Mortgage Backed Securities

Over the next couple installments I will attempt to demystify Mortgage Backed Securities (MBS). After reading this you will have enough information on this confusing asset class so you can make an informed decision as to whether they are appropriate for you or not.

MBS are complex enough that when I was a stockbroker, we had to take additional training and pass a test before we were allowed to offer them to our clients. Brokers liked them because they generally had a high payout, sometimes double or triple what corporate or municipal bonds paid. Borrowers liked them because they had a higher rate of return than the other similar asset classes. The interest rates on these products were higher in order to attract investors who may be a little put off when it came to the complexity of the product.

MBS were sold to fixed income clients, many of whom did not fully understand what they were getting into. A typical investor would likely be the seventy year old bond buyer whose realm of knowledge extended to munis and government and agency securities, and not to mortgage backed securities. It was common to run into an investor of MBS who had no idea why his bonds were repaid early. In some cases, the investor just plain forgot how the asset class worked. They may have been given all the necessary information ten years ago when they bought the security, but have sense forgotten how they worked. That was a very common scenario. Then of course you have the client who was railroaded into buying the security and was never really educated about them because the broker evidently felt that if his client knew what he/she was purchasing, they would not have bought them. That scenario, unfortunately, was not all that uncommon, but for the purposes of this article we are not going to get into why it was common.

Let’s talk a little bit about these were created. The process of pooling together various cash producing financial assets is called securitization. Any asset can be securitized as long as it produces a cash flow. For this article we are talking about assets that are secured by mortgages, or collateralized mortgage obligations, (CMO).

A mortgage security represents an ownership interest in mortgage loans made by financial institutions to finance borrower’s purchase of homes or other real estate. They are created when the mortgage loans are packaged together and sold to investors as a new type of security, like CMO’s (Collateralized mortgage obligations) for example. As the underlying mortgage loans are paid off by borrowers the investors receive principle and interest payments. This also gives lenders greater access to more capital so they can provide loans to borrowers like you and me.

Thirty years ago banks were portfolio lenders and they would hold the loans till they were paid off. Now days more and more loans are sold to investors and the lender sometimes retain the servicing rights and sometimes they do not. The two of the three lenders I worked for did not keep the loans, and just retained the servicing rights.

The most basic of mortgage securities are pass -through securities where the investor retains ownership in a pool of mortgage loans. Shortly after creation of pass through securities both Fannie Mae (Federal National home loan mortgage Corporation) and Freddie Mac (Federal Home Loan Mortgage Corporation) begin issuing their own mortgage securities. Have you ever taken out a student loan? You may be familiar with Sally Mae, or Student Loan Mortgage Association (SLMA).

Investors commonly became confused when all of a sudden they received all their money back long before the bonds were “due.” When interest rates are low or dropping homeowners refinance their mortgages so the loans that are in the pool of mortgages are paid off and investors in who have the ASB have their money returned to them. They are doubly unhappy because they have all this cash and cannot reinvest it at the rate they were enjoying. Now add this to the fact that many investors forgot or were not adequately informed about this asset class, and you have a very unhappy investor.

In the next article we will go over average life, and other important details for any one investing in ABS, and other sometimes confusing aspects of this asset class.

Good Luck and Happy Investing.