Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024 Fixed Income/Mortgage-Backed Security (MBS) Instrument and Market Features

Mortgage-Backed Security (MBS) Instrument and Market Features

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MBS Fundamentals and Residential Sectors5 min

MBS are bonds backed by mortgage loans where the lender holds a first lien on the property. If a borrower defaults, the lender can foreclose to recover funds. Two primary ratios assess credit risk: the Loan-to-Value (LTV) ratio and the Debt-to-Income (DTI) ratio. Lower values for both indicate lower default risk. The US RMBS market is split into three sectors: those guaranteed by a federal agency (full faith and credit), those guaranteed by Government-Sponsored Enterprises (GSEs, heavily supported but not explicitly government debt), and Non-Agency RMBS issued by private entities. Non-Agency RMBS rely on credit enhancements since they lack government guarantees.

Key Points

LTV: Mortgage Amount / Property Value.
DTI: Monthly Debt Payments / Pre-tax Gross Income.
Prime loans involve high credit quality; Subprime involves lower credit quality.
Agency RMBS (Ginnie Mae) have full government backing.
GSE RMBS (Fannie Mae, Freddie Mac) have GSE guarantees for a fee.

Mortgage Contingency and Cash Flow Mechanics6 min

Prepayment options allow borrowers to repay early, creating cash flow uncertainty. Lenders may impose penalties to mitigate this. Loans can be recourse (lender claims against borrower assets) or non-recourse (lender limited to collateral property). Strategic default is a risk in non-recourse underwater mortgages (LTV > 100 percent). In a mortgage pass-through security, monthly cash flows from the pool are passed to investors after deducting servicing and guarantee fees. Thus, the pass-through rate is lower than the Weighted Average Coupon (WAC) of the underlying loans.

Key Points

Prepayment risk involves contraction and extension risks.
Recourse loans allow claims beyond the property; Non-recourse do not.
Pass-through rate = WAC minus administrative/guarantee fees.
WAM is the Weighted Average Maturity of the pool.

CMO Structures and Tranching5 min

CMOs use tranching to redistribute prepayment risk. In a Sequential-Pay CMO, principal pays down the first tranche (Tranche A) to zero before the next tranche receives principal. This protects short-term tranches from extension risk and long-term tranches from contraction risk. Z-Tranches (accrual bonds) receive no interest until prior tranches are retired, instead accruing the interest to their principal balance, reducing reinvestment risk for other tranches but increasing the Z-tranche's duration and risk.

Key Points

Sequential-Pay: Time tranching structure.
Tranche A: Protected from extension risk.
Tranche B: Protected from contraction risk.
Z-Tranche: Accrues interest, paid last, high duration.

Stripped MBS and Support Tranches5 min

Stripped MBS separate principal and interest. Principal-Only (PO) securities benefit from falling rates (faster prepayments). Interest-Only (IO) securities benefit from rising rates (slower prepayments) and are used for hedging. Planned Amortization Class (PAC) tranches offer stable cash flows within a specified prepayment range, supported by Support Tranches that absorb excess prepayment variability.

Key Points

PO: Value rises when rates fall (high prepayment).
IO: Value falls when rates fall (high prepayment reduces interest cash flow).
PAC: High cash flow predictability.
Support Tranche: Absorbs prepayment risk for PAC.

CMBS Features and Credit Analysis6 min

CMBS are backed by commercial properties. Unlike RMBS, they offer call protection. Structural call protection prevents junior tranches from being paid down before senior ones. Loan-level protection includes lockout periods, defeasance (replacing collateral with Treasuries), and yield maintenance penalties. CMBS loans often have a balloon payment at maturity. If the borrower cannot refinance, this leads to balloon risk (extension risk). Credit analysis focuses on DSCR (NOI / Debt Service) and LTV.

Key Points

Call Protection makes CMBS trade like corporate bonds.
Defeasance: Borrower buys government securities to cover remaining cash flows.
Balloon Risk: Inability to make the lump sum payment at maturity.
DSCR measures ability to service debt from operating income.

Questions

Question 1

What right does a first lien give to a mortgage lender?

Mortgage-Backed Security (MBS) Instrument and Market Features

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