The Future of Mortgage-Backed Securities
Prior to the bursting of the housing bubble, the majority of borrowers probably had never heard the term mortgage-backed security (MBS) before, and the handful that had probably had only a vague sense of the vital function that they play(ed) in the mortgage finance system. Nowadays, most borrowers have at least a rudimentary understanding of MBS, thanks to the role that they played in the credit crisis. This role is evolving rapidly, however, and borrowers would be wise to stay abreast of these changes.
For those of you aren’t entirely clear, a mortgaged-backed security is simply a large portfolio of mortgages, bundled together for risk-management purposes, and sold to institutional investors. In theory, it’s a system that is designed to benefit everyone. Lenders are able to originate news loans freely without having to worry about holding them all on their balance sheets. Investors are happy because the MBS are structured such that a handful of individual defaults has minimal impact on the value of the whole portfolio. Borrowers, meanwhile, benefit in the form of lower interest rates.
In spite of the credit crisis, everyone is fighting to make sure that this system – or some semblance of it – remains in place. Currently, it is largely because of the interventions of the Fed and the government takeover of Fannie & Freddie that the market for MBS is even functioning. “More than 90 percent of home loans at the moment have some form of government backing, compared with about 30 percent at the peak of the housing boom.” In addition, the Fed’s $1.25 Trillion in purchases of MBS are keeping interest rates low, by “acting as a sponge, absorbing about $12 billion a week of what you might consider excess supply.” When either the government guarantees and/or the Fed’s purchases come to an end, surely the system will suffer a giant hiccup. The consensus is that when the Fed stops buying, rates could rise by as much as 1-2%, which could translate into more than $100,000 over the life of a typical mortgage. The Fed has attempted to allay these concerns by mulling an extension of the deadline of its asset purchase program for a second time (the original deadline was January 1, and the current deadline is March 31), but regardless, the end is near.
What will the new system look like? In form, not so much different from the current one. Namely, standards will be a lot tighter, That means higher credit score requirements, bigger down-payments, stricter documentation requirements, etc. From the standpoint of investors – who ultimately bankroll the mortgages – this means higher quality mortgages and greater transparency. As one such investor expressed, “I really want to know what the hell I’m buying.”
The government might also step in and beef up regulations. Lenders, might be required to begin holding a (larger) portion of mortgages that they originate on their balance sheets. “With some skin in the game, the theory goes, they would be more careful to ensure borrowers are screened properly. Another idea is for regulators to set a basic, industrywide level lending standard for things like down payments and borrowers’ debt levels.”
From the standpoint of borrowers, this translates into higher interest rates for prime borrowers, and even higher interest rates for everyone else.