Mortgage backed securities

Mortgage-backed Securities Market in US 2013
Table of Contents:
Executive Summary & Introduction….............................................................................................3
Mechanics of Mortgage-backed Securities……………………………………..............................................4
Types of Mortgage-backed securities………………………………............................................................6
Role of Mortgage-backed Securities in US Economy……………………………………………….....................8
Discussion of players, their profiles and objectives in the Market…………………………………...........10
o Issuers
o MBS Investors
o Regulatory Framework
Recent Trends in the Market……………………………………………………………………………………………………13
Conclusion....................................................................................................................................16
Bibiliography.................................................................................................................................17
1

Executive Summary:
Mortgage-backed securities also known as MBS is an asset-backed security issued by larger
financial corporations (bond issuers) representing a pool 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.
2

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.
In US, majority of the MBSs are issued by the Government Sponsored Enterprises like the
Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage
Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae).
There are few private investment banks as well
The MBS traded by government agencies are more attractive as there are guaranteed returns
backed by the Federal government itself. There are few factors that affect the MBS.
 Economic Growth : Greater economic growth accentuates the need of large capital and
it indirectly reduces the MBS prices
 Inflation: Increasing inflation can have an impact over the MBS pricing. Inflation causes
the dollar value to erode, lender demand for more interest rate.
This paper talks about the current MBS market prevailing in the US market. The paper also
encapsulates different aspects of the MBS markets like the mechanics of the MBS market, its
role in the US economy, different types of MBS bonds in the market.
The paper also provides a brief insight about the regulatory frameworks, key players in the
market and the current trends in the market.
Mechanics of Mortgage-backed Securities:
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 quasi-governmental agencies or the large investment firms pools numerous amounts of
such smaller housing loans as Mortgage Backed Securities and then issues them as bonds to the
MBS investors or “Certificate Holders”. Quintessentially representing indirect flow of funds
from MBS investors to the home buyers through the banks. Then these MBS are sold to
corporate, institutional or individual investors in the secondary market.
3

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 are particularly attractive, because the returns are
guaranteed by those agencies, which were themselves backed by the Federal government.
Hence this instilled faith in the investors about payment options.
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.
4

Types of Mortgage-backed securities
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:
5
Home
owners
Banks,
Mortgage
Lenders
Underwriters
Securities,
Brokers

• 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. They 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 called Pay through Bonds was 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
6

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.
• Principal-only Stripped MBS (PO): Represents a bond where the cash flows are
backed by cash component.
Role of Mortgage-backed Securities 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 bonds are the most actively traded bonds in US market and represents the largest portion
of the US securitization markets
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.
7

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 : Unformulated 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.
These led to creation of large number of subprime mortgage loans and 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.
8

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, MBS investors and
Regulators.
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
9

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” follows two ways:
 Cash program:
o In this mechanism, the mortgage initiators pick and sell a group of mortgages as
a package to the GSEs.
o The mortgage originators are provided with cash after GSEs buy the packages.
 Swap program:
o In the swap program, the mortgage lender identifies a pool of mortgages that
comply with 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.
10

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 shows 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 countries economy. It brings in the
integrity, market confidence and emphasizes financial stability.
Securities and Exchange Commission (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.
Financial Industry Regulatory Authority (FINRA): All the security firms operating in US
market are obligated to this 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)
11

Federal Housing Finance Agency: This was established as a merger of OHHEO and the Federal
Housing Finance Board (FHFB) post the subprime crisis loss. This new regulator would oversee
the functioning of the GSEs and the 12 Federal Home Loan Banks.
Recent Trends in the MBS Market:
Several factors are congregating in 2012 to help the capital markets stabilize after facing
significant unpredictability last year. There are great number of initiatives taken by the Federal
Government to tighten the monitory and financial policies post the 2008 financial crisis which
led to one of the worst financial crisis US has encountered post the Great Depression Era.
Here are few such MBS market trends of 2012 we’ll discuss in detail.
 Improvements in the regulatory framework. The US government has redefined their
regulatory frameworks post the 2009 subprime financial crisis to take necessary actions
regarding transparent credit ratings, qualifications of lenders, sterner underwriting
mechanism, bankruptcy protection, taxation policies.
In 2008, the Federal government issued a Housing and Economic Recovery Act that has
helped to reinstate the confidence of domestic mortgage industry. Below are the step
taken.
o Establishing to oversee the functioning of GSE and
o Increasing the national debt ceiling
o Raising mortgage dollar limits.
o Mortgage disclosure enhancements.
 Recent trends show increased activity by the Federal Government in buying the MBS.
According to a statistics, the FED is buying MBS worth more than $ 40 Billion every
month. This would help to tighten the mortgage spread. Hence the investors, holdings in
MBS would continue to benefit from Central Bank’s efforts of reducing long term
interest rates.
 Continued issuances of new variety of MBS. On Jan 3, 2013, Freddie Mac announced a
new set of structured pass through securities called multifamily mortgage backed
securities. These securities would be given to a syndicate of dealers comprising of large
investment banks and financial institutions.
12

 Improving housing market driving on the low mortgage rates. According to the
S&P/Case-Shiller “Home Prices Indices (HPI) for the twelve months ending in October,
the 10 City Composite Index rose 3.4% on an annual basis and the 20 City Composite
rose 4.3%. The October 2012 levels for both Indices are approximately 8.4 to 9% above
early 2012 levels. The increase in short sales resulted in a decrease of defaults, both of
which contributed to reducing inventory and stabilizing home prices.
o The high priced home market also saw improvements in 2012, in part due to the
availability of record low jumbo mortgage rates. According to DataQuick, a real
estate data firm, sales of homes priced at $1 million and over increased by 9%
during the first nine months of 2012 as compared to 2011 and was the highest
level in four years. In California, that increase was at 14.8% and at the highest
level since 2007 during the first nine months of 2012.”
 The FED government introduced new refinancing programs called Home Affordable
Refinance Programs (HARP) and FHA streamline refinance. This was developed in a
pursuit of the loans reaching the right home owners. The program would be extended
till 2013 and this would help the eligible home owners to get the refinancing done so
that they can free much needed cash.
 The commercial MBS market continues to rally in the 2012. The market is upbeat with
the recent regulations to foster seamless growth.
 More US banks continue improving their liquidly. With sustained efforts to repair the
balance sheet would increase the capital with in the commercial banking system.
Improving housing market driving on the low mortgage rates. Statistics:
References : http://bx.businessweek.com/mortgage-backed-securities/view?url=http%3A
%2F%2Fml-implode.com%2Fviewnews%2F2013-01-
02_HousingMarketChangesin2012fortheBetter.html
13

14

Conclusion:
When one invests in MBS they are basically lending money to a home consumer or business.
MBS is a way for a small bank to advance mortgages to its clients without having to worry about
the assets they have to protect the loan. As the bank acts as an intermediary between the
home consumer and the speculation market.
MBS is also frequently used to readdress the interest and principal payments from the group of
advances to shareholders. These payments can be additionally broken into altered classes of
securities, subject to the risks of different mortgages as per the classification by MBS.
MBS are one of the major sectors of the international fixed income market, proposing investors
a variety of latent benefits as below,
• A wide-ranging and diverse prospect set
• MBS are supported by U.S. homes and the majority are collateralized by compatible loans
and distributed by the mortgage Agencies.
• Striking yield premium to Treasuries and exchanges with over 30 years of price antiquity.
• MBS are amid the most liquid fixed revenue securities in the world and are considered as an
eye-catchy risk-based asset.
• MBS permit more individuals to buy homes. However during the real estate boom, large
financial companies issued low credit rating bonds and issued to non-documented users and
hence leading to the collapse of the financial market in 2008. The users were unable to repay
the debt and causing the large financial firms declaring bankruptcy.
MBS are not structured. Traditionally, banks were under the regulatory framework of the US
government which upholds the interests of the investors.
• MBS traded by the governmental agencies are predominantly attractive because the
returns are certain by these agencies, which are themselves supported by the Federal
government.
15

Bibliography
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
http://blog.kimcorealty.com/2012/03/7-capital-market-trends-to-watch-in-2012/
http://bx.businessweek.com/mortgage-backed-securities/blogs/
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