Introduction to Mortgage-Backed Securities (MBS)
and Other Securitized Assets
PRIMER
Executive Summary
A large and diverse market
The US mortgage market, with $7.2 trillion in mortgage-related debt outstanding, has developed into one of the largest segments of the US bond market, surpassing both the US Treasury and US corporate sectors.1
The MBS sector offers investors diverse investment options and tools for evaluating mortgage securities.
Mortgage passthrough securities
Agency mortgage passthrough securities, issued by US Federal Housing Agencies, are the most common type of mortgages. Agencies create pools of mortgages by purchasing mortgage collateral and
repackaging it for resale in the securities market. The cash flows of the underlying mortgages in the pool ‘pass through’ to the holders of the mortgage securities. Cash flows are based on the interest rates, maturities and payment schedules of the underlying mortgages.
One of the most important aspects of the underlying mortgage is the embedded prepayment option, where the buyer can accelerate the prepayment of principal beyond what is set by the payment schedule. Since borrowers will tend to prepay in falling rate environments, and they ultimately benefit at the expense of the lender, the prepayment option exposes the mortgage securities holder to risks associated with changing prepayments rates. Mortgage passthrough securities are also subject to additional risks, such as interest rate risk, spread risk and model risk.
When valuing a mortgage, it is critical to consider its underlying prepayment option. To most accurately determine the value of mortgage securities, the option-adjusted spread model was developed. This valuable tool takes into account the embedded option.
Diversity of investment options
The introduction of collateralized mortgage obligations (CMOs) in the early 1980s widened investor participation in the mortgages market by creating securities with a broad range of risk/return profiles. Other investment options introduced to the mortgage/securitized market were commercial mortgage-backed securities (CMBS) and asset-mortgage-backed securities (ABS). CMBS, which are mortgage-backed by pools of commercial mortgage loans, differ from agency passthroughs in prepayment risk and structure. ABS differ from traditional residential mortgages, as their cash flows tend to be much less sensitive to interest rates and are, thus, more stable.
Why include securitized assets in a US Treasury portfolio?
We believe investors have the opportunity to significantly improve their risk/return profile by strategically allocating a portion of their portfolio to the MBS/securitized sector for two important reasons:
1) the historically attractive risk/return profile of the securitized sector and attractive yield opportunities relative to Treasuries and 2) the diversification benefits from introducing new sources of risk and potential return to the portfolio.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.
1930s
Prior to the mid 1930s, most mortgages were balloons with the entire principal due at once. During the Great Depression, these mortgages were adversely affected by the lack of liquidity in the capital markets and contributed to the high level of defaults.
1934
Congress passes the National Housing Act. This act establishes the Federal Housing Authority (FHA) and what is to become the Federal National Mortgage Association (Fannie Mae). FHA is intended to provide mortgage insurance and FNMA to provide liquidity to the mortgage market.
1968
Federal National Mortgage Association breaks into Fannie Mae and the Government National Mortgage Association (Ginnie Mae). Fannie Mae becomes privately owned, while Ginnie Mae is wholly owned by the US government. 1970
US government establishes Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae starts its mortgage passthrough program.
EARLY 1980s
First collateralized mortgage obligation (CMO) deals are issued. 1986
Lehman Brothers launches the Aggregate Index that includes MBS Agency passthroughs for the first time. The initial market capitalization of these mortgages is $300 billion.
1992
Lehman Brothers adds asset-backed securities (ABS) to the Aggregate Index. Late 1990s
The ease of refinancing via the internet leads to more rapid refinancing. 1999
Lehman Brothers adds commercial mortgage-backed securities (CMBS) to the Aggregate Index. 2003-2006
A boom in housing market and strong originations lead to rapid growth of the mortgage market. The mortgage market reaches $6.5 trillion in 2006.
2007
Lehman Brothers adds adjustable rate mortgages (ARMs) to the Lehman Aggregate Bond Index. 2008
The market capitalization of passthroughs in the Lehman Brothers Aggregate index is $3.7 trillion, the largest component of the Index. The overall mortgage market (including Agency and Non-agency mortgages) surpasses $7 trillion.
I. Introduction and Historical Perspective
What is a mortgage?
A mortgage loan is a debt instrument by which a borrower gives the lender a lien on real property as security for a repayment of the loan. The borrower has the use of the property and the lien is removed when the obligation is fully paid.
What is a mortgage-backed security?
Mortgage-backed securities (MBS) are bonds that are secured by a collection of underlying mortgage loans. The mortgage payments of the individual real estate assets are used to pay interest and principal on the bonds.
The development of today’s mortgage-backed securities market
Prior to the 1970s, the US mortgage market was largely a primary market. Financial institutions, such as thrifts and commercial banks, would make residential loans directly to individuals and then hold these mortgages on their balance sheets until maturity. Due to the lack of a robust secondary market, individual financial institutions were limited in the number of mortgages they could extend and this, in turn, limited the size of the overall mortgage market.
Financial institutions were restricted in mortgage lending in terms of their level of capital and risk in their loan portfolio. For instance, since many thrifts were local in nature, collecting deposits from a local community and making loans to this same community could create imbalances. If in aggregate, the community wanted to borrow more than save, the thrift would not be able to meet the demand for mortgages and not everyone would be able to borrow. Also, if a bank thought that its portfolio had become too risky due to either credit or liquidity concerns, the bank might choose to reduce this risk by extending fewer mortgages.
During the 1970s and 1980s, the US government, through its agencies and enterprises, began to establish an active secondary mortgage market by introducing the concept of securitization. The agencies would pool individual residential mortgage loans originated by the private sector, issue securities against the pool and provide some guarantee for the payments expected from these securities. These newly created securities were called mortgage passthrough securities.
The introduction of securitization provided great benefits to the marketplace. On the supply side, it provided greater flexibility to financial institutions originating mortgage loans by removing the constraints mentioned earlier. On the demand side, it introduced many new investors, such as pension funds, to the mortgage marketplace. These benefits helped the market grow significantly in size and diversity of securities since the 1970s. Alongside this growth, there have been significant developments in the investment technology used to value these securities and measure their risk.
Prior to the 1970s, the mortgage market was largely a primary market. During the 1970s, the US government established an active secondary market by introducing securitization. This development led to significant growth in the market’s size and the diversity of securities available for investment.
II. The US Agencies and their Role in the Mortgage Market
Three US Federal Housing Agencies account for nearly all the mortgage passthrough issuance in the US mortgage market. These agencies are formally known as the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), though they are usually referred to by their nicknames. GNMA differs from FNMA and FHLMC in several important ways.
Year
Formal Name Nickname Abbreviation Established Tie to Federal Government Government National Ginnie Mae GNMA 1968 Backed by full mortgage faith
Association and credit of the US Government
Federal National Fannie Mae FNMA 1938 Line of credit
Mortgage Association to the US Treasury
Federal Home Loan Freddie Mac FHLMC 1970 Line of credit
Mortgage Corporation to the US Treasury
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.
Source: Goldman Sachs Asset Management
Explicit versus implicit backing of the US federal government
First, while GNMA is explicitly backed by the full faith and credit of the federal government, the other two agencies are not. FNMA and FHLMC only have the implicit backing of the federal government. This difference is very important and in recent years the marketplace has become more focused on its practical implications. If, due to some financial crisis, GNMA were hampered from honoring its guarantees, the law would require that the federal government honor the agency’s obligations for them. The federal government does not have such an explicit legal responsibility in the case of FNMA or FHLMC. However, many marketplace participants believe that although there is not an explicit obligation, the federal government would nonetheless take action in a crisis, since these two agencies are so important to the mortgage market and the US economy.
Agencies as quasi-public corporations
Second, GNMA is a public federal agency whereas FNMA and FHLMC are federally chartered, publicly owned corporations. This means that one of FNMA’s and FHLMC’s primary goals is to produce a profit for shareholders. These two agencies are accountable, not only to the federal government, but also to their shareholders.
The Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) are the main government issuers of mortgage passthroughs. While GNMA is explicitly backed by the full faith and credit of the US government, FNMA and FHLMC are not. FNMA and FHLMC only have an implicit backing from the US government.
III. Mortgage Passthrough Securities
Agency mortgage passthrough securities are the most common type of mortgage and represent one of the largest capital markets in the world. To gain a better understanding of how these securities behave, it is useful to study the characteristics of the underlying mortgage loans.
The creation of mortgage passthroughs
As outlined earlier, the agencies create passthrough securities by securitizing residential mortgages. The agencies create pools of mortgages that are underwritten by the private sector and provide a credit enhancement to these pools. The diagram below illustrates the flow of this process.
The resulting passthrough securities represent a pro-rata share of the underlying pool of individual mortgages and receive a proportionate amount of the pool’s net cash flows. These cash flows are the payments made by borrowers into the pool less the fees associated with servicing (the processing of the mortgage payments), agency guarantees and any other costs. These resulting cash flows ‘pass through’ to the holders of the mortgage securities.
Mortgage characteristics
To understand how these cash flows behave and, consequently, how the passthrough security behaves, it is helpful to understand the structure of the underlying mortgages in the pool. The agencies have simplified their passthrough securities by only pooling together mortgages with similar structures. This underlying homogeneity eases some of the complexity in analyzing these securities and this
simplification has led to increased trading and market liquidity.
Rate
Mortgages may have either a fixed rate or a floating rate. A fixed rate mortgage charges a fixed rate of interest over the life of the mortgage, while a floating rate mortgage does not. The interest charged on a floating rate mortgage will reset periodically according to some preset formula. The formula used to determine the newly set rate is usually a fixed basis point spread over the yield of a specified short debt instrument (e.g., Treasury bill rate or LIBOR rate).
Another important attribute of a mortgage is the interest rate that the borrowers pay. The coupon of the passthrough security will be a function of the interest that the borrowers are paying less the fees mentioned earlier. The higher the interest rate, the higher the coupon the investor in the passthrough will receive. When the agencies pool the individual mortgages, they will ensure that only mortgages with approximately similar interest rates are aggregated in the same pool.
Mortgages are loans secured by real property. 100% of the collateral consists of residential real estate, with single family homes representing 70% of the total.
Pools of individual mortgages, now packaged in a standard, diversified form, are sold to institutional investors. These include pension funds, banks, governments, corporations and insurance companies. Commercial banks,
savings and loans and insurance companies lend money collateralized by the property directly to the home owner. Two mortgage loan
structures are most common: Fixed Rate and Adjustable Rate. In both cases, principal and interest are typically repaid in equal installments over 15-30 years.
GNMA, FNMA and FHLMC are governmental agencies that provide liquidity and credit enhancement in the mortgage market. They purchase conforming mortgage collateral and repackage it for resale in the securities market.
쑺
쑺
Individual Home Mortgage Deed Financial Institution US Agency Investor
One widely used measure of the interest rate paid by the underlying mortgages is the weighted average coupon (WAC). This measure is the interest rate of each individual mortgage weighted by its outstanding balance. The coupon represents the interest that flows through to the passthrough investor (the WAC less any fees). Depending on the level of the coupon relative to the market, the bond will either be trading at a premium, at par or at a discount.
Level of the Coupon Price Name
Above the Market Premium (above $100) Premium Coupon
At the Market Par ($100) Current Coupon
Below the Market Discount (below $100) Discount Coupon Source: Goldman Sachs Asset Management
Bonds that are trading very close to par (typically with coupons either 100 bps below or 50 bps above the current coupon) are often referred to as cusp coupons. Given the relatively small changes in rates, their prepayment speeds can change significantly.
Term
Another important feature of a mortgage is its term (also called maturity) and its payment schedule over its term. The most common mortgage terms are 15-year and 30-year. When creating a passthrough security, the agencies will only pool mortgages with similar terms together.
Payment schedule
When a fixed rate mortgage is originated, a set payment schedule is established. Most mortgages do not have a single bullet payment of principal at maturity, but rather, are amortizing. These amortizing mortgages will pay back principal over the entire life of the loan. Another market convention is that the payments on the fixed rate mortgage are constant over time–that is, all the periodic scheduled payments are an equal dollar amount.
Each payment will represent interest on the outstanding principal and a paydown of principal. Payments made early in the life of the mortgage will represent mostly interest, as the outstanding principal is high. Payments made late in the life of the mortgage will represent mostly principal, as the outstanding principal is much lower. The figure below illustrates how the composition between interest and principal varies over time for the net cash flows of a mortgage pool with no prepayments.
To understand how an Agency passthrough behaves, an investor should be familiar with the underlying mortgage loans. Some important characteristics of the individual loans are: • Fixed or floating
interest rate charged to the borrower
• Term or maturity (15-year and 30-(15-year maturities are most common)
• Payment schedule over the term
• Prepayment option
0 $100 $200 $300 $400 $500 $600 $700 $800
Interest Principal
Payment
Years
0 5 10 15 20 25 30
For illustrative purposes only.
Source: Goldman Sachs Asset Management
Prepayment options
One of the most critical aspects of the underlying mortgages is the embedded prepayment option. Each individual borrower has the option to accelerate the payment of principal beyond what is required by the set payment schedule. When exercising this option, the borrower has the right to pay down a portion of the outstanding principal or all of the outstanding principal. These prepayments can occur for a number of reasons:
• Buyer sells home:If a home owner chooses to relocate to another home, the owner will probably sell his current house and entirely prepay the home’s current mortgage. The one exception to this occurs when the mortgage is ‘assumable.’ With an assumable mortgage, the buyer can assume the
obligations of the previous mortgage. The mortgage, along with the house, is passed from the seller to the new buyer. This assumption option is particularly attractive when rates have risen and the property has not appreciated significantly. Only Federal Housing Administration (FHA) or the Veterans Administration (VA) loans securitized by GNMA passthroughs have this assumable option. • Buyer refinances:When rates fall, a home owner will consider closing his current mortgage and
taking out a new mortgage at a lower rate.
• Borrower defaults:In a passthrough security, any defaults will be treated as prepayment of principal that is guaranteed by the agencies. The impact of these defaults is relatively small.
Quantifying prepayments: CPR and PSA
For a pool of mortgages, the level of prepayments is typically based on housing turnover or, in falling rate environments, refinancing activity. One of the most widely used measures to quantify the impact of prepayment is the Constant Prepayment Rate (CPR). This metric expresses prepayments on an
annualized basis as a percentage of principal outstanding. For instance, if the historical CPR were 5% over the past two years, this means that each year the borrowers prepaid 5% of the outstanding principal in addition to the scheduled principal payments. CPR can be used to quote realized historical experience or to quantify future expected experience.
Another prepayment measure sometimes used by the market is the Public Securities Association (PSA) standard. This measure, developed in the mid 1980s, was designed to reflect the gradual ramp-up in mortgage prepayments experienced by new mortgages, an effect called seasoning. Newly issued
mortgages tend to have lower initial prepayments because new home owners will usually live for several years in a house before moving. However, after several years, the expected housing turnover
experienced by the pool will rise as people may move to larger houses or to a new community, and prepayments will rise accordingly.
One of the most critical aspects of the underlying mortgages is the embedded prepayment option, which allows a borrower to accelerate the payment of principal beyond what is required.
0 2 4 6 8 10
150% PSA
100% PSA
50% PSA
Months
CPR (%)
0 60 120 180 240 300 360
Source: Goldman Sachs Asset Management
The benchmark PSA curve, or 100% PSA, assumes that the CPR gradually ramps up from 0% to 6% over 30 months and then levels off at 6%. These assumptions are based on historical numbers and actual experience may differ. The measure is flexible, as it can be quoted as varying percentages of the base case. For instance, 200% PSA would mean that over 30 months, the CPR ramps up to 12% instead of 6%. This flexibility permits mortgage portfolio managers to use the PSA curve to 1) reflect their best estimate of future prepayments or 2) analyze the sensitivity of the mortgages to changes in prepayment rates.
Prepayments will affect the cash flow composition between interest and principal and the level of overall payments that are passed through the pool to the investor. With greater prepayments, a greater portion of the principal will be returned early in the life of the security and the later total payments will decrease. The graph below depicts how, under an assumption of 100% PSA, principal payments are front-loaded in the life of a mortgage passthrough security and in later years the overall payments decline.
The embedded option is always going to benefit the borrower at the expense of the lender.
Interest Principal
Years
Payment
0 $200 $400 $600 $800 $1000 $1200
0 5 10 15 20 25 30
For illustrative purposes only.
Source: Goldman Sachs Asset Management
Payments on a $100,000 Pool of 30 Year 8% Mortgages at 100% PSA
The embedded option is always going to benefit the borrower at the expense of the lender. The borrower has received a valuable option from the lender in exchange for agreeing to a relatively high nominal yield. A simple example might be helpful to illustrate how this option would work against the lender. A borrower who takes out a mortgage at an 8% interest rate may choose to refinance if rates fall to 6%. This is a very attractive for the borrower, as it will significantly lower his monthly payment; now he is paying only 6% interest instead of 8%. However, it is unattractive to the lender who must now reinvest the returned principal at 6%, well below the 8% rate he previously enjoyed.
The risk of receiving principal back at an inopportune time (i.e., a lower rate environment) is called prepayment risk. The prepayment risk associated with the individual mortgages will pass through to the holder of a mortgage security, as prepayments are shared across all the mortgage securities on a pro-rata basis.
Path dependency and prepayments
The level of future expected prepayments is a function of historical interest rates. For instance, a mortgage security may be issued in a high rate environment and experience significant refinancing when rates fall. The more informed borrowers will refinance quickly, but others may lag because they are less aware of the refinancing opportunity or they are constrained from refinancing. A potential refinancing constraint may be that the borrowers’ credit-worthiness has fallen and they cannot refinance or, perhaps, the value of their home has fallen making refinancing difficult. After this initial wave of refinancing, the passthrough is backed by mortgages of borrowers that are less likely to refinance. This effect is called ‘burnout.’ So, if rates move back up and then come down again, the increase in prepayments will be much less in this second cycle than it was when rates dropped initially. This aspect of prepayment risk is called path dependency and it makes modeling and understanding how mortgages behave much more challenging.
Trading conventions
Trading conventions in the mortgage market have developed over many years as the market tends to be quite technical from an operational standpoint. Operational challenges have deterred non-US asset managers from entering the market, despite the large weight of passthroughs in the Lehman Brothers Global Aggregate Index.
Most passthrough securities are traded on a To Be Allocated (TBA) basis. An investor does not know the specific security he will receive, only its general characteristics, e.g., GNMA 6% 30 year. All the TBA trades of a similar type settle on one specified day each month. Securities can also be purchased on an individual pool basis, ‘specified pools,’ but this is less common. The TBA market, like many other forward and future markets, allows an investor to gain economic exposure to an asset class without necessarily taking delivery of actual securities.
The Non-Agency Mortgage Market
While the three housing agencies account for the majority of MBS issuance, private companies also issue MBS. The housing agencies are limited to the types of mortgages they can securitize. Agencies securitize “conforming” mortgage loans, i.e., the borrower credit and loan characteristics must meet the agencies’ underwriting standards. Non-conforming loans do not meet agency underwriting standards due to one or a combination of the following factors: mortgage balance exceeds the amount permitted by the agencies, borrower and loan characteristics fail to meet the underwriting standards established by the agencies, and/or loan documentation required by the agencies is not complete due to either the borrower’s inability to provide or the lender’s decision to waive.
“Private-label” MBS, or non-agency MBS, are typically issued by homebuilders or financial institutions through subsidiaries and are backed by residential loans that do not conform to the agencies’
underwriting standards. Non-agency issued mortgage-backed securities are now a major component of the MBS market.
Below, we have provided a description of the general “sectors” of the agency and non-agency mortgage markets and the typical characteristics of the collateral type which falls under each of those sectors.
Mortgage collateral
Mortgage securities can be backed by a wide variety of loans with different borrower characteristics but the market is generally divided into four main sectors: agency mortgages, prime jumbo mortgages, Alt-A mortgages and subprime mortgages.
• Agency mortgages:Must conform to the agencies’ standards in terms of loan size, the borrower’s credit score and documentation, and the loan amount relative to the value of the home (loan-to-value ratio). Other types of mortgages do not comply with these standards for one or more reasons. • Prime Jumbo:Exceed the agency maximum loan size (traditionally $417,000 but the maximum was
raised to $729,000 through 2008), but borrowers generally have high credit scores.
• Alt-A:Generally conform with agency standards in terms of loan size and borrower credit score, but have other features that do not conform, such as low documentation.
• Subprime:Do not conform with agency standards primarily due to lower credit scores (generally 605-640 out of a possible 850, compared to 680-730 for agency mortgages as measured by FICO) and higher borrower leverage (as measured by the debt-to-income ratio, typically 40% for subprime borrowers). Documentation on subprime mortgages also tends to be significantly lower than agency standards, but may actually be higher than documentation on an Alt-A mortgage.
Option-adjusted duration measures the interest rate risk of mortgages by taking into account the changes in prepayments that occur at different interest rate levels.
IV. Risks of Mortgage Passthrough Securities
The main risks of mortgage passthroughs are interest rate risk, convexity/volatility risk due to prepayments, spread risk, credit risk and model risk.
Interest rate risk
The main risk of agency passthroughs is interest rate risk. Just like other fixed income securities, when yields rise, passthrough prices fall; and when yields fall, passthrough prices rise. However, due to the embedded options in these agency passthroughs, traditional measures such as Macaulay duration and modified duration are not appropriate for measuring the interest rate risk of mortgages. To address this issue, option-adjusted duration, a new measure of interest rate risk that incorporates the impact of embedded options, was developed.
Option-adjusted duration will take into account the changes in prepayments that occur at different interest rate levels. For instance, when rates rise, the expected cash flows for the passthrough will tend to extend; borrowers are less likely to refinance at higher rates. When rates fall, the expected cash flows for the passthrough will tend to shorten; borrowers are more likely to refinance since lower rates are more attractive.
The option-adjusted duration captures these effects by shocking the yield curve up and down by equal amounts and recalculating the security’s price in each scenario, given the new expected cash flows. The price changes that result from these shocks are then used to estimate the security’s sensitivity to changes in interest rates. This sensitivity is the option-adjusted duration.
There are other measures of interest rate sensitivity that the market will sometimes quote, but they are not as useful as an option-adjusted duration estimate. These other measures include weighted average life (WAL), which is an average time to receive back principal on the underlying loans and weighted average maturity (WAM), which is weighted average maturity of the underlying loans.
Convexity/volatility risk due to prepayments
For non-callable securities (plain vanilla bonds), duration measures underestimate price gains and overestimate price losses. This estimation error (the curvature of the price/yield relationship) is called convexity and, in the case of a non-callable bond, it favors the investor and is called positive convexity. The opposite occurs for mortgages with prepayment risk. Duration measures overestimate price gains and underestimate price losses. In this case, the estimation error is called negative convexity and will always work against the investor. The more prepayment risk a security has, the worse the estimation error will be and, in turn, the more negative its convexity will be.
Unlike non-callable bonds, mortgages have negative convexity, which works against the investor. Convexity becomes more negative, as the prepayment risk of the security increases.
88 93 98 103
108 Price change estimated by duration
Actual price change
Example: Conventional 30 year
Duration overestimates the price appreciation
Duration underestimates the price appreciation
Price ($)
-200 -150 -100 -50 0 50 100 150 200
For illustrative purposes only.
Source: Goldman Sachs Asset Management
Many managers will adjust their mortgage hedges frequently. This practice of constantly hedging the portfolio is called ‘dynamically hedging.’ The cost of this practice reflects the portfolio’s negative convexity. Whenever prices go down (rates up), the manager has to sell securities and whenever prices go up (rates down), the manager has to buy securities. In very volatile markets, the cost of negative convexity becomes expensive, reflecting the increased value of the options that the manager is short. Investors in mortgages are often said to be short volatility because when volatility increases, a mortgage investor loses as the cost of hedging rises (i.e., the cost of the negative convexity rises).
If a portfolio manager decides not to hedge, the portfolio’s duration will tend to drift. In rallying markets, the portfolio will become shorter and in sell-offs, the portfolio will become longer. In trending markets, this could lead to significant underperformance. Additionally, if liabilities are being matched with these securities, it may lead to an asset/liability mismatch.
Spread risk
The mark-to-market risk of mortgages may be broken into several components. The most volatile component of this risk is Treasury interest rate risk, which was described earlier. This risk may be hedged by taking short positions on US Treasuries or more easily by selling US Treasury interest rate futures.
The other two components of mark to market risk are associated with the swap spreads (the yield difference between swap rates and Treasury rates) and the mortgage/swap basis (the yield differential, adjusted for embedded options, between mortgage rates and swap rates). These two risks are often referred to as ‘spread risk’: the risk that a change in either of these two spreads will lead to a change in price.
Many investors will use swaps or eurodollar contracts to hedge any unwanted swap risk in their portfolios. As swap spreads are positive in the US, most managers will want to be exposed to this type of risk. However, if the manager thinks that the portfolio has too much swap spread risk or the manager has a negative tactical view on swap spreads, then he will hedge back this risk. This type of hedging became more common after the second half of 1998.
A major component of mark-to-market risk is referred to as ‘spread risk.’ This risk is driven by swap spreads and the mortgage/swap basis.
The chart below illustrates that as yields move, negative convexity becomes more costly. Since this negative convexity is tied to prepayment risk, this relationship should make sense. When markets are very volatile, the prepayment option is worth more and, as a result, the security’s performance relative to non-callable securities suffers more.
-200 0 -1 -2 -3 -4
-150 -100 -50 0 50 100 150 200
Loss from
Convexity ($)
* Assumes no dynamic hedging. For illustrative purposes only. Source: Goldman Sachs Asset Management
Typically, most managers do not hedge the mortgage/swap basis risk for two reasons. First, most managers do not have the ability to hedge this risk because it requires carrying short mortgage
positions which are usually not permitted. Second, many managers do not wish to hedge this risk as the risk may be embedded in their benchmark or the managers view the risk as attractive.
Estimated Volatility
Source of Mark to Market Risk Definition of spread/rate Hedging Vehicles MBS/Swap Basis MBS Spread 30-50 bps Shorting other mortgages
(adjusted for option) less Swap Spreads
Swap Spread Swap rates less 20-30 bps Selling interest rate swaps Treasury rates or eurodollar contracts Treasury Rates Treasury rates 100-110 bps Selling Treasury interest rate
contracts or shorting Treasuries Source: Goldman Sachs Asset Management
Credit risk
The credit risk in agency passthrough securities is fairly minimal. In the case of GNMA passthroughs, the investor may view these bonds as secure as US Treasuries since they carry an explicit federal guarantee. In the case of FNMA and FHLMC passthroughs, though there is not an explicit guarantee upon which to rely, there are several other sources of credit support. First, there is the credit-worthiness of the two agencies themselves. Even without federal support, the market considers these agencies financially sound. Second, there is an implicit guarantee. It is thought by many market participants that if the agencies were in financial trouble, the federal government would assist them. Finally, these passthrough securities are not general obligations of the agencies but are collateralized by the underlying pool of mortgages.
Credit risk resides primarily in the non-agency mortgage market. As mentioned above, for agency MBS, agency guarantees assure investors that they will receive timely payment of interest and principal, regardless of the delinquency or default rates on the underlying loans. Because non-agency MBS have no such guarantees, some other form of protection is needed to shield investors from borrower delinquencies.
Private-label MBS are rated by rating agencies and often feature credit enhancements, such as
subordination and overcollateralization, that are designed to help protect investors from delinquencies or losses on the underlying loans.
Modeling the aggregate behavior of many individual residential mortgage borrowers is extremely challenging and, as a result, models may not be perfectly reliable.
A typical capital structure will include investment grade bonds, as well as “junk” or unrated bonds. The senior bonds are rated AAA and have first priority on cash flow. The investment grade
subordinates are rated AA to BBB and have a lower priority on cash flow. At the bottom of the credit stack are the non-investment grade subordinates. These bonds are rated BB+ or lower and are significantly exposed to losses from the underlying mortgage loans.
Model risk
A final risk to investing in mortgages is the reliability of the quantitative model used to predict prepayments. For most callable securities, such as agency or corporate callables, there is little uncertainty about how the borrowers will behave. They will nearly always call the bonds if it is attractive to call them or will not call them if it is unattractive to call them.
On the other hand, not every individual residential borrower may refinance when it looks as if they should. This behavior may be driven by economic constraints or a lack of information on the individual borrower’s part. It is more difficult to predict the aggregate decisions of many individual borrowers than it is to predict the decision of a single corporation. A model must attempt to predict this overall behavior of borrowers and the model may not always be successful in this attempt.
One way to manage this model risk is to stress test the assumptions underlying the model and see how much the model’s results change as a result of varying assumptions. For instance, if normal housing turnover were 25% greater or less than the model’s base case, what happens to the model’s output? It is important to understand the sensitivities of models and not treat them as a perfectly reliable black box.
Cash Flow Mechanics Mortgage
Loans
Loss Priority
Principal Payments Generic Deal
Structure
First Loss
Pool of Mortgage Loans
Loss Positio
n
Cash Flow
AAA / Aa
Unrated B / B BB / Ba BBB / Baa
A / A AA / Aaa
Subordination
Senior-subordinated credit structures are created with single or multiple subordinated credit classes. In these structures, the “junior” tranches are subordinated to the “senior” tranches in terms of the prioritization of principal cash flows. In addition, the subordinate tranches are designed to absorb losses before they are allocated to senior tranches. In other words, these designated junior securities provide the credit support to the senior securities.
V. Relative Value in Mortgage Passthrough Securities
In many fixed income markets, a primary driver in valuing a security is its nominal spread relative to a comparable maturity Treasury. Typically, nominal spreads of mortgages relative to Treasuries tend to be very high and would suggest that mortgages are very attractive. However, nominal spread analysis, as an indicator of relative value, is not complete in the case of mortgages and will yield misleading conclusions.
Option-adjusted spread
The reason that nominal spreads are a misleading indictor of value with respect to mortgages is that mortgages are composed of two separate underlying investment positions. The investor is long a set of fixed cash flows but is also short an option. The nominal yield does not incorporate the value of the option that the investor has sold to the borrowers and, thus, this yield tends to overstate a mortgage’s attractiveness. As a result of this shortcoming, option-adjusted spread (OAS) models were developed to create a measure of valuation that accounts for the embedded short option. This type of model adjusts the nominal spread to account for the option value and provides a better indicator of relative value. This same model is also used for calculating the option adjusted duration discussed earlier.
Interest rate and prepayment models
An OAS model is based upon two submodels: an interest rate model and a prepayment model. The interest rate model is a tool that will simulate future, potential interest rate paths.
One of the critical inputs into the interest rate model is the level of volatility. The level of volatility used can potentially make the OAS look attractive or unattractive. The more volatile interest rates are expected to be, the more valuable the embedded option will be and the lower the OAS will be, if all else is equal. This occurs because more volatile markets are more likely to create refinancing opportunities for borrowers. The less volatile interest rates are expected to be, the less valuable the embedded option will be and the higher the OAS will be. At the extreme, if volatility were zero, there ceases to be any uncertainty regarding the option and the time premium of the option is zero.
The prepayment model predicts how individuals behave regarding prepayments. It predicts prepayments stemming from normal housing turnover, interest rate shifts and any other factor deemed relevant. To predict housing turnover, modelers will examine factors such as historical experience, demographic trends and any recent changes to the tax law. Even the impact of the internet has been incorporated into these models.
Predicting refinancing activity due to interest rate shifts is very important as this suggests how efficiently the borrower’s option will be used against the lender. Predicting how a corporation will behave when it has a refinancing opportunity is usually fairly simple. If it is profitable to refinance, a company will usually do so. This is not the case with home owners. While some may be quite efficient in refinancing, others may not be. Some may only refinance after the opportunity has existed for a while and some may not refinance at all. Generally, individuals have become more efficient at
refinancing due to the internet, which has improved the flow of information and market access and has made refinancing easier. The outputs of different OAS models can vary a great deal. When examining the output of an OAS model, it is important to understand the model’s biases and limitations. It also makes sense to stress test the model and understand how it behaves under different assumptions. Mortgage traders regularly use these models as a tool in managing mortgage positions but should not use them as black boxes.
The option-adjusted spread model is a helpful indicator of relative value because it takes into account the short embedded option.
VI. Other Types of Mortgage-Backed Securities
This introduction to mortgage-backed securities has focused entirely on agency mortgage passthroughs. Passthroughs are the most basic type of mortgage-backed security. One of the unique aspects of the mortgage market is the diversity of instruments and products available to market participants. We have highlighted below some other types of residential mortgage-backed securities:
Adjustable Rate Mortgage (ARM)
A passthrough security that has predetermined adjustments of the interest rate at specific intervals. Mortgage payments are tied to varying indices, such as the interest rate on US Treasury bills, LIBOR or the average national mortgage rate. Adjustments are made regularly, usually at intervals of one, three, or five years. Different types of ARMs, include Hybrid ARMs, where the interest rate on the note is fixed for a period of time and then floats thereafter, as well as Option ARMs, where the borrower has the option to make minimal payments which allow for negative amortization or to make fully
amortizing payments.
Collateralized Mortgage Obligations (CMOs)
One disadvantage of standard agency passthrough securities is that their durations often do not match the duration of the investor’s liabilities. The introduction of CMOs in the early 1980s solved this problem and increased the investment universe for mortgage securities.
The most basic CMO structure is called a ‘sequential.’ This structure breaks an agency passthrough into multiple bonds or tranches. Instead of passing through all cash flows on a pro-rata basis to these new securities, principal payments are paid in sequential order. A simple deal might be broken into three tranches with principal payments being sequentially paid to only one tranche at a time. Once the first tranche has been completely paid down, principal payments would be directed towards the second tranche. Once the second tranche has been completely paid down, principal payments would be directed towards the third tranche. This methodology would break the passthrough into three securities with varying interest rate risk: a short duration tranche, an intermediate duration tranche and a long duration tranche. The securities created from this type of structure would be called ‘sequentials.’ The figure below illustrates how the principal would be directed in this type of sequential structure:
0 $100 $200 $300 $400 $500
$600 Tranche A (Weighted-Average Life 3.5)
Tranche B (Weighted-Average Life 10.1) Tranche C (Weighted-Average Life 20.5)
Year
0 5 10 15 20 25 30
Principal Payment
For illustrative purposes only.
Source: Goldman Sachs Asset Management
Sequential Structure at 100% PSA
The introduction of CMOs in the early 1980s increased the mortgage investor base by broadening the range of MBS investment options available.
By using a CMO structure to break up an agency passthrough in this way, many investors, who might not normally purchase mortgages, may now find opportunities in the mortgage market given the broader range of investments available. Since the early 1980s, CMO deals have become increasingly complex as a wide variety of CMOs were created in response to the needs of individual investor bases. CMOs may be created from either agency passthroughs or from pools of non-agency mortgages. The CMOs created with non-agency collateral are often referred to as ‘private label’ and most tranches are AAA-rated. CMOs are not included in the Lehman Aggregate Index since the agency mortgage passthroughs that are backing many of these structures are already included in the index.
VII. Non-Residential Securitized Assets
So far, we have focused only on residential mortgage-backed securities. However, there are other sectors of the market that are interesting in the current environment. These include commercial mortgage-backed securities (CMBS) and asset-mortgage-backed securities (ABS). CMBS are bonds mortgage-backed by pools of mortgages on commercial mortgage loans. ABS are one of the most diverse sectors in the global fixed income markets, but have one trait in common: they are backed by a pool of homogeneous assets.
Commercial Mortgage-Backed Securities (CMBS)
CMBS are securities backed by pools of commercial mortgage loans. These loans are typically secured by commercial property, such as apartment buildings, shopping malls, warehouse facilities, hotels and office buildings. This asset class emerged in the early 1990s as a result of the weak commercial real estate market. This weak market caused many traditional lenders, such as banks, insurance companies and pensions funds making direct loans, to exit the market. The CMBS market replaced some of this traditional lending and began to grow significantly in the late 1990s. Though CMBS share many similarities with residential passthroughs, there are many differences as well.
Lower prepayment risk
CMBS have much less prepayment risk than agency passthroughs. This lower level of risk is a result of prepayment lockouts and prepayment penalties embedded in the underlying commercial loans. A lockout prevents any prepayments over a particular specified time period, while a prepayment penalty reduces the economic benefit of refinancing as interest rates fall.
Credit enhancement in CMBS
There is no government guarantee for securities in the CMBS market as the housing agencies do not have the mandate to offer such credit support. However, the majority of the market is AAA-rated. CMBS securities achieve a AAA-rating through senior/subordinated structuring. In each deal, a certain amount of the securities will be junior to the AAA-rated bonds and will absorb losses prior to the senior bonds. The deals are often broken into four credit classes of bonds:
• Senior bonds: Nearly always AAA-rated
• Mezzanine bonds:Investment grade, but subordinated to senior bonds
• Junior bonds (or B-pieces):Below investment grade with significant credit exposure
• First loss piece: Most junior class and likely to experience complete loss if there is a significant credit event.
CMBS, which are backed by pools of commercial mortgage loans, differ from agency passthroughs in prepayment risk, credit quality and structure.
Balloon structures
Unlike residential mortgages that are typically fully amortizing, loans in the commercial real estate market usually have a balloon structure with a 5- to 10-year term. In a balloon structure there is a large payment of principal (often called a bullet) at the end of the loan’s term. This balloon structure
introduces the risk that the borrower may not be able to refinance their loan at the end of its term, often called ‘balloon extension risk.’ However, this risk is primarily borne by the subordinate bondholders.
Deal types
CMBS deal types are generally classified by the level of diversification of the underlying collateral. The most common deal type is collateralized by loans originated in a securitization conduit. The conduit enables an investment bank to originate and securitize commercial loans while minimizing balance sheet exposure to the loans. This strategy differs from that of banks and insurance companies, which
typically originate and retain commercial mortgages. The loans in these conduits tend to be very well diversified with multiple borrowers, property types and locations and are typically backed by a hundred or more loans. The originators strive for this diversification because it is favorably looked upon by the rating agencies. The good credit ratings that come from strong diversification are important to the originator as they make the economics of the deal much more attractive and the deal more profitable. Many investors prefer these diversified conduit deals to other deals with more concentrated real estate risk as extensive real estate experience may not give an investor a significant advantage over other investors. For example, an isolated default on a $5 million loan will not jeopardize a senior bond holder in a $1 billion deal. The most important skill in these deals is an understanding of the structure, the credit enhancement and the overall quality of the loan underwriting procedures. Other deal types that are less common are single asset/borrower deals, large loan deals and fusion deals. Single
asset/borrower and large loan deals have more concentrated real estate risk. Understanding the quality of each of the underlying loans and related real estate collateral becomes more important.
Asset-Backed Securities (ABS)
Asset-backed securities can represent attractive, conservative core portfolio holdings due to their cash flow stability and strong structural credit support. Unlike traditional residential mortgages, ABS cash flows are relatively insensitive to changes in interest rates and display much greater cash flow stability than typical passthroughs. From a credit perspective, ABS are secured by diversified pools of obligors and due to various potential credit enhancements, are often rated AAA. These credit enhancements may include insurance wrappers, junior/senior structures and certain performance triggers that dynamically adjust the level of protection based on actual credit performance. The ABS sector is comprised of many collateral subtypes, including credit card, auto, home equity, manufactured housing and utility rate-reduction receivables.
Adding MBS, CMBS and ABS to a 100% US Treasury portfolio can increase the portfolio’s return without increasing its risk.
VIII. Why Do Investors Buy Mortgages?
A question of interest to a high credit quality investor is whether to include mortgages in their investment universe. Historically, mortgages have offered investors attractive yield pick-up versus Treasuries with little credit risk:
Spread vs. T
reasuries
0 50 100 150 200 250 300
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 As May 28, 2008
Source: Lehman Brothers
Agency Mortgage Spreads (vs. Treasuries)
We believe that inclusion of the securitized sector in a fixed income portfolio can offer very attractive advantages:
• Historically, the securitized sectors have been very attractive on a risk/return basis. Although mortgage passthrough securities are short prepayment options, the incremental yield advantage of these securities has more than made up for the cost of these embedded options.
• Adding these other sectors to a fixed income portfolio should provide diversification benefits to the portfolio. Though mortgages, like Treasuries, have exposure to general interest rate risk, they also have potential exposure to many other risks (described earlier) that do not affect Treasuries.
VIII. Conclusion
Since the introduction of the first agency passthrough securities over thirty years ago, the mortgage/securitized market has grown significantly in size, diversity of investment options, and capacity of investment tools.
• Size: The US mortgage market has developed into the largest fixed income market in the United States, with a market capitalization of $7.2 trillion. Additionally, the success of securitization in the agency passthrough market has given rise to other securitized markets such as the CMO, CMBS and ABS markets.
• Diversity: As the secondary passthrough market matured, the diversity of investment options in the securitized market increased. The introduction of CMOs in the early 1980s made it possible to create securities with a broad range of risk/return profiles. This innovation increased the number of market participants as some investors, previously not active in the passthrough market, could now find investments suitable for their portfolios. The development of the CMBS and ABS markets also introduced further investment options to the market.
• Credit quality and depth:Agency market is AAA, and senior/subordinated credit enhancement allows AAA creation from non-agency mortgage loans. While the bulk of the mortgage universe is highly rated, equity-like risk is available in credit tranching whole loans (passthroughs not wrapped by the agencies) and commercial mortgages.
• Investment tools: Alongside this growing market, the investment community has increased and refined its understanding of these securities and has developed tools to evaluate their distinctive risk/return profiles. Such tools include option-adjusted spread and option-adjusted duration technology. Given the risk/return profile of the securitized sector, fixed income investors should consider a strategic allocation to it.
The inclusion of the securitized sector as a strategic asset class has largely been embraced by fixed income investors in the US, and is becoming a growing part of fixed income portfolios of global investors. This adoption is apparent in the widespread use of the Lehman Aggregate Index (which includes the securitized sectors) over the older Lehman Government Corporate Index. A similar trend is emerging globally as fixed income investors outside of the United States also begin to embrace the securitized sector on a strategic basis. This trend is apparent in the growing popularity of the Lehman Global Aggregate (which includes the securitized sectors) at the expense of older, traditional all-government benchmarks. This trend will gain momentum as these global investors increase their understanding of this market and how it can play a beneficial role in their portfolios.
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The strategy discussed herein may include the use of derivatives. Derivatives often involve a high degree of financial risk because a relatively small movement in the price of the underlying security or benchmark may result in a disproportionately large movement, unfavorable or favorable, in the price of the derivative instrument.
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