Mortgage-Backed Securities & Adjustable-Rate Pricing

Learn The Various Components Of Securities In The Mortgage Sector

A notecard reading Mortgage Backed Securities

Insider

Contributing Writer

The secondary marketing side of the residential lending business is focused on residential mortgage-backed security (RMBS) prices, usually shortened to MBS. The supply and demand of mortgages, which are sold and then treated as assets by the owner, determine prices, and therefore the price and rates that borrowers see in the primary markets.
As can be seen, this is one of the key reasons that adjustable-rate mortgage pricing is so off kilter: the market for ARM securities is not liquid. It is important to take a look at MBS and “asset-backed” securities: Are they the same thing?

The answer is no. Yes, asset-backed securities (ABS) and mortgage-backed securities are two important types of asset classes. MBS are securities created from the pooling of mortgages, and then sold to interested investors, whereas ABS have evolved out of MBS and are created from the pooling of non-mortgage assets. ABS are usually backed by credit card receivables, home equity loans, student loans, and auto loans. Even music concert receivables!

Involved Parties

There are similarities. There are three parties involved in the structure of ABS and MBS: the seller, the issuer, and the investor. Sellers are the companies that generate loans and sell them to issuers. They also take the responsibility of acting as the servicer, collecting principal and interest payments from borrowers. Issuers buy loans from sellers and pool them together to issue ABS or MBS to investors.

ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to acquire additional funding. Or put another way, think of a non-depository mortgage banker selling the loan and then simultaneously paying off its warehouse line.

Investors of ABS and MBS (which include securities backed by ARM loans) are usually institutional investors and they use ABS and MBS to obtain higher yields than government bonds while diversifying their portfolios. Both have prepayment risks, the risk of borrowers paying more than their required monthly payments, thereby reducing the interest of the loan, though these are especially pertinent for MBS.

Investors in current ARM securities are especially concerned about prepayment risk: Few want to pay a premium and then have the ARM pay off early when the borrower refinance into a fixed-rate loan. And when there is uncertainly, prices tend to drop or be lower than what one would normally expect. This is what we’re currently seeing in the ARM market.

Prepayment Risk

Prepayment risk can be determined by many factors, such as the current and issued mortgage rate difference, housing turnover and path of mortgage rate. If the current mortgage rate is lower than the rate when the mortgage was issued or housing turnover is high, it will lead to higher prepayment risk, as any loan officer knows.

Historically, most homeowners refinance their mortgages the first time rates drop. Therefore, when the mortgage rate falls again, refinancing and prepayment would be much lower compared to the first time.

To deal with prepayment risk, ABS and MBS have tranching structures, which help by distributing prepayment risk among tranches. Investors can choose which tranche to invest based on their own preferences and risk tolerance. One additional type of risk involved in ABS is credit risk. ABS have a senior-subordinate structure to deal with credit risk called credit tranching. The subordinate or junior tranches will absorb all of the losses, up to their value before senior tranches begin to experience losses.

In the Tranches

Subordinate tranches typically have higher yields than senior tranches, due to the higher risk incurred. Investors can choose which one they want to invest in according to their risk tolerance and their outlook on the market. There are many types of ABS, each with different characteristics and cash flows, examples of which include Home Equity ABS, Auto Loan ABS, and Credit Card Receivable ABS. And it is important to measure the spread and pricing of bond securities and know which type of spread should be used for different types of ABS and MBS for investors.

“It is important for those involved in lending to see what happens to the loans they originate.”

Although no one can predict where mortgage rates will go, there are plenty of forecasts. And with those forecasts come a solid historical working knowledge of how fixed-rate mortgage borrowers will behave. Borrowers with adjustable mortgages, however, have more variability. ARMs have always represented the minority of mortgage originations, and there is less historical data concerning the “what ifs.” Many ARMs are held in portfolios where information is tracked by the holder, usually a bank or credit union, and there is little reason to divulge this information to the marketplace.

It is important for those involved in lending to see what happens to the loans they originate. Pools are sliced and diced based on risk, pool characteristics, and so on, and can be very complicated in terms of their structures, characteristics, and valuations. Anyone investing in MBS, whether fixed or adjustable, should be sure they match their risk tolerance, just as underwriting does in the primary markets.