Mortgage-backed Securities & Collateralized Mortgage Obligations: Prudent CRA INVESTMENT Opportunities by Andrew Kelman,Director, National Business Development M Securities Sales and Trading Group, Freddie Mac Mortgage-backed securities (MBS) have Here is how MBSs work. Lenders because of their stronger guarantees, become a popular vehicle for finan- originate mortgages and provide better liquidity and more favorable cial institutions looking for investment groups of similar mortgage loans to capital treatment. Accordingly, this opportunities in their communities. organizations like Freddie Mac and article will focus on agency MBSs. CRA officers and bank investment of- Fannie Mae, which then securitize The agency MBS issuer or servicer ficers appreciate the return and safety them. Originators use the cash they collects monthly payments from that MBSs provide and they are widely receive to provide additional mort- homeowners and “passes through” the available compared to other qualified gages in their communities. The re- principal and interest to investors. investments. sulting MBSs carry a guarantee of Thus, these pools are known as mort- Mortgage securities play a crucial timely payment of principal and inter- gage pass-throughs or participation role in housing finance in the U.S., est to the investor and are further certificates (PCs). Most MBSs are making financing available to home backed by the mortgaged properties backed by 30-year fixed-rate mort- buyers at lower costs and ensuring that themselves. Ginnie Mae securities are gages, but they can also be backed by funds are available throughout the backed by the full faith and credit of shorter-term fixed-rate mortgages or country. The MBS market is enormous the U.S. Government. Some private adjustable rate mortgages. with the volume of outstanding MBSs institutions issue MBSs, known as “pri- exceeding $3.8 trillion. Investors in- vate-label” mortgage securities in con- LIQUIDITY clude corporations, banks and thrifts, trast to “agency” mortgage securities Agency MBSs are extremely liquid. Be- insurance companies and pension issued and/or guaranteed by Ginnie cause there is a large amount of out- funds. MBSs are popular because they Mae, Freddie Mac or Fannie Mae. In- standing mortgage securities and inves- provide a number of benefits to inves- vestors tend to favor agency MBSs tors, there is a sizable and active sec tors including liquidity, yield and capi- tal management flexibility. CRA offic- ers should understand these benefits to enable them to work with bank in- vestment officers. U.S. Fixed Income Market Outstanding Bond Debt as of June 30, 2001* UNDERSTANDING MBSS An MBS is similar to a loan. When a Total = $17.7 Trillion bank purchases an MBS, it effectively lends money to the borrower/home- Money Market Corporate owner who promises to pay interest $2.6 – 15% $3.6 – 20% and to repay the principal. The pur- Municipal Securities chase effectively enables the lender to $1.7 – 10% make more mortgage loans. MBSs are U.S. Government U.S. Treasury known as “fixed-income” investments Agency $2.8 – 16% and represent an ownership interest in $2.0 – 11% ABS mortgage loans. Other types of bonds $1.2 – 7% include U.S. government securities, Mortgage-Backed Securities municipal bonds, corporate bonds and $3.8 – 21% federal agency (debt) securities. Source: The Bond Market Association Estimates 20 Community Investments March 2002 ondary market. Investors can easily buy, ban Development (HUD) set for to create additional LMI lending op- sell or borrow against MBSs. The liquid- Freddie and Fannie (e.g., 50% of their portunities in communities, which is ity of MBSs is enhanced by the relative business must be to low-and-moderate the essence of the CRA. Bank pur- homogeneity of the underlying as- income (LMI) borrowers) help deposi- chases of MBS pools from Freddie Mac sets, compared with corporate bonds tory institutions to achieve their LMI support this affordable housing initia- (different issuers, industries and cre- objectives through MBS investments. tive. Since more than 2/3 of mortgages dit) or municipal bonds (state issued, Usually, MBSs are comprised of are originated by companies whose authority issued, revenue bond, etc.). loans scattered throughout the coun- loan officers work on commission and try to borrowers with varying incomes. have an incentive to originate mort- YIELD To support CRA objectives, affordable gages on expensive homes. SS&TG cre- Mortgage-backed securities offer attrac- housing MBSs are created with loans ates an incentive to originate LMI loans. tive risk/return profiles. There are to LMI borrowers in specified geogra- higher yielding fixed-income invest- phies. As a “qualified investment,” the Here are reasons to consider MBSs as ments in the marketplace, but they MBS should include loans in an part of a CRA strategy: have greater credit risk. MBSs have tra- institution’s assessment area or in a ditionally provided returns that exceed “statewide or regional area that in- ➤ Payment of principal and interest those of most other fixed-income se- cludes the assessment area.” At least is guaranteed curities of comparable quality.1 MBSs 51% of the dollars in the MBS should are often priced at higher yields than be in loans to LMI borrowers, although ➤ Market rate return Treasury and corporate bonds of com- most total 100%. In addition, a finan- parable maturity and credit quality. cial institution that, considering its ➤ No management fees performance context, has adequately CAPITAL MANAGEMENT addressed the community develop- ➤ Favorable capital treatment For banks and thrifts, agency MBSs are ment needs of its assessment area(s) considered bank-qualified assets. They will receive consideration for MBSs ➤ Liquid investment – can be sold or can be held in higher concentration with loans located within a broader borrowed against than other assets. In addition, the risk- statewide or regional area. “Examin- based capital treatment of agency ers will consider these activities even ➤ Flexible – can be tailored to bank’s MBSs is superior to that for corporate if they will not benefit the institution’s assessment area and sold in vary- and many municipal bonds. For ex- assessment area(s).”2 ing amounts ample, depositories holding Ginnie The Federal Financial Institutions Maes do not have to hold risk-based Examination Council (FFIEC) issued ➤ Low transaction costs capital (RBC) against the assets and an opinion letter (#794) indicating that they have to hold just 20% of the RBC targeted MBSs may receive positive ➤ Available everywhere—even in requirement for Freddie and Fannie CRA consideration. This has been re- rural areas MBSs. This contrasts with a 100% RBC inforced by scores of CRA examina- requirement for corporate bonds and tions. Moreover, as lending-related EVALUATING AND PURCHASING up to 50% for municipal bonds. Finally, qualified investments, CRA-qualified MBSS there is an active repurchase (“repo”) MBSs assist “small banks” with their Banks and other investors buy MBSs market for MBSs that enables institu- CRA performance by enabling an up- from securities dealers such as SS&TG, tions to earn increased income from ward adjustment of their loan-to-de- Freddie Mac’s in-house mortgage se- their investments by lending in the posit ratio. curities dealer operation. New MBSs repo market. CRA-qualified MBSs increase the usually sell at or close to their face supply of affordable housing. Freddie value. However, MBSs traded in the SUPPORTING CRA OBJECTIVES Mac’s Securities Sales & Trading Group secondary market fluctuate in price as WITH MBSS (SS&TG) pays a premium to origina- interest rates change. When the price The affordable housing goals that the tors for the LMI loans that they pro- of an MBS is above or below its face U.S. Department of Housing and Ur- vide, giving originators an incentive value, it is said to be selling at a pre 1 Source: The Bond Market Association 2 FFIEC Question and Answer Document on CRA Community Investments March 2002 21 mium or a discount, respectively. The As fixed-income securities, MBS find their principal committed longer price paid for an MBS is based on vari- prices fluctuate with changing inter- than expected, which prevents them ables including interest rates, the cou- est rates: when interest rates fall, prices from reinvesting at the higher prevail- pon rate, type of mortgage backing the rise, and vice versa. Interest rate move- ing rates. This scenario can be thought security, prepayment rates and supply ments also affect prepayment rates of of as extension risk. and demand. MBSs. When interest rates fall, MBSs issued in book-entry3 form ini- homeowners refinance mortgages, COLLATERALIZED MORTGAGE tially represent the unpaid principal and prepayment speeds accelerate. OBLIGATION (CMO) amount of the mortgage loans. Freddie Conversely, rising rates tend to de- The prepayment uncertainty of MBSs Mac and Fannie Mae MBSs issued in crease the prepayment speed. An ear- led to Freddie Mac’s development of book-entry form are paid by wire trans- lier-than-expected return of principal the collateralized mortgage obligation fer through the central paying agent, increases the yield on securities pur- (CMO) in 1983. This more complex the Federal Reserve Bank of New York, chased at a discount. However, when type of mortgage security helps com- which wires monthly payments to de- an MBS is purchased at a premium, partmentalize prepayment risk and pository institutions. Depositories put an earlier-than-expected return of better addresses investment time the MBS in “held to maturity” or “avail- principal reduces yield. frames and cash-flow needs. Since 1986, able for sale” accounts, depending on Each MBS has a coupon, which is most CMOs have been issued in real their investment strategy. Some inves- the interest rate passed on to the in- estate mortgage investment conduit tors hold bonds until they mature, vestor. The coupon is equal to the in- (REMIC) form for tax purposes.