First developed in the 1970s, mortgage-backed securities werecreated by pooling together groups of whole mortgage loans withsimilar characteristics to form one security. Corporates haveinvested in MBSs almost since their inception. Why? Because until afew years ago, MBS structures were relatively simple and risk-free.They largely consisted of conforming, fixed-rate loans, guaranteedby government-sponsored entities like Fannie Mae and FreddieMac.

The GSEs provide a secondary market from which mortgage loanscan be traded and securitized, packaging loans together to formpass-throughs and marketing them through a primary broker-dealernetwork. The principal and interest payments are then passed to theinvestor, but the credit risk exposure is retained by the GSE.Investors are not exposed to credit losses on agency securities.All GSE-issued MBSs are AAA rated, which is how they pass highcorporate standards.

Earlier this decade, the private mortgage market exploded,fueled by rising home prices and the willingness of organizationslike Countrywide to purchase loans that Fannie and Freddiewouldn't. Not all private, non-agency MBSs are made up of subprimeloans; Fannie and Freddie lagged in raising conforming limits asvalues rose, driving a majority of mortgages in high-value areasinto the private market. Additionally, not all subprime loans weremade to borrowers with poor repayment histories. High valuescreated low affordability in many areas, leaving subprimequalification one of the few ways average income earners couldqualify for median-priced homes.

The securities also became more complex. Rather than beingstructured as simple pass-throughs, in which investors collectedprincipal and interest payments throughout the life of the loan,investors were divided into risk and cash flow categories. Thiscreated several layers of credit quality within the samesecurity--those holding the highest quality paper have repaymentpriority but earn the smallest returns. Those holding lower creditpaper receive high returns, but are hit by losses first.

For the most part, corporates invest in high-quality MBS paper,only suffering actual losses after all other investors have lostout. This means that write downs of corporate-owned MBSs paint agrim picture of the security's value because it means all otherinvestors have already taken a hit.

The value of MBSs are determined by assumptions of performance.Because newly structured MBSs had no historical performancerecords, projections were based on boom year numbers. So, not onlyhave the homes behind MBS lost value, but the performanceassumptions of the securities themselves have also decreased.

Write downs have occurred for two main reasons. First, thesupply and demand of the MBS market is highly irregular, withsupply extremely high and demand extremely low. Second, becausevalues are based on performance assumptions, some believe themortgage bust has resulted in overly pessimistic assumptions, abacklash to the overly optimistic assumptions from a few yearsprior.

Even though corporate-owned MBS portfolios have experienced somewrite downs, unlike charged off loans, these securities stillremain on the aggregates' balance sheets. So, corporates canpotentially gain back the value they've lost when the mortgagemarket recovers. MBSs are pass-through investments, which meanspayback--and value--are determined by performance. If performanceis in doubt, the value suffers, though it doesn't necessarilyreflect the collateral's actual value. This is why prepayments havea big impact on the value of mortgage-backed securities; the valueof the collateral doesn't drop, but when a mortgage is paid offearly, the cash flow of loan ends.

Sources:

Dwight Johnston, vice president of economic and marketresearch, WesCorp.

Johnston serves as WesCorp's economic forecaster and marketobserver and is best-known for his daily and long-term commentarieson the U.S. economy appearing on WesCorp's Web site, his weeklyaward-winning podcast, OnDeck with Dwight Johnston and, his webcastpresentations, Breaking News and Quarterly Market Update. He alsooversees WesCorp's investment-related educational commitments,including online ALM training and InsideRISK, a quarterly magazinedevoted to optimizing the balance sheet.

Brian Turner, director of advisory services, SouthwestCorporate.

Brian Turner joined Southwest Corporate Investment Services in1999 with nearly 17 years of senior financial management experiencein the financial services industry. In his position as director ofadvisory services, Brian manages the daily operations and strategicdirection of advisory services and works directly with a number ofcredit unions on their strategic investment and financialmanagement endeavors.