THIS CHAPTER DESCRIBES two types of mortgage securities. We first start with mortgage pass-through securities that are guaranteed by an agency. They're called "agency mortgage securities." We then describe the more complex "collateralized mortgage securities" that may or may not have an agency guarantee.
In its basic form, a mortgage pass-through security (generally known as a mortgage-backed security) represents an ownership interest in a number of similar mortgage loans made by financial institutions such as savings and loans, commercial banks, and mortgage companies. When these mortgage loans are combined or pooled, they become mortgage-backed securities. U.S. government agencies issue and/or guarantee many of these mortgage-backed securities. For simplicity's sake we'll refer to mortgage-backed securities as mortgage securities. The cash flow, consisting of both principal and interest payments, from the pool of mortgage loans, reduced by fees, is passed through to holders of the mortgage securities.
Although there's a lot of money to be made from these financial instruments, their complex structure makes them more difficult to understand than other investments. It helps first to understand how a mortgage security's underlying asset, a simple mortgage loan, is created. Mortgages came into being because most people have only enough money for a down payment when purchasing a house. They require help in the form of a mortgage loan to pay the balance. Banks provide this sort of help. For example, let's say you borrow $100,000 for thirty years to finance the purchase of your house. Your loan agreement is documented by a mortgage, and it stipulates how much and how frequently you will make payments. The bank might charge a series of fees for making the loan.
After receiving your $100,000 mortgage document, your bank—without your knowledge—will probably turn around and sell it to another entity. If the bank agrees to collect your mortgage payments and provide you with payment records even though it no longer owns your mortgage, it receives a fee from the buying entity for doing so. The bank now has its $100,000 back and can lend that money to another borrower.
In its turn, the purchasing entity creates a mortgage pool by combining your mortgage with other, similar mortgages. The purchasing entity then may either guarantee the creditworthiness of that mortgage pool or obtain a guarantee from another institution. The resulting financial package, highly desirable because of the value of the underlying mortgages and the credit guarantees, is divided into units that are sold to investors as mortgage securities. Many of these mortgage securities are agency mortgage securities, and one of three government agencies—Fannie Mae (originally named Federal National Mortgage Association), Freddie Mac (originally named Federal Home Loan Mortgage Corporation), and the Government National Mortgage Association (which is widely known as Ginnie Mae)—either issues or guarantees them. When we refer to agencies, we mean these three companies.
The creation of mortgage securities can benefit all parties.
The homeowner is able to borrow money at the lowest rate available because a financially strong agency guarantees the payment of principal and interest of the mortgage loan.
The bank earns its fees and may sell the mortgages, reducing its risk. The investors in the mortgage securities are happy they have an easily traded (liquid) security that an agency collateralizes and guarantees. In addition, the mortgage security may yield more than an equivalent Treasury bond.
Finally, the agencies are fulfilling their mandate, which is to increase home mortgage liquidity while enabling banks and other lenders to finance mortgages for low-income and middle-income families.
It is important to note that the agencies are barred by their charters from originating mortgages. A network of lenders, which includes mortgage bankers, savings and loan associations, and commercial banks, originates the mortgages in the pools. After ensuring that the mortgage loans meet established credit quality guidelines, the agencies either directly or indirectly convert the loans into mortgage securities—a process known as securitization. The resulting mortgage securities may carry an agency's guarantee of timely payment of principal and interest to the investor, whether or not there is sufficient cash flow from the mortgage pool. Agency mortgage securities provide investors with an investment that offers liquidity, safety of principal, and attractive yield. They are one of the most widely held and safest securities in the world.
A little history will be useful in understanding why the agencies that guarantee mortgage-backed securities were created and how they differ. Until the late 1930s, affording a home was difficult for most people because a prospective homeowner had to make a down payment of 40 percent and then pay the mortgage off in three to five years. During the three- to five-year period, the mortgage holder paid only interest on the mortgage. At the end of that time, the principal had to be paid in one lump sum, called a "balloon payment." As the boom of the 1920s turned into first a stock market crash and then a depression, more people defaulted on their mortgages because they could not meet the final balloon payment. Thus, while prospective homeowners preferred long-term, fixed-rate mortgages, banks and other mortgage lenders were reluctant to offer them because of the risk of default on the mortgages.
The government stepped in and created the Federal National Mortgage Association as part of the Federal Housing Administration (FHA) on February 10, 1938, charging the association with bolstering the housing industry by expanding the flow of mortgage money. Throughout its first years of operation, the Federal National Mortgage Association primarily bought mortgages issued to lower-income people; banks held on to the lucrative returns from mortgages issued to more prosperous customers. This situation changed during a credit squeeze in which banks and savings and loan institutions were receiving 6 or 7 percent annual interest on 30-year fixed-rate mortgages and paying out 9 percent to 12 percent interest on bank deposits. By the late 1960s, banks found the idea of selling a greater number of mortgages more attractive because of their realization that holding them could be risky.
Once again the government stepped in. In 1968, it split the Federal National Mortgage Association into two separate legal entities. One became a shareholder-owned, privately managed public corporation supporting the secondary market for conventional loans. This corporation became popularly known as Fannie Mae, a nickname legally sanctioned in 1997. Although a shareholder-owned public corporation, it didn't completely sever its ties with the government because it operates under a congressional charter and is subject to oversight from the U.S. Department of Housing and Urban Development (HUD) and the U.S. Department of the Treasury. The association with HUD and the Treasury gives Fannie Mae a powerful backing in the event of any financial problems; the aura of the association with the U.S. government extends to its securities, which, as noted previously, carry an implicit AAA rating.
Fannie Mae has two primary business activities: (1) portfolio investment, in which it buys mortgages and mortgage securities (the debt securities it issues, which were described in the last chapter, fund this activity); and (2) credit guarantees, in which it charges fees to guarantee the credit performance of single-family and multifamily loans.
The second entity resulting from the government's 1968 split of the original Fannie Mae is the Government National Mortgage Association, known as Ginnie Mae. Ginnie Mae differs from Fannie Mae in four important respects:
It is a government corporation located within HUD;
Its obligations are fully rather than implicitly backed by the full faith and credit of the United States;
Its purpose is to serve low-income to moderate-income home buyers as opposed to all home buyers; and
It does not form mortgage pools but rather guarantees the timely payment of principal and interest on qualified pools of mortgages, which are known as Ginnie Mae pools. There are hundreds of issuers of qualified pools, and they administer more than 400,000 Ginnie Mae mortgage pools. All mortgages in a Ginnie Mae pool are insured by the FHA, the Veterans Administration (VA), or other governmental entities.
In 1970, Congress further increased mortgage activity by chartering the Federal Home Loan Mortgage Corporation as an active participant in the secondary mortgage market. In 1989, this agency followed in Fannie Mae's footsteps and became a shareholder-owned, privately managed public corporation subject to oversight from HUD and the Treasury. In 1997, it once again copied Fannie Mae's example and legally changed its name to the popularly known Freddie Mac. Although there is little discernable difference between Fannie Mae and Freddie Mac, competition between the two ensures that the benefits of the secondary market are passed on to home buyers and renters in the form of lower housing costs.
Each agency has a Web site that provides helpful information: www.fanniemae.com, www.freddiemac.com, and www.ginniemae.gov.
Let's take a closer look at mortgage pools and how securities are created from them. In our example at the beginning of this chapter, we noted that your mortgage might be combined with many other similar mortgages to form a mortgage pool. Assume that your mortgage is in the amount of $100,000 and that there are nine other similar mortgages also in the amount of $100,000 each. In this case the value of the mortgages in the pool is $1 million (100,000 × 10). This mortgage pool will receive cash flow from three sources:
First, the homeowners pay interest on their mortgages.
Second, the homeowners pay scheduled principal payments on their mortgages.
Third, and most important to understand, the homeowners may make nonscheduled prepayments on their mortgages, creating additional cash flow. These nonscheduled prepayments are the result of homeowners refinancing or prepaying their mortgages, selling their homes, or defaulting on their mortgages. Refinancing is particularly prevalent when interest rates go down and homeowners pay off existing mortgages to obtain new, cheaper ones. As a result, a pool of 30-year mortgages might be paid off in twelve to fourteen years. Thus, while debt securities such as bonds are traded in terms of their due dates, mortgage securities are traded in terms of their assumed "average life."
When any nonscheduled prepayments take place, additional cash comes into the mortgage pool. The originator/servicer of the mortgage pool collects all the cash flow and charges a fee of about 0.5 percent for this work. Each month the originator/servicer distributes all the cash collected minus its fee pro rata to the owners of the mortgage securities.
Put another way, when you hold a mortgage security, you may receive a monthly, quarterly, or semiannual cash flow from three sources: interest on the mortgages; principal payments on the mortgages; and nonscheduled payments resulting from homeowner refinancing, prepayments, home sales, and defaults.
Keep in mind that not all this cash flow is income. The principal payments and nonscheduled prepayments are an early return of your principal. When you invest in a mortgage security, you're in the position of a bank lending money on a mortgage to a homeowner. When you are repaid, you receive back mostly interest in the early years and mostly principal in the later years.
Agency mortgage securities are very attractive because they often yield more than Treasuries of comparable maturity. Although there is a difference in the underlying credit of each agency, all agency mortgage securities are very safe and have AAA ratings. The U.S. government directly guarantees the Ginnie Mae mortgage securities as to timely payment of interest and principal. Fannie Mae and Freddie Mac can borrow directly from the U.S. Treasury if conditions so warrant. However, in 2006, some members of Congress expressed opposition to this borrowing power.
Even though the U.S. government does not directly guarantee the Fannie Mae and Freddie Mac mortgage securities, they have an implied AAA rating because the assumption is that the federal government will stand behind the debt. It is unlikely that the U.S. government would let one of its government-sponsored enterprises, such as Fannie Mae or Freddie Mac, default. It is interesting to note, however, that in 2001 Standard & Poor's issued a credit rating report for Fannie Mae and Freddie Mac stating that if the agencies were viewed on their own without the support of the U.S. government, their credit rating would be AA–, rather than AAA.
Finally, keep in mind that in practice there has been no difference in the safety record of the three agencies' securities. None has ever defaulted or missed a payment of interest or principal to an investor.
Mortgage securities have a number of significant disadvantages when compared to Treasuries, most notably their uneven and unpredictable cash flow, which results from prepayments. These prepayments are a wild card in analyzing mortgage securities because they make it impossible to predict the overall cash flow. If you can't predict cash flow, you can't predict current return, and you certainly can't compute a yield-to-maturity. Thus, it is difficult to compare the yield on a mortgage security to the yield on a Treasury or corporate bond. This unpredictability of cash flow causes the mortgage securities to often yield more than Treasuries.
The prepayment assumptions used to evaluate mortgage securities are based on complicated statistical models. Usually, the payment history of the mortgage securities is compared to prepayment patterns prepared by the FHA. If interest rates change markedly, the FHA may issue new prepayment guidelines. Unless you purchase mortgage securities through a fund, the relatively small blocks that an individual can purchase might actually be statistical aberrations from the norm. Another concern that individual investors have is that they might get an unfavorable price on the mortgage security that they buy because of the difficulty in evaluating the price.
Unpredictable prepayments may cause other problems. If you base the estimated yield on the mortgage security on the mortgage pool remaining in existence for, say, twelve years, prepayments may result in a pool coming to an end in only nine years. This might result in a lower yield on the mortgage security. Under these circumstances, if you purchased a mortgage security at a premium, you could lose money.
Capital depletion is a potential problem for the inexperienced investor in mortgage securities. The large cash flows look like manna from heaven. But if you spend all the cash flow that you receive from the mortgage security as it comes in, you will deplete your capital and have nothing to reinvest when the cash flow stops. Thus, a mortgage security is similar to an investment in an oil well: large cash payments in the early years but declining payments in the future as the oil is depleted. By comparison, a debt security, such as a Treasury bond, pays you the principal at its maturity date as well as interest payments twice a year.
Mortgage securities also have interest rate risk. If interest rates rise, homeowners will generally not refinance their mortgages, thereby causing the average life of the mortgage pool to extend. This will result in a yield lower than originally estimated because it will take longer for you to get your capital back. Mortgage securities perform best when interest rates remain within a narrow range.
Finally, there is not much daily pricing information available to investors about mortgage securities. Even the Wall Street Journal provides little information on mortgage securities.
All agency mortgage securities are subject to federal income tax and state income tax on all interest income and original issue discount (OID). OID exists if a mortgage security is issued at a discount from its face value. Your broker will report the amount of interest income and original issue discount to you on Forms 1099-INT and 1099-OID. The portion of any payment from a mortgage security that represents a return of the principal that you originally invested is tax free.
It's difficult for individual investors to evaluate information about specific mortgage securities offered by brokers and to commit enough cash to properly diversify a portfolio of mortgage securities. For these reasons, mortgage securities may not be suitable for individuals to purchase on their own. Some investors, however, may find buying individual Ginnie Mae certificates to be attractive if they want a large cash flow and do not care if their principal is returned unpredictably.
For most investors, the best way to invest in mortgage securities is through buying a Ginnie Mae open-end mutual fund. This approach uses the expertise of the fund's investment adviser and provides diversification among different Ginnie Mae securities. You might wish to consider the following Ginnie Mae funds: Vanguard GNMA Fund (877-662-7447), Fidelity Ginnie Mae Fund (800-544-6666), and USAA Invest-GNMA Trust (800-382-8722).
Collateralized mortgage obligations (CMOs) are similar to mortgage securities in that they are based on underlying mortgages. A CMO is a package of mortgage securities and/or mortgage loans that an issuer assembles as a multiclass security offering.
Financial engineers in the investment-banking world created CMOs in 1983 to alleviate the problem of how to deal with the pre-payment uncertainties associated with mortgage pools. The CMO solved the prepayment problem, at least in part, by allowing a greater certainty of return for those willing to accept a lower yield, while rewarding those who assume a much more unpredictable return and maturity with a higher yield. CMOs created a whole new range of profitable financial products for Wall Street. They have become a big business. There are more than $1 trillion in CMOs outstanding.
Mortgage-backed securities may seem complicated, but CMOs are much more complex. They consist of endless variations of combined cash flows originating from mortgage pools. Michael Vranos, the former head of mortgage securities at Kidder Peabody, once boasted to the Wall Street Journal that his job is to sell securities to the dumb guys. Some of his clients understandably resented the assessment. Grudgingly, however, many investors concede that Vranos's tactless remark contained a kernel of truth. The following simplified explanation captures the basics: although holders of mortgage securities receive cash through pro rata monthly distributions, owners of CMO securities receive cash from a mortgage pool on a prioritized basis. That prioritization is called a class or a tranche, a word derived from the French word for slice.
Let's consider a simple example of a CMO with three classes of securities and see how it works. In practice, there may be as many as fifty different classes, the thought of which can induce nightmares for people trying to understand this product. We'll call our three classes the A Class, the B Class, and the Z Class. The term Z Class originally referred to the last class to be paid; today, it often describes an accrual bond that may or may not be the last in the CMO to be paid. This class is also known as an accrual tranche, or a Z bond.
In our example assume that $1 million has been invested in the three classes as follows:
A Class. The face value of the securities in the A Class is $600,000. Interest at the annual rate of 6 percent is paid monthly on the face value of the securities until they are paid off. All scheduled principal payments and all prepayments are paid monthly to the A Class until $600,000, representing the full face value of the A Class, is paid off. No principal payments or prepayments are paid to the B Class or Z Class until all the A Class securities are paid off.
B Class. The face value of the securities in the B Class is $300,000. Interest at the annual rate of 8 percent is paid monthly on the face value of the securities even when the A Class is still outstanding. All scheduled principal payments and all prepayments are made monthly to the B Class, but only after all the A Class is paid off. No principal payments or prepayments are made to the Z Class until $900,000, representing the full face value of the A Class and B Class securities, is paid off.
Z Class. The face value of the securities in the Z Class is $100,000. Interest at the annual rate of 10 percent is accrued but not paid on the face value of the securities until $900,000, representing the full face value of the A Class and B Class, is completely paid off. Such interest as well as scheduled principal payments and all prepayments are made monthly to the Z Class only after all the A Class and B Class are both paid off. Thus, the Z Class gets the remainder of the payments from the mortgage pool. The Z Class bears some similarity to a zero-coupon bond in that interest is accrued but not paid. The Z Class may have a very long life and no definite maturity. It may also be difficult to determine the tax consequences of the Z Class.
Note the higher interest rates for the B Class and Z Class to make up for the longer life and higher risks in these classes as compared to the A Class.
The A Class security is similar to a short-term bond. Since the A Class receives a share of the interest and all the prepayments initially, it will turn out to be a shorter-term security and will have a more predictable return than the B Class or the Z Class securities. It might be possible to predict with a high degree of reliability that the A Class will retire in, say, three years. The life of and thus the return on the B Class will be more difficult to predict than the A Class, and, thus, the B Class should earn a higher return.
As noted, the last class, the Z Class, will receive no interest or principal payments until all the other classes are repaid in full. Although the A Class may have an expected life of three years, the Z Class may not retire for twenty or thirty years. The return on the Z Class is the most difficult to predict and value. It should have the highest yield because of its uncertainties. It will lose value quickly when interest rates rise because prepayments decline and lengthen the life of the Z Class. Many CMO investors have lost money when their estimates were not met with respect to Z Class securities.
There are two major types of CMO structures. One, as in our example, provides that only principal payments be redirected, and interest goes pro rata. In the other type, principal as well as interest payments are redirected. The pattern for the latter, while Byzantine, is similar to that described previously and makes later tranches even more volatile.
CMOs can be, and often are, categorized by type of issuer. The term agency CMOs refers to those issued by the agencies. The mortgages in the agency CMOs are already pooled mortgages and in securitized pass-through form. They are of similar size, age, and quality. Investors in agency CMOs have only prepayment risk, but no credit risk.
The terms private-label CMO, nonagency CMO, and whole-loan CMO refer to investments comprising mortgages that do not have an agency guarantee. Some private institutions, such as subsidiaries of investment banks and other financial institutions, issue nonagency CMOs, usually consisting of jumbo loans. Agency CMOs do not use jumbo loans. Nonagency CMOs often carry an AA or AAA rating due to credit enhancements. Within the same issue, individual tranches may carry different ratings.
Agency CMOs have minimal credit risk, and they may offer a higher return than Treasuries because of the market risk relating to the uncertainty of the CMO's maturity. In the absence of a government or other guarantee, nonagency CMOs may provide a potentially higher return than agency CMOs or agency debt bonds of comparable maturity, reflecting the greater credit risk on the nonagency CMOs.
If you buy the A or B classes in a CMO (that is, the top classes), the cash flow should be more predictable than with other agency mortgage securities. This is the purpose of CMOs. If you buy the A Class, it should resemble a short-term bond, although with a less predictable maturity. The A or B Class CMOs will provide high monthly cash flows. You can buy CMOs in $1,000 pieces, rather than the $25,000 minimum required for a Ginnie Mae security.
The attractiveness of CMO securities varies considerably because of repayment unpredictability. The safest are the A Class and B Class agency CMOs. Predictions relating to the life of the CMO and, thus, the yield predictions may be very far from the actual outcome. What may appear to be a short-term investment could lengthen by many years if interest rates later rise sharply (resulting in smaller prepayments). Even the shortest classes are not immune to maturity extensions.
The Z Class nonagency CMO is generally the riskiest and should not be approached unless you or your financial adviser can do a careful analysis of the risks. Any Z Class security may be hard to analyze. Called "toxic waste" in the trade, the Z Class will also be more volatile than other mortgage securities, particularly when interest rates are moving rapidly. The Z Class has poor liquidity. Finally, the Z Class may have accounting and tax aspects that are difficult to understand.
It is very difficult to find information about CMOs. Neither the New York Times nor the Wall Street Journal provides price quotes on these securities.
The tax treatment of CMOs is complex, and you must consult your tax adviser for specific advice. The portion of the payment treated as interest is subject to federal and state income tax, whereas the portion treated as return of principal or original cost is not subject to tax. However, if you purchase the CMO securities at a discount from their original issue price, part of the discount (the OID) may be taxed as interest income, and some may be taxed as capital gain.
For CMOs held in a brokerage account, your broker will report the tax consequence to you. However, there is a risk that the outside source that's reporting to your brokerage firm may not report the tax consequence of the CMO before March 15, and that might delay you in preparing your income taxes.
You can buy CMO securities in minimum amounts of $1,000. Many CMOs are created for institutions, however, and their minimum purchase price is much higher. You might also buy CMO securities by buying a mutual fund or unit trust that invests in CMO securities. Many of these entities have minimum investments of $1,000.
Because of the inherent disadvantages in CMOs, particularly nonagency CMOs, you should proceed with caution and seek answers to the following questions:
Is the CMO an agency CMO? If not, what is its credit rating? Can I lose some of my principal?
Can I get a full prospectus for the CMO? If not, where can I get detailed information on the CMO?
Am I buying the CMO at original issuance or on the secondary market? If on the secondary market, how can I be sure that the price is appropriate?
If the CMO has a trading history in the secondary market, has it met its original assumptions? If not, why not?
What is the exact class of CMO that I'm buying, and what are the exact terms of the payout?
Is the return the CMO will yield compared to that of a comparable Treasury or agency debt security high enough to merit the additional risk of the investment?
What are the tax consequences of the CMO?
Is there an active market in this CMO if I want to sell it?
Keep in mind that what looks like a high yield might be a high return of your principal. Don't make the mistake of spending that principal because you think it's income.
Are these CMOs proprietary products, that is, products that are created by a particular brokerage house? If so, you might receive a relatively low price if you need to sell your securities because the broker that originally sold you the CMO might be the only interested buyer.