In the field of macroeconomics, Mortgage Backed Securities play a crucial role in economic development and fluctuation. This comprehensive guide provides a detailed analysis of Mortgage Backed Securities, beginning with a basic overview, before delving into the structure and the various types. Further discussions encompass the significance of these securities in the economy, including their influence on macroeconomic factors and their notable effects during financial crises. This resource offers thorough insights into the complexities of Mortgage Backed Securities - an invaluable knowledge tool for students, professionals or anyone wishing to enhance their understanding of this primary economic instrument.
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Jetzt kostenlos anmeldenIn the field of macroeconomics, Mortgage Backed Securities play a crucial role in economic development and fluctuation. This comprehensive guide provides a detailed analysis of Mortgage Backed Securities, beginning with a basic overview, before delving into the structure and the various types. Further discussions encompass the significance of these securities in the economy, including their influence on macroeconomic factors and their notable effects during financial crises. This resource offers thorough insights into the complexities of Mortgage Backed Securities - an invaluable knowledge tool for students, professionals or anyone wishing to enhance their understanding of this primary economic instrument.
In simplest terms, Mortgage Backed Securities are investment products that are backed by a pool of mortgages. They provide a way for lenders to free up capital and transfer the risk of default to investors.
For example, imagine a bank has issued 100 home loans. Instead of waiting for all 100 borrowers to repay their loans, the bank packages these loans together into a single security, known as a Mortgage Backed Security, and sells it to investors. These investors receive the cash flow from the mortgage payments as return on their investment.
1. The originator (usually a bank or other lending institution) lends money to borrowers in the form of mortgages. 2. These loans are then pooled together by the originator. 3. The pooled loans are sold to a financial intermediary, often an investment bank. 4. The intermediary issues a security, backed by the pool of mortgages, which is then sold to investors.Why is this done? Securitisation, and by extension, the creation of Mortgage Backed Securities provides banks and lenders with a way to move loans off their books, freeing up capital and transferring the risk associated with those loans to investors.
A tranche represents a slice or portion of the pooled loans. These tranches are set based on the quality of the loans in the pool, including each loan's interest rate, borrower creditworthiness, and the loan-to-value ratio.
One popular type of Mortgage Backed Security is a non-recourse loan which entails that even if the debt is not fully repaid, the borrower has no further personal liability. All the lender can do is take the property, sell it, and apply the proceeds to the unpaid balance of the loan.
Homeowners | → | Original Lenders (Banks) | → | Investment Banks (Issuers) | → | Investors |
Makes mortgage payments | Creates Mortgage Backed Securities by pooling loans | Sells Mortgage Backed Securities to investors | Receives payments from homeowners through the trustee |
Agency Mortgage Backed Securities are securities guaranteed by the US government or governmental entities. Unlike private entities, they bear a significantly lower credit risk for investors since the repayments are essentially guaranteed by the government. Key agencies involved are Ginnie Mae, Fannie Mae and Freddie Mac.
The existence of the Agency MBS helps to keep the housing market, and in broader terms, the overall economy stable. They play an integral role during economic recessions, as they continue to function and keep the mortgage lending process fluid, even when private lenders might pull back.
• Pass-Through Securities: In this type, all principal and interest payments from the underlying loans are 'passed through' to investors, less certain fees. Example: Freddie Mac's PC Gold. • Collateralized Mortgage Obligations (CMOs)/Real Estate Mortgage Investment Conduits (REMICs): These are complex securities that reallocate the cash-flows from the underlying pool to different classes (tranches) based on investors’ needs.Every Security has its own identification number (CUSIP), and all necessary information regarding the security can be found on the agencies' websites. As an investor, while examining these securities, they would need to consider various factors.
• This process enables more people to access credit for purchasing homes, thereby supporting the housing market. • As homeowners repay their mortgage loans, the amount is transferred to the holders of these securities, facilitating a cyclic fluidity of money.So, we see that Mortgage Backed Securities play a large role in the circulation of money in an economy. They essentially ensure that lenders have sufficient funds to disburse loans. Thereby, contributing to maintaining a healthier financial system. They also play a crucial role in portfolio diversification. Being income-generating assets, MBS provide investors with an additional investment avenue contributing to sound risk management. But there's more to their role: MBS indirectly influence the cost of borrowing in an economy.
Yield spreads which denotes the difference between the yield on MBS and risk-free Treasury securities may increase or decrease based on the perceived risk of mortgage-backed securities. Such variations influence the broader interest rate environment, affecting the cost of borrowing for consumers and businesses alike.
• MBS maintain fluidity in the mortgage lending market, ensuring that homebuyers still have access to mortgage loans. • By promoting housing affordability, they indirectly stimulate consumption and investment.Notably, Agency MBS (specifically those issued by Ginnie Mae, Fannie Mae, and Freddie Mac in the U.S) play a significant role in periods of financial instability. Since these securities are either explicitly or implicitly backed by the government, they provide reassurance to investors, consequently stabilising the financial system. In the larger scheme of things, Mortgage Backed Securities foster a more inclusive economy. They make it easier for people—particularly those from lower-income segments—to become homeowners. Not only does this have positive implications for wealth distribution, but it also encourages social stability. Overall, the influence of Mortgage Backed Securities stretches far beyond the financial realm. They are integral tools for economic development, driving growth and stability, and fostering an inclusive economic environment.
Counterparty risk is a risk to either party in a financial transaction that comes from the potential that the other involved party will fail to meet its obligations.
• Subprime lending: In the years leading up to the crisis, there was a substantial increase in mortgage lending to subprime borrowers (borrowers with lower credit ratings). These subprime mortgages were then securitised into MBS, which were sold to investors globally. • Financial Innovation: Financial institutions created complex and opaque financial products (like CDOs: Collateralized Debt Obligations), which made the true risk associated with MBS difficult to assess. • Rating Agencies: The credit rating agencies assigned overly optimistic ratings to these securities, and many investors were not fully aware of the risks they were taking on.These factors led to an overvaluation of the MBS, which eventually collapsed, triggering the crisis. However, it's important to remember that MBS can also play a stabilising role during an economic downturn. In particular, Agency MBS (those issued by government agencies like Ginnie Mae, Fannie Mae, and Freddie Mac) can provide a secure investment during times of uncertainty due to government backing.
Subprime Mortgages are home loans provided to individuals with poor credit histories, who, as a result, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate.
• Unsuitable Lending: Lenders relaxed their credit standards and extended loans to high-risk borrowers. • Misleading Ratings: Rating agencies failed to accurately assess the risk of these securities. • Unchecked Financial Innovation: The creation of complex MBS products outpaced the industry's understanding of those products. • Poor Risk Management: Many financial institutions did not adequately manage the risks associated with MBS.However, understanding this history can provide valuable lessons for the future handling of Mortgage Backed Securities, particularly in terms of lending practices, transparency, risk management, and regulatory oversight.
Pass-through securities are the most straightforward type of MBS. In these, investors receive a pro-rata share of all principal and interest payments from a pool of mortgages. When the homeowners make their mortgage payments, these go directly (or "pass through") to the holders of the securities.
• Collateralized Mortgage Obligations (CMOs): These are more complex MBS where the mortgage payments are directed to different classes or "tranches" each with varying degrees of risk and return.CMOs were developed to counter prepayment risk inherent in Pass-through securities. In a Pass-through, all investors receive principal repayments simultaneously. But in a CMO, principal repayments are channeled to different tranches in a sequential manner. Some tranches get repaid earlier, thus are less exposed to prepayment risk. Beyond these basic forms, you have MBS types distinguished by the nature of the underlying mortgages. In particular, you might encounter residential MBS (RMBS) and commercial MBS (CMBS).
Residential MBS (RMBS) are based on residential mortgages. These can be owner-occupied residences or rental properties. RMBS is the most common type of MBS.
• Commercial MBS (CMBS): These MBS are backed by commercial mortgages, for example, mortgages on commercial properties like office buildings, retail space or hotels.It's worth noting that most commercial mortgages are set up so that the business owner occupies at least 51% of the property. This makes the risk profile of CMBS somewhat different from that of RMBS. Lastly, Mortgage Backed Securities can be classified based on the issuer. There are Agency MBS and Non-Agency MBS:
Agency MBS are those issued by government agencies or government-sponsored enterprises, like Ginnie Mae, Fannie Mae, and Freddie Mac in the U.S.
• Non-Agency MBS: These are issued by private institutions, like banks or other financial entities. These securities are subject to greater credit risk due to the absence of explicit government backing. However, they may offer higher potential returns to compensate for this additional risk.These categories represent the main types of Mortgage Backed Securities you would come across in the market. But for a more nuanced understanding, we need to delve deeper into the classification of these securities.
• Ginnie Mae securities are explicitly backed by the full faith and credit of the U.S government. This means that the U.S government guarantees the timely payment of principal and interest on these securities. • Fannie Mae and Freddie Mac, on the other hand, are government-sponsored entities. The securities they issue are not explicitly guaranteed by the U.S government but have an implicit guarantee.The perceived guarantee on Fannie and Freddie securities has led to their wide acceptance in the market. The yield on these securities is slightly higher than on Ginnie Mae because of the small differential in credit risk. In contrast, the Non-Agency MBS includes securities issued by various private entities. These securities do not have an explicit or implicit government guarantee and therefore, come with higher potential rewards, albeit at a greater risk. We also have another category of MBS known as Jumbo MBS. These securities are backed by mortgages that exceed the conforming loan limits set by the Federal Housing Finance Agency. Since these mortgages are larger, the securities are often deemed more risky. Lastly, there are Stripped MBS. These are MBS where the cash flows from the underlying pool of mortgages are separated into two classes: principal-only (PO) and interest-only (IO) securities. This bifurcation allows investors to choose between cash flows of principal repayments and interest payments, catering to diverse risk and return requirements of investors.
For example, a pension fund looking for regular, predictable income may invest in an interest-only security (IO). A bank with excess reserves may opt for a principal-only security (PO) that provides bulk payments over time.
What are Mortgage Backed Securities (MBS)?
Mortgage Backed Securities are investment products that are backed by a pool of mortgages. They are a way for lenders to free up capital and transfer the risk of default to investors.
What is the structure and flow of payments in Mortgage Backed Securities?
Homeowners make mortgage payments to original lenders who pool these loans and sell them as Mortgage Backed Securities to investment banks. These banks sell the securities to investors who receive payments through a trustee.
What does a tranche represent in the context of Mortgage Backed Securities?
A tranche represents a slice or portion of the pooled loans in a Mortgage Backed Security. These tranches are set based on the quality of the loans in the pool.
What are Agency Mortgage Backed Securities (MBS)?
Agency Mortgage Backed Securities are securities guaranteed by the US government or its agencies. They bear a significantly lower credit risk for investors as the repayments are essentially guaranteed by the government. The key agencies involved are Ginnie Mae, Fannie Mae and Freddie Mac.
What are the types of Agency Mortgage Backed Securities?
The types of Agency MBS are Pass-Through Securities, where all principal and interest payments from the underlying loans are passed on to investors, and Collateralized Mortgage Obligations (CMOs)/Real Estate Mortgage Investment Conduits (REMICs), which reallocate cash-flows to different classes based on investors’ needs.
What are the risks to consider when investing in Agency MBS?
Investors need to consider prepayment risk, interest rate risk, and minimal credit risk when investing in Agency MBS. Prepayment risk affects the yield, changing interest rates can affect prepayment or MBS market price, and despite government backing, there's a small credit risk involved.
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