MORTGAGE-BACKED SECURITY (MBS) INSTRUMENT AND MARKET FEATURES
Prepayment Risk -> It is the risk that the actual prepayment is higher/lower than expected.
Extension Risk -> Actual Prepayment < Expected Prepayment
Contraction Risk -> Actual Prepayment > Expected Prepayment
Key Driver for prepayment -> Prevailing level of interest rate.
If Interest Rate , Refinancing activity . This will lead to higher level of
prepayment, and it will cause contraction risk. This is bad for investors for two reasons –
a) Investor will receive cash flow sooner than expected.
b) They will face reinvestment risk as the cash flow will be invested at lower interest
rates.
c) MBS value will not increase as it reflects expectations for prepayment in low-rate
environments.
Residential Mortgage Loan -> They are recourse loan i.e the lender can claim on the
remaining asset of the borrower if the collateral is insufficient to cover the loan amount in
case of default.
Common Features of residential mortgage loans –
1) Prepayment Penalties
2) Recourse/non-recourse
Key measure to evaluate default risk –
a) Loan to Value ratio = Loan/Appraisal Value
|
Lower the ratio better it is.
b) Debt to Income Ratio = Total Debt/Total Income
|
Higher the ratio better it is
Prime Loans -> mortgages made to borrowers with good credit, low LTV, and low DTI
Sub Prime Loans -> Mortgages to borrowers of lower credit quality, with higher DTI, higher
LTV, or that have a lower-priority claim to the collateral in event of default.
Agency RMBS -> MBS issued by the company which are backed by the government.
Non-Agency RMBSs -MBS are issued by private entities such as banks and have no
government or GSE guarantee.
Information Classification: GENERAL
Non-agency RMBSs typically include credit enhancements to improve credit ratings
through
a) external insurance
b) letters of credit
c) Tranche
d) private guarantees.
Metrics to evaluate the pool of mortgage-backed security
Weighted Average Maturity (WAM) = ∑(wi*mi)
wi = Market Value of bond i/Total Portfolio Market Value
mi = Maturity of Bond i
Weight Average Coupon (WAC) = ∑(wi*ci)
ci – Interest on loan i
Pass through Rates -> Return to the MBS investor
WAC – Commission = Pass through rate
Example -
Information Classification: GENERAL
Collateralized Mortgage Obligation -> Time Tranching
Home Borrow loan sell loans Issue MBS/ABS CMO
Borrower ---------------→ Bank ------------→ SPV -------------------→ Pool
--------------
cash Managed by
Financial Institution
Issue CMO
Security
They are created to segregate prepayment risk. Types of CMO –
1) Sequential Pay CMO
Short Tranche (Interest +Principal Payment)
CMO Face Contraction Risk (Protection against extension risk)
Pool
Long Tranche (Interest +Principal Payment only when
short tranche is exhausted)
Face Extension Risk (Protection against contraction
risk)
2) Other CMO Structure
Z Tranche – CMO holders do not receive any interest payment during the accrual
period. Instead, the principal amount is increased by the interest accrued. Once
the accrual period ends, the principal and interest payment are repaid to the
CMO Investor.
Principal Only Tranche – The CMO tranche cash flow pays face value like a zero-
coupon bond i.e. no interest is paid. If Interest rate decrease and prepayment
increase, PO investor will receive their principal payment early and hence they
will earn a higher annualized return.
Interest Only Tranche – They pay regular interest along with a principal payment
(ballon payment). Higher prepayment leads to lower frequency of coupon as the
prepayment is passed to CMO holder. Hence, it harms the CMO holders.
Information Classification: GENERAL
Floating Rate Tranche – Coupon = Variable rate (subject cap and floor)
Investor Floater -: Coupon = 16% - MRR
If MRR is high, coupon is low
If MRR is low, coupon is high
Residual Tranche – It is similar as equity tranche. It comes with high risk and high
return characteristics.
PAC Tranche -
PAC Tranche (Only
scheduled payment
if prepayment speed
PAC is within a certain
Tranche range)
Support Tranche
(Absorbs contraction
and extension risk)
Commercial Mortgage-Backed Securities
They are backed by pool of commercial mortgages on income-producing real estate,
typically in the form of
Apartments (multifamily),
Industrial property (e.g., warehouses),
Shopping centers,
Office buildings,
Health care facilities (e.g., senior housing),
Hotels
Weight Average Maturity Proceeds (WAMP) -> Regular income from collateral of CMBS
For RMBS, focus on credit risk of the borrower
For CMBS, focus on credit risk of the property
Information Classification: GENERAL
Two key metrics to asset credit risk
1) Debt service coverage ratio = Net Operating Income
| Debt Service --→(It includes principal + interest)
Higher the ratio better it is
2) Loan to value ratio = current mortgage amount
| current appraised value→(property value)
Lower the ratio better it is
Two key differences between RMBS and CMBS –
a) Call protection (Loan Level and CMBS structure)
b) Ballon payment provision
Loan Level Call Protection
a) Prepayment Lockout -> Borrower is prohibited to prepay the loan for starting few years.
b) Prepayment Penalty points -> Penalty fees charged on prepayment.
c) Defeasance -> Prepayment are accepted in government securities. This help to improve
the credit quality of the pool and protect the CMBS investor to receive prepayment.
CMBS Level Call Protection -> CMO can be used to segregate the prepayment risk for
CMBS.
Balloon Payment -> Commercial property borrower rely on rent to repay the loan.
If the property is vacant during the borrowing period, the borrower is liable to pay a ballon
payment at the maturity of the period.
If the borrower is unable to repay or refinance the loan, then he may default. This is known
as ballon risk.
Hence, the lender is forced to restructure the loan by extending the maturity and charging
higher risk.
Information Classification: GENERAL
