Mortgage-Backed Securities

Good Morning! On today’s walk, we’re going to talk about mortgage-backed securities– MBS. But at its core, we’re talking about securitization. That’s a very large, fancy word for making products that pay cash as their value. You can’t talk MBS without understanding securitization and debt.

I’ll touch on debt in a second. But if you’ve never heard of securitization… let’s take a moment. Think about a payment– outside of mortgage payments– that everyone you know makes monthly. Two things I can think of… one big, one small. The big one: credit card payments… and most people do the worst thing possible and pay only the minimum required from their bank on their credit card. Monthly. So they keep paying $50 let’s say a month. Now hold that thought. Here’s the smaller example of payments everyone makes– or at least everyone wealthy makes: 99 cents per month for Apple’s iPhone-iCloud storage. I personally have grown numb to the 99 cent monthly charge. And my wife who takes enough pictures to fill a library every day pays $5 a month. Like clockwork.

Now imagine that I wanted to sell you cash flow. You have money but you want to buy more money, a regular monthly flow of money. I could buy a million people’s credit card debt… that those million people are still paying for every month… minimum due, minimum due, minimum due– and I could securitize that cash flow. Meaning I could sell you the cash flow I get from those million people paying off their credit cards. They keep paying monthly…. They think their money is going to their bank… but its going to me now… and I’ve sold it to you. Their monthly goes to the bank then to me then to you.

That’s me securitizing credit card debt. Credit-Card-Backed Securities.

One more example. That Apple iCloud payment I make (which I’m not paying interest… but still illustrative of potential securitization). I’m confident that a 100M other iPhone users also make it. In theory, I could buy that regular stream of income from Apple… package it as a cash-flow-producing product and sell it to you. So all those iPhone users– who have no idea how to download their pictures to their pc… for free… all those iPhone users who will make 99 cent payments for the rest of their lives… they would keep paying Apple, Apple would forward that cash to me… and I would sell that cash flow as iCloud-Based Securities.

You just need to find something that large numbers of people are compelled to pay for– preferably that they’re paying interest on… buy that debt from whoever is receiving the monthly checks… package it as a cash-producing product and get pension funds to buy it.

Easy peezy.

Apply that iCloud principle to your parent’s mortgage and you get mortgage-backed securities.

That’s the high level. On this walk, I’ll get into the details about the more commonly encountered types of mortgage-backed securities– what are called pass-through securities– and do a tiny bit on CMOs (collateralized mortgage obligations)-- don’t worry I’ll explain that– as well as a lot of the concepts used to assess the attractiveness of mortgage-backed securities and I’ll get into some details that should help you understand the mortgage securities market and how it works.

I said I’d also touch on debt. If you’re not familiar with debt instruments– D.E.B.T debt instruments– they’re assets that require a fixed payment to the holder, usually with interest. Examples would be bonds (government or corporate) and mortgages. Debt instruments are the boring cousin of equity instruments – you know, the flashy, stock market.

Who buys debt instruments? Usually, it’s institutional players– corporations, governments– that have a lower risk tolerance than those crazy hedge fund nuts. Institutions that can’t lose the money that they’re safeguarding… like pensions. Imagine that you’re ready to retire and you get a letter from your pension saying “sorry, we lost it all on Gamestop.” Not cool.

And it's not *just* institutions that hold debt instruments. If you have a well-balanced portfolio, debt instruments help diversify that portfolio… reducing your risk… earning you reliable monthly income…. fixed income.

So mortgage-backed securities are debt instruments built by pooling large numbers of similar individual mortgage contracts– securitized into products where you’re selling their cash flow. Securitization: the process by which certain types of debt (99c iCloud storage or $99 credit card payments or $9K mortgage payments) are pooled as assets so that they can be repackaged into interest-bearing securities. The payments from the assets in the pool are passed through to the purchasers of the securities.

Ok… we’ll soon get into the detail of the most common type of mortgage-backed securities, which I already said are known as pass-through securities. That'll be a good starting point for learning about mortgages– before they’re securitized… and what the process of securitization entails.

I’ll also talk about what causes mortgages to have risks that differ from all those other types of securities. Risks like the uncertainty related to the prepayment, what’s called prepayment risk– which I’ll define shortly. And I’ll touch on other big words that have easy definitions like “embedded optionality” and “uncertain average life” – which would be a great title for my autobiography.

If I have time on this walk, I’ll get into the numbers involved: concepts like the rate of return, price, prepayment rates… but if I don’t you can google that… and I’ll probably need a second walk to get into all the different types of mortgage-backed security… you know… the ones that are more complicated than pass-through securities. Those are the CMOs I mention 1000 yards back… collateralized mortgage obligations… C.M.O.

Ok… let’s talk risk.

TITLE: CREDIT RISK

What is a mortgage-backed security? It is an investment where the cash flows to investors come from mortgage loans– not one mortgage loan but a group of mortgage loans held together in some legal entity. That entity is also called a mortgage pool. And these structures can get complicated… and I’ll try to touch on some of that on this walk.

But that's what distinguishes mortgage-backed securities from other sorts of investments. The cash flows to investors are being paid by borrowers who are just paying their mortgage loans. And that money– after passing through some number of hands– ends up in the hands of investors.

Now, just that cash flow would be compelling enough as a product– but it’s better than that with mortgage-backed securities because many also have additional guarantees or credit enhancements… which means that when some poor person whose mortgage is in the pool.. when he or she or they… can’t make their mortgage payment– when they default or are delinquent… there’s some other source of cash, like a government or government agency guarantee, some sort of private insurance or cash reserves built inside of the structure itself… that makes up for that potential loss. So you’re not getting *potential* cash flow. It’s guaranteed.

Not all mortgaged-backed securities are that solid… as 2008 showed us… but we’ll get to that… because as with all my walks, we’ll talk risk… not generally… like the risks in other debt instruments… fixed income securities… like – what’s a good example of a general risk? Inflation and its negative impacts on the investor’s purchasing power. That’s a standard risk.

Mortgage-backed securities have their own flavor of risks. It’s a little more spicy.

Two broad categories of risk.

One relates to the uncertainty around how slowly or quickly the borrower– the mortgagor– is going to pay off the loan. And the other big risk– especially for investors who care about the credit quality of what they’re buying– is the complexity around what’s called “average life.” The story of my life… In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization. Investors use the average life calculation to measure the risk associated with amortizing bonds, loans, and what we’re talking about: mortgage-backed securities.

And while we’re riffin’ on risk, there’s also credit risk… which is the possibility of loss tied to a borrower's defaulting on a loan or not meeting contractual obligations. That credit risk is mitigated by guarantees that make certain mortgage-backed securities golden. Little confession: I’ve memorized some credit-score ranges exactly for this and we’ll get into it in about a mile.

Just know– before we get there– that there are certain types of mortgage-backed securities that mitigate credit risk because they’re backed by a government or government agency guarantee. Zero chance that I won’t mentions those agencies: Ginnie Mae, Fannie Mae, Freddie Mac… there I mentioned them.

They’re not the only providers of mortgage-backed securities– which should tell you that there are plenty of mortgage-backed securities that are NOT protected by any sort of guarantee… where credit risk leads to credit crisis. Think 2008 financial crisis… which I’ll also mention on the walk.

You can’t talk about MBS without understanding credit risk. Two kinds.

One revolves around the question of the quality of the loans… something called the underwriting standards (industry jargon for the rules that determine whether a borrower is worthy of credit… if they rise up to the standard of a good mortgage taker).

How serious are lenders in figuring that out? Deadly serious. Because the credit quality of the borrower will determine in large part whether the lender can get the mortgage off their books… by selling it into a pool.

It’s in the name of credit risk that everyone in the biz asks questions like: was there a large or small down payment, what sort of income or assets did the borrower have to fall back on? Why was the property purchased? Is the property going to be the borrower’s primary residence? Or was it purchased as an investment?

And as we'll see later on the walk, all of those answers go into assessing the creditworthiness of the larger pool of assets that are bundled into mortgage-backed securities… and all of those answers go into assessing the amount of credit risk investors in mortgage-backed securities are exposed to.

The other question worth asking: are there any guarantees or credit enhancements that can offset credit risk.

TITLE: CREATING A MORTGAGE POOL (Syndication)

So, let’s talk origin story. How are mortgage-backed securities created or syndicated? The process– called origination or asset securitization– involves 1) creating an underlying legal structure… also called a pool. 2) Filling that legal entity with a ton of similar mortgages, and then 3) selling the cash flow from that pool to investors. That is asset securitization in 3 steps.

That's the most basic sort of structuring that goes on: the pooling together of a bunch of mortgage loans, usually very homogeneous loans. So asset securitization uses the money that those people with mortgages in the pool to serve as cash flow to investors.

Why is it important that you do it at scale– to buy a pool… not just one or two mortgages? Well, there are two reasons securitized loans– POOLS– are more attractive than individual loans.

One is the benefit of diversification because by investing in the pool, in effect, you offset all the hiccups that happen in onesies and twosies. They become tolerable blips in large pools. So your investment is diversified across many borrowers as opposed to only one borrower if you were to own only one or two mortgages.

The other potential advantage to a POOL is that in general, securitized assets are going to be a lot more liquid– easy to sell. Part of the securitization process is structuring these instruments in a form that makes the ownership interest relatively easily transferred to some other party as opposed to the difficulty of selling one or two individual mortgage loans. Think of all the lawyers you’ll need if you’re doing onesie-twosies. Individual mortgage loans *can* be traded between parties, but each loan is a unique document (this thick), and moving it around will require going over the details in [same visual queue].

Because of the standardization of these structures– these pools– they all have common features… like a common legal framework… it makes the transfer of ownership for a piece of that pool from one holder to another relatively painless. Fewer lawyers. It’s never no lawyers. Fewer is better.

And with a POOL your investment is diversified and more liquid. And that’s by design. These markets were created by governments to grow homeownership… by making mortgage markets work more efficiently. POOLs also help recycle capital back into the lending system… in theory, allowing borrowers to land the loans they need to buy their dream homes. And that, in theory, benefits those governments and their societies, because property ownership leads to responsible citizenship. In theory.

I know plenty of homeowners who are terrible. I call them my friends.

Now, that is one part of the structuring– a fancy word for designing– so one part of designing structured securities. The other part is designing/structuring the payout to investors.

The first kind of securities we’re going to talk about– the pass-through securities– there is no structuring of the payouts. Everyone gets a proportional share of the cash flows. The downside is investors have a relatively harder time managing the risk exposure of holding that investment.

That’s why the product matured to have structured payouts… which I’ll explain further down… probably when we talk about collateralized mortgage obligation.

But first, let’s understand the trees in this forest– the individual mortgages.

TITLE: From Mom and Dad’s Boring Mortgage to Sexy Financial Product

Historically– pre-1970, pre-securitization– loans just sat there earning interest as boring assets on the balance sheet of the lender. Yawn. The mortgages would just watch paint dry as interest-earning assets for the entire life of the loan.

Then… someone on Wall Street saw a way to make it sexy… well, sexy by Wall Street standards– This was the 1970s and lenders started selling those loans to parties that would securitize them– pool the loans– and allow investors to would buy an interest in that pool of loans.

I want to buy a house. So I’d go to a lender– usually a bank– and they’d sell me a 30-year loan…. But only after I’d put 10% down… 10% of the home’s cost. My money. Why? They wanted me to have skin in the game. Back then, a home cost $100K. I’d put down $10K… which was a lot of money back then… and I’d pay the other $90K plus interest over the next 30 years. In the first few years of the loan, I’d do anything to keep paying my mortgage because I didn’t want to lose that $10K. And that fear of loss would grow with each passing year. Because after 10 years of paying my loan, I’ve built equity in the home. I don’t own $10K worth of that home anymore. I own $30K. So the incentive to keep paying the mortgage would grow with time…. Making a mortgage loan one of the safest uses of a bank’s money.

Then securitization came along… and the banks who had all these safe, individual loans sitting on their balance sheets… realized that they could make more money on them by selling them to the syndicator of the pool– the creator of these giant mortgage pools. The bank or lender would get an interest in that loan pool in return for handing their safe loans over to the creator of the pool.

Now I’m still that guy in the 1970s with the $90K mortgage. I’m paying it off month-by-month… and each month, I’m paying mostly interest (in the first 10 years of the loan) and if I’m lucky, a little piece of the principal… I pay more and more of the principal towards the back end of the 30 years.

As the borrower, I just think I’m paying my bank each month. But once my mortgage becomes a part of a pool, I… along with everyone else who owns a mortgage in that pool… are actually paying the investors in that securitized pool.

The interest I’m paying– the interest everyone in that pool is paying– is cash flow to the investors of that pool. That loan pool is actually a legal entity… a trust or a corporation. And all monthly income (the interest we’re paying and the principal we’re paying) is passed to investors in that legal entity… Those investors are getting our payments based on their percent participation in that pool. Meaning if I own 50% of that pool, I get 50% of all the money that the pool is generating. Not exactly 50% because the people who put the pool together charge various fees and expenses… but enough of the money– of all of those homeowners' monthly checks– comes thru to make it an attractive investment for certain investors, like large mutual funds, or any large institutions charged with protecting and investing people's money. Hell, the U.S. government buys mortgage-backed securities. Up until the syndicators– the creators of the pools– started messing around with sub-prime loans (garbage loans to people who weren’t going to lose any of their money if they stopped paying their mortgages)... up until then, mortgage-backed securities were solid, safe investment vehicles. We’ll get into the why later on the walk.

TITLE: How Investors Get Paid (Pay-Through vs Pass-Through)

How does the distribution to the investors work? Depends on the securitization. For instance, I kept using the term pass-through… which basically means that the money given to the loan pool (by all the mortgage owners in that pool) is passed-thru to the investors. Investors get their percent share, their pro-rata, their pre-agreed, fair share… of every dollar passing through. But that’s pass-thru.

There’s also another structure called a pay-through… where all the money the pool collects will pay out (minus fees and expenses) to investors… based on tranches… or groups that are organized by their risk, reward, and cost. Let me explain but first, let me use those three big words again… collateralized mortgage obligations (CMO)...

If I’m the syndicator and I’ve made this pool of a thousand mortgages, I can start to slice and dice them to produce bundles within those 1000 mortgages that are safer (and therefore more expensive) or riskier (and therefore less expensive). I can create these bundles… these tranches… that would appeal to different kinds of buyers. I can name those bundles, those tranches, something that signals their risk-reward-and-cost… like a silver, gold, and platinum tranche… or a double-A, triple-A, or a zillion-A tranche.

As a syndicator, it’s in my best interest to offer different risk-reward-cost bundles at different prices because there are investors with different needs.

But that’s what a pay-through structure is… as opposed to a pass-thru structure. A pay-thru says “hey, if you bought the platinum bundle, the triple-A, you get more, or better than the gold-double-A… and that gold-double-A gets more, or better than the silver-single-A…. And the word better— for these investors– is always tied to risk management. For instance, if something awful happens with the pool, an investor defines “better” as “being paid out before all the other investors who are in line.”

You pay more for platinum-tripleA so you can sleep easier at night.

So the best bundle or tranche of a collateralized mortgage obligation (CMO) would be like… not only do you get the interest being paid on these loans, but you also get the principal… which lower tiers or tranches don’t get. OR… not only do you get more of the principal and interest, but if something goes boom, you get paid out first.

So you see this kind of differentiation across all tranched or CMO sorts of investments.

While the vast majority of investors in the various tranches will be earning some interest from the pool, there’s a first-class cabin on that plane… which you pay more for… and in there, you get champagne (principle) and caviar (risk-reduction like… if this plane goes down, you’re first out the exit). Not all investors want first-class tickets or can afford them. Some are fine with just interest… not monthly chunks of the principal. Some are fine with being in the row farthest back… because they know how to swim. The CMO product returns to investors the value that they’re willing to pay for… the kind of priority and access they’re willing to pay for…. And it’s done by having different tranches of risk-reward trade-offs.

So that’s a high-level view. Now let’s go deep.

TITLE: The Different Dimensions of a Mortgage (or Pool of Mortgages)

Cash flows. What is the source of cash flows for mortgage-backed securities?

Answer: The individual mortgages on various types of property. The vast majority of mortgage-backed securities are what they refer to as RMBS, the R before MBS stands for residential. So the vast majority of mortgage securitizations are based on people’s homes– residential properties.

But that’s not all. There are also C-MBS… and the C stands for commercial… people’s businesses.

This is a good point to introduce 2 more terms of art. Industry-specific jargon: recourse and nonrecourse loans. This is a way of describing who you can sue and for what… if you’re a lender. You can also think about it as lender rights. What can they do if the borrower defaults on the loan?

There are nation-by-nation, jurisdiction-by-jurisdiction differences here. The US, for instance, is a non-recourse country. If I’m in the US and I default on my loan, because it’s a non-recourse country– my lender *can’t* go after any other personal assets of mine. They have no recourse… other than to recover their money by selling the property I took the loan on. As the borrower or mortgagor on that property, they can’t go after my car or my bank account…. They’re limited to repossessing any properties I pledged in the contract or the mortgaged property itself.

That's the only right the lender has if the loan is a non-recourse loan. That’s very uncommon outside the US. Around the world, it's much more common to give lenders recourse… to let them go after you… no holds barred.

So in the US, no matter how wealthy I am, no matter how many second and third homes I might have, no matter how much I have in the bank or in stocks, if I decide to walk away from my loan, the only recourse the lender has is repossession of the mortgaged property. We live in a remarkable country… one with limited financial consequences… remarkable or remarkably irresponsible. Potaytoes. Potaaatoes.

Lenders in the US have no right to go after any of our other personal assets.

Outside the US, god help you. It's mostly recourse loans. If you were to default on a property, you would end up being liable for the full amount of the unpaid debt, even if the lender has repossessed the property.

The point here is that the exposure of the investor (in a pool) or the lender is very heavily affected by whether the loan is considered recourse or nonrecourse.

What were we talking about? Different categories of MBS… the important dimensions that let you slice and dice mortgages and risk.

So… other categories of mortgages. They can be categorized by property type, the R and C in RMBS and CMBS… residential mortgage-backed securities (RMBS) or commercial mortgage-backed securities (CMBS). RMBS… where people live. CMBS… where people work and shop.

What else? Mortgages can be characterized by the terms of the loan. Was there a large down payment, a small down payment? No down payment? Was the borrower a prime borrower (credit score of 660-719) or a subprime borrower (credit scores of 580-619)? Man, he’s good with numbers. Did you know that there are people who are Super-prime borrowers? Their credit scores are 720 or above… and they can fly. They’re super.

Ok. Other terms… of the loan… that bundles can be characterized by? Are the loans fully amortizing or interest only? Fully amortized means that you’re paying down both the interest and the principal every month… while interest-only means… you really needed a lower monthly payment and made an unholy deal with the devil.

Other categories? Is it conforming or nonconforming? That is US-specific jargon for which agency underwriting guidelines are used. And that’s an important distinction because there’s a whole industry tied to conforming loans… giant businesses that securitize loans. Names like: Fannie Mae, Freddie Mac, Ginnie Mae…. all these giant mortgage players are confined to securitizing conforming mortgage loans… because they satisfy their underwriting guidelines…. They conform to their underwriting standards. If you want to play with the big players, the big 3– well, you have to meet certain terms and conditions. Any loan that doesn't satisfy those underwriting guidelines is non-conforming.

TITLE: Other Risks

Underwater mortgage: a mortgage where the loan balance– the amount you still owe somehow is more than the value of the house. Housing bubbles that burst tend to do that. If your loan balance exceeds the property value– if it’s underwater– you better love that house… or plan on living in it forever– because if you sell it right there and then, you might not get your equity back… the money that you put as a downpayment… and any amount you’ve chipped off the original principal by paying your mortgage up to this point. An underwater mortgage sounds awful for the homeowner– and it is, if they need to move soon– and for the mortgage pool that they’re in… well, that’s risk. The risk of the person who is underwater… just stepping away from the home and the mortgage.

Normally I’d say that an underwater mortgage is rare… and it is in good economic times– but I’ve lived through enough downturns– and the cycle of upturns to downturns seems to be speeding up. So… if there was a massive downturn in the 1930s… and then 40 years passed before there was another (in the 1970s)... the next one wasn’t in 40 years… it was in 20 (in the 90s)… and then again in the financial crisis of 2008.

I think it's reasonable to think that the lazy sine wave is going to get… more caffeinated… denser. From buuuuuuubble, crash to bubble, crash, bubble, crash.

In the last big downturn, 25% of residential real estate mortgages in the US were underwater. If you weren’t in the top tranches of RMBS– that triple-A platinum level… well, you got what you paid for.

So what happens to an underwater mortgage if the homeowner wants to walk away… or has to walk away? A short sale. That’s when the property is sold for less than the amount of the outstanding loan. The lender is screwed… another reason why lenders would bundle their loans for sale as RMBS… because then, the pool is screwed… the investors in the mortgage-backed security eat the risk. That’s actually why the process of securitization bundles thousands of loans together… to distribute the risk of just holding a small number of mortgages.

A short sale on an underwater mortgage, especially if it's a nonrecourse loan– the kind where you can’t go after the homeowner's other assets… well, someone’s eating that loss.

The risks of doing business.

If you get to a point where the amount of the outstanding loan– let’s call that the debt– where the amount of the debt is greater than the property value… and the loan is nonrecourse, you have an incentive as a mortgage-holder– the homeowner– to walk away from that loan.

The risk is lessened if that's my primary home… because no one wants to move back into Mom and Dad’s basement. So the quality of the loan– in that mortgage pool’s view– improves if the loan is for primary residences. That makes sense. If the loans in the pool are for second homes or investment properties… the kind you flip during bubble markets– well, that pool carries additional risk.

Most adults don’t walk away from their primary home. They bunker down and think long-term. Because down markets don’t last forever. What you’re really giving up by committing to be underwater is your optionality for moving.

That kind of commitment does not hold for investment properties. Most people walk away from those kinds of underwater loans, especially if it's non-recourse, because it’s completely transactional… much less emotion involved with investments than say, with the house that your kids grew up in.

So investor-owned, investment-driven properties where the loan is underwater, see a lot of walk-aways… and that lowers the quality of the pool… even before the walkaway happens.

TITLE: Deepening Your Personal Understanding of Mortgages

More definitions. What types of mortgages are there? Two broad categories. Fixed-rate and variable-rate. Fixed-rate… means that the interest you pay– the terms of the loan– remain the same for the life of the loan. 30-year-fixed means that your fundamentals– like your interest rate– remain the same for 30 years… until it’s fully paid off. And variable rate means that the interest rate– the fundamentals– will change. There’s a little bit of magical thinking that goes into taking a variable-rate loan…. Thoughts like: I’ll get a better interest rate in a few years. The bank clearly isn’t as smart as I am. What I’ve told my kids is simple: the bank is smarter. If the only loan you can afford is a variable rate, it’s not time to become a homeowner. Wait longer. Save more. Put more down. Never eat a hamburger today that you intend to pay for next week… and never ever… if the price of that burger is “market price.”

Anyway, you’re not my kids… and who knows, maybe you’re smarter than the banks. (Nod no.)

Movin’ on… the most common type of mortgage loan in the United States is something called a fully amortizing loan… which means you make every payment according to the original schedule on your loan… so if you have a 30-year-fixed… after 30 years of sticking to the same terms… your loan will be fully paid off. The word amortization just refers to the amount of principal and interest paid each month over the course of your loan.

All you need to know– as a borrower– on a fully amortizing loan is the amount you’re borrowing, your rate, and the term… how long. Let’s say you need a million dollars, the rate is currently 7%, and your term is 30 years…. Well, your fully amortizing loan calculates the amount of your monthly payment– all your monthly payments for the next 30 years– the life of the loan– 360 monthly payments… all that’s calculated before you sign any docs. It’s like clockwork. By your last payment, you will have paid off every cent… principal and interest. No drama.

If you enjoy drama: enter balloon loans… which is where I think Stephen King got his inspiration for the horror classic “It.” With balloon loans, you actually have 2 schedules. there's one schedule– an amortization schedule– where you're supposed to pay down the debt regularly, but there's also a balloon date… sometime in the future– usually 5 years from the first payment– the entire principal comes due. I don’t know anyone who actually pays the balloon. They just go to some other lender before that 5-year mark and refinance the loan. Kick the ball down the road. That’s the reason I think Stephen King called that balloon-carrying clown, Pennywise.

Balloon loans… red-balloon loans: pennywise, pound foolish.

Similarly, there’s a kind of mortgage called “Interest Only.” Because that's all you're paying for the first several years, the interest. It used to be tax-beneficial back in the day when you got breaks on the amount of interest you paid. But I’m not sure why a homeowner would take that option anymore.

Don’t get me wrong. On interest-only loans, you’re not JUST paying the interest… you’re paying the principal too. There's something called a maturity date of the interest-only loan– on which–the full amount borrowed becomes due.

The advantage– outside of the old tax laws– is that the initial payments are– in theory– cheaper but…. it’s still a red balloon… a clown in a sewer grate.

Ok… so we just talked about fixed-rate mortgages (fully amortizing, balloon and interest only). The other broad category of mortgage types is variable rate or adjustable rate mortgages.

This is where you start talking about ARMs… which is an acronym for adjustable… rate… mortgage… ARM.

ARMs are loans with an interest rate that adjusts over time based on the market. ARMs usually start with a lower interest rate than fixed-rate mortgages, so an ARM is– I was going to say great– but it’s really a terrible– option if your goal is to get the lowest possible mortgage rate starting out. The interest rate on an ARM won’t last forever. All the variable products… I advise my own children to stay from– because after the initial cheap period, your monthly payment will fluctuate— that’s my polite way of describing it. Instead of reading the word variable as cheap, you should read it as dangerous. Especially if you care about budgeting… and you’re not independently wealthy.

The other class of variable rate mortgages– not ARMs– are called hybrids, because like good fusion cooking– they’re a combination of two things. They’re usually one part fixed rate mortgage, and one part adjustable rate mortgage. With hybrids, there will be 3 to 5 years when the rate of interest is fixed, and then the rate is going to reset. And despite what we all tell ourselves, there are rarely any pleasant surprises when the reset happens.

The main difference between ARMs and hybrids is the length of that quiet fixed period. The calm before the storm. If the initial period is a year or less, it's an ARM. If that initial calm is more than one year, then it’s a hybrid.

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Ok… that’s enough of a foundation on mortgages to get to securitization and issuance… that’s a fancy way of saying… how millions of mortgages are bundled into mortgage-backed securities.

TITLE: Pass-Through Securities

The first kind of mortgage-backed securities that we’ll want to go deep on are known as pass-through securities. The process of assembling a bundle starts with the kind of home buying we just described. A buyer and seller are involved. A bank or a lender or a credit union are involved. And it's not just poor people who take out mortgages. People take them out even if they’re sitting on enough wealth currently to pay for the property in full. Why?

Well, in the old days, richer people took out mortgages because of tax reasons… all mortgage interest was deductible… but these days it’s because rich people stay rich by having their money work for them. And sinking their savings into home equity isn’t work. It’s lazy.

Most mortgages require the homeowner to make a down payment of somewhere between 5 and 30 percent of the property value. Why? It puts their skin in the game from a lender’s point of view. It reduces the chances that they’ll walk away from the obligation.

If you remember the brief history earlier in the walk, up until the 1970s, the vast majority of mortgage loans originated or were held by the originating lender as a boring interest-bearing asset, but starting slowly in the early 1970s and speeding up by the late 70s and early 80s, and in fact, running like Usain Bolt by late 80s… securitization became the default in the industry. By that point, somewhere between 85 to 90 percent of all conforming mortgages (the ones that satisfy the agency's standards) were being securitized.

In the build-up to the financial crisis– from the mid-90s to 2008, home loans were an industry intent on only one thing: securitization. There were giant lending machines just cranking out loans. Not because they cared about the dream of homeownership but because they needed to keep demonstrating growth to their shareholder… long after all the qualified buyers were satiated… well, they started giving loans to anyone with a heartbeat. Subprime loans. No money down. Nothing. These were huge companies… subprime lenders… Countrywide (is on your side) and Washington Mutual here in the States, Northern Rock in the UK... Ameriquest, New Century, American Freedom, any company with an eagle logo, hell E-Trade was doing subprime lending.

Why? Certainly not because they wanted to keep those loans on their books. They were doing it purely for the securitization.

And taxpayers paid for it all in 2008.

The lender industry has lost that fever. They’re back– for the most part– giving loans to good credit-worthy moms and pops who can satisfy agency standards.

The securitization that continues today… put those higher-quality loans together and sells them to investors… all the payments made on those loans by the borrowers flow through servicers who in turn pass the money into the legal entity– the pool, the trust account, the corporate structure. The legal title to the mortgages themselves are held by the pool, the legal entity… that investors buy into.

If you’re the one making those loan pools, if you’re the syndicator, you want them to be as homogeneous as possible. It makes risk management a lot easier. You want them to be the same type of properties, the same kinds of terms on all the loans– for instance, they should all be 30-year fixed loans. And you’d definitely want them to have the same or similar interest rates.

Your clients– the investors in the pool– will always appreciate homogeneity. As I said, it makes it easier for them to calculate risk. To figure out the rate at which the homeowners in the pool will repay or walk away.

That’s easier– not easy… but easier… when you’re comparing apples to apples. If you were to create a pool and just randomly throw a bunch of different mortgage types and different borrower types… of different term types… well, you’d need a much better, more sophisticated model for risk management.

Homogeneity in a pool allows for simpler (and therefore more accurate) analysis of risk. And that’s all investment really is: risk management.

The big US players in mortgage securitizations– the Freddie Macs of the world– focus on pass-through securities. They don’t always use those exact words. Freddie Mac calls them participation certificates. I’m guessing they have kids who play sports.

Time for some history.

TITLE: The Agencies

Quick history break: the infrastructure for all this– the secondary market for mortgages in the US– was laid in the 1930s… when the government created Ginnie Mae– the Government National Mortgage Association (1936). Then in 1968– when only the best people were born– the US government reorganized Ginnie Mae and split it into two pieces: giving birth to Fannie Mae– the Federal National Mortgage Association. The idea was to split the two by the types of mortgages they were intending to securitize.

A couple of years later, in 1970, the US congress chartered Freddie Mac… again not to lend directly to borrowers, but to operate in the U.S. secondary mortgage market, buying loans… so in theory, those lenders could then provide more loans to you and me. It was meant to keep capital flowing into the housing market. 

Freddie Mac (the Federal Home Loan Mortgage Corporation)– like Ginnie Mae and Fannie Mae– became the titans of mortgage syndication… pooling all the mortgages they bought into securities, which they continue to sell to investors around the world.

Ginnie Mae issued its first pass-through securities in 1970.

Freddie Mac issued its first mortgage-backed securities in 1974.

Fannie Mae issued its first pass-through securities in 1981.

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The main difference between Ginnie Mae on the one side and Fannie Mae and Freddie Mac on the other… is the type of mortgages that will be in their securitizations.

Ginnie Mae pools can only include mortgages that were originated under US government mortgage guaranty programs: FHA (which stands for Federal Housing Administration), the Veterans Administration, something called RDA (the Rural Development Association).

Government programs meant to help veterans and other underserved communities… help them own homes… that help the government expand homeownership.

Those same kinds of loans– government-backed or government-guaranteed– can also land in Fannie and Freddie securitizations, but they make up a tiny portion of their pools. Fannie and Freddie focus mostly on conventional mortgages– not ones tied to government programs.

Oh and today Fannie Mae and Freddie Mac compete with one another.

Why would two government agencies compete with one another? Because they’re not actually government agencies.

Well, Ginnie Mae is… a government agency,

But whenever you hear the word agencies in the MBS space… it’s really a reference to all three– Ginnie Mae, Fannie Mae, and Freddie Mac.. even though Fannie and Freddie are GSEs– which stands for Government Sponsored Enterprise.

Don’t get me wrong. Fannie and Freddie’s origin stories start with the US government, but they were privatized early on– sold off to investors with the US government owning just a few shares in each.

This is where it gets all funny. Agency securities are all considered incredibly safe because they're backed by guarantees. Ginnie Mae– the only one of the three that’s still a govt agency– well, their securities are backed by the full faith and credit of the US government. “Full faith and credit” means that if there's ever a default on a loan in a Ginnie Mae securitization, it won't impact investors at all. Can’t get more solid. They guarantee timely payment of both interest and principal. As steady as govt bonds. If they ever go under, we got bigger problems than late payments.

So from the investors' perspective, Ginnie Mae is solid… or as solid as the US govt.

Fannie Mae and Freddie Mac… well… technically… once they privatized, they only offer self-guarantee. Market participants know that but they also know that if the govt lets them go down… we’ll have bigger problems…. System-wide problems. That’s the kind of moral hazard that kept popping up in the 2008 financial crisis.

Market participants know that Fannie Mae and Freddie Mac do not officially have the “full faith and credit of the US government,” but they behave like they do. Investors believe that there’s sort of an implicit US government guarantee… just proved itself out in 2008… when investors were fearful of holding Fannie Mae and Freddie Mac debt… well, Uncle Sam stepped in– for good reason… to avoid an implosion of the US financial system… but still, proved that investors were right to treat the non-guarantee as a guarantee.

After the crisis, the US put what’s called “government conservatorship” over the once-governmental, now-privatized, Fannie Mae and Freddie Mac.

And all gamesmanship started again. Right now, the U.S. government explicitly says they will provide all the cash needed for Fannie Mae and Freddie Mac to continue to carry on mortgage securitizations. Why? Because the govt wants to expand homeownership to a wider range of previously underserved populations in the United States.

Conservatorship means that while there are still shares outstanding– meaning that they’re still private companies– their shareholders no longer elect the board of directors.

It’s weird. Instead of a corporate board holding their c-levels accountable, the US Treasury does. Or more accurately, board members appointed by the Treasury do. Their mandate is to minimize losses to those entities and in so doing… minimize claims on US taxpayers.

It’s a fine line in the US. Treasury officials get in front of congress and they do this little dance. They say “yes, we stand ready to provide all the cash Fannie and Freddie need to continue to support their mission to expand homeownership” but that does not mean the U.S. government is guaranteeing Fannie Mae and Freddie Mac. (cough bullshit)

The government does not guarantee Fannie Mae and Freddie Mac. But the power of the government rests on the power of the economy. So they create perverse incentives for investors to hold Fannie and Freddie debt. That's what mortgage-backed securities are: they’re debt… debt-based security (like a bond)-- backed by the interest paid on loans.

Remember how we talked about conforming versus nonconforming mortgages earlier in the walk, and how we talked briefly about agency underwriting guidelines?

I don’t think I defined underwriting. Because it means a lot of different things. In this context, underwriting guidelines are the terms or conditions a person selling mortgages into a pool needs to have satisfied before their mortgages are accepted into agency securitization.. Into those pools. In other words, if you want to work with Fannie or Freddie, you have to know their rules, follow their rules.

Once every mortgage you’re selling meets ALL the terms and conditions required by them, they’re called “conforming loans” and can be packaged inside the pool, inside the agency securitization.

Back to the history lesson: remember subprime mortgages? Those toxic pools that almost brought down the global economy in 2008? Fannie and Freddie did NOT hold subprime mortgage-backed securities in their investment portfolios because their rules didn’t allow them to securitize garbage. Their rules wouldn’t let them securitize subprime mortgages. Because they could only securitize conforming mortgages.

There are many loans out there that are not conforming mortgages. Some - garbage. Some - not. Some of their terms and conditions fall outside agency underwriting guidelines… some don’t. And nothing prevents private sponsors or originators– NOT FREDDIE, NOT FANNIE– from creating mortgage-backed securities on garbage… pools of yuck….

The funny thing is that Fannie and Freddie still had to be rescued… despite their high standards… because of the fragility of the system. If one institution falls out of the boat and starts to sink, well… they’re handcuffed to a couple of other institutions…. who are each also handcuffed to a couple of other institutions, and so on and so on. And so without government intervention, everyone’s at the bottom of the lake.

And where the banks go, so too go your deposits… whether you have a mortgage or not. Whether you know what the acronym MBS stands for or not.

Ok. Enough history. No one ever learned anything from history anyway!

TITLE: Conforming Mortgages

So now that you know about the agencies– let’s get into some details about what it means to strictly follow their standards– remember– that’s how you get a “conforming” mortgage– one that you could have them securitize– versus a “nonconforming mortgages” that doesn’t follow their standards– that you can’t have them securitize.

When it comes to conforming loans– size matters, politics matter. There is a max size for the loans– how big it can get–… tied to an index of residential real estate values… the politics of it being that you’re helping the little guy or gal– the middle classes. Every politician can get behind helping mom-and-pop buy their first house. And no one in the government wants the optics of “we’re helping rich people buy really big houses… with fences to keep away the unwashed.”

So there is a maximum size to a conforming loan. It changes because housing prices keep going up and up… decade after decade. Right before the financial crisis of 2008, that max was $417K dollars… which if you were living in San Francisco, meant you could buy a really nice parking spot.

And to be fair, the government tried to fix that– by raising the limits– adjusting for the higher cost of living in cities. I could keep throwing numbers at you but those numbers change over time. You can google “maximum size of conforming loan.” And you’ll see it. It’s a little over a million now.

The point is that there’s a size limit if you need a loan to be eligible for inclusion in an agency pool… and it’s driven by politics.

There will always be larger loans available… and non-agency syndicators who will be interested in creating “rich people pools”... “second home pools.” That’s where we get “jumbo mortgages”... they’re too big for the agencies… given the politics of homeownership.

Non-agency syndicators would be interested in a “Hamptons pool” because, in theory– the credit quality of richer borrowers is better than poorer borrowers. Lenders don’t just say “hey, you’re rich, here’s some free money…” Governments do that… but not lenders. If you need a jumbo loan, the bank will make sure you’re creditworthy… reducing their credit risk.

Jumbo mortgage loans were one of the first primary sources of securitization for non-agency syndicators… for exactly that reason. Long before they started messing with sub-prime garbage, they were dealing in rich-people-backed, high-credit-quality product… from a credit risk perspective. And it was partly from a history of building that trust with investors that they were able to sell subprime garbage.

Investors who dabble outside product that is government or government agency guarantees… well, they’re going to focus more on the credit quality of the loans. The paradox here is that if your borrowers have high credit quality, they also have easy access to credit, which is a fancy way of saying rich people aren’t as reliable as that middle-class mom-and-pop. To use industry jargon, rich people don’t have the most attractive prepayment characteristics. The spoiled are spoiled by easy access to money.

Ok… so 1) size matters. What else makes a loan eligible for inclusion in agency securitization?

2) The borrower has to be top-rated. That’s where you get terms like double-A borrower. That’s the highest credit rating for someone in the U.S. We’re talking individual credit rating standards now. And, that depends on your credit history– do you have a history of making all your payments on time? Car payments, credit cards, iCloud storage. Have you declared bankruptcy in the last seven years?

If you have a decent credit score, you qualify as a prime borrower.

If you don’t, if your credit quality is less than Beyonce’s, you're considered a subprime borrower.

And only loans tied to prime borrowers get into agency securitizations.

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What else? Size matters. The borrower matters. Next: some jargon. “Loan to value (LTV).” It’s a ratio… something-to-something… in this case loan-to-value. It’s the ratio of the mortgage amount as a percentage of the total appraised value of a property. That wasn’t helpful. An example. Let’s say I’m buying a $1M property and you’re my lender. Would you rather that I borrow $200K from you (because I have the other 800) or would you rather that I borrow $950K from you because I have the other $50K? You’re the lender. It’s not a question of whether you have the money to lend. You do. It’s a question of what lets you sleep better at night. Think of it as a little slider… $1 at one end, the full million at the other… where on that slide do you sleep better at night? That slider… loan to value.

As a lender, if you want that loan to land in a pool… the agency standard is 80% max… loan to value.

The amount of the debt I would be taking in that example can’t be more than 80 percent of the cost of the property at the time of the loan.

If that still wasn’t helpful, well LTV is why every bank would love for you to put a 20% down payment on your house. It’s part of why you pay less after you own 20% of your property… you stop paying mortgage insurance… which is insurance that the lender forces you to pay in case you default. The probability of default reduces after that 20% marker.

Can a borrower put down less than 20%... say 10%? Sure. If they have good credit. And if they pay mortgage insurance. But that mortgage that they take out won’t land in an agency pool.

What else? Size, borrower, Loan-to-Value. And… the final one.. prove to me… the lender… how much you make. Your income. And prove it in a way that’s acceptable– that meets agency guidelines. In the US, for instance, that’s a W2– which is a tax form that says how much your employer paid you.

If you’re self-employed, you’re called a no-doc loan– no documentation of income, but as long as your credit quality is acceptable, you’ll still qualify for the loan. But that loan will not land in an agency pool. Your mysterious source of income disqualifies you… Your loan is then classified as an Alt-A loan. Back in the day, that used to mean you were a good credit risk but during the lead-up to 2008, standards outside the agencies fell so low that Alt As were called Liar Loans.

No one in the industry thought the borrowers were lying. It was the disreputable lenders that were lying. Throwing credit risk to the wind.

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TITLE: The Securitization Process

Using what we’ve learned, we get to the point where we have a pool of loans that are relatively similar: similar maturity, all high credit quality, they meet agency guidelines, they all have interest rates relatively close to one another. Yay. Securitization can proceed.

Let’s walk thru it step-by-step… but fast… the people who have mortgages in the pool keep paying their monthly bill to what they think is their bank… which many times isn’t the actual bank, but a servicer… think Ops for the incoming checks… pass the principal and interest (less a servicing fee) on to the legal entity that owns the mortgages and the money then gets distributed to investors in the pool.

That servicing fee is payment for handling the money, running the operations, sending out payment notices… sending out late notices.

In other words, NOT all of the principal and interest that’s flowing into the pool is going to be paid out to investors. There are those service fees– kept by the servicers for doing their job… and there’s something called the excess spread that is kept by the sponsor– the entity that created the mortgage pool.

The servicers and sponsors have bills to pay too– various administrative fees and the expenses they have– and once those fees and expenses– the excess spread– are taken out of the interest– and they’re only ever taken out of the interest– the whole principal and the remaining interest move forward in the process… getting paid out to investors. That’s also called the prorated distribution of funds.

How does it pay out? The math is straightforward. Let’s say there are only 2 investors in the pool that has $1M of mortgages in it. One investor has bought 10% of the pool and the other 90%. Because this is a pass-thru Mortgage-Backed Security, that’s how much they get of the money that passes through. Investor One who has bought 10% gets 10% of the principal that’s passing thru– and Investor Two who has bought 90% of the pool gets 90% of the principal that’s passing thru. Same distribution percentages– 10%, 90%-- on the interest that’s passing thru but again, remember that its less the servicer fee and the excess spread.

All the principal we collect from the borrowers are used to make what’s called a return of principal distribution of the investors.

When does it pay out? The beginning of every month. If one of those borrowers was late that month with their payment– and this is an agency pool– well, the agency sends the full amount due to the pool. Because they guaranteed that delinquencies wouldn’t happen.

One subtlety worth pointing out and it has to do with the coupon rate which I haven’t talked about on the walk so far. A coupon rate is the annual income that an investor can expect to receive while holding a particular security or bond. The investors might or not know the interest rates that their pool of borrowers are paying (each individually) but the investors will definitely know the coupon rate of the pool– because that’s what they themselves expect to get. That’s what they paid for.

The sponsors and syndicators of the pool know that… so they price the pool appropriately. They know how much the servicers are going to demand, and how much they need to pay monthly expenses, so the coupon rate manages the investor’s expectations down to the penny.

The money that doesn’t pass all the way thru to the investors is the money paid in fees and expenses– what’s left after the middlemen are paid.

And this payment distribution model is pass-thru specific. It doesn’t work like this for CMOs– collateralized mortgage obligations.

Remember, CMOs have more expensive tranches– triple-A, platinum, first-class seats… that usually get ALL the principal. Then, they share the interest with lower tranches… the coach-class, economy-class seats… the investors who paid less.

That’s intentional design. CMOs structure payouts so that *unlike* pass-throughs, all investors are NOT going to get an equal split or a pro-rata share of every dollar that comes through the structure. Instead, they’ll get paid out for their quality-of-seat on the metaphorical plane. And first class is more expensive… so… it might have a different rate of interest returned than business class… which itself has a better seat and terms than economy class. And that’s interest. CMOs design their payouts to do the same thing with principal. And the most egregious part of that structure… the design of that plane…. is that they only have exit doors in first class.

So if you’re sitting in first class– what’s called the first tranche– and you were promised a million dollars of principal… well, no one in business class– in the second tranche– gets a penny of principal until you’ve gotten your million…. The term of art for that is tranche retirement… no one in business class– in the second tranche– gets a penny of principal until the first tranche is retired… and the same rules apply between that 2nd tranche and the third tranche… between the third tranche and the fourth tranche… all the way down to the last seats on that plane… the last tranche.

And that’s the simplest of all CMO structures– it’s known as sequential pay bonds or just sequentials. Think airplane seating. If you have the money, you can buy certainty… you can buy less risk… you can manage the uncertainty of the average life… you can manage prepayment risk.

And CMOs– the planes in my crappy analogy– can and are designed to be a lot more complex than sequentials. You can google “Z-Bond tranches”..or.. “Floating rate tranches”... or… “inverse floaters”... PAC bond tranches (P.A.C. – Planned Amortization Class)... google them to get a sense of the more common kinds of complexity. Just know that it’s not complexity for complexity’s sake. It’s because plane designers– CMO syndicators– understand the complexities of risk management… they understand their client’s businesses… their client’s risk management needs– and they build more and more complex planes– CMOs– to address those client needs.

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Everything in finance is about risk management… so let’s talk about the language of risk that surrounds mortgage-based securities. The jargon that everyone uses to manage risk.

Let’s talk acronyms.

TITLE: Metrics of Mortgage Risk (And Some Formulas)

The lingo investors use when they’re evaluating mortgage pools. Three big ones: the whack (WAC), the wham (WAM), and the Wala (WALA). WAC is short for Weighted Average Coupon. WAM is Weighted Average Maturity. And WALA is Weighted Average Loan Age.

Let’s define them. WAC– the weighted average coupon is a measurement of the rate of return on a pool of mortgages that is sold to investors. The underlying mortgages are repaid at different lengths of time, so the WAC represents its return at the time it was issued and may differ from its WAC later. Don’t worry, I’ll simplify in a sec.

WAM– the weighted average maturity– is a measure of how quickly principal will be repaid according to the bond's debt service structure… to its terms.

WALA– the weighted average loan age– is a measure of the maturity of the mortgages in a pool. WALA is dollar-weighted based on mortgage size and the time left until it matures (usually in months).

Ok, that was densely packed. Let’s break it down.

They’re all weighted averages; calculations that take into account the varying degrees of importance of the numbers in a data set. In calculating a weighted average, each number in the data set is multiplied by a predetermined weight before the final calculation is made.

If you’re not a math whiz, I’m still talking Klingon.

The weighting is what percent… of the principal on any one loan.. is as a percent of all of the principal currently outstanding. It changes over time as some of the homes in the pool are sold and the mortgages of homes in the pool are paid off… or some of the loans in the pool are refinanced. The point here is that weighted averages allow you to get your arms around data sets… numbers that keep changing.

Each month these weighted averages are recalculated. That’s both expected and useful. So you know what you have… on a month-by-month basis… as a bundle… it spells out the forest so you don’t have to know all the details about every tree… every mortgage.

So how do you calculate the WAC? You take the coupon rate of each mortgage in the pool and multiply it by its remaining principal balance. The results are added together, and the sum total is divided by the remaining balance. You don’t need to memorize, you just need the formula in Excel… and you can find that by googling “weighted average coupon calculation.” Life is the kind of test where you can use notes.

How do you calculate the WAM? We’ll use an example here– I’ll try to put it up above me once I get back home– so you can understand the calculation. I’m going to split a $1M pool into 3 weird chunks deliberately so that you can better match the numbers once I get to the calculation. So.., let’s say our investor has a $1M pool– and she has all of it– Everything she wants– $1M is easy to remember– and let’s say that the pool is down to 3 mortgages as of Last Christmas– and these three mortgages are some Bad Boys.

Mortgage A is for $167,000 (16.7% of the total portfolio) and matures in 10 years

Mortgage B is for $333,000 (33.3%) that matures in six years.

Mortgage C is for $500,000 (50%) with a maturity of four years.

To compute WAM, each of the percentages is multiplied by the years until maturity, so in this example, the formula is: (16.7% X 10 years) + (33.3% X 6 years) + (50% X 4 years) = 5.67 years, or about five years, eight months. WAM.

If you’re a math whiz, that calc is the Edge of Heaven.

But if you struggle with math, then I’m your man… because math puts people like you and me to sleep. Which is ok. Just wake me up before you go-go.

WAM. Rest in Peace George.

Next, let’s calculate WALA - the weighted average loan age. You multiply the value of each individual mortgage in a pool by the number of months since the mortgage loan was originated.. when it was first birthed. WALA is used to estimate both profit potential and prepayment risk… profit potential is precisely what it sounds like: how much money am I going to make. Prepayment risk… in this context… is how likely is it that mom-and-pop homeowners are going to prepay their principal (to get out of their loan faster…) and while that might benefit mom-and-pop, to the investor: that’s bye-bye future interest payments.

Ok, that was WAC, WAM, and WALA. Now we just need to define Whop bop adoobop a Whop bam boom.

Let’s talk WAC-and-WAM subtleties: WAC- the weighted average coupon. The relationship between WAC and the pass-through rate… also called the coupon rate… the rate that the investor was sold as their return… Well, that pass-through rate is going to be lower than the WAC. In fact, the agency guidelines say that the lowest interest rate on a loan in the pool has to be at least 25 basis points– or one-quarter of one percent– above whatever the pass-through rate is. AT LEAST that much more. If our pass-through was–say 7%-- then the WAC would be more.. like 7.somethingsomething%... at least one basis point… probably a lot more than that. It makes sense that the weighted average coupon will be bigger than the coupon rate. And know that the WAC will decline over time…. because the highest interest rate mortgages are the ones that are most likely to be paid off first… and as they’re paid off early, the weighted average is recalculated… and WAC declines.

WAM… the weighted average maturity. The only subtlety in the calculation is that the weighted average maturity at origination is less than you’d think. If you were new to the biz, you might think that the magic number is 360… 30 times 12…. 30 from the number of years in a typical 30-year loan times 12… because there are 12 months in a year. 30 times 12: 360… the number of months in a loan’s life. But the reason the magic number is not 360 months because loans don’t get immediately securitized. The magic number is probably closer to 358 because a few of the loans being securitized will inevitably be held by the lender for a few months or maybe a few years before they get securitized. And when you’re talking averages, the once-in-a-while cases pull the topmost number towards them.

For instance, the average number of arms-per-person in the world… is less than two.

And the only subtlety with WALA is that it's useful… because to an investor, it matters less when the final payment is due and more how old the loan is. WALA infers how long the loans have existed… the L.A. in WALA… Loan Age. That's more insightful when you care about prepayment rates and managing risks.

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OK let’s get into some formulas. The monthly mortgage calculation… which I’ll put up here. Do you need to know it by heart? Not really. Just google “How do I figure out my monthly mortgage calculation?”

M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1]

The M is your total monthly payment.

The P: The total amount of your loan… the mortgage balance.

The I is Your interest rate, as a monthly percentage.

N = The total amount of months in your timeline for paying off your mortgage.

It’s very similar to the formula for the most common annuities– the term of art is “a fixed annuity certain”: Annuity = r * PVA Ordinary / [1 – (1 + r)-n]... because that’s kind-maybe-a little– what mortgage-backed securities are… except they don’t pay out for the rest of your life. If you’re lucky enough to grow real old, an annuity keeps going… well past the 360-month max on a mortgage-backed security.

Tangent! Let’s all hope that I never do a walk on insurance or annuities. The horror!

Ok… you’ve stared at the monthly mortgage calculation long enough. You know how to google it. Download the formula into Excel or Google Sheets and play with it. No better way to learn.

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So… all those formulas and calculations are at the tree level, not the forest. They’re at the individual mortgage level, not the mortgage pool level.

If you remember from earlier in the walk, mortgage pools try their best to put together loans that have the same or similar terms. They’re all 30-year fixed… and/or they all have the same or similar interest rates. There isn’t any “one of these things is not like the other”... they’re all like each other… because… risk is easier to manage that way.

So if you were to look at a graph of any one dimension for any one individual loan in a pool– for instance, its scheduled payments– it would look eerily similar to a graph of scheduled payments for the entire pool. But that’s deceptive as it related to the prepayment rate. Let me remind you again what the prepayment rate is. In plain English… it’s all mortgage owners in a pool that are paying off their principal earlier than expected.

If you look at the forest-level view of scheduled payments and it looks like the tree view… it could lead you to think there’s a zero prepayment rate at the pool level. Zero chance of that… because life gets in the way.

The aggregate prepayment rate of mortgages in a pool should remind you of the 7 year itch… this idea that if your marriage can last until year 8 it’ll last forever. Well, a large chunk of the mortgages in the pool prepay between years 5 and 7. Why? Because life gets in the way. Families grow, they shrink, Mom get a job across the country, Dad goes out for cigarettes and never comes back.

The point is that people with mortgages prepay a lot between years 5 and 7. Not because they suddenly won the lottery. But because mortgages– at least in the US– come with this thing called a “due on sale” clause… which basically says that if you sell your house, the first thing you’re obligated to do with that money… is to pay off the loan. To become someone who– from the pool’s perspective– is prepaying on what is now their old mortgage.

In other words, even if the interest rate environment gives you zero financial incentive to refinance your loan, a mortgage pool will still have a fair share of prepayments by the homeowners in the pool… or at least for those homeowners where life just got in the way.

So the graph for prepayment for the pool… doesn’t look like the one for scheduled payments…. Scheduled payments – a gentle hill, sloping down slowly over the course of 30 years. The prepayment slope, rises up to year 7, precipitously drops, and evens out over the next 20 years. Either way… the pool gets ALL the principal from ALL its mortgages. All the mortgagers that prepay… they just reduce the pool’s long-term profitability… because each prepayment takes some or all of its future interest payments– the profit– off the table.

That’s why no one gets excited by years 15 thru 30 in a pass-thru pool. Most of the interest has been paid in years 1 thru 15 and the loans are just sitting on the porch, in a rocking chair, watching the sunset. Cash flows were something it had when it was young.

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TITLE: Prepayment Risk

Ok so let’s get into the details of mortgage prepayments. If you’re working with the agencies, credit risk is not an issue. Because they guarantee full payment every month, even if some of the mortgagers are late in their payments or worse.

What do investors focus on when credit risk ain’t a concern? Prepayment uncertainty– a less-than-spectacular average life of a pool that could result from a high or lower-than-anticipated rate of prepayment. I briefly touched on the factors that drive prepayment– like 200 yards back… but let's go deep.

The most obvious fuel for mortgage prepayments is: interest rates. At what rate can a person who already has a mortgage take out a better mortgage with better terms today? And ideally, can they do it today without paying some unreasonable lump sum… like exorbitant closing costs. An example of what I mean by that: let’s say I personally take out a loan at 7%. And magic happens in the macroeconomic view and tomorrow’s interest rate is 6%. If I refinanced immediately, that could give me thousands or even potentially tens of thousands in savings in any given year, depending on the purchase price of my property, and the total amount of the mortgage being refinanced.

That might be a no-brainer… if it weren’t for closing costs– the fees you pay for the process of buying or selling. Average closing costs for a buyer run between about 2% and 6% of the loan amount. That means, if I had a $300,000 home loan, I would pay from $6,000 to $18,000 in closing costs in addition to the down payment.

Do I have $18K today? Is it worth the hassle?

Only the homeowner can answer that question. The point is that interest rates drive a lot of homeowners to at least ask those questions for themselves. It’s an expensive question not to ask.

Usually, when mortgage rates go up… the opposite direction than in our example– prepayment rates tend to go down. Makes sense. Why would a person with a 30-year fixed at 7% refinance when the interest rate goes up to 8%? They wouldn’t. And when that happens usually housing sales slow down…. Another economic indicator that prepayment rates in pools will go down.

Flip that, and the opposite is also true. Falling interest rates mean more people are refinancing which because of the “due on sale” clauses we talked about– the pool will experience the refinance as a prepayment. And.. falling interest rates… tend to drive housing activity up… which means prepayment rates in pools will go up.

So the whole process is interest-rate-sensitive.

What else do investors focus on… if not credit risk… if not interest rates….

The economy, demographics, politics. Is the population growing, shrinking, moving from where to where… and at what scale? How old is that population? Younger folks = higher demand for housing.

How is the jobs market? Are people losing jobs, getting jobs, switching jobs… because buying a home usually needs you to be making money. Good money. Ideas like a consumers purchasing power, their access to disposable income, intergenerational wealth… ALL these factors play into prepayment models– which just try to figure out people’s willingness and ability to buy a house or refinance their existing house– all in the hopes of trying to predict prepayment rates.

Hell, even the weather needs to be modeled in. Seasonal considerations… whether it's sunny or cloudy or raining or worst of all snowing– impact prepayment rates.

For instance, pre-payment rates are great in the winter… because who the hell wants to move when it’s cold?

Remember WAC and WALA? Weighted Average Coupon… Weighted average loan age?

WAC and WALA are important for exactly what we’re talking about: they were designed to assess prepayment rates… prepayment risk…

The WAC gives investors some insight into prepayment across pools. What’s the likelihood that pool A will prepay relative to pool B? Because investors have lots of pools to pick from.

Imagine that two pools– A & B– have the same pass-through rate: 6%. How would you differentiate? Well, look at their WAC.

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If pool A has a WAC that is higher than pool B, buy pool A… less risk…more potential cash flow over time. The higher WAC has a greater likelihood that its prepayment rate will pick up sooner. And going back to the definition of WAC, we’d know that pool’s A higher WAC means it has higher interest rate mortgages in that pool. And that correlates with pool A having its prepayment rate rise sooner.

Pool B would catch up at some point… but Pool A’s “sooner” is better.

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TITLE: The Benchmarks

How else are mortgage-backed securities different? They’re similar to other fixed-income products– like bonds– because you’re supposed to make money from the cash flows 1) by reinvesting the income, and/or 2) you make money by changes in the product’s price. But… unlike other fixed-income products, pass-through mortgage-backed securities give you… a ton of cash flow… which means you have more reinvestment risk. That’s a fancy way of saying you’ll get so much cash flow that it might actually be hard to invest it all. Plus the pricing on pass-through is different. More like callable bonds. It’s something called negative convexity. Words only used to make you sound smart. It means they get cheaper as interest rates go down. And that’s unusual because when interest rates fall, bond prices typically rise.

What else is different? Unlike bonds that can tell you exactly how much you’ll get in month 1, month 2, month 20… every month… MBS comes with uncertainty for exactly the reasons we’ve been talking about. Homeowners in a pool can make repayments… which means month 1’s cash flow might be a little less than you expected.

Google the formulas… for price… for MBS. The denominator– the bottom– for MBS will look exactly like the denominator for treasury bonds: one, plus the yield to maturity expressed as a periodic rate… (1 + i) sub 1,2,3, month by month by month.

The numerator– the top of the equation– the cash flow– will be three numbers added together… also on a month-by-month basis: 1) the monthly amortization of the principal… all the planned, predictable principal from that month… plus 2) the pre-paid principal… if someone in the pool sells their house or refinance…plus 3) the pass-through rate or coupon rate on the outstanding principal. One of those 3 numbers– the pre-paid principal… will be an educated guess at best.. The other two will be accurate in month one… and they’ll need to be recalcuted each month after… because prepayment affects them too… it brings uncertainty in terms of monthly cash flow.

That uncertainty is not a show-stopper because investors know what they’re getting into and they use projections based on some assumed prepayment rate. For instance, there’s something called PSA– short for Public Securities Association Standard Prepayment Model– good reason to shorten it… Anyway there’s something called PSA which is a prepayment benchmark (not a model but a benchmark)… based on another benchmark called CPR – the Conditional Prepayment Rate- C.P.R. They’re a measure of relative prepayment speeds. So for instance, 100% PSA equals a starting rate of point-2% each month for 30 months, at which point prepayments… level off… and stay constant at 6% CPR for the remainder of the life of the mortgage. (I’ll do the math in one sec.)

How do you talk about PSA… about the pre-payment benchmark? Well, PSA speeds always rise steadily over the first 30 months, after which they level off. So the prepayment rate rises up to the 30-month mark and then flattens at a constant level for the next 330 months. Investors talk about PSA speeds in terms of percentages, like 50 percent of PSA, 150 percent of PSA… where the standard is 100 percent. That 100% mark is actually called the PSA standard.

The other way investors talk about the PSA is thru the analogies of aging mortgages or the seasoning of mortgages. Because new mortgages– baby mortgages– their prepayment rate will be close to zero. Because why put yourself through the hassle of lawyers and closing costs just to immediately sell or refinance?

As mortgages age… up to that 30-month mark, their prepayment rates are going to rise… unpredictably but predictably unpredictable.

If you’re a math person… and need a formula for the ramp speeds… that monthly increase in CPR…. is terminal CPR– the conditional prepayment rate… divided by the length of the ramp.

Remember how I said “That the 100% mark is actually called the PSA standard”... well if you take the formula of terminal CPR divided by the length of the ramp…. For the standard PSA… that would be 6% (the CPR) divided by 30 months (the length of that standard ramp). And 6% divided by 30 is… point-2%.

That’s me showing the math of what I talked about 100 yards ago.

That point-2% is also called the step up. So if we're using PSA standard, you can just take the month you’re in– like you’re in the 6th month– and multiply it by the step-up (.2%) and you’d get the CPR– the conditional prepayment rate.. of 1.2%... at 12 months the CPR: 2.4%.

Next, there’s something called SMM (single monthly mortality) SMM… which is measured as a per-month percentage of mortgages in a pool that will be paid off early. When investors want to estimate monthly prepayments, they take the CPR and converted it into a monthly prepayment rate, the SMM. The formula for SMM for a given CPR: SMM = 1 - (1 - CPR) to the 1/12th.

And finally, if you multiply the SMM and the outstanding principal… you get what’s called prepaid principal which is… any portion of the principal amount of any pool being paid for any reason prior to its regularly scheduled maturity date.

That’s a lot of TLAs.. three-letter acronyms… and each one sets the foundation for the next one. The PSE allows you to calculate the CPR which allows you to calculate the SMM which allows you to calculate prepaid principal.

So… PSE, CPR, SMM are how you understand cash flows using some prepayment rate, the benchmarks, and methodology for how you express the potential amount of principal that will be prepaid.

If you’re in tech… and in the MBS space… this is the business depth you need. Because your business partners are going to keep trying to use code to improve their models for predicting prepayments. Because the better your projections of prepayment rates, the more money you make… the more risk you mitigate.

That’s it. I hope you learned something.