Mortgage-Backed Securities Flashcards
Mortgage Backed Securities (MBS)
-banks will underwrite then sell mortgages to an intermediary
-intermediary will then pool large numbers of loans into a porfolio
-intermediary will then sell securities backed by the portfolio
MBS structures
-pass through MBS
-collateralized mortgage obligation (CMO)
pass through MBS
principal and interest paid on the mortgages are immediately passed through to the investors
collateralized mortgage obligation (CMO)
securities which are collateralized by MBS. this allows for various distinct traches, depending on investor needs
2 types of CMO
- credit tranching
- time tranching
credit tranching
there will be one, or multiple, subordinated tranches. these are the tranches which take the first loss.
senior tranches are protected by the subordinated. subordinated pay a higher rate of return
time tranching
the first tranche receives all principal repayment from the pool, before the other tranches. this allows investors to match the duration to their time horizon
important organizations in MBS
Government national mortgage association (GNMA, ginnie mae)
federal national mortgage association (FNMA, fannie mae)
federal home loan mortgage corporation (FHLMC, freddie mac)
government national mortgage association GNMA
guarantees timely payments on MBS. GNMA is a government agency, so this guarantee dramatically reduces the risk of loss
very low risk
federal national mortgage association FNMA
purchases mortgages from larger commercial banks, then guarantees these mortgages and sells them as MBS
federal home loan mortgage corporation FHLMC
purchase mortgages from smaller banks or credit unions, securitizes said mortgages, guarantees repayment, then sells these MBS
if an MBS is issued by any of the above it is an
agency MBS
(guaranteed)
if an MBS is issued by any other issuer it is a
non-agency MBS
benefits of MBS for lenders
improved liquidity in banking sector
improved liquidity in banking sector
when a bank sells mortgages, it receives cash and is then able to underwrite more mortgages
-capital requirement
-when the bank sells a mortgage to an intermediary, it generates a profit, and no longer needs to keep capital on hand to service that mortgage
capital requirement
banks must keep a certain threshold of capital on hand, for every loan it has extended
benefits of MBS for investors
tranching
diversification
tranching
the tranching allows investors to purchase cash flows which meet their specific time horizon and risk tolerance
-funds or family offices
-pension funds or investment grade debt fund
funds or family offices
purchase junior tranches for yield
pension funds or investment grade debt fund
purchase senior tranches for low risk yield
diversification
there is a lesser chance of loss when investing in a pool backed by 1,000 different mortgages than investing in one mortgage
-there are some flaws in this logic which was demonstrated by 2008
-how diversified are defaults of various borrowers?
factors which impact cash flow
amortization schedule
weighted average coupon
weighted average maturity
default rate
prepayment
amortization schedule
when will borrowers be required to repay principle?
-fully amortizing
-partially amortizing
-interest only
fully amortizing
there will be no principal left outstanding at maturity. principal is evenly split up among the monthly mortgage payments
partially amortizing
monthly payments include some principal payments, but there is a lump sum due at maturity. this lump is called a bullet
interest only
monthly payments only represent interest, the entire mortgage amount is due at maturity
weighted average coupon
the weighted average of the interest rates of all the mortgages in the pool
weighted average maturity
the weighted average of the final maturities of all the mortgages in the pool
default rate
if a borrower defaults on a non-agency MBS, this reduces the cash flow to the investors
prepayment
if an investor prepays the entire mortgage balance, it will speed up cash flows. this most often occurs during a refinance
factors which impact prepayment
most common during fallen interest rate environment
general economic conditions
age of borrowers
interest rates
general economic conditions
during poor economic conditions, people may default on their home– this is a prepayment (and potentially a loss)
age of borrowers
people have a higher probability of selling their home when they retire, to roll equity into their retirement home
interest rates
during periods of declining interest rates, borrowers refinance to a lower rate in order to lower monthly payments
what accounts for the majority of prepayment?
interest rates
MBS are a
fixed income security
MBS valuation
MBS are a fixed income security and as a result have the same interest rate sensitivity as a bond
prices decline when
interest rates increase
prices increase when
interest rates decline but at a slower rate than bonds
