First developed in the 1970s, mortgage-backed securities were created by pooling together groups of whole mortgage loans with similar characteristics to form one security. Corporates have invested in MBSs almost since their inception. Why? Because until a few years ago, MBS structures were relatively simple and risk-free. They largely consisted of conforming, fixed-rate loans, guaranteed by government-sponsored entities like Fannie Mae and Freddie Mac.
The GSEs provide a secondary market from which mortgage loans can be traded and securitized, packaging loans together to form pass-throughs and marketing them through a primary broker-dealer network. The principal and interest payments are then passed to the investor, 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 high corporate standards.
Earlier this decade, the private mortgage market exploded, fueled by rising home prices and the willingness of organizations like Countrywide to purchase loans that Fannie and Freddie wouldn’t. Not all private, non-agency MBSs are made up of subprime loans; Fannie and Freddie lagged in raising conforming limits as values rose, driving a majority of mortgages in high-value areas into the private market. Additionally, not all subprime loans were made to borrowers with poor repayment histories. High values created low affordability in many areas, leaving subprime qualification one of the few ways average income earners could qualify for median-priced homes.
The securities also became more complex. Rather than being structured as simple pass-throughs, in which investors collected principal and interest payments throughout the life of the loan, investors were divided into risk and cash flow categories. This created several layers of credit quality within the same security–those holding the highest quality paper have repayment priority but earn the smallest returns. Those holding lower credit paper 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 lost out. This means that write downs of corporate-owned MBSs paint a grim picture of the security’s value because it means all other investors have already taken a hit.
The value of MBSs are determined by assumptions of performance. Because newly structured MBSs had no historical performance records, projections were based on boom year numbers. So, not only have the homes behind MBS lost value, but the performance assumptions of the securities themselves have also decreased.
Write downs have occurred for two main reasons. First, the supply and demand of the MBS market is highly irregular, with supply extremely high and demand extremely low. Second, because values are based on performance assumptions, some believe the mortgage bust has resulted in overly pessimistic assumptions, a backlash to the overly optimistic assumptions from a few years prior.
Even though corporate-owned MBS portfolios have experienced some write downs, unlike charged off loans, these securities still remain on the aggregates’ balance sheets. So, corporates can potentially gain back the value they’ve lost when the mortgage market recovers. MBSs are pass-through investments, which means payback–and value–are determined by performance. If performance is in doubt, the value suffers, though it doesn’t necessarily reflect the collateral’s actual value. This is why prepayments have a big impact on the value of mortgage-backed securities; the value of the collateral doesn’t drop, but when a mortgage is paid off early, the cash flow of loan ends.
Dwight Johnston, vice president of economic and market research, WesCorp.
Johnston serves as WesCorp’s economic forecaster and market observer and is best-known for his daily and long-term commentaries on the U.S. economy appearing on WesCorp’s Web site, his weekly award-winning podcast, OnDeck with Dwight Johnston and, his webcast presentations, Breaking News and Quarterly Market Update. He also oversees WesCorp’s investment-related educational commitments, including online ALM training and InsideRISK, a quarterly magazine devoted to optimizing the balance sheet.
Brian Turner, director of advisory services, Southwest Corporate.
Brian Turner joined Southwest Corporate Investment Services in 1999 with nearly 17 years of senior financial management experience in the financial services industry. In his position as director of advisory services, Brian manages the daily operations and strategic direction of advisory services and works directly with a number of credit unions on their strategic investment and financial management endeavors.