There are countless investment options for individuals and institutions, and in the mortgage industry, attention is often focused on residential mortgage-backed securities (MBS), which play a key role in the secondary market. With renewed uncertainty surrounding Freddie Mac and Fannie Mae, it's important to understand how MBS compare to asset-backed securities (ABS). While both involve pooling financial assets and selling them to investors, MBS are backed by residential mortgages, whereas ABS are typically backed by things like credit card debt, student loans, or auto loans.
Despite their differences, ABS and MBS share structural similarities involving three main participants: sellers, issuers, and investors. Sellers originate the loans and may also service them, issuers bundle the loans into securities, and investors purchase these for higher yields and portfolio diversification. These securities allow lenders to remove assets from their balance sheets and free up capital for additional lending, similar to how a mortgage banker pays off a warehouse line after a loan sale.
One of the key risks in these instruments is prepayment risk (borrowers paying off loans early, which affects returns), especially common with MBS during periods of refinancing or high home turnover. Both ABS and MBS attempt to manage this through tranching, which segments securities into different levels of risk and return. ABS often also face credit risk, which is managed through a senior-subordinate structure where losses are absorbed first by junior tranches.
Investors can choose which tranches to buy based on their risk appetite and market view. Measuring the value and risk of these securities requires tools like the Z-spread (for securities without embedded options) or the option-adjusted spread (OAS) for those with call, put, or prepayment features. OAS can be calculated using models like binomial trees or Monte Carlo simulations, depending on the complexity of the cash flows involved.
For mortgage professionals, understanding how these loan pools are structured and sold is critical. Securities backed by loans are carefully sliced and categorized by risk, and as debate continues over the roles of Fannie Mae and Freddie Mac, being informed about the structure and pricing of these instruments will help industry participants navigate the evolving landscape.