About Mortgage Backed
Securities
Brief History of the MBS Market
Throughout the 1970s and early 1980s, most mortgage-backed securities
were issued in pass-through
form. Pass-throughs are participations in the cash flows from pools
of individual home mortgages, have long maturities and the potential
for early repayment of principal. In 1983, a dramatic fall in mortgage
rates and a surging housing market caused mortgage origination to
almost double. Much of this production was sold in the capital markets.
To accommodate this surge in supply, financial
engineers created an investment vehicle that would broaden the existing
MBS
investor base. In mid 1983 the Federal Home Loan Mortgage Corporation
issued the first collateralized mortgage obligation (CMO). It was
a three class structure that offered short, intermediate and long
term securities from the cash flows of a pool of mortgages. The
development of CMOs has allowed more investors to become active
in the MBS market.
The U.S. mortgage backed securities market has
grown significantly since the creation of the first collateralized
mortgage obligation (CMO)
in 1983. In fact the CMO sector has become the dominant sector within
the mortgage market. CMOs are basically large pools of mortgage
cash flows that are carved up and structured into different types
of securities. The creation of the CMO gave investors a near U.S.
treasury credit quality, customized performance characteristics,
attractive yields across a range of maturities, and a variety of
risk and return profiles to fit investors’ needs. The MBS
market has come a long way since 1983. A major breakthrough was
the introduction of REMICs
in the Tax Reform Act of 1986, which created efficient tax treatment
for both issuers and investors. The CMO market continues to grow
at a rapid pace. Annual CMO issuance has grown from just $5 billion
in 1983, to $312 billion 1992, and to about $820 billion in 2004.
This growth has helped fuel similar growth in the agency mortgage
pass-through market. Agency pass-through issuance has grown from
$53 billion in 1982 to $1.01 trillion in 2004.
In addition to agency
CMO issuance, there has developed a market backed by nonconforming
mortgages and issued by non-agency
entities (known as whole loan or private label CMOs). In 2004 whole
loan CMO issuance was $478 billion, and at Feb 2005 the outstanding
balance of whole
loan CMOs was approximately $784.2 billion.
The Risk Inherent
in MBS Securities
There are several risks that an investor must be aware of when buying
a CMO. These consist of prepayment
risk, interest rate risk, yield
curve risk, index risk (LIBOR, CMT, COFI etc), duration
risk and structure risk. All of these potential risks must be analyzed
and considered before one can make an educated decision on buying
a CMO.
Prepayment risk
Prepayments are the primary feature that differentiates the MBS
market from other fixed income sectors. A prepayment is the early
repayment of mortgage principal that results from the sale of a
home, or the refinancing or partial principal pay down (curtailment)
of an existing mortgage. Prepayments result from two causes: housing
turnover and refinancing. Since most mortgages are not assumable,
the sale of a home results in a full repayment of the current loan
balance. Various factors such as economic activity, seasonality
(time of year), and family migration patterns affect the level of
housing turnover. Refinancing occurs when borrowers take out new
mortgages (at lower rates) and pay off existing ones. Since most
U. S. residential mortgages do not carry a prepayment penalty, the
decision to refinance is driven by interest rates. As mortgage rates
decline, a homeowner may choose to refinance his existing mortgage
with a lower rate mortgage. The size of the refinancing incentive,
combined with the borrower's ability to be approved for a new mortgage
(reflecting home price appreciation and the borrower's credit situation)
affect the likelihood of prepayments from refinancing.
Prepayments affect MBS investors in three ways:
- Uncertainty about when or at what rate prepayments will occur
leads to uncertainty about the length of time the MBS will remain
outstanding and the schedule of principal cash flows that will
be received. This can be a problem for investors who are trying
to match the maturity of a liability.
- MBS prepayments are made at par ($100). An MBS investor who
paid a premium will lose the premium on the prepaid principal;
an investor who bought at a discount will also receive par, resulting
in a gain.
- Reinvestment risk: Since prepayments rise as rates fall, investors
will generally receive more principal to reinvest when rates are
low, and less principal to reinvest when rates are high.
Investors can measure their prepayment risk via
computerized models
that have been developed by the major broker dealer firms like Lehman
Brothers, Bear Steams, Merrill Lynch and others. These models will
predict how fast prepayments will come in on a monthly basis under
different interest rate scenarios while taking into consideration
various factors like the time of year, geographic economic patterns
and housing migration data.
Interest rate risk
Interest rates affect the value of all fixed income securities in
one way or another. In particular, interest rate movement is very
closely tied to the trading and evaluation of MBS securities and
CMOs because it will affect prepayment rates. For example, when
interest rates increase and mortgage rates increase the expected
rate of prepayment will decrease and certain MBS product may extend
in duration and average life. These longer bonds will either be
worth more or worth less depending on their structure. For example,
if an investor owns an interest only (I0)
bond, he would receive interest payments for a longer period of
time and thus receive a higher rate of return. Conversely, when
rates drop and mortgage rates decrease, refinancing and housing
turnover in general will increase. This will have the effect of
shortening the average life of most MBS. Bonds bought at a discount
will experience an increase in yield and bonds bought at a premium
will result in lower yields in this case. Some examples of these
bullish securities would be inverse floaters
and principle only strips. As you can see, interest rate risk is
not a simple, one dimensional risk in the MBS market. Because of
the ability to structure bonds according to the needs of the investor,
bullish and bearish bonds can be created and used for investing
and hedging in many different interest rate scenarios.
Yield curve risk
The shape of the yield curve is very important when analyzing the
risk of MBS. The shape of the curve is measured by looking at the
difference in yields between two places on the yield curve. The
most common measure of curve shape is the difference in yield between
the long bond and the two-year note. The curve can be characterized
as "steep" (when the difference in yield is large), flat
(a smaller difference than when it was "steep") or inverted
(a negative difference in yield). This concept of curve shape is
important because long rates and short rates affect the Mortgage
market differently. Long rates determine fixed rate mortgage rates
and are closely tracked when watching prepayment speed expectations.
Short rates are influenced largely by Federal Reserve policy and
affect any LIBOR risk that may be inherent in a structured MBS.
Curve shape becomes important when evaluating certain mortgage product
such as inverse IOs. Inverse IOs are worth more in a steep yield
curve environment because you have high long rates (which means
slow prepayments) and low short rates (which means LIBOR is low
and you are maximizing your coupon income). As the curve flattens,
the values of these securities will usually decline. These securities
are complex in nature and have many different kinds of risk embedded
in them. One must be very familiar with the various structures of
CMOs to understand how curve movement or interest rate movement
will affect their value.
Index risk
When we speak about an index we are referring to the following:
LIBOR,
COFI,
and Prime
rate. Each of these indices is published and used in a uniform
fashion by the financial community in evaluating certain MBS product.
Many MBS derivative products have a coupon tied to one of these
indices, For example, if one buys an inverse
floater with an index tied to LIBOR, as LIBOR decreases, coupon
payments increase (hence the name "inverse" floater) and
vice versa. This is considered a very bullish instrument. If the
security is a floater, the coupon will adjust in the same direction
as LIBOR. Floaters are generally neutral to bearish instruments.
The index risk is greater when securities are financed and the financing
cost is tied to an index other than the index to which the coupon
is tied.
Duration risk
Modified duration is a measure of price sensitivity to changes in
yields. Specifically, it is an estimate of the percentage change
in the price of a security if treasury yields change. Effective
duration is modified duration further adjusted by a prepayment model,
which estimates MBS price changes as a function of Prepayment rate
movements as well as interest rate changes. Effective duration is
important to the valuation of prepayment sensitive securities. One
can see the significance of this difference when analyzing an inverse
floater: the high yields of most inverses produce short modified
duration that would substantially understate price sensitivity.
Effective duration is therefore a better guide to price sensitivity
and volatility.
Note: Weighted Average Life is different from
Duration. Weighted Average Life (WAL) is the weighted average
time to receipt of principal for a given pass-through or CMO.
Structure risk
CMOs come in many different shapes and sizes. As mentioned above,
they can be customized to fit the financial needs and objectives
of investors. Today, many CMO structures have complicated formulas
for allocating prepayment risk among the various classes. This prepayment
risk will often change over time as certain bonds pay off. Knowing
that a security has a high initial yield will not necessarily protect
an investor from potential problems if interest rates move, prepayment
rates move or spreads widen. One must be able to analyze and understand
the complete structure of the CMO deal, as well as the structure
of the security that they may be interested in buying within that
deal. It will ultimately be the entire structure of the CMO deal
and the structure of the individual bond within the CMO deal that
will affect the value of the bond the investor owns.
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