Mortgage Backed Securities (MBS)

A mortgage-backed security (MBS) offers investors a monthly distribution of principal and interest payments made by homeowners, allocated on a pro-rata basis.

Pass-throughs

In a pass-through MBS, the issuer gathers monthly payments from a collection of mortgages and distributes a proportional share of the collected principal and interest to bondholders. A pass-through MBS generates cash flow from three sources:

• Scheduled principal (typically fixed)
• Scheduled interest (usually fixed)
• Prepaid principal (generally variable, influenced by homeowner actions and prevailing interest rates)

Collateralized Mortgage Obligations (CMOs)

CMOs are restructured pass-through mortgage-backed securities, with cash flows allocated in a prioritized manner based on the bond's structure. The goal of a CMO is to offer additional protection against prepayment risk beyond what pass-throughs provide, while still maintaining credit quality and high yields.

CMOs take the cash flow from pass-throughs and divide it into different bond classes known as tranches, which specify a timeframe for expected repayments. This structure gives investors a degree of predictability regarding payments. The tranches prioritize the distribution of principal payments among various classes, creating a series of maturities throughout the life of the mortgage pool.

CMOs versus Traditional Mortgage-Backed Securities

The primary distinction between traditional mortgage pass-throughs and CMOs lies in the principal payment process:

In a traditional MBS, each investor receives a monthly pro-rata share of any principal and interest payments made by homeowners. Bondholders receive a portion of the principal until the final maturity, when homeowners fully repay the mortgages in the pool. This process introduces uncertainty regarding the timing of principal returns, as borrowers may pay off part or all of the debt early.

CMOs replace the pro-rata distribution process found in pass-throughs with a prioritized principal pay-down schedule among tranches, resulting in a more predictable rate of principal repayment.

MBS may be backed or issued by organizations such as the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae).

Government National Mortgage Association (Ginnie Mae)

Ginnie Mae is the only fully owned government corporation backed by the full faith and credit of the US government. Its purpose is to ensure the availability of mortgage funds across the US. It guarantees timely payment of principal and interest on loans originated through the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service (RHS), and Public and Indian Housing (PIH). Ginnie Mae plays a crucial role in eliminating disparities in mortgage credit availability across different regions. Securities are offered in various maturities, with a minimum denomination for new issues set at $25,000, in increments of $1,000. Investments below $25,000 may be available through purchasing securities that are either discounted or have partially repaid their principal.

Federal Home Loan Mortgage Corporation (Freddie Mac)

Freddie Mac is a publicly owned government-sponsored enterprise that is not explicitly guaranteed by the US government. Its purpose is to enhance the availability of mortgage credit for residential financing. It raises most of its funds by creating and maintaining an active secondary market for residential mortgages. Freddie Mac issues both mortgage-backed securities and standard corporate bonds, known as government-sponsored enterprise (GSE) bonds. Securities are available in $1,000 increments.

Federal National Mortgage Association (Fannie Mae)

Fannie Mae is also a publicly owned government-sponsored enterprise that is not explicitly guaranteed by the US government. Its purpose is to sustain an active secondary market for mortgages. Fannie Mae issues both mortgage-backed securities and standard corporate coupon bonds, with securities available in $1,000 increments.

MBS typically offer attractive yields that are higher than those of government bonds. Securities with higher coupons present the potential for greater returns but also come with increased credit and prepayment risk, meaning the actual yield could be lower than initially anticipated. Investors may receive higher payments compared to income generated by investment-grade corporate issues, with a portion of these payments potentially representing a return of principal due to prepayments.

The credit risk associated with MBS is influenced by the number of homeowners or borrowers in the mortgage pool who default on their loans. Credit risk is generally minimal for mortgages backed by federal agencies or government-sponsored enterprises.

Credit and Default Risk

While MBS backed by Ginnie Mae carry negligible default risk, there is some risk associated with MBS issued by Freddie Mac and Fannie Mae, and an even higher risk for securities not backed by these agencies. However, pooling mortgages can help mitigate some of that risk. Investors considering mortgage-backed securities, especially those not backed by these entities, should thoroughly assess the characteristics of the underlying mortgage pool (e.g., mortgage terms, underwriting standards, etc.). The credit risk of the issuer may also be a consideration, depending on the legal structure and entity that retains ownership of the underlying mortgages.

Interest Rate Risk

Generally, bond prices in the secondary market increase when interest rates fall and decrease when rates rise. However, due to prepayment and extension risk, the secondary market price of a mortgage-backed security, particularly a CMO, may not rise as much as a typical bond when interest rates decline, but may fall more sharply when rates increase. Therefore, these securities may carry greater interest rate risk compared to other bonds.

Prepayment Risk

This risk arises when homeowners make higher-than-required monthly mortgage payments or pay off their mortgages entirely through refinancing, a risk that escalates when interest rates are declining. As prepayments occur, the amount of principal retained in the bond decreases more quickly than initially projected, shortening the bond's average life by returning principal to the bondholder prematurely. Since this typically happens when interest rates are falling, reinvestment opportunities may be less appealing. Prepayment risk can be lessened when the investment pools a large number of mortgages, as each individual mortgage prepayment would have a diminished impact on the overall pool.

Prepayment risk is highly probable with MBS, making cash flow estimates subject to change. Consequently, the quoted yield is also an estimate. In the case of CMOs, if prepayments occur more frequently than anticipated, the average life of a security will be shorter than originally estimated. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life remains, at best, an estimate dependent on how closely actual prepayment speeds align with assumptions.

Extension Risk

This risk occurs when homeowners choose not to make prepayments on their mortgages to the extent initially expected. This situation typically arises when interest rates are rising, providing homeowners little incentive to refinance their fixed-rate mortgages. As a result, a security may lock up assets for longer than anticipated, yielding a lower-than-expected coupon due to reduced principal repayment. Thus, during periods of rising market interest rates, the price declines of MBSs would be exacerbated due to the declining coupon.

Liquidity

The secondary market for MBSs is generally liquid, with active trading by dealers and investors, although this can vary by issue. The characteristics and risks of a specific security, such as the presence or absence of GSE backing, may influence its liquidity compared to other mortgage-backed securities.

CMOs may be less liquid than other mortgage-backed securities due to the unique features of each tranche. Investors should possess a high level of expertise to understand the implications of tranche specifications before purchasing a CMO. Additionally, investors may receive more or less than their original investment when selling a CMO.