Mortgage-Related Securities

(MRS) (C.S. Chpt. 10)

(or Mortgage-Backed Securities, MBS)

Characteristics of acceptable
securities
1. Credit Enhancement. MRS
should have be “less risky” than
the underlying mortgages that
serve as collateral
2. Avoiding Double Taxation. A 2nd
market entity that issues MRS’s (and
uses the fund to purchase mortgages)
will have “interest income,” which it
passes through to the investors in the
MRS’s. MRS issuers must make sure
that these income and the cash flow to
the investors are not both taxed.
3. “Tailor-made” Cash Flow. Many
investors do not desire to invest in
securities whose cash flows exactly
replicate that of a mortgage. If the cash
flows from the mortgage can be
rearranged in amount and timing and
then distributed to the MRS investors,
there will be a larger and more liquid
market for them.
 Types of MRS
• Mortgage pass-through
securities
• Mortgage-backed bonds
• Mortgage pay-through bonds
• Collateralized mortgage
obligations (CMO)
 Pass-through securities
With a pass-through, the investor is
said to have an undivided interest in
the pool of mortgages. The investor
has an “ownership” position in the
mortgages. He/She will receive the
mortgage payments and any
prepayments just as if he/she were the
lender.
For instance, a bank can package a
collection (say 100) of fixed-rate
mortgages with same principal, same
interest rate and same maturity and
issues bonds against them, to finance the
mortgages. The bonds may be of 25,000
US$ each. Any payments and pre-
payments will be distributed
proportionally among investors.
Investors are attracted to pass-
through securities because of their
relatively high yield, liquidity, and
risk-pooling quality (in the US,
some of them are risk-free since the
agency which issue the bonds
guarantee the payments and charge
certain fees in return).
However, many investors do not like the
uncertainty of the timing of the cash
flows, due to unpredictable prepayments
of mortgages. Furthermore, mortgages
prepay more quickly when interest rates
drop, so that the money from prepayments
are more likely to re-invest at lower rates
of return. Pass-throughs face the same
“callability risk” as mortgage lenders.
To avoid the uncertainty
surrounding the timing of the cash
flows, securities other than pass-
throughs have been developed.
In the U.S., some pass-throughs are
rated by the rating agencies
(Standard and Poor’s and Moody’s).
Mortgage-Backed Bonds (MBB)
MBB promise payments similar to
corporate bonds: they deliver
semiannual payment of interest only
until maturity, with the face value due
at maturity. Unlike pass-throughs, the
mortgages are still owned by the
issuer of the bonds. MBB are issued
primarily by private financial firms.
MMB are usually, but not
always, backed by conventional
residential and commercial
mortgages. The maturity on the
bonds will be less than that on the
mortgages, and the yield will be
slightly below that on the
mortgages.
Credit enhancement is achieved by
“over-collateralization.” That is,
the face value of the pool of
mortgages will be greater than that
of the bonds. The issuer makes up
the difference with the equity
contribution. The issuers bear the
default risk as well as the pre-
payment risk.
Ideally, the issuer invest the monthly
interest and principal payments from the
pool of mortgages in a fund that earns
interest. Then, semi-annually, the
issuer will remit interest payments to
the bondholders from that fund. The
fund should be able to grow since the
revenue from the pool of mortgages will
be larger than the interest payments on the
bonds.
At the maturity date, the fund
should be large enough to pay
the face value of the bonds and
the residual will be taken by
the issuer as a return on the
original equity investment.
In practice, the mortgages are usually
placed in the hands of a trustee who
will mark-to-market any changes in
the value of the mortgages and make
sure that the agreed-upon
overcollateralization (say 125%) is
maintained. (i.e. the mortgages will
be valued on a frequent basis as a
result of interest rate changes).
 Mortgage Pay-through Bonds
(MPTBs)
This kind of securities share the features
of both pass-throughs and MMB. As
with MMBs, the issuer retains
ownership of the pool of mortgages and
issues the MTPB as a debt obligation.
The issuer also will over-collateralize
the debt obligation.
As with pass-through, the cash-flows to
the investor are based on the coupon rate
of interest, while principal from
amortization and prepayments is passed
through as received from the pool of
mortgages. Thus, the investor in these
bonds faces the same callability risk as
those in pass-throughs. Pay-throughs are
also rated by agencies.
Because the scheduled
amortization of the mortgages
and prepayments is pass through
to reduce the principal of the
bonds, the extent of over-
collateralization is less than with
MMBs.
 Collateralized Mortgage
Obligations (CMOs)
The objective of CMO is to
rearrange the mortgage cash
flows into several different bond-
like securities with different
maturities, called tranches. A
typical CMO will have three or four
tranches.
Consider the following example (CS
p.209-210).
Tranch A bondholders are paid off first.
In addition to interest, Tranch A
bondholders receive (1) any scheduled
amortization of the mortgages; (2) any
prepayments of the mortgages, and (3)
deferred interest earned by the Tranch Z
Bondholders but transferred to the
Tranch A bondholders. The principal
amount of the Tranch A bonds is
reduced by these items. If there are a
large amount of prepayments, the
maturity of the Tranch A bonds will be
shortened. For this reason, the maturity
of these bonds is stated as a range of
five to nine years.
Tranch B bondholders receive interest
payments only, but no prepayment of
principal until the Tranch A
bondholders are completely paid. This
pattern is followed for the remaining
tranches. In any year, payments not
given to any of the tranches is a residual
that accrues to the equity interest of the
issuer.
 SWAP
A swap is a secondary mortgage
market transaction that occurs when a
lender sells mortgages to an agency
that in turn issues an MRS, such as
pass-through, back to the lender. It is
well known that the investor in the
mortgage-related security might very
well be the lender that desired to sell
the portfolio of mortgages. We say that
the agency “swap” the mortgages
for the MRS. Swap has some liquidity
advantage over individual loans.
Investors (such as banks) can use sawps
as collateral to borrow funds. They can
also send them to meet urgent liquidity
needs. Even if the lender sells the MRS,
it is likely to receive a servicing fee.