Mortgage Backed Securities

MBS Basics (Mortgage-Backed Securities 101)

Bonds, loans, debt...  All three mean the same thing.  All three refer to an arrangement where one party is borrowing money and paying it back over time based on certain terms. 

In the bond world, an "issuer" is the party seeking to borrow money by issuing a bond to an investor.  The investor pays a lump sum upfront, typically the principal or face value plus a premium.  In other words, if you borrow $100k, an investor might pay $104k total (a $4k premium) for the privilege of collecting interest over time. 

If you understand the description above, you understand the underpinnings of mortgage-backed securities (MBS). 

A mortgage is essentially a bond where the mortgage borrower is the issuer.   Investors can buy individual mortgages as bond-like investments, but that exposes them to significantly more risk than the alternative.  Why is that?  

A mortgage bondholder (the investor who pays the big lump sum and collects interest over time) risks losing money in 3 key ways. 

1. Default Risk. The borrower defaults on the loan and is unable to pay.

2. Extension Risk. The borrower got a great rate and never wants to refi.  If rates are rising, this means the investor has cash tied up in an investment that's earning less than it could be.  That might not sound like a big deal to the average person, but it's a huge deal in a portfolio of mortgages.

3. Prepayment Risk. Just the opposite of extension risk where rates are falling quickly enough that the borrower refinances or buys a new home before the investor had a chance to collect enough interest to make the investment profitable.  (read more on prepayment risk...).

One of the most important things to understand about a vast majority of loans originated in the U.S. today is that investors are protected from default risk by housing agencies.  For example, if a loan meets guidelines set forth by Fannie Mae, Freddie Mac, FHA, VA, etc. those agencies guarantee timely payment of principal and interest to investors.  For most investors, the biggest risk associated with default is that it occurs in a falling rate environment.  In that case, the resolution of default (short sale, foreclosure, etc.) often results in a mortgage being retired earlier than the investor hoped.  At that point, the default risk is actually prepayment risk (see number 3 above).

Premature prepayment is really the definitive concern for mortgage investors.  Extension risk is far more manageable by comparison because there's no change in the amount of interest an investor is collecting each month.  Sure, their cost of capital may be rising if rates are rising, but that's typically a slower, gentler hit to the balance sheet compared to prepayment risk.

If you're an investor who just paid a premium for a bunch of loans and rates suddenly drop enough to prompt a majority of those borrowers to refinance, you are going to lose a lot of money instantly.  

The bottom line on these risks is that mortgage investors are constantly trying to find the perfect balance between a rate that's low enough to minimize the risk that it will be paid off too quickly and a rate that's high enough to not  hurt the balance sheet too badly if they get stuck holding that loan in a rising rate environment.

Investors can manage their risk by owning multiple loans and by understanding the average percentage of loans that are likely to be paid off too quickly or not quickly enough.  In fact, if an investor knew exactly how many of their loans would be paid off too early or too late, they could adjust the prices paid for all loans to account for that risk.  An investor who is always making the rate of return they expect is very happy.  The benefit for consumers would be more money available to borrower in the mortgage market and at the lowest possible rates.

Unfortunately, even if an investor knows exactly how likely they are to lose money on any given loan, it will still be more expensive for them to account for that risk on a small number of loans versus a huge number.  

For instance, consider an example where 20 investors buy 20 mortgages and where 5% of all similar mortgages will end up paying off early.  That means 1 of those 20 investors will lose big while the rest will do just fine.  If you could afford to buy all 20 loans, you'd have a 100% chance of 5% of your portfolio costing you money.  Easy to account for!  But if you only buy one mortgage, you have a 5% chance of 100% of your portfolio losing money.  Much harder to account for!

Need an even simpler way to understand?  Imagine we're talking about 20 people who love orange juice.  They're each going to juice one orange and drink up.  19 oranges are delicious and one is terrible--terrible enough that it will seriously ruin your day if you drink it (and you have to finish the whole thing)!  

Would you rather take your chances that you end up with the bad orange or propose a new arrangement where all the juice is combined and evenly distributed?  Diluting that nasty orange with the juice from 19 other outstanding oranges means everyone has a refreshing cup of juice with only a faint hint of bitterness and no one is at risk of having their day ruined.

With that in mind, wouldn't it be great if investors could combine multiple portfolios of multiple loans in order to spread the risk of nasty bitterness around evenly?  That's EXACTLY how the MBS market works.

As investors have gravitated toward the safety, predictability, and liquidity of the modern MBS market, it has become the definitive venue to determine the value of a mortgage.  Thus, the prices of MBS are the definitive ingredients in determining mortgage rates. 

Simply put: MBS prices are the largest and most meaningful building block in the mortgage rate equation.

MBS can be sold by anyone with a group of loans to sell, but the big league is the TBA-MBS market.  This is the realm of loans guaranteed by the GSEs and Ginnie Mae (via FHA/VA/USDA).  The GSEs (government-sponsored enterprises) are Fannie Mae and Freddie Mac.  Collectively, all of these entities can be referred to as "the agencies." 

The agencies' primary function is to ensure loans meet certain standards and to guarantee the timely payment of principal and interest to any investor who buys MBS meeting those standards.  Ginnie is considered to have an explicit "government guarantee" as it is explicitly a government enterprise.  Fannie and Freddie have always had an implicit guarantee, and we saw why in 2008 when they were bailed out by Treasury.  The consequence--government conservatorship--only strengthened the implicit guarantee.  In other words, investors have little-to-no doubt that the US government will backstop the GSEs in case they run out of funds.  That government guarantee (implicit or otherwise) means that agency MBS trade at higher prices than they would if they were random private-label MBS.

What does TBA mean?

TBA (to be announced) MBS refers to a virtual MBS marketplace where buyers and sellers trade MBS constantly, but only actually settle those trades once a month.  This is actually way more efficient than it sounds.  It means I can sell you 25,000,000 of MBS instantly without having to disclose all of the tedious little details of the underlying pool of loans.   You can buy it without needing to do any due diligence.  As long as you know you want the type of MBS I'm selling, the agencies are guaranteeing you that they have vetted all the loans I will ultimately put in the pool.  They are guaranteeing you a certain "coupon" (a nominal rate of return) regardless of the actual average interest rates of the underlying loans.  It would be extremely tedious and inefficient to make on-the-fly trading decisions about such massive pools of loans multiple times per day in a highly competitive marketplace.  Imagine trying to constantly buy and sell every stock in the S&P 500 every minute of every day.  Now imagine you can just deal with the entire S&P index all at once (people love ETFs for this reason).  MBS offer the same sort of easy button.