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Many investors are looking to increase income during this period of tight spreads. Many of those investors have decided to purchase private-label, mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) backed by private-label MBSs. They get a higher spread, but what additional risks are they taking? What do the regulators think? How can we do our due diligence?
PRIVATE-LABEL MBS: A DEFINITION
A pool of mortgage loans that have been "securitized" by the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corp. (FHLMC) is called an "agency" MBS in the market. Only mortgage loans that meet certain qualifications and underwriting criteria can be securitized by the agencies.
Investors love FNMA and FHLMC pools, because the agency accepts the credit risk on the underlying loans and guaranties timely payment of principal and interest. FNMA and FHLMC get paid a "guarantee fee" for providing this service.
A lot of mortgages are created that do not fit into the agency mold. For example the mortgage might be too large. Each agency has a limit on the size of an individual mortgage that it can guarantee.
For single-family lending, the FNMA and FHLMC limit currently is $417,000. (The limit may adjust annually.) If a borrower wishes to purchase a home for more than $525,000, the mortgage might need to be larger than $417,000. These mortgages are known as "jumbo" loans.
They could qualify in all respects for underwriting by FNMA or FHLMC, except that they are simply too large. With home prices having increased so dramatically during the last few years, many homes cost more than $525,000. In fact more private-label MBSs were created in 2005 than agency MBSs for the first time.
If the originator/underwriter wishes to securitize and sell a pool of such mortgages, it will have to create a security that is attractive to investors, which means it will have to find a way to eliminate (or significantly reduce) the credit risk. In addition it will have to ensure that the pools are liquid, have no operational or legal problems, and will have to resolve certain legal questions relating to foreclosure procedures and other servicing issues.
THE RATING AGENCIES: THE GOLD STANDARD
Before investors will purchase...