US MBS market.

Securitisation in its present form has been originated in the mortgage markets in the United States. It has been promoted with the active support of the government. The latter wanted to promote secondary markets in mortgages to allow liquidity for mortgage finance companies, critical factor in the development of home ownership. We review the existing US MBS structures.

I. FEDERAL AGENCIES

The MBS market is dominated by three agencies that purchase mortgage loans from banks, saving institutions and mortgage companies. They are the Government National Mortgage Association (GNMA or "Ginnie Mae"), the Federal Home Mortgage Corporation (FHLMC or "Freddie Mae") and the Federal National Mortgage Association (FNMA or "Fannie Mae").

As part of the Department of Housing and Urban Development, Ginnie Mae is a federal institution. MBS issued by Ginnie Mae are guaranteed by the full faith and credit of the United States government with respect to timely payment of both interest and principal. For the guarantee, Ginnie Mae receives a fee. Freddie Mae and Fannie Mae are commonly referred to as agencies of the US government. Their stocks trade on the NYSE and they are quasi private corporations. Although their guarantee does not carry the full faith and credit of the US government, the market believes that there is an "implicit" state guarantee.

Ginnie Mae was the first one to buy mortgages from mortgage companies and to convert them into pass through securities--this was in 1970. Fannie Mae and Freddie Mae jumped in later.

In addition to securities issued by the three agencies, there are also MBS issued by private banks or corporations ("private conduits"). The MBS issued by agencies are restricted to mortgage loans which satisfy a certain standard of underwriting. Such mortgages are called conforming mortgages. The private conduits, on the other hand, can also bundle loans which do not satisfy those underlying standards. Such mortgages are called non-conforming.

II. MARKET DEVELOPMENT

The US MBS market has experienced phenomenal growth over the past 20 years. The total outstanding volume of MBS has increased from about USD 100 bn in 1980 to about USD 3 tn in 2000. Nowadays, MBS form a major component of the US fixed income market.

Explanation for this rapid growth can be found on the "offer side" as well as on the "demand side".

A. Offer drivers

On the offer side, mortgage originators became much more disposed to sell loans into the secondary market after the high interest rates environment of the late 1970s and early 1980s, when the disadvantages of holding fixed-rate long-term loans in their portfolio became apparent. The growing market share of mortgage bankers, who have little interest in keeping mortgage loans in their balance sheet also contributed to their increased securitisation. As a general rule, many institutions became more and more aware of the benefits of the new process as a way to turn illiquid assets into liquid securities and hence improve overall balance sheet management.

The federal government-through its three "federal" housing finance agencies--has played a crucial role in the development of MBS in the US. These federal housing financing agencies were created to facilitate the flow of mortgage capital--in terms of cost and availability--and, hence, to ensure that lenders had adequate funds to make new mortgage loans.

B. Demand drivers

On the demand side, MBS represent nowadays an important portion of fixed-income holdings for many types of investors. This popularity is due to several factors.

These are:

* Higher returns. MBS typically yield 100bp or more over Treasuries and offer higher yields than comparable-quality corporate bonds. Although some of this higher yield compensate for their complexity and embedded prepayment options, MBS still have outperformed comparable Treasuries and other corporate bonds in most years since the early 1980s.

* Credit quality: As it has been mentioned previously, Ginnie Mae MBS are backed by the full faith and credit of the US government and, hence, like Treasuries, are considered to carry no credit risk. Fannie Mae and Freddie Mae MBS do not have US government guarantees, but because of Fannie Mae's and Freddie Mae's close ties to the government, their MBS are perceived to have minimal credit risk. MBS from other private issuers typically carry AAA or AA ratings.

* Variety of investment profiles: A large variety of MBS has been created. As an example, MBS are available with negative, short, or very long duration. Prepayment sensitivities can range from low to very high. Coupons can be fixed or floating. A concise review of existing US MBS structures will follow (see Section III).

* Liquidity: The amount of outstanding MBS, trading volume, and the involvement of major dealers provide an active, liquid market for most MBS.

* Development of analytic tools: Since the mid-1980s, many major dealers have devoted considerable resources to developing analytic models for evaluating MBS.

III. MORTGAGE-BACKED ABS (MBS)

The MBS market represents an important portion of the total ABS market. In this category we can further distinguish between different structures. The basic, "plain vanilla" mortgage-backed security structure is the Pass-through. Otherwise, the market offers structured MBS, such as the Collateralized Mortgage Obligation (CMO). Their respective characteristics are explained in what follows.

A. Pass-through

As the name implies, this structure passes through all cash flows--the monthly principal and interest payments, less a servicing fee--from a pool of mortgage loans to holders of the securities in proportion to their share ownership. In other words, investors in the pass-through are buying shares of the cash flows from the underlying loans.

The growth of the pass-through market is due in large part to the active role of the US housing finance agencies in the primary and secondary mortgage markets. Ginnie Mae, Freddie Mae and Fannie Mae account for nearly all of the issuance and outstanding principal amount of mortgage pass-throughs.

B. Collateralized Mortgage Obligation (CMO)

CMOs comprise a number of classes of bonds issued against specified mortgage collateral. The collateral can be agency pass-through pools, whole loans, or classes from other CMO deals.

Those classes, or tranches are related securities that are offered at the same time but have different risk, reward, and/or maturity. For example a CMO tranche might have mortgages that ,are 1 year, 2 year, 5 year, and 20 year maturity's.

The most basic CMO structure has tranches that pay in a strict sequence. Each tranche receives regular interest payments, but the principal payments received are made to the first tranche alone, until it is completely retired. Once the first tranche is retired, principal payments are applied to the second tranche until it is fully retired, mad the process continues until the last tranche is retired. The first tranche of the offering may have an average life of 2- 3 years, the second tranche 5-7 years, the third tranche 10-12 years, and so forth. This type of CMO is known as a "sequential pay", "clean", or "plain vanilla" offering.

The CMO structure allows the issuer to meet different maturity requirements and to distribute the impact of prepayment variability among tranches in a deliberate and sometimes uneven manner. This flexibility has led to increasingly varied mad complex CMO structures. CMOs may have 50 or more tranches, each with unique characteristics that may be interdependent with other tranches in the offering. The types ofCMO tranches include:

1. Planned Amortization Class (PAC) Tranches

PAC tranches use a mechanism similar to a "sinking fund" to establish a fixed principal payment schedule that directs cash-flow irregularities caused by faster- or slower-than-expected prepayments away from the PAC tranche and toward another "companion" or "support" tranche (see below). With a PAC tranche, the yield, average life, and lockout periods estimated at the time of investment are more likely to remain stable over the life of the security. PAC payment schedules are protected by priorities which assure that PAC payments are met first out of principal payments from the underlying mortgage loans. Principal payments in excess of the scheduled payments are diverted to non-PAC tranches in the CMO structure called companion or support tranches because they support the PAC schedules. In other words, at least two bond tranches are active at the same time, a PAC and a companion tranche. When prepayments are minimal, the PAC payments are met first and the companion may have to wait. When prepayments are heavy, the PAC pays only the scheduled amount, and the companion class absorbs the excess.

PAC tranches are now the most common type of CMO tranche, constituting over 50% of the new-issue market. Because they offer a high degree of investor cash-flow certainty, PAC tranches are usually offered at lower yields.

2. Targeted Amortization Class (TAC) Tranches

TAC tranches also provide more cash-flow certainty and a fixed principal payment schedule, based on a mechanism similar to a sinking fund, but this certainty applies at only one prepayment rate rather than a range. If prepayments are higher or lower than the defined rate, TAC bondholder may receive more or less principal than the scheduled payment. TAC tranches' actual performance depends on their priority in the CMO structure and whether or not PAC tranches are also present. If PACs are also present, the TAC tranche will have less cash-flow certainty. If no PACs are present, the TAC provides the investor with some protection against accelerated prepayment speeds and early return of principal. The yields on TAC bonds are typically higher than yields on PAC tranches but lower than yields on companion tranches.

3. Companion Tranches

Every, CMO that has PAC or TAC tranches in it will also have companion tranches (sometimes called support bonds), which absorb the prepayment variability that is removed from the PAC and TAC tranches. Once the principal is paid to the active PAC and TAC tranches according to the schedule, the remaining excess or shortfall is reflected in payments to the active companion tranche. The average life of a companion tranche may vary widely, increasing when interest rates rise and decreasing when rates fall. To compensate for this variability, companion tranches offer the potential for higher expected yields when prepayments remain close to the rate assumed at purchase.

Companion tranches are often offered for sale to retail investors who want higher income and are willing to take more risk of having their principal returned sooner or later than expected.

4. Z-Tranches

Z tranches (also known as Accretion Bonds or Accrual Bonds) are structured so that they pay no interest until the lockout period ends and they begin to pay principal. Instead, a Z-tranche is credited "accrued interest" and the face amount of the bond is increased at the stated coupon rate on each payment date. During the accrual period the principal amount outstanding increases at a compounded rate and the investor does not face the risk of reinvesting at lower rates if market yields decline. Typical Z-tranches are structured as the last tranche in a series of sequential or PAC mad companion tranches and have average lives of 18 to 22 years. However, Z-tranches can be structured with intermediate-term average lives as well. After the earlier bonds in the series have been retired, the Z-tranche holders start receiving cash payments that include both principal and interest.

While the presence of a Z-tranche can stabilize the cash flow in other tranches, the market value of Z-tranches can fluctuate widely, and their average lives depend on other aspects of the offering. Because the interest on these securities is taxable when it is credited, even though the investor receives no interest payment, Z-tranches are often suggested as investments for tax-deferred retirement accounts.

5. Principal-Only (PO) Securities

Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral. These Principal-Only (PO) securities may be created directly from mortgage pass-through securities, or they may be tranches ha a CMO. In purchasing a PO security, investors pay a price deeply discounted from the face value and ultimately receive the entire face value through scheduled payments and prepayments.

The market values of POs are extremely sensitive to prepayment rates and therefore interest rates. If interest rates are falling and prepayments accelerate, the value of the PO will increase. On the other hand, if rates rise and prepayments slow, the value of the PO will drop. A companion tranche structured as a PO is called a "Super PO".

6. Interest-Only (IO) Securities

Separating principal payments to create PO mortgage securities necessarily involves the creation of Interest-Only (IO) securities. CMOs that have PO tranches will therefore also have IO tranches. IO securities are sold at a deep discount to their "notional" principal amount, namely the principal balance used to calculate the amount of interest due. They have no face or par value. As the notional principal amortizes and prepays, the IO cash flow declines.

Unlike POs, IOs increase in value when interest rates rise and prepayment rates slow; consequently, they are often used to "hedge" portfolios against interest rate risk. IO investors should be mindful that if prepayment rates are high, they may actually receive less cash back than they initially invested.

The structure of IOs and POs exaggerates the effect of prepayments on cash flows and market value.

7. Floating-Rate Tranches

First offered in 1986, "floating-rate CMO" tranches carry interest rates that are tied in a fixed relationship to an interest rate index, such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI), subject to an upper limit, or "cap", and sometimes to a lower limit, or "floor".

The performance of these investments also depends on the way interest rate movements affect prepayment rates and average lives.

Sometimes the interest rates on these tranches are stated in terms of a formula based on the designated index, meaning they move up or down by more than one "basis point" (1/100 of one percent) for each basis point increase or decrease in the index. These so-called "superfloaters" offer leverage when rates rise. The interest rates on "inverse floaters" move in a direction opposite to the changes in the designated index and offer leverage to investors who believe rates may move down. The potential for high coupon income in a rally can be rapidly eroded when prepayments speed up in response to falling interest rates. All types of floating-rate tranches may be structured as PAC, TAC, companion, or sequential tranches, and are often used to hedge interest rate risks in portfolios.

8. Residuals

CMOs also contain a "residual" interest tranche, which collects any cash flow remaining from the collateral after the obligations to the other tranches have been met. Residuals are not classified as regular interest and may be structured as sequential, PAC, floating-rate, or inverse-floater tranches, and differ from regular tranches primarily in their tax characteristics, which can be more complex than other CMO tranches.

MATHILDE FRANSCINI Graduated from HEC Lausanne, Switzerland in 2001. She is a titular of a Licence en Sciences Economiques, a Master in Banking and Finance (MBF) and a Certificate FAME (Financial Asset Management and Engineering). She currently works at ABB Financial Services.

TAMARA SCHILLINGER obtained a Licence en Sciences Economiques from University of Lausanne, Switzerland in 2000; a Master of Science in Banking and Finance from University of Lausanne, Switzerland in 2001 2002. Tamara is currently working for ABB Financial Services.