Introduction to mortgage-backed securities, Financial Management

  • A mortgage may be defined as a pledge of property to secure payment of a debt. Depending upon the terms of mortgage agreed upon between the lender and the borrower, mortgages can be classified into traditional and
    non-traditional mortgages.

  • Securitization is the process of aggregating similar instruments, such as loans or mortgages, into a negotiable security.

  • A Mortgage Backed Security (MBS) is a bond financed by home mortgage payments. This is the essential concept behind the mortgage backed securities definition. The mortgage principal and interest paid by the homeowner is the principal and interest paid to the MBS holder. The basic mortgage-backed security is the mortgage pass-through security which is created from a pool of mortgage loans.

  • There is always a prepayment risk attached with investing in mortgage pass-through securities. Prepayment can be defined as the amount paid in excess of the required monthly mortgage payment. Due to prepayment, the cash flow of a mortgage-backed security is unknown. The risk of prepayment makes it a less attractive instrument to hold for some financial institutions from an asset/liability perspective.

  • Collateralized Mortgage Obligations (CMOs) retain many of the yield and credit quality advantages of pass-throughs, while eliminating some of the less desirable elements of the traditional mortgage-backed security. CMOs are bonds or debt obligations issued by mortgage originators by offering whole loan mortgages or mortgage pass-through securities as collateral. The cash flows generated by the assets in the collateral pool are first used to pay interest and then pay principal to the CMO bondholders.

  • The CMO structure offers issuers a flexible tool with which to design tranches to meet investor needs and respond to market conditions. Some of the tranches designed to reduce an investor's exposure to prepayment risk are sequential-pay tranches, planned amortization class (pac) tranches, support or companion tranches, accrual bondsĀ 
    (z bonds), floating-rate tranches.

  • A stripped mortgage-backed security is a derivative mortgage-backed security that is created by redistributing the interest and principal payments to two different classes viz. principal-only mortgage strip ( PO ) and the Interest-only mortgage (IO) strip. While OP strip benefits from declining interest rates and fast prepayments, the IO strip benefits from rising interest rates and a slowing of prepayments.

  • A non-agency mortgage-backed security does not carry precise government guarantee of payment of interest and principal as there is with an agency security.

  • Commercial Mortgage-Backed Securities (CMBS) are securities that are backed by income-producing real estate, usually in the form of warehouses, shopping centers, apartments, office buildings, senior housing, health care facilities, and hotel/resort properties.

  • International mortgage-backed securities are nothing but mortgage-backed securities that are issued in a country by a non-domestic entity.

Posted Date: 9/8/2012 8:32:11 AM | Location : United States

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