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Market Description (Continued)

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.

             

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