Although the scheduled payments on a mortgage are fixed from one month to the next, the cash flows to the holder of a mortgage pass-through are not fixed. This is because mortgage holders have the option of prepaying their mortgages. When a mortgage holder exercises that option, the principal prepayment is passed to investors in the pass-through. This accelerates the cash-flows to the investors, who receives the principal payments early but never receive the future interest payments that would have been made on that principal. A possible pattern of payments, taking into account principal pre-payments, of a mortgage pass-through is illustrated in Exhibit 2:
Pooled mortgages continue to be serviced by the originator who collects a monthly fee for doing so. This servicing fee is a fixed percent of outstanding principal, say 0.25% annualized. The fee is subtracted from interest payments to investors. If a pool of mortgages has an average mortgage rate of 8.50% and the servicing fee is 0.25% annualized, then investors in the pool receive an average yield of 8.25% annualized. Their actual rate of return depends upon what they pay for the pass-through. The originator may sell the rights to service the mortgages to a third party. There is a market for such servicing rights. Prepayments introduce uncertainty into the cash flows of a mortgage pass-through. The rate at which fixed-rate mortgagors prepay is influenced by many factors. A significant factor is the level of interest rates. Mortgagors tend to prepay mortgages so they can refinance when mortgage rates drop. By acting in their own best interest, mortgagors act to the detriment of the investors holding the mortgage pass-through. They tend to return principal to investors when reinvestment rates are unattractive, and they tend to not do so when reinvestment rates are attractive. Risk due to uncertainty in prepayment rates is called prepayment risk. To compensate investors for taking pre-payment risk, pass-throughs offer higher yields than comparable fixed income instruments without embedded options.
Despite their prepayment risk, mortgage pass-throughs entail little credit risk. In the United States, most have principal and interest payments guaranteed by government sponsored enterprises Fannie Mae, Freddie Mac, or Ginnie Mae that explicitly or implicitly have the full backing of the US Treasury. The Federal National Mortgage Association (FNMA) was formed by the US Federal Government in 1938. Its purpose was to promote home ownership in the United States. It did so by purchasing mortgages from originators. This freed up the originators' capital so they could originate more mortgages. Market participants dubbed the firm "Fannie Mae." The Government National Mortgage Association and the Federal Home Loan Mortgage Corporation were formed in 1968 and 1970, respectively. They play a similar role to Fannie Mae, but target different segments of the mortgage market. Today, they are called Ginnie Mae and Freddie Mac. Ginnie Mae issued the first mortgage pass-through in 1970. Today, all three organizations actively repackage and sell mortgages as pass-throughs. Ginnie Mae guarantees timely payment of principal and interest on its pass-throughs. Fannie Mae and Freddie Mac guarantee payment of principal and interest. Private firms—banks or mortgage originators—also pool mortgages and sell them as pass-throughs without implicit government guarantees. Such private label MBS traditionally had some form of credit enhancement to obtain a triple-A credit rating. Credit enhancement fees would be subtracted from mortgage cash flows along with servicing fees. Starting in the early 2000s, private label MBS were increasingly issued with little or no credit enhancement and on pools of risky sub-prime mortgages. For the first time, MBS posed significant credit risk. Because credit risk made these instruments fundamentally different from earlier mortgage pass-throughs, many market participants avoided calling them MBS, preferring to label them asset-backed securities instead. Volume in these risky instruments grew rapidly until 2007, when defaults accelerated and the market values of the instruments plunged. This caused a liquidity crisis that spilled into other segments of the capital markets. A number of hedge funds with leveraged exposures to sub-prime mortgages folded. It is possible to segregate the cash flows from a pool of mortgages into different bonds offering different maturity, risk and return characteristics. The bonds can then be sold to investors with different investment objectives. Such mortgage-backed securities are called collateralized mortgage obligations (CMO). In addition to structural differences and issuer differences between mortgage-backed securities, there are profound differences that depend upon the underlying mortgages. Mortgages take many forms: single family home, multi family home, 30-year fixed, 15-year fixed, adjustable rate mortgages, etc. Also, mortgage pools exhibit different patterns of prepayment, depending upon such factors as the mortgagors' income level and geographic location. The age of mortgage collateral can also influence prepayment rates. All such factors affect the risk and pricing of mortgage-backed securities. Mortgage-backed securities are issued in countries around the world, including countries in Latin America and Southeast Asia. Volume is high in Europe and Japan. Some important markets are described in the books recommended below.
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