As of March 31, 2006, credit unions held $24 billion in mortgage-backed securities (MBS)—about 12 percent of their total investments. The following three steps describe some best practices in selecting and managing investments in MBS.
First: Determine a good fit
Credit unions can invest in two main types of MBS: pass-throughs and collateralized mortgage obligations (CMO). The first best practice is to know what type of MBS fits your credit union’s current risk appetite, cash flow needs and ALM requirements.
Pass-throughs are the most basic type of MBS. A pass-through represents an ownership interest in a pool of mortgages that share some common characteristics (such as 30-year fixed-rate mortgages on residential housing). Most pass-throughs are issued by a government agency that offers a guarantee as to timely payment of principal and/or interest, and thus have an implied AAA credit rating. Pass-throughs can be backed by fixed-rate or adjustable-rate mortgages, or by hybrid ARMs.
Pass-throughs typically offer a higher yield than other bonds of similar quality because of their primary risk: uncertainty regarding the timing of principal repayments. Because few homeowners keep the same mortgage for 30 years straight, mortgages are sold on the basis of expected average life, rather than final maturity. As the interest rate environment changes, so does the expected average life. This variability makes it a challenge to estimate return prospectively.
Although CMOs are more complex than pass-throughs, their complexity has a benefit: it can provide greater cash flow certainty for some investors. Like pass-throughs, CMOs are also backed by a pool of mortgages, but the cash flows thrown off by the underlying mortgages is engineered to create different investor classes, called tranches. The risk of the underlying pool is reallocated among tranches so that more senior tranches typically have greater cash flow certainty and in theory, a more stable average life than pass-throughs. More subordinated tranches, on the other hand, accept greater uncertainty in exchange for more yield.
Carefully selected CMO tranches can offer mortgage exposure without the unchecked variability of pass-throughs. Bret Sears, VP/CFO from Island Federal Credit Union ($327m in Hauppauge, NY), described how the credit union dipped its toe into the CMO waters. “We’ve never invested in CMOs before, and we chose to invest in the first tranche to increase the comfort level of the board.”
Second: Know the collateral
The characteristics of the mortgages that underpin a pool or CMO can provide insight into how the security will perform both initially and as interest rates change. For example, a pool comprised of seasoned 6.5% mortgages will perform differently than a pool of new 7.5% mortgages.
The following are some of the essential facts to know before investing in a specific MBS:
- The types of mortgages in the pool
- The weighted average coupon (WAC) on the collateral and the range of coupons
- The mortgage rate formula, if other than fixed
- The weighted average age of the collateral
- The weighted average maturity of the collateral
- The number and size of the underlying mortgages
- The geographic distribution of the underlying mortgages
- If CMOs, the tranche type and principal payment parameters
Third: Test MBS sensitivity to interest rate changes.
The average life, yield to maturity and price of an MBS is driven by prepayment expectations. Past prepayment rates provide some but ultimately incomplete insight into future experience.
Forecasted prepayments are one source of variability in pricing among brokers. Therefore, it is essential for credit unions to obtain prepayment estimates from multiple—at least three—brokers and assess the reasonableness of the assumptions prior to purchase.
To learn more about investing in mortgage-backed securities, join us for a webinar on “Optimizing Investment Performance Using Mortgage-Backed Securities,” sponsored by the Callahan Center for Credit Union Leadership.