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Introduction to Mortgage-Backed Securities
Mortgage-Backed Securities (MBS) are bonds created by securitizing pools of mortgage loans. They represent the largest segment of the Asset-Backed Securities (ABS) market. This module covers the unique features of the underlying mortgage loans and the structures used to manage their specific risks, focusing on Residential MBS (RMBS) and Commercial MBS (CMBS).
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Understanding Mortgage Loans
A mortgage loan is a loan secured by real estate property. The borrower makes regular payments, and if they fail to do so, the lender can foreclose on the property.
Key Loan Underwriting Metrics
| Metric | Description | Implication |
|---|---|---|
| Loan-to-Value Ratio (LTV) | The ratio of the loan amount to the appraised value of the property. | A lower LTV indicates that the borrower has more equity in the property, which reduces the lender's risk. |
| Debt-to-Income Ratio (DTI) | Compares the borrower's total monthly debt payments to their gross monthly income. | A lower DTI suggests the borrower has a better ability to handle their debt payments. |
Contingency Features of Mortgages
- Prepayment Rights: Most residential mortgage borrowers have the right to repay their loan principal faster than scheduled, or all at once, without penalty. This creates significant risk for MBS investors.
- Default and Foreclosure: If a borrower defaults, the lender can foreclose and sell the property to recover the loan balance.
- Recourse vs. Non-Recourse Loans:
- Recourse: If the foreclosure sale proceeds are not enough to cover the loan, the lender can pursue the borrower's other assets.
- Non-Recourse: The lender's claim is limited to the proceeds from the property itself. Non-recourse loans can lead to strategic defaults, where a borrower walks away from a property if its value falls far below the loan amount (i.e., LTV > 100%).
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Prepayment Risk and Time Tranching
Prepayment risk is the uncertainty in cash flows that arises when borrowers repay their loans faster or slower than scheduled. It is the primary risk distinguishing MBS from other fixed-income securities.
The Two Sides of Prepayment Risk
| Risk Type | Cause | Effect on MBS Investors |
|---|---|---|
| Contraction Risk | Falling interest rates lead to widespread refinancing, causing faster-than-expected principal repayments. | Investors get their principal back early and must reinvest it at lower market rates. |
| Extension Risk | Rising interest rates reduce refinancing activity, causing slower-than-expected principal repayments. | Investors are stuck receiving lower-than-market interest rates for a longer period than anticipated. |
Managing Prepayment Risk with Time Tranching
Securitization uses time tranching to manage and redistribute prepayment risk among different classes of bondholders. This is often done through a sequential-pay structure.
Sequential-Pay Tranching
This structure creates several tranches with different maturities from a single pool of mortgages. All principal payments (both scheduled and prepaid) are directed to the shortest-maturity tranche first until it is fully paid off. Then, all principal is directed to the next-shortest tranche, and so on. This creates more predictable cash flows for each tranche.
- Short-Term Tranches: Offer protection against extension risk.
- Long-Term Tranches: Offer protection against contraction risk.
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Residential Mortgage-Backed Securities (RMBS)
RMBS are bonds backed by pools of residential mortgages.
Agency vs. Non-Agency RMBS
- Agency RMBS: Backed by government agencies or government-sponsored enterprises (GSEs) in the U.S. (e.g., Ginnie Mae, Fannie Mae, Freddie Mac). These securities have guarantees against default, meaning investors are primarily exposed to prepayment risk, not credit risk.
- Non-Agency RMBS: Issued by private institutions without any government guarantee. Investors in these securities are exposed to both credit risk and prepayment risk.
Mortgage Pass-Through Securities
This is the simplest form of RMBS. The security "passes through" the monthly principal, interest, and prepayments from the mortgage pool to the security holders on a pro-rata basis. Key metrics for a pass-through pool include:
- Weighted Average Coupon (WAC): The weighted average of the interest rates on the mortgages in the pool.
- Weighted Average Maturity (WAM): The weighted average of the remaining months to maturity of the mortgages in the pool.
Collateralized Mortgage Obligations (CMOs)
CMOs are more complex structures that take the cash flows from a pool of mortgages and redistribute them to different tranches using time tranching rules to create securities with varying risk profiles.
- Sequential-Pay CMOs: The basic time tranching structure described earlier.
- Planned Amortization Class (PAC) Tranches: These are highly sought-after tranches designed to provide very stable and predictable principal payments, as long as prepayments stay within a specified band. They offer protection against both contraction and extension risk.
- Other CMO Structures: Other specialized tranches include Z-tranches (accrual bonds), Principal-Only (PO), and Interest-Only (IO) securities, each with unique sensitivities to prepayments.
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Commercial Mortgage-Backed Securities (CMBS)
CMBS are backed by a pool of commercial mortgage loans for income-producing properties like office buildings, retail centers, and hotels.
Unique Features of CMBS
| Feature | Description | Risk Implication |
|---|---|---|
| Call Protection | Commercial loans often have significant prepayment penalties, which provides strong protection against prepayment for the CMBS investor. This makes CMBS trade more like corporate bonds. | Reduces contraction risk. |
| Balloon Maturity | Commercial loans are often not fully amortizing, requiring a large "balloon" payment at maturity. | Creates significant balloon risk—the risk that the borrower will be unable to make the final payment or refinance the loan, leading to default and extension of the loan term. |
| Concentration Risk | CMBS pools often contain fewer, larger loans compared to RMBS pools. | The default of a single large loan can have a much greater impact on the performance of the entire security. |
Credit Performance Analysis
The success of a CMBS investment depends on the credit performance of the underlying loans. Two key metrics used are:
- Loan-to-Value Ratio (LTV)
- Debt-to-Service-Coverage Ratio (DSCR):
DSCR = Property's Net Operating Income (NOI) Debt ServiceA higher DSCR indicates that the property's income can more comfortably cover its debt payments.
Congratulations! Course Complete
🎉 You have successfully completed all 19 chapters of the CFA Level I Fixed Income curriculum! 🎉
What You've Mastered
- Fixed-Income Fundamentals: Instrument features, cash flows, and valuation principles
- Yield Analysis: Comprehensive understanding of yield measures and spread analysis
- Interest Rate Risk: Duration, convexity, and advanced risk management techniques
- Credit Analysis: Framework for evaluating government, corporate, and structured credit
- Securitization: Deep dive into ABS, MBS, and structured finance products
Next Steps for CFA Level I Success
- Practice Questions: Apply your knowledge with CFA Institute question banks
- Mock Exams: Test your understanding under exam conditions
- Review & Reinforce: Revisit challenging concepts and formulas
- Stay Current: Keep up with market developments and regulatory changes