28 Sep Mortgage Backed Securities
What are they?
A mortgage‐backed security (MBS) is a form of securitized debt backed by home mortgages. They are created by pooling together a number of individual mortgages, oŌen hundreds of thousands of them, placing them in a pass‐through trust, and then selling an interest in that trust to investors. It is called a pass‐through trust because as individual mortgage holders make their monthly payments, the principal and interest is passed through to the investors.
Government Guarantee
A primary function of the Government Sponsored Entities who issue MBS is to insure the principal of the underlying mortgages. They do this by promising that if a mortgage held in a pass‐through trust defaults, they will pay the investors the outstanding principal in full. This makes these institutions by far the largest mortgage insurance companies in the world. It is worth noting that there is a difference in the Government’s relationship with these GSEs. FNMA and FHLMC are backed by an implied Government guarantee, while GNMA is backed by the full faith and credit of the United States.
How they pay
MBS are very different than traditional bonds. Traditional bonds pay semi‐annual coupon interest payments and have a stated maturity, at which time all of the outstanding principal is repaid. MBS pay both interest and principal monthly because the individual mortgages underlying the securities pay interest and principal monthly. Monthly interest is calculated by multiplying approximately one‐twelfth of the coupon rate times the remaining face value of the bonds held. The remaining face value is calculated by multiplying the original par value of the bonds times its factor (the percentage of principal still outstanding). It is important to note that because principal is returned to bondholders monthly, there is no lump sum repayment of principal at maturity like a traditional bond.
Structure Risk
The amount of monthly principal returned to bondholders is entirely dependent on the amount of principal paid on the mortgages in the pool. A mortgage can be prepaid at any time without penalty. Mortgage holders prepay principal for any number of reasons (refinancing, selling home, destruction of home, desire to pay down mortgage ahead of schedule, et.). This prepayment feature makes the cash flows on MBS unpredictable. Generally, as mortgage rates fall, more homeowners refinance and prepayments increase. As rates rise, fewer refinancings result in slower prepayments. As prepayment rates change, so do the expected average maturities of MBS. To compensate for this uncertainty, also know as structure risk, MBS pay a higher yield than an equivalent maturity Treasury bond.