Mortgage Backed Security

A mortgage-backed security (MBS) is a securitized interest in a pool of mortgages. It is a bond. Instead of

paying investors fixed coupons and principal, it pays out the cash flows from the pool of mortgages. The
simplest form of mortgage-backed security is a mortgage pass-through. With this structure, all principal
and interest payments (less a servicing fee) from the pool of mortgages are passed directly to investors
each month.

A 30-year fixed-rate residential mortgage makes a fixed payment each month until its maturity. Each
payment represents a partial repayment of principal along with interest on the outstanding principal. Over
time, as more of the principal is paid off, the size of the interest payment declines. Accordingly, the
portion of each payment representing principal repayment increases over the life of the mortgage.

Although the scheduled payments on a mortgage are fixed from one month to the next, the cash flows to
the holder of a mortgage pass-through are not fixed. This is because mortgage holders have the option of
prepaying their mortgages. When a mortgage holder exercises that option, the principal prepayment is
passed to investors in the pass-through. This accelerates the cash-flows to the investors, who receives the
principal payments early but never receive the future interest payments that would have been made on
that principal.

Prepayments introduce uncertainty into the cash flows of a mortgage pass-through. The rate at which
fixed-rate mortgagors prepay is influenced by many factors. A significant factor is the level of interest
rates. Mortgagors tend to prepay mortgages so they can refinance when mortgage rates drop. By acting in
their own best interest, mortgagors act to the detriment of the investors holding the mortgage pass-
through. They tend to return principal to investors when reinvestment rates are unattractive, and they tend
to not do so when reinvestment rates are attractive.

Risk due to uncertainty in prepayment rates is called prepayment risk. To compensate investors for taking
pre-payment risk, pass-throughs offer higher yields than comparable fixed income instruments without
embedded options.

Despite their prepayment risk, mortgage pass-throughs entail little credit risk. In the United States, most
have principal and interest payments guaranteed by government sponsored enterprises Fannie Mae,
Freddie Mac, or Ginnie Mae that explicitly or implicitly have the full backing of the US Treasury.

Private firms banks or mortgage originators also pool mortgages and sell them as pass-throughs without
implicit government guarantees. Such private label MBS traditionally had some form of credit
enhancement to obtain a triple-A credit rating. Credit enhancement fees would be subtracted from
mortgage cash flows along with servicing fees.

Starting in the early 2000s, private label MBS were increasingly issued with little or no credit
enhancement and on pools of risky sub-prime mortgages. For the first time, MBS posed significant credit
risk. Because credit risk made these instruments fundamentally different from earlier mortgage pass-
throughs, many market participants avoided calling them MBS, preferring to label them asset-backed
securities instead. Volume in these risky instruments grew rapidly until 2007, when defaults accelerated
and the market values of the instruments plunged. This caused a liquidity crisis that spilled into other
segments of the capital markets. A number of hedge funds with leveraged exposures to sub-prime
mortgages folded.

It is possible to segregate the cash flows from a pool of mortgages into different bonds offering different
maturity, risk and return characteristics. The bonds can then be sold to investors with different investment
objectives. Such mortgage-backed securities are called collateralized mortgage obligations (CMO).

Collateralized Mortgage Obligation

A collateralized mortgage obligation (CMO) is a type of mortgage-backed security (MBS). Unlike a

mortgage pass-through, in which all investors participate proportionately in the net cash flows from the
mortgage collateral, with a CMO, different bond classes are issued, which participate in different
components, called tranches, of the net cash flows. A CMO is any one of those bonds. The tranches are
structured to each have their own risk characteristics and maturity range. In this way, investors can select
a bond offering the characteristics which most closely meet their needs. Collateral for the securitization
may represent a pool of mortgages, but it is often a mortgage pass-through.

Many arrangements are possible. One of the simplest is a sequential pay structure comprising three or
four tranches that mature sequentially. All tranches participate in interest payments from the mortgage
collateral, but initially, only the first tranche receives principal payments. It receives all principal
payments until it is retired. Next, all principal payments are paid to the second tranche until it is retired,
and so on.

CMOs entail the same prepayment risk as mortgage pass-throughs. The riskiness of a specific bond
depends upon how that tranche is structured and on the underlying collateral.

Like mortgage pass-throughs, CMOs typically have minimal credit risk. Either they have a high quality
mortgage pass-through or similar MBS as collateral, or the collateral is bundled with suitable credit
enhancement.

CMOs are issued by various organizations, including Fannie Mae, Freddie Mac, investment banks,
mortgage originators, insurance companies, etc.

Collateralized Debt Obligations

Collateralized debt obligations are securitized interests in pools of generally non-mortgage assets. Assets
called collateral usually comprise loans or debt instruments. A CDO may be called a collateralized loan
obligation (CLO) or collateralized bond obligation (CBO) if it holds only loans or bonds, respectively.
Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the CDO,
offering investors various maturity and credit risk characteristics. Tranches are categorized as senior,
mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the
CDO's collateral otherwise underperforms, scheduled payments to senior tranches take precedence over
those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those
to subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with the former
receiving ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the
credit quality of underlying collateral as well as how much protection a given tranche is afforded by
tranches that are subordinate to it.

A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and
issue securities. Sponsors can include banks, other financial institutions or investment managers, as
described below. Expenses associated with running the special purpose vehicle are subtracted from cash
flows to investors. Often, the sponsoring organization retains the most subordinate equity tranche of a
CDO.

CDOs can be structured as cash-flow or market-value deals. The former is analogous to a CMO. Cash
flows from collateral are used to pay principal and interest to investors. If such cash flows prove
inadequate, principal and interest is paid to tranches according to seniority. At any point in time, all
immediate obligations to a given tranche are met before any payments are made to less senior tranches.

With a market value deal, principal and interest payments to investors come from both collateral cash
flows as well as sales of collateral. Payments to tranches are not contingent on the adequacy of the
collateral's cash flows, but rather the adequacy of its market value. Should the market value of collateral
drop below a certain level, payments are suspended to the equity tranche. If it falls even further, more
senior tranches are impacted. An advantage of a market value CDO is the added flexibility they afford the
portfolio manager. She is not constrained by a need to match the cash flows of collateral to those of the
various tranches.

CDOs are mostly about repackaging and transferring credit risk. While it is possible to issue a CDO
backed entirely by high-quality bonds, the structure is more relevant for collateral comprised partially or
entirely of marginal obligations.

This leads us to another important distinction: that between cash and synthetic CDOs. So far, we have
been discussing cash CDOs. These expose investors to credit risk by actually holding collateral that is
subject to default. By comparison, a synthetic deal holds high quality or cash collateral that has little or no
default risk. It exposes investors to credit risk by adding credit default swaps (CDSs) to the collateral.
Synthetic CDOs can be static or managed. They can be balance-sheet or arbitrage deals.

The biggest advantage to (balance sheet or arbitrage) synthetic CDOs often is the fact that they don't have
to be fully funded. For a cash CDO to have credit exposure to USD 100MM of bonds, it must attract USD
100MM in investments so it can buy those bonds. With a synthetic deal, credit exposure to USD
1000MM in obligations might be supported by just USD 150MM in high-quality collateral. In such a
partially-funded deal, the entire USD 1000MM reference portfolio is tranched, but only the lower-rated
tranches are funded. In this example, the most senior USD 850MM tranche would be called a super senior
tranche. It might be retained by the sponsor or sold off as a CDS. The funded piece might comprise USD
100MM of investment grade tranches and USD 50MM of mezzanine and unrated tranches.

In arbitrage deals, partial funding offers higher capital relief than does full funding under the Basel capital
requirements. For synthetic deals, it is generally less expensive to sell the super senior tranche as a CDS
than it would be to fund that tranche.
Credit default swap

Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the
specified life of the agreement. The other party makes no payments unless a specified credit event occurs.
Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a
specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and
the swap then terminates. The size of the payment is usually linked to the decline in the reference
asset's market value following the credit event.

Securitization

A securitization is a financial transaction in which assets are pooled and securities representing interests
in the pool are issued. An example would be a financing company that has issued a large number of auto
loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing
loans, but there isn't a liquid secondary market for individual auto loans. Instead, the firm pools a large
number of its loans and sells interests in the pool to investors. For the financing company, this raises
capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid
investment in a diversified pool of auto loans, which may be an attractive alternative to a corporate bond
or other fixed income investment. The ultimate debtors the car owners need not be aware of the
transaction. They continue making payments on their loans, but now those payments flow to the new
investors as opposed to the financing company.

All sorts of assets are securitized:

 auto loans
 student loans
 mortgages
 credit card receivables
 lease payments
 accounts receivable
 corporate or sovereign debt, etc.

Assets are often called collateral.

In a typical arrangement, the owner or "originator" of assets sells those assets to a special purpose vehicle
(SPV). This may be a corporation, US-style trust, or some form of partnership. It is established
specifically to facilitate the securitization. It may hold the assets collateral on its balance sheet or place
them in a separate trust. In either case, it sells bonds to investors. It uses the proceeds from those bond
sales to pay the originator for the assets.

Most collateral requires the performance of ongoing servicing activities. With credit card receivables,
monthly bills must be sent out to credit card holders; payments must be deposited, and account balances
must be updated. Similar servicing must be performed with auto loans, mortgages, accounts receivable,
etc. Usually, the originator is already performing servicing at the time of a securitization, and it continues
to do so after the assets have been securitized. It receives a small, ongoing servicing fee for doing so.
Because of that fee income, servicing rights are valuable. The originator may sell servicing rights to a
third party. Whoever actually performs servicing is called the servicing agent.

Cash flows from the assets minus the servicing fees flow through the SPV to bond holders. In some cases,
there are different classes of bonds, which participate differently in the asset cash flows. In this case, the
bonds are called tranches. If the securitization is structured as a pass-through, there is only one class of
bonds, and all investors participate proportionately in the net cash flows from the assets.

When assets are transferred from the originator to the SPV, it is critical that this be done as a legal sale. If
the originator retained some claim on those assets, there would be a risk that creditors of the originator
might try to seize the assets in a bankruptcy proceeding. If a securitization is correctly implemented,
investors face no credit risk from the originator. They also face no credit risk from the SPV, which serves
merely as a conduit for cash flows. Whatever cash flows the SPV receives from the collateral are passed
along to investors and whatever party is providing servicing.

Depending on the nature of the collateral, it may or may not pose credit risk. For example, people may
fail to make their credit card payments, so credit card receivables entail credit risk. On the other hand,
many mortgage-backed securities in the United states have little or no credit risk. Ginnie Mae guarantees
timely payment of principal and interest on its mortgage pass-throughs. Ginnie Mae is backed by the full
faith and credit of the US government, so the pass-throughs are free of credit risk.

If collateral entails credit risk, a securitization will often be structured with some sort of credit
enhancement. This may include over-collateralization, a third party guarantee, or other enhancements.
Also, by their nature, securitizations diversify the default risk of the underlying assets.

Credit ratings are often obtained for those securitizations that entail credit risk, and most ratings are
investment grade. If a securitization has different classes of bonds, each may receive a different credit
rating. Credit ratings can be misleading for novices. The fact that a securitization has a AAA rating
doesn't mean it is risk free. It only means that the chance of a bond holder incurring a loss attributable to
default on the underlying assets is remote. Other risks, which can affect the timing of payments, may be
considerable. Also, because valuing the underlying assets is often difficult, there is a risk that an investor
will overpay for a securitization the investor is ill-equipped to value on its own.

Standard categories of securitizations are

 mortgage-backed securities (MBS), which are backed by mortgages;

 asset-backed securities (ABS), which are mostly backed by consumer debt;
 collateralized debt obligations (CDO), which are mostly backed by corporate bonds or other
corporate debt.

Each segment of the market offers unique opportunities and risks, reflecting the nature of the underlying
assets and market conventions that have evolved over time.