Basic Types of Mortgage-Backed Securities and Related Profits
Mortgage-backed security (MBS) denotes a fixed-income investment product that resembles bonds. It comprises a bundle of mortgages sold to investors by the banks that issued them. Essentially, investors in MBS serve as money lenders to home buyers and receive periodic payments resembling those of bond coupons. MBS comes in two basic types: pass-throughs and collateralized mortgage obligations (CMOs). In addition, another possible variation is stripped mortgage securities.
Also known as a participation certificate, the pass-through MBS provides investors with direct ownership of the bundle of mortgages. They get a proportional share of all incoming to the bundle principal and interest payments as the issuer receives the borrowers’ monthly payments. Pass-throughs’ maturities can range from five to 30 years. However, the monthly cash flow can vary contingent upon the number of mortgages paid off annually, which, in turn, depends on the current interest rates.
The fluctuation of interest rates can affect both borrowers’ decisions and investors’ returns. Borrowers might decide to refinance or prepay their obligations when current interest rates decrease. As a result, investors must look for returns matching their initial investment in circumstances with declining interest rates. The opposite scenario of increasing current interest rates can be equally detrimental. Borrowers will keep their loans while investors are stuck with lower returns in a situation with rising interest rates.
CMOs comprise multiple bundles of mortgages. The aim is to minimize the investors’ risk from borrowers prepaying their loans. One way of doing so is the so-called sequential pay CMO, which involves CMO issuers distributing cash flow to bondholders via classes or tranches. Each tranche consists of MBS that have close maturity and cash flow models. The whole tranche, however, differs from the others comprising the CMO. For example, one CMO might have five tranches, each with mortgages averaging three, five, seven, 15, and 20 years.
When the CMO issuer receives the mortgage payments, it will first pay the respective coupon interest rate to each tranche’s bondholders. The investors in the first tranches will receive both scheduled and unscheduled principal payments. Investors in later tranches will receive principal payments only after the first’s are complete. The idea is to shift the prepayment risk from tranche to tranche. The number of interdependent tranches in some CMOs can exceed 50.
Finally, stripped mortgage securities or strips are a type of MBS whose investors receive principal-only (PO) or interest-only (IO) payments. They can consist of MBS or be part of CMO tranches. Investors obtain PO strips at a highly-discounted price and receive principal payments from the mortgage that backs them up. Current interest rates fluctuations highly affect PO market value, and the latter varies accordingly. Lower interest rates may trigger an increase in prepayments, which, in turn, may increase POs value and vice versa.
Investors receive from IO strips solely interest payments calculated on the outstanding principal amount. With the amortization or reduction in the price of mortgages and their prepayments decreasing the principal balance, the IO’s cash flow also drops. IO’s value is in inverse correlation with that of POs. If current interest rates decline and prepayments rise, the IO income can decrease. Conversely, higher current interest rates increase investors’ likelihood to receive interest payments for a longer period, thus raising IO’s market value.
