Mortgage-backed securities also called as MBS is an asset-backed security issued by larger financial corporations (bond issuers) representing a collection of mortgages into a single financial instrument.
The MBS undergoes a securitization process, which is a financial exercise that involves pooling of various contractual debts like commercial mortgages, residential mortgages, credit card debt commitments or auto loans and trading those securities as bonds, Collateralized mortgage obligation (CMOs), pass-through securities to its stockholders in secondary markets. The various investors are provided with periodic payments on principal and interest similar to coupon payments.
MBS offers the below benefits in the market:
Excellent Interest Rates: It offers a better value proposition to its investors in terms of return interest rates as compared to government backed Treasury Bonds or investment rank corporate securities or bonds.
Safer investment opportunity: These are guaranteed by the large investment organizations (issuer) as these are composed of pool of mortgages, and essentially return not depending upon single mortgage in the pool. Hence these are considered a safe investment.
Highly liquid: These provide access to the huge secondary market, where anybody can trade their securities, regardless of whether those are matured. It infuses in additional capital in mortgage industry that could be reused to fund commercial and residential real estate.
This is a good way to convert the fixed income into stream of cash.
Easy to trade: Could be easily sold and bought through bank or brokers.
MBS also provide required portfolio diversification to investors by offering higher return rates at lower risks. These are usually a long term investment few of them having a maturity period of around 30 years. However investors seeking short term plan of investment in MBS can trade in the secondary market with ease.
This paper helps us to understand the dynamics of Market Based Securities in the US market. It also encompasses an insight into the major players in the market, regulatory obligations.
Introduction:
Market backed Security is one of the most prolific and innovative financial instruments to be introduced in the US market. It has revolutionized the mortgage, finance and banking industry in US. The MBS in US are issued by investment banks or Quasi Government agencies like Fannie Mae, Freddie Mac or Ginnie Mae.
The MBS traded by government agencies were more attractive as there are guaranteed returns backed by the Federal government itself.
In USA, majority of MBSs are issued by the Government National Mortgage Association ( will be referred as Ginnie Mae from now on), a U.S. government agency, or the Federal National Mortgage Association (will be referred as Fannie Mae from now on) and the Federal Home Loan Mortgage Corporation (will be referred as Freddie Mac from now on), 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. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.
Mechanics of MBS:
These are essentially home loans given by the smaller banks to the homeowners and which in turn are traded to big investment enterprises. The smaller banks act as intermediary between the home buyers and the investment markets.
The large investment companies or quasi-governmental agencies collates hundreds of such smaller home loans as Mortgage Backed Security and issue them as bonds to the MBS investors or "certificateholders.". Quintessentially investors would be indirectly lending money to the home buyers through a bank. Then these MBS are sold to corporate, institutional or individual investors in the secondary market.
The investment companies establish different portfolios called pools by purchasing the loans from Mortgage Lenders across the country. Mortgage Lenders represent an individual or a company that loans money and defines a security interest in the borrower's chattels.
MBS follows a pass through structure as both the principal payments and the interest payments are passed through to the MBS dealers. The MBS provides flexible repayment options on both interests and principal. The securitization of MBS shields the financial institutions from untowardly fluctuating market interest rates.
The MBSs sold by the governmental agencies were particularly attractive, because the returns were guaranteed by these agencies, which were themselves backed by the Federal government. Therefore, those who bought a Fannie Mae or Freddie Mac MBS knew they would get something in return for their investment. Ginnie Mae absolutely guaranteed that investors would receive their payments.
The newer MBS derivatives are sold several months prior to the delivery and hence those are referred as TBA (To Be Announced). The rudimentary details like type of MBA, coupon rates and month of settlements as mentioned in the documentation however few details like number of pools are during the time of delivery.
Securities, Brokers
Underwriters
Banks, Mortgage Lenders
Home owners
Types of MBS:
These financial instruments are complicated. There are multiple sub types of MBS available.
Pass through Securities:
The rudimentary version of the MBS is called Pass through Participation certificates.
These are issued by trusts and allot the cash flows to the security holders from the underlying pool. These are treated as safe Treasury Securities as these are backed by the federal government
Internal Revenue Code and Grantor Trust Rules obligations are applied to these securities and hence these are taxable instruments. Under this obligation, the pass through certificate holders are taxed as direct owner of the portion of the trust allot able to the certificate.
There are varieties of Pass Through Securities:
Commercial Mortgage Backed Security (CBMS) :Backed by mortgages against commercial properties. These are organized as multiple tranches where tranches refer to one of a set of related securities presented as an entity of the same business transaction.
These are obligated to a securitization process called Real Estate Mortgage Investment Conduit (REMIC). This defines a tax law where it sanctions the trust to be a pass through without imposing tax at the trust level.
With government regulations in place, CBMS offers a great level of liquidity and organized structure in market, hence attracting large number of investors.
These pools are closely monitored by the credit rating agencies. These award ratings to the bonds at the time of securitization. They keep the investors updated with the performances, potential loss events that might occur.
Residential Mortgage Backed Security (RMBS): Backed by Mortgages against residential properties. This was first issued by Ginnie Mae way back in 1968. This bond collected the amount of house loans, collated the periodic interest payments and monthly principals and then utilized the monthly cash flows as sponsorship for these bonds.
This could lead to a possible outcome called "Prepayment risk". Since the mortgage principal was assured by the Ginnie Mae, but it did not cover the risk that borrowers pay off the principal balance early or choose refinancing the loan.
This way of selling pooled mortgages created liquidity in the market and allowed the federal agency to buy additional house loans from mortgage dealers.
Due to the ubiquitous demand of the RMBS in early 00s, there were quite a large number of low quality mortgages backed by securitization. This eventually led to the financial crisis in 2008 and it is termed as Subprime mortgage crisis.
Collateralized Mortgage Obligation (CMO) also call Pay through Bonds. These were the first security debt instruments that were given to Freddie Mac in 1983. Since pass through carry a larger repayment risk, those were not seen attractive for long term investors. Hence the agencies reinvented the financial instruments and came up with CMOs.
These represent multi class bonds by a pool of mortgage loans or pass through securities. These are collateralized by both pass through securities and / or mortgage loans. The cash flows are distributed by the issuer as cash flows by means of Tranches. Each CMO constitute a set of two or more tranches
Real Estate Mortgage Investment Conduit (REMIC) : These instruments were developed as CMOs ran into difficulties with the tax laws.
The Tax Reform Law of 1986 facilitated the restructuring of the cash flow of mortgage loans called REMICs.
A stripped mortgage-backed security (SMBS). In this format of MBS, a fragment of payment is done against the outstanding principal amount and another fragment is used to pay the interest on it. Based on the payment options, it could further be sub divided into below
Interest Only Stripped MBS (IO) : Represents a bond where the cash flows are backed by interest component.
A principal-only stripped MBS (PO): Represents a bond where the cash flows are backed by cash component.
Role of MBS in US Economy:
The USA MBSs offers a large pool of highly liquid, high-credit fixed-income securities with attractive yield spreads over US Treasuries. US market has seen an exponential increase in the past 2 decades. In the late 90s the MBS market was pegged around $ 2.3 Trillion representing a major chunk of US economy. It grew by $3.3 trillion dollar in 2001.
In September 2008, the mortgage market was pegged at 26% of all the outstanding bond market debt hence making it the largest segment in the US market.
(Refer: http://www.sec.gov/news/studies/mortgagebacked.htm#secii )
MBS market constitutes the biggest chunk of the securitization market and is the most actively traded bond in US market. According to a statistics, the primary dealers like large financial institution used to trade around $360 Billion per day.
The government backed securitizes trio of Ginnie Mae, Fannie Mae Freddie Mac constitute two thirds of the market.
MBS market plays a significant role for mortgage financing in the US market. The securitization of these mortgage loans facilitates access to the enormous secondary market. This reduces the interest rates for the home buyers.
US government made large number of reforms to facilitate the MBS. All the securities were subjected to the underwriting guidelines. The credit rating agencies rate the mortgages based on their credit scores as below.
Prime Mortgages involves prime borrowers and involves strong credit rating from the credit rating agencies, complete documentation, verifications of income and assets etc.
Alt -A : Nebulous category, these are generally prime borrowers but not complying to the obligations in some way for ex improper documentation.
Jumbo mortgages: The size of the loan is larger than Fannie Mae's "confirming loan amount"
Subprime mortgages: These have weaker credit ratings, incomplete or no verification process of the income or assets. An excessive demand of such mortgages led to the financial crisis in late 2000s and its termed as SubPrime crisis.
With the increase in the competitive market securitization during mid 2000s accompanied by declining underwriting skills, there was a huge demand for subprime mortgages. There was huge competition between the non - GSE securitizers like large investment banks, financial institution and the federal backed GSEs.
This led to creation of large number of subprime mortgage loans as these were vulnerable to repayment risks. The subprime mortgages were subjected to low credit ratings, no proper verification against the assets and hence could not repay the amount. Hence leading to high default rates and foreclosure of the subprime mortgages and causing the financial crisis in 2008. This was term as Subprime mortgage crisis.
The subprime mortgage crisis put the federal government through the worse recession period since the great depression. It was also shot in the arm for larger investment banks like AIG, Lehmann Brothers as they suffered huge losses and had to declare bankruptcy.
The below graph shows how the home mortgage volume drastically went down post the subprime mortgage crisis.
Reference : http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1924831
Discussion of players, their profiles and objectives in the Market:
The major players in the MBS market could be categorized into MBS issuers and MBS investors.
MBS Issuers: MBS Issuers are further categorized into GSE and non-GSE. GSE are Government Sponsored Enterprises and non-GSE includes large investment firms, financial institutions.
GSE are federal government agencies that were established to enhance the credit flow in the market and regulate the liquidity in the market. These carry high credit scores of AAA
There are three GSEs in US. These were forefront in establishing the MBS market and are the largest issuers.
Fannie Mae: Federal National Mortgage Association
The history of MBS in US economy could be traced back to great depression era. During 1938, the federal government setup Federal National Mortgage Association (Fannie Mae) to purchase government backed securities including Federal Housing Administration (FHA) and Veterans Administration loans to infuse liquidity in the mortgage so that banks could lend loans to home owners. It was privatized in 1968 and was split into two entities Fannie Mae and Ginnie Mae.
Freddie Mac ( Federal Home Loan Mortgage Corporation) : The primary reason for its establishment is to make foray into the huge secondary market and enhance it. Lenders in the secondary market would sell the mortgages to Freddie Mac which in turns pools them as Market Backed Securities and push them to the open market hence creating great volume of liquidity in the market.
Ginnie Mae: It is wholly owned federal government corporation. These are fully backed by U.S. Government. It regulates the market and assures timely repayments to the investors. This has special privileges to borrow from U.S. Treasury while the other GSEs cannot.
There are a variety of mechanisms used by GSEs to create MBS. Government sponsored enterprises ("GSEs") - "Fannie Mae" and "Freddie Mac" follow two ways:
Cash program:
In this mechanism, the mortgage initiator picks and sell a group of mortgages as a package to the GSEs.
The mortgage originators are provided with cash after GSEs buy the packages.
Swap program:
In the swap program, the mortgage lender identifies a pool of mortgages that comply to GSEs underwriting criterions and swaps them for MBS issued and assured by the federal government symbolizing interests in the same pool.
Non - GSE Issuers (Private Firms): These include large homebuilders, banks and financial institutions. The MBS issues by these firms are labeled 'private issued' MBS. These MBS are rated by the credit rating agencies. The MBS are backed by residential loans and do not comply with the agencies' protocols.
Investors:
Traditional primary investors of MBS finance instruments were used to be insurance companies, pension funds, thrift institutions, commercial banks, charitable endowments. However over the period there is gradual change in the investors.
Recent market analysis show that Fannie Mae , Freddie Mac and international institutions have become major investors and play an active role. There is also a gradual increase in the number of individual investors.
Investors invest in MBS for either to diverse their long term portfolios or for short term trading purposes. The GSEs and private label MBS market are sensitive to the customers need and changing demands. Hence they have evolved over the years.
Regulatory Framework:
Regulatory framework plays a pivotal role in growth of a country. It brings in the integrity, market confidence and also emphasized financial stability.
SEC:
In US the MBS market is regulated by the SEC Securities and Exchange Commission, it is the primary overseer and regulator. It enforces the regulatory framework for issuance of Residential MBS through Regulation AB issued in 2005. The Regulation AB provides a comprehensive framework that safeguards the interests of the investors as well emphasizing on capital formation.
The SEC amended and adopted the Securities Act of 1933 and Security Exchange act of 1934 to define clear guidelines for registration, disclosure and reporting requirements for asset-backed securities.
FINRA: All the security firms operating in US market are obligated to the largest independent regulator.
FINRA amended the TRACE rules to facilitate the dissemination of the securities.
Office of Federal Housing Enterprise Oversight ( OFHEO) : It was established as a part of Federal Housing Enterprises Financial Safety and Soundness Act of 1992. It's an sub entity with in Department of Housing and Urban Development. Its main function is to oversee the financial safety and capital adequacy of the two GSEs (Freddie Mac and Fannie Mae)
http://www.sec.gov/news/studies/mortgagebacked.htm
http://www.freddiemac.com/mbs/docs/about_MBS.pdf
http://www.sec.gov/pdf/annrep01/ar01marketr.pdf
http://www.sec.gov/rules/final/33-8518.pdf
