Types of Mortgage-Backed Securities

Answer 1

In my last post I introduced the concept of Mortgage-Backed Securities (MBS for short). These are the securitized bonds that result from an agency that pools residential mortgages together for the purpose of reselling shares in the pool to investors.

There are three main types of Mortgage-Backed Securities. They are mortgage pass-through securities, Collateralized Mortgage Obligations (typically abbreviated as CMOs), and stripped mortgage-backed securities. The first and most basic type is the mortgage pass-through security, which I will try to explain now.

The typical pass-through security is built on a pool of mortgages, usually having similar characteristics – similar loan term, interest rate, and credit rating of homeowner. This pool is used to make up the backbone of the MBS. Then shares of the pool are created and sold. The holders of these shares are then entitled to a proportional interest in the monthly payments resulting from the mortgages. These monthly payments are made up of three different elements. First, there is the monthly interest on the underlying mortgages. Secondly, the scheduled principal payments are part of the monthly cash flows. The third element is the most difficult to predict, the additional principal payments that the homeowners choose to make. In a pass-through security, all these cash flows are passed-through evenly to the investors in the MBS.

Here, let me quickly recap one of the main risks associated with investing in MBS, which is prepayment risk. Prepayment risk, the reason that tricky third element of the monthly cash flows is a problem, is the risk that the homeowners will pay down their mortgages sooner than anticipated in their amortization schedules. This can be due to the sale of the home, a refinancing due to a favorable interest rate environment, or simply the homeowners’ desire to be rid of the dreaded monthly mortgage payments.

In the traditional pass-through securities there is no way to hedge against prepayment risk. That is why the CMO was invented. CMOs operate in similar fashion to the pass-through securities, with one critical difference. The investor pool, not to be confused with the pool of mortgages, is broken into different share classes. Each share class is assigned a par value and the additional principal payments are filtered down through the levels of share classes. For example, in a $1 million dollar MBS there could be three share classes labeled A, B, and C. Let’s say the par values are $400,000, $300,000, and $300,000 respectively. When the monthly payments are made, class A absorbs all the excess principal payments until its par value of $400,000 is reached. Then the excess principal payments flow to class B until its par value is reached. Finally class C receives the remaining excess payments after all the other classes have been entirely paid down. In essence each subsequent share class has a longer effective maturity than the level above it. In this way the prepayment risk can be mitigated by investors by choosing the share class that most closely aligns with their risk tolerance.

Stripped MBS assets are instruments in which the interest has been stripped from the principal portion. They are sold as either interest-only or principal-only investments and are mostly used to manage the risk associated with investing in other mortgage-related securities.