Mortgage-Backed Security

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Mortgage-Backed Security</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <a href="#Fannie Mae">Fannie Mae</a><p class="word_list"> <a href="#Freddie Mac">Freddie Mac</a><p class="word_list"> <a href="#Ginnie Mae">Ginnie Mae</a><p class="word_list"> <a href="#mortgage-backed security">mortgage-backed security</a><p class="word_list"> <a href="#mortgage pass-through">mortgage pass-through</a><p class="word_list"> <a href="#prepayment risk">prepayment risk</a><p class="word_list"> <a href="#private label MBS">private-label mortgage-backed security</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table5"> <tr> <td valign="top"> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table6"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table>  <p class="body" style="margin-top: 12">A <b><a name="mortgage-backed security">mortgage-backed security</a></b> (MBS) is a <a href="../articles/securitization.htm">securitized</a> interest in a pool of mortgages. It is a <a href="../articles/coupon_bond.htm">bond</a>. Instead of paying investors fixed <a href="../articles/coupon_bond.htm">coupons</a> and <a href="../articles/par_value.htm">principal</a>, it pays out the cash flows from the pool of mortgages. The simplest form of mortgage-backed security is a <b> <a name="mortgage pass-through">mortgage pass-through</a></b>. With this structure, all principal and interest payments (less a servicing fee) from the pool of mortgages are passed directly to investors each month. </p> <p class="body">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: </p> </td> </tr> </table> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table7"> <tr> <td> <p class="exhibit_header" style="margin-top: 18"><span class="exhibit_header">Scheduled Cash Flows for a 30-Year Fixed-Rate Mortgage</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex1_mortgage_backed_securities.gif" width="250" height="160"></td> </tr> <tr> <td> <p class="exhibit_legend">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.</td> </tr> </table> </center> </div> <p class="body">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 <a href="../articles/option.htm">option</a> of <a href="../articles/prepayment.htm">prepaying</a> 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. </p> <p class="body">A possible pattern of payments, taking into account principal pre-payments, of a mortgage pass-through is illustrated in Exhibit 2: </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table8"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Possible Cash Flows of a Mortgage Pass-Through</span><br> <span class="exhibit_subheader">Exhibit 2</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex2_mortgage_backed_securities.gif" width="350" height="160"></td> </tr> <tr> <td> <p class="exhibit_legend">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.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table9"> <tr> <td width="160">  </td> <td width="11"> </td> </tr> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">Pooled mortgages continue to be <a href="../articles/securitization.htm">serviced</a> by the originator who collects a monthly fee for doing so. This <a href="../articles/securitization.htm">servicing fee</a> 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 <a href="../articles/yield.htm">yield</a> of 8.25% annualized. Their actual <a href="../articles/return.htm">rate of return</a> depends upon what they pay for the pass-through. </p> <p class="body">The originator may sell the rights to service the mortgages to a third party. There is a market for such <a href="../articles/securitization.htm">servicing rights</a>.</p> <p class="body">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. </p>  <p class="body">Risk due to uncertainty in prepayment rates is called <b> <a name="prepayment risk">prepayment risk</a></b>. To compensate investors for taking pre-payment risk, pass-throughs offer higher yields than comparable fixed income instruments without embedded options. </p> <p class="body">Despite their prepayment risk, mortgage pass-throughs entail little credit risk. In the United States, most have principal and interest payments guaranteed by <a href="../articles/agency_securities.htm">government sponsored enterprises</a> <b> <a name="Fannie Mae">Fannie Mae</a></b>, <b><a name="Freddie Mac">Freddie Mac</a></b>, or <b><a name="Ginnie Mae">Ginnie Mae</a></b> that explicitly or implicitly have the full backing of the US Treasury.</p> <p class="body">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' <a href="../articles/capital_allocation.htm">capital</a> 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.</p> <p class="body">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 <b> <a name="private label MBS">private label MBS</a></b> typically have some form of <a href="../articles/credit_enhancement.htm">credit enhancement</a> to obtain a triple-A credit rating. Credit enhancement fees may be subtracted from mortgage cash flows along with servicing fees.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table10"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">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 <a href="../articles/collateralized_mortgage_obligation.htm">collateralized mortgage obligations</a> (CMO). </p>  <p class="body">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.</p>  <p class="body">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.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table12"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/agency_securities.htm">agency security</a> A security issued by a US federal agency or government sponsored enterprise.</p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/asset_backed_security.htm">asset-backed security</a> A securitized interest in non-mortgage assets.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/coupon_bond.htm">bond</a> Securitized debt.</p> <p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/collateralized_debt_obligation.htm">collateralized debt obligation</a> A securitized interest in debt.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/collateralized_mortgage_obligation.htm">collateralized mortgage obligation</a> A type of MBS with cash flows segregated into bonds offering different maturity and risk characteristics.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/off_balance_sheet_finance.htm">off-balance sheet financing</a> Financing that doesn't appear on a firm's balance sheet.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/option_adjusted_spread.htm">option-adjusted spread</a> Yield spread not attributable to embedded options.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/prepayment.htm">prepayment</a> The early retirement of debt. This article discusses metrics for MBS prepayment, including SMM, CPR and PSA.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/securitization.htm">securitization</a> The process of pooling assets and selling interests in the pool to investors.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table13"> <tr> <td width="100%"> <p class="explanatory_text">Fabozzi (<a target="_blank" href="http://www.riskbook.com/link/fabozzi_f_(2001).htm">2001</a>) and Hayre (<a target="_blank" href="http://www.riskbook.com/link/hayre_l_(2001).htm">2001</a>) are two excellent, comprehensive books on MBS. Lewis (<a target="_blank" href="http://www.riskbook.com/link/lewis_m_(1998).htm">1989</a>) is a classic personal accounts of Wall Street during the 1980's. It includes a detailed and hilarious account of the early MBS market.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap430"> <area target="_blank" href="http://www.riskbook.com/link/fabozzi_f_(2001).htm" shape="rect" coords="0, 0, 84, 124"> </map> <img border="0" src="../images/book_fabozzi_MBS_125.gif" usemap="#FPMap430" width="85" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/fabozzi_f_(2001).htm"> Handbook of Mortgage-Backed Securities</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Frank Fabozzi (ed.)</b></td> </tr> <tr> <td width="10%"> <map name="FPMap431"> <area target="_blank" 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