Mortgage-backed securities (MBS) are debt obligations that are backed by the cash flows from pools of mortgage loans on residential and commercial property. These mortgages were originally extended to homeowners and investors by banks and other lending institutions, then purchased and assembled into pools by a variety of government and private entities. These entities then issue securities with tranches of various maturities and credit quality. The coupons and principal payments from the residential mortgages provide the cash flow to repay the residential mortgages, while rental income provides the revenue stream to repay the commercial mortgages.

First developed in late 1970s, the residential mortgage backed securities (RMBS) market has grown tremendously in the past few decades and is currently estimated to be a $8 trillion market. The majority of RMBS are issued by government sponsored entities (GSEs) Ginnie Mae, Fannie Mae or Freddie Mac, and are (now that the government has taken over Fannie and Freddie) explicitly backed by the Federal government. These securities are generally referred to as “agency” paper/RMBS. The rest of the RMBS market has been structured and issued by private institutions such as banks, thrifts, broker-dealers and homebuilders. The RMBS transactions are generally backed by homogeneous pools exclusively comprised of either prime, subprime, adjustable rate mortgages or home equity loans. These securities are often referred to as “private label” or “non-agency” paper/RMBS and represent an estimated $1.8 trillion of the RMBS market.

SecondMarket has also opened its marketplace for the trading of commercial mortgage backed securities (CMBS). The mortgage pools backing CMBS are also grouped together relatively homogeneously, consisting of pools of multi-family, office, retail, industrial and medical properties, with principal and interest payments backed by streams of rental income. CMBS are all issued by private entities, and the market is estimated to be over $700 billion in CMBS outstanding.

RMBS Liquidity
The agency RMBS market, due to a combination of implicit and explicit government guarantees continues to function in an orderly manner, with tight bid-ask spreads and a significant number of market participants. RMBS issued by the private sector, however, have come under significant pressure not only from the downturn in housing prices and the fallout from the sub-prime mortgage crisis, but also from a variety of legal and regulatory changes/proposals that have caused considerable uncertainty regarding the future performance of the underlying loans.

With many traditional market makers on Wall Street either closed or no longer making markets for RMBS securities, investors have had no place to turn for price discovery, or outlets to sell their positions. Further, there remains significant uncertainty about the future direction of TARP and how that will impact the distressed mortgage market. With all this ongoing uncertainty about the future economic, legal and regulatory environment, opportunities exist on for non-traditional investors to step in and potentially profit from all the dislocation in the markets. Today, there are new distressed mortgage investors coming into the market constantly.

General RMBS Structure
Most RMBS securities are sliced up into many (typically 10-30) different tranches, each of which is relatively small compared with the entire issuance. The senior tranches are traditionally time-tranched, meaning that each tranche has a different expected maturity and expected time window for principal repayment. The actual maturities vary based upon realized prepayments, but are marketed based upon an assumed prepayment model. The lower tranches, usually referred to as credit-tranched, are riskier and subordinated to the all the senior tranches. There is a critical trigger applicable to the credit tranches that kicks in, typically after the third year, which allows for potential early repayment of the credit tranches if the pool performance has been sufficiently robust.

Major RMBS Types
The pools of mortgages which are securitized to form RMBS are traditionally homogenous in composition, by both borrower type and mortgage structure. The following five collateral types were the most common residential mortgage types:

Prime
These loans were generally plain-vanilla fixed and floating-rate 30-year mortgages, issued to homeowners with the highest credit quality - individuals with high FICO scores, called ”prime” borrowers. These mortgages were taken out by the majority of homeowners and form the greatest percentage of RMBS collateral. Agency RMBS can only be backed by prime mortgages. Non-agency prime mortgages, otherwise known as “jumbo”, are underwritten with loan balances which exceed conforming loan limits set by Fannie Mae and Freddie Mac. While defaults continue to rise, prime RMBS have seen the least collateral deterioration, and many of the higher rated tranches continue to perform well.

Sub-Prime
Sub-prime borrowers generally have low FICO credit scores. Statistically, they have a higher probability of default and thus generally have higher interest payments- generating higher coupons for sub-prime RMBS purchasers- which help drive initial demand in the market. Sub-prime defaults have skyrocketed, eroding the collateral and cashflows of the RMBS they are backing.

Alt-A
These loans were generally extended to borrowers with “prime” creditworthiness. However, certain other lending parameters were relaxed such as documentation, debt service to income ratio, loan-to-value ratio, inclusion of teaser rates, etc.-leading many of these loans (and hence their RMBS securities) to be riskier. In the current crisis, Alt-A loans have had higher default rates than Prime, but lower than Sub-Prime.

Adjustable Rate Mortgages
Often called option ARMs, pay option ARMs or negative amortization loans, these mortgages were often offered to home buyers with low introductory “teaser” rates to make them more affordable for the buyer. With their low initial rates, mortgage payments were sometimes half as much as a traditional mortgage, while accruing additional principal to make up the difference. After 2-3 years many mortgages are re-set to much higher, often unaffordable rates, contributing to defaults as the now higher payments cannot be met.

Home Equity Loans
Many home equity loans were securitized as well. With the majority having second lien or even a 3rd lien on the home, these loans have seen higher defaults with home values falling.

Specialty Tranches
Many RMBS transactions include particular tranches that are structured with unusual or customized structural terms. These are often created based upon a specific investor’s preferences. In general, they make up only a small percentage of total RMBS issuance, but it is important to carefully examine each tranche for any unusual features. Some of these include Planned Amortization Classes (PAC) and Companion Bonds, Non-Accelerating Senior Bonds (NAS), Interest Only (IO), Principal Only (PO), and many more exotic forms.
 

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