THE ROLE OF MORTGAGE-BACKED

SECURITIES

Words Count: 2939

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Abstract................................................................................................................................3
Keywords..........................................................................................................................................3

Introduction.........................................................................................................................3
P ASS- THROUGHS.....................................................................................3
C OLLATERALIZED MORTGAGE OBLIGATIONS (CMO):.........................................4
Subprime Mortgages....................................................................................................................4
Prime Mortgages...........................................................................................................................4

Unique Benefits of MBS....................................................................................................5

High Historical Sharpe Ratio.....................................................................................................5
Low Correlation to Risk Assets:................................................................................................5
Ample Liquidity:.............................................................................................................................5
Active Management Opportunities:........................................................................................5

The Role of MBS in Financial Crisis................................................................................6

R ISKS OF MBS.......................................................................................7
Spreads.............................................................................................................................................7
Prepayment.....................................................................................................................................7
Convexity.........................................................................................................................................7
Volatility............................................................................................................................................7
THE GROWTH OF SUBPRIME MORTGAGES......................................................8
EFFECT OF FED R ATES ON SUBPRIME BORROWERS..........................................9

Conclusion.........................................................................................................................10
References.................................................................................................................................10
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Abstract
This case study helps to understand MBSs. This case study provides a
backdrop for understanding the US financial crisis (2008) and the evolution
and growth of Mortgage-Backed Securities (MBS) market during the booming
years of US housing industry. The case provides an understanding on how
the greed nurtured by the financial institutions to earn hefty profit margins
from subprime lending finally led to the meltdown of housing and subprime
mortgage markets. It provides the history of development of MBS market and
the spread of risks across the firms, by Government Sponsored Enterprises
like Fannie Mae and Freddie Mac and leading Wall Street firms like Bear
Stearns, Lehman Brothers, Merrill Lynch, etc., and how the collapse of US
housing boom resulted in global financial turmoil.

Keywords: Prime, Subprime, Mortgage, MBSs, CMBS, ARM, SEC, GSE, CMOs,
CDO, Housing Market, Foreclosures, Bear Stearns, AIG, Financial Derivatives,
Financial innovation, Delinquencies, Financial turmoil, US housing bubble

Introduction
A Mortgage-backed security (MBS) is a type of asset-backed security
that is secured by a mortgage or collection of mortgages. It can be bought
and sold through a broker and the minimum investment varies between
issuers. It is issued by either a federal government agency
company, government-sponsored enterprise (GSE), or private financial
company.

Mortgage-backed security is a way for a smaller regional bank to lend

mortgages to its customers without having to worry about whether the
customers have the assets to cover the loan. Instead, the bank acts as
a middleman between the home buyer and the investment market
participants. When an investor invests in a mortgage-backed security, he is
essentially lending money to a home buyer or business.

This type of security is also commonly used to redirect the interest and
principal payments from the pool of mortgages to shareholders. These
payments can be further broken down into different classes of securities,
depending on the riskiness of different mortgages as they are classified
under the MBS.

There are two common types of MBSs

Pass-throughs: These are structured as a trust in which mortgage payments

are collected and passed through to investors. Pass-throughs typically have
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stated maturities of five, 15, and 30 years. Adjustable-rate

mortgages (ARM), fixed-rate mortgages and other types of loans are pooled
to create pass-throughs. The average life of pass-throughs may be less than
the stated maturity, depending on the principal payments of the pool of
mortgages.

Collateralized mortgage obligations (CMO): consist of multiple pools of

securities, which are known as slices, or tranches. The tranches are given
credit ratings, and the rates that are returned to investors depend on the
tranches. For example, pools of securities in the senior secured tranche
typically have lower interest rates than those in the unsecured tranche, due
to the low degree of risk assumed in the senior secured tranche.

Under CMOs category there’re two types of mortgages which are important
to understand are

Subprime Mortgages

A subprime mortgage is a type of loan awarded to those with poor

credit histories, usually below 600, but often, anything below 620 is
considered low. These people would otherwise not be able to qualify for
conventional mortgages. Subprime borrowers pose a higher risk
to lenders. As such, subprime mortgage rates are higher than a prime
mortgage to make up for the potential risk to the lenders.
There are many different types of subprime mortgages, however, the
most common is the adjustable rate mortgage (ARM). An ARM initially
charges a fixed interest rate, which then converts to a floating rate. The most
known ARMs are a 3/27 ARM and a 2/28 ARM. However, ARMs can be a little
misleading, as they have a smaller interest rate at first. This lead to many
mortgage foreclosures in 2006.

Prime Mortgages

Prime mortgages meet the standards set out by Fannie Mae and
Freddie Mac. To be approved for a prime mortgage, borrowers must have a
good credit history and an income at least three to four times greater than
their mortgage payments. Borrowers with a credit score of 620 – 650 often
qualify for a prime mortgage. Prime mortgages also feature rates lower than
average. Additionally, prime mortgages usually require borrowers to pay a
down payment, which is most commonly 10%, but can be as much as 20%.
Fixed rate mortgages are the most common types of prime mortgages. Fixed
rate has an interest rate that is stays the same over the loan life.
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Prime mortgages save borrowers money. This is because their low

interest rates lower monthly mortgage rates by hundreds of dollars.
Additionally, the down payment requirements give the new homeowners
immediate equity value. Furthermore, if the down payment is high enough,
the lender won’t require private mortgage insurance, which can lead to even
more savings.

Unique Benefits of MBS

In our view, investors should consider four historical benefits provided by
agency MBS:

High Historical Sharpe Ratio: The MBS sector has provided among the most
consistent sources of risk-adjusted returns relative to like-duration U.S.
Treasuries of any fixed income asset class. More recently, massive central
bank accommodation and global demand for yield have resulted in outsize
risk-adjusted returns in many credit sectors. However, the agency MBS
Sharpe ratio has remained consistent over time.

Low Correlation to Risk Assets: MBS have generally exhibited less volatility
and lower correlation with the equity markets than other fixed-income
sectors. Unlike many other spread sectors, relative to like-duration U.S.
Treasuries the primary risk factor in agency MBS is prepayment risk rather
than exposure to credit fundamentals and/or bond market liquidity. Even
within the credit component of the MBS market, private label commercial
mortgage-backed securities (CMBS) have had a lower correlation to equities
than corporate and emerging market debt.

Ample Liquidity: Liquidity is another key distinguishing factor of the agency

MBS sector, especially in an environment where regulation has reduced the
role of intermediaries and negatively affected liquidity across many credit
sectors. Diminished liquidity can result in wider bid/ask spreads and more
fragility during periods of market dislocation. While liquidity in agency MBS
may be weaker than historical levels, on average the sector continues to
trade more than $200 billion per day (see Figure 3), according to the
Securities Industry and Financial Markets Association, and with minimal bid-
ask spreads relative to many other credit sectors.

Active Management Opportunities: An active manager had the flexibility to

maintain exposure to the CMBS sector, greatly improving the risk/reward
profile of its positions through rotation out of CMBS cash bonds in favor of
synthetic CMBX exposure. Active management allows investors to gain
access to the most efficient means of exposure to certain sectors
represented by a benchmark, whether in cash or synthetic form.
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Active management can help investors navigate the dislocations in

value across the securitized mortgage market, particularly in an investment
landscape which continues to be heavily influenced by ongoing policy
initiatives, rating agency dysfunction and structural changes to the mortgage
finance system. As valuations and fundamentals change, active managers
can adjust their portfolios accordingly.

The Role of MBS in Financial Crisis

Mortgage-backed securities played a central role in the financial crisis
that began in 2007 and wiped out trillions of dollars, bringing down Lehman
Brothers and roiling world financial markets. At the core, an MBS allows a
bank to move a mortgage off its books by turning it into a security and
selling it to investors. When a bank can move mortgages off the books, it
frees up room for more lending capital. With investors encouraged by the
traditional strength of the housing market and the ratings on MBS, there was
steady demand for these repackaged mortgages.

In retrospect, it seems natural that the demand for MBS would

encourage banks to reach further down in creditworthiness to supply more to
eager investors. So, the MBS market started seeing more subprime MBS.
With Freddie Mac and Fannie Mae also aggressively supporting the mortgage
market, the quality of all mortgage backed securities declined below their
increasingly meaningless ratings. When subprime borrowers began to
default, the housing market tightened and then began to collapse, hurting
even conventional mortgage holders. More and more people walked from
their mortgages and the primary assets underpinning the MBS market saw
steep declines.

The avalanche of non-payments meant that many of the MBSs and

collaterized debt obligations (CDO) based off of the pools of mortgages were
vastly overvalued. The market for MBSs dried up and losses piled up as
institutional investors and banks attempted to unload bad MBS investments.
Credit also tightened, causing many banks and financial institutions to teeter
on the brink of insolvency. The U.S. Treasury stepped in with the $700 billion
bailout to mitigate the credit crunch, but it was the Federal Reserve that led
the charge on creating a market for unloading the MBSs. The Fed bought
$1.75 trillion in MBSs directly while the Troubled Asset Relief Program
(TARP) injected capital into banks. The financial crisis passed, but the total
government commitment, implicit and explicit, was much larger than the
$700 billion figure often reported.

Wall Street firms put thousands of home mortgages into one basket of
securities and sold them to investors and banks. These were considered safe
investments, since homeowners historically had rarely failed to pay back
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their home loans. But the mortgage bankers lent money to people who
weren’t financially sound enough to buy a house. So more and more risky
mortgages were put in that basket of securities.

Even there’re several benefits of MBS but the Changes in the following will
impact prices and these are some of the factors which fuelled the Financial
Crisis

Risks of MBS

Spreads
Like any non-government fixed-income security, agency MBS generic
valuations are subject to changes in spreads. If spreads widen, the
prices of agency MBS will decline. If spreads tighten, the prices of
agency MBS will increase.

Prepayment
When homeowners pay back more principal than required by the
regular amortization schedule, this constitutes a prepayment. This may
occur for several reasons; for example, the homeowner might
refinance into a lower rate mortgage, experience a life-changing event
(e.g., relocation for a new job, divorce, death), or move into a new
home. Because the principal is being returned to the investor at par,
this can detract from returns if the MBS was purchased at a premium
dollar price. However, the idiosyncratic aspect of prepayment risk is
reduced by the aggregation of many loans across specified pools.

Convexity
Although the duration of the MBS sector is typically lower than that of
the Treasury sector, MBS are negatively convex due to the likelihood of
the homeowner to refinance into a lower rate mortgage when yields
fall, and conversely, the homeowner’s tendency to remain in the
mortgage when yields rise. This can cause MBS prices to decrease in
rate selloffs more than they increase in rate rallies.

Volatility
Due to the homeowner’s embedded option, MBS are exposed to
changes in volatility. An increase in volatility can result in MBS
underperformance.
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The financial crisis was primarily caused by deregulation in the

financial industry. That permitted banks to engage in hedge fund trading
with derivatives. Banks then demanded more mortgages to support the
profitable sale of these derivatives. They created interest-only loans that
became affordable to subprime borrowers.

In 2004, the Federal Reserve raised the fed funds rate just as the
interest rates on these new mortgages reset. Housing prices started falling
as supply outpaced demand. That trapped homeowners who couldn't afford
the payments, but couldn't sell their house. When the values of the
derivatives crumbled, banks stopped lending to each other. That created the
financial crisis that led to the Great Recession.

Once you get a mortgage from a bank, it sells it to a hedge fund on

the secondary market. The hedge fund then bundles your mortgage with a
lot of other similar mortgages. They used computer models to figure out
what the bundle is worth based on several factors. These included the
monthly payments, total amount owed, the likelihood you will repay, and
future home prices. The hedge fund then sells the mortgage-backed security
to investors.

Since the bank sold your mortgage, it can make new loans with the
money it received. It may still collect your payments, but it sends them along
to the hedge fund, who sends it to their investors. Of course, everyone takes
a cut along the way, which is one reason they were so popular. It was
basically risk-free for the bank and the hedge fund.

The investors took all the risk of default. But they didn't worry about
the risk because they had insurance, called credit default swaps. These were
sold by solid insurance companies like the American International Group.
Thanks to this insurance, investors snapped up the derivatives. In time,
everyone owned them, including pension funds, large banks, hedge funds,
and even individual investors. Some of the biggest owners were Bear
Stearns, Citibank, and Lehman Brothers.

A derivative backed by the combination of both real estate and

insurance was very profitable. As the demand for these derivatives grew, so
did the banks' demand for more and more mortgages to back the securities.
To meet this demand, banks and mortgage brokers offered home loans to
just about anyone. Banks offered subprime mortgages because they made so
much money from the derivatives, rather than the loans themselves.

The Growth of Subprime Mortgages

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In 1989, the Financial Institutions Reform Recovery and Enforcement

Act increased enforcement of the Community Reinvestment Act. This Act
sought to eliminate bank “redlining” of poor neighborhoods. That
practice had contributed to the growth of ghettos in the 1970s. Regulators
now publicly ranked banks as to how well they “greenlined” neighborhoods.
Fannie Mae and Freddie Mac reassured banks that they would securitize
these subprime loans. That was the “pull” factor complementing the “push”
factor of the CRA.

Effect of Fed Rates on Subprime Borrowers

Banks hit hard by the 2001 recession, welcomed the new derivative
products. In December 2001, Federal Reserve Chairman Alan Greenspan
lowered the fed funds rate to 1.75 percent. The Fed lowered it again in
November 2002 to 1.24 percent.

That also lowered interest rates on adjustable-rate mortgages. The

payments were cheaper because their interest rates were based on short-
term Treasury bill yields, which are based on the fed funds rate. But that
lowered banks' incomes, which are based on loan interest rates.

Many homeowners who couldn't afford conventional mortgages were

delighted to be approved for these interest-only loans. As a result, the
percentage of subprime mortgages doubled, from 10 percent to 20 percent,
of all mortgages between 2001 and 2006. By 2007, it had grown into a $1.3
trillion industry. The creation of mortgage-backed securities and the
secondary market ended the 2001 recession.

It also created an asset bubble in real estate in 2005. The demand for
mortgages drove up demand for housing, which homebuilders tried to meet.
With such cheap loans, many people bought homes as investments to sell as
prices kept rising.

Many of those with adjustable-rate loans didn't realize the rates would
reset in three to five years. In 2004, the Fed started raising rates. By the end
of the year, the fed funds rate was 2.25 percent. By the end of 2005, it was
4.25 percent. By June 2006, the rate was 5.25 percent. Homeowners were hit
with payments they couldn't afford. These rates rose much faster than past
fed funds rates.

Housing prices started falling after they reached a peak in October

2005. By July 2007, they were down 4 percent. That was enough to prevent
mortgage-holders from selling homes they could no longer make payments
on. The Fed's rate increase couldn't have come at a worse time for these new
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homeowners. The housing market bubble turned to a bust. That created

the banking crisis in 2007, which spread to Wall Street in 2008.

Conclusion
Mortgage-backed securities have changed the banking and housing
industry, making it easier to buy real estate. Before the global financial crisis,
many financial institutions offered zero down payment to borrowers who
proved unable to meet their monthly payments. Lenders sold risky loans to
pooling agencies, thus contributing to the subprime mortgage crisis.
Everyone was affected because many financial entities, pension funds, and
investors held MBSs. While selling home loans is a way to gain access to
funds and offer new loans, banks did not pay the consequences for offering
bad loans. They extended loans to borrowers with poor credit and low or no
down payment. Finally, mortgage-back securities were not regulated which
contributed to the asset bubble.

References
By Ronald Utt on April 22 2008 - “The Subprime Mortgage Market Collapse: A
Premier on the Causes and Possible Solutions”

BY JASON MANDINACH September 2005 - “The Unique Benefits of Mortgage-

Backed Securities”

BY JOSH CLARK – “How can mortgage-backed securities bring down the U.S.
economy”

By Neil Fligstein and Alexander Roehrkasse – “The Causes of Fraud in

Financial Crises: Evidence from the Mortgage-Backed Securities Industry”

By BONNIE M. WONGTRAKOOL JAN 2016-“The Advantages of Agency

Mortgage Backed Securities”

BY KIMBERLY AMADEO – “What really caused crisis?”

by Dori Gelman –“Difference between prime and subprime mortgages”

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