A mortgage-backed security
(MBS) is a securitized interest in a pool of
mortgages. It is a bond.
Instead of paying investors fixed
principal, it pays out the cash flows from the pool of
mortgages. The simplest form of mortgage-backed security is a
mortgage pass-through. With this
structure, all principal and interest payments (less a servicing fee) from
the pool of mortgages are passed directly to investors each month.
A 30-year fixed-rate residential mortgage makes a fixed payment each
month until its maturity. Each payment represents a partial repayment of
principal along with interest on the outstanding principal. Over time, as
more of the principal is paid off, the size of the interest payment
declines. Accordingly, the portion of each payment representing
principal repayment increases over the life of the mortgage. This is
illustrated in Exhibit 1:
A 30-year fixed-rate residential mortgage
makes a fixed payment each month until its maturity. Each payment
represents a partial repayment of principal and interest. Over time,
as more of the principal is paid off, interest payments reflect a
decreasing portion of each cash flow.
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
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:
Possible cash flows for a pass-through are
illustrated. Principal and interest are paid to investors. Servicing
fees are deducted from interest payments and are paid to whomever
services the pooled mortgages—usually the originator.
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
The originator may sell the rights to service the mortgages to a third
party. There is a market for such
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
Fannie Mae, Freddie
Mac, or Ginnie Mae that explicitly
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 also pool mortgages and
sell them as pass-throughs without implicit government guarantees. Such
private label MBS typically have some
form of credit enhancement to obtain a triple-A credit rating.
Credit enhancement fees may be subtracted from mortgage cash flows along
with servicing fees.
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
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 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