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Mortgage-backed securities (MBS) are batches of residential mortgages, packaged in pools with similar interest rates and terns, and sold as securities in the secondary mortgage market. The MBS program was launched in 1968, to increase the supply of funds available for mortgage lending. This is accomplished when banks and other mortgage lenders sell portfolios of their existing home mortgage loans as mortgage-backed securities. The sellers recover the underlying value of the mortgage pools, allowing them to expand mortgage lending in their communities. In addition to receiving monthly principle passed-through from mortgagors to the buyers, MBSs are popular because buyers also receive a sure rate of interest (based on the pools of mortgages that make up the security).

MBSs are highly-regarded investment vehicles. Large institutional investors often purchase one of more pools of mortgage-backed securities, and many small investors buy shares of popular Ginnie Mae MBS mutual funds.

Companies Affected By Mortgage-Backed Securities

This section is written with the subprime lending crisis of 2007-2008 as its focus; as such it is framed as "winners" and "losers" from the subprime crisis and the companies that invested heavily in sub-prime MBS.

Losers

Most Wall Street banks have taken significant hits from subprime MBS. Data as of April 14 2008.^[1]

Investment Banks

Many large investment firms have seen their stock prices plummet as a result of their heavy exposure to mortgage-backed securities, as they took heavy write downs in the wake of the subprime bust.

• Merrill Lynch (MER) reported on January 17, 2008, an $8.6 billion net loss from continuing operations due to significant write downs on its sub-prime investments ^[2]. On October 30, 2007 Chairman and CEO Stan O’Neal was ousted after Merrill posted a $2.3 billion loss for the third quarter which included an $8.4 billion write down on its sub-prime related investments. Merrill bought subprime mortgage lender First Franklin Financial Corp. for $1.3 billion in 2006, just before the downturn in the subprime market.
• Citigroup (C) Chairman and CEO, Charles Prince, resigned on November 4, 2007, becoming another casualty of the subprime crisis ^[3]. On January 15, 2008, Citi reported a fourth quarter net loss of $9.83 billion which included $18.1 billion in pre-tax write downs on its sub-prime related assets, the biggest in Wall Street History ^[4].
• UBS AG (UBS) shut down one of its hedge funds in 2007 after it incurred $123 million in subprime-related losses, putting a damper on the firm's profits. UBS reported a $4.4 billion loss on fixed-income securities for the third quarter 2007. UBS currently has exposure to $16.8 billion in subprime mortgage backed securities and $1.8 billion in collateralized debt obligations. ^[5]
• Bear Stearns Companies (BSC) had a significant investment in the subprime mortgage boom. So far, Bear has lost around $3.4 billion on subprime investments, mostly in two of its hedge funds. The subsequent 30% drop in its market value prompted speculation about potential takeovers.
• Morgan Stanley (MS) also purchased a nonprime mortgage lender, Saxon Capital, in 2006. On December 19, 2007, Morgan Stanley reported a $9.4 billion write down on its subprime assets which was much greater than the $3.7 billion the Street was expecting.^[6][7]

Rating agencies

• Moody's (MCO) and the McGraw-Hill(MHP) owned S&P rated mortgage-backed securities with triple-A ratings, because they were issued by banks with high credit scores or because they were insured by companies with similarly high credit lines, such as monoline bond insurers. The securities took on the risk rating of the insurer, rather than reflecting the true risk of default on the underlying loans. The reputation of the credit rating firms took a major hit when it became obvious that they had grossly underestimated the risk of these securities.

Mortgage companies

• Countrywide Financial (CFC) focuses on lending and other aspects of the mortgage industry, making it sensitive to changes in the housing market.
• NovaStar Financial (NFI) originates, purchases, securitizes, and sells (mostly non-prime) mortgages and mortgage-backed securities. On February 21, 2007, NFI announced that it didn't expect to make any net income until 2011, which sent its stock plummeting 42.5% in one day.
• PMI Group (PMI) and MGIC Investment (MTG) offer mortgage insurance, which covers loans that are delinquent or in default. In Q1 2007, MGIC's net income dropped by 44%, while losses from defaulted loans rose 58% from the same quarter in 2006. PMI has seen losses from defaulted loans rise as well, though on July 16, 2007, PMI Canada (the Canadian division of PMI) received a guarantee from the Canadian government promising to cover 90% of all its Canadian loans in case of default.
• IndyMac Bancorp (IMB), one of the largest independent U.S. mortgage lenders, posted a loss more than five times greater as the one it had projected for the third quarter 2007. IndyMac incurred a net loss of $202.7 million compared to $86.2 million the same period last year.^[8]
• Fannie Mae (FNM) reported a $1.39 billion loss for the third quarter 2007 as a result of the worsening subprime mortgage crisis. The net loss was caused by a $2.24 billion decline in derivative contracts and $1.2 billion in credit losses. Net income for the first three quarters of 2007 is down 57 percent from the same period last year.^[9]
• E*TRADE Financial (ETFC), while not a mortgage company, has based its business model on the mortgage industry. E*trade uses the cash left in customer accounts to lend money for mortgages and other purchases, and keeps the difference between the interest it owes its customers and the interest earned on the loan. Bad loans and the credit crunch decimated E*trade's stock price in Q4 2007.

Construction and home improvements

• D.R. Horton (DHI), Lennar (LEN), Toll Brothers (TOL), Pulte Homes (PHM), and other homebuilders are highly leveraged to conditions in the housing market. The collapse of subprime MBS has exerted downward pressure on the housing market and negatively impacted the demand for new home construction.
• Home Depot (HD) and Lowe's Companies (LOW) are both sensitive to conditions in the housing market. Home Depot recently stated that it expected 2007 earnings per share to fall by 15-18%, a larger drop than was previously expected.^[10]
• Williams-Sonoma (WSM), Bed Bath & Beyond (BBBY), Pier 1 Imports (PIR) and other domestic merchants are vulnerable in a weak housing market.

Winners

Apartment REITs

When it's easy to buy homes, rental prices drop. When financing for mortgages dries up, people rent instead of buying. As a result, Apartment REITs, which own and operate rental apartments, benefit in some areas from the subprime fallout as the decreased availability of mortgages makes rental apartments more attractive.

Financial institutions

• Wells Fargo (WFC) is the largest originator of subprime mortgages in the U.S. Wells Fargo, however, avoided the adjustable-rate mortgages that triggered the higher payments (and subsequent delinquencies and defaults) seen by other lenders, limiting its exposure to the bust while still maintaining a significant presence in the subprime market. Though some short-term losses are possible, Wells Fargo could emerge from the subprime collapse as a leading figure in the market.
• Clayton Holdings (CLAY) provided due diligence on billions of dollars of loans in the recent years. More than 40% of the time Clayton said that a mortgage did NOT meet the standards of the MBS, the mortgage was included anyway. Their due diligence may become a legislated compliance requirement, as per Moody's (MCO) and McGraw-Hill Companies (MHP) congressional testimony.
• Goldman Sachs Group (GS) has generally steered clear of subprime-backed securities and collateralized debt obligations, though it did take around $3 billion in write-downs in the first quarter of 2008.^[11]

Hedge funds

Other potential winners are the few hedge funds that have bet against the subprime market recently, by shorting subprime-heavy firms' stocks and securities backed by subprime mortgages.

• Paulson & Co. established a fund specifically for this purpose, and it has reported yearly earnings growth for 2006 in excess of 100%.

Commercial Real Estate Investment Trusts (REITs)

Commercial REITs have faired well relative to REITs with significant holdings in residential property, as the subprime lending crisis has primarily affected home mortgages.

• Vornado Realty Trust (VNO) is a commercial REIT with investments spanning many property types (office, retail, merchandise mart, warehouse/industrial, etc.) that with few investments in housing has largely avoided direct damage from the subprime crisis.

How Mortgage Backed Securities Were Created

The creation of these securities is credited to the Government National Mortgage Association [1] (Ginnie Mae), a wholly-owned federal corporation within the U.S. Department of Housing and Urban Development (HUD) [2]. The MBS program was designed to increase the supply of funds available for home mortgages.

MBSs made a small splash in 1968 when they first were issued, and today are at the heart of a billion dollar securitization industry. MBSs are called "pass-through" certificates. The monthly principal and interest payment from each of the underlying mortgage loans is "passed through" to investors. The interest rate of the security is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. By selling a pool of mortgage loans to an MBS servicer, the lender receives funds equal to the underlying value of the pool, which will be used to make more home mortgage loans.

MBS and Subprime Lending

MBS have garnered controversy for their role in subprime lending. MBS allow originating banks to offload their exposures to homeowners to the bond market, recycling their capital so they can originate more mortgages. Investors count on the investment banks and, crucially, the rating agencies to rate and then monitor the credit quality of the resulting MBS. Apparently compromised by their reliance on this flow of business, however, the agencies and investment banks failed to spot (or, say some, deliberately ignored) the deteriorating underwriting standards of the originating banks, and rated as triple-A (AAA to Standard & Poor's and Fitch, Aaa to Moody's Corporation) some MBS that were, in fact, much riskier. This mistake was compounded by the emergence of CDO's (Collateralized Debt Obligations) that invested in these MBS on the basis of their ratings, and got their own AAA/Aaa ratings on their bonds as a result.

Whether the resulting meltdown was the result of corruption, or simply incompetence, is still under debate. The rating agencies, not without some reason, can claim to have been duped alongside the investors -- to have lost 'reputation capital' just as the investors lost money capital. Many observers, though, point to the enormous growth in their business on the back of the securitization phenomenon.

Future for MBS

While highly visible and distressing, subprime MBS and CDOs are only a fraction of the securitization market; many MBS are still considered high-grade either because of the high credit quality of the mortgage pools that back them, or because of the guarantee of the federal housing agencies. Securitization remains a pillar of all modern capital markets because of its ability to move risk onto the balance sheets of investors and creditors who are better able to bear that risk than the originating institutions.

See especially Government National Mortgage Association (also known as Ginnie Mae, or GNMA).