Mortgage Backed Securities

Wed, Nov 5, 2008

Mortgage Backed Securities Basics
BY JAY DROZD chammond
Certified Mortgage
[Part 1] [Part 2] [Part 3] [Part 4] [Return to the blog] Planning Specialist
Mortgage Network, Inc
Deciphering the Greek
clint-hammond.com

Now that there are graphs and MBS prices posted periodically, chammond@mortgagenetwork...
we've received numerous questions about the significance of the Phone: (803) 771-6933
data. This is intended to be a brief companion to the daily mortgage Mobile: (803) 422-6797
rate analysis that will "get you by" until we release more Fax: (803) 771-6944
comprehensive literature on the topic. To some of you this will be
Facebook
old hat, but I'll start completely at the beginning so it is accessible
Twitter
even to the first timer. Keep in mind this will be brutally
oversimplified due to the fact that a more detailed version will be Linked In
released at a later date.

What is MBS?
Any time you see me write MBS in this blog, or anywhere else for that matter, I am always going to
be referring to Mortgage Backed Securities. These are bonds that have a PRICE and a YIELD just
like treasuries. The PRICE always refers to the cost of buying $100 of that particular bond. For
instance, if the price of a bond is 101.00, then an investor would pay $101.00, and in exchange,
would then own only $100.00 worth of that bond. So why pay more or less?

In a word: YIELD. Yield is the rate of return paid on that bond over time. There are multiple different
types of bonds, and each bond has a certain yield that it pays. You will sometimes hear me refer to
yield as "coupon" or "issue." As you might guess, the higher the yield, the more the buyer will make
over time, so the more the buyer is willing to pay. For instance, at the very moment this tutorial is
being typed, a certain class of MBS (a bond) with a 5% yield costs $97.25. So for every $97.25 you
spend, you get $100 dollars of bond, paying you back at a 5% rate of return. Another bond in the
same class with a yield of 6.5% is currently costing $103.10. So you'd have to pay over the face
value to get the $100 dollars to pay you back at 6.5%. So hopefully this illustrates as we move from
coupon to coupon (i.e. 5% to 5.5% to 6.0% to 6.5%) that the cost of ownership will get higher, but
so will the yield.

Now it gets confusing because all this time I've been telling you that "as PRICE goes up, YIELD
goes down." Well, it does, but only when we're talking about one coupon at a time. Talking about the
full spectrum of coupon rates means that naturally the price will be higher when we're talking about
higher yields. But that concept is not central to bond analysis. We are only ever interest in Price
VS. Yield as it relates to supply and demand, and even if we are considering several coupon rates,
we will only analyze one at a time.

In this way, when price goes up, yield goes down. Why!? Because if the bond's coupon rate is 6.5%
and the price drops from 103.10 to 102.10, now the investor that is buying it gets more for his
money, plain and simple. So because his 1 million dollars now buys almost 1% MORE than it did at
the higher price, the yield on that investment will be higher as well! If this doesn't click for you,
please spend some time google searching bonds or try PIMCO's Bond Basics. I'm not saying this to
be pedantic or derogatory, but rather because the concept requires immersion for some, and there is
a definite learning curve that cannot be achieved simply by trying to digest my definitions. Moving
on...

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Wed, Nov 5, 2008

Mortgage Backed Bonds and Securitization
Certified Mortgage
So MBS's are bonds! Where do they come from?
clint-hammond.com

Grossly oversimplified and leaving out numerous items that are not chammond@mortgagenetwork...
germane to rate analysis, MBS are the bonds that mortgage loans Phone: (803) 771-6933
are turned into when they are bought or sold. That's a tough one to Mobile: (803) 422-6797
grasp your first time around. I know it was for me. Fax: (803) 771-6944
Facebook
Basically, Big Bank will write a check for your mortgage, say it's Twitter
$100,000. Big Bank A then has a promissory note saying that you
Linked In
will pay them a certain interest rate over time (sound familiar?). But
Big Bank A needs some more money to lend other people... Where
to get it? I know! They can sell your mortgage note to someone else
in the form of a bond! Hopefully, that investor is willing to pay something like $102,000 for the right to
collect interest on your $100,000 loan. Big Bank A just made $2000, and the investor has something
that will hopefully pay them interest over time. Remember price vs. yield? The higher your interest
rate, the more the investor would be willing to pay Big Bank A. That's YSP Baby! And if the investor
is only going to pay $97,000 for the loan, that means Big Bank has to pay them a discount to buy it,
which was probably passed on to you on line 802 of the GFE! Now YSP starts to become clear I
hope!

But there's a big problem! The investor doesn't want all of their risk riding on one loan, so we have to
find a way to spread out the risk. Because even if you only have a 3% chance of defaulting, in the
event that you do, the investor would lose his hat. So to spread out the risk, Big Bank A combines
your loan with 10's to hundreds of other similar loans with similar rates and similar credit quality.

Then either by selling them directly to Fannie Mae and Freddie Mac or by utilizing Fannie and
Freddies Protocols and doing it themselves, Big Bank A accomplished what is known as
SECURITIZATION. Now the "pool" (collective of all the bundled loans which will now be in the
millions of dollars) can be broken up into bond-sized chunks. Now instead of buying one loan for
$100,000 dollars (give or take), and investor can buy a portion of 10's to hundred's of loans for the
same amount of money, with the same rate of return, with the same risk of default. BUT NOW, if you
apply the 3% rate of default, the investor only loses 3%! Brilliant! And it's a concept that has allowed
a significantly larger amount of money to be available for home loans than ever before.


Wed, Nov 5, 2008

Why do MBS's matter to mortgage rates?
Certified Mortgage
We just said that investors are paying 102% of the face value of a
bond in certain cases right? So what happens if they are not clint-hammond.com
interested at that price any more? No more liquidity for the chammond@mortgagenetwork...
mortgage market. So how do you combat this? In a nutshell, the Phone: (803) 771-6933
market forces of supply and demand take care of it. If demand for a Mobile: (803) 422-6797
bond is low when the price is 102.00, then the sellers of the bonds Fax: (803) 771-6944
may lower the price to 101.50 to ENTICE investors to start buying
again. And what did we already say would happen to the YIELD Facebook
when the price got lower for a particular issue? It goes UP because Twitter
the same money the investor was going to spend, now buys more Linked In
shares. So their rate of return per dollar spent (yield) goes up.

Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the
same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES
OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE,
DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.

That is why we want to follow MBS instead of any other treasury or index in order to gauge the
direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up
(Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon,
which means they can originate a loan for your clients with either a slightly lower interest rate or a
slightly higher YSP. Your choice!

So that is the theme of any mortgage market analysis. We want to assess the movements of MBS
prices (which change by the second), in conjunction with the macroeconomic climate, in order to
determine which way they might be headed and what future events can have an impact.

For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if
inflation has devalued the dollar over time, the bond is not really worth as much as when it first was
purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another
popular correlation is that a booming economy draws money out of bonds and into more rapidly
appreciating stocks. This causes bond owners to lower the price to entice buyers which raises
mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will
almost always see recessions coincide with low rates.

Beyond that, there's only a little more you need to know when reading my analysis.

1. First of all, there are several coupon rates ranging from 4.5%-7.5%. Right now, we primarily
track the 5.5% coupon and the 6.0% coupon as most of the trades are taking place in that
range, giving us a higher sample size and thus more reliable data. We will always report on
the bond coupons that are closest to PAR for this reason (par meaning a cost of 100.00).

2. Bonds move in 32nds. So 101-32 would actually be 102-00. And 101-16 would actually be
101.50 in decimal form. So when you see prices improve by 16/32nds, that means that at
some point in the future, lenders have the ability to improve the YSP on rate sheets by .500.
NOW, in this day and age, lenders are not quick to pass on a price improvement to its full
effect. They want to see the market hold its gains for a bit. However, if the market worsens,
they will hedge their positions by taking even more away from you than they have lost on
price. This is just smart business, and it's a balancing act between lenders to see who
reprices and by how much. I will often times refer to 32nds as TICKS. So if I say "we're down
6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined in price by
6/32nds from yesterday's close. Lot less typing my way!

3. Tight or Wide. Bond investors have a choice between MBS and other types of bonds. The
benchmark competitor is the US 10 year treasury. MBS price relative to treasury price is
important because even if mortgage prices go up on the day, if treasury prices go up a whole
lot more, the MBS will still be the better investment all other things being equal. Because
there is a significantly higher amount of risk in MBS than in treasuries, the MBS prices will
ALWAYS be lower than treasury prices for a similar coupon amount. So when prices rise on
MBS and "close the gap" on treasuries, we say "MBS are trading tighter." You might also
hear "tighter to the curve," meaning the yield curve. Wide is simply the opposite.

4. Graphs. Hopefully the graphs I've been posting make much more sense now. They are
simply tracking the curve of the price of a particular coupon throughout the day. As the curve
gets higher, rates have the potential to go lower and vice versa. There is a school of thought
known as "technical analysis," which some think is crazy voodoo, while others think it is
gospel. Basically, technical analysis throws all economical analysis out the window and
simply focuses on the numbers, what they have done in the past, their propensity to "obey"
certain trends, their resistance to certain price floors or ceilings, etc... I am a fence-sitter
when it comes to Technicals. I will comment on them, but always keep in mind that
technical analysis must be considered in conjunction with the rapidly changing economic
climate.

So for instance, if I say "there is a price floor today that has been established at 99-16," that
means that bond prices have resisted going below the horizontal line on the graph at the 99-
16 mark. If bonds then were to break through that floor and go lower, it could indicate a
potential increase in pressure to sell, which would hurt rates. Hope that makes sense.





Wed, Nov 5, 2008

Some Final Thoughts
Certified Mortgage
A couple final thoughts...
clint-hammond.com

Lenders release rates at different times. They have different chammond@mortgagenetwork...
mentalities when it comes to pricing. I comment on MBS, not on Phone: (803) 771-6933
particular lenders. What your lender does can vary greatly from what Mobile: (803) 422-6797
is available them on MBS markets, especially if they are overworked Fax: (803) 771-6944
or underfunded.
Facebook
Twitter
Other services may tell you what you want to hear and some may
Linked In
take pride in their strong stance on lock recommendations. The bad
news for you and them is that lock recommendations can only ever
be accurate enough to help you if you are talking about a VERY
short time horizon. So I will present you with the raw data, give you my personal analysis of it,
present you with the potential outcomes from impending data, and suggest that you apply your own
lens to the facts. The exception is that we are all pretty accurate when it comes to reprice alerts.
Just make sure to keep track of who gets em to you quickest and cheapest.

If you've read this far, it means you are more dedicated to understanding the mortgage market
than 90% of your peers. It is very rewarding when a client chooses you because of your
understanding of the subject. It is even more rewarding when you see a .500 YSP reprice 30 minutes
before it hits on a $400,000 loan! So if you're not in the boat already, I invite you to come track the
mortgage market with me, learn from the data, share your thoughts about how what I am doing can
be improved, and we can both continue to improve together by delivering a higher level of quality to
our readers. Thanks!





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