[This page is a series of focused write-ups on applications in securitisation. For other applications, see the Securitisation Applications section on the Securitisation home page.]
last update: 12 Jan 2007
Links on RMBS/ Housing finance systems
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Securitisation of residential mortgages is the mother of all securitisations. Residential mortgage-backed securities (RMBS) are generally pass through securities or bonds based on cash flows from residential home loans, as opposed to commercial real estate loans.
Evidently enough, the residential mortgage market was one of the most appropriate applications of securitization. That is why, for good reasons, some or the other way of refinancing mortgages has been found in most parts of the world. If in USA, it was securitization, in Europe, a traditional mortgage funding instrument, Pfrandbriefe has been in vogue for almost 200 years.
There are two very strong reasons for RMBS being tuned to securitization: one, the long maturities of residential mortgages, and two, the fact that mortgage lending is backed by charge over real estate, which is a strong asset-backing enabling the investors to take an independent exposure on the receivables. The govt. support to development of secondary markets in mortgages has also been a strong reason, and the governments easily took this as one of their major welfare activities.
The RMBS or mortgage pass-through market originated in the United States with the active support of Govt. agencies. The three US Govt. agencies engaged in promoting securitisation with their guarantees are Government National Mortgage Association (GNMA) (nicknamed Ginnie Mae), Federal National Mortgage Association (FNMA) (nick named Finnie Mae), and Federal Home Loan Mortgage Corporation (FHLMC) (nick named Freddie Mac).
The Government National Mortgage Association (GNMA) is a US Govt. body promoting securitisations. GNMA pass through securities carry the full backing of the US Govt. GNMA guarantees the timely repayment of principal and interest.
The Federal National Mortgage Association (FNMA) is the oldest of the three agencies. The first FNMA pass throughs were issued in 1981. FNMA pools mortgages from its purchase programs and issues MBS to originators in exchange for pooled mortgages. Like GNMA, FNMA also guarantees repayment terms.
The third agency, FHLMC was created in 1970 to promote active secondary market for conventional home mortgages. The agency runs a participation certificate program under which it pools both fixed rate and adjustable rate mortgages.
- Most of the mortgage funding is for very long maturities: say, 15 years to 30 years.
- If the securitization is a pass-through, the investors will get paid over such a long period, say 20 years. As that is too long a period for most investors, it is common for mortgage securitizations to adopt the bond method (collateralized mortgage obligations) which are repayable in different maturities.
- RMBS could be either agency-backed or non-agency-backed. Agency-backed refers to the transactions pooled and bought by specialized securitization agencies such as FNMA and GNMA. Outside the USA also, several countries have put up their own models of FNMA as entities that buy mortgages and securitize them. Mortgages securitized by the agencies normally provides the guarantee of the agency to the investors.
- If the mortgages are secured by the guarantee of the government or the securitization agency (such as GNMA or FNMA in the USA), the only risk that the investors carry is the risk of prepayment.
- Depending on the level of development of securitization, mortgage securitization market can be a highly commoditised market where mortgage origination, servicing and administration can all be viewed by the market as independent commodities and be regularly traded.
- See our articles section for number of articles on the MBS market
- Ginnie mae, USA web site: http://www.ginniemae.gov/
- Freddie mac, USA home page: http://www.freddiemac.com/
- A general review of real estate financing:http://www.realpage.com/uliforecast/refinmkt.html
- Fitch IBCA site contains lots of reports on RMBS:https://www.fitchratings.com/site/home
Derivatives of the Mortgage markets:
The US mortgage market is noted for both its size and the variety of derivatives that make it a wide and deep marketplace. The derivatives have essentially been created to better serve investor interests.
Collateralised mortgage obligation (CMO) bonds
The CMO bonds are what later became the basis for most of the securitisation structure in the asset-backed market. The first CMO was issued by Freddie Mac in 1983. A CMO relies upon the cashflows in the mortgage pool, but not to pay the investors on as-is-whatever-is basis as in case of pass-throughs, but on a sequential payment basis. The bonds or notes of the SPV are broken into several tranches: Class A is thus the one which is paid off first and is therefore both fast-pay as well as senior, Class B is one which receives only the coupon till Class A is full paid, and comes for repayment thereafter, and so on. Class Z is the zero-coupon class which does not get any coupon or repayment throughout the term, and is paid off by way of a bullet repayment at the end of the term. Class Z, also known as accrual bonds therefore provides credit and well as liquidity enhancement to all the senior tranches.
PO and IO strips:
The PO and IO strips was a device to protect investors against the prepayment risk. Mortgage investors compute their yield on a predicted prepayment speed which is usually based on models (such as the PSA model for the US mortgage market; there are models for many countries). The prepayment speed is affected by number of economic and other factors, but most important of these is the rates of interest. If rates of interest increase, prepayment speed comes down, as existing borrowers who borrowed at lower interests would stick to their loans. If rates of interest decrease, prepayment speed goes up, for obvious reasons.
If a prepaymet takes place, it affects the interest stream, as the principal is repaid anyway in full. Thus, the PO strip holders will not be affected by prepayments: they will rather stand to benefit if prepayments take place, as they get paid off faster.
Thus, the market value of PO strips will fall, if interest rates increase (as lesser prepayments than projected will take place), and the market rate for IO strip will increase. The reverse will happen if interest rates come down.
Floaters and inverse floaters
Sometimes, the fixed rate mortgage cashflows are converted into floating rates by carving out a section which is reverse floating. The reverse floating class is subject to interest rates which are inversely-proportionate to market changes. If the market rates of interest (base rate, or reference rate) increases, the cashflows on the floating rate will increase, while the cashflows on the inverse floating class will be reduced.
For more on inverse floaters, see here