Agency Mortgage-Backed Securities (AMBS) are securities that are backed by the mortgage loans. These securities include mortgage passthrough securities, stripped mortgage-backed securities and Collateralized Mortgage Obligations (CMOs).
Mortgage securities are created when a mortgage provider, such as a savings association, commercial bank or mortgage company, sells its residential loans to a federally sponsored credit agency or a private institution. The agency then assembles these mortgages and issues certificates to investors with underlying residential or mortgage loans as collateral. These certificates are called mortgage pass through securities because when the residential house property owner pays his monthly mortgage payment, such payment is 'passedthrough' to the mortgage security holder as interest and return of principal on a monthly basis. In addition to 'mortgage passthrough securities', there exists another type called 'collateralized mortgage obligations' or 'mortgage derivatives.' The latter is said to be more complicated when compared to that of the former one.
Unlike a mortgage passthrough, in which all investors participate proportionately in the net cash flows from the mortgage collateral, in a CMO different bond classes are issued. These bonds called tranches participate in different components of the net cash flows. The tranches carry their own risk characteristics and maturity range. This helps investors to select a bond offering the characteristics, which most closely meet their needs.
The CMO structure offers issuers a flexible tool with which to design tranches to meet investor needs and respond to market conditions. There is a wide range of CMO tranches designed to reduce an investor's exposure to prepayment risk. The tranche types are defined according to general characteristics - a few of the major ones are sequential-pay tranches, planned amortization class (pac) tranches, support or companion tranches, accrual bonds (Z bonds), floating-rate tranches, etc.