Mortgage-Backed Security (MBS) Instrument and Market Features

This module builds on the prior ones that provided an overview of asset-backed securities (ABS) and described the benefits of securitization, the securitization process, and typical securitization structures. This module focuses on the largest ABS market in the world, mortgage-backed securities (MBS). It introduces mortgage loans and their characteristic features; discusses residential MBS (RMBS), including mortgage pass-through securities and collateralized mortgage obligations (CMOs); and describes commercial MBS (CMBS). It shows how to measure, mitigate, and share securitization-related risks across different tranches and their characteristics, and it examines MBS cash flows and risks. 

• Prepayment risk is the risk that the borrower does not repay the principal (or a portion of the principal) as scheduled. Contraction risk occurs when the borrower repays the principal faster than anticipated, while extension risk occurs when the borrower repays the principal more slowly than planned.
• Mortgage-backed securities (MBS) are bonds created from securitizing mortgage loans. Mortgage loans provide borrowers the funds to purchase property and require borrowers to repay lenders on a mutually agreed schedule, otherwise the lender has the right to seize the property.
• MBS can be created based on either residential or commercial mortgages. Bonds created from the securitization of mortgages backed by residential properties are residential mortgage-backed securities (RMBS).
• Because both scheduled principal repayments and unscheduled prepayments are made over the life of an MBS, the contractual maturity for an MBS does not reveal its actual payments and prepayments. The weighted average life is a measure widely used to assess when an MBS can be expected to be paid off.
• A mortgage pass-through security is a security created when mortgage lenders pool mortgages together and use them to back securities that they sell to investors. The cash flows of a mortgage pass-through security depend on the monthly cash flows of the underlying pool of mortgages.
• Collateralized mortgage obligations (CMOs) securitize mortgage pass-through securities or multiple pools of loans and are structured to redistribute the cash flows to different bond classes or tranches, thereby creating securities that have different exposures to prepayment risk.
• The tranching structure of a CMO can redistribute prepayment risk across the different tranches; the more senior a tranche is, the less exposure it has to prepayment risk and default risk.
• Commercial mortgage-backed securities (CMBS) can consist of just a few underlying commercial mortgages, and so one default in a CMBS pool may significantly impact the CMBS investors. Investors must evaluate this unique concentration risk by analyzing the individual loans and properties backing the CMBS, the owners of the commercial properties themselves, as well as the CMBS structure.
• Unlike RMBS, CMBS offer investors call protection at either the structural or individual loan level and thus trade more like corporate bonds than RMBS. However, commercial mortgages often include a large balloon payment at maturity, making CMBS more vulnerable to a type of extension risk, balloon risk.