Saturday, January 16, 2010

Thank You For Your Support

I have received many calls from financial advisers who ask me where they can find "three to five year GNMA bonds yielding 4.00% or more." When I tell them that no such security exists I usually get one of three responses.
1) "They certainly exists because my client is being offered such bonds by a competitor."
2) "Sure they exist, I found some in your inventory."
3) "You don't know what your talking about. May I please speak to someone who has more experience."
These responses highlight the dearth of knowledge in the financial advisory business when it comes to Mortgage Back securities (MBS). Let's first understand just what an MBS is.
MBS can come in a variety of flavors, but they fall into two main categories, pass-throughs and collateralized mortgage obligations (CMOs). A pass through does just what its name purports. Interest and principal paid by mortgage holders is passed through to bond holders. CMOs are more complex, too complex to discuss completely in this space. However we can discuss certain important aspects of CMOS.
MBS cash flows are inherently unpredictable. One never knows just how much principal or interest will be paid each month. This is because there is know way to know how much principle will be paid. In a large pool of mortgages there will be borrowers who pay back more principal than required as they attempt to pay off there homes early. Principal can also be paid back early when borrowers refinance mortgages or selling their homes. This is why is to average life rather than maturity which is referred. CMOs are structured to make cash flows somewhat less unpredictable.
CMOs are broken up into pieces called tranches. Each tranche is structured to payoff during a certain time period in the future. This known as a tranches window. But if cash flows are unpredictable, how can a security backed by mortgages, which have unpredictable cash flows, be carved up into tranches which have somewhat predictable cash flows. The answer is the support bond.
A support bond is true to its name. It supports the other tranches in the deal. If rates fall and many borrowers refinance their mortgages or take advantage of lower rates and buy a more expensive home the support tranche absorbs the flood of returned principal to keep the other cash flow of the other tranches more predictable. If rates rise and prepayments slow, the support tranche will receive little or no principal returns for extended periods of time. Instead, the cash flow goes to the other tranches of the deal. It is not uncommon for a support bond to have an average life of one year if rates fall 100 basis point and also extend out to an average life of 20 years or more if interest rates rise by 100 basis points. It is support bonds which are being shown to your clients.
Unscrupulous or (more likely) unknowledgeable salespeople are pitching clients with support bonds, which are being priced using fast prepayment speeds thanks to the tremendous amount of Fed stimulus promoting refinancing, as short-term vehicles. It would be bad enough if advisers were viewing average lives as being the time when one would receive all of one's principal, but that is not accurate. Worse still is that average lives of MBS change with financial conditions. Worse still is the fact that the least predictable tranches are being pitched to investors who need short-term and predictable return of principal. The is despicable behavior.
This is a very low interest rate environment. Government guaranteed short-term securities with yields above 4.00% to not exist. Don't be taken in.

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