Mortgage Backed Securities Introduction

The speaker provides a description of what a mortgage backed security is and then discusses the benfits and drawbacks of holding them in a fixed income portfolio.  He first explains how investment banks and GSE's will purchase home loans of all terms (ie. 30 year, 15 year, etc) and securitize them in order to sell them off to investors.  The cash flows from the borrower are passed through the bank that collects them onto the originator of the MBS who will then transfer these cash flows to the investor. 

In this series, the bank is paid a servicing fee to collect payments, escrow taxes, ect.  After the servicing fee is taken, the remaining balance is sent to the investment bank or GSE which created the security.  They will take a guarantee fee and other fees before passing the balance onto the investors. 

The speaker discusses three different types of loans which are securitized; governmental (FHA & VA), conventional (or conforming), and non-conforming.  Ginnie Mae handles securitizing the FHA and VA pools while Fannie Mae and Freddie Mac handles securitizing the conforming pools.  Non-conforming loans are not purchased by the GSE's and packaged into private label MBS securities by smaller institutions.

Over the past few years, the GSE's (Fannie and Freddie) have expanded their guidelines to allow them to purchase subprime loans and more speculative loans which were very risky.  This was in an effort to promote home ownership through lower income areas and this policy ended up backfiring. 

He talks through the risks of purchasing mortgage backed securities; these include prepayment risk and default risk (or cash flow risk).  Interest rates may fluctuate causing borrowers to refinance their mortgages, thereby increasing the prepayments and lowering the future cash flows.  This is known as negative convexity.