2. • MBS - An asset-backed security that represents a claim on the cash
flows from mortgage loans
• Subtypes:
– Pass through securities, Collateralized Mortgage Obligations, Stripped
mortgage-backed securities – interest only or principal only
• Mortgage classifications:
– Prime, Alt-A, Subprime, Jumbo
• Uses of MBS - Liquidity, free up capital, diversification
• CMO - Special purpose entity which is the legal owner of a pool of
mortgages. Investors buy bonds issued by the CMO and receive
payments according to a defined set of rules
• Mortgage is collateral, Bonds are tranches (classes), Structure is the
set of rules that dictates how money received from the mortgages will
be distributed
• CMO issuer assembles a package of MBS or actual loans and uses
them as collateral for a multiclass security offering
5. TRADING
• Mortgage-Backed Securities
– The securities are issued by a trust (Fannie or Freddie) and allocate the cash
flows from the underlying pool to the securities holders on a pro rata basis.
– Those MBS’s can then be used to create a special entity known as a CMO
– Not traded on a market. Investors buy MBS directly from
Fannie, Freddie, Investment Banks, REITs etc.
• Collateralized Mortgage Obligation
– CMO’s use the underlying loan pool to create different tranches
• One loan pool can support several tranches with a variety of different
structures that appeal to wide range of investors.
– CMO bonds are sold to investors by Investment banks
6. • 2 metrics for valuation:
• weighted-average maturity (WAM) and weighted
average coupon (WAC)
• Example:
Loan Outstanding Mortgage Remaining % of pool
Mortgage Rate Months to total
Balance Maturity $900,000
balance
Loan 1 $200,000 6.00% 300 22.22%
Loan 2 $400,000 6.25% 260 44.44%
Loan 3 $300,000 6.50% 280 33.33%
Overall $900,000 WAC: 6.277% WAM: 275.55 100%
7.
8. • Risks for MBS’s and CMO’s
– Credit Risk
• If the Mortgage pool is purchased from one of the GSE’s
it can be backed by the US government which
eliminates credit risk. “Private label” MBS’s offered by
REIT’s were popular prior to the economic meltdown
but didn’t offer the backing of the US government so
credit risk was an issue.
– Interest Rate Exposure
– Early Redemption
9. • Subprime Mortgages
Year 1994 1996 1999 2006
Amount ($) $35 billion $80 billion $160 billion $600 billion
Percentage (%) 5% 9% 13% 20%
– Subprime loans integrated into MBS loan pools with
higher credit ratings
– As homeowners started defaulting on loans in 2007,
subprime loan valuation decreased.
• CMO valuation dropped
• Fannie Mae and Freddie Mac portfolio losses skyrocketed
• Investments banks holding junk CMOs
Pass through securities – issued by a trust and allocate cash flows from the underlying pool to the securities holder on a pro rata basis. Collateralized mortgage obligation – debt obligations of a legal entity that is collateralized by the assets it owns. Typically divided into classes that have different maturities and different priorities for the receipt of principal and sometimes interest, sequential pay security structureStripped mortgage – each mortgage payment is partly used to pay down the loan’s principal and partly used to pay the interest on it – interest only stripped is a bond with cash flows backed by the interest component of property owners mortgage payments. Principal only – bond with cash flows backed by the principal repayment component of property owner’s mortgage paymentsClassifications:Prime – prime borrowers, full documentation (verification of income and assets), strong credit scores etc.Alt A – generally prime borrowers but often with lower documentation or different type of asset (vacation home etc)Subprime – weaker credit scores, no verification of income or assetsJumbo – size of the loan is bigger than the conforming loan amount as set by Fannie MaeAllows entity to offer a wider range of investment time frames and cash flow certaintyBasic Structure:Tranches pay in strict sequence with regular interest payments but principal payments received are made to the first tranche alone until completely retired – sequential payFirst tranche receives all available principal payments until its balance is down to zero, then the second and so onTranches mature at different times and have different yields
