A mortgage-backed security ( MBS ) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property.
First, mortgage loans are purchased from banks, mortgage companies, and other originators. Then, these loans are assembled into pools. This is done by government agencies, government-sponsored enterprises, and private entities. Mortgage-backed securities represent claims on the principal and payments on the loans in the pool, through a process known as Securitization. These securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools.
Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), 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.
Residential mortgages in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an MBS is not known in advance, and therefore presents an additional risk to MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1–3 years) are usually at variable rates and freely pre-payable.
History
The Federal National Mortgage Association (FNMA) was formed by the US Federal Government in 1938. Its purpose was to promote home ownership in the United States. It did so by purchasing mortgages from originators. This freed up the originators' capital so they could originate more mortgages. Market participants dubbed the firm "Fannie Mae." The Government National Mortgage Association and the Federal Home Loan Mortgage Corporation were formed in 1968 and 1970, respectively. They play a similar role to Fannie Mae, but target different segments of the mortgage market. Today, they are called Ginnie Mae and Freddie Mac.
Ginnie Mae issued the first mortgage pass-through in 1970. Today, all three organizations actively repackage and sell mortgages as pass-throughs. Ginnie Mae guarantees timely payment of principal and interest on its pass-throughs. Fannie Mae and Freddie Mac guarantee payment of principal and interest.
Market size and liquidity
There is about $14.6 trillion in total U.S. mortgage debt outstanding.
There are about $8.9 trillion in total U.S. mortgage-related securities.
The volume of pooled mortgages stands at about $7.5 trillion. About $5 trillion of that is securitized or guaranteed by GSEs or government agencies, the remaining $2.5 trillion pooled by private mortgage conduits.
Mortgage backed securities can be considered to have been in the tens of trillions, if Credit Default Swaps are taken into account.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
- 2005: USD 967 billion
- 2004: USD 1.019 trillion
- 2003: USD 2.131 trillion
- 2002: USD 1.444 trillion
- 2001: USD 1.093 trillion
The high liquidity of most mortgage-backed securities means that an investor wishing to take a position need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than investment or speculation) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing).
Structure and features
Weighted-average maturity
The weighted-average maturity (WAM) of an MBS is the average of the maturities of the mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an average across mortgages , as distinct from concepts such as weighted-average life and duration, which are averages across payments of a single loan.
To illustrate the concept of WAM, let's consider a mortgage pool with just three mortgage loans that have the below mentioned outstanding mortgage balances, mortgage rates, and months remaining to maturity.
The weightings are computed by dividing each outstanding loan amount by total amount outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists of three loans is computed as follows:
WAM = 22.22% (300) + 44.44% (260) + 33.33% (280) = 66.67 + 115.56 + 93.33 = 275.56 Months or 276 months after roundingWeighted-average coupon
The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages in the pool, weighted by their original balances at the issuance of the MBS. For the above example this is:
WAC = 22.22% (6.00) + 44.44% (6.25) + 33.33% (6.50) = 1.333 + 2.778 + 2.167 = 6.28% after roundingWhy and where we use WAM and WAC
WAM and WAC are used for describing a mortgage passthrough security, and they form the basis for the computation of cash flows from that mortgage passthrough. Just as we describe a bond by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for example, "this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month WAM."
Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that the investor would receive if he/she holds this mortgage passthrough security (or simply mortgage passthrough). Almost always, the passthrough rate is less than the WAC . The difference goes to servicing (i.e., costs incurred in collecting the loan payments and transferring the payments to the investors) the mortgage loans in the pool.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because some securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that 'vanilla' designates an option with no special features.
Mortgage-backed security sub-types include:
- Pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
- Residential mortgage-backed security ( RMBS ) - a pass-through MBS backed by mortgages on residential property
- Commercial mortgage-backed security ( CMBS ) - a pass-through MBS backed by mortgages on commercial property
- Collateralized mortgage obligation ( CMO ) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
- Stripped mortgage-backed securities ( SMBS ): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
- Interest-only stripped mortgage-backed securities ( IO ) - a bond with cash flows backed by the interest component of property owner's mortgage payments.
- Principal-only stripped mortgage-backed securities ( PO ) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
Varieties of underlying mortgages in the pool:
- Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
- Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
- Subprime: weaker credit scores, no verification of income or assets, etc.
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as set by Fannie Mae.
These types are not l
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