Definition of Structured Mortgage Products
A structured product is a financial instrument that combines the payments from a pool of assets such as mortgages. For example, a lender can either hold a portfolio of mortgages or sell it to be used as a security. Mortgages are sold to a bank, private institution or government entities such as Fannie Mae, Ginnie Mae or Freddie Mac.
Each product or package is known as the tranches in the mortgage market are also called Mortgage Backed Securities. Investors buy tranches that have the characteristics that align with their risk tolerance.
Types of Mortgage Backed Securities
There are two types of mortgage-backed securities:
Agency Mortgage Backed Securities: Created by the agencies Fannie Mae, Ginnie Mae or Freddie Mac.
Non-agency Mortgage Backed Securities (also called private labels): sold by private entities such as investment banks.
These securities are also varied by the types of mortgages underlying the security:
- Subprime Mortgages: when the underlying loans are to people with poor credit.
- Prime Mortgages: these mortgages are found as two types of loans:
- Conforming: meet the standards of the agencies mentioned above
- Non-conforming: meets credit requirements but does not meet the underwriting levels of the agencies
Once mortgages are sold, the originator usually, but not always, services them. The fee charged equals a percentage of the amount due to which is commonly 25 to 100 basis points. These rates are the PT or pass-through rate. The price of a security is based on the underlying issue’s balance. Value is a function of future cash flow, default risk, and maturity. They also have a prepayment risk, which is a function of interest rates.
History of Structured Products
Structured products saw exponentially increasing rates of growth in the period before 2007 in the form of Mortgage Backed Securities. At its peak, the market reached $900 billion dollars in 2007. An example of this type of security is a CDO (collateralized debt obligation). A CDO provides the investor with an income stream based on the payments collected by the company that services the mortgage.
The value of the security itself is based on the quality of the underlying mortgages that make up each Tranche. If a purchaser of the security believes that Tranche has relatively little risk, the value is higher. Less risk Tranches are called Super-senior Tranches.
A risk is influenced by the order in which one Tranche is paid over another. By prioritizing payments to one Tranche over another within the same CDO, risk and prices for the security can be adjusted.
To help investors understand collateralized debt obligation risk, mortgage-backed security ratings range from a senior AAA to an unrated rating. CDO’s are made up of 6 Tranches, with each Tranche receiving a rating.
Tranches are important since owners of lower risk Tranches are paid first while owners of higher risk securities are paid last. Payments are based on interest paid by holders of each mortgage.
As these securities become more complex than other financial instruments, they become increasingly difficult to rate. By managing the risk associated with each Tranche, investment banks were able to boost sales by appealing to risk-averse customers.
The Financial Crisis and Structured Products
Structured products can be complex. Along with complexity comes declining levels of transparency. During the financial crisis, it became difficult to assess the underlying risk of each product, resulting in a decrease in demand. Many mortgage markets relied on the secondary market to structure and sell securitized versions of the debt, causing a market disruption.
Part of the problem during the crisis was the inflated ratings provided by rating agencies. Investors who thought they were buying low-risk securities were actually purchasing products that in reality were high risk. Structured products were also used to avoid taxed or to shield risk from regulators. These products further complicated the housing market by making it difficult to modify mortgages faced with foreclosure. Since ownership of the mortgage is spread among many holders of a group of securities, it’s hard to determine how to address the best course for an individual property.
Issuers of Structured Mortgages
There are two types of agency, and non-agency. Agency issuers such as Fannie Mae sell securities backed by the U.S. Government. Non-agency issuers also provide guarantees, but these are from the banks or institutions issuing the security. With the later there is a risk of default.
The purpose of government agencies is to act as a secondary market for mortgage loans. Securities developed by these institutions range in value from $100,000 to several hundred million dollars.
- Ginnie Mae:
- True government agency
- Loans backed by the U.S. Government
- Guarantees mortgage-backed securities that meet the agency’s underwriting standards
- Ginnie Mae creates an ID or pool number to the mortgage-backed securities
- Securities are passed on to a trustee
- Two types of security pools:
- Ginnie Mae I: securities comprised of multifamily and single family loans. All loans are from one issuer.
- Ginnie Mae II: Loans have adjustable or fixed rates and multiple issuers. Also comprised of family homeowner loans.
- Freddie Mac and Fannie Mae
- Government-sponsored enterprises (GSE) that are now in conservatorship, which means that as of 2008 any issued mortgage-backed securities are guaranteed by the U.S. government
- Formed to create a market for mortgages (secondary market)
- Agencies are authorized to sell and buy mortgages
- Can guarantee and create mortgage-backed-pass-through-securities
- Can buy mortgage-backed securities
- Freddie Mac securities are called PCs or participation certificates
Non-Agency Pass Through
Mortgage-backed securities are also sold by banks and financial institutions such as Freedom Mortgage Structured Products Group, Bank of America, G.E. Capital Mortgage and Citigroup. These non-agency private label pass through products are comprised of pools of prime (good credit) or subprime (poor credit) non conforming mortgages. They also are set up as Real Estate Mortgage Investment Conduits (REMIC) so that they do not pay tax on the pass through mortgages.
These products are guaranteed by the institutions issuing the security. They come with either a bank letter of credit or a written guaranteed. Both are called external credit enhancements. They are also secured through the issuance of subordinate and senior bonds.
All of these bonds and securities are rated by S&P and Moody’s. They are also registered with the SEC.
Market for Securities
Investors can purchase these securities from the government agencies, mortgage originators or specialty dealers. A secondary over-the-counter market also exists that is operated by the Mortgage-backed Security Dealers Association. In general MBSs are available in denominations of $25,000 to $250,000 (up to $1M).
There are derivative securities based on mortgage-backed securities known as:
- Stripped Mortgage-Backed Securities
- Collateralized Mortgage Obligations (CMOs): Based on the dividing the cash flow of the security into different classes in order to appeal to a variety of investors. As mentioned above, each type is called a Tranche.
- Sequential-Pay Tranches
- Accrual Bond Tranche
- Floating-Rate Tranche
- Notional Interest-Only Tranche
- Planned Amortization Class Tranches (PAC)
- Sequential-Pay Tranches
Securities can also be sold in the form of “principal-only” (PO) or “interest-only” (IO).
Evaluation (Yield Analysis)
Structured mortgage products are evaluated based on their features. As you can see, these securities are complex, making it difficult to assess future cash flows.
To conduct a yield analysis, the analyst will look at the prepayment assumptions and Tranches associated with each mortgage backed security or Collateralized Mortgage Obligation. Securities are evaluated across a range of prepayment speeds, leading to the determination of a standard deviation. This provides a fixed in time point of view that does not necessarily incorporate factors such as interest rate fluctuation and the influence these changes have on prepayment.
In light of this problem, analysts perform what is called vector analysis. This assumes that speeds will change over time.