Turning pitfalls into opportunities.

Author:Hu, Joseph C.
Position:Mortgage-backed securities

Last year was an unusually rough year for investors in mortgage-backed securities. Runaway prepayments wreaked havoc on the average lifespan of the pools backing these securities. But the pitfalls of 1993 may have created the opportunities of 1994 for MBS investors.

MORTGAGE-BACKED SECURITIES HAVE ENJOYED A reputation for being high yielding, liquid and safe. But last year mortgage-backed securities produced a total return almost 400 basis points less than that of composite Treasury securities with one-year or longer maturities. Needless to say, this performance greatly disappointed mortgage investors.

What went wrong? Is the high-yielding aspect of mortgage securities fictitious? Can mortgage securities be counted on to deliver greater returns than Treasuries? Or is that assumption no longer valid?

In my view, what went wrong (for MBS investors) in 1993 was the unexpected 140 basis point drop in long-term mortgage rates--taking these rates to their lowest level in 25 years. In an environment marked by substantial changes in mortgage rates, mortgage securities tend to underperform Treasuries. But that does not change the underlying fact that mortgage securities are high-yielding instruments that can indeed provide significantly greater returns than Treasuries. To help put last year's performance in perspective, it would be helpfull to take a moment to point out a few important facts about investment in mortgage securities.

It is important to understand first that "mortgage-backed security" is a generic term covering many types of securities. But the rawest and simplest form of mortgage security is the single-class mortgage pass-through. As of year-end 1993, the outstanding balance of single-class mortgage pass-throughs stood at $1.5 trillion. Of this, about 90 percent are agency-guaranteed pass-throughs (which I will refer to as agency securities). The other 10 percent are private-label pass-throughs whose credit is enhanced most commonly through a senior/subordinate cash flow structure. In such offerings, the senior class usually obtains a top credit rating from the rating agencies. The credit rating of the subordinate class varies depending on the specific issue. But the house price appreciation on the underlying collateral is a critical element for sustaining the credit of the subordinate class.

It is also important when evaluating this market to understand that about 94 percent of agency securities carry a fixed-rate coupon and 55 percent of fixed-rate agency securities have been acquired by Fannie Mae and Freddie Mac for the reissuance of multiclass pass-throughs out of Real Estate Mortgage Investment Conduits (REMICs). In common parlance, these REMIC securities are still referred to as collateralized mortgage obligations (CMOs)--the original form of multiclass mortgage securities. The cash flow of single-class pass-through collateral is segmented to form multiclass pass-throughs. For each REMIC issue, there is a unique schedule of priority for the multiple maturity classes to receive principal repayment (amortized) and prepayment (unamortized) of the underlying collateral.

An additional crucial element to understanding the workings of the MBS market is the knowledge that because mortgages are prepayable at par before maturity, the average life of a mortgage pass-through is always far shorter than its stated final maturity. (If a security's principal payback is heavily front ended, its average life will be substantially shorter than maturity. Conversely, for a security with no principal payback until final maturity, such as a Treasury security, its average life is maturity.) The average life of a mortgage security is computed on the assumption of its future prepayment, which, of course, is unknown to investors at the time of investment.

Another fundamental characteristic of this market is that prepayment occurs primarily as a result of refinancing and housing transactions. Both depend critically on changes in interest rates. Thus, investors make assumptions about future prepayment according to their expectations of interest rates. The assumptions also take into consideration past prepayment patterns under various interest rate environments.

Further, the prepayment assumption has to recognize the coupon rate of the pass-through. Given its age, a higher coupon pass-through generally prepays faster than its lower-coupon counterpart because its underlying mortgages are more likely to be refinanced. All coupons, however, are equally likely to prepay when the prepayment is a result of a housing sales transaction. In general, higher coupon pass-throughs have shorter average lives than lower coupons. Pass-through...

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