20 Days of Real Estate: Day 1 （Mortgage-Backed Securities 101）

20 Days of Real Estate
Booyah Breakdown: MBS 101
By Tracy Byrnes
TheStreet.com Contributor
3/31/2007 11:24 AM EDT
URL: http://www.thestreet.com/funds/realestate/10347801.html

As a special feature for April, TheStreet.com offers a 20-part series on virtually everything to do with real estate. Today's installment is part one.

These days, if we're not talking about the paternity of Anna Nicole Smith's baby, we're talking about the subprime mortgage market.

That's probably why our Subprime 101 story got a ton of email and bunch of great questions.

And it seems that many of you had questions about the mortgage-backed securities that ultimately end up holding these subprime loans.

So the Booyah Breakdown is going to tackle that today. Welcome to MBS 101! (Do you feel like a freshman in college again?)

What Is a Mortgage-Backed Security?

The technical definition of a mortgage-backed security, or MBS, is that it's a securitized interest in a pool of mortgages. More simply put, it's like a bond and, instead of paying investors a fixed coupon and principal, an MBS pays out principal and interest payments from the mortgages in the pool.

Here's how it all works.

Joe Borrower walks into Local Bank because he needs a loan to buy a house.

Joe gives the bank enough information to prove he can afford the loan. Local Bank then checks Joe's credit (salary, assets, etc.) and establishes the worth of the property through an appraisal. Joe and Local Bank negotiate and establish the terms of the loan, such as the interest rate, the amortization of principal as well as the prepayment terms.

Everything checks out and Joe gets his loan. Yippee!

Local Bank issues lot of loans to borrowers like Joe. But at some point, Local Bank runs out of money to loan.

So Local Bank decides to clean up its balance sheet.

It chooses to sell those mortgages to a government-sponsored institution, like Fannie Mae (FNM) or Freddie Mac (FRE) , or to an investment bank.

The Federal National Mortgage Association, a.k.a. Fannie Mae, was formed by the by the government back in 1938 to promote home ownership in the America. Fannie would purchase the mortgages from the banks to free up the banks' money so they could originate more mortgages.

The Government National Mortgage Association, Ginnie Mae, and the Federal Home Loan Mortgage Corporation, Freddie Mac, were formed in 1968 and 1970, respectively. They play a similar role to Fannie Mae but target different segments of the mortgage market.

More recently, a number of Wall Street firms have gotten in on the act. A lot of the mortgages they are buying and securitizing are made to less creditworthy borrowers -- stuff Fannie and Freddie won't buy.

So Local Bank sells its mortgages to Fannie, Freddie or whomever, to free up its capital. Freddie, Fannie and the investment banks will now receive the principal and interest payments on those mortgages.

In most cases, our Local Bank will still service those loans, though. It will still collect payments, answer any questions and send out tax documents at the end of the year. It'll just keep a service fee, or percentage of the interest payment, for its work. So if the interest payment on the mortgage is, say, 5-3/4%, the bank will keep, say, 1/8% for its servicing. It will send the remaining interest payment on to Fannie or Freddie.

So now Fannie and Freddie are holding all this debt. But after a while, they too realize they need to free up some cash so they can continue to relieve the debt of Local Banks.

Fannie and Freddie also know that there's a whole market of bond investors out there looking to invest.

But bond investors don't want to hold a single mortgage in their portfolio. That does nothing for their portfolio's fixed-income diversification.

So a security is created. This security is basically a bunch of mortgages all under one umbrella, called a mortgage-backed security.

The mortgages can be pooled in a number of different ways -- by different maturity, risk and return characteristics. They can also be pooled by mortgages for single-family home only, multifamily home, 30-year fixed, 15-year fixed, adjustable-rate mortgages, geographic location and, of course, subprime loans. But the permutations are endless.

The investors of these securities are typically very large and sophisticated money managers, like mutual funds and pension funds.

Why Not Just Buy a Bond?

One of the biggest reasons you invest in MBS is that your cash flow comes faster. Joe Borrower (supposedly) makes monthly payments - which come to you -- as opposed to a bond's interest payment, which is usually paid out semiannually.

There's also more risk than buying a Treasury bond. That's because Joe Borrower has the option to pay his mortgage off early -- maybe he wants to refinance the loan, relocate for a new job or just get nicer digs. That deprives you of future income and forces you to put your money to work somewhere else.

And in some cases, you're depending on Joe Borrower to make his payments.

That extra risk entitles you to more money. The interest rate on a 30-year Treasury bond these days is around 4.8% vs. a 30-year mortgage loan, which could be around 6% for the most creditworthy borrowers. So you get a higher yield with the MBS.

The easiest way to get information on these securities is to call any fund family like Fidelity, T. Rowe Price (TROW) and Pimco. Or call the banks, like Bear Stearns (BSC) or Washington Mutual (WM) .

You could also consider the newly launched iShares Lehman MBS Fixed-Rate Bond Fund (MBB) , a new ETF that provides exposure to mortgage-backed securities. Big note: There are no subprime mortgages in this product.

The Big Question: What's the Risk?

First, an important distinction. The mortgages backing the securities issued by Fannie and Freddie are guaranteed. So if Joe Borrower misses a payment, the housing agenices foot the bill.

But for the most part, the folks who invest in mortgage-backed securities issued by an investment bank are relying on our original Joe Borrower to make his mortgage payment.

Well, what if he doesn't? What if he was a subprime borrower, turned deadbeat?

The individual or fund who bought the security won't get its payment stream.

So what does that investor do?

Well, on one hand, that risk is part of the game. On the other hand, he could go back to Local Bank and request that it cover the loan.

Now the bank does have some money set aside for defective loans that it could give to the investors. But the defaults are coming faster these days, and that reserve has run out.

So now the bank's losses begin to mount, its stock price falls, and its profits are gone. "In addition, the bank now has no access to cash to fund new loans and sell them, so their business model no longer performs," says Keith Gumbinger, vice president of HSH Associates of Pompton Plains, N.J., which tracks a variety of loan products.

So now both the banks and the MBS investors are suffering.

But the banks get hit from both ends when they're in the subprime world. That's because many times the banks that offer subprime loans aren't able to sell those loans, notes Mark Grinis, a partner in Ernst & Young's real estate, hospitality and construction group.

So our Local Bank bears all the risk of those loans. And these days, that's not such a good thing.

OK. So that's a very simple run-through of the mortgage-backed security world.

Whew!

I'm sure you'd much rather go back to talking about Anna Nicole right about now.