Mortgage Backed Securities

Mortgage-backed securities (MBS) are debt obligations that are secured by pools of mortgage loans (mostly residential) and that represent claims to the cash flows from these pools. MBS are created in a securitization process by the sale of the underlying assets from the company which granted the loans to a bankruptcy remote entity which in turn issues tradable securities to fund the purchase. Credit enhancement is an integral component of this process as it creates a security that has a higher rating than the issuing company. An external perspective on the liabilities being created is guaranteed by credit rating agencies which rate the securities.
The biggest market for securities is the United States accounting for almost 80 per cent of global securitisation issuance.[1] Mortgage-backed securitisation accounts for the largest share of deals; yet, the market has expanded both in the range of financial assets that are now securitised and globally with an increasing number of countries securitising assets. However, the financial crisis of the years 2007 to 2009 has radically reduced the issuance of new securities worldwide.[2]

Usage and Characteristics

The MBS market represents an important portion of the total asset-backed securities market. In this category we can further distinguish between different structures. The basic, “plain vanilla” mortgage-backed security structure is the Pass-through. As the name implies, this structure passes through all cash flows – the monthly principal and interest payments, less a servicing fee – from a pool of mortgage loans to holders of the securities in proportion to their share ownership. In other words, investors in the pass-through are buying shares of the cash flows from the underlying loans. If not mentioned differently, the term MBS refers only to these “plain-vanilla” MBS.
Otherwise, the market offers structured MBS, such as the Collateralized Mortgage Obligation (CMO). CMOs comprise a number of classes of bonds issued against specified mortgage collateral. Those classes or tranches are related securities that are offered at the same time but have different risk, reward, and/or maturity. The most basic CMO structure has tranches that pay in a strict sequence. Each tranche receives regular interest payments, but the principal payments received are made to the first tranche alone, until it is completely retired. Once the first tranche is retired, principal payments are applied to the second tranche until it is fully retired, and this process continues until the last tranche is retired. This arrangement is often referred to as a cash flow waterfall. On the other hand, in the event that the underlying asset pool becomes insufficient to make payments on the securities the loss is absorbed first by the subordinated tranches. Several different types of CMO tranches exist.
MBS transactions are off-balance sheet transactions as the originator of the loan sells them to a special entity, the issuer of the MBS. Thus, their risk-weighted assets are reduced and thereby capital is freed up, enabling them to originate still more loans as funding instruments. Furthermore, MBS issues serve not only as funding instrument but are also employed for credit risk transfer and balance sheet restructuring, with the aim of efficient management of economic and regulatory capital.
However, each of the advantages for the originator of the loan adds directly to investor risk.

The MBS market in the United States

The US-American MBS market has been by relative as well as absolute size the largest in the world. Around 60 per cent of US mortgages are securitized. In 2008, mortgage related securities (MBSs, CMOs) worth almost 9 trillion were outstanding. In the U.S. the MBS market was kick started and has been sustained by the activities of the Government Sponsored Enterprises (GSE) Fannie Mae and Freddie Mac as well as the government-owned Ginnie Mae. American originators can sell their mortgages to the GSEs or Ginnie Mae for cash/in exchange for MBSs or to private conduits for cash. Those finance purchases of mortgage pools usually via real estate investment mortgage conduits (REMICS – the typical vehicle of choice for the securitization of residential mortgages in the US) which issue MBSs, CMOs or other securities. Mortgages acquired by the GSEs have to meet their credit quality guidelines. Private label MBS are almost exclusively collateralised by loans that are ineligible for purchase by the GSEs.
The dominant position of the GSEs is the characteristic feature of the American residential MBS market. For a long time they had a market share of more than 90 per cent which declined until 2007 to around 70 per cent. As the issuance of non-GSE residential MBS is nearly zero since the beginning of the financial crisis the market share of the GSEs comes close to 100 per cent.
It is no accident that the government and quasi-governmental entities have been important in the MBS process. As the investor of a MBS does not know the homeowner to whom the mortgage was issued, a considerable risk premium would be demanded due to the concerns about the underlying credit risk. The credible guarantees (though only implicit for the GSEs until 2008) of governmental and quasi-governmental issuers provide an instant solution to that problem. The special treatment of GSE securities in federal law signals to investors that those securities are relatively safe. Therefore, GSE obligations are classified by financial markets as "agency securities" and priced below U.S. Treasuries and above AAA corporate obligations. This favourable rating reduces borrowing costs for the GSEs, in part by promoting institutional acceptance of the securities. However, such guarantees do not come free but represent a contingent liability of the United States Government. In the case of crises, this implicit guarantee might turn out to be an explicit one, like it happened in September 2008 when the GSEs were placed in conservatorship. 

Critical Acclaim

The securitization of mortgages allows the originators of loans to free up capital so that more mortgages can be originated. It enables the insurance and the worldwide diversification of risk last but not least by adding a new product for investors to buy that may be uncorrelated with their other bonds and securities. For the single bank, securitization makes it possible to transfer all risks of an underlying asset to another entity so that profits are locked in. In addition, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis. The securitization of mortgages may also offer the funds necessary to support (fast) growing real estate/housing finance markets as it enables the conversion of a hitherto non-traded and no-tradable mortgage into a liquid security. This expanded supply is also assumed to reduce interest rates.
However, the advantages can easily turn into disadvantages. The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any residual liability by selling the risk to investors, skews the incentives of originators in favour of loan volume rather than loan quality. This is an intrinsic structural flaw in the loan-securitization market – as the vertical disintegration of the finance process accompanied by the MBS approach creates the problems of asymmetric information and moral hazard – that were directly responsible for both the credit bubble of the mid-2000s as well as the credit crisis, and the concomitant banking crisis, of 2008. Furthermore, it is indeed true that the mortgage bankers have no asset/liability mismatch since they do not permanently hold assets but sell them to investors. But if these finance long-term assets like MBSs with the revolving issuance of short-term commercial papers substantial maturity mismatches can emerge like it was the case in the financial crisis of the years 2007-2009. There have been also a number of efforts to analyse the consequences of the introduction and expansion of the MBS channel in the United States on the interest rate. These results are at best ambiguous as most of these studies did not even disentangle the effects of the explicit or implicit government support. More recent studies indicate that the GSEs pass on only 30 to 60 per cent of the subsidies that they receive to households. It must be as well not an advantage that the securitization of mortgages links the interest rates of the housing finance sector to the wider capital markets. Rather, this linkage increases the exposure (and thus the vulnerability) of the housing market to the down- and upswings of the global capital markets. Critical for the MBS system are also the strong position of rating agencies as their business models might not generate trustworthy ratings (which are, however, without alternative) and the (usual though not necessary) implicit or explicit involvement of the government in the issuance process of MBSs so that the way is open for political influence on the mortgage loan process. 
In addition, the introduction of secondary intermediation into a well established and developed system of housing finance will, inevitably, result in some political and economic friction with the incumbent finance providers. On the other hand, in less developed markets (like in transition or developing countries) the introduction of secondary intermediation will often encounter unfavourable conditions, as it requires a well developed legal, tax and institutional framework as well as a sound securities market. It is also questionable whether the securitisation of mortgages will gain a larger market share without the hold up of a government supported secondary market agency.   

MBS in times of financial and real estate crises

The MBS market was created as an answer on the Saving & Loans Crisis of the 1980s and 1990s in the United States. It offered a solution to a grave problem: as the GSEs bought from the faltering Savings & Loans (S&L) mortgages in return for cash they were holding billions of dollars worth in home loans. But the GSEs needed to be liquid as well. Selling MBSs to investors allowed the GSEs to convert the mortgages they bought from the S&Ls into cash, which they could then use to purchase even more mortgages.
In the end of 2006, house prices started to fall in the United States and mortgage defaults accelerated which in turn sharply reduced the value of the MBSs and CMOs that had these mortgages as their underlying collateral. In this situation it turned out that the ratings assigned to MBSs and CMOs by the rating agencies had been initially far too optimistic – and had to be downgraded. In the course of falling property prices, accelerating mortgage defaults and declining asset values, residential MBS markets have shut, even for prime mortgage assets over which the discernable concerns on credit quality are not so serious. The destruction of major players (bank structured investment vehicles (SIVs) and conduits) and the reluctance of banks to take on what is now perceived as the significant market risk associated with this paper, accounts for the loss of around 60 per cent of previous demand. The market for non-GSE MBS has been almost eliminated while the market for GSE MBS is kept alive with heavy government support: the Emergency Economic Stabilization Act authorized the United States Secretary of the Treasury to spend up to 700 billion US Dollar to purchase also distressed assets, especially mortgage-backed securities and the Federal Reserve decided shortly after a program for the outright purchase of up to 500 billion US Dollar in GSE MBS.  Contagion from the U.S. subprime mortgage crisis has even virtually shut down the secondary market for all types of asset-backed securities even though analysts and investors insist underlying credit quality remains strong. Thus it is clear, that a market failure has occurred in international financial.
One feature of MBSs has especially contributed to the crisis: the vertical disintegration. First, the vertically disintegrated processes of the MBS model led to massive problems of moral hazard behaviour. Second, it hampers or even circumvents the renegotiation with a faltering borrower. This is so, because there is no simple one-on-one negotiation (e.g. fractional ownership) and because of the varying seniority of the tranches of the mortgage-related securities, i.e. the interests of the various claimants might differ as to whether a renegotiation or a foreclosure is in their best interests.
It is difficult to assess the future of the MBS market. What is clear is that it will not be like before the crises as the real risks of MBSs have become apparent.  

[1] For the following cp.: International Financial Services, Securitisation, London 2007, p. 1.

[2] Cp.: International Financial Services, Securitisation,London 2009,p. 1

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Mortgage Backed Securities - do they have a future?



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