A Mortgage-Backed security(MBS) is a debt obligation (bond) that represents claims to the cash flows from pools of mortgage loans. Mortgage providers sell the loans to an Agency or company that packages or pools loans together for sale to investors, creating a MBS. As the loans are paid, the MBS owner receives payments of interest and principle. Because mortgagors are have the option to pay more than the required monthly payment(curtailment) or pay off the loan in its entirety(prepayment)the monthly cash flow is not completely known in advance, increasing risk. Mortgage-Backed Securities are purchased at issuance or in the secondary market.

Most Mortgage-Backed Securities are issued by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae is a U.S. government agency backed by the full faith and credit of the U.S. government. Ginnie Mae guarantees that investors receive timely payments. Fannie Mae and Freddie Mac are U.S. government-sponsored agencies that also provide certain guarantees and have special authority to borrow from the U.S. Treasury. Some other private institutions, such as banks, brokerage firms,and home builders, also securitize mortgages, called as “private-label” Mortgage-Backed securities.

Mortgage Pass-Through
The most common form of a MBS is a mortgage pass-through. In this structure, payments of principle and interest (less service charge) from the loan pool are passed directly to investors each month.

In a fixed rate residential mortgage, the mortgagor makes a fixed payment each moth until maturity. This payment includes the principle and the interest. As time progresses, the interest portion of the monthly payment decreases because as the principle is paid off, the size of the interest payment declines.

When the mortgage holder exercises the option of prepaying their mortgage, this principle payment is passed through to the MBS holder. Although the MBS holder receives a larger cash payment, the MBS holder will not receive the future interest payments from the loan. Prepayments thus create risk in the market(prepayment risk) and uncertainty in future cash flows of the MBS.

Collateralized Mortgage Obligation (CMO)
In a CMO, different bond classes are issued, which participate in different components (tranches) of the net cash flows from the mortgage pool. A CMO is any one of those bonds. The tranches are structured to each have their own maturity range and risk characteristics, allowing investors to select bonds that better meet their needs. Collateral for the securitization may represent a pool of mortgages, but it is often a mortgage pass-through.

The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply to be to “split it”. For example, a $300′000 30 year mortgage with an interest rate of 6.5% could be split into 300 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00% for example (with the remaining .50% going to the servicing company to send out the monthly bills and perform servicing work). However, this format of bond has various problems for various investors

Even though the mortgage is 30 years, the borrower could theoretically pay off the loan earlier then 30 years, and will usually do so when rates have gone down, forcing the investor to have to reinvest his money at lower interest rates, something he may have not planned for. This is known as prepayment risk.

A 30 year time frame is a long time for an investor’s money to be locked away. Only a small minority of investors would be interested in locking away their money for this long. Even if the average home owner refinanced their loan every 10 years, meaning that the average bond would only last 10 years, there is a risk that the borrowers would not refinance, such as during an extending high interest rate period, this is known as extension risk. In addition, the longer time frame of a bond, the more the price moves up and down with the changes of interest rates, causing a greater potential penalty or bonus for an investor selling his bonds early. This is known as interest rate risk.

Most normal bonds can be thought of as “interest only loans”, where the bond issuer borrows a fixed amount and then pays interest only before returning the principal at the end of a period. On a normal mortgage, interest and principal is paid each month, causing the amount of interest earned to decrease. This is undesirable to many investors because they are forced to reinvest the principal.

On loans not guaranteed by the quasi-governmental agencies Fannie Mae or Freddie Mac, certain investors may not agree with the risk reward tradeoff of the interest rate earned versus the potential loss of principal due to the borrower not paying.

Salomon Brothers and First Boston created the CMO concept to address these issues. A CMO is essentially a way to create many different kinds of bonds from the same mortgage loan so as to please many different kinds of investors. For example:

A group of mortgages could create 4 different classes of bonds. The first group would receive any prepayments before the second group would, and so on. Thus the first group of bonds would be expected to pay off sooner, but would also have a lower interest rate. Thus a 30 year mortgage is transformed into bonds of various lengths suitable for various investors with various goals.

A group of mortgages could create 4 different classes of bonds. Any losses would go against the first group, before going against the second group, etc. The first group would have the highest interest rate, while the second would have slightly less, etc. Thus an investor could choose the bond that is right for the risk they want to take (ie. a conservative bond for an insurance company, a speculative bond for a hedge fund).

A group of mortgages could be split into principal only and interest only bonds. The principal only bonds would sell out a discount, and would thus be zero coupon bonds (ie bonds that you buy for 800 dollars a piece and which mature at 1000 dollars, without paying any cash interest). These bonds would satisfy investors who are worried that mortgage prepayments would force them to reinvest their money at the exact moment interest rates are lower. The interest payments would be sold off as interest only bonds. These kinds of bonds would dramatically change in value based on interest rate movements, allowing them to be used as an insurance against the changes in other bonds prices.

Striped Mortgage-Backed Securities (SMBS)
Stripped mortgage securities, first introduced in 1986, are created by segregating the cash flows from the underlying mortgage loans or mortgage securities to create two or more new securities, each with a specified percentage of the underlying security’s principal payments, interest payments or a combination of the two. For example, the cash flow on an 8 percent pass-through security might be redistributed to create one new security with a 10 percent coupon and another security with a 6 percent coupon.

Securities may be partially stripped so that each investor class receives some interest and some principal. When securities are completely stripped, all the interest is distributed to one type of security, known as interest-only (IO), and all the principal distributed to another, known as principal-only (PO). These securities may be custom-made to suit individual portfolio needs, depending on which portion of the cash flow the investor wants. Strips, IOs and POs can be created in a pass-through structure or as tranches of a CMO.

The market values of IOs and POs are very sensitive to fluctuations in prepayment rates and interest rates, making them more volatile than standard pass-throughs. As with most fixed-income securities, POs, for example, increase (or decrease) in value as interest rates decline (or rise). For this reason, the investors in these securities are primarily institutional.

Price behavior also depends on whether the mortgage collateral was purchased at a premium or a discount to its par value. Prepayments on discount coupon POs generally are much lower than prepayments on premium coupon POs.

On the other hand, IOs increase (or decrease) in value as interest rates rise (or decline). Since prepayment rates generally decrease as interest rates rise, investors in IOs are likely to receive interest payments over a longer time period, thus increasing the value of their investment. However, in a low-interest-rate, high-prepayment environment, the market value of an IO may decline considerably, and an investor may not recoup his or her initial investment. IOs can function as portfolio hedging vehicles, because prepayments cause the value of an IO strip to move in the opposite direction from many other mortgage and fixed-income securities.

Risks
Prepayment Risk – Changes in the prepayment speeds of the underlying mortgages will have a direct impact on the maturity structure of the pass-through security. An increase in prepayment speeds will lead to acceleration in principal returns and a contraction in the average life. A drop in prepayments, on the other hand, will lead to a slow down in principal returns and an extension in the average life.

Change in interest rates is the driving factor in the number of prepayments. As interest rates decline, fixed-rate mortgage holders are more likely to refinance mortgages to take advantage of the lower rates which would lower monthly mortgage payments. This is detrimental to MBS holders because, principle is normally returned to investors when reinvestment rates are unattractive, and not returned when reinvestment rates are attractive. MBS have higher yields than comparable fixed income instruments to compensate for prepayment risk.

Interest Rate Risk – Like any other fixed-income instrument, mortgage pass-through securities bear exposure to interest rate risk. For example, if principal returns on a mortgage security accelerate because interest rates are trending downward, the average life will contract and interest payments will be received over a shorter period of time. Conversely, if interest rates increase, return of principal can decelerate, causing the security’s average life to extend. In either case, changes in the level of interest rates can directly affect a mortgage security’s market value and total return.

Spread Risk – The yield spreads between Treasury and mortgage securities fluctuate on a daily basis. If the yield spread on a mortgage security widens versus Treasuries, an investor seeking to liquidate a position could suffer a capital loss, even if the Treasury market is virtually unchanged.

There are also differences between different MBS, resulting from the type of underlying mortgage and demographic or socioeconomic factors.

More Information and Sources:
http://en.wikipedia.org/wiki/Collateralized_mortgage_obligation
http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=23&id=134

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