Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

RETIREMENT INCOME

Part IV

RETIREMENT INCOME 1

PART IV

IBF | MINI-COURSE SERIES

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 in-

stead of semiannually like other fixed income securities. MBSs are known as pass-

throughs 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 pack-

aged 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 con-

vexity 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 fall-

ing 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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PART IV

IBF | MINI-COURSE SERIES

Types of Mortgage-Backed Securities

GNMA

Freddie Mac

PC

Freddie Mac

GMC

FNMA

CMBS

Mortgage-Backed

Payment

Stream Monthly Monthly 2x Year Monthly 2x Year

Underlying

Asset FHA/VA

mortgages

Conventional

Mortgages

Conventional

Mortgages

Conventional

Mortgages General Assets

Guarantee Treasury

full faith

and credit

Freddie

Mac’s net

worth and

private mort-

gage insur-

ance

Freddie

Mac’s net

worth and

private mort-

gage

insurance

Freddie

Mac’s net

worth and

private

mortgage

insurance

Overcollateralized

by 150-200%

with mortgage

portfolio

Liquidity Active

market Active mar-

ket

Less active Unknown at

this time

Same as

Institutional PC

Rating /

Risk

Government

security

~ Govern-

ment security

Same as

Freddie Mac

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 al-

ternative, the federal government created a number of agencies to facilitate mortgage

lending.

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PART IV

IBF | MINI-COURSE SERIES

Mortgage-backed issuers (originators) either issue “private” securities where mortgage

payments are passed through directly to investors or issue securities backed by a guaran-

tor such as a government agency. Private-label bonds are subject to the individual com-

pany’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 Ur-

ban Development (HUD). GNMAs are made up of mortgages that are Federal Housing

Administration (FHA) insured or Veterans Administration (VA) guaranteed. The gov-

ernment 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. How-

ever, 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 con-

ventional 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 in-

vestor 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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PART IV

IBF | MINI-COURSE SERIES

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 tra-

ditional callable bonds that are called away at a premium on specific dates, bits and piec-

es 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 small-

er. Even though the interest rate remains constant, the income paid to the investor de-

clines. 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 diminish-

es.

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. Av-

erage 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.

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PART IV

IBF | MINI-COURSE SERIES

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 av-

erage life shortens because you are getting principal back more quickly. So, the expecta-

tion 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 in-

vestments. 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-of-

the-month club: artificial financial alternatives. In the 1990s, the product du jour was the

collateralized mortgage obligation (CMO). Before the CMO was conceived, institu-

tional investors backed away from an MBS, complaining the securities’ negative con-

vexity 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 un-

derstand how all the pieces behave, not just the one you are buying.

RETIREMENT INCOME 6

PART IV

IBF | MINI-COURSE SERIES

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. Re-

member: 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 addi-

tional 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 hy-

brid security and are not frequently used by advisors. You may find that this is a wor-

thy 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 Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o 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.