In this article, We learn about “Mortgage-Backed Securities (MBS)”.Let’s Go!
Mortgage-Backed Securities (MBS) provide investors with a prorated monthly distribution of principal and interest paid by a homeowner.
MBS Type
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In pass-through MBS, the issuer collects monthly payments from a pool of mortgages and then transfers a percentage of the principal and interest collected to bondholders. Pass-through MBS generates cash flow from three sources:
- Predetermined principal (usually fixed)
- Predetermined interest (usually fixed)
- Prepaid principal (usually changes based on homeowner behavior and is affected by prevailing interest rates)
Mortgage Mortgage Obligation (CMO)
CMOs are repackaged pass-through mortgage-backed securities with cash flows directed on a senior basis based on the bond structure. The goal of a CMO is to provide a degree of protection against prepayment risk (beyond that provided by pass-through) while still providing credit quality and high yields.
CMOs take the cash flow from pass-throughs and divide it into different bond classes (called “tranches”), which provide a time frame or window for expected repayment. This provides investors with a degree of predictability of payments. These tranches prioritize allocating principal payments among classes and serve as a series of maturities over the life of the mortgage pool.
CMOs vs. Traditional Mortgage-Backed Securities
The main difference between traditional mortgage loan flipping and CMO is the principal payment process:
- With traditional MBS, each investor receives a prorated monthly distribution of the principal and interest paid by the homeowner. Bondholders will receive a partial return of principal until final maturity, when the homeowner pays the mortgage in the pool in full. This process creates some uncertainty about the timing of the return of principal, as the borrower can repay part or all of the debt early
- CMO replaces the pro rata process in pass-throughs with a principal repayment priority schedule between tranches, which provides a more predictable principal repayment rate
Issuer Type
MBS may be backed or issued by entities such as Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae).
Ginnie Mae:
- The only wholly owned government company backed by the full trust and credit of the U.S. government
- The purpose is to ensure mortgage funding is available throughout the United States
- Guaranteed timely payment of principal and interest on loans issued by Federal Housing Association (FHA), Department of Veterans Affairs (VA), Rural Housing Service (RHS), and Public and Indian Housing (PIH)
- Helps eliminate differences in mortgage credit availability between regions
- Securities available in multiple maturities
- Minimum face amount of new securities issued is $25,000, with additional increments of $1,000
- It is possible to invest less than $25,000 by purchasing securities that are sold at a discount or have been partially repaid
Federal Home Loan Mortgage Corporation (Freddie Mac):
- Publicly owned government-sponsored enterprises not explicitly guaranteed by the U.S. government
- The purpose is to increase the availability of mortgage credit for residential financing
- Raises the majority of its capital by developing and maintaining an active secondary market for residential mortgage loans
- Issues both mortgage-backed securities and standard corporate bonds, called government-sponsored enterprise (GSE) bonds
- Securities are offered in $1,000 increments
Federal National Mortgage Association (Fannie Mae):
- Publicly owned government-sponsored enterprises not explicitly guaranteed by the U.S. government
- The purpose is to maintain an active secondary mortgage market
- Issuing both mortgage-backed securities and standard corporate coupon bonds
- Securities are offered in $1,000 increments
Features and Benefits
Attractive output
Mortgage-backed securities typically have higher yields than government bonds. Securities with higher coupons have the potential to achieve greater returns, but there are also increased credit and prepayment risks, meaning realized yields may be lower than originally anticipated. Investors may receive higher payments compared to income from investment-grade corporate offerings. A portion of these payments may represent a return of principal due to an advance payment.
Credit Quality
Credit risk is affected by the number of homeowners or borrowers in the mortgage loan pool who are in default on their loans. The credit risk is considered minimal for mortgages backed by federal agencies or government-sponsored enterprises.
Risk
Credit and Default Risk
While MBS backed by GNMA have negligible default risk, MBS issued by FHLMC and FNMA have some default risk, and securities not backed by any of these institutions have even higher default risk, although pooled mortgages help Mitigating some default risk. That kind of risk. Investors considering mortgage-backed securities, particularly those not backed by one of these entities, should carefully examine the characteristics of the underlying mortgage pool (e.g., mortgage terms, underwriting standards, etc.). The credit risk of the issuer itself may also be a factor, depending on the legal structure and entity that retains title to the underlying mortgage loan.
Interest rate risk
Generally speaking, when interest rates fall, bond prices in the secondary market rise, and vice versa. However, due to the presence of prepayment and rollover risks, the secondary market prices of mortgage-backed securities, particularly CMOs, sometimes rise less than typical bonds when interest rates fall, but may fall more when interest rates rise. Therefore, these securities may be subject to greater interest rate risk than other bonds.
Prepayment risk
This is the risk that a homeowner will make a higher monthly mortgage payment than is required or pay off the mortgage completely by refinancing, and this risk increases when interest rates fall. When these prepayments occur, the amount of principal retained in the bond declines faster than originally anticipated, thereby shortening the bond’s average life by returning principal to bondholders sooner. Since this typically occurs when interest rates fall, reinvestment opportunities may become less attractive. Prepayment risk can be reduced when investing pools a large number of mortgages because the impact of each mortgage prepayment on the overall pool is reduced.
MBS is likely to be subject to prepayment risk, so cash flows can be estimated but may change. Given this, the quoted yield is also an estimate.
In the case of CMOs, when advances occur more frequently than expected, the average life of the security becomes shorter than originally estimated. While some CMO segments are specifically designed to minimize the impact of variable prepayment rates, average life is always an estimate at best and depends on how well the actual prepayment rate of the underlying mortgage matches the assumptions.
Extension risk
This is the risk that the homeowner decides not to pay off the loan as early as originally anticipated. This usually happens when interest rates rise, which gives homeowners less incentive to refinance their fixed-rate mortgages. This could cause the security to lock in the asset for longer than expected and provide a lower-than-expected coupon because principal repayments are reduced. Therefore, during periods of rising market interest rates, MBS price declines will be exacerbated by falling coupon rates.
Liquidity
According to the issuance situation, the overall liquidity of the MBS secondary market is good, and traders and investors are actively trading. The characteristics and risks of a particular security, such as the presence or absence of GSE backing, may affect its liquidity relative to other mortgage-backed securities.
Due to the unique characteristics of each tranche,
CMOs may be less liquid than other mortgage-backed securities. Before purchasing a CMO, investors should have a high level of expertise to understand what the lot specifications mean. Additionally, investors may receive more or less than their original investment when selling their CMO.
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