Beyond the Primary Market: How MBS and ABS Impact Lending Strategy

There’s a myriad of places where individuals, families, and institutions can invest their money. In the residential mortgage space, lenders and investors often focus on residential mortgage-backed securities (RMBS), commonly referred to as MBS. This falls under the “secondary market,” side of the business (versus the “primary” side of the business where lenders deal directly with borrowers). With the uncertainty surrounding Freddie Mac and Fannie Mae this summer, it’s a good time to examine MBS and asset-backed securities (ABS): Are they the same thing?

The answer is no. Yes, asset-backed securities (ABS) and mortgage-backed securities (MBS) are two important types of asset classes. MBS are securities created from the pooling of mortgages, and then sold to interested investors, whereas ABS have evolved out of MBS and are created from the pooling of non-mortgage assets. ABS are usually backed by credit card receivables, home equity loans, student loans, and auto loans. In fact, nearly any income stream can be securitized and sold to investors, even money from a musician going on tour.

While different, there are similarities. There are three parties involved in the structure of ABS and MBS: the seller, the issuer, and the investor.

1. Sellers are the companies that generate loans and sell them to issuers, such as many STRATMOR clients do. They also take the responsibility of acting as the servicer, collecting principal and interest payments from borrowers. ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to use the proceeds and acquire additional funding when the securities are sold. Or put another way, think of a non-depository mortgage banker selling the loan and then simultaneously paying off its warehouse line
2. Issuers buy loans from sellers and pool them together to issue ABS or MBS to investors.
3. Investors of ABS and MBS are usually institutional investors, and they use ABS and MBS to obtain higher yields than government bonds while diversifying their portfolios. Both have prepayment risks—the risk of borrowers paying more than their required monthly payments—thereby reducing the interest of the loan, though these are especially pertinent for MBS. Think of the government-sponsored refi programs currently put in place by Freddie and Fannie.

Understanding Tranching: Mitigating Risks in MBS and ABS

Supply and demand are the predominant determinants of price, with supply being impacted by mortgages being paid off early due to refinancing or selling the home. Prepayment risk can be determined by many factors, such as the current and issued mortgage rate difference, housing turnover, and path of mortgage rates. If the current mortgage rate is lower than the rate when the mortgage was issued or housing turnover is high, it will lead to higher prepayment risk, as any loan officer can tell you. Historically, most homeowners refinance their mortgages the first time rates drop. Therefore, when the mortgage rate falls again, refinancing and prepayment would be much lower compared to the first time.

To deal with prepayment risk, ABS and MBS have tranching structures, which help by distributing prepayment risk among tranches. Investors can choose which tranche to invest based on their own preferences and risk tolerance. One additional type of risk involved in ABS is credit risk. ABS have a senior-subordinate structure to deal with credit risk called credit tranching. The subordinate or junior tranches will absorb all the losses, up to their value before senior tranches begin to experience losses.

Subordinate tranches typically have higher yields than senior tranches, due to the higher risk incurred. Investors can choose which one they want to invest in according to their risk tolerance and their outlook on the market. There are many types of ABS, each with different characteristics and cash flows, examples of which include Home Equity ABS, Auto Loan ABS, and Credit Card Receivable ABS.

Why the Right Spread Matters in MBS and ABS Pricing

Measuring the spread and pricing of bond securities is essential, and investors should know which type of spread should be used for different types of ABS and MBS. Choosing the right type of spread depends on the structure of the security. If the security doesn’t have embedded options that are typically exercised, such as call, put, or certain prepayment options, the zero-volatility spread (Z-spread) can be used to measure them. The Z-spread is the constant spread that makes the price of a security equal to the present value of its cash flow when added to each Treasury spot rate (I bet you always wondered about that!). For securities with embedded options, the option-adjusted spread (OAS) should be used instead. The OAS accounts for the impact of these options on cash flow and adjusts the spread accordingly.

Perhaps this is more detail than the casual reader was seeking, but there are two ways to derive the OAS:

• The Binomial Model can be used if cash flows depend on current interest rates but not on the path that led to the current interest rate.
• The Monte Carlo Model is more complicated and needs to be used when the cash flow of the security is interest rate path dependent.

Mortgage-backed securities issued by Freddie Mac or Fannie Mae are a multi-trillion-dollar position in the capital markets. As the talk of Fannie and Freddie changes intensifies, their position in the hierarchy of ABS and MBS investments is important and should not be shrugged off. Likewise, knowing the basics of the structure of an MBS is also important, as these impact the demand, pricing, and overall appetite by investors, which in turn impacts the rates that borrowers see. Rob Chrisman

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