Mortgage Backed Securities

Mortgage Backed Securities: A Basic Overview

At their core, Mortgage Backed Securities offer you a chance to invest in the housing market without buying physical property. They are created when financial institutions bundle up a group of mortgages and sell them as a single investment product. But how do Mortgage Backed Securities work in detail? And how are they structured?

What are Mortgage Backed Securities?

Mortgage Backed Securities are complex financial instruments, created through a process called securitisation. This involves several steps.

1. The originator (usually a bank or other lending institution) lends money to borrowers in the form of mortgages.
2. These loans are then pooled together by the originator.
3. The pooled loans are sold to a financial intermediary, often an investment bank. 
4. The intermediary issues a security, backed by the pool of mortgages, which is then sold to investors. 

Why is this done? Securitisation, and by extension, the creation of Mortgage Backed Securities provides banks and lenders with a way to move loans off their books, freeing up capital and transferring the risk associated with those loans to investors.

Breakdown of Mortgage Backed Securities Structure

Mortgage Backed Securities are often further divided into tranches, or sections, each with its own risk profile and yield. Every Mortgage Backed Security has an issuer, guarantor, and trustee. The issuer is typically an investment bank that purchases the pool of mortgages from the original lenders. The guarantor is often a third-party entity that promises to make up for any defaults on the mortgages. Finally, the trustee acts as the administrator, processing all payments from borrowers and passing them on to investors. It really is an intricate and well-designed structure! To better understand the flow of payments and various entities involved in Mortgage Backed Securities, let's represent it in a simple table. The Mathematics of Mortgage Backed Securities is another facet of understanding these structured financial products. Stay tuned as our next segment will delve deeper into this.

Agency Mortgage Backed Securities

While exploring Mortgage-backed securities (MBS), you'll come across a type called Agency Mortgage Backed Securities. These are special types of Mortgage Backed Securities created by government-sponsored entities or other federal agencies in the United States.

Mortgage Backed Securities Guaranteed by the US Government

These government agencies purchase mortgages from banks, pool them together and then sell the pooled securities to investors. Since these securities are backed by the full faith and credit of the US government, they are considered very safe investments.

• Ginnie Mae (Government National Mortgage Association): Ginnie Mae MBS are explicitly backed by the full faith and credit of the US government.
• Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation): While not directly backed by the US government, the implicit guarantee of government support provides a similar sense of security.

These governmental agencies guarantee that the investors receive their principal and interest, even if borrowers default. As such, they bear the credit risk that could otherwise impact funds.

Exploring Agency Mortgage Backed Securities

When you dive into the world of Agency Mortgage Backed Securities, you'll encounter several types of these securities.

• Pass-Through Securities: In this type, all principal and interest payments from the underlying loans are 'passed through' to investors, less certain fees. Example: Freddie Mac's PC Gold.
• Collateralized Mortgage Obligations (CMOs)/Real Estate Mortgage Investment Conduits (REMICs): These are complex securities that reallocate the cash-flows from the underlying pool to different classes (tranches) based on investors’ needs. 

Every Security has its own identification number (CUSIP), and all necessary information regarding the security can be found on the agencies' websites. As an investor, while examining these securities, they would need to consider various factors.

• Prepayment Risk: This is the risk that the mortgage holders may prepay their mortgage earlier. This risk affects the yield received by the MBS investors.
• Interest Rate Risk: The risk that fluctuating interest rates could affect the rate of prepayment or the overall market price of the MBS.
• Credit Risk: Even though agency MBS are backed by the government, there is still minimal credit risk involved.

With return calculations, the estimated prepayment rate plays a significant role in Agency MBS. Cash flows from MBS are not as straightforward as traditional bonds, they depend heavily on the prepayment behaviour of homeowners, which further depends on the interest rate in the market. The key rate at which prepayments are assumed to occur is represented by the CPR (\(C_{0}\)) rate. Given \(PMT_{t}\) as the payment at each time t (includes both principal and interest), the formula for a mortgage payment is governed by the following equation: \[ PMT_{t} = \frac{r*P_{0}}{1 - (1 + r)^{-N}} \] where \(P_{0}\) is the initial loan amount, \(N\) is the number of payments, \(r\) is the interest rate per period (monthly rate if payments are monthly). Remember, this is a simplified calculation for illustrative purposes. Actual MBS returns calculations account for prepayments and are therefore much more complex. Agency MBS is indeed a unique facet of the Mortgage Backed Securities world that needs thorough understanding, particularly if you're planning to dive into the investing world.

The Role of Mortgage Backed Securities in Economy

In the realm of macroeconomics, Mortgage Backed Securities (MBS) play a powerful role in shaping the overall economic environment. The creation and trading of these securities contribute profoundly to both the financial sector and the broader economy.

Influence of Mortgage Backed Securities on Macroeconomics

The influence of Mortgage Backed Securities on Macroeconomics can be assessed on multiple levels. Homeownership has always been arguably the most significant wealth building tool for individuals, but the securitisation of mortgages into MBS has extended this wealth-building potential to larger economies. At the core, Mortgage Backed Securities serve as a reliable channel linking the capital markets and the housing market. Their first major impact is promoting liquidity. By securitising mortgages, financial institutions move loans off their balance sheets, freeing up capital that can stimulate more lending.

• This process enables more people to access credit for purchasing homes, thereby supporting the housing market.
• As homeowners repay their mortgage loans, the amount is transferred to the holders of these securities, facilitating a cyclic fluidity of money. 

So, we see that Mortgage Backed Securities play a large role in the circulation of money in an economy. They essentially ensure that lenders have sufficient funds to disburse loans. Thereby, contributing to maintaining a healthier financial system. They also play a crucial role in portfolio diversification. Being income-generating assets, MBS provide investors with an additional investment avenue contributing to sound risk management. But there's more to their role: MBS indirectly influence the cost of borrowing in an economy. What about MBS in the context of economic development?

Mortgage Backed Securities in Economic Development

MBS play a significant role in economic development. By facilitating homeownership, they have a direct impact on employment, consumption, and overall economic growth. Firstly, increased homeownership—as enabled by MBS—stimulates demand in the construction industry. This leads to job creation, which in turn boosts consumer spending and contributes towards economic development. Secondly, homeownership encourages household savings. Families investing in homes are likely to cut back on consumption and increase their savings to afford the down payments and regular mortgage payments. This can help to boost the national savings rate. Thirdly, they help cushion economic shocks. By providing a steady flow of capital during economic downturns, MBS can play a pivotal role in ensuring financial stability.

• MBS maintain fluidity in the mortgage lending market, ensuring that homebuyers still have access to mortgage loans.
• By promoting housing affordability, they indirectly stimulate consumption and investment.

Notably, Agency MBS (specifically those issued by Ginnie Mae, Fannie Mae, and Freddie Mac in the U.S) play a significant role in periods of financial instability. Since these securities are either explicitly or implicitly backed by the government, they provide reassurance to investors, consequently stabilising the financial system. In the larger scheme of things, Mortgage Backed Securities foster a more inclusive economy. They make it easier for people—particularly those from lower-income segments—to become homeowners. Not only does this have positive implications for wealth distribution, but it also encourages social stability. Overall, the influence of Mortgage Backed Securities stretches far beyond the financial realm. They are integral tools for economic development, driving growth and stability, and fostering an inclusive economic environment.

Effects of Mortgage Backed Securities in Financial Crisis

The role of Mortgage Backed Securities (MBS) in financial crises is not to be understated. As has been witnessed historically, these securities can both exacerbate a crisis and play a role in mitigating it.

Impact of Mortgage Backed Securities during Economic Downturns

Securitisation is often seen as a double-edged sword during tough economic conditions. On one hand, Mortgage Backed Securities can provide a potent source of liquidity, keeping markets fluid when they might otherwise dry up. On the other hand, when these securities are associated with risky mortgages or are poorly understood by the market, they can be instrumental in the creation and propagation of financial crises. During a market downturn, usually, credit quality deteriorates. Mortgage defaults rise, leading to a decrease in the value of MBS. This can potentially cause large losses for MBS investors and consequently, lead to broader financial instability. Concerning MBS, it's crucial to understand the concept of counterparty risk - the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk can intensify during a downturn when many investors are facing financial difficulties. For MBS, the counterparties are the individuals or institutions repaying the mortgages. If they default on their payments, it can lead to a cascade of losses for investors holding these securities. Reviewing the Global Financial Crisis (2008-2009), we can see clearly how MBS contributed to the crisis:

• Subprime lending: In the years leading up to the crisis, there was a substantial increase in mortgage lending to subprime borrowers (borrowers with lower credit ratings). These subprime mortgages were then securitised into MBS, which were sold to investors globally. 

• Financial Innovation: Financial institutions created complex and opaque financial products (like CDOs: Collateralized Debt Obligations), which made the true risk associated with MBS difficult to assess.

• Rating Agencies: The credit rating agencies assigned overly optimistic ratings to these securities, and many investors were not fully aware of the risks they were taking on.

These factors led to an overvaluation of the MBS, which eventually collapsed, triggering the crisis. However, it's important to remember that MBS can also play a stabilising role during an economic downturn. In particular, Agency MBS (those issued by government agencies like Ginnie Mae, Fannie Mae, and Freddie Mac) can provide a secure investment during times of uncertainty due to government backing.

Understanding the Financial Crisis and Mortgage Backed Securities

To comprehend the relationship between the financial crisis and Mortgage Backed Securities, we must first delve into the nature of these crises. A financial crisis is characterised by severe disruptions in the functioning of financial markets and institutions, typically marked by sharp declines in asset prices and firm failures. The triggers vary, but financial innovation, rapid growth, regulatory failings, macroeconomic shocks and investor panic are often involved. In the case of the 2008 financial crisis, a significant part of these disruptions was related to Mortgage Backed Securities. Specifically, the crisis was rooted in the subprime segment of the MBS market. When the housing market was booming, an influx of these subprime mortgages was issued. These mortgages were then packaged into MBS and transferred to global investors hungry for the high returns these securities seemed to offer. However, when the U.S. housing bubble burst, a significant number of subprime borrowers defaulted on their loans. This led to sizeable losses for holders of subprime MBS, causing a ripple effect throughout the global financial system. A widespread loss of confidence in banking systems followed, and this, combined with investments turning sour and massive withdrawal of funds, led to a full-blown financial crisis. In hindsight, numerous mistakes were made in the run-up to the crisis:

• Unsuitable Lending: Lenders relaxed their credit standards and extended loans to high-risk borrowers.
• Misleading Ratings: Rating agencies failed to accurately assess the risk of these securities.
• Unchecked Financial Innovation: The creation of complex MBS products outpaced the industry's understanding of those products.
• Poor Risk Management: Many financial institutions did not adequately manage the risks associated with MBS. 

However, understanding this history can provide valuable lessons for the future handling of Mortgage Backed Securities, particularly in terms of lending practices, transparency, risk management, and regulatory oversight.

Types of Mortgage Backed Securities

Mortgage Backed Securities (MBS) present a wide range of types. Each type is distinctive in its composition and the risk it carries. These types aim to cater to a diversity of investor preferences regarding risk and return. Understanding these types can greatly aid prospective investors in making informed decisions.

Various Forms of Mortgage Backed Securities

Mortgage Backed Securities are distinguished mainly by the type of mortgages they contain and by who issues them. Each type carries with it specific features that affect both the risk and potential returns to investors. For starters, there are two basic forms of Mortgage Backed Securities: Pass-through securities and Collateralized Mortgage Obligations (CMOs). On the other hand, you have Collateralized Mortgage Obligations.

• Collateralized Mortgage Obligations (CMOs): These are more complex MBS where the mortgage payments are directed to different classes or "tranches" each with varying degrees of risk and return. 

CMOs were developed to counter prepayment risk inherent in Pass-through securities. In a Pass-through, all investors receive principal repayments simultaneously. But in a CMO, principal repayments are channeled to different tranches in a sequential manner. Some tranches get repaid earlier, thus are less exposed to prepayment risk. Beyond these basic forms, you have MBS types distinguished by the nature of the underlying mortgages. In particular, you might encounter residential MBS (RMBS) and commercial MBS (CMBS).

• Commercial MBS (CMBS): These MBS are backed by commercial mortgages, for example, mortgages on commercial properties like office buildings, retail space or hotels.

It's worth noting that most commercial mortgages are set up so that the business owner occupies at least 51% of the property. This makes the risk profile of CMBS somewhat different from that of RMBS. Lastly, Mortgage Backed Securities can be classified based on the issuer. There are Agency MBS and Non-Agency MBS:

• Non-Agency MBS: These are issued by private institutions, like banks or other financial entities. These securities are subject to greater credit risk due to the absence of explicit government backing. However, they may offer higher potential returns to compensate for this additional risk.

These categories represent the main types of Mortgage Backed Securities you would come across in the market. But for a more nuanced understanding, we need to delve deeper into the classification of these securities.

Classifying Different Mortgage Backed Securities

Classifying Mortgage Backed Securities is more complex than it may initially appear. This is thanks to a convergence of factors, including the varying degrees of government backing, the risk profile of the underlying mortgages, and the divergent terms of each mortgage in the security. For instance, the Agency MBS are particularly favoured in the market due to their guaranteed payments.

• Ginnie Mae securities are explicitly backed by the full faith and credit of the U.S government. This means that the U.S government guarantees the timely payment of principal and interest on these securities.
• Fannie Mae and Freddie Mac, on the other hand, are government-sponsored entities. The securities they issue are not explicitly guaranteed by the U.S government but have an implicit guarantee.

The perceived guarantee on Fannie and Freddie securities has led to their wide acceptance in the market. The yield on these securities is slightly higher than on Ginnie Mae because of the small differential in credit risk. In contrast, the Non-Agency MBS includes securities issued by various private entities. These securities do not have an explicit or implicit government guarantee and therefore, come with higher potential rewards, albeit at a greater risk. We also have another category of MBS known as Jumbo MBS. These securities are backed by mortgages that exceed the conforming loan limits set by the Federal Housing Finance Agency. Since these mortgages are larger, the securities are often deemed more risky. Lastly, there are Stripped MBS. These are MBS where the cash flows from the underlying pool of mortgages are separated into two classes: principal-only (PO) and interest-only (IO) securities. This bifurcation allows investors to choose between cash flows of principal repayments and interest payments, catering to diverse risk and return requirements of investors. These classifications comprise the bulk of the types of Mortgage Backed Securities. Understanding these types enables you to comprehend the multifaceted strategies investors can utilise to manage their risk exposure and earn potential returns.