Mortgage backed securities offer attractive credit risk but that doesn’t mean they’re risk free. The direction of interest rates and pre-payment risks are hugely important when deciding whether to invest in MBS.
Mortgage Backed Securities
Mortgage backed securities (MBS) are securities based on a pool of underlying mortgages. MBS are usually based on mortgages that are guaranteed by a government agency for payment of principal and a guarantee of timely payment. The analysis of MBS concentrates on the nature of the underlying payment stream, particularly the pre-payments of principal prior to maturity.
History of Mortgage Backed Securities
Before the development of the mortgage backed securities market in the early 1980s, each residential mortgage underwritten was a unique transaction. Joe Q. Public would walk into his bank or trust company and enter into a mortgage. Say Joe chooses Lack Trust Company. Joe enters into a mortgage on a specific real estate property, 100 Easy Street in the Hills of Richmond, with the good people of Lack Trust. Sounds easy. But think of what has to happen for this mortgage to be underwritten. Lack Trust must check Joe’s credit (salary, assets etc.) and establish the worth of the property through an appraisal. Joe and Lack Trust then negotiate and establish the terms. This includes the amount and interest rate of the mortgage, the amortization of principal as well prepayment terms. Lack Trust then has to hire a lawyer to register the mortgage against the property with a property registry office.
It can easily be seen that Joe’s mortgage is a unique thing. There are no other mortgages on 100 Easy Street with Joe as the borrower on those terms and conditions. Most mortgages used to be held by the financial company that originated them because trading was awkward given that these unique mortgages had to each be evaluated and administered differently. The originating organization usually kept the servicing and was loath to part with their mortgages. Only very large institutional investors participated in the market. Smaller investors didn’t have the expertise to evaluate the mortgages or a large enough portfolio to properly diversify. If a single mortgage was in the $200,000 range, a maximum 10% position would require a total portfolio of over $2,000,000 to be properly diversified. Therefore, for an individual investor, if their portfolio was to be properly diversified, a mortgage was an awkward asset to own.
How They Work
By grouping a large number of mortgages together in a “pool”, the uniqueness of each mortgage is submerged in the whole. Let’s take 500 mortgages at $200,000. This gives us a pool of $100 million of mortgages. We can take the aggregated statistics such the “weighted average maturity” (WAM) or the “remaining amortization” (RAM) and use these to describe the pool. We can then make sure no mortgage is too large a portion of the pool. Arrangements are made such that the “servicing agent” collects the mortgage payments and gives them to “central paying agent” which, in turn, “passes through” the payments to the final investor. We now have mortgage backed securities, something that looks very much like a bond. However, we have a problem: how do we assess each of the mortgages for their creditworthiness?
Enter mortgage insurance. Mortgage insurance guarantees the principal of a mortgage against default by the borrower. This process provides investors with a “commoditized” credit risk. The large mortgage insurers in the United States and Canada are government or quasi-government agencies. These agencies use the credit standing of their respective national governments to guarantee mortgage loans. In Canada, the Central Housing and Mortgage Corporation (CHMC) guarantees mortgages for different programs backed by its borrowing power under federal government legislation, the National Housing Act (NHA). Investors could then view the credit risk on the principal amount as equivalent to the credit risk of Canadian government bond.
Investors were still wary of the “timely payment” issue, since the process of collecting on a defaulted loan was a lengthy affair. In the 1980s, some investors in NHA mortgages in Canada were unable to collect on their defaulted mortgages from the CHMC for several years. This meant they lost the use of their money and the interest it could earn for a lengthy period, although they eventually collected their principal and accrued interest. The Canadian Mortgage Backed Securities program remedied this by adding a “guarantee of timely payment” in 1987. This guarantee of principal and timely payment meant that the credit risk was removed from the equation. With a defaulted mortgage, the payments would be kept up until the principal amount was repaid by the guarantor – the CMHC.
Pre-payment and Other Risks
The removal of credit risk does not mean that MBS are without risk. There is a major risk inherent in the cash flows called “pre-payment risk”. Let’s say that Joe was unusually frugal and decided to pay off his mortgage early. All his neighbours, who were in the same pool, decide to follow suit. We, the investors, are sitting pretty. We know we’re safe credit-wise for the next five years. But when Joe and his neighbours walk in the door of Lack Trust, our portfolio starts to shudder. Their combined frugality means that we get our principal back early. Not bad, but how well the investors make out in this type of scenario will also depend on what interest rates did since the pool was issued.
Assessing the Risk
You won’t hear much about pre-payments from your favourite salesperson, but it’s the only thing that counts with mortgage backed securities.
A good trick is to watch out for the words “after analysis”. This means that a certain pre-payment experience has been assumed in calculating the yield. A smart analyst takes this with a “chunk of rock salt” and concentrates on the pool characteristics and prepayment experience of similar pools and issuers. She then tries out a few scenarios to see how things will go with varying interest rates and prepayment conditions. The trick is establishing the future payment stream and pricing it.
If you think interest rates are going to fall, avoid pre-payable mortgage backed securities. If you think they are going to rise, MBS might not be a bad investment. If you don’t think you have an insight into interest rates, don’t buy pre-payable or “open” MBS. Try closed MBS or normal bonds.
And remember your mantra: “It’s the prepayment risk, stupid”