored enterprises, and private entities which may offer credit enhancement features to mitigate the risk of prepayment and default associated with these mortgages. Since residential mortgages in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment), the monthly cash flow of an MBS is not known in advance, and therefore presents risk to MBS investors. These securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools. In the United States, most MBS's are issued by the Federal National Mortgage Association (FNMA, colloquially called Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.
History
After the Great Depression, the federal government of the United States created the Federal Housing Administration (FHA) with the National Housing Act of 1934 to assist in the construction, acquirement, and/or rehabilitation of residential properties. The FHA helped develop and standardize the fixed rate mortgage as an alternative to the balloon payment mortgage by insuring them, and helped the mortgage design garner usage.
In 1938, the government also created the government-sponsored corporation Federal National Mortgage Association (FNMA), colloquially known as Fannie Mae, to create a liquid secondary market in these mortgages and thereby free the loan originators to originate more loans, primarily by buying FHA-insured mortgages.
In 1968 Fannie Mae was split into the current Fannie Mae and the Government National Mortgage Association (GNMA), colloquially known as Ginnie Mae, to support the FHA-insured mortgages, as well as Veterans Administration (VA) and Farmers Home Administration (FmHA) insured mortgages, with the full faith and credit of the United States government.
In 1970, the federal government authorized Fannie Mae to purchase private mortgages, i.e. those not insured by the FHA, VA, or FmHA, and created the Federal Home Loan Mortgage Corporation (FHLMC), colloquially known as Freddie Mac, to do much the same thing as Fannie Mae. Ginnie Mae does not invest in private mortgages.
Securitization
Ginnie Mae guaranteed the first mortgage passthrough security of an approved lender in 1968. In 1971 Freddie Mac issued its first mortgage passthrough, called a participation certificate, composed primarily of private mortgages. In 1981 Fannie Mae issued its first mortgage passthrough, called a mortgage-backed security. In 1983 Freddie Mac issued the first collateralized mortgage obligation.
In 1960 the government enacted the Real Estate Investment Trust Act of 1960 to allow the creation of the real estate investment trust (REIT) to encourage real estate investment. In 1977 Bank of America issued the first private label passthrough, and in 1984 the government passed the Secondary Mortgage Market Enhancement Act (SMMEA) to improve the marketability of such securities. The Tax Reform Act of 1986 allowed the creation of the tax-free Real Estate Mortgage Investment Conduit (REMIC) special purpose vehicle for the express purpose of issuing passthroughs.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because a security derived from an MBS is also called an MBS. 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:
a) * A pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, it is a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
o A residential mortgage-backed security (RMBS) is a pass-through MBS backed by mortgages on residential property.
o A commercial mortgage-backed security (CMBS) is a pass-through MBS backed by mortgages on commercial property.
b) * A collateralized mortgage obligation (CMO) is 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.
c) * A stripped mortgage-backed security (SMBS) where 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:
o An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.
+ A net interest margin security (NIMS) is resecuritized residual interest of a mortgage-backed security
o A principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
There are a variety of underlying mortgage classifications in the pool:
* Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
* Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)
* Subprime mortgages have weaker credit scores, no verification of income or assets, etc.
* Jumbo mortgages when the size of the loan is bigger than the "conforming loan amount" as set by Fannie Mae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are not MBS can also have these subtypes.
Market size and liquidity
There is about $14.2 trillion in total U.S. mortgage debt outstanding. There are about $8.9 trillion in total U.S. mortgage-related securities. The volume of pooled mortgages stands at about $7.5 trillion. About $5 trillion of that is securitized or guaranteed by government sponsored enterprises (GSEs) or government agencies, the remaining $2.5 trillion pooled by private mortgage conduits. Mortgage backed securities can be considered to have been in the tens of trillions, if Credit Default Swaps are taken into account.
Uses
There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities
1. transform relatively illiquid, individual financial assets into liquid and tradable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. 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).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilise capital more efficiently and achieve compliance with risk-based capital standards.
The high liquidity of most mortgage-backed securities means that an investor wishing to take a position need not deal with the difficulties of theoretical pricing; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.[citation needed]
Real-world pricing
Most traders and money managers use Bloomberg and Intex to analyze MBS pools and more esoteric products such as CMOs, although tools such as Citi's The Yield Book and Barclays POINT are also prevalent across Wall Street, especially for multi-asset class managers. 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" or "generic" 30-year pools (FN/FG/GN) with coupons of 3.5% - 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. These are forward prices for the next 3 delivery months since pools haven't been cut — only the issuing agency, coupon and dollar amount are revealed. A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a "pay-up" depending on characteristics. These are called "specified pools" since the buyer specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or PSA. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases.
If the buyer acquired a pool at a premium (>100), 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 holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the low-coupon MBS 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.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS pools are loan amount ranges that each mortgage in the pool must pass. Typically, high premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance command the largest pay-ups. Even though the borrower is paying an above market yield, they are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
The plurality of factors makes it difficult to calculate the value of an MBS security. Quite often, market participants do not concur resulting in large differences in quoted prices for the same instrument. Practitioners constantly try to improve prepayment models and hope to measure values for input variables implied by the market. Varying liquidity premiums for related instruments as well as changing liquidity over time, makes this a devilishly difficult task.
The process of securitization is complicated, and is highly dependent on the jurisdiction upon which the process is conducted.
First, mortgage loans are purchased from banks, mortgage companies, and other "originators".
Secondly, these loans are assembled into collections, or "pools". While a residential mortgage-backed security (RMBS) is secured by primarily single-family real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multifamily properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites. A CMBS is usually structured differently than a RMBS.
Thirdly, these pools are securitized through various legal methods dependent on the type of MBS and jurisdiction. This securitization is done by government agencies, government-sponsored enterprises, and private entities which may offer credit enhancement features to mitigate the risk of prepayment and default associated with these mortgages. Since residential mortgages in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment), the monthly cash flow of an MBS is not known in advance, and therefore presents risk to MBS investors. These securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools. In the United States, most MBS's are issued by the Federal National Mortgage Association (FNMA, colloquially called Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.
History
After the Great Depression, the federal government of the United States created the Federal Housing Administration (FHA) with the National Housing Act of 1934 to assist in the construction, acquirement, and/or rehabilitation of residential properties. The FHA helped develop and standardize the fixed rate mortgage as an alternative to the balloon payment mortgage by insuring them, and helped the mortgage design garner usage.
In 1938, the government also created the government-sponsored corporation Federal National Mortgage Association (FNMA), colloquially known as Fannie Mae, to create a liquid secondary market in these mortgages and thereby free the loan originators to originate more loans, primarily by buying FHA-insured mortgages.
In 1968 Fannie Mae was split into the current Fannie Mae and the Government National Mortgage Association (GNMA), colloquially known as Ginnie Mae, to support the FHA-insured mortgages, as well as Veterans Administration (VA) and Farmers Home Administration (FmHA) insured mortgages, with the full faith and credit of the United States government.
In 1970, the federal government authorized Fannie Mae to purchase private mortgages, i.e. those not insured by the FHA, VA, or FmHA, and created the Federal Home Loan Mortgage Corporation (FHLMC), colloquially known as Freddie Mac, to do much the same thing as Fannie Mae. Ginnie Mae does not invest in private mortgages.
Securitization
Ginnie Mae guaranteed the first mortgage passthrough security of an approved lender in 1968. In 1971 Freddie Mac issued its first mortgage passthrough, called a participation certificate, composed primarily of private mortgages. In 1981 Fannie Mae issued its first mortgage passthrough, called a mortgage-backed security. In 1983 Freddie Mac issued the first collateralized mortgage obligation.
In 1960 the government enacted the Real Estate Investment Trust Act of 1960 to allow the creation of the real estate investment trust (REIT) to encourage real estate investment. In 1977 Bank of America issued the first private label passthrough, and in 1984 the government passed the Secondary Mortgage Market Enhancement Act (SMMEA) to improve the marketability of such securities. The Tax Reform Act of 1986 allowed the creation of the tax-free Real Estate Mortgage Investment Conduit (REMIC) special purpose vehicle for the express purpose of issuing passthroughs.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because a security derived from an MBS is also called an MBS. 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:
a) * A pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, it is a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
o A residential mortgage-backed security (RMBS) is a pass-through MBS backed by mortgages on residential property.
o A commercial mortgage-backed security (CMBS) is a pass-through MBS backed by mortgages on commercial property.
b) * A collateralized mortgage obligation (CMO) is 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.
c) * A stripped mortgage-backed security (SMBS) where 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:
o An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.
+ A net interest margin security (NIMS) is resecuritized residual interest of a mortgage-backed security
o A principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
There are a variety of underlying mortgage classifications in the pool:
* Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
* Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)
* Subprime mortgages have weaker credit scores, no verification of income or assets, etc.
* Jumbo mortgages when the size of the loan is bigger than the "conforming loan amount" as set by Fannie Mae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are not MBS can also have these subtypes.
Market size and liquidity
There is about $14.2 trillion in total U.S. mortgage debt outstanding. There are about $8.9 trillion in total U.S. mortgage-related securities. The volume of pooled mortgages stands at about $7.5 trillion. About $5 trillion of that is securitized or guaranteed by government sponsored enterprises (GSEs) or government agencies, the remaining $2.5 trillion pooled by private mortgage conduits. Mortgage backed securities can be considered to have been in the tens of trillions, if Credit Default Swaps are taken into account.
Uses
There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities
1. transform relatively illiquid, individual financial assets into liquid and tradable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. 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).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilise capital more efficiently and achieve compliance with risk-based capital standards.
The high liquidity of most mortgage-backed securities means that an investor wishing to take a position need not deal with the difficulties of theoretical pricing; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.[citation needed]
Real-world pricing
Most traders and money managers use Bloomberg and Intex to analyze MBS pools and more esoteric products such as CMOs, although tools such as Citi's The Yield Book and Barclays POINT are also prevalent across Wall Street, especially for multi-asset class managers. 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" or "generic" 30-year pools (FN/FG/GN) with coupons of 3.5% - 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. These are forward prices for the next 3 delivery months since pools haven't been cut — only the issuing agency, coupon and dollar amount are revealed. A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a "pay-up" depending on characteristics. These are called "specified pools" since the buyer specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or PSA. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases.
If the buyer acquired a pool at a premium (>100), 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 holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the low-coupon MBS 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.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS pools are loan amount ranges that each mortgage in the pool must pass. Typically, high premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance command the largest pay-ups. Even though the borrower is paying an above market yield, they are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
The plurality of factors makes it difficult to calculate the value of an MBS security. Quite often, market participants do not concur resulting in large differences in quoted prices for the same instrument. Practitioners constantly try to improve prepayment models and hope to measure values for input variables implied by the market. Varying liquidity premiums for related instruments as well as changing liquidity over time, makes this a devilishly difficult task.
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