Watch Your Step

Article excerpt

The safety checks to consider when purchasing mortgage-backed securities

Mortgage-backed securities have received a lot of coverage in this column over the last 15 years, and for good reason: They have proven to be a nice, predictable, safe and high-yielding alternative to bullets, callables or corporates.

And, since they have the additional characteristic of an amortizing balance, they have the element of periodic cash flow to soften the landing in a rising rate environment. No wonder that fixed-rate mortgage-backed securities comprised about 17 percent of the average high-performing community bank portfolio as of Sept. 30, 2005.

However, it is time to revisit some safety checks that should be in place for mortgage-backed securities, to be used either when considering a purchase or as a portfolio review. While most of this is simply sound fundamentals, we often see offerings from members of the broker/dealer community that are based on some specious or simply incorrect variables. The following present the most common potholes.

Look Out for Speeders

Some of you may recall that the September 2005 column attempted to explain the Public Securities Association (PSA)/Constant Prepayment Rates (CPR) relationship as it pertains to future prepayment speeds. That section really boiled down to two suggestions: Require your broker to make offerings using the CPR basis (and PSAs if you choose), and review actual history for the generic collateral using CPRs as well.

Here are the reasons:

* PSAs in the early stages of a pool's life will almost always overstate the future PSA speeds if used as a proxy. This is due to the "ramping" effect of the calculation. In spite of this, many regulators will want to see that your files include yield tables and price volatility tables using PSAs, because that was the standard for many years. It seems to be a sound practice to require CPRs as well.

* When the term "generic collateral" is used here, it refers to the population of pools that exist with homogeneous coupon rates and maturities. This data will be available from your broker at the time of the offering. By reviewing how the like-kind pools have performed, an investor will have a better feel for what may happen in the future.

Why the fuss about "speeds" and prepayment methodology? Because an offering could be made to look much better, or worse, by adopting a certain method. And where variables can be introduced lurks the possibility of, shall we say, misstatement. An example follows in the tables on pages 103 and 104:

Notice how the first yield table, which is presented using PSAs based on "historical" speeds, looks much better than the second, which uses CPRs. Since the pool has a big discount price, it will look much better under faster prepay scenarios. And PSAs, especially in the early stages of a pool's life, will tend to overstate future patterns.

To summarize: 1) Require CPR-based offerings. 2) Review historical speeds from generic collateral based on CPRs. And 3) Be wary of PSA-based yield and price volatility tables.

Problems with Cash Flows

There has been considerable energy spent over the years extolling the virtues of cash flow from amortizing securities. These range from the ability to gradually reinvest at higher rates should rates rise, to asset-liability management, to duration stabilization. And while all of these are absolutely true, it bears mentioning that, if the cash flows are not reinvested at same or higher rates, the overall portfolio yield will actually fall.

That is the reason that the Reinvestment field in ICBA Securities' Yield Forecaster model is so prominent. Portfolios with a duration of around two, which encompass many community banks' portfolios, will have a lot of cash flow in the next two years whether that is desirable or not (and at the present time it is).

Just the same, for proprietary yield models, especially total return models, the reinvestment yield needs to be noticed and considered. …