Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity
The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization
Ginnie Mae, backed by the full faith and credit of the U
government, guarantees that investors receive timely payments
Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U
government, have special authority to borrow from the U
Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities
Mortgage-backed securities exhibit a variety of structures
The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets
More complicated MBSs, known as collaterized mortgage obligations or mortgage derivatives, may be designed to protect investors from or expose investors to various types of risk
An important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall
Absent protection, such prepayments would return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive
You can learn more about mortgage securities by visiting the website of The Securities Industry and Financial Markets Association
Staff of the Department of the Treasury ("Treasury"), the Office of Federal Housing Enterprise Oversight ("OFHEO"), and the Securities and Exchange Commission (the "Commission") formed a joint task force ("Task Force") in August 2002 to conduct a study of disclosures in offerings of mortgage-backed securities ("MBS")
The purpose of the joint study was to evaluate current disclosure practices and consider whether disclosure enhancements are desirable in assisting investors to make informed investment decisions
In conducting the study, the Task Force reviewed the history and development of the MBS markets, the current disclosure requirements for these securities, and market-driven industry disclosure practices and standards
The Task Force also interviewed a variety of MBS issuers and investors, and other experienced market participants and observers, which provided the Task Force with additional perspectives about the evolution of the MBS markets, including changing disclosure standards
The Task Force received recommendations concerning changes to current disclosure standards based on investor needs, and assessments as to the likely impact of additional disclosure on the MBS markets' continued smooth functioning and liquidity
This report contains the Task Force's findings, conclusions, and recommendations regarding enhanced MBS disclosures
Privately owned financial institutions have become increasingly important as issuers in the so-called "private-label" market
The MBS markets are estimated to have grown by more than 800% in the past two decades
MBS investors continue to be almost exclusively institutional, but their expressed needs have changed with the evolving market and economic conditions
In recent years, investors have focused much more time, attention and resources on the evaluation of prepayment risk and, in the case of private label MBS, credit risk
Market participants interviewed by the Task Force indicate that the changes have been considered beneficial to the market
In interviews with the Task Force, MBS market participants also agreed, almost without exception, that the significant changes in disclosure did not affect the highly liquid nature of the GSE and Ginnie Mae pass-through and to-be-announced markets, and MBS markets generally operate reliably and efficiently
Yet, the Task Force also found that most market participants with whom it spoke, as well as most lenders and non-GSE issuers, believe the MBS markets could function better with additional pool-level disclosure
Moreover, consistent with their past experiences with changes in disclosure, these market participants expressed confidence that additional pool-level disclosures would not have a significant adverse effect on the markets' liquidity
Based on the study, the Task Force has concluded that additional pool-level disclosures would be both useful and feasible
Market participants interviewed by the Task Force were clear in suggesting additional information that they believed would be useful
This report sets forth and describes the most frequently mentioned information that market participants recommended be disclosed to supplement currently disclosed information
Examples of additional disclosure items that market participants suggested would present few practical obstacles are:loan purpose;
The Task Force believes there are no significant obstacles to the introduction of these additional pool-level disclosures and that the benefits of enhanced transparency would ultimately outweigh any costs
To implement additional disclosures, the Task Force recommends that investor interest and issues of practicality should be key criteria used to determine the specific items for additional disclosure in the MBS markets, as well as the appropriate timing and method of providing this additional disclosure
In the past, industry groups and other market participants have stepped forward to coordinate and implement additional disclosures in the MBS market
The Task Force encourages a continuation of this approach at this time
If market forces are unable to reach consensus on disclosure enhancements, the agencies represented on the Task Force will need to consider what additional action might be appropriate
In addition to its review of MBS disclosures, the Task Force inquired about allegations of selective MBS selling and purchasing practices arising from possible information imbalances among market participants
The Task Force looked at policies and procedures regarding information barriers at the GSEs
In addition, OFHEO reviewed OFHEO examination reports and inquiries of the GSEs as to specific allegations
Though questioned by the Task Force about such allegations, interviewees provided no evidence to substantiate allegations of improper activity
The Treasury, the Commission, and OFHEO will, in their separate capacities, continue to monitor the MBS markets to assess the implementation and potential impact of enhanced MBS disclosures
If future developments warrant, the Task Force members, in their separate capacities or jointly as they agree appropriate, could consider what additional steps might help provide additional, useful disclosures to MBS investors and market participants
In July of 2002, Treasury, OFHEO and the Commission made a joint announcement regarding the intention of Fannie Mae and Freddie Mac to voluntarily register their common stock under the Securities Exchange Act of 1934 (the "Exchange Act")
This voluntary registration, when in place, will trigger periodic disclosures regarding the GSEs
Treasury, OFHEO and the Commission also indicated they would review disclosure requirements and practices in the MBS markets, which would not be affected under this voluntary registration initiative
The purpose of the review on primary offering disclosures for MBS, which culminated in this report, was to examine disclosures to all investors in these securities, with a view to enhancing the availability of information that investors should have to evaluate the securities in the MBS markets and make investment decisions
Staff from Treasury, OFHEO and the Commission, acting as the Task Force, have conducted the review of the disclosure practices in the MBS markets
The Task Force reviewed regulatory disclosure requirements and current industry disclosure practices
The Task Force also interviewed Fannie Mae, Freddie Mac and Ginnie Mae, private-label issuers, institutional investors, dealers, individual analysts, MBS market and real estate finance trade groups, pension funds and others involved in the markets to hear their views ranging from evaluations of current markets, how the markets function and particular concerns regarding disclosures
As background to the Task Force's findings, the report discusses the development and operation of the MBS markets, the various market participants, and the types of MBS sold
The report also addresses current disclosure practices and investor interest regarding the assets of and structures used for the securitization vehicles, credit and repayment sources and other risks affecting the repayment and value of the MBS, and information imbalance issues
Finally, the report notes categories of information that the Task Force believes would enhance disclosures in the MBS markets
Growth in the MBS markets has been significant over the past 20 years
For example, single-family MBS grew from less than $367 billion outstanding in 1981 to more than $3
In order to understand the reasons for evaluating disclosure practices in the MBS markets, it is helpful to understand the development and operation of the MBS markets
As described in this section, the MBS markets consist primarily of the MBS issued or guaranteed by two government-sponsored enterprises, Fannie Mae and Freddie Mac, and one United States-owned corporation, Ginnie Mae
MBS are also issued by private-label issuers, which are private institutions
The GSEs and Ginnie Mae guarantee payments on their respective MBS, whereas private-label issuers use various forms of credit enhancement
The most commonly issued MBS are pass-through securities, which consist almost entirely of GSE and Ginnie Mae MBS, and REMICs, which are the primary security issued by private-label issuers
The MBS investor base has evolved, but remains largely institutional
The most important risks in the MBS market are prepayment risk and credit risk
This section includes a discussion of how these risks drive disclosures in the MBS markets
Other sections of this report discuss whether MBS disclosures can be enhanced
Fannie Mae, Freddie Mac, and Ginnie Mae were all created by federal law to address perceived deficiencies in the U
The GSEs and Ginnie Mae enhance liquidity by enabling lenders and originators to sell their mortgage loans and use the proceeds from the sales to make new mortgage loans
Fannie Mae was originally authorized only to buy FHA insured loans
After being split into two entities in 1968, Fannie Mae and Ginnie Mae, Fannie Mae was authorized to buy a broader range of loans
Freddie Mac was initially authorized to purchase conventional mortgages from federally insured financial institutions
Both Fannie Mae and Freddie Mac are now investor owned companies, and the common stock of both companies is traded on the New York Stock Exchange
Ginnie Mae does not buy or sell loans or issue MBS; instead, it guarantees payment on MBS that are backed by federally insured or guaranteed loans, mostly loans insured by the FHA and guaranteed by the Department of Veterans Affairs (the "VA")
Other guarantors or insurers of loans eligible as collateral for Ginnie Mae MBS include other offices in the Department of Housing and Urban Development ("HUD"), and the Department of Agriculture's Rural Housing Service
Ginnie Mae is a wholly-owned government corporation under the auspices of HUD
Private-label issuers include commercial banks, savings associations, mortgage companies, investment banking firms and other entities that acquire and package mortgage loans for resale as MBS
The types of investors in MBS have changed over time
Initially the primary purchasers of MBS were thrift institutions, commercial banks, insurance companies, pension funds, and mutual funds
More recently Fannie Mae, Freddie Mac, and international institutions have also become much more active market participants
Investments in MBS are made for a variety of reasons
Some investors purchase MBS to hold long-term in portfolios while others purchase for short term trading purposes
MBS are also widely used for hedging purposes
Much of the development of GSE, Ginnie Mae, and private-label MBS markets has been in direct response to investor interests and demands
The MBS market as we know it today can be traced back to 1970, when Ginnie Mae first guaranteed a pool of mortgage loans
The creation of Freddie Mac in 1970 helped to expand the market
In the basic MBS structure, a group of mortgage loans is sold to a trust or other investment vehicle
In the case of residential home mortgages, the pools usually include a large enough number of loans so that information on no one loan is important in analyzing the pool
The investment vehicle owns the mortgage loans, issues securities that are either backed by or represent interests in the loans, and makes payments to investors out of the payments made on the loans
A servicer is hired to collect the mortgage payments from the borrowers and to pass the payments, less fees, including guarantee and trustee fees, through to the trustee, who passes these payments on to the investors that hold the MBS
To facilitate sales of MBS, the GSEs and Ginnie Mae are authorized to guarantee the MBS
Thus, if for some reason, there is insufficient money to cover the payments due on the MBS, the GSEs make the payments due on the MBS
Ginnie Mae's guarantee arises if the issuer (typically the loan originator) does not make the delinquent payments to the MBS holders
Unlike Fannie Mae and Freddie Mac, which are permitted to issue, as well as guarantee the payments on, MBS, Ginnie Mae only guarantees the payment of MBS that are created by private entities
Ginnie Mae's guarantee of the payment of MBS is backed by the full faith and credit of the United States, whereas the guarantee obligations of Fannie Mae and Freddie Mac are not
There are significant differences in the composition and structure of typical private-label MBS compared to MBS issued or guaranteed by the GSEs or Ginnie Mae
The perceived strength of the guarantees, the evolution of tax law, and the demands of investors in an increasingly complex marketplace have contributed to current practices and product distinctions between GSE and Ginnie Mae MBS and private-label MBS
A number of regulatory and tax constraints initially impeded private entities from expanding into the MBS market created by the GSEs and Ginnie Mae
Many of the regulatory constraints affecting private entities were removed in 1984 with the passage of the Secondary Mortgage Market Enhancement Act of 1984 ("SMMEA")
SMMEA was intended to encourage private sector participation in the secondary mortgage market by, among other things, relaxing certain regulatory burdens that affected the ability of private-label issuers to sell their MBS
Tax law constraints also affected the types of MBS that could be sold
Until the passage of the Tax Reform Act of 1986 ("1986 Tax Act"), which recognized the Real Estate Mortgage Investment Conduit ("REMIC") structure with its beneficial tax treatment, most MBS were sold as "pass-through" securities
As discussed below, pass-through securities pay an investor principal and interest received from payments on the mortgage loans that are the assets of the trust
The payments on the mortgage loans are passed through the trust to the investors as they are made
Before 1986, the effect of the limitation on activity of grantor trusts under the tax laws restricted the use of trusts with multiple classes of securities with differing payment characteristics
In the multi-class structure, the principal and interest payments are not just passed through pro rata as paid to all investors, but rather are divided into varying payment streams to create classes with different expected maturities, different levels of seniority or subordination or other differing characteristics
Prior to 1986, the tax law treated these multi-class trusts as associations taxable as corporations, and distributions would have been taxable at the trust level and also at the trust investor level
This "double taxation" made multi-class structures generally unfeasible
The 1986 Tax Act eliminated the double taxation for multi-class vehicles structured as REMICs
With the advent of the REMIC, more complex structures with multiple classes were developed which divided up the payment streams on the mortgage loans that were collateral for the securities repayment obligations to investors
There are differences between the GSE and Ginnie Mae MBS and private-label MBS in the composition of the mortgage loans comprising the collateral for the respective pools
The types of underlying mortgage loans that are eligible to be included in GSE and Ginnie Mae MBS affect the composition of pools backing private-label MBS because originators can generally receive the best price for eligible loans in GSE and Ginnie Mae transactions
Because the GSEs require a higher fee to accept some loans of lesser credit quality, sometimes originators may find a private-label transaction more attractive
The mortgage loans included in Fannie Mae and Freddie Mac MBS generally have the following characteristics:mortgages are on residential properties, most commonly one to four family homes (these are referred to as single family loans);
mortgages are generally 15 year and 30 year maturities that are fully amortizing;16
the loans are due on sale of the underlying property and cannot be assumed by the buyer of the property;18
mortgage loans must be within the "conforming loan limit", which for one-unit homes in 2003 is $322,700
loans within the conforming loan limit generally satisfy other GSE specifications for loan documentation, credit information and property type, among other requirements
There are some mortgage loans made to borrowers with good credit histories that are within the conforming loan limit but do not satisfy all the standard GSE underwriting guidelines, including documentation, for mortgage loans
These mortgage loans are called "Alternative A" or "Alt A" loans
These Alt A loans fail to satisfy the GSE guidelines for reasons such as limited or low documentation of income from the borrower (for reasons of speed or convenience to the borrower), unstable income sources, higher loan-to-value ratios ("LTV") or other ratios of payments to income
Alternative A loans and some lower credit quality loans that are within the conforming loan limit can be swapped for Fannie Mae or Freddie Mac MBS or pooled and sold as private-label MBS
Fannie Mae or Freddie Mac will issue MBS backed by such loans if the lender pays a higher guarantee fee that compensates the GSE for the potentially higher risk
Apart from Alt A loans, there are other types of mortgage loans that do not satisfy standard GSE requirements
Mortgage loans that are larger than the conforming loan limit, called jumbo loans, cannot, by statute, be included in GSE or Ginnie Mae MBS pools
Mortgage loans are also made to borrowers who fail to meet GSE underwriting requirements because of certain borrower or loan characteristics
For example, mortgage loans made to borrowers with poor credit histories or high debt-to-income ratios may be ineligible for securitization by the GSEs or eligible only by payment of a higher guarantee fee
These are the types of loans that typically comprise the pools backing the private-label MBS
Under the Ginnie Mae MBS program, HUD-approved mortgage originators pool FHA, VA or certain other federally-insured mortgages into MBS and sell the MBS guaranteed by Ginnie Mae
The terms of the underlying mortgage loans must comply with the underwriting requirements of the FHA or VA, as applicable
As a result of the GSE underwriting criteria and conforming loan limits and FHA and VA underwriting requirements which do not apply to private-label issuers, the mortgage loans in private-label MBS generally have more diverse collateral, credit risk or other underwriting characteristics than GSE or Ginnie Mae MBS and have wider variances in a number of terms including interest rate, term, size, purpose and borrower characteristics
Private-label pools more frequently include second mortgages, high loan-to-value mortgages and manufactured housing loans
The coupon rates and maturities of the underlying mortgage loans in a private-label MBS pool may vary to a greater extent than those included in a GSE guaranteed pool
As noted above, the GSEs and Ginnie Mae guarantee payments to investors on their MBS
This guarantee ensures that investors receive scheduled payments of principal and interest, regardless of whether payments on the underlying mortgages are made
MBS issued in the private-label market are typically not guaranteed by the issuer and instead rely on other forms of credit enhancement or support to give investors greater assurance they will receive payments on their MBS
The credit enhancement in private-label MBS may be internal or external to the vehicle issuing the security
External credit enhancements generally involve insurance or a letter of credit purchased by private-label issuers to support the underlying mortgage payments
The most common credit enhancement currently used in private-label MBS is the senior-subordinated structure in REMICs
In the senior-subordinated credit enhancement, the trust will issue different classes of securities
There will be a senior class or tranche and at least one class that has a subordinated right of payment to the senior class
The senior class, which bears the least amount of risk of default of the underlying mortgages, will carry a lower interest rate
The subordinated class, which bears the greatest amount of risk of default of the underlying mortgage loans, will carry a higher interest rate in order to compensate for the greater risk exposure
The level of credit protection this structure provides to the senior class may decline over time due to prepayments and thus other mechanisms, such as prepayments going disproportionately to the senior class (known as shifting interest structures), must be in place to provide further safeguards
The most significant feature and risk that all MBS share is prepayment risk, which is the risk that principal payments on an underlying loan will be paid earlier or later than expected
Unscheduled prepayments may affect the return realized by MBS investors
When an investor purchases an MBS or any other fixed income security, the investor does so with the understanding that the price he or she is paying for the security reflects uncertainty about its expected life
Prepayment risk on MBS is influenced by a wide range of factors that relate both to general market conditions, including interest rates, and the performance on individual loans included in the portfolio of loans backing an MBS issuance
As interest rates fall below rates on existing mortgages, borrowers may, and commonly do, prepay their existing loans and refinance at lower rates
Refinancings are recognized as being the primary driver of prepayments
Most mortgage loans must be paid in full when a home is sold
The mortgage loan can also be paid prior to its due date or maturity if the homeowner does not pay the loan and the lender repossesses or forecloses on and sells the home
Finally, a borrower may prepay a loan, in whole or in part, at any time for any other reason
When MBS prepay as a result of borrower refinancing, investors seeking to reinvest in the fixed income market will generally be forced to make a new investment in a lower interest rate environment
When prepayments are slower than expected, it often means that interest rates have risen
The security pays later than expected, and the investor cannot take advantage of more attractive investment opportunities with those funds
The potentially significant risk to investors in private-label MBS that is generally thought by investors to be less significant in the case of GSE and Ginnie Mae MBS is credit risk
Investors in MBS, as with other fixed income instruments, evaluate the risk of whether they will receive the scheduled payments of principal and interest on their MBS
Credit risk reflects the risk that the borrowers on the underlying loans may not be able to make timely payments on the loans or may even default on the loans
In the absence of a guarantee or external credit enhancement, MBS investors generally can look only to the assets or collateral of the trust, the underlying mortgage loans, as the source of payments on their securities and to the structure of the transaction for any internal credit enhancement
The creditworthiness of the underlying borrowers becomes significantly more relevant in private-label MBS offerings because there is seldom an entity that is guaranteeing the payment of the securities
Therefore, if the borrowers do not pay the mortgage loans, the MBS securities will not pay, absent some credit enhancement
Consequently, GSE and Ginnie Mae MBS and the private-label MBS may pose differing degrees of risk for investors
Since the GSEs and Ginnie Mae guarantee the timely payment of principal and interest on the MBS, a GSE and Ginnie Mae MBS investor looks to the GSEs and Ginnie Mae to determine the credit risk
Ginnie Mae's guarantee is the full faith and credit guarantee of the United States
In contrast, Fannie Mae's and Freddie Mac's guarantees are based solely on their own credit quality
Fannie Mae and Freddie Mac provide extensive corporate disclosure and will soon register their common stock under the Exchange Act, subjecting the two companies to all of the disclosure requirements of the federal securities laws
Investors in Fannie Mae and Freddie Mac MBS may look to these disclosures to assess those companies' abilities to fulfill the guarantees of the MBS
Investors may also look to information provided by OFHEO about the GSEs' creditworthiness, including results of examinations and risk based capital stress tests
In addition to assessing the credit quality of the underlying mortgage loans, investors in private-label MBS must look to the creditworthiness of the provider of the external credit enhancement or must evaluate the reliability of the transaction structure to provide any internal credit enhancement and the reliability of a rating agency's rating
The amount of disclosure private-label issuers must provide with respect to third party credit enhancements varies with the type and level of support expected
Private-label issuers are required to discuss in their registration statements the material terms of any credit enhancement, whether internal or external and to provide information regarding the credit enhancer, insurer or guarantor
As noted above, the most common form of private-label MBS is in the form of a REMIC
The other common form of MBS is the pass-through security, which is used predominantly by the GSEs and Ginnie Mae
The most common type of MBS is a pass-through security backed by a pool of single-family mortgage loans
Generally, pass-through MBS are created by pooling or packaging mortgage loans together in a trust or other collective investment vehicle and selling the interests in the trust
All payments on the underlying mortgage loans, including principal, scheduled interest, and unscheduled prepayments are passed through, on a pro rata basis, to the holders of the pool interest or participation certificates after deducting the servicing fees, Ginnie Mae and GSE guarantee fees, and trust expenses
The assets of the trust or other vehicle are the mortgage loans in the pool
Most pass-through vehicles own fixed rate mortgages, although adjustable rate mortgages may also be assets of a pass-through MBS entity
The interest differential is used to pay for the guarantee fee to one of the GSEs and the servicing fee to the servicer
Generally, the underlying mortgage loans are serviced by the originating lender or another institution that has bought the servicing rights
Private-label issuers can, but in most cases do not, issue pass-through securities
In a private-label MBS, the interest differential would be used to pay for credit enhancement or credit support, the servicing fee to the servicer, and trust expenses
As previously noted, the REMIC is a multiple-class security vehicle that does not have the burden of double taxation
The assets underlying the REMIC securities can be either other MBS or whole mortgage loans
The assets are pooled and cash flows from the assets are distributed to the various REMIC security classes according to the priorities specified in advance
The REMIC structure allows issuers to create securities with short, intermediate and long-term maturities
This flexibility enables issuers to expand the market for the MBS to fit the needs of a variety of investors, not just investors looking for 30-year fixed-rate securities
The REMIC structure has allowed for a broader group of investors
REMICs may also be used to address particular investment objectives or concerns about prepayment risk by carving up principal and interest payments on the underlying mortgage loans to create different timing and levels of payments on the securities
REMICs are issued by private-label issuers and under the GSE and Ginnie Mae programs
The GSEs then guarantee the payment obligations on the REMIC securities
In the Ginnie Mae REMIC program, Ginnie Mae guarantees the timely payment of principal and interest on each of the classes
Due to the widely diverse coupon and payment characteristics of the underlying mortgage loans, most private-label securities are structured as REMICs
The GSE participation in the REMIC market has effectively priced most potential private-label REMIC securities backed by conforming loans out of the market
This is because, as a result of the GSE or Ginnie Mae guarantee, investors will likely pay more for GSE and Ginnie Mae securities backed by the same loans, even though guarantee fees are paid from the pool cash flows
In a standard REMIC structure, known as sequential pay, each class or tranche of the security is generally paid the coupon rate on a monthly basis
Principal is paid on the regular classes in sequential order: senior classes are paid first, and then the subordinated classes
Any prepayments are allocated in the same way
The effect of prepayments is that more senior classes may be paid off much sooner or later than anticipated
Prepayments to senior classes can also shorten the expected maturities of later maturity classes in a sequential pay structure, but later maturities have less prepayment risk than exists for securities in a pass-through structure
GSE and Ginnie Mae MBS are created through a variety of programs
A mortgage originator selects a group of mortgage loans that it determines to sell to one of the GSEs as a package
Under the "swap" programs, the lender selects and pools a group of conforming mortgage loans that meet the GSE underwriting standards and "swaps" them for MBS issued and guaranteed by one of the GSEs representing interests in that same pool of mortgages
Under their "cash" programs, Fannie Mae and Freddie Mac take whole mortgage loans and give the originators cash back
Subsequently, the GSE will decide which mortgages out of the pools it has purchased in the cash program to pool and use as collateral for new GSE MBS or whether to hold the mortgage loans as an investment
The GSE will then issue MBS backed by the loans it has purchased from lenders or originators, guarantee the timely payment of principal and interest on the securities and sell the MBS through dealers
The mortgage originator, not the GSE, decides whether to swap the loans for MBS or to receive cash
A small amount of Fannie Mae and Freddie Mac MBS are created through their respective "cash" programs, with the vast majority being created through their respective "swap" programs
The loan originator, of course, would also be free to use the loans in a private-label MBS issuance
Under the Ginnie Mae MBS program, a HUD-approved mortgage loan originator pools FHA, VA or certain other federally-insured mortgages and sells MBS guaranteed by Ginnie Mae
Ginnie Mae does not issue securities or own the underlying assets but rather guarantees the payment of the securities backed by the underlying mortgage loans or mortgage pools
Like the loans in the Fannie Mae and Freddie Mac swaps, the loans in the mortgage pools comprising Ginnie Mae guaranteed MBS are chosen by the lender, not by Ginnie Mae
The GSEs have other MBS products that are either larger pass-through structures, which can be pools of pools (small balance pools consolidated into one larger pool) or are collateralized mortgage obligations such as REMICs
In addition to the differences in the collateral and structures discussed above, private-label MBS are sold to investors through different market mechanisms than are GSE and Ginnie Mae MBS
Most pass-through MBS of each of Fannie Mae, Freddie Mac and Ginnie Mae are eligible to be sold in the "to-be-announced" or TBA market, which is essentially a forward or delayed delivery market
The TBA market allows mortgage lenders essentially to sell the loans they intend to fund even before the loans are closed
This also allows the lender to lock in an interest rate for the borrower
The lender, or other market participant, will enter into a forward contract to sell MBS in the TBA market, promising to deliver MBS on the settlement date sometime in the future
In the TBA market, GSE and Ginnie Mae MBS are traded on a forward or delayed delivery basis with settlement up to 180 days later
The actual mortgage pools comprising the MBS are not specified at the time of sale
In fact, many of the mortgage loans may not even be signed (and the mortgage pools created) at the time of sale
The largest volume of trading in the TBA market is for settlement within 30 days
In a TBA trade the seller and buyer agree to five pieces of information before entering into the transaction: the type of security, which will usually be a certain type of Fannie Mae, Freddie Mac or Ginnie Mae program and type of mortgage (i
, GNMA 30-year pass-throughs); coupon or interest rate; face value (the total dollar amount of MBS the purchaser wishes); price; and settlement date
The purchaser will contract to acquire a specified dollar amount of MBS, which may be satisfied when the seller delivers one or more MBS pools at settlement
Forty-eight hours before settlement, the seller specifies or allocates the identity and number of mortgage pools by the specific pool numbers and CUSIPs to be delivered to satisfy the TBA trade
The Bond Market Association, a private trade association of dealers in debt securities, publishes guidelines governing the mechanics of trading and settling MBS, which are intended to implement standard industry practices
The guidelines, titled "Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities," contain specific guidelines for trading and settling GSE and Ginnie Mae pass-through MBS in the TBA market, known as Good Delivery Guidelines
The Good Delivery Guidelines set forth the basic characteristics that GSE and Ginnie Mae pass-through MBS must have to be able to be delivered to settle an open TBA transaction
Most newly issued GSE and Ginnie Mae pass-through MBS are eligible to be sold in the TBA market
Already outstanding GSE and Ginnie Mae pass-through MBS may also be used to cover a TBA trade
Therefore, the mortgage originator has until 48 hours before the settlement date to decide whether to use new pools of mortgages or to buy outstanding GSE or Ginnie Mae MBS to cover the trade
The Task Force understands that roughly 75% of GSE and Ginnie Mae MBS are eligible to trade in the TBA market
The Good Delivery Guidelines were developed as a result of the unique nature of the GSE and Ginnie Mae MBS market
The TBA market developed in response to the demands of market participants for more liquidity in trading GSE and Ginnie Mae MBS
In order for the market to work on a delayed delivery basis, with sales of GSE and Ginnie Mae MBS occurring before the underlying mortgage loans close, and to account for the potential that not all commitments for mortgage loans will close (called pipeline risk), the market had to develop a process that would allow the identification of the securities that would be delivered in satisfaction of a trade a very short time before settlement, rather than at the time the forward trade was entered into
In addition, because there are over 1 million individual GSE and Ginnie Mae MBS, with huge variations in outstanding principal amount, it was recognized that it was impractical and inefficient, and would greatly limit liquidity, and generally reduce price, to attempt to trade these GSE and Ginnie Mae MBS on a pool-by-pool basis
Thus, it was essential to establish a concept of fungibility or interchangeability among pools that would facilitate both forward trading and an orderly and liquid trading market in GSE and Ginnie Mae pass-through MBS
As a result of the GSE and Ginnie Mae standardized underwriting guidelines for single-family mortgages and the trading and settling parameters of the Good Delivery Guidelines, GSE MBS that may be delivered to satisfy a TBA trade will have similar characteristics
The mortgage loans underlying GSE and Ginnie Mae pass-through MBS are pooled together according to similar characteristics that are based on guidelines established by the GSEs and Ginnie Mae and enable the pools to satisfy the Good Delivery Guidelines
The TBA market functions on the premise that even though each pool that will be created is unique, all pools eligible for delivery on a given TBA trade are equivalent in their characteristics and expected performance
Therefore, any distinct characteristics of the underlying mortgage loans comprising a pool delivered in a trade are considered to blend together so that the MBS they back can be considered a generic security
As a result, TBA market participants consider MBS of Fannie Mae, Freddie Mac and Ginnie Mae that meet the Good Delivery Guidelines to be interchangeable or fungible with other such MBS issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae, respectively
TBA trading vastly improves the liquidity of TBA-eligible pass-through MBS
Market participants have noted that the fungible nature of TBA securities promotes broad liquidity, which adds to efficiencies in pricing, execution, delivery and settlement
In addition, the TBA market allows lenders to finance mortgages, thereby locking in interest rates, prior to the actual closing of a mortgage
Using TBA forward sales to hedge pipelines is more efficient and has probably resulted in lower mortgage rates for borrowers
In a TBA transaction, the security traded is the one that the seller can buy or obtain at the lowest cost for delivery at settlement (and thus has a higher profit potential)
In other words, TBA prices are based on the GSE or Ginnie Mae pass-through MBS that are the "cheapest to deliver
" Thus, the price of the cheapest to deliver security or the generic security in a TBA trade is the base price for TBA trades
Because the generic security trade price is the base price for TBA trades, this price is also the floor off which other MBS trades are priced
Any extra amount paid for a perceived benefit is measured relative to the base price
Market participants note that the tremendous market liquidity has created pricing efficiency and reduced the bid/ask spread to 1/16 of a point or even 1/32 of a point
Bloomberg LP and other third party vendors publish average daily price quotations for TBA trades, which include only generic securities
There is also a competitive dealer and interdealer broker network from which daily pricing of trades in generic securities is available
As described above, the Good Delivery Guidelines establish standard notification and settlement dates for GSE and Ginnie Mae MBS
The trading guidelines require delivery of confirmations within one business day of the TBA forward trade
The confirmation must contain information regarding the security and the transaction, including product type, coupon rate and settlement month
The confirmation may contain other stipulated conditions that were negotiated as part of the trade
The Good Delivery Guidelines also address delivery and settlement
Allocation is the process by which the seller determines which GSE or Ginnie Mae MBS will be delivered to the buyer to satisfy good delivery and requires that GSE or Ginnie Mae MBS assigned pools must be within certain parameters
The parameters are necessary to maintain the fungible character of the MBS delivered to satisfy a TBA trade
These parameters include the permissible variance in the face value of MBS being delivered and the number of MBS pools per million dollars traded
The Good Delivery Guidelines prohibit delivery of securities until 2 business days after the seller provides pool information
As discussed below, the dollar roll market enables sellers to acquire pools to deliver to avoid settlement fails or to follow buy-in requirements
TBA-eligible MBS may be traded three ways: generic, stipulated and specified trades
Generic TBA trades are trades that merely fit the Good Delivery Guidelines
The majority of GSE and Ginnie Mae pass-through MBS are traded on a generic basis through the TBA market process
Stipulated TBA trades are TBA-eligible securities meeting Good Delivery Guidelines that have characteristics that have been requested by the investor
In general, the stipulations are based on publicly available information about the pools or alterations of the Good Delivery Guidelines
The most common stipulated terms are number of pools that can be delivered, the principal dollar amount variance, maturity year, weighted average loan age of the mortgage loans in the pool, and geographic location of the underlying properties
Recently, investors have increasingly stipulated Alternative A characteristics
Investors also commonly stipulate to late delivery to facilitate a seller's ability to obtain pools to satisfy an investor's trade
Investors entering into a stipulated trade will pay a higher price than the price for a generic pool in the TBA market
" As with generic TBA trades, there is no specific security identified at the time the parties enter into the trade
Finally, TBA-eligible securities may be traded on a specified pool basis
Unlike generic and stipulated trades, specified pool trades occur outside the TBA market
There are a number of reasons an investor may engage in a specified trade
For instance, an investor may want to purchase particular pools that have been in existence for a period of time, known as seasoned MBS, because of their better known prepayment characteristics
Although seasoned pools may trade in the TBA market, and can be used to settle any TBA trade, they often trade on a specified basis outside the TBA market because of the increased differentiation in prepayment histories
Among newly created MBS, specified pools generally command the highest price due to the additional available information regarding the content of the pool indicating the pool is worth more than a generic pool
Market participants have indicated that investors generally obtain information on these pools from dealers or originators
These market participants have indicated, however, that certain historical information they may receive about previously specified pools cannot be independently verified
In addition to the flexibility the TBA market gives to buyers to determine the level of specificity the buyer desires in terms of pool characteristics, the TBA market has two distinct trading uses
Investors, dealers, originators and other participants use the TBA market not only to acquire pools for investment or to form other investment vehicles, but TBA market participants trade TBA pools in "dollar rolls" as financing vehicles
Dollar rolls, which are a form of collateralized short-term financing where the collateral consists of mortgage securities, perform a function analogous to that provided by the repo (repurchase agreement) market
The vast majority of financing in the MBS market occurs through the dollar roll market, which takes advantage of the flexibility of the TBA market
Unlike a reverse repurchase agreement, which generally requires redelivery of exactly the same securities that are delivered during the first leg of the transaction, a dollar roll is a simultaneous purchase and sale of substantially similar (TBA) securities for different settlement dates
The dealer, who is said to "roll in" the securities received, is not required to deliver the identical securities, only securities that meet the Good Delivery Guidelines
Thus, the investor may assume some risk because the characteristics of the MBS delivered to the investor may be less favorable than the MBS the investor delivered to the dealer
Because the dealer is not obligated to return the identical MBS collateral that the investor has delivered, both parties usually transact the dollar roll with generic GSE or Ginnie Mae MBS pools that they believe to be of the same or less value than the average TBA-eligible security
Dollar roll deliveries are made pursuant to TBA Good Delivery Guidelines
Most dollar roll purchase and sale dates conform to the same dates as TBA MBS delivery
A private-label issuer generally creates MBS using whole loans that it either originates or acquires in the secondary whole loan market or uses MBS, including GSE and Ginnie Mae MBS, it acquires in the market
The MBS issuer will assemble pools of mortgage loans that it will deposit into a trust in exchange for MBS
Most private-label MBS are designed to meet specific investor needs; thus, the private label issuer will generally obtain dealer and investor input on the desired characteristics of the various MBS classes to be issued in any particular deal prior to depositing the pool of whole mortgage loans or MBS into the trust
Once the private-label MBS structure is established, the mortgage loans will be deposited into a trust and the MBS sold to investors for cash
The private-label issuer or its affiliates may also retain certain classes of the MBS offered in any deal
Private-label MBS, generally REMICs (backed by both GSE and non-GSE collateral), are composed of specified pools
The diversity of the underlying collateral and credit risk issues heighten investor demand for detailed information to assess prepayment and credit risk
Private-label MBS are not sold in the TBA market
Private-label MBS typically are offered initially through underwriters and generally are not traded on a registered exchange or other organized market
As a result of the fact that private-label MBS have a wide variety of multi-class structures, pool characteristics and issuer standards, they are not fungible and more information about the private-label MBS is provided to facilitate trading
While the private-label MBS market is less liquid than the TBA market, market participants indicate that there is a resale market for many private-label MBS
Because there is no established trading market for resales of private-label MBS, participants in this market must rely on dealer to customer interaction to effect transactions in these securities
The trades are carried out in the over-the-counter market by telephone, fax and e-mail with dealers
The GSEs and Ginnie Mae were created by federal legislation, and a number of provisions of federal law exempt their securities from most provisions of the federal securities laws
These exemptions extend to the offer and sale of MBS issued or guaranteed by the GSEs or Ginnie Mae
As discussed below, securities of private-label issuers, including the offer and sale of their MBS, are subject to regulation under these laws
Ginnie Mae is a wholly-owned corporation of the United States Government under HUD
As such, the securities it guarantees are exempt securities under Section 3(a)(2) of the Securities Act52 and Section 3(a)(12) of the Exchange Act
Government securities and as such are also exempt in the same manner as securities that Ginnie Mae guarantees
Furthermore, the securities are also considered government securities under the Exchange Act and may be traded by government securities brokers
These exemptions, however, do not mean that the GSEs and issuers of Ginnie Mae MBS are exempt from the antifraud provisions of the federal securities laws
Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder, apply to all issuers of securities, whether or not the offer and sale is registered under the Securities Act
Specifically, the provisions prohibit any person from making a false or misleading statement of material fact
In making disclosures, issuers also may not omit to state a material fact that is necessary in order to make the statements made not misleading
To be considered material, there must be a substantial likelihood that the disclosure of the omitted fact "would have been viewed by the reasonable investor as having significantly altered the total mix' of information made available
"59 GSE disclosures are also subject to OFHEO safety and soundness supervision and regulation
Unlike GSE and Ginnie Mae MBS, offerings of private-label MBS are subject to the registration requirements of the federal securities laws
As such the offer and sale of these securities must be done pursuant to a registration statement filed with the Commission or pursuant to an exemption
The registration statement must meet the Commission's disclosure requirements
If an exemption from the registration requirements is available, the private-label securities may be sold without filing a registration statement with the Commission
Rule 144A, a non-exclusive safe harbor from the registration requirements of the Securities Act, permits resales to institutional investors that meet the criteria for "qualified institutional buyer" ("QIB") of certain privately placed securities
The content and timing of disclosure vary with the type of issuer and type of security offered
Both private-label and GSE and Ginnie Mae MBS issuers provide disclosure to potential MBS investors in a series of documents and through a variety of means
The MBS structure used, whether pass-through or REMIC, will directly affect the form and content of disclosure, because disclosure will address the terms and risks of the securities being sold
While almost all pass-through MBS are issued by the GSEs or Ginnie Mae issuers, private-label issuers sell primarily REMIC securities
In MBS offerings, disclosure is particularly focused on helping investors evaluate the prepayment and credit risks
In addition, the different characteristics of the underlying mortgage loans included in GSE and Ginnie Mae MBS and private-label MBS affect the format and content of the disclosures in the respective MBS deals
As discussed above, there have been significant differences, historically, between the mortgage loans underlying GSE and Ginnie Mae MBS and those underlying private-label MBS
Some of these differences between the mortgage loans in GSE and Ginnie Mae or private-label MBS pools may be changing as the GSEs expand their programs to include mortgage loans that may have more or less advantageous payment characteristics than the majority of mortgage loans included in GSE MBS
Because these changes may affect the existing homogeneity of the GSE MBS pools, the changes may also impact the type of information that investors require to assess risk and that the GSEs provide about their MBS pools in the future
Private-label issuers and the GSEs and Ginnie Mae provide MBS disclosure to investors using different mechanisms
The differences in disclosure delivery arise for two primary reasons
First, while GSE and Ginnie Mae MBS are exempt from the registration and reporting requirements of the federal securities laws, private-label issuers must either file a registration statement meeting the Commission's disclosure requirements or rely on an exemption from registration
Second, GSE and Ginnie Mae pass-through MBS are often sold through a different market, the TBA market, than private-label MBS and GSE and Ginnie Mae REMICs backed by TBA-eligible pass-through MBS
As noted above, the mortgage loans may not even have been made at the time of sale in the TBA market, while the loans have been pooled and described by the time of issuance in the private-label market
Disclosure procedures for providing ongoing information are also different for the GSEs, Ginnie Mae and private-label issuers
A private-label issuer that registers the offer and sale of its MBS under the Securities Act must comply with the content and procedural requirements of the Securities Act covering such offering
In registered offerings under the Securities Act, private-label issuers will disclose material information to investors through the use of two primary documents: the core prospectus and the prospectus supplement
When private-label issuers file a registration statement to register an issuance of MBS, they typically use what is called "shelf registration
"64 Through this process, issuers first file a disclosure document that outlines the parameters of the various types of MBS offerings they may conduct in the future
This document is known as the "core" or "base" prospectus
The registration statement will also contain a form of prospectus supplement, which outlines the format of deal-specific information they will disclose when they later conduct an offering
In the private-label market, issuers may structure their MBS offerings to meet the particular investment needs of the investors to whom they wish to sell
In this regard, private-label issuers will often provide potential investors with computational materials and structural and collateral term sheets prior to finalizing the deal structure and printing the final prospectus supplement
Structural term sheets set out the proposed structure of the securities being offered, such as the parameters of the various types of classes in a REMIC
Private-label issuers using structural term sheets may be required to file them with the Commission and incorporate them by reference into the registration statement for the registered offering
Collateral term sheets, like structural term sheets, may also be required to be filed with the Commission and thereby incorporated by reference into the registration statement
A prospectus supplement describing the terms of the securities the issuer intends to offer, particular risks, information regarding the assets and other deal-specific information may also be prepared and used in the offering process
The final prospectus supplement must be filed with the Commission within two business days following its first use
The GSEs and Ginnie Mae are not subject to the registration requirements of the Securities Act in connection with their MBS offerings
However, the GSEs prepare offering documents similar in form to the core prospectuses filed by private-label issuers in registered offerings and make deal-specific information available through either final prospectus supplements or website disclosures
Fannie Mae and Freddie Mac post their offering documents on their websites
Investors also receive disclosures as part of the settlement process for TBA trades
Fannie Mae and Freddie Mac provide disclosures to investors through various documents including the base prospectuses and deal specific supplements
Fannie Mae and Freddie Mac also make available information statements that describe their business and operations, as well as include their full audited financial statements
An information statement provides information investors need in order to evaluate the GSEs' guarantees of the MBS
Ginnie Mae, unlike Fannie Mae and Freddie Mac, does not utilize either a core prospectus or prospectus supplement to disclose information regarding its guaranteed pass-through MBS issuances
Instead, Ginnie Mae requires each issuer to use a single required form of disclosure document for the initial MBS sale
Private-label issuers that have registered the offer and sale of MBS under the Securities Act generally will have a limited mandatory obligation to continue providing information on the MBS
However, registrants that become subject to reporting requirements pursuant to Section 15(d) of the Exchange Act may discontinue reporting after they file their first annual report on Form 10-K if they have less than 300 record holders
Therefore, most private-label issuers are not required to continue filing reports with the Commission after they file their first annual report
Although the securities were offered publicly, the small number of investors indicates that the issuer should no longer be considered a public entity
Because of the passive nature of MBS issuers, the staff of the Commission has allowed a modified reporting scheme under the Exchange Act for MBS issuers
Ginnie Mae and the GSEs provide ongoing disclosure regarding the pools underlying the securities they issue or guarantee
As noted above, the characteristics of the underlying mortgage loans and the marketplace's evaluation of their expected payment speeds will affect the structure, marketability and risk characteristics of the particular MBS
The yield, or return, on MBS is primarily determined by the timing of payments on the underlying mortgage loans
The underlying mortgage loans in a GSE or Ginnie Mae MBS will often have different payment (including default and prepayment) and other characteristics from those in a private-label MBS
This is due in large part to the eligibility requirements for the underlying mortgage loans and the underwriting standards and guarantee requirements that Ginnie Mae and the GSEs have established for their MBS programs
The effect of these requirements is that the mortgage loans underlying GSE and Ginnie Mae MBS may be less diverse than those underlying private-label MBS
GSE and Ginnie Mae MBS will have more common or homogeneous features and will benefit from the GSE and Ginnie Mae guarantees
As previously discussed, a major risk in an investment in MBS is prepayment risk
Due to the importance of prepayment risk to an investor's decision to invest in MBS, the key disclosures in MBS issuances relate to the various factors that might affect prepayment
Market participants have developed prepayment models to evaluate prepayment risks
Prepayment models make certain assumptions regarding probable payments on the underlying mortgage loans in order to estimate or predict cash flows
among other characteristics, the greater the need for more detailed information to be able to model for different prepayment scenarios
As discussed above, credit risk, the risk that the borrowers on the underlying loans may not make timely payments or may default on their loans, is thought by investors to be more significant in private-label MBS than in GSE or Ginnie Mae MBS
The GSEs and Ginnie Mae guarantee the timely payment of principal and interest on the MBS
The Ginnie Mae guarantee is backed by the full faith and credit of the United States
Investors should look to the audited financial statements and other disclosures of Fannie Mae and Freddie Mac, as well as safety and soundness information provided by OFHEO, to assess the credit risk
Characteristics of the loans backing MBS, of the properties that collateralize the loans, and of the borrowers can have a significant effect on the prepayment and default behavior of the loans and, therefore, on the expected payments to security holders
Market participants have focused on various pieces of information that may help them understand the risk of prepayment or payment failure
Factors that have been most widely noted, including those that are currently disclosed, and some that are not, are discussed below
The GSEs and Ginnie Mae disclosures discussed are only with regard to their pass-through MBS
The most important loan terms are the interest rates (coupons) paid by the borrowers, the loan maturity dates, the ages of the loans (including origination years), and the sizes of the loans
Coupon information is critical because a borrower's financial incentive to prepay a loan depends on the relationship between the coupon and current market rates
The difference between the interest rate on a mortgage loan and the prevailing market interest rate is the most important factor in evaluating the likelihood that the mortgage loan will be prepaid
In order to predict the prepayment of mortgage loans included within a pool underlying MBS, investors look to information that discloses the interest rates of mortgage loans within the MBS pool, and the interest rates that are most prevalent within the pool
One measure of the overall interest rates on mortgage loans underlying a MBS pool is the pool's weighted average coupon, or WAC
The WAC is the average of the coupons on the loans included in the pool, weighted by each loan's outstanding balance
At issuance, Freddie Mac and private-label issuers typically disclose the WAC for the pool and the distribution of the pool's total unpaid principal balances in various increments across coupon ranges
For example, private label issuers might disclose how much principal of the pool is subject to an interest rate of greater than six percent and less than or equal to 6 1/8 percent
Information on original loan maturities (most often 15 or 30 years), remaining maturities, and loan age make it possible for investors to estimate future loan amortization payments
Principal payments increase as loans age, and the payments are lower the longer the original maturities are
The difference between original maturity and remaining maturity may be greater than loan age if borrowers have partially prepaid loans because partial prepayments shorten remaining maturities
Given loan age and original maturity, a shorter remaining maturity implies faster amortization
The longest maturity date of a pool helps investors determine the latest possible date by which scheduled payments on the underlying mortgage loans and, in turn, the MBS should be made
The weighted average maturity of the pool provides investors with information about the maturity dates of the loans included in the pool
Calculated initially as of the date of pool formation, weighted average maturity is the average of the maturities of the loans included in the pools, weighted by each loan's outstanding balance
Many MBS issuers provide updated maturity information, which is the weighted average remaining maturity of all loans remaining in the pool at the date of calculation
As loans are paid off or prepaid, the number of remaining monthly payments decreases
To the extent prepayments are made, the remaining maturity decreases at a faster rate than it would if borrowers paid only the required amount each month
Thus, investors can evaluate prepayment speeds and make determinations as to when they expect to receive payment on the MBS by examining changes in the pool's weighted average remaining maturity or by comparing the pool's average remaining term to maturity with its weighted average original loan term and weighted average loan age
Unless loan age and loan maturity are evaluated together, prepayments could make a pool look older than it actually is
Information on loan age is also useful in predicting prepayment speeds because prepayments tend to increase during the first few years of newly issued pools and then level out
Prior to settlement, Freddie Mac discloses each pool's weighted average remaining term to maturity, weighted average loan age, weighted average original loan term, and latest loan maturity date, as well as the total number of loans, unpaid principal balance, and percent of the pool attributed to each loan origination year
Freddie Mac also discloses, again prior to settlement, quartile data for each pool's weighted average maturity, weighted average loan age, and weighted average original loan term
Prior to settlement, Fannie Mae discloses each pool's weighted average remaining term to maturity, latest loan maturity date, number of mortgage loans and unpaid principal balance
Private-label issuers typically provide information similar to that provided by Fannie Mae and Freddie Mac
In their offering documents, most private-label issuers disclose each pool's weighted average remaining term to maturity and some disclose weighted average original loan term
They also sometimes disclose, by ranges of original loan term and either remaining terms to maturity or loan maturity year, the number of loans, aggregate principal balance, and percent of pool principal balance included in each range
Private label issuers also typically disclose either the pool's weighted average loan age, with incremental disclosures comparable to those for remaining term to maturity, or loan origination year
Finally, MBS issuers generally disclose changes in a pool's aggregate unpaid principal balance
Disclosure of these changes over time may provide useful information regarding the levels of default and prepayment in a particular pool
This is most relevant in a REMIC structure
For example, a larger-than-expected decline in unpaid principal balance may indicate that some of the underlying loans have either defaulted or prepaid at a higher-than-expected rate
MBS issuers generally disclose the aggregate unpaid principal balance of the MBS pool at issuance and update that information monthly
In addition, the GSEs and Ginnie Mae disclose each pool's "current factor" on a monthly basis after settlement
The current factor is a decimal that represents the fraction of the pool's original unpaid principal balance that remains unpaid
The current factor data for MBS create, over time, a pool history of loan prepayments that is useful in projecting future prepayments
It has been suggested that other than the refinancing incentive, the most important factor in explaining prepayment behavior is loan size
Also, because loan commissions typically increase with loan size, servicers who solicit borrowers to refinance are more likely to target those with higher principal balances
Private-label loan size information is typically presented in increments of $50,000
Prior to settlement, Fannie Mae and Freddie Mac disclose the average original loan size and Freddie Mac discloses quartile data on average original loan size
Many borrowers pay points to obtain lower interest rates
The number of points paid, if any, to the lender at the time of loan origination may also be related to likely prepayment behavior
Borrowers who expect to move quickly or are eager to refinance at the earliest opportunity generally seek to avoid points
Also, borrowers with relatively poor credit and higher default risk may be forced to pay points
Prepayment by these borrowers may be less sensitive to interest rate declines but more sensitive to improvements in their credit standing
Neither private-label, the GSEs nor Ginnie Mae MBS issuers typically provide this information
The GSEs do not currently collect such data
Property characteristics may also affect expected prepayment and default behavior
The location of the mortgaged properties is of interest to investors, because differences in local or regional economies may affect borrowers
Also, state and local laws may affect the costs of refinancing or the costs of foreclosure
Because mortgage loan pools contain a number of mortgage loans, the mortgaged properties securing the mortgage loans in a single pool can be located over a diverse geographic area
Knowing the geographic distributions of the mortgaged properties aids in understanding concentration of credit and prepayment risk
A booming regional housing market, for example, could result in faster prepayment speeds, while a depressed regional job market might increase the credit risk of a pool
To the extent any adverse regional or local economic conditions exist, the smaller the number and the more geographically concentrated the mortgaged properties are, the greater the risk that any regional or localized economic factors will affect payments on the MBS
Private-label issuers typically disclose in their offering materials the number and aggregate principal balance of mortgage loans secured by properties in each state
They also disclose the percent of the total pool balance represented by loans in each state
Fannie Mae and Freddie Mac also provide this information prior to settlement
Geographic distribution information on mortgaged properties in Ginnie Mae MBS is provided quarterly following the MBS issuance
The mortgaged properties can be different property types
Common types include single-family detached, high-rise condos, low-rise condos, two family homes, and three to four family homes
Property type is relevant in analyzing both prepayment and credit risk
Some types of homes, for example single-family detached homes, are often more marketable than others
If a servicer is required to foreclose on a property, there is less risk of loss with a more marketable home
Mortgage loans on single-family homes also default less often than mortgage loans on other types of residential properties
Private-label issuers typically disclose at issuance the number of mortgage loans and aggregate principal balance outstanding in each property type category, as well as the percent of the pool's aggregate unpaid principal balance within each category
Fannie Mae and Freddie Mac segregate pools based on whether the mortgaged properties are for one to four families or more, but do not provide a breakdown of the type of single family homes
The required Ginnie Mae prospectuses mandate that issuers state whether the underlying mortgage loans are on single or multifamily residences, but no breakdown on type of single-family homes is required
The occupancy type of a mortgaged property indicates how the mortgage borrower will use the property
There are generally three types: owner-occupied; second home; and non-owner-occupied properties
Mortgaged properties occupied by the borrower default at a much lower rate than non-owner-occupied properties
It is also relevant to prepayment modeling in that, as compared to owner-occupied properties, borrowers on investment properties are more likely to sell the property in an expanding housing market to lock in profits but typically experience more difficulty in refinancing due to greater documentation requirements
Private-label issuers typically disclose in their offering documents the number of mortgage loans, the aggregate outstanding principal balance, and the percent of the pool's aggregate principal balance for each category of occupancy type
The GSEs do not provide any information with respect to occupancy types of the mortgage loans
All but a de minimis amount of loans in a Ginnie Mae single family pool are owner-occupied
The loan-to-value ratio of a mortgage loan is a measure of the loan balance compared to the value of the mortgaged property
Typically disclosed as a percentage, LTV is determined by dividing the principal balance of the loan at the date of origination by a measure of the property's value
In the case of a sale, the measure used is the lower of the sale price or the appraised value at the time of sale
In the case of a refinancing, the measure used is the appraised value of the property at the time of the refinancing
In a streamlined refinance underwriting, either the appraised value of the mortgaged property at the time the mortgage being refinanced was originated or an appraised value determined by a limited appraisal report at the time of the refinancing may be used in place of a full appraisal of the mortgaged property
LTV can be useful in assessing prepayment and credit risk of mortgage loans, and the likely severity of loss in the event of foreclosure
Loans with higher LTVs are considered more likely to default because the borrower has less invested and has less incentive to retain ownership of the mortgaged property
Private-label issuers generally disclose in their offering documents the distribution of mortgage loans by original LTV in incremental ranges, for example, five percent increments from 50 percent to 95 percent
For each separate LTV range, private-label issuers generally disclose the number of loans, unpaid balance, and percentage of total pool balance
They also disclose the weighted average original LTV ratio for the pool as a whole
A borrower's financial condition and borrowing purpose can also be indicative of future default and prepayment behavior
Lenders use a credit score to rank borrowers according to credit risk
One popular type of credit score used is FICO, a credit scoring system developed by Fair Isaac and Company
FICO scores are intended to show the likelihood that an individual might default on a debt based on past credit history
To determine an individual's FICO score, a credit reporting agency using the FICO system will analyze the individual's credit history, including its length, current debt level, payment history, type of credit in use and other new credit inquiries
Some, but not all, private-label issuers disclose credit scores in varying incremental ranges, such as in 20-point increments
For each credit score range, they may provide the number of mortgage loans, the aggregate unpaid principal balance, and the percentage of total unpaid principal balance
Neither the GSEs nor Ginnie Mae discloses credit scores
Mortgage lenders have different levels of documentation that they require prior to making a mortgage loan
The level of documentation required varies with the purpose of the mortgage loan and the credit profile of the borrower
For some borrowers, mortgage lenders may be willing to accept less documentation than they usually require because of the presence of other positive credit factors
Lenders may also agree to originate a loan with less than the full level of documentation they might otherwise require in return for higher origination fees
Private-label issuers typically provide some loan documentation information
It may be as few as two categories, such as "full documentation" or "reduced documentation," or it may be several different categories depending on what type of documentation levels the lender utilizes
A private-label issuer would typically disclose the number of loans and aggregate outstanding principal balance of mortgage loans underwritten with each level of documentation
The GSEs and Ginnie Mae do not provide such information
The GSEs do not currently collect data on categories of documentation types
There are generally three potential reasons for a borrower to take out a mortgage loan: to purchase a home; to refinance an already-purchased home to obtain a lower interest rate or different payment term; or to refinance a home in order to obtain access to additional funds
The last type is commonly referred to as a cash-out refinance or equity take-out loan
Loans used to purchase homes due to the relocation of a borrower, which are a subset of "purchase" loans, are referred to as relocation loans or relo loans
For example, a forecasting model may assume that borrowers whose loan purpose is a cash-out refinance may have more credit risk101 and are more likely to default102 than borrowers purchasing a home
Conversely, borrowers who have refinanced in the past may have better credit, be more aware of refinancing opportunities, and, therefore, may be more likely or able to refinance in any future declining interest rate environment
Private-label issuers generally provide the number of loans in the pool that relate to each of these categories
The information provided also discloses the aggregate outstanding principal balance, and the percent of the pool's aggregate principal balance by each loan purpose type
The GSEs and Ginnie Mae do not provide loan purpose information
The ratios of borrowers' required payments on their mortgage debt (or on all of their debt) to their income might provide additional information about their expected default and prepayment behavior
While a mortgage loan originator's underwriting standards may have certain debt-to-income caps for mortgage loans, private-label issuers typically do not disclose this information as to the particular mortgage loans in the pool
The GSEs and Ginnie Mae also do not provide debt-to-income information
The seller of a loan is the entity that sells the mortgage loan to the MBS issuer
The originator is the lender that made the mortgage loan to the borrower
Originators often sell the loans they originate directly to MBS issuers in order to obtain ready access to additional lending capital
Because of this, the seller and the originator are in most cases the same entity
However, since whole loans may be bought and sold in the secondary market, it is possible for an entity to sell to an MBS issuer whole loans that it did not originate, in which case the seller and the originator are different
Moreover, sellers or originators may sell servicing rights
The identity of the originator of a loan could be relevant for both credit and prepayment risk
With regard to credit risk, it is important to identify those originators that have less stringent underwriting standards because they are likely to include loans with greater credit risk in MBS pools
Identity of the seller could also be relevant to prepayment to the extent the seller originates loans primarily in areas where there is greater prepayment of mortgage loans
In private-label offerings the seller's name is disclosed in the prospectus supplement
Private-label issuers also sometimes disclose the amount of the pool, by number of loans or unpaid principal balance, which other lenders originated
Freddie Mac discloses the name of the seller prior to settlement and Fannie Mae discloses the name of the seller after settlement
For its multiple issuer pools, the sellers are identified post-settlement
The servicer is the entity that collects payment of the underlying loans and distributes payments on the MBS to the MBS holders either directly or through a trustee
The servicer collects a fee for performing these responsibilities as set forth in a servicing agreement with the issuer of the MBS
Servicer identification may allow investors to make assumptions regarding the expected prepayment risk
Servicers can be either master servicers or subservicers
In addition, pools may include loans that have different servicers or that have master servicers
Some private-label issuers may identify only master servicers in their offering documents, while others identify subservicers as well
Neither Fannie Mae nor Freddie Mac discloses the identity of servicers
In the Ginnie Mae I program the servicer is disclosed prior to settlement and in the Ginnie Mae II program the servicers are disclosed following settlement
Some market participants have expressed concern that participants in the MBS markets use information they obtain in their capacities as originators, guarantors and servicers, among others, to select for purchase, sale or retention MBS or underlying mortgage loans that have more favorable characteristics than the average universe of MBS or mortgage loans
Assertions have been made that these entities have an unfair advantage over the marketplace generally in purchasing and selling MBS
In order to evaluate these concerns, it is important to note that at each level of the process of creating and selling MBS, the market participants involved will make certain choices about which mortgage loans or MBS to retain or sell
For example, lenders or pool sponsors select the underlying mortgage loans that they will securitize
Investors may also decide, at the time of a trade that they wish to purchase MBS having certain characteristics
To review concerns about "favorable selection" or "cherry picking" based on possible information imbalances, it is also important to understand that market participants might view a transaction differently
In order to understand how selection practices may raise issues in the markets, it is helpful to identify the situations that raise a concern for some market participants
First, some market participants are concerned that when other market participants routinely decide to keep purchased or created MBS in their portfolio, they are relying on information not generally available in making these decisions
In the MBS market, situations exist where a market participant may determine to buy, sell or hold a security or mortgage loan in its portfolio based on information in its possession and not otherwise publicly available
Entities have different reasons for determining to buy, sell or retain securities or mortgage loans, including their knowledge of the product and their business goals and objectives
Any entity involved in originating a mortgage, compiling a pool of mortgages for securitization or creating a MBS may have detailed information about the characteristics of the underlying mortgage loans
Determinations about what securities to keep or sell remain within the control of the originator, sponsor or holder of the MBS
The Task Force understands that information is not provided for various reasons, including the fact that specific information is not generated or available to the MBS seller, there has been a lack of market demand for particular information, or disclosing the information could cause competitive harm
MBS issuers and originators might not reveal all the information in their possession about the MBS
Some market participants have indicated that even if the information is revealed to the initial purchaser, such information may not be disclosed to the marketplace generally
A second concern expressed was that, in addition to having business reasons to keep MBS in their portfolios, market participants use information that is not generally available to make portfolio decisions
Once the MBS is originated, securitized or purchased, the originator, securitizer or purchaser may determine to keep the highest quality of the MBS in its portfolio
The decision to keep MBS or mortgage loans in a portfolio also may be made about lesser quality products where a market may not exist or may not provide a fair price for a lower quality asset
Purchasing, originating or securitizing MBS or a mortgage loan and keeping it in a portfolio may be desirable for a number of reasons, such as investment and other business reasons
" It should be noted that market participants are under no obligation to distribute MBS or mortgage loans with any particular characteristics and that purchasers establish MBS prices according to their analysis of the relative value of the assets and the securities being offered
Finally, the Task Force heard that a central concern for market participants was that an originator or guarantor of MBS might purchase MBS in secondary trades through their investment arm based on information about particular securities not generally disclosed or available to the public, giving the internal or affiliated investment department the ability to use such information to the detriment of other prospective purchasers or sellers
Here the concern is that MBS sold into the market with information is purchased back at some later time based on information greater than that held by the current seller
The antifraud provisions of the federal securities laws prohibit persons from making fraudulent misuse of material inside information in connection with the offer and sale of securities
Market participants generally have in place policies and procedures to assure compliance with legal requirements
The Task Force confirmed, for example, that Fannie Mae and Freddie Mac have written policies to address internal sharing of information
These policies include their codes of conduct that prohibit insider trading and their internal safeguards (termed "firewalls" or "information barriers") that prevent information sharing among divisions, primarily loan level data acquired as part of the guarantor function for securitization that cannot be shared with the investment function that seeks to purchase MBS for portfolio
The goal of these policies is to prevent the trading desks at Fannie Mae and Freddie Mac from receiving information that is available only to Fannie Mae and Freddie Mac as a result of their purchases of underlying mortgage loans or in their capacities as guarantors
Under the policies, the trading desks should trade with the same information available to other market purchasers
The allegation was made that the GSEs' own mortgage asset portfolios performed better than the outstanding MBS guaranteed by the GSEs
The Task Force found this in itself to be unpersuasive as the GSEs' mortgage portfolios include other instruments and the GSEs, like other investors, may hold better portfolios by purchasing better performing MBS that they select on the basis of publicly available information for which they may pay a higher price
No evidence was brought forward of any impropriety in creating their portfolio mix
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