A New Post By The Mortgage Cicerone
A Guide for Mortgage Professionals.
Read other posts by The Mortgage Cicerone.
Before looking at the factors driving mortgage rates, it's helpful to understand a little about the process through which a mortgage passes from the originator to the ultimate investor who will own it. In the early days of the mortgage industry, a typical transaction involved a bank originating a mortgage loan which would be held by the bank as part of its portfolio for the entire life of the loan. In this system, the bankers had to be very careful in evaluating the risk of each loan since they were the ones who suffered from making bad loans. The major downside to this approach was a lack of diversification in most portfolios. All of the loans were made in the same region to the bank's customers, so an economic downturn such as the oil bust in Texas might cause many of the loans to go into default at the same time.
As financial markets grew more sophisticated and financial institutions increased in size, new techniques were developed which helped alleviate the risks of concentrated loan portfolios. Through a process called securitization, pools of mortgages were combined together and sold as Mortgage Backed Securities. Mortgages from across the country were packaged together so that a downturn in the prospects of one industry or region would affect only a small portion of the mortgages in the portfolio. This made investors, such as mutual funds and pension funds, much more willing to own mortgages as an investment. The greater demand resulted in higher prices paid and conversely lower mortgage rates.
The last remaining major objection by investors to owning MBS was that suddenly the bankers no longer had much incentive to scrutinize the quality of the loans they originated because they were selling them off immediately to someone else. Freddie Mac, Fannie Mae and Ginnie Mae were created largely to address this issue. The credit standards created by them meant that investors no longer had to worry about the quality of the loans. Loans were also guaranteed by the agencies, removing nearly all the risk to investors of default. So when loans are underwritten to, say FNMA Guidelines, investors know there is a certain underlying credit quality for the MBS that they purchase.
To summarize, MBS are simply pools of mortgages backed by Fannie Mae, Freddie Mac, or Ginnie Mae which are traded in a manner very similar to Treasury bonds. The size of the MBS market is comparable to the Treasury market. Investors receive payments based on the level of interest and principal made by the consumers who obtained the mortgages. The calculation of the actual value of a MBS requires some extremely sophisticated mathematics, but most of the major factors can be easily understood. The main difference between MBS and other types of fixed income investments is that consumers have the option to prepay a mortgage. When a mortgage is paid off early, the expected stream of payments comes much sooner than expected. Predicting the effects of prepayments on the value of MBS is what requires the advanced mathematical models.
As a simple example, say current mortgage rates are 5.5% and there is a MBS made up of mortgages at 8%. The security would sell at a premium due to the high return, but not as high as that of a comparably yielding Treasury bond, due to concerns about prepayment. An investor would be reluctant to pay too large a premium for the security, because the mortgages are likely to be refinanced and paid off. In that scenario, the investor would receive the principal balance of the loans, but would never realize the higher return it paid a premium for. If the MBS offers a lower yield than the prevailing rates, it will be offered at a discount rather than a premium to compensate.
Comments