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Primer on mortgage backed securities, Part 2

MBS tranchingEnlarge GraphContinued from Primer on mortgage backed securities, Part 1.

Basic mortgage backed securities: Fannie Mae, Freddie Mac, and Ginnie Mae

Most mortgage backed securities are agency securites, which means they are associated with government guaranteed loans. Fannie Mae and Freddie Mac are government sponsored entities (GSE’s) and do not carry an explicit government guarantee like Ginnie Mae mortgages do. As a result, Fannie and Freddie mortgage backed securities trade at lower prices (higher yields) than Ginnie Maes. The starting point for mortgage backed securities is what is called the To Be Announced (TBA) market. A mortgage originator will deliver funded loans into a TBA mortgage backed security. The buyer of that security will not know the terms of the actual loans underlying it until it actually settles. All the buyer knows is that the loans that will be delivered to that security have a certain range of coupon payments and conform to the rules and regulations of the guaranteeing agency.

Agency MBS will cover any number of different types of mortgages. There are separate MBS for Ginnie Mae 30-year fixed rate loans (which covers FHA, VA, USDA loans), Fannie Mae 30-year fixed rate loans, Freddie Mac 30-year fixed rate loans, and then separate ones for 15-year fixed rate loans, and then adjustable rate loans as well. Agency securities do not bear credit risk. If the borrower defaults, the government will reimburse bondholders for any losses.

Agency MBS are by far the most dominant sector of the MBS space, but there is also the non-government section, which is called the private label market. These issuers sell securities backed by mortgages that are not government-guaranteed, which introduces a new risk: credit risk. In the private label market, if a borrower defaults on their mortgage, the bond holder will get the proceeds of the property after it is foreclosed, and if the proceeds from the foreclosure don’t cover the amount borrowed, investors start taking losses, starting with the equity tranches and moving up the waterfall. The biggest difference between the agency MBS space and private label space is credit risk and the fact that losses are allocated to investors.

Continue to Part 3.

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