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About Mortgage-Backed Securities

Mortgage-Backed Securities (MBS) offer a unique opportunity for monthly income, relative safety, and attractive yield advantages compared to other similar quality investments.

The Evolution of Mortgage-Backed Securities

Mortgage-backed securitization is the creation and issuance of debt securities or bonds whose payments of principal and interest derive from the cash flows of a specific group of similar mortgages. The Government National Mortgage Association (GNMA) issued the first mortgaged-backed security (MBS or pass-through) in 1970 and while it took a couple of years to gain traction, the MBS market is now one of the largest fixed income markets.

The growth in the pass-through market led to innovations in order to broaden the MBS investor base. The Federal Home Loan Mortgage Corporation (more commonly known as “Freddie Mac”) first introduced collateralized mortgage obligations (CMOs) in 1983. The main goal of a CMO was to provide a range of duration options to MBS investors. The Tax Reform Act of 1986 authorized the establishment of Real Estate Mortgage Investment Conduits (REMICS), creating certain tax and accounting advantages for issuers and for certain large institutional and foreign investors. For investment purposes, REMIC securities are indistinguishable from CMOs. The CMO market has grown to over $4 trillion in size since its inception in 1983 and today accounts for an ever increasing and important segment of the overall mortgage market.

The first type of mortgage-backed securities created were mortgage pass-through securities. To create these pass-through securities, similar home mortgages meeting the standard criteria of the issuing Government Agency are grouped together into “pools”. Investors are then able to purchase an interest in these pass-through securities. As the mortgage holders make monthly payments of principal and interest, the pass-through security holder is entitled to a pro-rata portion of the payments received. The mutual advantage of this process is that it makes funds available for home mortgages at attractive rates, while at the same time creating high quality securities for investors. Mortgage pass-through securities are typically considered to have an investment horizon of approximately ten to twelve years on average, even though the mortgages are typically thirty-year loans. This shortened horizon occurs because most mortgage loans pay back monthly principal and also allow borrowers to prepay their principal before the stated maturity of the mortgage-backed security. Prepayments can occur as a result of refinancing, homeowners moving, death, foreclosure, etc.

In an effort to attract clients with investment objectives shorter or longer than the typical pass-through security, the CMO was created by placing pools of mortgage pass-throughs in a trust as collateral. The pools in the trust produce monthly cash flow of principal and interest which can be directed by a set of rules to create short, intermediate and long term bonds with various degrees of prepayment sensitivity. The features of CMOs do not go without certain risks that need to be considered before investing. CMOs are complex securities and the average life and yield of a MBS will fluctuate depending on the actual prepayment experience of the underlying mortgages and changes in current interest rates. If MBS are sold in the secondary market prior to maturity, the proceeds received may be more or less than the original amount invested.

Who Issues Mortgage-Backed Securities?

Mortgage originators produce loans which are divided and grouped into similar sets so securities can be formed or issued. Typically these homogeneous sets of loans are submitted to one of the three issuing GSEs who create the MBS pass-through. The Federal Home Loan Mortgage Corporation (FHLMC or commonly referred to as “Freddie Mac”), the Federal National Mortgage Association (FNMA or commonly referred to as “Fannie Mae”), as well as Government National Mortgage Association (GNMA or commonly referred to as “Ginnie Mae”) are the largest issuers of mortgaged-backed securities pass-throughs. CMOs are created by dealers who purchase MBS pass-throughs, establish the cash flow rules, and submit all of this data to either FHLMC, FNMA or GNMA to create the CMO. While FHLMC, FNMA and GNMA dominate the new issue market, in the past many private issuers also regularly brought CMOs to market, known as Private Label or Whole Loan CMOs. 

How Does the CMO Structure Work?

A typical collateral group is structured into 10-20 different classes or tranches. Each class can have a different coupon, expected average life (the weighted average time the principal is outstanding) and cash flow schedule. This unique structure enables the issuer to transform a pool of 30-year mortgage pass-through securities into a series of bonds each designed to meet the need of a different investor group.

The issuer predetermines the order in which the classes will be retired. Each month as the cash flow from the underlying collateral is received, the trustee will disburse the interest and principal to the classes based on a predetermined set of rules. Thereby, principal and interest will be directed to some classes while others will receive interest only for some period. After the shortest maturity class has been fully retired, the principal will then be directed to the next class in line. This type of structure allows investors in the longer-term classes to enjoy steady interest income for several years as the early classes absorb the principal prepayments. It is important to note that the yield and average life of each class will fluctuate depending on changes in current interest rates.

The following illustrations depict the most basic CMO structure - the sequential pay. However, most issues have more classes with different cashflow allocations.

Cashflow Example

Related Information

MBS are complex securities and are not suitable for all investors. The average life and yield of a MBS will fluctuate depending on the actual prepayment experience of the underlying mortgages and changes in current interest rates. If MBS are sold in the secondary market prior to maturity, the proceeds received may be more or less than the original amount invested.