Five Quick Questions About Mortgage-Backed Securities

What is a mortgage-backed security?

Mortgage-backed security, often referred to as a MBS, is a bond secured by a real estate property. Investors generally buy a group of these mortgages from investment banks or government agencies.

Why are they so special?

There are a handful of reasons why. First off, each monthly payment goes through a bank and then reaches an investor. Secondly, MBSs tend to amortise. In other words, you receive a little bit of the principal payment alongside the regular monthly payments. Thirdly, MBSs have a floating maturity date due to the unscheduled prepayments that occur for a variety of reasons, from refinancing to homeowner bankruptcy. This is where risks lie, or to be more precise, the prepayment risks.

How long do they live?

There is a special metric that measures the effective maturity of mortgage-backed securities. It's called a WAL or simply an 'average life' of a MBS. To be able to define WAL, multiply the following: the date of each monthly payment and the percentage of the final payment paid off at this very date. Then we have the sum of the results.

Thus, the life of a MBS directly depends on the final payment bits you receive each month.

What about yields?

This is where the prepayment assumption comes in. It is the central concept that defines a yield on a on mortgage-backed security. An investor involved with MBSs can say for sure that prepayment will occur. The thing is that they have no idea when.

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However, there is a kind of structure, as assumed prepayment rates are conventionally divided into models or groups. The most basic are following:

• Standard Mortgage Yield

This one is very simple, really. The specification implies that there will be no prepayments till the 12th year.

• Constant Prepayment Rate

According to this specification, the principal percentage paid off over a certain period of time is constant.

What is the difference between a mortgage backed security (MBS) and a collateralized mortgage obligation (CMO)?

Collateralized mortgage obligations is a subset of mortgage backed securities. Investing in MBS you are buying an interest in pools of loans. Over time, as the borrowers pay off the underlying loans, the investors get payments of interest and principal. A multi-class security, collateralized mortgage obligation is backed by mortgage loans or mortgage pass-through securities. CMOs were created to provide investors with broader investment terms and risk level than is available for pass-throughs.

The final word on MBSs

Despite the 2007 American financial crisis that devoured millions of dollars, and in which MBSs played a huge role, leaving many thousands of people homeless, thus defaulting on their mortgage payments, MBSs are still actively traded today.