Mortgage
Backed
Securities
Masaryk University 2014- Brno, CZ
Authored by: Vukman Manić Supervised by: Luděk Benada
12/6/2014
AGENDA
1. Introduction- Mortgage Backed Securities (MBS)
2. The MBS Market- in numbers
3. Why Mortgage Securities?
a. Higher return
b. Credit quality
c. Choice of investment profiles
d. Liquidity
e. Analytic tools
4. MBS- the process
5. Valuation of the MBS
6. Trenching
7. The Crisis
Introduction- Mortgage Backed Securities (MBS)
Investing in a mortgage-backed security is basically lending money to a home buyer or
business. An MBS is a way for a smaller bank to lend mortgages to its clients without having to
burden about whether the clients have the assets to pay the loan. Instead, the bank acts as a
wholesaler between the clients buying the home and the investment markets. “Mortgage-backed
securities (MBS) are debt obligations that represent claims to the cash flows from pools of
mortgage loans, most commonly on residential property. Mortgage loans are purchased from
banks, mortgage companies, and other originators and then assembled into pools by a
governmental, quasi-governmental, or private entity.” Also, “The entity then issues securities
that represent claims on the principal and interest payments made by borrowers on the loans in
the pool, a process known as securitization.” (US Sec and Ex Commission 2014, pg 1)
Thus, MBS is a type of asset-backed security that its underlying asset is mortgage, or
commonly understandable collection “pool” of sporadically hundreds of mortgages.
Furthermore, the “traditional” mortgages that are in a (asset) collection are sold by banks to a
group of individuals (investment bank or a government agency) that “securitizes” or packages,
the debt obligation into a security that can be sold or resold to investors. Correspondingly, sense
those assembled mortgages that represents single asset, is now tradable. Also, other important
dimensions are that MBS is credit classified and credit guaranteed, which will be explained later
in the paper.
The MBS Market in Numbers
“Over the past few decades, the residential mortgage market in the United States has
emerged as one of the world’s largest asset classes. At its peak in the first quarter of 2008, the
total face value of household mortgage debt exceeded $10.6 trillion dollars. The growth of the
residential mortgage market reflected the rapid growth in the aggregate value of real estate
between 2001 and 2006, along with consumers’ propensity to monetize their home equity
through additional borrowing.” (Frank, Anand, and Belnirel 2011, pg 3)
The US had a yearly output of 15 trillion in 2010, thus comparing it with Mortgage Debt
Instrument valuing of 9.5 trillion, MBS market is one of the largest in the US but also globally.
At the same time, just for paper’s data, the market cap of NYSE is 18. 7 billion and NASDAQ’s
market cap of 6.6 billion. It is clear that debt financial instrument (in total 9.465 trillions) where
only MBS valuing 5.4 trillions of dollars has huge impact on the US economy and to the foreign
investors.
WHY Mortgage Securities?
MBSs are/were core investments for most institutional investors, for a number of reasons:
 Higher return
 Credit quality
 Choice of investment profiles
 Liquidity
 Analytic tools
Higher Return
“MBSs typically yield 100bp or more over Treasuries and offer higher yields than comparablequality
corporate bonds. Although some of this higher yield compensates for their complexity
and embedded prepayment options, MBSs still have outperformed comparable Treasuries and
corporate bonds over time.”
Credit Quality
“Ginnie Mae MBSs are backed by the full faith and credit of the US government and, hence, like
Treasuries, are considered to carry no credit risk. Fannie Mae and Freddie Mac MBSs do not
have US government guarantees, but because of Fannie Mae’s and Freddie Mac’s close ties to
the government, their MBSs are perceived to have minimal credit risk. MBSs from other
(private) issuers typically carry triple-A or double-A ratings from one or more of the credit rating
agencies.”
Choice of investment profiles
“The MBS sector provides a wider range of investment characteristics than most other parts of
the fixed-income market. For example, MBSs are available with negative, short, or very long
durations. Prepayment sensitivities can range from low to very high. Coupons can be fixed (from
0% to more than 1,000%) or floating (directly or inversely with a range of indices).”
Liquidity
“The amount of outstanding MBSs, trading volume (second only to US Treasuries), and
involvement of major dealers provide an active, liquid market for the majority of MBSs.”
Development of Analytic Tools
“Since the mid-1980s, many major dealers (and some buy-side firms) have devoted considerable
resources to developing analytic models for evaluating MBSs. These efforts have led to a better
understanding of mortgage cash flows and greater comfort with the characteristics of mortgage
securities.” (Robert and Lahkbir 2004, pg7)
Firstly, we have to recognize that these reasons for most investors investing in MBS are
2008 pre-crisis motives. To analyses the impact of the debt crisis of 2008, we have to look indepth
of these instruments pre-crisis and to understand them fully, especially how were they
perceived before crisis occurring. Thus, MBS had higher yields than T-bills and corporate bonds.
Also, they were insured by the government, which gave the confidence to the investors (Fannie
Mae and Freddie Mac). The MBS market was highly liquid due to previously explained
characteristics. It is clear when analyzing these features of MBS, why it gave such an benefits to
investors to hold them.
Valuation of MBS
In this paper, the focus is on basics of MBS. On the other hand it is important to briefly
and simply explaining the valuation of the mortgage backed-securities. The cash flows of an
MBS characteristically occur monthly. Calculating the MBS’s bond equivalent yield (BEY) is to
compare the yield on a MBS to that of a treasury coupon security. The BEY for a Treasury
coupon security is found by doubling the semiannual yield. The market practice is to compute a
yield so as to make it equivalent to the yield to maturity on a BEY basis. The formula for
annualizing the monthly cash-flow yield/the mortgage yield for an MBS is:
BEY= 2[1+im/12]^6 - 1
As an example, a 6.0% mortgage yield would be converted to a BEY of 6.07%.
Trenching
It all started perfectly, banks had transferred its risks on mortgages, which have taken
high volume of liquidity over long period (mortgages were from 15-30 years on average). Due to
securitization- a means of turning illiquid assets into liquid securities, it has created an efficient
tool for balance sheet management of a bank. Likewise, investors were better diversified and
hedged in their portfolios, giving them financial efficiency and effectiveness for holding the
packed mortgages. They have better efficiency over the risk by holding mortgages. The
trenching is a sub-levels of mortgages, because it is a pool of mortgages, but more importantly
they were not the same by its financial stability and certainty of payments. Thus, the following
explains the trenching:
The Crisis
In 2008, the US families lost $11 trillion dollars in wealth. Moreover, consider by many
economists the worst financial crisis since Great Depression of the 1930’. In addition, the peak
of 2006 US housing bubble, triggered by the complex interplay of policies that had encouraged
home ownership ( in 2007 app. 69.2% Americans owned the house), providing easier access to
loans for barrowers, overvaluation of the subprime mortgages bundled based on notions that
housing prices will continue to escalate (to continuously rise), questionable trading practices on
behalf of both buyers and sellers, and a lack of adequate capital holdings for both investors and
insurances companies led to bank solvency, declines in credit availability and damaged investor
confidence had an impact on stock markets, where the crisis have showed and securities suffered
large losses during 2008.
Many people consider that financial innovation as MBS are the one to blame for the 2008
Crisis. As a matter of fact, many economists seem to blame sub-prime mortgages. But, by the
definition sub-prime mortgages are bad debt instruments. On the other hand “In the midst of the
most serious financial crisis in a generation, some claim that deregulation is entirely to blame.
This is simply not true and more importantly serves to grossly oversimplify a problem whose
roots run deep and involve myriad actors and issues. The simple truth is that many share the
blame, and pointing to just one person or organization does a disservice to the American people.”
also “The current credit crisis is a complex phenomenon with its roots in a number of places
involving a myriad of people and institutions.” (Carey 2009, pg 3). All things considered, it is
complex to understand the financial innovations and its impact on economy, is it bad or good?
In conclusion, the financial innovation as MBS purely had creation of financial efficiency
and effectiveness. The problem was in its use and management. Moreover, the political polices
of 2001 (Clinton Administration) allowed “extreme deregulation” and allowances for bad
mortgages that were trenched with other mortgages effecting them. As stated “If Congress had
successfully restructured Fannie Mae and Freddie Mac in 2005 after the Office of Federal
Housing Enterprise Oversight (OFHEO) reported on their fraudulent accounting activities, we
would likely not be in the crisis we have today. The over $ 1 trillion dollar binge into subprime
and mortgage backed securities that Fannie Mae and Freddie Mac embarked upon from 2005 to
2007 would likely not have happened.” (Carey 2009, pg 4)
Word Citation
"Mortgage-Backed Securities." SEC.gov. Ed. SEC US. US Securities and Exchange
Commission, n.d. Web. 04 Dec. 2014.
Fabozzi, Frank J., Bhattacharya, Anand K., and Berliner, William S.. Frank J. Fabozzi Series :
Mortgage-Backed Securities : Products, Structuring, and Analytical Techniques (2nd Edition).
Hoboken, NJ, USA: John Wiley & Sons, 2011.
Young, Robert, and Lakhbir S. Hayre. "Guide to Mortgage Backed-Securities." GGuide to
Mortgage Backed-Securities (2004): 1-83.
Carey, Arlene V., ed. Understanding Mortgage Meltdowns. New York, NY, USA: Nova Science
Publishers, Inc., 2009. ProQuest ebrary.