Mini-Course Series - Income (Part 4) by Institute of Business & Finance

MINI-COURSE SERIES

RETIREMENT INCOME Part IV

RETIREMENT INCOME

MORTGAGE-BACKED SECURITIES A mortgage-backed security (MBS) is a group of real estate mortgages like the one you may have on your home. These groups of mortgages, known as pools, are then sold to investors who receive the mortgage payments as the MBS’s income payments. Like the underlying mortgage, the MBS payments are made up of both interest and principal. Since homeowners make mortgage payments monthly, MBSs pay interest monthly instead of semiannually like other fixed income securities. MBSs are known as passthroughs because the interest and principal paid by the homeowner passes through to the bondholder. The issue’s trustee or servicer administers all payments associated with the mortgage. Cash flow from these securities is best described as unpredictable. There are other types of pass-through securities that pool together other types of loans: auto loans, boat loans, credit card debt, student loans, equipment leases and RV loans. These are known as asset-backed securities (ABS). The type of loan that can be packaged together and sold is limited only by the imagination. In fact, David Bowie sold the rights to future royalties from his extensive collection of songs. All future sales of his work will be paid to the bondholders who in effect now own the rights to his music. MBS have negative convexity while most bonds have positive convexity. Negative convexity is just a way of saying MBS prices tend to go up less when bond prices are rising due to falling interest rates and down more in price than other bonds when prices are falling due to rising interest rates. Because they exhibit this less than desirable behavior, mortgage-backed bonds usually offer higher yields than comparable bonds. The fact that MBSs are usually of the highest quality and yet pay relatively higher levels of income on a monthly basis is the main reason for this fixed income security’s popularity. MBSs are not the asset of choice for investors who:   

Need a steady level of income Are concerned about their investment’s value in the secondary market Are concerned about reinvestment risk

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RETIREMENT INCOME

Types of Mortgage-Backed Securities GNMA

Freddie Mac PC

Freddie Mac GMC

FNMA CMBS

Mortgage-Backed

Monthly

2x Year

Monthly

2x Year

FHA/VA mortgages

Conventional Mortgages

Conventional Conventional Mortgages Mortgages

Guarantee

Treasury full faith and credit

Freddie Mac’s net worth and private mortgage insurance

Liquidity

Active market

Less active

Payment Stream Underlying Asset

Rating / Risk

Government ~ Governsecurity ment security

Same as Freddie Mac PC

General Assets

Freddie Mac’s net worth and private mortgage insurance

Overcollateralized by 150-200% with mortgage portfolio

Unknown at this time

Same as Institutional PC

Same as Freddie Mac PC

AAA

MBS CONCEPTION Here is how a mortgage-backed security is made. A soon-to-be homeowner goes to the bank and borrows money to buy a house. The bank lends the money at 8.5%. Soon after, the bank sells its loan portfolio to mortgage brokers. The bank does this in order to clear loans off its plate so it will be able to make new loans. The mortgage broker who bought the bank’s loan portfolio then packages the loans and sells them to investors. At each stage, a little of the cream is skimmed off. For example, say, the bank sells a mortgage with a number of similar 8.5% loans. The mortgage broker pays the bank for the loan portfolio, takes a cut for its services, and sells the resulting 8% mortgage-backed bonds to investors. Private pass-through securities often do not have any payment guarantees; they are a pure conduit. The private issue MBS investor receives only what the mortgage holders pay. These MBSs are issued by private companies, such as finance companies. As another alternative, the federal government created a number of agencies to facilitate mortgage lending.

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RETIREMENT INCOME

Mortgage-backed issuers (originators) either issue “private” securities where mortgage payments are passed through directly to investors or issue securities backed by a guarantor such as a government agency. Private-label bonds are subject to the individual company’s ability to evaluate the mortgage borrower’s creditworthiness. Such bonds offer no guarantee of timely principal and interest payment, whereas MBSs issued by government agencies are subject to standardized underwriting requirements specified by the Federal National Mortgage Association (FNMA).

Ginnie Mae Government National Mortgage Association (GNMA or “Ginnie Mae”) is a corporation owned by the U.S. government and operating under the Department of Housing and Urban Development (HUD). GNMAs are made up of mortgages that are Federal Housing Administration (FHA) insured or Veterans Administration (VA) guaranteed. The government guarantees the timely payment of both principal and interest regardless of whether payment has been received from the mortgage borrower. Since they are backed by the full faith and credit of the U.S. government, they currently enjoy the AAA rating.

Fannie Mae Federal National Mortgage Association (FNMA or “Fannie Mae”) MBS pools are made up of conventional mortgages (not FHA-insured or VA-guaranteed). The agency, FNMA, guarantees timely payment of principal and interest, but the difference between these and GNMA is these are not backed by the full faith and credit of the U.S. government. However, it is felt the government would bail out the agency if it were in danger of defaulting on payments so the securities are still AAA-rated. But, because the government guarantee is implied and not explicitly stated, FNMAs can yield slightly more than GNMAs.

Freddie Mac Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”) also pools conventional mortgages. Their MBSs are known as participation certificates (FHLMC PCs). FHLMC guarantees the timely payment of interest and eventual payment of principal. This means it passes through whatever principal it receives and guarantees the MBS investor will receive scheduled but unpaid principal within a year. Like FNMAs, FHLMC PCs are not backed by the full faith and credit of the U.S. government. The index below shows returns for investment grade agency mortgage-backed securities.

Barclays MBS Bond Index 2011

2010

2009

3 years*

5 years*

10 years*

6.2%

5.4%

5.9%

5.3%

6.3%

5.6%

*annualized (through 3/31/2012)

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WHY AN MBS YIELDS MORE    

Principal can be returned at any time. Reinvestment risk is higher because principal is returned when rates low. The income you receive decreases over time as face value erodes away. The MBS’s secondary market price does not go up as much but goes down more than traditional fixed income securities (negative convexity).

Return of Principal Mortgage payments are primarily interest during the early years; over time principal makes up a larger portion of the payment. As the mortgages in the pool age, a higher and higher percentage of an MBS’s monthly payment will be principal. Since there is less principal earning interest, income payments will decline. Most home mortgages allow prepayment of principal at any time without penalty. For the MBS investor this means the face amount of the bond can be prepaid at the homeowner’s whim. The MBS’s natural acceleration of principal being returned to investors can be magnified by prepayments. In essence, the security is perpetually callable, and unlike traditional callable bonds that are called away at a premium on specific dates, bits and pieces of the MBS can eat into par (prepayment risk).

Reinvestment Risk Homeowners usually refinance when interest rates are low. So, when interest rates drop, this MBS principal prepayment trickle can turn into a deluge. The MBS investor gets principal back and has to reinvest at a lower rate.

Decreasing Income As the investment’s face value declines over time, the income it pays out also gets smaller. Even though the interest rate remains constant, the income paid to the investor declines. Mortgage analysts are constantly monitoring prepayment speeds. If prepayments pick up, yields to MBS investors decline; if they slow down, yields increase. The MBS, the amount of principal earning income gets smaller so the income it produces diminishes. An MBS pool that is made up of 30-year mortgages would have a stated maturity of 30 years. However, since principal is usually being paid out to the investor throughout the life of the bond, most of the investors end up owning only a small portion of the original face value at maturity. Therefore, with mortgage-backeds, rather than using maturity, a more meaningful measure of how long principal will be outstanding is average life. Average life is the estimated time until half of a mortgage pool’s principal has been paid off; it is based on past experience with similar pools. PART IV

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A pool’s average life can change with interest rates. In the summer of 2002 the Lehman Brothers (Barclays) Mortgage index had an average maturity of 6.3 years. A 30-year MBS with a 6% coupon had an average life of 6.6 years, while a 30-year MBS with a 6.5% coupon had a 4.2-year average life. The longer the security’s average life, the more price volatility it will have. The shorter the average life, the lower the security’s price volatility for a given change in interest rates. How quickly homeowners prepay mortgages changes with interest rates, so does the MBS’s average life. As interest rates drop and homeowners refinance more often, the average life shortens because you are getting principal back more quickly. So, the expectation about how long the time will be before half of the principal is returned is shorter. The expected yield drops because it is projected you will have less principal remaining to earn interest. As rates rise, prepayments slow. The average life extends out into the future. It then is expected it will take longer before half the face value is paid out.

Negative Convexity Besides the yield being affected, the problem with this shortening and lengthening is the MBS becomes more responsive to interest rate moves when interest rates rise and bond prices are falling. Its price drop accelerates and falls faster than other fixed income investments. Then, when interest rates fall and bond prices are rising, the MBS becomes less responsive and its price rise is slower relative to other fixed income investments.

CMOS Wall Street loves to slice and dice securities, creating new entrants in the investment-ofthe-month club: artificial financial alternatives. In the 1990s, the product du jour was the collateralized mortgage obligation (CMO). Before the CMO was conceived, institutional investors backed away from an MBS, complaining the securities’ negative convexity could cause underperformance. So, Wall Street conceived and delivered the CMO. While an MBS is a pool of mortgages, a CMO is a pool of MBSs that is then cut up into component parts. Asset-backeds and corporates also package together their securities, slice and dice, and sell them as CDOs (collateralized debt obligations) in two types: CBOs (collateralized bond obligations) and CLOs (collateralized loan obligations). You can think of a CMO as an apple pie. This pie is so skillfully cut that one piece would have all the choice apples, while another piece would consist of only butter and sugar, leaving yet a third piece with worm-infested apples. All of a CMO’s pieces (traunches) are interrelated; a change in one causes all the others to change as well. You need to understand how all the pieces behave, not just the one you are buying.

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When CMOs first came to market, they often had only four traunches. Face value of each traunche was paid off sequentially. Traunche A was paid off first, then traunche B, and so on. As time went on, CMOs got even harder to decipher because as the type of traunches got more complex, the number of traunches increased exponentially. Some CMOs had as many as 60 traunches; it became difficult to figure out how the traunches interacted. Some traunches would suddenly completely pay down. Some would lose half their value in a week. Some would decline in value instead of rising when interest rates fell. Some traunches jumped. Many investors were hurt by these bonds; they now say CMO stands for “Count Me Out.” It is not hard to understand how CMOs got such a bad name. Remember: Do not buy something for a client if you do not fully understand it.

THINGS TO DO 

Your Practice

Briefly list the pros and cons of mortgage-backed securities and CMOs. Compare these two types of securities to other types of debt instruments. Determine if the additional complexity and possible negative features is a fair trade-off or if other types of bonds are a better choice. 

The Next Installment

Your next installment, Part V, covers convertibles. Convertibles are considered a hybrid security and are not frequently used by advisors. You may find that this is a worthy addition to your arsenal. You will receive Part V in a few days. 

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

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