Mortgage Backed Securities
What are Mortgage Backed Securities (MBS)?
Large banking institutions and government sponsored entities (GSE's) purchase mortgages, which abide by certain standards, and package them together into securities which investors can buy. These securities are referred to as mortgage backed securities, or MBS. Mortgage backed securities bring liquidity into the mortgage markets and allow lenders to issue more loans and enable them to offer better pricing with their loans. Lenders no longer have to hold the mortgages on their books which frees up cash and removes the portfolio risk at the same time. Additionally, MBS securities offer investors the opportunity to buy securities with very high credit ratings. GSE's, such as Fannie Mae and Freddie Mac are two of the largest originators of MBS and have the backing of the U.S. government to ensure investors payment of principal and interest from the underlying mortgages in the security. Securities issued from these two entities are also known as "Agency" mortgage backed securities.
From an investors point of view, there are a few key benefits to an MBS. Firstly, they offer substantially higher returns than treasury securities of similar term, in the area of 100 to 200 basis points. MBS securities also have very high credit quality ratings as well. Agency securities are typically considered as safe as treasury securities while non agency securities are AA to AAA rated. Finally, investors will receive regular monthly income from these securities, especially pass-throughs.
There are three variations of a mortgage backed security: mortgage pass-through, collateralized mortgage obligations (CMO), and stripped mortgage backed securities. The most common type is a pass-through MBS.
When you purchase an pass-through security, you receive pro-rata cash flows generated from the mortgage payments made by the underlying mortgage holders in the security. This cash flow comes in three forms: interest payment, principal payment, and principal prepayments. Pass through MBS are a efficient means to purchasing many mortgages as there is much greater liquidity than that of an individual mortgage.
Collateralized Mortgage Obligation (CMO)
A CMO is a special purpose entity which is created by the issuer of the security and this entity owns the pool of loans that will be securitized. Collateralized mortgage obligations are structured in that they have different classes of bonds, also known as tranches. Each one of these classes follow a set of rules which governs items such as principal repayment and prepayment absorption. Unlike the pass-through MBS, CMO's provide certain classes of bond holders with less uncertainty regarding prepayment risks.
For example, a CMO deal may be established with 3 separate groups of bond holders. The deal may stipulate that the the first group will receive its principal back first; therefore, all mortgage principal payments will be split pro-rata among that group of bond holders until their principal is fully repaid. Effectively, this first group is going to be a shorter term security due to the fact that it will absorb the prepayment risk first. Remember, prepayments on mortgages are a risk to bond holders because it prevents them from receiving interest payments on those amounts. The second group will then receive its principal back while the third group will follow. This is a very simple example of a CMO but it was given to illustrate the idea that prepayment risk can be less uncertain based on the tranche you are in.
Stripped MBS securities are slightly different than CMO's; rather than have principal distribution priorities, stripped MBS's split the principal and interest portions between tranches. There is an IO and a PO class. These acronyms refer to interest-only and principal-only. As there are no interest payments in the PO class, PO securities are purchased at a substantial discount to par. Basically, the faster the prepayments occur, the faster they receive their principal back and the higher the yield on the investment. As you can see, PO tranches benefit from lower interest rate environments where prepayments are much faster. IO investors on the other hand would prefer higher interest rates which result in lower prepayments. The longer the principal remains unpaid, the more interest they will make.