Mortgage Backed Securities-A Quick Education

The US mortgage market is huge and part of a sector known as securitized loans, worth about $10.8 trillion at the end of 2017. That’s about twice the nominal GDP of Japan, the world’s third-biggest economy, and represents about a quarter of the US bond market.

Mortgage-related instruments account about 86% of securitized loans, with asset-backed securities -- bundles of auto loans, credit card debt, student loans, corporate bank loans and even restaurant franchise fees or other commercial income contributing the rest.

So what are Mortgage Backed Securities, or MBS?

MBS are collections of mortgages that are packaged into individual securities and sold to a range of investors including individuals or institutions such as fund managers, pension plans, ETF sponsors or even the US government.

By far the largest portion is agency MBS, which accounts for about 75% of the total.

Agency MBS are bundles of mortgages packaged together into one security issued or guaranteed by one of the three government or quasi-government agencies known as Fannie Mae, Freddie Mac and Ginnie Mae.

They play a crucial role in the US housing market, providing liquidity that allows lenders to offer mortgages that are known as conforming loans.

Non-agency or non-conforming mortgages account for about 10% of the market and mostly comprise of loans that are unable to meet the criteria to qualify as conforming loans for example because they exceed the agencies’ caps on loan size.

The rest are loans made on commercial properties.

Agency MBS can be divided into tranches based on traits such as size of loan, interest rate, loan term and year of origination.
Crucially, all agency securities carry the same credit rating -- that of the US government -- meaning the risk of principal loss is negligible.

While many associate MBS with the Global Financial Crisis that began in 2007, it is generally accepted that faulty non-agency mortgages and Collateralized Debt Obligations, or CDOs, were two of the major contributing factors.

Tranches of non-agency sub-prime mortgages and other non-standard products made to borrowers whose income wasn’t verified were sold on the premise that, while one such loan might present a high default risk, there is safety in numbers. That turned out not to be the case as millions of people lost their jobs and stopped paying their mortgages as home values plummeted.

Steps were consequently taken across both agency and non-agency MBS to reduce the risk of a repeat. In return for coming under the conservatorship of the Treasury, Fannie and Freddie protected tax payer liability by instituting stricter controls.

Similarly, non-agency lenders made it tougher to get a loan. As a result, both agency and non-agency MBS are much higher-quality investments than they were going into the crisis.

If you own broad-based fixed-income funds, you probably already hold some MBS, but why are MBS different to other fixed-income instruments?

Typically, bond risk is related to credit quality -- the likelihood that the user can meet its obligations; and to duration -- a measure of how sensitive a bond’s price is to interest-rate fluctuations.

Because they are regarded as obligations of the US government, agency mortgages are generally considered credit-risk free, yet they typically carry higher yields than Treasuries. But because home owners can normally refinance their loans or sell their property at any time, the timing of principal receipt in mortgages can be difficult to predict. That duration risk has historically provided enhanced yields.

And because the many thousands of MBS are very actively traded, the liquidity of the market means transaction costs are often a fraction of corporate bonds.

These unique features can combine to make MBS a valuable part of a diversified portfolio and provide opportunity for active managers to generate returns above the market.

Market data sources: Janus Henderson Research and SIFMA, as of December 2017.
ETF is Exchange-Traded Fund. GDP is Gross Domestic Product. Tranche is a portion of a larger financial instrument or security.