How do borrower defaults impact investors of agency Mortgage-Backed Securities (MBS)?
This is a reasonable question, especially considering the pain of the great financial crisis that remains etched in our collective memory. Important differences in loss exposure between agency MBS and private label MBS help clarify this question for investors.
For virtually all private label MBS, the credit risk of borrower defaults within a mortgage pool are passed on to the investor, which is what we all remember from the MBS melt down that occurred during the great financial crisis. However, for agency-backed MBS, the sponsoring agency (e.g., Fannie Mae, Freddie Mac, Ginnie Mae), assumes the credit risk for borrower defaults by pledging to buy those defaulted loans out of the pool. This guarantee transforms the credit loss risk into prepayment risk to the investor. This guarantee comes at a cost though, as agency-backed MBS carry lower yields than private label MBS.
When will principal be returned?
When we layer the implicit government guarantees for Fannie and Freddie and the explicit government guarantee for Ginnie Mae, the question of whether principal will be returned is not if, but when? During the great financial crisis, no agency MBS investors experienced any principal losses on their holdings. Additionally, conventional mortgages purchased by Fannie and Freddie offer some of the strongest credit profiles among mortgage borrowers.
As for managing prepayment risk (which is comprised both of voluntary prepayments and defaults as discussed above), there are Collateralized Mortgage Obligations (CMOs) constructed off agency MBS pools with structures that limit interest rate risk and extension/contraction risk for the investor. For example, front sequential-pay structures allow investors to receive the initial principal cashflows from a mortgage pool, thereby shortening the cashflow window. Planned Amortization Class (PAC) bonds, offer similar benefits with a predictable cashflow structure so long as prepayments remain within a predefined range.
The other variable to consider when purchasing agency MBS or CMOs which carry prepayment risk is the degree to which those prepayments or defaults can impact the security’s yield. When the borrowers prepay their loans (or the GSEs purchase defaulted loans out of a pool), that principal is returned to the investor immediately, which can shorten the security’s life and cause premiums to be amortized more quickly, negatively impacting yield. The opposite is true for securities purchased at a discount.
The agency MBS market also offers a high degree of liquidity, as the third largest bond market after US Treasury and corporate bonds. According to 2018 data from SIFMA, more than a quarter of US bond market trading volume resides in this asset class, second only to US Treasury trading volume.
Agency MBS are often the core of a financial institution’s investment portfolio, offering a healthy spread to Treasury rates and amortizing cashflows which can be redirected to other places on the balance sheet as needed. Even better, these securities offer income potential without the addition of credit risk (default risk) to the balance sheet.
Past performance is not indicative of future results. Advisory services offered through Accolade Investment Advisory, LLC.