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| This article or section deals primarily with the United States and does not represent a worldwide view of the subject. Please improve this article or discuss the issue on the talk page. |
In finance, a mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.
Residential mortgagors in the United States have the option to pay more than the required monthly payment (curtailment) or pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an MBS is not known in advance, and therefore presents an additional risk to MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
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The total market value of all outstanding U.S. MBS at the end of the first quarter of 2006 was approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger than the market value of outstanding asset-backed securities. The MBS market overtook the market for US Treasury notes and bonds in 2000.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
The high liquidity of most mortgage-backed securities means that any investor wishing to take a position need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than speculation) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing) and certain predatory lending schemes.
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Please help improve this article or section by expanding it. Further information might be found on the talk page or at requests for expansion. (February 2008) |
The weighted-average maturity (WAM) of an MBS is the average of the maturities of the mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an average across mortgages, as distinct from concepts such as weighted-average life and duration, which are averages across payments of a single loan.
To illustrate the concept of WAM, let\'s consider a mortgage pool with just three mortgage loans that have the below mentioned outstanding mortgage balances, mortgage rates, and months remaining to maturity.
| Loan | Outstanding Mortgage Balance | Mortgage Rate | Remaining Months to Maturity | Each Loan\'s Weighting |
|---|---|---|---|---|
| Loan 1 | $200,000 | 6.00% | 300 | 22.22% |
| Loan 2 | $400,000 | 6.25% | 260 | 44.44% |
| Loan 3 | $300,000 | 6.50% | 280 | 33.33% |
The weightings are computed by dividing each outstanding loan amount by total amount outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists of three loans is computed as follows:
WAM = 22.22% (300) + 44.44% (260) + 33.33% (280)
= 66.67 + 115.56 + 93.33
= 275.56 Months or 276 months after rounding
Why and where we use WAM and WAC?
WAM and WAC are used for describing a mortgage passthrough security, and they form the basis for the computation of cash flows from that mortgage passthrough. Just as we describe a bond by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for example, "this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month WAM."
Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that the investor would receive if he/she holds this mortgage passthrough security (or simply mortgage passthrough). Almost always, the passthrough rate is less than the WAC. The difference goes to servicing (i.e., costs incurred in collecting the loan payments and transferring the payments to the investors) the mortgage loans in the pool.
The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages in the pool, weighted by their original balances at at the issuance of the MBS.
Any bond ultimately backed by mortgages is classified as an MBS. This can be confusing, because securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that \'vanilla\' designates an option with no special features.
Mortgage-backed security sub-types include:
Varieties of underlying mortgages in the pool:
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as set by FannieMae.
In Europe exists a type of asset-backed bonds called "covered bonds" (commonly known by the German term Pfandbriefe). Pfandbriefe were first created in 19th century Germany when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated since the creation of a law governing the securities in Germany in 1900. The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep those loans on their books. This means that when a company with mortgage assets on its books issue the covered bond its balance sheet grows, which it wouldn\'t do if it issued an MBS, although it may still guarantee the securities payments.GT News -- Covered Bonds: a European ExperienceBond Basics: Everything You Need to Know About Bonds
There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure. The MBS adds a third risk: early redemption (prepayment). The number of homeowners in residential MBS securitizations who prepay goes up when interest rates go down. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection.
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution exists. In models of this type numerical methods provide approximate theoretical prices. These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.
Theoretical pricing models must take into account the link between interest rates and loan prepayment speed. Mortgage prepayments are most often made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). Hence the term: prepayment risk.
To compensate investors for the prepayment risk associated with these bonds, they trade at a spread to government bonds. This is referred to as an option adjusted spread.
There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, for instance:
The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high because:
If the MBS was not underwritten by the original real estate & the issuer\'s guarantee the rating of the bonds would be very much lower. Part of the reason is the expected adverse selection against borrowers with improving credit (from MBSs pooled by initial credit quality) who would have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).
Most traders and money managers use Bloomberg and Intex to analyze MBS pools. Intex is also used to analyze more esoteric products. Some institutions have also developed their own proprietary software. TradeWeb is used by the largest bond dealers ("primaries") to transact round lots ($1 million+).
For "vanilla" or "generic" 30-year pools (FN/FG/GN) with coupons of 4% - 7%, one can see the prices posted on a TradeWeb screen by the primaries called To Be Announced (TBA). This is due to the actual pools not being shown. These are forward prices for the next 3 delivery months since pools haven\'t been cut — only the issuing agency, coupon and dollar amount are revealed. A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a "pay-up" depending on characteristics. These are called "specified pools" since the buyer specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or PSA. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases.
If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every dollar that\'s prepaid, possibly significantly decreasing the yield. This is likely to happen as holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the low-coupon MBS pool was bought at a discount. This is due to the fact that when the borrower pays back the mortgage he does so at "par". So if the investor bought a bond at 95 cents on the dollar, as the borrower prepays he gets the full dollar back and his yield increases. This is unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS pools are loan amount ranges that each mortgage in the pool must pass. Typically, high premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance command the largest pay-ups. Even though the borrower is paying an above market yield, they are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
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| Securitization |
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| Types of Securities |
Asset-backed security · Mortgage-backed security · Credit derivative · Collateralized debt obligation · Collateralized mortgage obligation · Collateralized bond obligation |
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