What are Mortgage-Backed Securities?

Although it is not yet widely known in the Philippines as an investment tool, Mortgage-Backed Securities (MBS) have been in vogue in the United States and other western nations. In fact, these financial instruments played a huge role in the financial crisis of 2008 caused by a huge number of borrowers who defaulted on their residential mortgages. To get an idea of what that was all about, read my previous blog where I posted an article from Wikipedia about the documentary movie “The Inside Job.” So what is an MBS and how is it sold and used as an investment vehicle?

Generally, real estate investments are classified into three categories: (1) Agricultural; (2) Residential; and (3) Commercial. MBS falls under the second category. In an MBS transaction, an issuer sells bonds to investors that are backed by a pool of mortgages. Specifically, the issuer acquires mortgage loans from various third-party lenders and other mortgage loan sellers (“originators”), pools those loans, and transfers them to a trust. The trust then issues certificates that are secured by some or all of the pooled mortgage loans and pays a yield to the investor linked to the cash flow—i.e., the principal and/or interest payments—from the loans. This process is called securitization.

If the borrowers whose mortgage loans back the certificates fail to pay their mortgages, the holders of the certificates backed by the loans might not receive the yield that they expected. The securitization process takes this risk into account in calculating the price and expected yield of the bonds backed by pools of mortgages.

MBS can be backed by different kinds of loans. Mortgage loans are designated prime if the borrowers to whom the loans are made have good credit scores, the loans are fully documented, and the mortgage loans conform to specified guidelines. These loans are considered less risky to investors when securitized, and as a result, pay lower yields. Subprime mortgages are mortgage loans made to borrowers with weaker credit scores and less documentation of income or assets. These loans are riskier because the borrowers are considered more likely to default on their loans. Alt-A mortgages fall between the prime and subprime categories, often involving prime borrowers but lower documentation than would be required for a prime mortgage.

To ensure that the loans they are making are appropriate and that the borrowers can repay them, the originators of the loans have underwriting guidelines that guide their decisions concerning whether to issue a mortgage loan to a borrower. These guidelines, however, are subject to a variety of “exceptions,” which allow an originator to make loans that did not fully comply with guidelines.

When determining whether to purchase a mortgage loan certificate, an investor might consider various statistics regarding the loans underlying the securitization, which were generally provided to them by the sponsor and underwriter of the transaction (described below). These figures would generally be represented to the investor in a document called the prospectus supplement. For example, the prospectus supplement would state the percentage of properties that were occupied by their owners (“owner-occupancy rates”) and the loan-to-value (“LTV”) ratios of the loans (the relationship between the amount of the loan and the value of the property securing the loan). This would give the investor information about how likely the borrowers on the loans underlying the securitizations would be to default on their mortgages. In addition, the prospectus supplement also generally summarized the underwriting guidelines for certain of the mortgage lenders, also known as originators, and represented that the originators made loans in accordance with their underwriting guidelines.

Each securitization would be divided into tranches, representing different ‘slices’ of risk exposure.  Each tranche had its own risk profile and was assigned its own credit rating, with the most senior tranches generally being the least risky and junior tranches having a higher degree of risk exposure.  Investors would select a tranche for purchase based on their appetite for risk.

The date on which a securitization was issued is known as the securitization’s closing date.  Each securitization was assigned a CUSIP number: an alphanumerical identifier unique to that securitization.

MBS were sold to the public by large investment banks such as Morgan Stanley, Bear Stearns, Goldman Sachs, Merrill Lynch, and the Lehman Brothers as profitable and safe investment vehicles. Only time will tell if and when such instruments or those similar thereto will become popular investment instruments in the Philippines and other developing countries in Asia. When that time comes, you would better be prepared. Remember, knowledge is power!

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