Investing in Mortgage-Backed Securities

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US News & World Report quoted me in Why Investors Own Private Mortgage-Backed Securities. It opens,

Private-label, or non-agency backed mortgage securities, got a black eye a few years ago when they were blamed for bringing on the financial crisis. But they still exist and can be found in many fixed-income mutual funds and real estate investment trusts.

So who should own them – and who should stay away?

Many experts say they’re safer now and are worthy of a small part of the ordinary investor’s portfolio. Some funds holding non-agency securities yield upward of 10 percent.

“The current landscape is favorable for non-agency securities,” says Jason Callan, head of structured products at Columbia Threadneedle Investments in Minneapolis, pointing to factors that have reduced risks.

“The amount of delinquent borrowers is now at a post-crisis low, U.S. consumers continue to perform quite well from a credit perspective, and risk premiums are very attractive relative to the fundamental outlook for housing and the economy,” he says. “Home prices have appreciated nationwide by 5 to 6 percent over the last three years.”

Mortgage-backed securities are like bonds that give their owners rights to share in interest and principal received from homeowners’ mortgage payments.

The most common are agency-backed securities like Ginnie Maes guaranteed by the Federal Housing Administration, or securities from government-authorized companies like Fannie Mae and Freddie Mac.

The agency securities carry an implicit or explicit guarantee that the promised principal and interest income will be paid even if homeowners default on their loans. Ginnie Mae obligations, for instance, can be made up with federal tax revenues if necessary. Agency securities are considered safe holdings with better yields than alternatives like U.S. Treasurys.

The non-agency securities are issued by financial firms and carry no such guarantee. Trillions of dollars worth were issued in the build up to the financial crisis. Many contained mortgages granted to high-risk homeowners who had no income, poor credit or no home equity. Because risky borrowers are charged higher mortgage rates, private-label mortgage securities appealed to investors seeking higher yields than they could get from other holdings. When housing prices collapsed, a tidal wave of borrower defaults torpedoed the private-label securities, triggering the financial crisis.

Not many private-label securities have been issued in the years since, and they accounted for just 4 percent of mortgage securities issued in 2015, according to Freddie Mac. But those that are created are considered safer than the old ones because today’s borrowers must meet stiffer standards. Also, many of the non-agency securities created a decade or more ago continue to be traded and are viewed as safer because market conditions like home prices have improved.

Investors can buy these securities through bond brokers, but the most common way to participate in this market is with mutual funds or with REITs that own mortgages rather than actual real estate.

Though safer than before, non-agency securities are still risky because, unlike agency-backed securities, they can incur losses if homeowners stop making their payments. This credit risk comes atop the “prepayment” and “interest rate” risks found in agency-backed mortgage securities. Prepayment risk is when interest earnings stop because homeowners have refinanced. Interest rate risk means a security loses value because newer ones offer higher yields, making the older, stingier ones less attractive to investors.

“With non-agencies, you own the credit risk of the underlying mortgages,” Callan says, “whereas with agencies the (payments) are government guaranteed.”

Another risk of non-agency securities: different ones created from the same pool of loans are not necessarily equal. Typically, the pool is sliced into “tranches” like a loaf of bread, with each slice carrying different features. The safest have first dibs on interest and principal earnings, or are the last in the pool to default if payments dry up. In exchange for safety, these pay the least. At the other extreme are tranches that pay the most but are the first to lose out when income stops flowing.

Still, despite the risks, many experts say non-agency securities are safer than they used to be.

“Since the financial crisis, issuers have been much more careful in choosing the collateral that goes into a non-agency MBS, sticking to plain vanilla mortgage products and borrowers with good credit profiles,” says David Reiss, a Brooklyn Law School professor who studies the mortgage market.

“It seems like the Wild West days of the mortgage market in the early 2000s won’t be returning for quite some time because issuers and investors are gun shy after the Subprime Crisis,” Reiss says. “The regulations implemented by Dodd-Frank, such as the qualified residential mortgage rule, also tamp down on excesses in the mortgage markets.”

Reiss on Dimming of FIRREA

Inside MBS & ABS quoted me in Judge Recommends Dismissal of DOJ’s Fraud Case Against BofA, But It May Not End FIRREA Claims (behind paywall). It reads,

A North Carolina federal magistrate has recommended that a Justice Department fraud case against Bank of America be dismissed, but he also said a separate Securities and Exchange Commission lawsuit against the bank based on a different federal law should proceed.

The DOJ last August filed suit against BofA under the Financial Institutions Reform, Recovery and Enforcement Act, accusing the bank of defrauding investors in the sale of $855 million of nonagency MBS. Last week, U.S. Magistrate David Cayer of the U.S. District Court for the Western District of North Carolina found that the government failed to prove the bank made “material” false statements to the former Federal Housing Finance Board.

The DOJ claimed that BofA “willfully” misled investors, including the Federal Home Loan Bank of San Francisco and Wachovia Corp. – now owned by Wells Fargo – about the risks in the 2008 offering by failing to fully disclose the risk of 1,191 jumbo adjustable-rate mortgages backing the deal.

FIRREA allows the government to seek civil penalties equal to losses suffered by federally insured financial institutions, with a maximum of $1.1 million per violation. The 1989 law was a little used relic of the savings and loan aftermath until government lawyers began recently to invoke it widely in addition to other charges.

The law gives agency lawyers the ability to tap grand jury material and to subpoena documents. FIRREA also has a 10-year statute of limitations, longer than the typical five years for fraud cases, allowing government lawyers more time to pursue cases related to the 2007-2008 financial crisis.

The magistrate rejected the government’s claim that BofA’s statements were in violation of FIRREA because the FHLBank of San Francisco was within the jurisdiction of the FHFB. Cayer found that policing such statements did not fall within the agency’s purview and there was no indication that either the FHFB or the FHLBank ever complained about the MBS.

The magistrate recommended the DOJ’s case be dismissed without prejudice, although District Judge Max Cogburn will have the final word. Cayer allowed a parallel complaint filed by the SEC to move forward.

David Reiss, a professor at Brooklyn Law School, noted that U.S. district judges often give deference to reports from magistrate judges. But even if Cogburn opts to dismiss the DOJ’s case, it’s less an indictment against the use of FIRREA and more an indication that the government filed its case incorrectly, he said.

“Is it a harbinger that all other judges are going to change their minds about the broad reading of FIRREA? I don’t see that at all,” Reiss told Inside MBS & ABS. “I see judges in New York and in other jurisdictions continuing to allow the government to broadly interpret FIRREA based on its plain language. They are reading the text of the statute and saying the government can act.”