Mortgage-backed Securities

In 1971, Freddie Mac issued its first mortgage pass-through security, a participation certificate. In 1981, Fannie Mae issued its first mortgage pass-through or MBS; in 1983, Freddie Mac issued the first collateralized mortgage obligation or CMO.

Agency MBS pass-through mortgages deliver a pro-rata share of the interest and principal payments made monthly by homeowners to the investors who have purchased the security. At the same time, CMOs use tranches to distribute the risk and cash flows associated with a mortgage pool.

Mortgage-backed securities (MBS) are bonds backed by pools of residential mortgages. They are generally categorized as either agency or non-agency.

Agency MBS are issued or guaranteed by government-sponsored entities such as the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Because of these guarantees, agency MBS carry minimal credit risk to investors.

Non-agency MBS, also referred to as private-label securities, are issued by banks or other private institutions. These securities are not guaranteed by a US government agency or government-sponsored entity. As a result, investors bear the credit risk of the underlying mortgage borrowers.

The primary distinction between the two lies in credit risk and the presence — or absence — of a government-related guarantee.

Freddie Mac and Fannie Mae are considered government-sponsored enterprises (GSEs) but do not carry an explicit guarantee from the US government. Conversely, Ginnie Mae MBS are backed by the US government's “full faith and credit” guarantee. While there is no explicit guarantee on the MBS issued by Fannie Mae and Freddie Mac, consensus has been that these securities maintain an implied guarantee that would prevent a disastrous default.

The non-agency MBS market began in the late 1970s as an alternative to the government-backed MBS market. Although Salomon Brothers' initial issuance was considered a failure, it laid the groundwork for the eventual development of the non-agency MBS market.

Congress passed the Secondary Mortgage Market Enhancement Act of 1984, which called on National Recognized Statistical Rating Organizations to provide credit opinions on each mortgage pool and charged the SEC with regulating the trading of these securities. This significant change opened the mortgage market to federally chartered financial institutions, including credit unions.

Non-agency MBS issuers separate pooled mortgages into tranches to create bonds considered of equal quality to those of GSEs and Ginnie Mae, at least from a rating agency standpoint.

Tranching enables non-agency MBS issuers to appeal to various investors by delivering different options based on investors' risk appetite.

In the following exhibit, the senior class tranche is positioned such that the underlying tranches support and absorb any losses before they reach the senior class. Cash flows for the overall pool flow into the senior tranche first, paying it down with interest and principal payments. In contrast, the underlying tranches only receive interest payments once the tranche directly above is paid off in full.

The mortgage-backed securities market is diverse and includes To Be Announced (TBAs) mortgages, Specified Pools, Collateralized Mortgage Obligations (CMOs), Planned Amortization Class (PAC) Tranches, as well as Sequential Tranches. Learn more about these specific security types below.

In a TBA mortgage transaction, the MBS seller agrees on a sale price without specifying which individual mortgages will be delivered on the settlement date. Fundamental characteristics, such as coupon rate and face value of the bonds to be delivered, are agreed upon, but little else is.

The process of combining a variety of different pools into a standard format ensures the TBA market is the most liquid mortgage market. Since these are the most liquid and readily tradable mortgage securities, they are the basis for pricing various MBS. The cash flows in both TBA mortgages and specified pools utilize the pass-through process, whereby investors receive a pro-rata share of principal and interest for the mortgages included in the pool (see illustration below). This process can expose investors to prepayment or extension risk as rates move lower or higher.

In the agency MBS market, most trading occurs through the “to-be-announced” (TBA) market. In a TBA transaction, buyers and sellers agree on general parameters — such as issuer, coupon and maturity — but the specific underlying mortgage pools are not identified at the time of trade.

A Specified Pool, by contrast, represents an interest in an identified group of mortgages with known characteristics. Investors can evaluate attributes such as loan size, geographic concentration or seasoning.

Because Specified Pools offer greater transparency and allow investors to target particular loan characteristics, they may trade at a premium or discount relative to TBA securities. However, they are typically less liquid than the standardized TBA market.

Collateralized mortgage obligations (CMOs) were first introduced to the market in 1983, fueled by investors looking to split out various cash flows from specified pools. Investment banks dissected mortgage pools into various cash flows, each targeted to different risk/return profiles.

CMOs were initially established as a sequential alternative to the pass-through market. As the cash flows in a mortgage pool were broken into tranches, each tranche had an assumed weighted average life, and tranches were not paid until the bond ahead of it was paid off.

The CMO market evolved as investment bankers created more types of CMOs to address specific client needs. The following image illustrates the combination of mortgage pools and the subsequent breakdown into CMO tranches.

Planned Amortization Class (PAC) bonds are tranches within collateralized mortgage obligations (CMOs) designed to provide more stable principal repayment schedules.

Unlike traditional pass-through MBS, where cash flows fluctuate directly with borrower prepayments, PAC bonds are structured around a predefined principal payment schedule. As long as prepayments remain within an established range, the PAC tranche receives principal payments according to plan.

This stability is achieved through the presence of companion tranches. In periods of faster-than-expected prepayments, companion bonds absorb excess principal payments. In slower prepayment environments, they may receive reduced principal so that the PAC tranche can maintain its schedule.

While PAC bonds reduce prepayment variability relative to other tranches, they remain subject to interest rate risk and structural limitations if prepayments move outside the projected range.

A sequential tranche structure distributes principal payments to bondholders in a defined order.

All tranches receive interest payments, but principal is directed first to the most senior tranche until it is fully paid down. Principal payments then move sequentially to the next tranche, and so on.

This structure creates bonds with varying expected maturities — short, intermediate and long — from the same underlying mortgage pool. However, because mortgage borrowers can prepay or refinance, the timing of principal payments remains sensitive to changes in interest rates.

Sequential structures allow investors to select exposure based on desired maturity profile, while still accepting prepayment-related uncertainty.

Convexity recognizes the relationship between bond prices and interest rates, which is typically sloped or convex, and measures the change in duration itself as rates move higher or lower. Conversely, duration illustrates a bond's sensitivity to interest rate movements and assumes a linear relationship between rates and price wherein rates increase and duration increases (and vice versa). For small moves in interest rates, duration provides insight into how a bond behaves from a pricing standpoint; convexity is a better measure for significant fluctuations in interest rates.

If a bond's duration increases as yields increase and the opposite occurs as rates decrease, the bond has negative convexity. An example would be a plain vanilla passthrough mortgage: as rates rise, the bond's duration extends as prepayments slow down. As rates decrease, the bond's duration shortens as prepayments increase and borrowers refinance their mortgages.

Credit risk transfer (CRT) refers to transactions that shift a portion of mortgage credit risk from an originator or guarantor to private investors.

In the US agency mortgage market, CRT programs allow government-sponsored entities to transfer some of the credit exposure associated with residential mortgage loans while retaining their role in guaranteeing timely principal and interest payments.

By transferring credit risk, these institutions can manage capital requirements and reduce balance sheet exposure. Investors in CRT securities assume defined levels of credit risk tied to the performance of specified mortgage pools.

CRT transactions illustrate how structured finance techniques can redistribute risk within the housing finance system without altering the borrower’s experience.

In the residential mortgage sector, CRTs have played a crucial role for Government-Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac. Additionally, CRT structures have been employed in non-agency residential mortgage-backed securities (RMBS) deals, as well as in credit card securitizations.