Investing in Non-Agency MBSs and CMOs
   
  Over the past few years, the growth in mortgage origination has prompted mortgage underwriters to develop some innovative new products. Loans with interest-only periods, flexible amortization loans, loans with limited or no documentation, Jumbos, and Alt-A loans have garnered greater market share over the last few years. Perhaps your credit union has shifted some of its mortgage originations to these non-traditional loan types. Has your credit union also considered purchasing mortgage-backed securities (MBSs) composed of this type of collateral?

The Growth of Non-traditional Mortgages
As the issuance of these non-traditional mortgage products grew, the financial markets found buyers for them in the form of MBSs and collateralized mortgage obligation (CMO) securities. While credit unions cannot yet invest in asset-backed securities (backed by simple home equity loans), investment in domestic MBSs and CMOs is allowed, and is not limited to just government agency-issued mortgage-backed securities.

The private-label mortgage security market developed as mortgage originators started offering and closing more mortgages that did not conform to the government agency standards. Often, this was because these mortgages were larger than the agency limits (jumbo mortgages), and generally originated in high-priced real estate markets. Non-conforming mortgages expanded to include applicants who provided less than complete documentation, and those seeking to finance second homes or investment properties. These mortgages were initially targeted at high-end applicants. Interest-only loans were originally developed as money and tax management tools for wealthy individual investors. 

Eventually, mortgage markets expanded to include sub-prime borrowers. All of these markets developed because mortgage applicants had needs that were not being addressed by conforming mortgage loans. The growing supply of non-traditional loans spurred innovation by mortgage loan securitizers.

The CMO market actually started when investment banks pooled agency MBS pass-through securities and structured them into separate tranches with different characteristics. Eventually, the agencies allowed brokerage houses to issue CMOs in the agencys’ names as long as agency collateral was used. This occurred after the investor community showed its strong interest and acceptance of agency CMOs. While the agencies came to dominate the conforming mortgage MBS and CMO markets, private issuers were innovating structures with the non-conforming mortgages.

What This Means for Your Credit Union
What does a novice credit union investor in non-conforming mortgages need to consider before adding these securities to its investment portfolio? As with actual loan underwriting, look at the characteristics of the borrowers and the properties mortgaged. You will not be able to review each loan application, but you should be able to access aggregated information on the loans included in the pool. 

It is imperative to request and study the deal prospectus and supplements. This material should provide:
• Stratification and average information on loan size
• Loan types (this is where you should be able to find out if you have non-traditional loan types as collateral for the security)
• Loan rates
• Loan-to-value ratios
• Property types
• Loan purpose
• Occupancy status of the home
• Remaining terms to maturity
• Geographic distribution of the mortgaged properties
• Documentation types
• Borrower credit scores 

The prospectus should also tell you which companies originated the loans, who is servicing them, and who is acting as trustee for the deal. It will also disclose the deal structure and identify where the piece you are considering buying (typically referred to as a tranche), fits in the grand scheme of the deal. Specifically, it lists where your tranche is in the payment priority and how credit losses in the pool are allocated. 

Credit Enhancement
An important element to review is the type and amount of credit enhancement supporting the tranche you are considering. Agency MBS and CMO securities are backed (GNMA) or have the implied backing (FNMA, FHLMC) of the U.S. Government. Privately issued MBSs and CMOs must rely on other forms of credit enhancement. Over-collateralization, senior/subordination structuring, and surety coverage (an insurance wrap guaranteeing timely interest and ultimate principal) are the most common types of credit enhancement for privately issued MBSs and CMOs.

The rating agencies (Moody’s, Standard and Poor’s, and Fitch) will usually provide a credit rating on the deals. They also typically provide feedback ahead of time to the issuers as to how much credit enhancement is needed to achieve the ratings desired. It is important to note that the rating agencies are not infallible. It is incumbent upon your credit union to perform its own review and due diligence of the issuer, the underwriting, the credit enhancement, and the servicing. If possible, review prior deal performance and try to compare it to other deals. This can help you determine if it is priced appropriately to the risks of the collateral in the pool.

Risk vs. Reward
So, why would a credit union invest in such securities? The answer: risk versus reward. Because these securities are not backed by the U.S. government (and, somewhat as a result of this), they enjoy less liquidity in the marketplace. Therefore, the spreads available on non-agency MBSs and CMOs are generally more attractive than those on agency issues. 

For example the option-adjusted spread (OAS) of the current par coupon FNMA 15-year pass-through to the five-year point on the LIBOR/Swap curve was -30 basis points. Simultaneously, the OAS for an Aaa/AAA tranche on a 15-year Jumbo Mortgage pass-through deal was flat to LIBOR/Swaps. This is a potential pickup of 30 basis points. For 30-year pass-throughs, the then current FNMA OAS was -23 to LIBOR/Swaps, while Jumbos were earning eight basis points over LIBOR/Swaps. And, Alt-A pass-throughs were earning 39 OAS points over LIBOR/Swaps. For those credit unions that take the time to understand these securities, they offer a potentially substantial reward.

Summary
Profitability is a challenge for many credit unions in the current economic environment. While remaining competitive in lending products is usually a high priority for credit unions, staying competitive by investing in new security types does not often get the attention it deserves. 

As with any change in business practice, it is incumbent upon your credit union to “look before you leap” by learning all you can about a new investment. Non-agency MBS and CMO securities may help increase your credit union’s profitability, with a manageable increase in associated risks.