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Foundations of MBS Investing

During the 2008 credit crisis, MBS developed a bad rap, and understandably so. But now more than a decade on from the crisis, the landscape is changed such that the diversification benefits and good yield opportunity offered by MBS are recapturing the attention of investors

Of course, contributing to the improved safety record of MBS are now long-standing regulations like Dodd-Frank Wall Street Reform, which was designed to tighten restrictions on financial institutions in order to prevent crises like this from happening again. And presently, the number of delinquent borrowers in the US is at a record low since the crisis. All of this is good news for investors interested in expanding their portfolio with MBS assets.

How do MBS work?

An MBS is created when a mortgage loan is extended by a financial institution to finance a borrower’s house or other dwelling. The borrower then repays the loan over time (often in 15 or 30 years), by paying monthly installments to the financial institution. 

In order to get funds to write more loans, lenders will pool groups of mortgages together. The pools of mortgages are then sold as securities by entities such as, in the US, Freddie Mac or Fannie Mae. The money that a given borrower pays towards their loan is distributed to the securities holders.1

Types of MBS

The two most common forms of MBS are Pass-Throughs and Collateralized Mortgage Obligations (CMOs).

Pass-Throughs: A pass-through (or agency security) is a pool of fixed income securities backed by a bundle of assets. Investors make their money by obtaining a share of cash flows from the underlying pool of mortgage loans. This is perhaps the simplest and most popular type of MBS.

A clear benefit of these “agency securities” is the financial guarantee offered by the government-sponsored enterprise (GSE). Thus, if a mortgage borrower defaults in the underlying pool, the GSE will make up the principal shortfall to the pass-through investors. This effectively removes credit risk from agency MBS investing.

CMOs: This form of MBS traditionally carries more risk, as CMOs are often issued by private financial firms and do not have the same guarantees in place as agency MBS. Often mortgages contained in CMOs are ones that have been extended to “higher-risk” homeowners with potentially a less reliable payment history, poorer credit, and an increased likelihood to default. So, there is greater risk to consider here. Back in 2007-2008, this became a real problem, when a rush of borrowers defaulted on their home loans and precipitated the financial crisis.

However, on the flipside these mortgages are often extended at a higher rate because of the risky financial position of the borrowers. Thus, some investors choose to swallow the risk in hopes of gaining a higher yield than other securities can offer. Furthermore, nowadays non-agency securities are typically safer. Still in all, they make up only a small percent of total MBS issued. 

MBS and Specialized Considerations 

What we hear from our clients, is the largest challenge they have with MBS comes down to modeling. The fact is that MBS are a complex investment type, and thus require very specialized modeling considerations.

To get MBS modeling right, you need access to a highly flexible MBS analytics framework. Modeling MBS is an area where FINCAD F3 shines and offers unique advantages over other providers out there. 

F3’s MBS framework design is generic and flexible enough to support any kind of MBS analysis that you want to carry out. Using F3, you can identify the fundamental concepts in your analysis workflow. From there, you can use these concepts as building blocks that combine to form a complete MBS analytics system.

Another area that sets F3 apart is that it provides one consistent modeling framework to be used across all assets in your portfolio, including MBS. So, you are able to model, value and run risk on your entire portfolio of securities and derivatives—and even build out custom reporting for all of it. This is an ability that no other MBS modeling solution provider has matched to date and one that has proven very advantageous for our clients.

For more information on modeling MBS, check out our related blog: Is MBS investing picking up steam? 

1 Investor’s Guide: Mortgage-backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs), Fidelity Investment: https://www.fidelity.com/static/dcle/learning-center/documents/MBS-CMOs.pdf

About the author

Eric Peng's picture

Eric Peng

Senior Manager, Quantitative Framework, FINCAD

Eric Peng is Senior Manager, Quantitative Framework at FINCAD, where he supervises a team of quantitative analysts and works on analytics research and development. Prior to joining FINCAD, Eric held positions at Manulife Financial and the Canada Pension Plan Investment Board. He holds a Master of Mathematical Finance from the University of Toronto, and a BSc in Mathematics from the University of British Columbia.

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