You asked for an explanation of mortgage-backed securities.

SUMMARY

According the Securities and Exchange Commission (SEC), mortgage backed securities (MBSs) are “debt obligations that represent the claims to the cash flows from pools of mortgage loans, most commonly on residential properties.” Basically an MBS is an investment in mortgage loans. An MBS investor owns an interest in a pool of mortgages and is paid from the cash flow from that pool. Some of the common benefits associated with MBSs are higher yields, low credit risks (because they are usually backed by federal or federally-sponsored agencies), and liquidity. Risks include the possibility that mortgagors will prepay or fail to prepay as expected (altering the length of the investment) and the dynamics of the underlying mortgage.

In recent years, the popularity of MBSs has increased. At the same time, MBSs have been issued more frequently on pools of subprime mortgages and, for private MBSs, without the necessary credit enhancement to provide security. As the “subprime crisis” grew and borrowers began to default, and the housing market declined generally, MBSs have declined in value and investors have been reluctant to reinvest in them. This has lead to a lack of liquidity (mainly because mortgagees use the proceeds from the sale of MBSs to offer new loans) in the market and has also impacted other capital markets (as MBSs are sold to hedge funds, insurance companies etc.) Below is a general description of MBSs.

PASS-THROUGH MORTGAGE-BACKED SECURITY

The most common form of MBS is a “mortgage pass-through participation certificate,” whereby principal and interest payments from the pool of mortgages (minus service charges) are repackaged as shares and passed from the originating entity through an agency or investment bank to investors each month.

The possibility of prepayment creates some risk for the investors. While they receive their share of the principal repayment, they will not receive the interest payments they had expected. Mortgage interest rates tend to have a direct effect on prepayment as mortgagors tend to refinance when rates drop. Investors then have to try to reinvest at a less desirable time (i.e., cash flow might not be as great from a new mortgage pool because interest rates are lower). Although the risk is offset somewhat if the pool is larger, MBSs tend to have a higher yield to compensate for the prepayment risk.

According to the SEC, most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), which issued the first mortgage pass-through in 1970, the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). As a government agency, Ginnie Mae securities are backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are government sponsored and have special authority to borrow from the United States Treasury. Therefore, despite the prepayment risk, these instruments tend to be somewhat sound investments.

Private institutions also securitize mortgages without the help of the aforementioned entities (usually for loans they cannot touch). Private MBSs, which were estimated to comprise 10 to 20% of the market in 2006, traditionally had some form of credit enhancement to obtain an AAA credit rating to offer more security.

COLLATERALIZED MORTGAGE OBLIGATIONS

Collateralized Mortgage Obligations (CMOs) are another form of MBS. According to Barron's Dictionary of Finance and Investment terms, a CMO is a MBS that separates mortgage pools into different maturity classes, called trenches (each sold as a separate security with a maturity date that is not necessarily tied to the life of the mortgage). This is accomplished by applying income (principal and interest) from mortgages in the pool in the order that the CMO pays out. Trenches pay different rates of interest and can mature in a few months, or as long as 20 years. The maturity date lessens the prepayment risk by providing a timeframe when repayment can be expected. CMOs offer a lower yield (than pass-throughs) in exchange for this security. However, Barron's notes that, if mortgage rates drop sharply, causing a flood of refinancings, prepayments will rise and the trenches will be repaid before their expected maturity. According to some commentators, because buyers of these securities were looking for yields, subprime loans make up a large portion of most collateralized debt obligations.

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