Enhance Your Portfolio by Investing in Mortgage-Backed Securities
Deep-sea diving is an intense and potentially dangerous activity if you don’t know what you are getting yourself into. That is why you must take the time to learn and train with a diving professional to prepare yourself for the exhilarating activity. The same can be said of investing. It’s a tricky business and trying to understand the innerworkings of each investment and how they will fit into your portfolio can be time-consuming. While some investment options like callables and certificates of deposits (CDs) can be easier to understand and may have a lower risk, others like mortgage-backed securities can be more difficult to understand and may carry a higher risk. However, that is not to say that mortgage-backed securities couldn’t be a potentially good fit for a credit union’s portfolio; they could be. But it’s important to understand and learn the innerworkings of these investments before you dive in. And while both deep-sea diving and investing can be rewarding, it’s important to understand the risks first. So, before we wade too far into the water, let’s start with what a mortgage-backed security is.
Mortgage-Backed Securities
Mortgage-backed securities (MBS) are securities backed by a pool of residential mortgages like single family homes. They are sometimes referred to as residential mortgage-backed securities or pass-throughs because a portion of the principal and interest payments are passed through to the investor. An MBS represents a claim on a cash flow stream from underlying mortgage loans that have been securitized. Securitization is a process where a financial institution originates mortgage loans, sells a bulk of them to a trust, which then assembles all these loans and others into collections or “pools.” The pools receive a guarantee or credit enhancement during this process. The securities, which are backed by mortgages, are then issued to investors. Investors will then receive monthly cashflows in the form of principal and interest from the underlying mortgages. A great example to use here would be an individual with a mortgage. Every month, the individual will pay principal and interest to the financial institution that issued the mortgage. The financial institution is taking that mortgage, selling it to Wall Street and securitizing it, which creates the MBS.
How does an MBS work, you might ask?
Principal and interest payments are collected from the homeowners by the mortgage originators or trustee who services the loans. The payments are then aggregated and “passed through” to investors. The process is typically broken down into “before securitization” and “after securitization:”
Before securitization, the financial institution makes the loans and holds the loans. The financial institution will originate a loan to the buyer, and the homeowner will pay the monthly principal and interest amount. The financial institution will take those funds and originate another loan to another buyer. This process just continues until the financial institution runs out of liquidity. To fix the issue of liquidity, the financial institution could sell that mortgage to Wall Street instead of holding it.
After securitization, the financial institution will make the loan, but instead of holding the loan, they will sell the loans to Wall Street to agencies like Fannie Mae, Freddie Mac, etc. The financial institution will sell the mortgages to these agencies for a couple of reasons. One reason may be, they want the mortgage off their balance sheet because they don’t want the risk. The other reason could be because they want more liquidity to issue more mortgage loans. Whatever the reason may be though, these agencies will buy thousands of mortgages and put them in a pool, which creates the mortgage-backed securities. Investors will buy that security which is backed by thousands of mortgages. When the time comes for homeowners to make their monthly payment, the principal and interest payment will go to the bank who services it, to the agency, and then back to the investor on the other side where they will get paid, and the cycle continues. Now that you know what a mortgage-backed security is, let’s go farther into the waters to the agencies that issue mortgage-backed securities.
Mortgage-Backed Securities Issuers
The main issuers of mortgage-backed securities are the Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC). GNMA, also known as Ginnie Mae, is a government owned and operated agency that promotes homeownership to low-to-middle income families. GNMA pools usually include smaller loan sizes between $80,000 to $200,000. They are backed by the full faith and credit of the U.S. Government. FNMA, also known as Fannie Mae, is a privately owned and operated government-sponsored enterprise (GSE) and is not backed by the U.S. Government. Like FNMA, FHLMC, also known as Freddie Mac, is a privately owned and operated GSE that is not backed by the U.S. Government. Both FNMA and FHLMC pools promote liquidity in the secondary market for mortgages, and they include medium size loans. Both are known as MBS agencies and guarantee timely payments of principal and interest. While GNMA has a 0% risk weighted, FNMA and FHLMC have a 20% risk weighted. However, before we get into the risks, let’s dive into the advantages of mortgage-backed securities.
Advantages of Mortgage-Backed Securities
An MBS has an attractive yielding asset; it could fit well within most investment portfolios. It has excellent credit quality and a built-in cashflow ladder. Every month, the investor will get principal and interest back, where with a callable or CD, the investor will only get interest semi-annually or not until it reaches maturity and then they’ll get their principal back. An MBS is also good liquidity and can be used as collateral for borrowing. However, it is important to choose the right MBS for your investment portfolio. MBS pools come in maturities similar to mortgage loan offers of 30 years, 20 years, 15 years and 10 years. Like mortgages, they also come in a variety of coupons. There are numerous individual options inside each category of an MBS pool that allows the investor to select a pool that fits with their parameters. While there are advantages to an MBS, there are also risks.
Risks of Mortgage-Backed Securities
An MBS can pay and pre-pay differently than expected or modeled. Prepayment refers to the ability of the homeowner to prepay, or pay extra, principal at any time without penalty. A normal paydown of an MBS is when a homeowner makes their contractual monthly mortgage payment which includes their principal and interest. If a homeowner makes more than their normal monthly mortgage payment, this is called a prepayment. Prepayments can come from a homeowner receiving more income and, as a result, paying off their mortgage. It can also come from a homeowner refinancing their mortgage and their rate changes or a homeowner selling their house due to a lifestyle change and paying off their mortgage. There are a few factors that can be used to determine if homeowners are going to prepay their mortgage.
One factor that plays into whether a homeowner may choose to prepay is the seasoning of the loan. If homeowners have an older mortgage, they have more incentive or ability to payoff the mortgage. They may not have a lot left on their mortgage or they may have more income and can pay more on their mortgage. The newer the loan the less likely the homeowner is to refinance because of the mortgage origination or finance costs. However, it is possible to have older loans that never refinance either. Another factor that plays into whether a homeowner may choose to prepay is the homeowner’s ability to refinance the mortgage. As current mortgage rates fall, homeowners may find it advantageous to refinance their mortgage loan into a newer and lower rate mortgage that will reduce their monthly payment. Once the current loan is paid off, the funds will get passed through to the investor. Additionally, another determinant of prepayments is if the homeowner decides to sell their house. When a homeowner sells their house, this pays off their mortgage and the lump-sum payment flows down to the investor. While the reasoning behind prepayments may differ from one homeowner to the next, there is a way to measure these prepayments.
MBS investors usually measure prepayments by using one of two methods that determine at what speed prepayments will happen. These two methods are known as conditional payment rate (CPR) and public securities associate (PSA) benchmark. The CPR is an estimate of the percentage of outstanding principal that will repay over the next 12 months at a constant rate. CPR measures prepayments; it does not include regular principal payments. For example, a 10 percent CPR means an additional 10 percent of cashflow payments over and above the normal paydown. A zero percent CPR means there was no prepayments of principal that month. The higher the CPR, the faster the MBS is being paid down; therefore, a bond paying at a 25 percent CPR is paying faster than bond paying at a 12 percent CPR. While most MBS investors prefer CPR as a measurement tool when looking at the base case, the standard is the PSA benchmark.
The PSA benchmark considers the tendency for loans to prepay faster as they age. Remember, newer loans tend to not refinance as much and there is less incentive for turnover. PSA acknowledges that prepayments will change during the life of the mortgage and assumes a ramp of the prepayment rate starting at .2 percent in the first month and as the mortgage ages, the higher the change of prepayment. It assumes a gradual rise in prepayments, which peaks after about 30 months of seasoning. Again, a higher PSA speed, the faster the bond is prepaying principal. It is important to note that you can’t really predict prepayments because it depends on the pool of mortgages. However, an investor can make some estimate of future cashflows by analyzing the MBS pool statistics.
Analyzing an MBS
When analyzing an MBS, there are key items that should be analyzed. The first item is the weighted average coupon (WAC) which is the average loan interest rate weighted by the principal balance of each individual loan. A lower WAC in a potentially rising interest rate environment may mean the MBS will not prepay as fast. Conversely, a high WAC may mean the MBS pool may prepay faster if rates fall. Another item that should be analyzed is the weighted average maturity (WAM) which is the average loan maturity weighted by the principal balance of each individual loan. The WAM tells the investor the average term of the mortgages. For example, a WAM of 120 months tells the investor this MBS pool is made up of 10-year mortgage loans which generally have a slower prepayment compared to a 30-year mortgage loan pool that is a longer security. The weighted average loan age (WALA) should also be analyzed. The WALA is the average loan age weighted by the principal balance of each individual loan or the average amount of time each individual loan has been outstanding. Again, newer loans typically tend to prepay slower since the homeowner just completed the mortgage loan. The number of loans in the pool should also be analyzed. The higher the number of loans, the more protected the investor is from a small amount of loans prepaying. An investor has a high risk of prepayment with an MBS with five loans in the pool versus an MBS pool with 4,500 loans. The best and easiest place to analyze this information is on the Bloomberg platform.
Bloomberg is a software package that lets an investor analyze bonds. The main screens from Bloomberg that are needed for a preliminary analysis are the description (DES) screen and the yield table (YT) screen. Both screens provide a wealth of information. The DES screen provides information regarding geographic location, seasoning, pool information and more, while the YT screen allows the investor to analyze the performance of the MBS pool under multiple prepayment scenarios. It also provides the investor with an overview of the collateral data and previous prepayment behavior. Investors can also use the YT screen to evaluate an MBS pool on an average life basis since the MBS pool pays down each month. Because of the nature of MBS, the stated, or final, maturity of the MBS will most likely not be its true life. Average life is calculated as the weighted average time to principal payment, with the individual loan balances creating the weights. It is important to note that different prepayments speeds create a different weighted average life (WAL). The slower the loans in the pool prepay (lower CPR and PSA speeds), the longer it will take for the bond to paydown; therefore, the longer the WAL. Conversely, the faster the loans prepay (higher CPR and PSA speeds), the faster the bond will pay off; therefore, the shorter the WAL. Investors can enter in extreme prepayment speeds in the YT to see the outer limits of the WAL. Here, the speed will also impact the yield. The Bloomberg screens allow the investor to also look at premium prices, which depend on the coupon and the current rate environment, and cashflows.
MBS are also known as pass-throughs, meaning they have a built-in ladder of cashflows. The investor needs to analyze the collateral specs of the pool to make an estimate of the cashflows. Investors can get an estimate of expected cashflows under different prepayment speeds on Bloomberg. Typically, investors will want to focus on a variety of prepay speeds to determine the degree of “shortening” or “extension” of cashflows because both of these scenarios could be a risk. The risk with contraction or “shortening” is the risk of the loans in the pool prepaying faster than expected at purchase. This means more cash flows back to the investor each month which usually happens in a falling rate environment as homeowners have a higher propensity to refinance or prepay their mortgage. This is a problem for the investor because cashflows are back to the investor earlier than modeled at the time of purchase. If the investor paid a premium to purchase the bond, the premium will need to be recognized quicker, potentially creating a possible negative yield on the investment. When higher cash flows back to the investor, it may need to be reinvested in a lower rate environment. Conversely, an extension risk is the risk of the loans in the pool prepaying slower than expected at purchase which means less cash flows back to the investor each month. This typically happens in a rising rate environment as homeowners have a lower propensity to refinance or prepay their mortgage. This is a problem for the investor because lower cashflows back to the investor means less cash flow to reinvest at higher rates or to fund loan demand or withdrawal activity. If an investor bought the bond at a premium, the premium can be written down at a slower pace, therefore, enhancing the yield.
When an investor is purchasing an MBS, the investor should request the following: description of the bond, the yield table/analysis, the cashflow analysis, the collateral analysis, option adjusted spread analysis and the total return analysis. The investor should also develop a commentary section discussing the thought process/strategy behind buying the bond and why it fits into the portfolio. If it is possible, the investor should run the bond through an ALM model to see changes under a variety of scenarios. If buying a group of bonds, these should be modeled in an ALM model prior to purchase. After analyzing the MBS pool, there are some considerations to keep in mind when choosing the right one.
Choosing the right MBS
As mentioned earlier, MBS pools come in maturities similar to mortgage loan offerings of 30 years, 20 years, 15 years and 10 years. It is important to determine the structure that would fit best on the balance sheet and not just the highest yielding MBS. When choosing the right MBS, the investor should compare bonds and parameters, look at WAL, yield, cashflow projections and price sensitivity that are the best fit for their investment portfolio. Investors need to look at areas like coupons, final maturity and expected prepayment behavior. A thorough analysis of the collateral will help the investor develop the estimate for prepayments and determine the cashflow profile of the MBS. There are a few strategies an investor can consider when choosing the right MBS.
One strategy is the investor buys high coupon MBS if the rates are moving higher. This means a higher dollar price, or a premium bond. Higher rates could mean slower prepayments, and therefore a better yield and better protection for writing down slower prepays. Another strategy is the investor buys low coupon MBS with a shorter final, 10-year MBS, if rates are low and may remain flat or moving higher. This means a lower dollar price which is less premium risk. Prepayment will be slower here, so higher rates or slightly lower rates won’t impact prepayments as much. This strategy limits extension and contraction risk. A third strategy could be the investor buys seasons MBS pools with longer loan ages, low coupon MBS with a shorter final, a 10-year MBS, if rates are low and may remain flat or moving higher. This means a higher dollar price which is premium risk. These are just a few strategies, and it’s crucial to note here that there isn’t a “perfect strategy” to use when determining investments for your credit union’s investment portfolio. However, no matter if your credit union chooses one of these strategies or none of them, it is always important to work with a broker you know and trust.
It’s also important to remember that bond prices fluctuate, and the market is always changing, so if your credit union is considering investing in an MBS pool, it’s imperative to get a second opinion on the price of the bond you are considering in a timely manner.
Investing, like deep-sea diving, can lead to many rewards. And just like training to deep-sea dive, a lot of information and learning goes into it. It can be tricky to choose which investment will fit with your credit union’s investment portfolio, but Vizo Financial’s investment representatives are here to help! Let us be your “diving professionals” that will guide you through the sea of investments.
Fred Eisel is Vizo Financial’s chief investment officer. In this role, he is responsible for actively managing Vizo Financial’s investment portfolios as well as overseeing the Corporate’s asset/liability management and investment services.