MORTGAGES/MORTGAGE-BACKED
SECURITIES

A mortgage-backed security (MBS) is a derivative debt issue secured by groups, or pools, of home or commercial mortgages. The mortgages are grouped together by lenders or other institutions and then either sold to investors who purchase ownership shares in the pool or used to back a debt issue. MBSs shift risks related to changes in interest rates, prepayment and refinancing of mortgages, and default or nonpayment, and thus trends in these same areas affect the market for mortgage securities. The investors receive the interest and principal payments in the form of distributions as the loans are paid off by the mortgage holders (or by the federal government in some cases of default), or simple cash disbursements from the institution that owns the mortgages.

Besides providing an investment alternative, MBSs serve the important function of bringing additional funding into the mortgage industry that can be used to finance residential or commercial real estate. In addition to debt financing obtained by securitizing pools of mortgages, capital flows into the secondary mortgage market via equity shares in mutual funds and mortgage-buying companies such as Freddie Mac and Fannie Mae, which are government-sponsored quasi-private-sector companies. These publicly traded stocks (Freddie Mac and Fannie Mae are both traded on the New York Stock Exchange) aren't MBSs in the formal sense, but are closely related and serve very similar functions.

MBSs are a major component in a broader market known as the asset backed securities market, which also includes securities based on other forms of loans. In the late 1990s the mortgage-backed securities market was worth some $2 trillion, representing a major segment of the U.S. economy and serving as a primary money supply for the home mortgage industry. Freddie Mac, Fannie Mae, and Ginnie Mae, the trio of government-chartered mortgage securitizers, account for roughly two-thirds of that capitalization. At more than $3 trillion, the entire asset-backed securities market rivals the size of the bellwether U.S. Treasury debt market. Internationally, markets for MBSs are also forming rapidly, notably in places like Australia and the United Kingdom, but none are as developed as that in the United States. Common buyers of MBSs include pension funds, mutual funds, and individual investors.

DEVELOPMENT AND MECHANICS

FANNIE MAE.

The MBS market emerged during the 1970s as the result of U.S. government initiatives related to the secondary mortgage market. The secondary mortgage market was created in 1938, when the federal government created Federal National Mortgage Association (Fannie Mae) to purchase government-backed mortgages, which include Federal Housing Administration (FHA) and Veterans Administration loans. The effort was designed to supply banks and other financial institutions with cash to make new mortgage loans; the banks continued to profit from servicing the mortgages, but Fannie Mae effectively paid the banks cash and assumed ownership of the loans. Fannie Mae was privatized in 1968.

GINNIE MAE.

In the same year, a similar entity—the Government National Mortgage Association (Ginnie Mae)—was created with the power to purchase and/or provide payment guarantees (timely payment of principal and interest) on securities backed by FHA and VA mortgages. That effectively made it more feasible for loan originators (i.e., banks and other financial institutions) to begin creating securities backed by pools of mortgages. A bank, for example, could package all of its mortgages together into a debt security backed by Ginnie Mae. Unlike Fannie Mae, however, Ginnie Mae is a government agency with a narrow scope of operations.

FREDDIE MAC.

In 1970 Congress chartered the Federal Home Loan Mortgage Corporation, or Freddie Mac, to create competition in the MBS industry and better position it for growth. As part of a related reform effort, both Fannie Mae and Freddie Mac were authorized to purchase conventional, non-government mortgages on the secondary market. Freddie Mac continues to be somewhat smaller than Fannie Mae, but it has grown quickly and some observers believe its more aggressive buying strategy will one day allow it to overtake its older sibling.

SECURITIZATION PROCESS AND INSTRUMENTS.

Typically, an investment firm underwrites the security for the institution and sells it to investors. The original lender continues to make money servicing the mortgage, and uses the money from the sale of the security to fund new mortgage loans that may also eventually be securitized. Rather than pool the mortgages themselves, lenders can also sell their mortgages to Fannie Mae or Freddie Mac, which use the mortgages to create their own securities. Indeed, Fannie Mae and Freddie Mac typically function as market rivals.

By the 1980s the MBS industry had expanded to include four major investment vehicles: mortgage passthrough securities (MPTs); mortgage-backed bonds (MBBs); mortgage pay-through bonds (MPTBs); and collateralized mortgage obligations (CMOs).

MPTs were initiated by Ginnie Mae in 1968. They most closely represent the MBS structure—the securities are issued by the mortgage originator and backed by the federal government. In MPTs, as in most MBSs, investors receive participation certificates (PCs), which come with different interest and principal payment configurations.

MBBs are used by private mortgage companies such as banks and savings and loans, and may include mortgages not backed by a government entity. They are similar to MPTs, but the cash flows from interest and principal payments do not pass through directly to the security holders. Instead, the entity that creates the security retains ownership of the mortgages in the pool—the mortgages are usually placed in trust with a third party that ensures that the issuer adheres to the bond provisions—and makes predetermined, periodic cash payments to the bondholders. The net effect is that investors are exposed to different kinds of risk; for example, the risk of mortgage prepayment, which reduces income from interest, is borne by the issuer rather than the security holder, as is the case with an MPT. Underwriters are typically used to sell the securities, and the securities are often rated by a bond rating agency. As with other bonds, the value of MBBs is influenced by their riskiness and yields in relation to other securities, and by interest rate fluctuations.

MPTBs are a hybrid of MPTs and MBBs. The MPTB is a bond, but the principal and interest payments are passed through to the owners of the securities. Like the MBB, the issuer retains ownership of the mortgages in the pool and the bond is rated by an agency. The MPTB must be overcollateralized to provide protection against default of some of the underlying mortgages. Still, investors are exposed to various risks inherent to both MBBs and MPTs.

CMOs, created in the early 1980s, are complicated versions of MPTBs. The issuer retains ownership of the mortgages, and principal and interest is passed through. The chief difference is that the mortgages in the pool are separated into different groups, or tranches, based on the date the mortgage matures. By separating the mortgages, the issuer can use the pool to create a number of securities with different characteristics. For example, tranches can be designed to simulate low risk, short-term coupon bonds, or higher risk, long-term zero coupon bonds. The different risk classes theoretically maximize the value of the mortgage pool to the overall investment market.

Related to CMOs are real estate mortgage investment conduits (REMICs). A REMIC is essentially a legally recognized entity that creates a CMO. REMICs evolved following Congress' passage of the Tax Reform Act of 1986. The act allowed CMOs, through REMICs, to be issued with a minimum of tax complications. Among other functions, REMICs are used by companies like Freddie Mac to resecuritize a class of MBSs to provide alternative investment vehicles to investors.

COMMERCIAL MBSS

Commercial MBSs (CMBSs) are simply securities based on commercial real estate loans. They are relatively new—and outside the sphere of residential MBS giants like Fannie Mae and Freddie Mac—but have been an area of rapid development since the mid-1980s. Between 1985 and 1994, the value of annual new CMBS issues jumped tenfold, from just over $1 billion to more than $10 billion. By 1997, it had more than quadrupled again, topping $45 billion; however, a volatile 1998—though still record-setting at $79 billion—was expected to hold 1999 issues at around $50 billion. As of 1998, approximately half of all CMBSs took the form of REMICs.

This explosion in CMBS issues was in part set off by deregulatory policies of the federal government. The REMIC tax advantage, for one, has contributed to its popularity as an investment vehicle. Another important factor was the 1998 decision by the Federal Financial Institutions Examination Council (FFIEC) to ease restrictions on higher risk portfolios in CMOs. The regulatory body cited improvements in accounting standards and unintended consequences of its risk test as reasons for abandoning the much maligned test. In addition to the favorable regulatory climate, the parsimonious commercial real estate lending environment of the early 1990s, triggered by the real estate bust of the late 1980s and early 1990s, created a liquidity crunch that CMBSs helped relieve.

Still, particularly in light of deregulation, the CMBS market places a heavy burden on investors to scrutinize the make-up of the securities in order to determine whether the risk level is acceptable.