Brad Czajkowski, Ganesh Paranthaman, Janine Yip

• 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

Source: Investopedia

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

• 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%

• 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

• 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

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