Mortgage-Backed Securities and Collateralized Mortgage Obligations
Mortgage-backed securities (MBS) have traditionally been referred to as relatively high-quality, high-cash-flow-generating investment vehicles. For these reasons, many of these investments continue to command the attention of investors. However, recent turmoil associated with mortgage loan originations reveals the need to understand these investments and the factors that drive their performance. Many potential investors shy away from MBS, while others consider this an opportune time to invest.
The discussion that follows will focus on investments securitized with residential mortgages. Private label mortgage-backed securities and other types of asset-backed securities are omitted from this piece. The market is vast and the information below covers only the simplest and most common types of mortgage securities – those issued by one of the government-sponsored enterprises, such as Ginnie Mae, Fannie Mae and Freddie Mac. The U.S. government guarantees payments of interest and principal from securities issued by Ginnie Mae. This backing applies only to the face amount of the CMO and not to any premium paid. Fannie Mae and Freddie Mac are public companies that solely assure payments of interest and principal from their mortgage securities. However, the two companies are currently under U.S. government conservatorship.
Mortgage-backed securities represent an ownership interest in a pool of mortgages originated by financial institutions, such as commercial banks, savings and loans, or mortgage bankers, to finance a borrower’s purchase of a home or other real estate. Mortgages with similar characteristics are pooled together, packaged into one investment and then sold in the secondary mortgage market. The principal and interest payments from homeowners’ mortgages are passed through to mortgage bond investors.
Pass-through securities are pooled together and used as collateral for issuance of a more complex type of mortgage security known as a collateralized mortgage obligation (CMO). The cash flow from a CMO is distributed according to a predetermined schedule based on the repayment of principal. CMOs are designed to appeal to investors with specific needs for cash flow and/or term.
Tip 1
- Pools of mortgage loans form a mortgage-backed security.
- Pools of mortgage-backed securities form a collateralized mortgage obligation.
Prepayment Speed Assumptions (PSA)
The cash flow from MBS can be somewhat irregular because the speed and timing of repayments can vary. Generally, homeowners will prepay or refinance their mortgage loans early if market interest rates decline. If interest rates remain stable or increase, homeowners may put off prepayments until rates decline or other circumstances arise. A mortgage borrower may also prepay the loan regardless of interest rates, due to personal reasons, such as job relocation, death, divorce or default. They may also reduce their mortgage faster by making larger monthly payments. Over the years, many mathematical models have been developed to help predict how fast mortgage loans will be prepaid under different scenarios. These prepayment rates are represented as a percentage called the prepayment speed assumption (PSA). The higher the PSA number, the faster the principal is being returned. Prepayment assumptions may be based on historic prepayment rates for each type of mortgage loan, various economic conditions, and geographic locations of specific properties, among other factors. MBS market prices and yields depend on prepayment assumptions made by these models. However, because the cash flow on mortgage securities is somewhat irregular, if actual prepayment rates are faster or slower than anticipated, the realized yield may be different than estimated.
Average Life
Average life of MBS is the average time that each principal dollar in the pool is expected to be outstanding based on estimated PSA. If the actual prepayment speed is faster or slower than estimated, the average life will be shorter or longer. It is a general practice to quote average life rather than the stated maturity date when evaluating mortgage-backed securities. Yield-to-average life (YTAL) is a standard measure of return used to compare MBS to other fixed income alternatives with similar characteristics. However, average life is only an estimate and largely depends on the accuracy of prepayment speed assumptions.
TIP 2
Due to uncertainty of future interest payments and repayment of principal, MBS usually offer higher yields than other comparable investments.
- Do not invest in MBS if you will need access to funds by a specific date as the assumptions of homeowners’ prepayments may or may not be met.
- Do not invest in MBS if you will need predictable and stable monthly cash flow.
- Do consider MBS securities as a cash-generating vehicle that will provide you with reinvestment opportunities and longer-term competitive returns.
Types of Mortgage-Backed Securities
Pass-Through Securities
Mortgage securities play a crucial role in the availability and cost of housing in the United States. Before the 1970’s, banks were essentially portfolio lenders – they would lend and hold the loans in their portfolios until the loans either matured or were paid off. A homeowner, as an ultimate borrower, agreed to make monthly payments that included both principal and interest. As real estate became more affordable, lenders needed to obtain more funds to meet the demand for mortgage loans. The lenders created and sold their own mortgage-backed securities (known as private label MBS) or sold the outstanding loans to other issuers of mortgage-backed securities.
The first mortgage pass-through security was created in 1970 with a guarantee by the Government National Mortgage Association (GNMA or Ginnie Mae). It is referred to as a “pass-through” because monthly mortgage payments of principal and interest, minus a servicing fee, are passed through to MBS investors from the homeowners on a pro-rata basis.
Most fixed income securities make periodic interest payments and repay the principal on the maturity date. With pass-throughs, the principal is amortized over the life of the security. This means that the principal value is paid back during a security’s life rather than returned to an investor in one large payment at the end of the term. It is, therefore, a self-liquidating investment that matures when an investor receives the final principal payment, which may be before the final stated maturity of the bond.
While MBS mature when the last interest and principal payment is received from the homeowner, there is a degree of uncertainty associated with income payments because most mortgage loans are repaid prior to the original term of the loan. The repayment, or prepayment, may result from a sale of property, refinancing or paying off a mortgage, or default on a loan. Once a loan is prepaid early, an investor’s share in the mortgage pool is reduced by the amount of returned principal. This causes the amount of monthly cash flow to decrease because the interest is now earned on the reduced outstanding portion of principal.
Collateralized Mortgage Obligations (CMOs)
CMOs were developed to meet investor demand for more predictable cash flows and specific maturity ranges. CMOs may be backed by a group of mortgages or by pools of existing pass-throughs or some combination of both. CMOs contain classes, also called “tranches” (a French word for “slices”), with various average lives, which are designed to meet specific investment objectives. Mortgages and/or pools of mortgages are held in a trust. As monthly principal and interest payments from homeowners are received in a trust, the cash flows are distributed to the various classes in a predetermined order. Usually, interest payments are first allocated to meet the obligations on all classes. Principal payments, both scheduled and prepaid, are then distributed to different classes according to priority order outlined in the prospectus or offering circular. The class receiving principal repayment is referred to as the “active” or “currently paying” class. The “window” is the period in which principal repayments are expected to occur. The period when investors receive only interest payments is known as the “lockout” period.
Investors who purchase CMOs on the first issuance date may find that their transactions take up to a month to settle due to the time necessary to assemble the collateral, deposit it with the trustee, and complete other legal and reporting requirements. Certain information, such as the CUSIP and stated maturity date, may not be available at the time of the trade. In this case, a corrected confirmation will be issued when this information becomes available. As a result of the time required to collect and redistribute the payments made by holders of the underlying mortgage collateral, a payment delay occurs each month for CMO investors. This delay is factored in to the yield calculations.
Types of CMO Classes
Sequential class (plain Vanilla) is the basic CMO structure. Each class receives regular monthly interest payments. Principal is paid to only one class at a time until it is fully paid off. Once the first class is retired, the principal is then redirected to the next class until it is paid off, and so on. The classes are paid off based on their corresponding average maturities, which may be two to three years, five to seven years, 10 to 12 years, etc. This type of structure allows the issuer to meet specific maturity requirements, and may reduce prepayment variability.
The following illustration shows how interest and principal are distributed among classes (tranches).
Tip 3
As illustrated, you would invest in the first class if you need to receive the highest amount of cash flow returned to you as soon as possible.
Alternatively, you would invest in the third class if you desire a fixed monthly interest stream for a longer period. This class gives you protection from receiving back principal too quickly, since the first two classes must be paid off first.
Planned Amortization Class (PAC) offers a fixed principal payment schedule. This is done by redirecting cash flow irregularities caused by faster-than-expected principal repayments away from the PAC class and towards another class referred to as a support (or companion) class. In other words, two or more classes (PAC and Support classes) are active at the same time. When repayment of principal is less than scheduled, principal is paid to the PAC class while principal to the support class is suspended. With a PAC class, the yield, average life, principal window, and lockout periods estimated at the time the deal is structured are more likely to remain stable over the life of the security. This is accomplished by offering a range of prepayment speeds (e.g. 75% to 300% PSA). As long as principal prepayments fall within the PSA range, the average life and yield will remain constant. Since PAC classes offer the highest degree of stability, they offer lower yields than other classes. PAC II classes were created to offer investors slightly higher yields, but they offer less stability. The typical PAC II class will have a narrower PSA “band” (e.g., 100% to 210% PSA).
Targeted Amortization Class (TAC) offers payment stability at one prepayment speed instead of a range (e.g., 200% PSA). If PSA deviates from a predetermined rate, TAC investors may receive more or less principal than expected. The degree of payment certainty of these classes depends on the overall CMO structure and the presence of PAC classes. If a CMO structure contains both TAC and PAC classes, TAC investors may experience higher principal payment fluctuations. As with PACs, any shortfall or excess of principal payments is absorbed by support classes. TACs are typically offered at higher yields than PACs, but lower yields than support classes.
Support (or Companion) Class – Any CMO structure that has PACs or TACs will also have support classes. These classes are designed to stabilize the principal payments of PAC and/or TAC classes. Payment variability is redistributed rather than eliminated or reduced. Supports are typically less predictable than other classes because they are designed to absorb any deviation from prepayment assumptions. Most support classes have a targeted average life; however, the average life can extend or shorten if prepayment speeds become volatile. Support classes can either absorb excess mortgage payments or extend their average lives in periods of lower repayments, in favor of PAC or TAC classes. Because of inherent volatility, support classes generally offer higher yields and may be suitable for investors who do not expect steady income payments.
There are other, more complex CMO structures. Each CMO class is unique and may work in sync or independently from other classes in the CMO. Detailed information about these and other CMOs is available from the Securities Industry and Financial Markets Association (SIFMA) at investinginbonds.com.
Features and Benefits
Investors may purchase new-issue MBS and CMOs or participate in the secondary market where existing securities are traded among investors through broker/dealers.
Seeks Attractive Yields and Monthly Income
Mortgage-backed securities offer higher yields than unsecured securities but with less predictability of interest and principal payments. Interest income is paid monthly on the outstanding principal value. While the coupon rate is set at the time of issuance, monthly payments, which include interest and principal, may vary. For investors with flexible time horizon, MBS may offer attractive returns.
Credit Quality
Although not rated by nationally recognized rating agencies, GSE-issued mortgage securities are backed by financial assets that are designed to generate a cash flow. These assets include single-family mortgages, multi-family mortgages and commercial mortgages. Payments of interest and principal are assured by the issuer. As a reminder, only Ginnie Mae securities are direct obligations of the U.S. government, and even these are subject to market risk. To reduce the risk of default, some homeowners are required to carry mortgage insurance if the mortgage loan amount exceeds 80% of the home value. According to the Census Bureau, more than 67% of Americans own a home (as of the second quarter 2009).
Flexibility
From basic pass-throughs to more complex CMOs, MBS investors can further define potential maturities and cash flow schedules to better fit their individual investment objectives.
Liquidity
Although not obligated to do so, many broker/dealers participate in the secondary market for mortgage-backed securities. Investors may sell their bonds prior to the stated maturity date at prevailing market prices. As with other fixed income securities, secondary market prices of pass-throughs and CMOs react to changes in interest rates. As rates increase (decline), MBS market prices fall (rise). Additionally, CMOs may be less liquid because of the complexity of each tranche, which may or may not find demand in the secondary market. Proceeds from a sale may be more or less than the original investment.
Risks and Investment Considerations
Mortgage bonds with higher coupons generally have a shorter average life based on higher prepayment speed estimates. It is assumed that homeowners whose mortgage rates are higher than prevailing rates will refinance or pay off loans faster. In contrast, homeowners tend to hold on to low-rate mortgages, thus resulting in a longer average life of MBS securitized by those loans.
Prepayment Risk
Prepayment risk is the risk that the homeowners will pay off their mortgages faster by making higher-than-required monthly payments, refinancing or selling the property. Prepayments usually occur when interest rates decline. As the principal is returned sooner than expected, MBS holders may be forced to reinvest at prevailing lower yields. A CMOs yield and average life will fluctuate depending on the actual rate at which mortgage holders prepay the mortgages underlying the CMO and changes in current interest rates.
Extension Risk
Extension risk is the risk that the homeowners will not pay off their mortgage loans as soon as expected, resulting in lower PSA estimates and extension of the average life. If this occurs, mortgage investors may end up holding bonds with longer maturities than expected and the yield may or may not keep up with rising inflation or market interest rates.
Interest Rate Risk
Market values of mortgage bonds are more sensitive to movements in interest rates than other fixed income securities. Rising or falling interest rates have a trickling effect on MBS prices as they affect the underlying mortgage loans, the rate at which they are prepaid and, hence, their average life.
Self-Liquidating Investments
Unlike other fixed income investments, MBS do not return principal in one lump sum on the maturity date. These securities mature when the last payment of interest and principal is paid to investors. For this reason, investors may choose to accumulate the principal portion over the life of the bond in order to take advantage of future investment opportunities.
Taxation
The interest portion of income payments is fully taxable. Payback of principal is not taxable unless mortgage bonds were purchased at a discount from par. Tax implications may be more complex for MBS investors, thus they should seek professional tax advice prior to investing.
Before Investing
Before investing in mortgage-backed securities, investors should have a clear understanding of all the terms of the issue.
Type of Security
Identify the collateral behind the mortgage loans, whether purchasing a pass-through or a more complex CMO.
Issuer Guarantee
Verify the existence of any guarantee or other credit enhancements and the credit quality of the guarantor.
Quality of Security
Understand what types of mortgage loans are held in a pool.
Average Life versus Stated Maturity
Average life, which may be shorter or longer than estimated, and the final stated maturity should match an investor’s investment horizon.
YTAL versus YTM
Compare a yield-to-average life to a yield-to-maturity of another comparable investment. A YTAL takes into account the return of principal over time, whereas a YTM is the yield based on a bond’s stated maturity date.
Prepayment Speed Assumptions
Analyze possible scenarios of interest rate movements and how they may affect a PSA rate. The lower the PSA rate, the longer the average life.