How To Look Under The Hood When Investing In Mortgage-Backed Securities

Many MBS pools look alike on the surface but digging deeper can reveal major differences.

 
 

Purchasing mortgage-backed securities (MBS) is a lot like shopping for a car. Just as you would look at various different options when researching an automobile, so should you look at the different options when examining MBS. There are many cars that all look alike on the surface but after looking "underneath the hood" and checking out all the options you can see why similar looking cars can sell at a wide range of prices. Mileage, accidents, engine wear, A/C, manual/automatic are among the numerous factors that go into the price of a car.

When evaluating an MBS pool, it is just as important to look at the underlying characteristics of the assets. Many pools look alike on the surface but digging deeper can reveal major differences. Characteristics such as originator, origination year, loan-to-value (LTV), loan size, weighted average coupon (WAC), weighted average maturity (WAM), and geography are some of the things that you should pay attention to when evaluating securities.

Let's take a look at two securities that look very similar on the surface.

POOL # Coupon   Issue Date Maturity Date
FG C03728 4.00% 1/01/2012 01/01/2042
FG Q05077 4.00% 12/01/2011 12/01/2041


Both are 4% pools issued by Freddie Mac within one month of each other. So on the surface one could say that they look alike, but underneath they are very different. Let's dig a little deeper.

Below is a yield table showing the current profile for each pool.

3728
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Pool C03728 is currently trading in the market at 106-08. (Trading at 106-08 means 106 and 8/32 or 106 and a quarter. 100-00 is par. 106-08 is a premium price.) Current long-term projections are for a 345PSA prepayment speed which would result in 2.32% yield. The other calculations that follow are for different interest rate projections. The first example is for a 300 basis point rise in rates at which this pool is projected to pay 113PSA resulting in a 3.17% yield with a 9.39 year average life. Note that these are projections and can vary greatly as we will see later.

5077
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Pool FG Q05077 is currently trading in the market at 108-24. This pool is similar on the surface to FG C03728 but is trading 2 ½ points higher. Why does it trade that much higher? You can drill down deeper either by using Bloomberg or you can get the data from each agencies respective website.

In this case, the biggest difference in this pool is the maximum loan size – $150,000. This is called a "150k max pool" by traders. A premium is placed on MBS pools like this because loans of this nature tend to prepay at a much slower and consistent rate than regular 4% pools thereby increasing the yield. There is less financial incentive for a homeowner to refinance a mortgage with a lower balance due to the embedded costs of refinancing the mortgage. There also some other factors at play here such as the originator (US Bank) and geography (very diverse states and few in California) which would cause the pool to trade at a price premium to similar securities.

So just as you do your homework when shopping for a car, it is just as important to look underneath the hood when evaluating mortgage-backed securities. Consider asking your broker these questions:

  1. What is the yield at the current prepay speed? How does that yield look at historical prepay speeds?
  2. Is this a generic pool or are there certain characteristics that make a pool more valuable?
  3. Is this pool a fit for my portfolio?  Does the actual duration fit for what my portfolio needs are?

Stay tuned for the next segment when we look at these two pools again. We will examine the prepayment speeds and their effect on the true yield versus the expected yield.

 

 

 

Feb. 4, 2013


Comments

 
 
 
  • Great information. I think your readers need more MBS related articles like this that are short with easy to understand bullet points.
    Matt Johnson
     
     
     
  • Thanks Matt. Part II should be out tomorrow
    Kevin Heal