This Discussion is about Asset-Backed Securities and Mortgage Backed Securities and use of it for releasing obligation for a specific fund created with specific purposes, say pension fund. A new Pension Investment committee has been formed for managing investments for pension funds. The committee is interested in investing up to $25 million of pension assets in assets backed securities for 10 years to payout pension obligation for pensions. This discussion includes following-
• Types of Asset-Backed Securities (ABS) and Mortgage Backed securities (MBS).
• Specific example of ABS and MBS with their maturity pattern and comparisons of it with treasury securities for relatively same maturity period.
• Risk other than credit risk and interest risk involve with MBS for investors.
• What will be most appropriate MBS for Pension fund having in mind its 10 years period of maturity.
Asset & Debt Management
ABS – A security which is backed up by cash flows of a pool of assets.
MBS – MBS is a security backed up by the cash flows of payments of mortgage.
Both ABS and MBS provides lenders liquidity i.e. a way to obtain cash from assets which are normally generating cash at certain times or in maturity only. ABS and MBS provides investors a chance to invest in diversified portfolio of assets, hence it is less risky as compared to other securities. As ABS market is not always overvalued as compared to other securities like bonds or treasuries. Investors must done pre research of features of an underlying ABS before investing. MBS are securities backed by payments from mortgage assets whereas ABS is a security backed up by cash flow from non mortgage assets. There are many types of ABS, each having different characteristic and cash flow pattern, so each of them are unique in nature. Here are some of the most common ABS types:
ABS using Home Equity Loans
This asset is backed up by polling of Home Equity Loans. As this type of ABS is backed up by Home Equity Loans which are very similar to mortgages, hence this ABS is similar to MBS. However credit risks involved to this ABS is significantly higher than that of MBS because borrowers of home equity loans normally have poor credit ratings than mortgages. Hence investor should have a look at this factor when analyzing this type of ABS.
ABS using Auto Loan
Auto loans are amortizing asset. Therefore auto loans payments include monthly interest, principle and prepayment, if any. However as it is an amortizing asset it has less prepayment risk than that of other ABS and MBS. Prepayment happens only in a situation when the borrower has extra funds to pay the loan off. Refinancing rarely happen when the interest rate drops significantly. This happens because depreciation of car is faster than the loan balance resulting collateral value of asset is less than the outstanding balance. Most of the time balance of this loan is small and borrowers won’t be able to save much from refinancing based on a lower interest rate, so there is not much incentive of refinancing. However subprime auto loans i.e. borrower with a poor credit history involved in such loans make it more risky one in terms of credit risk.
ABS using Credit Card Receivables
This type of ABS is backed up by credit card receivable which is a non- amortizing asset, hence this ABS doesn’t have payment schedule and the pool of assets can be changed and new loans can be added.
Cash flow of credit card receivable consists of interest, principle and annual fees. Most of the time there is a lock up period for credit card receivables during which no principle will be paid. However if principle is paid within this lock up period, fresh loans will be added to the asset pool to keep the pool intact. After this lock up period principle payment will pass to the investor. Major risk involved in this ABS is obviously credit risk.
Types of MBS:
As it is discussed earlier MBS are securities which are created by pooling of various mortgages. Depends upon type of mortgage and characteristic of Mortgage MBS can be classified into following types:
Residential Mortgage Backed Securities (RMBS)
As name suggests this security is backed by mortgage on residential property. If home owner’s sale or refinance their home loans to take advantage of low interest rates or prepay for any other reason, the principle is distributed among investors on a pro rata basis. Investors receive payments based on class of assets belongs to them. Because of this Pool of assets gets reduced by amount of prepayments of principle. As pool of assets is reduced, interest income also decreases in terms of absolute amounts paid to investors.
Commercial Mortgage Backed Securities (CMBS)
This is a security backed by mortgage on commercial property. CMBS can provide liquidity to real estate investors and to commercial lenders. As there are lots of details associated with commercial property, it is quite difficult to value CMBS(Singleton & Pedersen, 2003). However CMBS has lower degree of prepayment risk because commercial mortgages are most often set for a fixed period.
Collateralized Mortgage Obligation (CMO)
It is debt obligation of an entity backed up its own assets. It is popularly known as pay-through bond. Pay through bonds can be typically divided into various classes that have different maturity period and different interest rates and different priorities for receipt of principle.
Stripped Mortgage Backed Securities (SMBS)
A Mortgage payment has two components i.e. Principle and interest. These components are separated in two parts to create a SMBS which include:
• Interest Only Stripped Mortgage Backed Securities (IO) – It is a security backed up by interest component of mortgage payment. Re-securitized residual interest of a mortgage-backed security is known as Net Interest Margin Securities (NISM).
• Principal Only Mortgage Backed Security (PO) – It is a security backed up by principal component of mortgage payment.
Example of MBS
GNMA 30 years MBS: – GNMAs, in particular, are backed by pools of first-lien mortgage loans insured or guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the Rural Housing Service (RHS). The borrowers associated with these loans are typically first-time homebuyers, have a low to medium income profile, and can afford only a small down payment—5% or less. Graphs showing comparisons of yield on MBS and Treasury-
Overall scenario of MBS yield as compared to Treasury Yield can be shown in this graph-
Example of ABS
Lehman ABS Index: 91.5 percent ABS of the Lehman Index have a credit rating of AAA. Investment grade ABS rated by Standard & Poor’s on 1st January, 2013 shows none of the ABS had defaulted by 30th June, 2003. Based on multiyear rating transition data by rating category and considering the rating composition of the Lehman ABS Index, we calculate three year default rate for the index which is less than 1/10th of 1 percent. Duration of ABS index is 2.98; however duration of Government 1-5 Index is 2.17. Therefore investing in ABS Index has more exposure to changes in the term structure of interest rates than investment in the Government Index. Bellow table shows the data adjusted for difference of duration. This will also show average monthly return, standard deviation of return and Sharpe ratios for the Lehman Index and for the Government 1-5 Index. Excess return shows differences between the two.
Risk associate with MBS other than Credit Risk and Interest Risk is Prepayment Risk.
Prepayment Risk:
This is the risk that investors decide to pay back the principal on their mortgages ahead of schedule. The result, for investors in MBS, is an early return of principal. This means that the principal value of the underlying security shrinks over time, which in turn leads to a gradual reduction in interest income(Becketti, 1989). Prepayment risk is typically highest when interest rates are falling.
Four factors to affect the prepayment rates:
• Refinancing Incentive
• Age of the mortgage (Seasoning)
• The month of the year (Seasonality)
• Premium Burnout (Principal balance)
The most appropriate MBS for pension fund planning would be RMBS. It has highly secured as it is a pass through security. Payment of mortgage can be disbursed on a pro rata basis under RMBS. In this investors receive payments according to the payment priorities and the class of securities they own. So, it will be most beneficial for pension fund management.
References
Becketti, S. (1989, February). The prepayment risk of mortgage-backed securities. Economic Review, Retrieved from
https://www.kansascityfed.org/PUBLICAT/REV/econrevarchive/1989/1q89beck.pdf
Duffee, G. R. (1998). The relation between treasury yields and corporate bond yield spreads. The Journal of Finance 53, Retrieved from https://onlinelibrary.wiley.com/doi/10.11/0022-1082.00089/abstract
Singleton, K. J. & Pedersen, L. H. (2003). Modeling sovereign yield spreads: a case study of Russian debt. The Journal of Finance 58, 119 – 159. Retrieved from https://onlinelibrary.wiley.com/doi/10.11/1540-6261.00520/abstract
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